Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON DC 20549
FORM 10-K
/ X / ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
-----------------------------
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OR THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to ___________________
Commission file number 0-21824
--------------------
HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in its charter)
Oregon 93-0981138
- --------------------------------------------------------------------------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) identification No.)
25600 SW Parkway Center Drive Wilsonville, OR 97070
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(503) 570-1600
- --------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Name of Each Exchange
Title of Each Class on Which Registered
------------------- -------------------
Common Stock Nasdaq National Market
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period than the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment to this
Form 10-K. [ ]
On March 14, 1997, the registrant had 36,560,596 outstanding shares of
Common Stock, and on such date, the aggregate market value of the shares of
Common Stock held was $927,725,123 based upon the last sale price reported for
such date on the Nasdaq National Market.
DOCUMENTS INCORPORATED BY REFERENCE
Part III - Portions of registrant's Proxy Statement which is anticipated to be
filed within 120 days after the end of the registrant's fiscal year ended
December 31, 1996
Hollywood Entertainment Corporation
Annual Report on Form 10-K
Year Ended December 31, 1996
Item Page
- ---- ----
PART I
1. Business................................................................. 1
2. Properties............................................................... 9
3. Legal Proceedings........................................................10
4. Submission of Matters to a Vote of Security Holders......................11
4(a) Executive Officers of the Registrant.....................................11
PART II
5. Market for Registrant's Common Stock and Related
Stockholder Matters................................. 14
6. Selected Financial Data..................................................15
7. Management's Discussion and Analysis of Financial Condition and
Results of Operations....................................................17
8. Financial Statements and Supplementary Data..............................24
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................................24
PART III
10. Directors and Executive Officers of the Registrant.......................25
11. Executive Compensation...................................................25
12. Security Ownership of Certain Beneficial Owners and Management...........25
13. Certain Relationships and Related Transactions...........................25
PART IV
14. Exhibits, Financial Statement Schedules and Reports on Form 8-K..........26
PART I
Item 1. Business
General
Hollywood Entertainment owns and operates 551 video retail superstores in
29 states as of December 31, 1996 and is the second largest video retailer in
the United States. According to video industry analyst Paul Kagan Associates,
Inc., the Company operates the highest volume video stores in the country.
Hollywood Entertainment's goal is to be a dominant national video retailer
and to build a strong national brand which consumers will identify with the
entertainment industry. As part of its strategy to achieve this goal, the
Company has developed a store format and design that captures the bright lights,
excitement and energy of the motion picture industry and enables the public to
easily identify and recognize Hollywood Video superstores. Hollywood Video
superstores average approximately 7,500 square feet and typically carry
approximately 10,000 titles and 16,000 videocassettes, consisting of many copies
of popular new releases and an extensive selection of older or "catalog" movies.
Hollywood Entertainment's goal is to be the category killer in its industry,
offering more copies of popular new videocassette releases and more titles than
its competitors to achieve greater customer satisfaction and encourage repeat
visits. Hollywood Video stores are primarily located in high traffic locations,
in stand-alone buildings, at the end of shopping strips or in other highly
visible locations.
The Company opened its first video superstore in October 1988 and had grown
to 25 stores in two states at the end of 1993, 113 stores in eight states at the
end of 1994, 305 stores in 23 states at the end of 1995, and 551 stores in 29
states at the end of 1996. As a result, the Company's revenue increased from
$17.3 million in 1993 to $302.3 million in 1996, and its pro forma net income
increased from $1.5 million to $20.6 million over the same period. The Company
opened 250 new stores in 1996 and intends to open at least 300 new stores in
1997.
Decentralization and Creation Of Zone Offices
To support its larger store base and continued expansion, the Company has
opened four zone offices, in Chicago, Illinois; Dallas, Texas; Portland, Oregon;
and Boston, Massachusetts. Each zone now includes approximately 100 to 250
stores, and the Company believes each zone will be capable of opening 75 to 100
stores annually and of supporting the operations of 400 to 500 stores. Each zone
is headed by a senior vice president of operations, who has responsibility for
new store development and store operations in the zone, including recruiting,
training, marketing and budgeting, and is accountable for the profitability of
all stores in the zone. The Company recently hired four senior vice presidents
with significant experience managing large, national chains to fill these
positions. When fully implemented, the senior vice presidents will be supported
by a complete team that will include a vice president of new store development,
a vice president of store operations, directors of construction, recruiting and
training, product and marketing, and a controller. As part of the Company's
decentralization strategy, the
1
corporate office and warehouse will provide central support to the zones,
including systems, product purchasing, distribution, accounting and national
marketing programs. In addition, the corporate office will continue to give
final approval for all new store sites and store design and oversee quality
standards and other critical elements of the Hollywood concept. The Company
believes the creation of geographic zones managed from zone offices that are
accountable for the profitability of the stores will allow the Company to more
effectively manage its business, thereby enhancing its ability to achieve its
expansion plans without compromising operating standards.
Industry Overview
Video Retail Industry. According to Paul Kagan, total U.S. consumer
spending on movies has increased from less than $3.0 billion in 1980 to
approximately $27.0 billion in 1995. The U.S. videocassette rental and sales
industry has grown at a compound annual growth rate of approximately 8.6%, from
$9.8 billion in revenue in 1990 to $14.8 billion in 1995, and is expected to
reach $18.2 billion in 2000. The video retail industry is highly fragmented and
in recent years has been characterized by increased consolidation as larger
"superstore" chains, video stores with at least 7,500 videocassettes, have
continued to increase market share by opening new stores and acquiring smaller,
local operators. According to the Video Software Dealers Association, the number
of video specialty stores has decreased from 31,500 in 1990 to 27,000 in 1995,
approximately 6,500 of which were "superstores," including approximately 3,180
Blockbuster stores. The Company believes this consolidation will continue as the
video retail industry evolves from "mom-and-pop" stores to regional and national
superstore chains.
Movie Studio Dependence on Video Retail Industry. According to Paul Kagan,
the video retail industry is the single largest source of revenue to movie
studios and represented approximately $4.3 billion, or 47%, of the $9.3 billion
of estimated domestic studio revenue in 1995. Of the hundreds of movies produced
by the major studios each year in the U.S., relatively few are profitable for
the movie studio based on box office revenue alone. The Company believes the
consumer is more likely to view "non-hit" movies on rented videocassette than
through any other form of distribution because video retail stores provide an
inviting opportunity to browse and make an impulse choice among a very broad
selection of new releases, which includes hits (movies that are successful at
the box office) and non-hits. As a result, video retail stores, including those
operated by the Company, purchase on videocassette almost all new release movies
produced theatrically (approximately 400 per year) regardless of whether the
movies were successful at the box office, thus providing the major movie studios
a reliable source of revenue for almost all of the hundreds of movies produced
each year. Consequently, the Company believes movie studios are highly motivated
to protect this unique and significant source of revenue.
Historically, movie studios have sought to generate incremental sources of
revenue through the addition of new distribution channels. To maximize revenue,
the studios have implemented a strategy of sequential release "windows," giving
each distribution channel the rights to its movies for a limited time before
making them available to the next sequential channel. The studios have
determined the sequential order in which they release movies to each
2
distribution channel based upon the order they believe will maximize their total
revenue from all distribution channels combined. These distribution channels are
set forth below.
Order of Sequential Release Windows to Primary Channels of Distribution
o Movie theaters
o Video retail stores
o Pay-per-view television (including direct
broadcast satellite)
o Pay cable (HBO, Showtime, etc.)
o Basic cable television
o Network television
o Syndicated television
Trends in Video Rentals and Sales. The domestic video retail industry
includes both rentals and sales. According to Paul Kagan, video rental revenue
has increased from $6.6 billion in 1990 to $7.5 billion in 1995 and is expected
to increase to $8.3 billion in 2000, video sales have increased from $3.2
billion in 1990 to $7.3 billion in 1995 and are expected to increase to $9.9
billion in 2000. Videocassettes released at a relatively high price, typically
$60 to $65 wholesale, are generally purchased by video retail stores and
promoted primarily as a rental title and then later re-released by the studios
at a lower price, typically $10 to $20 wholesale, to promote sales directly to
consumers. Certain high grossing box office films, generally with box office
revenue in excess of $100 million, are released on videocassette at a relatively
low initial price, typically $10 to $15 wholesale, and are generally purchased
by video retailers, mass merchants, grocery stores and other retailers and
promoted both as a rental title and for sale directly to customers. Because
these videocassettes are initially priced much lower, video retailers can stock
more copies of these movies for rental at a substantially lower aggregate cost.
The best selling sell-through titles are usually among the leading rental titles
because of the substantial advertising and awareness of these titles, and the
return on investment in rental inventory for those titles is typically much
higher than for comparable titles initially priced and promoted for rental.
Expansion Strategy
The Company opened its first video superstore in October 1988 and had grown
to 25 stores in Oregon and Washington by the end of 1993. In 1994 the Company
significantly accelerated its store expansion program, adding 88 new stores (55
of which were acquired) and expanding into California, Texas, Nevada, New
Mexico, Virginia and Utah. In 1995 the Company opened 122 new stores, acquired
70 stores and entered major new markets in the midwest, southwest, east and
southeast regions of the United States. In 1996 the Company opened 250 new
stores (no acquired units) and entered into 6 new states. The Company's
expansion strategy is to continue to open or, to a lesser extent, acquire stores
in regions where it has existing operations and to expand into new geographic
regions where it believes it can become one of the dominant video retailers.
3
The Company plans to open at least 300 new stores in 1997. The Company has
signed leases for approximately one-half of these anticipated new stores. The
Company's expansion is dependent on a number of factors, including its ability
to hire, train and assimilate management and store-level employees, the adequacy
of the Company's financial resources and the Company's ability to identify and
successfully compete in new markets, to locate suitable store sites and
negotiate acceptable lease terms and to adapt its purchasing, management
information and other systems to accommodate expanded operations. See "Item 7
Management's Discussion and Analysis of Financial Condition and Results of
Operations Liquidity and Capital Resources." The Company's expansion is also
dependent on the timely fulfillment by landlords and others of their contractual
obligations to the Company, the maintenance of construction schedules and the
speed at which local zoning and construction permits can be obtained.
There is no assurance that the Company will be able to achieve its planned
expansion or that expansion will be profitable. The Company's planned expansion,
including possible growth through acquisitions, will place increasing pressure
on the Company's management controls. A failure to manage successfully its
planned expansion would adversely affect the Company's business. There is also
no assurance that the Company's new stores will achieve sales and profitability
comparable to the Company's existing stores.
Business Strategy
The Company's goal is to create a strong national brand which consumers
will identify with the entertainment industry. The Company plans to build the
brand by becoming a dominant national videoretailer. The Company's business
strategy includes the following key elements:
Broad Selection and Superior Availability. The Company strives to provide
its customers with the broadest selection of videocassette movies and video
games. Hollywood Video superstores typically carry approximately 10,000
titles and 16,000 videocassettes and video games. The Company's goal is to
be the category killer in its industry, offering more copies of popular new
videocassette releases and more titles than its competitors. The Company
typically purchases 35 to 95 copies of "hit" movies for each Hollywood
Video store and may purchase as many as 200 copies for high volume stores.
4
Exciting, Enjoyable and Convenient Shopping Experience. The Company's
superstores are designed to capture the bright lights, excitement and
energy of the motion picture industry. The Company focuses on creating an
atmosphere that invites consumers into the store, encourages browsing and
generates repeat customers. Hollywood Video stores are typically located in
high traffic, high-visibility locations. The Company believes excellent
customer service, a bright, clean and friendly shopping environment and
convenient store locations are important to its success.
Excellent Entertainment Value. The Company offers consumers the opportunity
to rent any of its approximately 10,000 catalog movie titles for five days
for only $1.50. All new release movies and video games can be rented for
approximately $3.00. The Company believes movie rental in general, and its
pricing structure and rental terms in particular, provide consumers
convenient entertainment and excellent value. The Company is testing
increased prices and may increase prices in the future.
Products
Videocassette Rental. The Company's primary source of revenue is the rental
of videocassettes. Each mature Hollywood Video superstore carries approximately
10,000 movie titles and 16,000 videocassettes. Excluding new releases, movie
titles are classified into 28 categories, such as "Action," "Drama," "Family"
and "Children, and are displayed alphabetically within those categories. The
Company does not rent or sell adult movies in Hollywood Video superstores. The
Company is committed to offering more copies of popular new releases than its
competitors.
Videocassette Sales. Hollywood Entertainment also offers new and previously
viewed videocassettes for sale. The Company believes it can profit from either
the rental or sale of videocassettes.
Video Games. In addition to video rentals and sales, Hollywood Video also
rents video games licensed by NintendoTM, SegaTM and SonyTM. Each mature
Hollywood Video store offers between 1,200 and 4,000 video games.
Other Products. The Company rents audio books, including abridged fiction
classics and religious, self-improvement and education materials such as foreign
language instruction. The Company also rents videocassette and video game
players for the convenience of its customers and sells blank videocassettes,
video cleaning equipment and confectionery and other items.
Hollywood Video Store Design
Hollywood Video superstores average approximately 7,500 square feet and are
substantially larger than the stores of most its competitors. The store
exteriors generally feature large Hollywood Video signs and colors, which make
the Company's stores easily visible to and recognizable by consumers. The
interior of each store is clean and brightly lit. Hollywood video superstores
are decorated with colorful neon, murals depicting popular screen stars and
walls of video monitors with hi-fi audio accompaniment to create an exciting
Hollywood environment. Movies in all of the Company's superstores are organized
into 28 categories, and
5
videocassettes are arranged alphabetically by title within each category to
assist customers in locating the movies. New releases are prominently displayed
in easily recognizable locations within the store. Videocassettes are displayed
with the box cover facing the customer for ease of selection and visual impact.
The Company uses wall-mounted and free-standing shelves arranged in wide aisles
to provide access to products and to encourage the movement of customers
throughout the store.
Site Selection
The Company believes the selection of locations for its superstores is
critical to the success of its operations. Important criteria for the location
of a Hollywood Video superstore include density of local residential population,
traffic count on roads immediately adjacent to the store location, visibility
and accessibility of the store and availability of ample parking. The Company
typically attempts to locate its stores in either stand-alone structures or at
the end of a shopping strip. Within a shopping center or other retail
development or area, the Company's strategy is to seek the most desirable site
with respect to its selection factors. The Company typically competes for these
prime sites with other retailers, including other video retailers, banks,
restaurants and fast food operators.
The Company maintains its own architectural staff and also uses outsourced
architectural services. The ability of the Company to use its staff to customize
its standard store design increases the Company's flexibility with respect to
the type of sites that are acceptable to it, and the Company believes this
flexibility gives it an advantage in competing for retail sites. All of the
Company's stores are in leased premises; the Company does not own any real
estate.
Marketing and Advertising
The Company primarily has used radio and direct mail advertising. The
Company frequently uses cooperative movie advertising funds made available by
studios and suppliers to promote certain videocassettes. The Company intends to
increase its advertising expenditures in the future.
Inventory and Information Management
Inventory Management. Generally, inventory for existing stores is received
by and maintained in each individual store. Inventory for new stores is
processed and stored in the Company's warehouse in Oregon. The Company's
inventory of videocassettes for rental is prepared according to uniform
standards. Each new videocassette is removed from its original carton and placed
in a rental case with a magnetic security device and bar coding is affixed to
each videocassette.
Management Information Systems. Hollywood Video stores use software
modified and periodically updated by the Company's information systems
department for use in the Company's operations. The Company maintains
information, updated daily, regarding revenue, current and historical
6
sales and rental activity, demographics of store membership and videocassette
rental patterns. The Company upgraded its management information systems by the
addition of a scalable Oracle-based client-server system.
The Company maintains two distinct system areas: A point-of-sale ("POS")
system and a corporate information system. All rental and sales transactions are
recorded by the POS system when scanned at the time of customer checkout.
Nightly, the POS system transmits each store's data into the corporate
information system. The systems track products using scanned bar code
information and also maintain rental history of each customer and title. This
information is used to produce the reports used by the Company, including
reports used in making purchasing decisions on new releases. All of the
Company's stores, including all of the acquired stores, use the Company's POS
system.
Competition
The video retail industry is highly competitive. The Company competes with
other local, regional and national video retail stores, including the
Blockbuster Entertainment Division of Viacom, Inc. ("Blockbuster"), and with
supermarkets, pharmacies, convenience stores, bookstores, mass merchants, mail
order operations and other retailers, as well as with noncommercial sources such
as libraries. According to the Video Software Dealers Association, in 1995 there
were approximately 27,000 video specialty stores in the U.S., of which
approximately 6,500 were video retail superstores. Some of the Company's
competitors have significantly greater financial and marketing resources, market
share and name recognition than the Company.
The Company believes the principal competitive factors in the video retail
industry are title selection, the number of copies of popular titles available,
store location and visibility, convenience of store access and parking and, to a
lesser extent, pricing. The Company's stores compete with stores operated by
Blockbuster, many in very close proximity. As a result of direct competition
with Blockbuster, rental pricing of videocassettes may become a more significant
competitive factor in the Company's business, which could have an adverse impact
on the results of operations of the Company. The Company believes it generally
offers more titles and more copies of popular titles than the majority of its
competitors. In addition to competing with other video retailers, the Company
competes with all leisure-time activities, especially entertainment activities
such as movies, sporting events, the Internet and network and cable television
programs.
The Company competes with cable, satellite and pay-per-view cable
television systems, in which subscribers pay a fee to see a movie selected by
the subscriber. Existing pay-per-view services offer a limited number of
channels and movies and are only available to households with a direct broadcast
satellite receiver or a cable converter to unscramble incoming signals. Digital
compression technology and other developing technologies are expected eventually
to permit cable companies, direct broadcast satellite companies, telephone
companies and other telecommunications companies to transmit a much greater
number of movies to homes at more frequently scheduled intervals throughout the
day on demand. Certain cable and other
7
telecommunications companies have tested and are continuing to test movie on
demand services in some markets. The Company believes movie studios have a
significant interest in maintaining a viable movie rental business because the
sale of videocassettes to video retail stores represents the studios' largest
source of revenue. In addition, home video provides the only viable source of
revenue on "non-hit" or "B-title" movies which make up the majority of movies
produced by the major studios each year. As a result, the Company believes movie
studios will continue to make movie titles available to cable television or
other distribution channels only after revenues have been derived from the sale
of videocassettes to video stores. In addition, the Company believes substantial
technological developments will be necessary to allow pay-per-view television to
match the viewing convenience and selection available through video rental, and
substantial capital expenditures will be necessary to implement these systems.
Although the Company does not believe cable television or other distribution
channels represent a near-term competitive threat to its business, technological
advances or changes in the manner in which movies are marketed, including in
particular the earlier release of movie titles to pay-per-view, including direct
broadcast satellite (DBS), cable television or other distribution channels,
could make these technologies more attractive and economical, which could have a
material adverse effect on the business of the Company.
Seasonality
The video retail industry generally experiences relative revenue declines
in April and May, due in part to the change to Daylight Savings Time and to
improved weather, and in September and October, due in part to the start of
school and introduction of new television programs. The Company believes these
seasonality trends will continue.
Employees
As of December 31, 1996, the Company had approximately 10,150 employees, of
which 9,500 were in the retail stores and the remainder in the Company's
corporate administrative, zone office and warehousing operations. None of the
Company's employees are covered by collective bargaining agreements and employee
relations are considered to be excellent.
Service Mark
The Company owns United States federal registrations for its service marks
"Hollywood Video" and "Hollywood Video Superstores". The Company considers its
service mark important to its continued success.
8
Item 2. Properties
Store Locations
As of December 31, 1996, the Company's stores by location are as follows:
California.......................................... 120
Texas............................................... 78
Michigan............................................ 41
Washington.......................................... 30
Oregon.............................................. 28
Ohio................................................ 28
Minnesota........................................... 22
Arizona............................................. 22
Illinois............................................ 22
Virginia............................................ 14
Indiana............................................. 14
Georgia............................................. 14
Utah................................................ 13
Wisconsin........................................... 12
Tennessee........................................... 12
Pennsylvania........................................ 12
Missouri............................................ 10
Oklahoma............................................ 9
Colorado............................................ 8
Maryland............................................ 8
Nevada.............................................. 6
Kansas.............................................. 6
North Carolina...................................... 6
Nebraska............................................ 4
New Mexico.......................................... 3
Iowa................................................ 3
Kentucky............................................ 3
Arkansas............................................ 1
Louisiana........................................... 1
District of Columbia................................ 1
---
551
===
All of the Company's stores are located in leased premises with an initial
lease term of five to 15 years and options to renew for between five and 15
additional years. Most of the store leases are "triple net," requiring the
Company to pay all taxes, insurance and common area maintenance expenses
associated with the properties.
The Company's corporate headquarters and warehouse facility is located in
Wilsonville, Oregon and consists of approximately 170,000 square feet of leased
space.
9
Item 3. Legal Proceedings
In December 1995 three complaints were filed against the Company, certain
of the Company's directors and officers and certain other parties and
consolidated in a single action entitled Murphy v. Hollywood Entertainment
Corporation et al., case no. C95-1926-MA, U.S. District Court for the District
of Oregon. The consolidated case is a class action encompassing persons who
purchased common stock of the Company between June 20 through December 6, 1995.
The plaintiffs alleged violation of certain federal securities laws with respect
to statements made to the public and losses allegedly suffered by plaintiffs as
a result of the decline in the trading price of the Company's stock. In May 1996
the court certified the class but dismissed claims based on violations of
sections 11, 12(2) and 15 of the Securities Act of 1933. The remaining claims
dealt with alleged violations of the Securities Exchange Act of 1934. Prior to
trial, the parties reached a settlement, which is subject to court approval. The
settlement consists of warrants valued at $9 million to purchase Hollywood
common stock and $6 million in cash. It is anticipated that the warrants will be
issued on or about August 31, 1997, will expire on August 31, 1998, and will
have an exercise price of approximately $5 per share in excess of the Company's
Common Stock price at the time of issuance. The Company may, however, at its
option reduce the spread between the stock price and the exercise price and/or
lengthen the exercise period so long as the value of the warrants remains at $9
million on the date of issuance. The Company agreed to the settlement to avoid
further litigation expense and inconvenience and to put an end to all
controversy and claims related to the subject of litigation. In the proposed
settlement, the Company has specifically disclaimed and denied any liability or
wrongdoing and that any person has suffered any harm or damage as a result of
any of the matters alleged in the litigation.
10
Item 4. Submission of Matters to a Vote of Security Holders.
Not Applicable.
Item 4(a) Executive Officers Of The Registrant.
The following table sets forth information with respect to the Company's
executive officers as of the date of this document.
Name Age Positions with the Company
- ---- --- --------------------------
Mark J. Wattles 36 Chairman of the Board, President and Chief
Executive Officer
F. Mark Wolfinger 41 Chief Financial Officer
Donald J. Ekman 44 Senior Vice President, General Counsel, Secretary
and Director
Max G. Fratto 53 Executive Vice President of Store Operations
James O. George 49 Executive Vice President of Product and Marketing
F. Bruce Giesbrecht 36 Senior Vice President of Product Management
Douglas A. Gordon 29 Senior Vice President of Finance
Glen E. Hahn 44 Senior Vice President of Operations
John R. Hnanicek 32 Senior Vice President of Information Systems
Dale A. Naftzger 51 Senior Vice President of Operations (Western
Zone)
Roger J. Osbourne 44 Senior Vice President of Operations (Northeast
Zone)
William M. Spae 44 Senior Vice President of Operations (Southern
Zone)
William P. Zebe 38 Senior Vice President of Development
Mark J. Wattles founded the Company in June 1988 and has served as Chairman
of the Board, President and Chief Executive Officer since that time. In May 1986
Mr. Wattles founded Convenience Video Movies, Inc., a videocassette distributor
that operated video rental centers in approximately 300 convenience stores
throughout the country, and served as its Chief Executive Officer until November
1987. Mr. Wattles founded Downtown Video, a two-store video rental company, in
1985 and served as its general manager until 1986.
F. Mark Wolfinger became Chief Financial Officer of the Company in January
1997. Mr. Wolfinger joined the Company from Metromedia Restaurant Group, which
owns, operates and franchises multiple nationwide restaurant chains. Prior to
joining Metromedia as Chief Financial Officer, Mr. Wolfinger was with Grand
Metropolitan, PLC where he served in various capacities, including Chief
Financial Officer of Pearle Vision, Vice President and Group Controller of Grand
Met and Vice President for Burger King.
11
Donald J. Ekman became a director of the Company in July 1993 and became
Vice President and General Counsel in March 1994. Mr. Ekman was a partner in
Ekman & Bowersox from January 1992 until March 1994, and from August 1990 until
December 1991 he practiced law with Foster Pepper & Shefelman.
Max G. Fratto joined the Company as Executive Vice President of Store
Operations in May 1994. From 1991 to 1994 Mr. Fratto was a partner in Wallpaper
Warehouse of Idaho, a small retail chain. From 1986 to 1991 he served as Vice
President of W.N.S., Inc., a retail holding company, where he was responsible
for the Wallpapers to Go division. Prior to his employment with W.N.S., Mr.
Fratto was Vice President of Store Operations for several General Mills, Inc.
specialty retailing companies.
James O. George joined the Company in October 1995 as Executive Vice
President of Product and Marketing. Previously, Mr. George was employed by
Blockbuster Entertainment for eight years. Most recently, Mr. George served as
Zone Vice President, where he managed the operations of over 450 Blockbuster
stores.
F. Bruce Giesbrecht was named Senior Vice President - Product Management in
January 1996 and joined the Company in May 1993 as Vice President of Corporate
Information Systems and Chief Information Officer. Mr. Giesbrecht was a founder
of RamSoft, Inc., a software development company specializing in management
systems for the video industry, and served as its President.
Douglas A. Gordon was named Senior Vice President - Finance in November
1995 and joined the Company as Vice President of Strategic Analysis and
Forecasting in May 1995. From September 1991 to May 1995, Mr. Gordon worked for
Montgomery Securities as a Vice President and senior analyst covering the
entertainment and retail industries.
Glen E. Hahn joined the Company in April 1996 as Senior Vice President of
Operations (Central Zone). From 1993 to 1996 Mr. Hahn was Senior Vice President
- - Director of Stores for Fayva/Parade of Shoes (a specialty retail footwear
division of J. Baker), overseeing approximately 400 stores. From 1979 to 1993
Mr. Hahn worked for Payless Shoesource (a division of May Department Stores) in
various capacities. From 1987 to 1993 Mr. Hahn worked as Division Operations
Manager for Payless Shoesource, overseeing the development of nearly 200 new
stores during this period and the overall operations of approximately 580
specialty retail footwear stores at the time of his departure.
John R. Hnanicek joined the Company in October 1996 as Senior Vice
President of Information Systems. From March 1996 to October 1996 Mr. Hnanicek
was Chief Information Officer for HomePlace, a privately owned home furnishings
speciality retailer, operating 37 stores at the time of his departure. From July
1995 to February 1996 Mr. Hnanicek was Chief Information Officer for
Communicate! Powerstores, Inc., a start-up communications superstore. From 1990
to 1995, Mr. Hnanicek worked for OfficeMax, Inc., in various capacities,
including most recently as Senior Vice President - Information Systems and
Logistics.
12
Dale A. Naftzger joined the Company in April 1996 as Senior Vice President
of Operations (Western Zone). From May 1995 to November 1995, Mr. Naftzger was
Chief Operating Officer of Caribou Coffee Company, a privately owned speciality
coffee retailer with approximately 40 company-owned units. From 1994 to 1995 Mr.
Naftzger was President and Chief Executive Officer of Chop Chop Chinese to You,
a venture capital financed Chinese food delivery business, operating 40 units
and three distribution centers at the time of his departure. From 1992 to 1994
Mr. Naftzger was Senior Vice President - Operations for Checkers Drive-In
Restaurants, overseeing all 248 company-owned and 200 franchised units. From
1987 to 1992 Mr. Naftzger worked for Taco Bell Corporation as Zone Vice
President, overseeing the development of approximately 100 new units and the
overall operations of approximately 350 units. From 1980 to 1987 Mr. Naftzger
worked for Wendy's International, Inc. in various capacities, including as Zone
Vice President-Operations, overseeing more than 500 company-owned and 400
franchised units at the time of his departure.
Roger J. Osbourne joined the Company in December 1996 as Senior Vice
President of Operations (Northeast Zone). From January 1995 to December 1996,
Mr. Osbourne was Senior Vice President/Director of Stores for J. Baker, Inc.,
overseeing approximately 1,100 stores. From October 1988 to January 1995, Mr.
Osbourne was Senior Vice President/Director of Stores for Pic 'n Pay Stores,
Inc., a subsidiary of Bata Shoe Company, where he was responsible for
approximately 1,000 stores.
William M. Spae joined the Company in July 1996 as Senior Vice President of
Operations (Southern Zone). From 1991 to June 1996 Mr. Spae worked for Wendy's
International as Divisional Vice President, overseeing the development of
approximately 130 new units during this period and the overall operations of
more than 100 company-owned and 150 franchised units at the time of his
departure. From 1987 to 1991 Mr. Spae was a Zone Vice President for Taco Bell
Corporation, overseeing more than 160 company-owned and approximately 100
franchised units.
William P. Zebe was named Senior Vice President - Development in January
1996 and joined the Company as National Vice President of Real Estate in May
1994. Mr. Zebe previously worked from June 1993 to April 1994 as the Real Estate
Manager for the Western Zone for Blockbuster Video, Blockbuster Music and
Blockbuster franchisee-owned Discovery Zone. From 1992 to May 1993 Mr. Zebe was
a Real Estate Representative for Blockbuster.
13
PART II
Item 5. Market for Registrant's Common Stock and Related
Stockholder Matters
The Company's common stock is traded on the Nasdaq National Market under
the symbol "HLYW". The following table sets forth the quarterly high and low
last sale prices per share, as reported on the Nasdaq National Market, adjusted
for two stock splits through December 31, 1996.
1996 1995
---- ----
High Low High Low
------ ------ ------ ------
First Quarter $13.88 $ 6.50 $18.25 $11.25
Second Quarter 18.13 13.31 23.13 15.00
Third Quarter 21.75 11.88 35.00 19.00
Fourth Quarter 22.44 17.88 28.63 7.38
As of December 31, 1996, there were 195 holders of record of the Company's
common stock. The Company has not paid any cash dividends on its common stock
since its initial public offering in July 1993 and anticipates that all future
earnings will be retained for development of its business. The payment of any
future dividends will be at the discretion of the Company's Board of Directors.
14
Item 6. Selected Financial Data
The following selected financial data have been derived from the
consolidated financial statements of the Company. The data set forth below
should be read in conjunction with Item 7, "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and the Company's consolidated
financial statements and notes thereto.
Year Ended December 31,
---------------------------------------------------------------------
1996 1995 1994 1993 1992
---- ---- ---- ---- ----
Statement of Operations Data: (In thousands, except per share and other operating data)
Revenue:
Rental $ 252,625 $ 123,894 $ 61,941 $ 15,267 $ 9,762
Product sales 49,717 25,536 11,347 2,072 1,282
----------- ----------- ----------- ---------- ----------
$ 302,342 $ 149,430 $ 73,288 $ 17,339 $ 11,044
=========== =========== =========== ========== ==========
Operating income $ 38,418 $ 17,537 $ 12,610 $ 3,643 $ 2,270
=========== =========== =========== ========== ==========
Income before cumulative effect of a
change in accounting principle (1) $ 20,630 $ 11,786 $ 8,143 $ 2,146 $ 1,177
Cumulative effect of a change in
accounting principle (2) -- (2,560) -- -- --
----------- ----------- ----------- ---------- ----------
Net income (1) $ 20,630 $ 9,226 $ 8,143 $ 2,146 $ 1,177
=========== =========== =========== ========== ==========
Earnings per common and common
equivalent share (3):
Earnings before cumulative effect
of a change in accounting principle $ 0.59 $ 0.36 $ 0.32 $ 0.14 $ 0.09
Cumulative effect of a change in
accounting principle -- (0.08) -- -- --
----------- ----------- ----------- ---------- ----------
Net income $ 0.59 $ 0.28 $ 0.32 $ 0.14 $ 0.09
=========== =========== =========== ========== ==========
Pro forma amounts assuming the new
accounting principle were applied
retroactively (2):
Net income $ 20,630 $ 11,786 $ 6,277 $ 1,507 $ 892
Net income per share $ 0.59 $ 0.36 $ 0.25 $ 0.10 $ 0.07
Operating Data:
Number of stores at end of period 551 305 113 25 15
Comparable store revenue increase (4) 7% 1% 7% 16% 27%
Balance Sheet Data:
Working capital $ 6,393 $ 17,733 $ 27,738 $ 5,025 ($ 1,179)
Total assets 449,783 334,660 142,861 22,791 7,475
Long-term debt (including
current portion) 82,361 7,971 3,505 2,399 1,873
Mandatorily redeemable common stock -- 54,250 -- -- --
Shareholders' equity 274,703 217,783 110,765 13,303 2,282
- ------------
(1) Income before cumulative effect of a change in accounting principle and net
income for 1993 and 1992 include pro forma income tax adjustments to
reflect taxation of the Company as a C corporation rather than an S
corporation.
(2) Effective January 1, 1995, the Company changed its method of amortizing the
cost of videocassette rental inventory as discussed in Note 2 of Notes to
Consolidated Financial Statements. The change in
15
amortization method resulted in a charge to earnings in 1995 totaling $2.6
million representing the cumulative effect as of January 1, 1995 if the new
method had been applied retroactively to all videocassettes in service as
of such date. The pro forma amounts shown herein reflect the impact to net
income had the new amortization method been in effect as of the beginning
of each of the periods presented.
(3) Earnings per share are based on the weighted average shares outstanding
during the period after giving effect to all stock splits through December
31, 1996.
(4) A store becomes comparable after it has been open and owned by the Company
for 12 full months. An acquired store converted to the Hollywood Video name
and store design is removed from the comparable store base when the
conversion process is initiated and returned 12 full months after the
retrofit is completed.
16
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations
General
Hollywood Entertainment opened its first video superstore in October 1988
and had expanded to 551 superstores in 29 states as of the end of 1996. The
Company's revenue growth has been accomplished through a combination of new
store openings, strategic acquisitions and, to a lesser extent, comparable store
revenue increases Store activity for the last three years is summarized as
follows:
Video Superstores
Open
Beginning Open End
of Period Opened Closed Acquired of Period
--------- ------ ------ -------- ---------
1994 25 33 0 55 113
1995 113 122 0 70 305
1996 305 250 4 0 551
The Company plans to open at least 300 stores during 1997. The Company's
results are impacted by the timing of and costs incurred in connection with new
store openings. New Hollywood Video stores typically experience lower sales
volume in the first year of operation than do mature stores. Because a portion
of store-level operating expenses is fixed, new stores generally have lower
operating margins in their first year of operation. In addition, pre-opening
expenses are charged to earnings in the first full month of a store's operation.
Therefore, the addition of a significant number of new stores to the Company's
existing store base has had and is expected to continue to have an adverse
impact on the Company's operating margins.
Forward-Looking Statements
The information set forth in this report in Item 1- Business under the
captions "Expansion Strategy" and in Item 7 - "Management's Discussion and
Analysis of Financial Condition and Results of Operations" includes
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933 and is subject to the safe harbor created by that section. Certain
factors that could cause results to differ materially from those projected in
the forward-looking statements are set forth in Item 1 - Business under the
captions "Expansion Strategy," "Competition," and "Legal Proceedings" and in
Item 7 - "Management's Discussion and Analysis of Financial Condition and
Results of Operations" under the captions "Liquidity and Capital Resources" and
"General Economic Trends, Quarterly Results and Seasonality".
17
Results of Operations
The following table sets forth, for the periods indicated, (i) selected
statement of operations data expressed as a percentage of total revenue; (ii)
the percentage change from the same period of the prior year in such selected
statement of operations data, and (iii) the number of stores open at the end of
each such period.
Percentage Change in Dollar
Year Ended December 31, Amounts From
--------------------------------------- -----------------------------
1996 1995 1994 1995 to 1996 1994 to 1995
------------ ----------- ----------- ------------- -------------
Revenue
Rental income 83.6% 82.9% 84.5% 104% 100%
Product sales 16.4 17.1 15.5 95 125
------------ ----------- -----------
100.0 100.0 100.0 102 104
------------ ----------- -----------
Operating costs and expenses:
Cost of product sales 10.2 9.9 9.9 108 104
Operating and selling 69.1 70.6 64.6 98 123
General and administrative 6.0 5.3 6.0 131 79
Amortization of intangibles 2.0 2.5 2.3 60 123
------------ ----------- -----------
87.3 88.3 82.8
------------ ----------- -----------
Operating income 12.7 11.7 17.2 119 39
Interest (expense) income, net (1.4) 0.8 (0.2) N/A N/A
------------ ----------- -----------
Income before income taxes and
cumulative effect of a change in
accounting principle 11.3 12.5 17.0 84 49
Income taxes 4.5 4.6 5.9 99 58
------------ ----------- -----------
Income before cumulative effect
of a change in accounting principle 6.8 7.9 11.1 75 45
Cumulative effect of a change in
accounting principle (1) -- (1.7) -- N/A N/A
------------ ----------- -----------
Net income 6.8% 6.2% 11.1% 124 13
============ =========== ===========
Pro forma net income assuming new
accounting principle is applied
retroactively (1) 6.8% 7.9% 8.6% 75 88
============ =========== ===========
Number of stores at end of period 551 305 113
- -----------
(1) Effective January 1, 1995, the Company changed its method of amortizing the
cost of videocassette rental inventory as discussed in Note 2 of Notes to
Consolidated Financial Statements. The change in amortization method
resulted in a charge to earnings in 1995 totaling $2.6 million,
representing the cumulative effect as of January 1, 1995 as if the new
method had been applied retroactively to all videocassettes in service as
of that date. The pro forma amounts shown herein reflect the impact to net
income had the new amortization method been in effect as of the beginning
of each of the periods presented. As a result, pro forma results for 1995
do not include the charge of $2.6 million.
18
1996 Compared to 1995
Revenue
Revenue for 1996 increased $152.9 million, or 102%, to $302.3 million
compared to $149.4 million for 1995. The increase in revenue was primarily the
result of new store expansion. During 1996, the Company increased the number of
superstores operated by 246, ending the period with 551 superstores, compared to
305 superstores at the end of 1995. Comparable store revenue increased 7% for
1996.
Product sales as a percentage of total revenue decreased to 16.4% for 1996
from 17.1% for 1995. Product sales have decreased as the Company has
de-emphasized the sale of certain movie accessories.
Operating Costs and Expenses
Cost of Product Sales
The cost of product sales as a percentage of product sales increased from
57.8% for 1995 to 61.8% for 1996. The gross margin on product sales has
decreased as the Company has de-emphasized the sale of certain high gross margin
movie accessories. The Company believes the operating costs associated with
maintaining those products offset the higher gross margins that they generated.
Operating and Selling
Operating expenses, which principally consist of all store expenses,
including payroll, occupancy, advertising, depreciation and rental revenue
sharing, decreased as a percentage of total revenue to 69.1% for 1996, compared
to 70.6% for 1995.
Depreciation expense combined with rental revenue sharing costs was 27.0%
of total revenue for 1996, compared to 29.6% for 1995. The decrease was due to
lower revenue sharing expense and the implementation of improved budgeting
procedures in the purchase of new releases for existing stores. Other operating
and selling expenses increased as a percentage of total revenue primarily due to
lower average revenue per store, resulting from the addition during 1995 and
1996 of a large number of new stores, which have lower revenue per store than
mature Hollywood Video stores.
General and Administrative
General and administrative expenses increased from $7.9 million, or 5.3% of
total revenue, for 1995 to $18.3 million, or 6.0% of total revenue, for 1996.
The percentage increase is primarily attributable to the cost associated with
establishing and staffing the Company's new regional zone offices.
19
Amortization of Intangibles
Amortization of intangibles increased from $3.8 million, or 2.5% of total
revenue, for 1995 to $6.0 million, or 2.0% of total revenue, for 1996. The
dollar increase in 1996 was attributable to the inclusion of the amortization of
intangible assets arising from the Title Wave and Video Watch acquisitions for
the year, while only partially included in 1995.
Interest (Expense) Income, Net
Net interest (expense) income decreased from $1.1 million for 1995 to ($4.1
million) for 1996. This change was primarily attributable to the Company's
higher level of borrowing under its revolving line of credit and a decrease in
interest earned on cash investments for 1996 compared to 1995.
Income Taxes
The Company's effective tax rate increased from 36.8% of income before
income taxes for 1995 to 39.8% for 1996 due to increased operations in states
with higher income tax rates in 1996 compared to 1995 and a decrease in tax
exempt interest income.
20
1995 Compared to 1994
Revenue
Revenue for 1995 increased $76.1 million, or 104%, to $149.4 million from
$73.3 million for 1994. Comparable store revenue increased 1%. During the year,
the Company opened 122 new stores and acquired 70 stores, including 42 stores
purchased in August 1995 operating under the name "Video Watch" and 12 stores
purchased during March 1995 from Title Wave Stores, Inc.
The Company believes comparable store revenue was negatively impacted by
lower revenues from the rental and sale of video games, lower revenues at stores
acquired during 1994 prior to conversion to the Hollywood Video name and store
design and an uneven and therefore less favorable distribution of new release
"hit" movies during 1995 compared to 1994.
Product sales as a percentage of total revenue increased to 17.1% for 1995
compared to 15.5% during 1994. The increase in product sales as a percentage of
revenue was due to improved merchandising techniques and higher per store
product inventory levels.
The Company's pricing of video cassettes for rental and for sale
merchandise did not change significantly compared to 1994.
Operating Costs and Expenses:
Cost of Product Sales
The cost of product sales decreased as a percentage of product sales from
63.9% in 1994 to 57.8% for 1995. The gross margin on product sales increased in
1995 compared to 1994 due to expanded offerings of merchandise with higher gross
margins.
Operating and Selling
Operating and selling expenses, which consist of all store expenses
including payroll, occupancy, advertising, depreciation and rental revenue
sharing expense, increased as a percentage of total revenue to 70.6% in 1995
compared to 64.6% in 1994. Operating and selling expenses increased as a
percentage of total revenue primarily due to lower average revenue per store,
resulting primarily from the addition during 1995 of a large number of new and
acquired stores which have lower revenue per store than mature Hollywood Video
stores.
Depreciation expense combined with rental revenue sharing expense was 29.6%
of total revenue in 1995 compared to 27.9% in 1994. The increase was primarily
due to a change in the Company's method of depreciating videocassette rental
inventory effective January 1, 1995.
21
General and Administrative
General and administrative expenses, which principally consist of corporate
overhead, decreased from 6.0% of total revenue for 1994 to 5.3% for 1995. The
decrease in expenses as a percentage of revenue was due to the Company's ability
to increase revenue without proportionally increasing corporate overhead
expenses.
Amortization of Intangibles
Amortization of intangibles increased from $1.7 million, or 2.3% of total
revenue, during 1994 to $3.8 million, or 2.5% of total revenue, during 1995. The
dollar increase was primarily attributable to the amortization of intangible
assets arising from the Title Wave, Video Watch and other store acquisitions in
1995.
Interest (Expense) Income, Net
Net interest expense was $0.1 million, or 0.2% of total revenue, in 1994
while net interest income was $1.1 million, or 0.8% of total revenue, in 1995.
The change in net interest was primarily due to the receipt of the net proceeds
of the Company's public stock offering completed in July 1995, resulting in a
decrease in average debt outstanding and an increase in interest earned on cash
investments.
Income Taxes
The Company's effective tax rate for 1995 was 36.8%, compared to 34.9% in
1994. The increase in 1995 was due to a higher federal statutory rate and a
higher aggregate state tax rate, partially offset by higher tax exempt interest
income.
Liquidity and Capital Resources
The Company's principal capital requirements are for opening new stores,
the purchase of rental inventory and the possible acquisition of existing
stores. The Company has funded its operations primarily through cash from
operations, the proceeds of five public offerings, loans under the Company's
revolving bank line of credit, trade credit and equipment leases.
At December 31, 1996, the Company had cash and cash equivalents of
approximately $12.8 million and working capital of $6.4 million. Videocassette
rental inventories are accounted for as noncurrent assets under generally
accepted accounting principles because they are not assets which are reasonably
expected to be completely realized in cash or sold in the normal business cycle.
Although the rental of this inventory generates a substantial portion of the
Company's revenue, the classification of these assets as noncurrent excludes
them from the computation of working capital. The acquisition cost of
videocassette rental inventories, however, is reported as a current liability
until paid and, accordingly, included in the computation of working capital.
Consequently, the Company believes working capital is not as significant a
measure of financial condition for companies in the video retail industry as it
is for companies in other industries. Because of the accounting treatment of
videocassette rental inventory as a noncurrent asset, the Company may, from time
to time, operate with a working capital deficit.
22
Net cash provided by operating activities was $125.4 million for 1996
compared to $68.7 million for 1995. The increase in cash provided by operations
was primarily due to higher net income from operations and higher depreciation
and amortization expenses, partially offset by an increase in merchandise
inventories.
Cash used in investing activities was $198.7 million for 1996 compared to
$168.9 million for 1995. For 1996, cash used in investing activities consisted
primarily of net purchases of videocassette rental inventory for new and
existing stores totaling $124.3 million and capital expenditures and related
increase in landlord receivables totaling $73.7 million. Capital expenditures
included the costs to open new stores, remodel certain existing stores and
enhance information systems.
Cash provided by financing activities for 1996 totaled $56.2 million and
included a cash reduction due to the repurchase of all of the shares issued in
connection with the Video Watch acquisition for aggregate consideration of $54.3
million, the repayment of $7.6 million of long-term debt, borrowings on the line
of credit of $82.0 million, and net proceeds from the Company's fifth equity
offering of $34.7 million.
Future capital requirements consist primarily of financing the addition of
new retail stores and converting certain acquired stores to the Hollywood Video
name and store design, together with the possible acquisition of existing
stores. The Company anticipates opening at least 300 new stores in 1997. Each
video store opening requires initial capital expenditures, including leasehold
improvements, inventory, equipment and costs related to site location, lease
negotiations, construction supervision and permits, of approximately $500,000,
excluding leasehold improvements that are customarily paid for by the property
developer.
At December 31, 1996, the Company had a $100 million revolving credit
agreement with a syndicate of banks. In January 1997 the Company replaced its
existing revolving credit agreement with a new $150 million revolving credit
agreement. Under the new agreement funds borrowed bear interest, at the
Company's option, at IBOR or the bank's base rate, plus approximately 1.25%,
depending on the amount of borrowings. The Company must also pay a fee of 0.3%
per annum on the available and unused portion of the credit facility. Amounts
outstanding under the credit line are collateralized by substantially all the
assets of the Company. The availability of borrowings under the revolving credit
agreement is based on the level of eligible inventory, the Company's financial
performance and compliance with certain covenants and financial ratios. The
credit line expires on December 28, 1998. As of December 31, 1996, $82.0 million
was outstanding under the revolving credit agreement that was in place at that
time. Of this amount, approximately $50.0 million was borrowed to fund the share
repurchase. (See Note 3).
The Company believes the net proceeds from its December 1996 public
offering, its recently increased borrowing capacity, projected cash flow from
operations, cash on hand and equipment leases and trade credit will provide the
necessary capital to fund the opening of approximately 300 new video retail
superstores in 1997.
23
General Economic Trends, Quarterly Results and Seasonality
The Company anticipates that its business will be affected by general
economic and other consumer trends. Future operating results may be affected by
various factors, including variations in the number and timing of new store
openings, the performance of new or acquired stores, the quality and number of
new release titles available for rental and sale, the expense associated with
the acquisition of new release titles, additional and existing competition,
marketing programs, weather, special or unusual events and other factors that
may affect retailers in general. In addition, any concentration of new store
openings and the related new store pre-opening costs and other expenses
associated with the opening of new stores near the end of a fiscal quarter could
have an adverse effect on the financial results for that quarter and could, in
certain circumstances, lead to fluctuations in quarterly financial results.
The video retail industry generally experiences relative revenue declines
in April and May, due in part to the change in Daylight Savings Time and due to
improved weather, and in September and October, due in part to the start of
school and the introduction of new television programs. The Company believes
these seasonality trends will continue.
Item 8. Financial Statements and Supplementary Data
Incorporated by reference to Item 14 of this report on Form 10-K.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Information with respect to this item has been previously reported in the
Company's Current Report on Form 8-K dated December 13, 1995 (and Amendment
No. 1 thereto on Form 8-K/A).
24
PART III
Item 10. Directors and Executive Officers of the Registrant
Information with respect to directors of the Company is hereby incorporated
by reference from the Company's definitive proxy statement, under the caption
"Nomination and Election of Board of Directors," for its 1997 annual meeting of
shareholders (the "1997 Proxy Statement") to be filed pursuant to Regulation 14A
promulgated by the Securities and Exchange Commission under the Securities
Exchange Act of 1934, which proxy statement is anticipated to be filed no later
than 120 days after the end of the Company's fiscal year ended December 31,
1996. Information with respect to executive officers of the Company is included
under Item 4(a) of Part I of this report.
Item 11. Executive Compensation
Information required by this Item 11 is hereby incorporated by reference
from the 1997 Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information required by this Item 12 is hereby incorporated by reference
from the 1997 Proxy Statement.
Item 13. Certain Relationships and Related Transactions
Information required by this Item 13 is hereby incorporated by reference
from the 1997 Proxy Statement.
25
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
Listed below are all financial statements, notes, schedules and exhibits
filed as part of this Annual Report on Form 10-K:
(a)(1), (2) Financial Statements
The following financial statements of the Registrant, together with
the Independent Auditors' Report dated February 20, 1997, except as to
Note 11, which is as of March 15, 1997, on pages F-1 to F-23 of this
report on Form 10-K are filed herewith:
(i) Financial Statements
Independent Accountants' Reports
Consolidated Balance Sheets as of December 31, 1996 and 1995
Consolidated Statements of Operations for the years ended December 31,
1996, 1995 and 1994
Consolidated Statements of Changes in Shareholders' Equity for the
years ended December 31, 1996, 1995 and 1994
Consolidated Statements of Cash Flows for the years ended December 31,
1996, 1995 and 1994
Notes to Consolidated Financial Statements
(ii) Financial Schedules
All financial schedules are omitted as the required information is
inapplicable or the information is presented in the respective
consolidated financial statements or related notes.
26
(a)(3) Exhibits
The following exhibits are filed with or incorporated by reference
into this Annual Report:
Exhibit
Number Description
------ -----------
3.1 1993 Restated Articles of Incorporation. (1)
3.2 Bylaws. (1)
4.1 Rights of Security Holders - See Article II of Exhibit 3.1 and
Articles I and V of Exhibit 3.2.
10.1 1993 Stock Incentive Plan, as amended. (2)
10.2 Employment Agreement of Mark J. Wattles, dated February 1, 1994.
(3)
10.3 Tax Indemnification Agreement dated as of February 3, 1994 between
the Registrant and Mark J. Wattles and Scott D. South. (2)
10.4 Amended and Restated Revolving Credit Agreement, dated February
12, 1997, among the Registrant and a syndicate of banks led by
Bank of America National Trust & Savings Association. (5)
10.5 Purchase and Sale Agreement, dated July 27, 1995, among the
Registrant, Video Watch Inc., Ray Sumon and Mahmood Sohrabi. (4)
23.1 Consent of Price Waterhouse LLP (5)
23.2 Consent of Coopers & Lybrand L.L.P. (5)
- -------------
(1) Incorporated by reference to the Registration Statement on Form S-1 of the
Company (File No. 33-63042).
(2) Incorporated by reference to the Annual Report on Form 10-K of the Company
for the year ended December 31, 1995.
(3) Incorporated by reference to the Registration Statement on Form S-1 of the
Company (File No. 33-73966).
(4) Incorporated by reference to the Company's Current Report on Form 8-K dated
August 23, 1995.
(5) Filed herewith.
(b) Reports on Form 8-K:
No reports on Form 8-K were filed by the Company in the three months
ended December 31, 1996.
27
Report of Independent Accountants
To the Board of Directors and Shareholders
of Hollywood Entertainment Corporation
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of operations, of changes in 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, 1996
and 1995, and the results of their operations and their cash flows for each of
the two years in the period ended December 31, 1996, in conformity with
generally accepted accounting principles. 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 generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit 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 the opinion expressed above.
As discussed in Note 2 of the consolidated financial statements, the Company
changed its amortization method for videocassette rental inventory.
PRICE WATERHOUSE LLP
Portland, Oregon
February 20, 1997, except as to Note 11,
which is dated as of March 15, 1997
F-1
Report of Independent Accountants
To the Board of Directors and Shareholders
Hollywood Entertainment Corporation
We have audited the accompanying statements of income, changes in shareholders'
equity and cash flows of Hollywood Entertainment Corporation for the year ended
December 31, 1994. 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 audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the statements of income, changes in shareholders'
equity and cash flows are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the statements of income, changes in shareholders' equity, and cash flows. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall presentation of
the statements of income, changes in shareholders' equity and cash flows. We
believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the results of operations and cash flows of Hollywood
Entertainment Corporation for the year ended December 31, 1994 in conformity
with generally accepted accounting principles.
COOPERS & LYBRAND L.L.P.
Portland, Oregon
February 14, 1995 except for Note 3
as to which the date is March 29, 1995
F-2
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
December 31,
--------------------------------------
1996 1995
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $12,849 $29,980
Construction and other receivables 25,785 16,154
Merchandise inventories 45,255 25,991
Prepaid expenses and other current assets 3,232 1,555
------------- -------------
Total current assets 87,121 73,680
Videocassette rental inventory, net 144,264 86,889
Property and equipment, net 115,812 65,958
Excess of cost over net assets acquired, net 99,229 104,679
Deferred income taxes 783 1,345
Other assets 2,574 2,109
------------- -------------
Total assets $449,783 $334,660
============= =============
LIABILITIES, MANDATORILY REDEEMABLE COMMON
STOCK AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt $205 $7,616
Accounts payable 67,207 42,778
Accrued expenses 10,402 5,553
Income taxes payable 2,914 --
------------- -------------
Total current liabilities 80,728 55,947
Long-term debt, excluding current maturities 156 355
Line of credit 82,000 --
Deferred rent and other liabilities 6,452 3,369
Deferred income taxes 5,744 2,956
------------- -------------
175,080 62,627
------------- -------------
Commitments and contingencies (notes 9 and 11) -- --
Mandatorily redeemable common stock -- 54,250
------------- -------------
Shareholders' equity:
Preferred stock, 25,000,000 shares authorized; no
shares issued and outstanding -- --
Common stock 100,000,000 shares
authorized; 36,006,201 and 33,879,738 shares
issued and outstanding, respectively 238,021 202,005
Retained earnings 38,992 18,362
Intangible assets, net (2,310) (2,584)
------------- -------------
Total shareholders' equity 274,703 217,783
------------- -------------
Total liabilities and shareholders' equity $449,783 $334,660
============= =============
See notes to consolidated financial statements.
F-3
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share amounts)
Year Ended December 31,
-----------------------------------------
1996 1995 1994
------------ ---------- -----------
Revenue:
Rental revenue $ 252,625 $ 123,894 $ 61,941
Product sales 49,717 25,536 11,347
------------ ---------- -----------
302,342 149,430 73,288
------------ ---------- -----------
Operating costs and expenses:
Cost of product sales 30,707 14,769 7,251
Operating and selling 208,895 105,433 47,312
General and administrative 18,302 7,916 4,419
Amortization of intangibles 6,020 3,775 1,696
------------ ---------- -----------
263,924 131,893 60,678
------------ ---------- -----------
Operating income 38,418 17,537 12,610
------------ ---------- -----------
Nonoperating income (expense):
Interest income 203 1,614 687
Interest expense (4,339) (490) (795)
------------ ---------- -----------
(4,136) 1,124 (108)
------------ ---------- -----------
Income before income taxes and cumulative
effect of a change in accounting principle 34,282 18,661 12,502
Income taxes 13,652 6,875 4,359
------------ ---------- -----------
Income before cumulative effect of a change
in accounting principle 20,630 11,786 8,143
Cumulative effect of a change in accounting
principle (note 2) -- (2,560) --
------------ ---------- -----------
Net income $ 20,630 $ 9,226 $ 8,143
============ ========== ===========
Earnings per common and common equivalent share:
Income before cumulative effect of a change
in accounting principle $ 0.59 $ 0.36 $ 0.32
Cumulative effect of a change in accounting principle -- (0.08) --
------------ ---------- -----------
Net income $ 0.59 $ 0.28 $ 0.32
============ ========== ===========
See notes to consolidated financial statements.
F-4
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(In thousands, except share amounts)
Common Stock
-------------------------- Intangible Retained
Shares Amount Assets Earnings Total
------------- ----------- ---------- ----------- ----------
Balance at December 31, 1993 18,150,244 $ 12,890 $ (580) $ 993 $ 13,303
Public offerings of common stock, net 10,152,750 87,164 -- -- 87,164
Issuance of common stock under option plan 230,600 45 -- -- 45
Warrants exercised 450,000 1,260 -- -- 1,260
Tax benefit from exercise of stock
options and warrants -- 567 -- -- 567
Issuance of stock options in
connection with acquisitions -- 2,598 (2,598) -- --
Amortization of intangible assets -- -- 283 -- 283
Net income -- -- -- 8,143 8,143
------------- ----------- ---------- ----------- ----------
Balance at December 31, 1994 28,983,594 104,524 (2,895) 9,136 110,765
Public offering of common stock, net 4,600,000 95,436 -- -- 95,436
Issuance of common stock under
option plan 296,144 1,341 -- -- 1,341
Tax benefit from exercise of
stock options -- 704 -- -- 704
Amortization of intangible assets -- -- 311 -- 311
Net income -- -- -- 9,226 9,226
------------- ----------- ---------- ----------- ----------
Balance at December 31, 1995 33,879,738 202,005 (2,584) 18,362 217,783
Public offering of common stock, net 2,000,000 34,705 -- -- 34,705
Issuance of common stock under option plan 126,463 838 -- -- 838
Tax benefit from exercise of stock options -- 473 -- -- 473
Amortization of intangible assets -- -- 274 -- 274
Net income -- -- -- 20,630 20,630
------------- ----------- ---------- ----------- ----------
Balance at December 31, 1996 36,006,201 $ 238,021 $ (2,310) $ 38,992 $ 274,703
============= =========== ========== =========== ==========
See notes to consolidated financial statements.
F-5
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOW
(In thousands, except share amounts)
Year Ended December 31,
------------------------------------------
1996 1995 1994
------------- ------------- ------------
Operating activities:
Net income $20,630 $9,226 $8,143
Adjustments to reconcile net income
to cash provided by operating activities:
Cumulative effect of a change in accounting principle -- 2,560 --
Depreciation and amortization 87,115 47,292 19,826
Deferred rent and other liabilities 3,083 1,288 640
Deferred income taxes 3,350 5,045 1,270
Changes in assets and liabilities:
Merchandise inventories (19,264) (13,571) (6,532)
Prepaid expenses and other current assets (1,677) (1,251) (125)
Accounts payable 24,429 19,053 16,867
Accrued expenses 4,849 (154) 1,942
Income taxes payable 2,914 (749) 668
------------- ------------- ------------
Net cash provided by operating activities 125,429 68,739 42,699
------------- ------------- ------------
Investing activities:
Construction and other receivables (9,631) (11,332) (3,963)
Purchases of videocassette rental inventory, net (124,253) (85,634) (34,251)
Purchases of property and equipment (64,038) (54,337) (10,401)
Investment in businesses acquired -- (16,988) (53,750)
Other (794) (570) 26
------------- ------------- ------------
Net cash used in investing activities (198,716) (168,861) (102,339)
------------- ------------- ------------
Financing activities:
Proceeds from the issuance of common stock, net 34,705 95,436 88,424
Proceeds from long-term debt -- 23,500 18,979
Repayments of long-term debt (7,610) (29,896) (18,465)
Proceeds from exercise of stock options 838 1,341 45
Tax benefit from exercise of stock options 473 704 69
Repurchase of common stock (54,250) -- --
Borrowings on line of credit 82,000 -- --
------------- ------------- ------------
Net cash provided by financing activities 56,156 91,085 89,052
------------- ------------- ------------
Increase (decrease) in cash and cash equivalents (17,131) (9,037) 29,412
------------- ------------- ------------
Cash and cash equivalents:
Beginning of year 29,980 39,017 9,605
------------- ------------- ------------
End of year $12,849 $29,980 $39,017
============= ============= ============
Other Cash Flow Information:
Interest expense paid $4,339 $455 $796
Income taxes paid, net of refunds 6,130 1,953 2,421
See notes to consolidated financial statements.
F-6
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements
(1) Nature of the Business and Summary of Significant Accounting Policies
Nature of the Business
Hollywood Entertainment Corporation and subsidiaries (the "Company")
operates a chain of video superstores 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, 1996 and 1995, the Company
operated 551 stores in 29 states and 305 stores in 23 states, respectively.
Basis of Presentation
The consolidated financial statements include the Company and its wholly
owned subsidiaries. All significant intercompany balances and transactions
have been eliminated. Certain amounts in the 1995 and 1994 consolidated
financial statements have been reclassified to be consistent with the 1996
presentation. The reclassifications had no effect on previously reported
net income or shareholders' equity.
Certain Risks and Uncertainties
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at 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.
Cash and Cash Equivalents
The Company considers highly liquid investment instruments, with an
original maturity of three months or less, to be cash equivalents.
Construction and Other Receivables
Construction and other receivables consist primarily of leasehold
improvements paid by the Company, which will be reimbursed by the lessor.
Merchandise Inventories
Merchandise inventories, consisting primarily of prerecorded video
cassettes, concessions, and other accessories held for resale, are stated
at the lower of cost or market value. Cost is determined on a first-in,
first-out basis.
F-7
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Videocassette Rental Inventory
Videocassette rental inventory, which includes video games and audio books,
is stated at cost and amortized over its estimated useful life to a $6 per
videocassette salvage value. See note 2 for a discussion of the
amortization policy applied to videocassette rental inventory and a
discussion of the change in amortization method effective January 1, 1995.
Videocassette rental inventory and related accumulated amortization at
December 31 for each of the last two years are as follows (in thousands):
1996 1995
-------------- ---------------
Videocassette rental inventory $ 201,444 $ 119,135
Less: accumulated amortization (57,180) (32,246)
-------------- ---------------
$ 144,264 $ 86,889
============== ===============
Amortization expense related to videocassette rental inventory was $67.1
million, $37.6 million and $16.1 million in 1996, 1995 and 1994,
respectively, and is included in operating and selling expenses. As
videocassette rental inventory is sold, the applicable cost and accumulated
amortization are eliminated from the accounts, determined on a first-in,
first-out basis applied in the aggregate based on monthly purchases. Any
gain or loss thereon is recorded in the Company's consolidated statement of
operations.
Property and Equipment
Property and equipment are stated at cost. Depreciation is computed using
the straight-line method over the estimated useful lives of the assets,
which range from approximately five to ten years. Leasehold improvements
are amortized over the lesser of the lease term or the estimated useful
life of the improvement. Property and equipment at December 31 consist of
the following (in thousands):
1996 1995
----------- -----------
Fixtures and equipment $43,428 $24,059
Leasehold improvements 91,648 46,978
Equipment under capital leases 3,525 3,525
----------- -----------
138,601 74,562
Less: accumulated depreciation and
amortization (22,789) (8,604)
-----------
$115,812 $65,958
=========== ===========
F-8
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Depreciation and amortization expense related to property and equipment was
$14.2 million, $5.9 million and $2.0 million in 1996, 1995 and 1994,
respectively. Accumulated amortization of equipment under capital leases
was $3.0 million and $2.3 million at December 31, 1996 and 1995,
respectively.
Additions to property and equipment are capitalized and include
acquisitions of property and equipment, costs incurred in the development
and construction of new stores, major improvements to existing property and
major improvements in management information systems. 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.
Intangible Assets
Intangible assets primarily consist of the cost of acquired businesses in
excess of the market value of net identifiable assets acquired (goodwill).
Goodwill is amortized on a straight-line basis over 20 years. The Company
annually reviews the realizability of recorded goodwill based upon
expectations of nondiscounted cash flows and operating income. As of
December 31, 1996, the Company believes that there are no materially
impaired intangible assets. Accumulated amortization of intangible assets
at December 31, 1996 and 1995 was $11.6 million and $5.6 million,
respectively.
In March 1995, the Financial Accounting Standards Board issued Statement
No. 121, "Accounting for the Impairment of Long-Lived Assets". This
pronouncement requires long-lived assets to be reviewed for impairment
whenever events or changes in circumstances indicate that the carrying
amount of the assets may not be recoverable. This new standard is required
for fiscal years beginning after December 15, 1995. The Company adopted the
new standard and it had no impact on the Company's consolidated financial
position or results of operations.
Deferred Rent
Many of the Company's operating leases contain predetermined fixed
increases of the minimum rental rate during the initial lease term. For
these leases, the Company recognizes the related rental expense on a
straight-line basis and records the difference between the amount charged
to expense and the rent paid as deferred rent.
Advertising
Advertising costs, net of cooperative reimbursements from vendors, are
expenses when incurred.
F-9
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Store Pre-opening Costs
Store pre-opening costs, including store employee labor costs and
advertising, incurred prior to the opening of a new store are expenses
during the first full month of a store's operation. Incremental costs
incurred by existing stores to prepare and train new employees are expenses
as incurred.
Income Taxes
The Company accounts for income taxes under the provisions of Statement of
Financial Accounting Standard No. 109. Accordingly, deferred income taxes
are provided at the current statutory rates for the difference between the
financial statement and tax basis of assets and liabilities and are
classified in the consolidated balance sheet as current or long-term,
consistent with the classification of the related asset or liability giving
rise to the deferred income taxes.
Net Income per Common Share
Net income per share of common stock is computed using the weighted average
number of common and common equivalent shares (if dilutive) outstanding
during each period, as adjusted for stock splits through December 31, 1996
(35,158,846 shares in 1996, 32,961,806 shares in 1995 and 25,578,240 shares
in 1994).
Fair Value of Financial Instruments
The carrying amount of cash and cash equivalents, construction and other
receivables, accounts payable, accrued liabilities, debt and mandatorily
redeemable common stock approximate fair value at December 31, 1996 and
1995 because these financial instruments bear interest at competitive rates
or have a short maturity.
Stock-based Compensation
The Company adopted Statement of Financial Accounting Standards Number 123
(SFAS 123) "Accounting for Stock-Based Compensation", in 1996. SFAS 123 was
issued by the Financial Accounting Standards Board in October 1995 and
allows companies to choose whether to account for stock-based compensation
under the current method as prescribed in accounting Principles Board
Opinion Number 25 (APB 25) or use the fair value method described in SFAS
123. The Company continues to follow the measurement provisions of APB 25.
F-10
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
(2) Change in Amortization Method for Videocassette Rental Inventory
Effective January 1, 1995, the Company adopted an accelerated method of
amortizing its videocassette rental inventory. Under this new method,
videocassette rental inventory, which includes video games and audio books,
is stated at cost, including the related costs to prepare such video
cassettes for rent, and amortized, beginning on the date video cassettes
are placed into service, to its salvage value ($6 per videocassette during
1995 and 1996) over an estimated useful life of 36 months. All copies of
new release video cassettes are amortized on an accelerated basis during
their first four months to an average net book value of $15 and then on a
straight-line basis to their salvage value of $6 over the next 32 months.
The method for calculating amortization of videocassette rental inventory
in 1994 and prior years was as follows: base stock video cassettes,
together with the related costs to prepare such video cassettes for rent,
were amortized over 36 months on a straight-line basis. New release video
cassettes were amortized as follows: the tenth and succeeding copies of
each title per store were amortized over nine months on a straight-line
basis; the fourth through ninth copies of each title per store were
amortized 40% in the first year and 30% in each of the second and third
years; and copies one through three of each title per store were amortized
as base stock. Under the old method, no provision for salvage value was
established.
The new method of amortization was adopted because the Company believes
accelerating expense recognition for new release video cassettes during the
first four months more closely matches the typically higher revenue
generated following a title's release, and believes $15 represents a
reasonable average carrying value for tapes to be rented or sold after four
months and $6 represents a reasonable salvage value for all tapes after 36
months.
The new method of amortization has been applied to videocassette rental
inventory that was held at January 1, 1995. The cumulative effect of the
change as of January 1, 1995 was to reduce net income by $2.6 million after
income taxes of $1.6 million. The application of the new method of
amortizing videocassette rental inventory increased 1995 amortization
expense by $2.6 million and reduced net income by $1.6 million and earnings
per share by $0.05.
F-11
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
(3) Acquisitions
The Company made no acquisitions in 1996. The following acquisitions were
made in 1995:
Title Wave
In March 1995, the Company purchased all of the outstanding capital stock
of Title Wave Stores, Inc. ("Title Wave"), an operator of 14 music and
video retail superstores located in Minneapolis, Minnesota. The aggregate
purchase price, including the assumption of Title Wave's liabilities, was
$15.7 million. The Company closed two Title Wave stores immediately
following the acquisition.
Video Watch
In August 1995, the Company acquired, in two separate transactions, the
assets of 42 video retail superstores operating under the name of "Video
Watch". The aggregate purchase price was approximately $60.3 million,
including 2,127,452 shares of the Company's common stock. The Company
granted the sellers an option to sell any of the shares issued in
connection with the Video Watch acquisition to the Company on January 27,
1996 at the original issuance price of $25.50 per share, for a maximum
repurchase obligation of $54.3 million. Consequently, the common shares
issued in connection with the Video Watch acquisitions are classified as
"Mandatorily Redeemable Common Stock" at December 31, 1995.
Pursuant to the option described above, in January 1996 the Company
repurchased all of the shares issued in the Video Watch acquisition. Of the
aggregate purchase price of $54.3 million, $50.0 million was provided by
borrowings under the Company's revolving credit line, and the remainder was
provided by then existing cash balances.
Other Acquisitions
In addition to the acquisitions discussed above in 1995, the Company
acquired six video retail superstores operated under the name "Video Watch"
for $7.0 million and acquired 10 other video retail superstores in eight
separate transactions for an aggregate purchase price of $4.8 million. The
purchase price for the Video Watch stores was paid in the form of a note
bearing interest at 5.75% per annum and paid January 4, 1996.
All of the acquisitions consummated by the Company during 1995 were
accounted for as purchases. Accordingly, the results of operations of the
acquired stores subsequent to the date acquired are included in the results
of operations of the Company.
F-12
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
The excess of cost over net identifiable assets acquired for the above
acquisitions totaling $72.1 million is being amortized over 20 years.
The Company's consolidated results of operations for the years ended
December 31 on an unaudited pro forma basis assuming the acquisitions of
Title Wave and Video Watch had occurred as of January 1, 1995 and assuming
the new method of amortizing videocassette rental inventory was in effect
during each period are as follows (in thousands, except per share amounts):
1995 1994
-------------- ------------
Total revenue $ 166,028 $ 136,848
Net income $ 12,275 $ 6,443
Net income per share $ 0.36 $ 0.23
The unaudited pro forma results of operations are not necessarily
indicative of actual results that would have occurred had the acquisitions
been completed as of January 1, 1995 or of the results which may occur in
the future.
(4) Leases
The Company leases all of its stores, corporate office and distribution
center under noncancelable operating leases and leases certain fixtures and
equipment under capital leases. All of the Company's stores have an initial
operating lease term of five to 15 years and options to renew for between
five and 15 additional years. Most operating leases require payment of
property taxes, utilities, common area maintenance and insurance. Total
rent expense, including related lease-required costs, incurred during 1996,
1995 or 1994 was $54.1 million, $25.3 million and $9.3 million,
respectively.
At December 31, 1996, the future minimum annual rental commitments under
all noncancelable leases were as follows (in thousands):
Operating Capital
Year Leases Leases
---- --------------- -------------
1997 $ 65,842 $ 218
1998 65,396 131
1999 63,295 --
2000 60,568 --
2001 58,974 --
Thereafter 300,396 --
--------------- -------------
Total $ 614,471 349
===============
Less: interest 27
-------------
Present value 322
Less: current maturities 205
-------------
Long-term obligations $ 117
=============
F-13
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
(5) 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 $50,000 and for annual Company claims which
exceed $1.0 million in the aggregate. While the ultimate amount of claims
incurred are 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 resulting from ultimate payments
will be reflected in operations in the period in which such adjustments are
known.
The Company does not maintain any retirement plans nor offer any form of
post-retirement benefits.
(6) Long-term Debt
Long-term debt consisted of the following at December 31, 1996 and 1995 (in
thousands):
1996 1995
----------- ------------
Borrowings under bank
revolving credit agreement $ 82,000 $ --
Notes payable, bearing interest
at 5.75%, due January 4,
1996. Secured by assets of
six acquired stores 7,000
Capital lease obligations 322 905
Other 39 66
----------- ------------
Total long-term debt 82,361 7,971
Less: current maturities 205 7,616
----------- ------------
Long-term debt, less current
maturities $ 82,156 $ 355
=========== ============
The Company's $19 million revolving line of credit with Bank of America
Oregon expired on July 2, 1995. Borrowings under the line were repaid by
the expiration date. Interest expense related to borrowings under the
expired line of credit was $251,000 in 1995 at an average interest rate
equal to 9.8%.
In December 1995, the Company executed a new $75 million revolving credit
agreement with a syndicate of banks led by Bank of America National Trust &
Savings Association. This facility had a maturity date of December 28, 1998
and was increased to $100 million in July of 1996. The borrowings bore
interest, at the Company's option, at the bank's base rate or LIBOR plus
approximately 1.25%, depending on the borrowing levels. The Company paid a
fee of 0.2% per annum on the available and unused portion of the credit
facility. Among other things, the revolving credit agreement required the
Company to maintain a specified level of net worth, a cash flow coverage
ratio, a funded debt to adjusted EBITDA ratio and minimum quarterly average
per store revenue amounts and restricted the Company from incurring certain
additional debt. The credit
F-14
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
facility was secured by substantially all assets of the Company. There were
no borrowings outstanding at any time during 1995 under this credit
facility.
At December 31, 1996, the Company had a $100 million revolving credit
agreement with a syndicate of banks. In January 1997 the Company replaced
its existing revolving credit agreement with a new $150.0 million revolving
credit agreement. Under the new agreement, funds borrowed bear interest, at
the Company's option, at IBOR or the bank's base rate, plus approximately
1.25%, depending on the amount of borrowings. The Company must also pay a
fee of 0.3% per annum on the available and unused portion of the credit
facility. Amounts outstanding under the credit line are collateralized by
substantially all the assets of the Company. The availability of borrowings
under the revolving credit agreement is based on the level of eligible
inventory, the Company's financial performance and compliance with certain
covenants and financial ratios. The credit line expires on December 28,
1998. As of December 31, 1996, $82.0 million was outstanding under the
revolving credit agreement that was in place at that time. Of this amount,
approximately $50.0 million was borrowed to fund the share repurchase
described in Note 3 above.
The Company's maturities of long-term debt for years subsequent to 1996 are
as follows: 1997 - $205,000; 1998 - $82,123,000; 1999 - $13,000; 2000 -
$15,000; and 2001 - $5,000.
(7) Income Taxes
The provision for income taxes consists of the following (in thousands):
1996 1995 1994
------------- ------------- ------------
Current:
Federal $ 8,052 $ 2,521 $ 2,652
State 2,250 456 437
------------- ------------- ------------
Total current 10,302 2,977 3,089
------------- ------------- ------------
Deferred:
Federal 2,757 3,302 1,128
State 593 596 142
------------- ------------- ------------
Total deferred 3,350 3,898 1,270
------------- ------------- ------------
Total provision $ 13,652 $ 6,875 $ 4,359
============= ============= ============
F-15
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
A reconciliation of the statutory federal income tax rate with the
Company's effective income tax rate is as follows:
1996 1995 1994
-------------- --------------- --------------
Statutory federal rate 35.0% 35.0% 34.0%
State income taxes, net of
federal income tax benefit 4.6 3.9 3.4
Tax exempt interest income (0.3) (2.6) (1.9)
Other, net 0.5 0.5 (0.6)
-------------- --------------- --------------
39.8% 36.8% 34.9%
============== =============== ==============
Deferred income taxes reflect the impact of "temporary differences" between
amounts of assets and liabilities for financial reporting purposes and such
amounts as measured by tax laws. The tax effects of temporary differences
that give rise to significant portions of deferred tax assets and
liabilities at December 31 are as follows (in thousands):
1996 1995
------------- ------------
Deferred tax assets:
Stock option exercises $ -- $ 96
Difference between assigned
value and tax basis of
acquired entities 591 1,249
Tax loss carry forwards 192 752
------------- ------------
783 2,097
Less: valuation allowance -- (752)
------------- ------------
$ 783 $ 1,345
============= ============
Deferred tax liabilities:
Depreciation $ 6,165 $ 2,162
Capital leases 1,091 822
Deferred Rent (1,225) --
Other (287) (28)
------------- ------------
$ 5,744 $ 2,956
============= ============
During 1995, the Company established a valuation allowance related to the
net operating loss carry forwards of Title Wave, a company acquired during
1995 through a stock purchase. The valuation allowance was reversed during
the year ended December 31, 1996 for the recognition of a deferred asset
that was previously reserved. At December 31, 1996, the Company has
approximately $0.5 million of operating loss carry forwards available to
reduce future income taxes which expire in varying amounts commencing in
year 2009.
F-16
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
(8) Shareholders' Equity
Preferred Stock
At December 31, 1996, the Company is authorized to issue 25,000,000 shares
of preferred stock in one or more series. The Board of Directors has
authority over the designations, preferences, special rights, limitations
or restrictions thereof as it may determine. No shares of preferred stock
have been issued.
Common Stock
In December 1996, the Company completed a public offering of 2,000,000
shares of its common stock. The net proceeds from the offering were
approximately $34.7 million. Additionally, in January 1997, the
underwriters purchased an additional 300,000 shares pursuant to the
overallotment option for net proceeds to the Company of approximately $4.7
million.
In July 1995, the Board of Directors and the Company's shareholders
approved an increase in the number of authorized shares of common stock to
100,000,000 and effected a 2-for-1 split in the form of a stock dividend.
All share and per share amounts have been given retroactive recognition in
each period in the accompanying financial statements.
In July 1995, the Company completed a public offering of 4,600,000 shares
of its common stock. The net proceeds from the offering were approximately
$95.4 million.
During 1994, the Company completed two public offerings resulting in the
sale of 10,152,750 shares of its common stock. The combined net proceeds
were approximately $87.2 million.
In March 1994, in connection with the Video Central acquisition, the
Company issued stock options to purchase 339,000 shares of common stock at
a price of $0.005 per share which were immediately exercisable and expire
March 2, 2003. The stock options had a fair market value on the date of
issuance of approximately $2.6 million, of which $2.5 million was allocated
to excess of cost over net assets acquired and $100,000 was allocated to
covenant not to compete. The excess of cost over net assets acquired is
being amortized over 20 years and the covenant not to compete was amortized
over two years. Amortization expense for the years ended December 31, 1996,
1995 and 1994 totaled $171,000, $171,000 and $143,000, respectively.
F-17
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
In July 1993, the Company sold 5,175,000 shares of its common stock in an
initial public offering registered under the Securities Act of 1933. The
net proceeds from this offering were approximately $10.4 million. In
connection with this offering, the Company issued to underwriters warrants
to purchase up to an aggregate 450,000 shares of common stock at an initial
exercise price of $2.80 per share. The warrants were exercised during 1994.
In September 1992, the Company issued a warrant to purchase 300,000 shares
of common stock for $0.035 per share effective as of the closing of the
Company's initial public offering. The warrant relates to a prepaid
ten-year rental contract with a supplier executed in September 1992. The
original estimated value of this warrant of $350,000 and the related shares
are included in common stock. The value is being amortized on a
straight-line basis over 60 months. Upon completion of the Company's
initial public offering, certain terms of the warrant and the related
contract were amended, thereby increasing the estimated value by $350,000
which is also being amortized over 60 months. The warrant was exercised in
July 1993. Amortization expense for the years ended December 31, 1996, 1995
and 1994 totaled $140,000, $140,000 and $140,000, respectively.
Stock Option Plan
In May 1993, the Board of Directors adopted, and the shareholders of the
Company approved, the 1993 Stock Incentive Plan (the "Plan"). The Plan
provides for the award of non-qualified stock options, stock appreciation
rights, bonus rights and other incentive grants to employees, independent
contractors and consultants. In November 1995, the Board of Directors and
the Company's stockholders approved an increase in the number of shares
reserved for issuance under the Plan to 5,200,000. As of December 31, 1996,
options for a total of 599,687 shares were exercisable. The options are
granted at fair market value as determined by the Company's Board of
Directors at the date of grant. The options are exercisable over a period
of up to nine years from the date of the grant. The vesting schedules for
the options are from zero to five years.
During 1995, the Financial Accounting Standards Board issued SFAS 123,
"Accounting for Stock Based Compensation", which defines a fair value based
method of accounting for an employee stock option or similar equity
instrument and encouraged all entities to adopt that method of accounting
for all compensation cost related to stock options issued to employees
under these plans using the method of accounting prescribed by the
Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for
Stock Issued to Employees." Entities electing to remain with the accounting
APB 25 must make pro forma disclosures of net income and earnings per
share, as if the fair value based method of accounting defined in this
Statement has been applied.
F-18
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
The Company has elected to account for its stock based compensation under
Accounting Principles Board Opinion No. 25; however, as required by SFAS
123 the Company has computed for pro forma disclosure purposes the value of
options granted during 1995 and 1996 using the Black-Scholes option pricing
model. The weighted average assumptions used for stock option grants for
1995 and 1996 were:
1996 1995
---- ----
Risk free interest rate 6.4% 5.4%
Expected dividend yield 0% 0%
Expected lives 5 years 5 years
Expected volatility 60% 60%
Options were assumed to be exercised over the five-year expected life for
purposes of this valuation. Adjustments are made for options forfeited
prior to vesting. For the years ended December 31, 1995 and 1996, the total
value of the options granted was computed as the following approximate
amounts of $6.4 million and $12.4 million, respectively, which would be
amortized on a straight line basis over the vesting period of the options.
The weighted average fair value per share of the options granted in 1995
and 1996 are $7.93 and $4.84, respectively.
If the Company had accounted for these stock options issued to employees in
accordance with SFAS 123, the Company's net income and pro forma net income
(in thousands) and net income per share and pro forma net income per share
would have been reported as follows:
Year Ended Year Ended
December 31, 1996 December 31, 1995
------------------------------------ ----------------------------------
Net Income Earnings per Share Net Income Earnings per Share
As Reported $20,630 $0.59 $9,226 $0.28
Pro Forma 18,252 0.52 8,556 0.26
The effects of applying SFAS 123 for providing pro forma disclosure for
1995 and 1996 are not likely to be representative of the effects on
reported net income and earnings per share for future years since options
vest over several years and additional awards are made each year.
F-19
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Activity in the Company's stock option plan is as follows:
Weighted
Average
Shares Exercise Price
------------- ----------------
Outstanding at December 31, 1993 618,000 $ 2.47
Granted 1,194,500 5.89
Exercised (230,600) 0.20
Cancelled (34,200) 3.35
-------------
Outstanding at December 31, 1994 1,547,700 5.38
Granted 1,297,594 15.21
Exercised (296,144) 4.55
Cancelled (375,500) 8.17
-------------
Outstanding at December 31, 1995 2,173,650 6.57
Granted 2,858,150 10.24
Exercised (126,463) 6.62
Cancelled (865,150) 15.29
-------------
Outstanding at December 31, 1996 4,040,187 $ 9.25
=============
The following table sets forth the exercise prices, the number of options
outstanding and exercisable, and the remaining contractual lives of the
Company's stock options at December 31, 1996:
Weighted Average
Number of Options Contractual Life
Exercise Price Outstanding Exercisable Remaining
-------------- ----------- ----------- ----------------
$2.34-$5.67 563,250 186,750 5.96 years
6.50 1,130,337 86,837 8.05
6.66-9.67 686,600 212,000 7.30
10.00-15.00 1,221,500 114,100 8.07
15.50-19.87 438,500 -0- 8.82
(9) Legal Proceedings
In January 1995, Viacom, Inc. filed a lawsuit against the Company alleging
unfair competition, misappropriation of trade secrets and intentional
interference with contracts in connection with the hiring of five former
Blockbuster Entertainment employees. In addition, Viacom filed a separate
lawsuit against two of the employees, both of whom are officers of the
Company, in a Florida court alleging breach of employment agreements and
misappropriation of trade secrets. In April 1996, the Company and its
affected employees settled the litigation and, although the settlement
required the Company and Viacom to keep the terms confidential, the effect
of the settlement on the Company's results of operations and financial
condition was insignificant.
F-20
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
In December 1995 three complaints were filed against the Company, certain
of the Company's directors and officers and certain other parties and
consolidated in a single action entitled Murphy v. Hollywood Entertainment
Corporation et al., case no. C95-1926-MA, U.S. District Court for the
District of Oregon. The consolidated case is a class action encompassing
persons who purchased common stock of the Company between June 20 through
December 6, 1995. The plaintiffs alleged violation of certain federal
securities laws with respect to statements made to the public and losses
allegedly suffered by plaintiffs as a result of the decline in the trading
price of the Company's stock. In May 1996 the court certified the class but
dismissed claims based on violations of sections 11, 12(2) and 15 of the
Securities Act of 1933. The remaining claims dealt with alleged violations
of the Securities Exchange Act of 1934. Prior to trial, in March 1997 the
parties reached a settlement, which is subject to court approval. See Note
11.
(10) Quarterly Financial Data
The following table sets forth certain selected quarterly financial data as
previously reported, adjustments thereto to reflect the effects of the
accounting changes set forth in note (1) below and as adjusted.
Selected Quarterly Financial Data (Unaudited)
(In thousands, except per share data)
Quarter Ended
-----------------------------------------------------
1996 March June September December Full Year
- ------------------------------------------- ------------ ------------ ------------- ------------ ------------
Total revenue $ 65,073 $ 63,949 $ 75,696 $ 97,624 $ 302,342
Operating income 6,631 5,985 10,957 14,845 38,418
Net income 3,727 3,005 5,842 8,056 20,630
Net income per share 0.11 0.09 0.17 0.23 0.59
Quarter Ended
-----------------------------------------------------
1995 March June September December Full Year
- ------------------------------------------- ------------ ------------ ------------- ------------ ------------
Total revenue $ 27,088 $ 29,110 $ 39,290 $ 53,942 $ 149,430
============ ============ ============= ============ ============
Operating Income:
As previously reported $ 4,084 $ 4,421 $ 5,926
Adjustments (1) (309) (20) (166)
------------ ------------ -------------
As adjusted $ 3,775 $ 4,401 $ 5,760 $ 3,601 $ 17,537
============ ============ ============= ============ ============
Income before cumulative effect of a
change in accounting principle:
As previously reported $ 2,789 $ 2,740 $ 4,227
Adjustments (1) (286) (45) (134)
------------ ------------ -------------
As adjusted $ 2,503 $ 2,695 $ 4,093 $ 2,495 $ 11,786
============ ============ ============= ============ ============
Net income (loss)
As previously reported $ 2,789 $ 2,740 $ 4,227
Adjustments (1) (2,846) (45) (134)
------------ ------------ -------------
As adjusted $ (57) $ 2,695 $ 4,093 $ 2,495 $ 9,226
============ ============ ============= ============ ============
F-21
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Earnings per common share:
Income before cumulative effect of a
change in accounting principle:
As previously reported $ 0.09 $ 0.09 $ 0.12
Adjustments (0.01) -- (0.01)
------------ ------------ -------------
As adjusted (2) $ 0.08 $ 0.09 $ 0.11 $ 0.07 $ 0.36
============ ============ ============= ============ ============
Net income (loss):
As previously reported $ 0.09 $ 0.09 $ 0.12
Adjustments 0.09 -- (0.01)
------------ ------------ -------------
As adjusted (2) $ 0.00 $ 0.09 $ 0.11 $ 0.07 $ 0.28
============ ============ ============= ============ ============
- --------------
(1) During the fourth quarter of 1995, the Company changed its method of
amortizing videocassette rental inventory, effective January 1, 1995. In
addition, the Company changed the estimated life of the excess of cost over
net assets acquired for store acquisitions completed in 1995 from 40 years
to 20 years. The impact of these changes, including related income tax
effects, was to reduce previously reported net income by $2.8 million,
$45,000 and $134,000 for the quarters ended March, June and September 1995,
respectively. A charge of $2.6 million, net of tax, relating to the
cumulative effect on prior years of the change in amortization method for
videocassette rental inventory was made effective as of January 1, 1995 and
is included in the March 1995 change in net income described above.
(2) As adjusted earnings per share for the full year exceed the sum of as
adjusted earnings per share for the four fiscal quarters therein because of
rounding.
(11) Subsequent Events
Settlement of Securities Litigation
In March 1997 the Company reached a settlement of the securities litigation
initiated in December 1995. See Note 9. The settlement, which is subject to
court approval, consists of warrants valued at $9 million to purchase
Hollywood common stock and $6 million in cash. It is anticipated that the
warrants will be issued on or about August 31, 1997, will expire on August
31, 1998, and will have an exercise price of approximately $5 per share in
excess of the Company's Common Stock price at the time of issuance. The
Company may, however, at its option reduce the spread between the stock
price and the exercise price and/or lengthen the exercise period so long as
the value of the warrants remains at $9 million on the date of issuance.
The Company agreed to the settlement to avoid further litigation expense
and inconvenience and to put an end to all controversy
F-22
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
and claims related to the subject of litigation. In the settlement, the
Company has specifically disclaimed and denied any liability or wrongdoing
and that any person has suffered any harm or damage as a result of any of
the matters alleged in the litigation.
F-23
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, as of March 22, 1997.
Hollywood Entertainment Corporation
By: FORREST MARK WOLFINGER
---------------------------------------
Forrest Mark Wolfinger
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities indicated as of March 22, 1997.
Signatures Title
MARK J. WATTLES Chairman of the Board of Directors,
- ----------------------------- President and Chief Executive Officer
Mark J. Wattles
FORREST MARK WOLFINGER Chief Financial Officer
- ----------------------------- (Principal Financial and Accounting Officer)
Forrest Mark Wolfinger
DONALD J. EKMAN Director
- -----------------------------
Donald J. Ekman
JAMES N. CUTLER Director
- -----------------------------
James N. Cutler
RICHARD A. GALANTI Director
- -----------------------------
Richard A. Galanti
Exhibit Index
Exhibit Sequential
Number Description Page Number
- ------ ----------- -----------
3.1 1993 Restated Articles of Incorporation. (1)
3.2 Bylaws. (1)
4.1 Rights of Security Holders - See Article II of Exhibit 3.1
and Articles I and V of Exhibit 3.2.
10.1 1993 Stock Incentive Plan, as amended. (2)
10.2 Employment Agreement of Mark J. Wattles, dated February 1,
1994. (3)
10.3 Tax Indemnification Agreement dated as of February 3, 1994
between the Registrant and Mark J. Wattles and Scott D.
South. (2)
10.4 Amended and Restated Revolving Credit Agreement, dated
February 12, 1997, among the Registrant and a syndicate of
banks led by Bank of America National Trust & Savings
Association. (5)
10.5 Purchase and Sale Agreement, dated July 27, 1995, among the
Registrant, Video Watch Inc., Ray Sumon and Mahmood
Sohrabi. (4)
23.1 Consent of Price Waterhouse LLP (5)
23.2 Consent of Coopers & Lybrand L.L.P. (5)
- -------------
(1) Incorporated by reference to the Registration Statement on Form S-1 of the
Company (File No. 33-63042).
(2) Incorporated by reference to the Annual Report on Form 10-K of the Company
for the year ended December 31, 1995.
(3) Incorporated by reference to the Registration Statement on Form S-1 of the
Company (File No. 33-73966).
(4) Incorporated by reference to the Company's Current Report on Form 8-K dated
August 23, 1995.
(5) Filed herewith.