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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, 1997
---------------------------
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to ___________________
Commission file number 0-21824
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HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in its charter)
Oregon 93-0981138
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(State or other jurisdiction of (IRS Employer
incorporation or organization) identification No.)
25600 SW Parkway Center Drive Wilsonville, OR 97070
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(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: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Title of Each Class Name of Each Exchange on Which Registered
- ---------------------------- -----------------------------------------
Common Stock Nasdaq National Market
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 13, 1998, the registrant had 36,882,046 outstanding shares of
Common Stock, and on such date, the aggregate market value of the shares of
Common Stock held by nonaffiliates of the Registrant was $328,152,437 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, 1997.
1
Hollywood Entertainment Corporation
Annual Report on Form 10-K
Year Ended December 31, 1997
Item Page
- ---- ----
PART I
1. Business................................................................ 3
2. Properties..............................................................10
3. Legal Proceedings.......................................................11
4. Submission of Matters to a Vote of Security Holders.....................12
4(a). Executive Officers and Key Employees of the Registrant..................12
PART II
5. Market for Registrant's Common Stock and Related Stockholder Matters....16
6. Selected Financial Data.................................................17
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................19
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
2
PART I
Item 1. Business
General
Hollywood Entertainment Corporation (the "Company") operates the nation's
second largest video store chain. Founded in 1988, the Company operates 907
video retail superstores in 42 states as of December 31, 1997 and, according to
video industry analyst, Paul Kagan Associates, Inc. ("Paul Kagan"), the Company
operates the highest volume video stores in the nation. The Company opened its
first video superstore in October 1988 and had grown to 25 superstores in two
states at the end of 1993, 113 superstores in eight states at the end of 1994,
305 stores in 23 states at the end of 1995, 551 superstores in 29 states at the
end of 1996 and 907 superstores in 42 states at the end of 1997. As a result,
the Company's revenue increased from $17.3 million in 1993 to $500.5 million in
1997. The Company opened 356 superstores in 1997 and plans to open approximately
400 new superstores in 1998.
As part of its goal to build a strong national brand, 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 and video games, consisting of many copies of
popular new releases and an extensive selection of older or "catalog" movies
classified into 28 categories, including "Adventure," "Comedy," "Drama,"
"Classics," and "Children." The Company's goal is to offer more copies of
popular new videocassette releases and more titles than its competitors to
achieve greater customer satisfaction and to encourage repeat visits. Each
Hollywood Video superstore rents videocassettes, video games and videocassette
and video game players and sells videocassettes, video games, accessories and
confectionary items. Hollywood Video superstores are typically located in high
traffic locations, in stand-alone buildings, at the end of shopping strips or in
other highly visible locations.
Industry Overview
Video Retail Industry. According to Paul Kagan, the United States ("U.S.")
videocassette rental and sales industry has grown from $9.8 billion in revenue
in 1990 to approximately $15.6 billion in revenue in 1996, and is expected to
reach $18.6 billion in 2001. 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, a video
retailing industry association, the number of video specialty stores has
decreased from 31,500 in 1990 to 27,000 in 1996. The Company believes
approximately 7,200 of the remaining stores were superstores, including
approximately 3,700 stores owned by the Blockbuster Entertainment, Division of
Viacom, Inc. ("Blockbuster"). 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 $4.5 billion, or 45%, of the $9.9 billion
of estimated domestic studio revenue in
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1996. Of the hundreds of movies produced and released by the major studios each
year in the U.S., relatively few are profitable for the movie studio based on
box office revenue alone. According to the Motion Picture Association of America
("MPAA"), between 1990 and 1996 only 7% of all movies released generated in
excess of $20 million in U.S. theater revenue for studios. Over the same period,
members of the MPAA reported that the average production, advertising and
distribution cost per movie increased from $38.8 million to $59.7 million. The
Company believes the consumer is more likely to view "non-hit" movies on rented
videocassette than in any other medium because video retail stores provide an
inviting opportunity to browse and make an impulse choice among a very broad
selection of new releases. As a result, video retail stores, including those
operated by the Company, purchase movies on videocassette 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
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
First Movie theaters
Second Video retail stores
Third Pay-per-view television (including direct broadcast
satellite)
Fourth Pay cable (HBO, Showtime, etc.)
Fifth Basic cable television
Sixth Network television
Seventh Syndicated television
Trends in Video Rentals and Sales. The domestic video retail industry
includes both rentals and sales. Movie studios determine videocassette suggested
retail prices to both consumers and video rental stores and, through that
pricing, influence the relative levels of videocassette rental and sales.
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
("sell-through"). 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 $12 to $17 wholesale, and are generally
purchased by video retailers, mass merchants, grocery stores and other retailers
and promoted both as a rental title and for sell-through.
The availability of "hit" sell-through movie titles, with their lower
initial prices, allows video retailers to stock more copies of these "hit"
movies for rental at a substantially lower aggregate cost. In addition, movie
studios typically spend substantial amounts to promote these "hit" sell-through
titles, which the Company believes creates extraordinarily high consumer
awareness. As a result, rental demand for these titles is much higher than for
comparable "hit" titles initially priced and promoted for rental. Because the
best selling sell-through titles are often among the leading rental titles, the
return on investment in rental inventory for those titles
4
is typically much higher than for comparable titles initially priced and
promoted for rental.
The consumer market has historically been primarily a rental market.
According to Paul Kagan, video rental revenue has increased from $6.6 billion in
1990 to $7.7 billion in 1996 and is expected to increase to $8.2 billion in
2001. At the same time, consumers attracted by cross promotions and lower
videocassette prices have begun to spend more on purchasing videos. Video sales
have increased from $3.2 billion in 1990 to $7.9 billion in 1996 and are
expected to increase to $10.4 billion in 2001. As a result, video sales as a
percentage of total industry revenue have increased from approximately 32% in
1990 to approximately 50% in 1996.
Business Strategy
The Company'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. The Company has developed an effective superstore format that
distinguishes it from competitors. The Company attempts to quickly establish a
leadership position in each of the markets in which it opens stores and has
successfully competed in both well-developed and relatively untapped markets.
The Company's business strategy includes the following key elements:
Expansion Through Company-Built Stores. Of the Company's 907 video
superstores at December 31, 1997, 782 superstores had been opened as new stores,
and since December 31, 1995, all of the Company's expansion has been through the
opening of new superstores rather than through acquisitions.
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 offer 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 store.
Exciting, Enjoyable and Convenient. 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 superstores 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 in most
locations for $3.00 per day. The Company believes movie rental in general, and
its pricing structure and rental terms in particular, provide consumers
convenient entertainment and excellent value.
Advertising and Marketing
The Company primarily has used radio and direct mail advertising and
occasionally television to promote its business. The Company primarily uses
cooperative movie advertising funds made available by studios and suppliers to
promote certain videocassettes. The Company also benefits from advertising and
marketing by studios and theaters to promote films and increase box office
revenues. The Company utilizes alternative pricing strategies and
5
promotions in building customer loyalty and building market share. The Company
intends to increase its advertising expenditures in the near future.
Inventory and Information Management
Inventory Management. The Company maintains detailed information on
inventory utilization. Rental activity is tracked by individual videocassette
and video game to determine appropriate buying, distribution and disposition of
videocassettes and video games. The system provides information allowing the
Company to determine the appropriate time to move videocassettes and video games
from new releases to catalog, sell-through, or to redistribute to new stores.
The Company's inventory of videocassettes and video games for rental is prepared
according to uniform standards. Each new videocassette and video game 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 and video game.
Information Management. The Company utilizes a scalable client-server
system and maintains two distinct system areas: a point-of-sale ("POS") system
and a corporate information system. The Company maintains information, updated
daily, regarding revenue, current and historical rental and sales activity,
demographics of store membership, individual customer history, and videocassette
rental patterns. This system allows the Company to compare current performance
against historical performance and the current year's budget, manage inventory,
make purchasing decisions on new releases and manage labor costs. The Company
believes its system has the ability to continue to improve customer service,
operational efficiency and management's ability to monitor critical performance
factors. The Company has and will continue to make certain investments in its
software systems and applications to ensure the Company is year 2000 compliant.
The financial impact to the Company has not been and is not anticipated to be
material to its financial position or results of operations in any given year.
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. The Company's 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 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.
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
6
opened 250 new stores. 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. In 1997, the Company opened 356 new
superstores and operated in 42 states and plans to open approximately 400 new
superstores in 1998.
The Company believes the selection of locations for its superstores is
critical to the success of its operations. The Company has assembled a new store
development team with broad and significant experience in retail tenant
development. The majority of the Company's new store development personnel are
located in the geographic area for which they are responsible, but all final
site approval takes place at the corporate office, where new sites are approved
by a committee of senior management personnel. Final approval of all new sites
is the responsibility of the Company's Chief Executive Officer. 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 generally seeks what is considered the most desirable
sites, typically located in high-visibility stand-alone structures or in
prominent locations in multi-tenant shopping developments. The Company typically
competes for these prime sites with other retailers, banks, restaurants and gas
stations. All of the Company's superstores are in leased premises; the Company
does not own any real estate.
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.
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 and video games. Excluding new
releases, movie titles are classified into 28 categories, including "Action,"
"Drama," "Family," and "Children." The Company is committed to offering more
copies of popular new releases than its competitors. The Company does not rent
or sell adult movies in Hollywood Video superstores.
Videocassette Sales. Hollywood Video also offers new and previously viewed
videocassettes for sale. The Company believes it can profit from both the rental
and sale of videocassettes.
7
Video Games. Hollywood Video also rents video games and sells previously
viewed video games licensed by NintendoTM, SegaTM and SonyTM. Hollywood Video
stores offer approximately 1,000 video games.
Other Products. Hollywood Video also rents audio books, including abridged
fiction classics and religious, self-improvement and education materials such as
foreign language instruction. Each store 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.
Competition
The video retail industry is highly competitive. The Company competes with
other local, regional and national video retail stores, including 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 1996 there were approximately 27,000 video specialty stores in
the U.S., of which approximately 7,200 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, customer service and employee friendliness,
convenience of store access and parking and, to a lesser extent, pricing.
Substantially all of 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 and greater availability of
new releases 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 and generally for longer
rental periods than any of its major 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 (DBS) receiver or a cable converter to unscramble incoming signals.
Digital compression technology and other developing technologies are enabling
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 telecommunications companies have tested "video on
demand" service in some markets. Video on demand service would allow a viewer to
pause, rewind and fast forward movies. Based upon publicly available
information, the Company believes these tests have been unsuccessful. The
Company also 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
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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. In contrast,
according to Adams Media Research, 78.8 million, or 82%, of all U.S. television
households own a VCR. Although the Company does not believe cable television,
video on demand 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, 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, 1997, the Company had approximately 19,808 employees, of
which 18,917 were in the retail stores and the remainder in the Company's
corporate administrative, zone offices and warehousing operations.
Store managers report to district managers who supervise the operations of
the stores. The district managers report to regional managers, who report
directly to the Company's Senior Vice President of Operations for each zone
office. The corporate support staff periodically has meetings with zone
personnel, regional managers, district managers and store managers to review
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.
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Item 2. Properties
Store Locations
As of December 31, 1997, the Company's stores by location are as follows:
California........................................181
Texas.............................................105
Ohio...............................................54
Illinois...........................................52
Michigan...........................................52
Washington.........................................34
Pennsylvania.......................................33
Oregon.............................................32
Minnesota..........................................27
Arizona............................................26
Georgia............................................24
Tennessee..........................................24
Virginia...........................................23
Indiana............................................20
Utah...............................................18
Missouri...........................................18
Colorado...........................................17
New York...........................................17
Wisconsin..........................................16
North Carolina.....................................15
Maryland...........................................14
Oklahoma...........................................13
Kentucky...........................................10
Florida.............................................9
Iowa................................................8
Kansas..............................................8
Nevada..............................................8
Nebraska............................................7
Louisiana...........................................6
South Carolina......................................6
Idaho...............................................5
Arkansas............................................4
Alabama.............................................3
Connecticut.........................................3
New Jersey..........................................3
New Mexico..........................................3
Massachusetts.......................................3
Rhode Island........................................2
Delaware............................................1
District of Columbia................................1
Mississippi.........................................1
South Dakota........................................1
---
907
===
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All of the Company's stores are located in leased premises with an initial
lease term of five to 15 years and most have 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 anticipates that future new stores
will also be located in leased premises.
The Company's corporate headquarters and warehouse facility is located at
25600 Southwest Parkway Center Drive, Wilsonville, Oregon, and consists of
approximately 175,000 square feet of leased space. The Company also leases a
portion of an office building located at 8105 Southwest Boeckman Road,
Wilsonville, Oregon, consisting of approximately 15,000 square feet of leased
space. These facilities are leased pursuant to agreements that expire November
2005 and July 1998, respectively.
Subsequent to year end the Company entered into an agreement to lease space
for its new corporate headquarters located at 9275 Southwest Peyton Lane,
Wilsonville, Oregon. The new facility is expected to be ready for occupancy by
the summer of 1998. The new facility has approximately 123,000 square feet.
Item 3. Legal Proceedings
There are no material legal proceedings.
11
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 4(a). Executive Officers and Key Employees of the Registrant
The following table sets forth information with respect to the Company's
executive officers as of March 13, 1998.
Name Age Positions with the Company
- ---- --- --------------------------
Mark J. Wattles (1) 37 Chairman of the Board and Chief
Executive Officer
Jeffrey B. Yapp (1) 39 President
F. Mark Wolfinger (1) 42 Chief Financial Officer
Donald J. Ekman (1) 45 Senior Vice President, General
Counsel, Secretary and Director
Max G. Fratto (1) 54 Executive Vice President of Store
Operations
F. Bruce Giesbrecht 38 Senior Vice President of Program
Management
Douglas A. Gordon 30 Senior Vice President of Purchasing
and Product
Glen E. Hahn 46 Senior Vice President of Human
Resources
John R. Hnanicek 34 Senior Vice President of Information
Systems and Logistics
Scott E. Klein 40 Senior Vice President of Operations
(Eastern Zone)
Dale A. Naftzger 52 Senior Vice President of Operations
(Western Zone)
William E. Shull III 39 Senior Vice President of Operations
(Midwest Zone)
William M. Spae 46 Senior Vice President of Operations
(Southern Zone)
William P. Zebe 39 Senior Vice President of Development
- --------------------------------------------------------------------------------
(1) Executive Officers
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Mark J. Wattles founded the Company in June 1988 and has served as Chairman
of the Board and Chief Executive Officer since that time. Mr. Wattles also
served as President until September 1997. Mr. Wattles has been owner and
operator in the video rental industry since 1985. He has been a participant and
key speaker in several entertainment industry panels and conferences and
currently serves as a member of the Video Software Dealers Association (VSDA)
Board of Directors.
Jeffrey B. Yapp became President in September 1997. Prior to joining the
Company, Mr. Yapp served as President Worldwide of Twentieth Century Fox Home
Entertainment, Inc. from May 1997 until September 1997, and as President of Fox
International from 1994 to 1997. Previously, Mr. Yapp was Vice President of
Marketing for Pizza Hut, Inc. from 1992 to 1994 and International Vice President
of Ernest and Julio Gallo from 1986 to 1992. Mr. Yapp held marketing positions
with General Foods from 1981 to 1986.
F. Mark Wolfinger became Chief Financial Officer 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, Finance for Burger King.
Donald J. Ekman became a director of the Company in July 1993, and became
Vice President and General Counsel in March 1994 and was elected Senior Vice
President in May 1996. 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.
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F. Bruce Giesbrecht was named Senior Vice President of Program Management
in January 1998. Mr. Giesbrecht joined the Company in May 1993 as Vice President
of Corporate Information Systems and Chief Information Officer. Mr. Giesbrecht
was then promoted to Senior Vice President of Product Management in January
1996. Mr. Giesbrecht was a founder and the President of RamSoft, Inc., a
software development company specializing in management systems for the video
industry.
Douglas A. Gordon was named Senior Vice President of Purchasing and Product
in November 1997. Mr. Gordon joined the Company in May 1995 as Vice President of
Strategic Analysis and Forecasting. Mr. Gordon became Senior Vice President of
Finance in November 1995 and served in that role until November 1997. From 1991
to 1995, Mr. Gordon was Vice President and senior analyst for Montgomery
Securities covering the entertainment and retail industries.
Glen E. Hahn was named Senior Vice President of Human Resources in November
1997. Mr. Hahn joined the Company in April 1996 as Senior Vice President of
Operations (Central Zone) and become Senior Vice President of Operations in
January 1997. 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 and Logistics. From March 1996 to October 1996
Mr. Hnanicek was Chief Information Officer for HomePlace, a privately owned home
furnishings specialty 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 of
Information Systems and Logistics.
Scott E. Klein joined the Company in April 1997 as Senior Vice President of
Operations (Eastern Zone). Mr. Klein previously served as the Senior Vice
President of the Retail Division for Nordic Track, Inc. overseeing the
operations of approximately 350 retail stores.
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 specialty
coffee retailer with approximately 40 company-owned stores. 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 of Operations for Checkers Drive-In
Restaurants, overseeing 248 company-owned and 200 franchised units.
14
William E. Shull III joined the Company in February 1998 as Senior Vice
President of Operations (Midwest Zone). Mr. Shull previously served in various
capacities at AutoZone, most recently as the Regional Vice President overseeing
the operations and development for 250 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 Inc. 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.
William P. Zebe was named Senior Vice President of Development in January
1996 and joined the Company as National Vice President of Real Estate in May
1994. Mr. Zebe previously worked from 1993 to 1994 as the Real Estate Manager
for the Western Zone for Blockbuster Video, Blockbuster Music and Blockbuster
franchisee-owned Discovery Zone. From 1992 to 1993 Mr. Zebe was a Real Estate
Representative for Blockbuster.
15
Part II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
The Company has not paid any cash dividends on its common stock since its
initial public offering in July 1993 and anticipates that future earnings will
be retained for the development of its business. The payment of any future
dividends will be at the discretion of the Company's Board of Directors.
Furthermore, pursuant to loan covenants contained in its senior subordinated
notes, the Company is restricted from paying dividends and from repurchasing its
common stock in excess of $3.5 million as of December 31, 1997. The Company's
common stock is traded on the Nasdaq National Market ("Nasdaq") under the symbol
"HLYW". The following table sets forth the quarterly high and low last sale
prices per share, as reported on Nasdaq.
In August 1997, the Company issued $200 million principal amount of 10.625%
Senior Subordinated Notes in an unregistered offering pursuant to Section 4(2)
of the Securities Act of 1933. The initial purchasers of the Notes were
Montgomery Securities, Donaldson, Lufkin & Jenrette Securities Corporation,
Goldman, Sachs & Co. and Societe Generale Securities Corporation. All of these
notes were subsequently exchanged by the holders for Series B Senior
Subordinated Notes in an exchange offer registered under the Securities Act of
1933.
1997 1996
----------------------- -----------------------
Quarter High Low High Low
--------- --------- --------- --------- ---------
First $25.38 $18.50 $13.88 $ 6.50
Second 24.50 17.50 18.13 13.31
Third 22.88 11.63 21.75 11.88
Fourth 13.63 8.25 22.44 17.88
As of December 31, 1997, there were 223 holders of record of the Company's
common stock.
16
Item 6. Selected Financial Data
Year Ended December 31,
---------------------------------------------------------------------------
1997 1996 1995 1994 1993
---------------------------------------------------------------------------
(in thousands, except per share amounts)
Operating Results:
Revenue $500,501 $302,342 $149,430 $ 73,288 $17,339
--------------- ------------- ------------- ------------- -------------
Income from operations 41,681 38,418 17,537 12,610 3,643
--------------- ------------- ------------- ------------- -------------
Interest expense 13,806 4,339 490 795 322
--------------- ------------- ------------- ------------- -------------
Income before extraordinary item and
cumulative effect of a change
in accounting principle (3) 5,559 20,630 11,786 8,143 2,146
--------------- ------------- ------------- ------------- -------------
Net income (3) 4,996 20,630 9,226 8,143 2,146
--------------- ------------- ------------- ------------- -------------
- ---------------------------------------------------------------------------------------------------------------------------------
Net Income per Share before Extraordinary
Item and Cumulative Effect of a Change
in Accounting Principle:
Basic $ 0.15 $ 0.60 $ 0.37 $ 0.33 $ 0.14
Diluted 0.15 0.59 0.36 0.32 0.14
- ---------------------------------------------------------------------------------------------------------------------------------
Net Income per Share:
Basic $ 0.14 $ 0.60 $ 0.28 $ 0.33 $ 0.14
Diluted 0.13 0.59 0.28 0.32 0.14
- ---------------------------------------------------------------------------------------------------------------------------------
Balance Sheet Data:
Videocassette rental inventory, net $226,051 $144,264 $ 86,889 $ 36,656 $ 6,801
Property and equipment, net 234,497 115,812 65,958 14,606 3,550
Total assets 689,123 451,295 334,660 142,861 22,791
Long-term obligations (1) 233,496 82,361 7,971 3,505 2,399
Shareholders' equity 289,896 274,703 217,783 110,765 13,303
- ---------------------------------------------------------------------------------------------------------------------------------
Other Data:
Adjusted EBITDA (2) $ 76,880 $ 57,740 $ 31,516 $ 17,875 $ 4,474
- ---------------------------------------------------------------------------------------------------------------------------------
(1) Includes the current portion of long-term obligations.
(2) Adjusted EBITDA is significant to the Company's calculations of its
financial covenants and represents income from operations before
depreciation and amortization plus non-cash expenses that reduced EBITDA,
less 30% of rental revenue after deducting from such 30% of rental revenue
any cash charges associated with the acquisition of new release
videocassettes. The non-cash expenses represent the cost of goods sold on
previously viewed videocassettes and losses on inventory shrink. The
Company believes 30% of rental revenue approximates amounts spent on
purchase of new release videocassettes which are capitalized. Adjusted
EBITDA should not be viewed as a substitute for Generally Accepted
Accounting Principles (GAAP) measurements such as net income or cash flow
from operations.
(3) For 1993, includes a pro forma income tax benefit of $140,000 to reflect
the Company as a C corporation rather than as an S corporation for federal
and state income tax purposes for the period which commenced January 1,
1993 and ended July 18, 1993.
17
Financial Highlights
Year Ended December 31,
------------------------------------------------------------------
1997 1996 1995 1994 1993
------------------------------------------------------------------
(in thousands, except per share amounts and other operating data)
Financial Data:
Rental revenue $ 418,527 $ 252,625 $ 123,894 $ 61,941 $ 15,267
Product sales 81,974 49,717 25,536 11,347 2,072
---------- ---------- ---------- ---------- ----------
Total revenue 500,501 302,342 149,430 73,288 17,339
---------- ---------- ---------- ---------- ----------
Net income (1) 4,996 20,630 9,226 8,143 2,146
- ----------------------------------------------------------------------------------------------------------------------------
Pro Forma Statement of operations Data (2) (3) (4) :
Income from operations $ 53,083 $ 38,418 $ 17,537 $ 9,745 $ 2,795
Net income 23,573 20,630 11,786 6,277 1,647
Net income per diluted share 0.63 0.59 0.36 0.25 0.11
- ----------------------------------------------------------------------------------------------------------------------------
Operating Data:
Number of stores at year end 907 551 305 113 25
Comparable store revenue increase 3% 7% 1% 7% 16%
- ----------------------------------------------------------------------------------------------------------------------------
Other Data:
Weighted average shares outstanding:
Basic 36,659 34,162 32,230 24,717 15,189
Diluted 37,718 35,159 32,962 25,578 15,357
- ----------------------------------------------------------------------------------------------------------------------------
(1) Net income for the years presented includes the following special and/or
unusual charges:
(in thousands) 1997 1996 1995 1994 1993
- -------------------------------------------- ---------- ---------- ---------- ---------- ----------
Special and/or unusual pre-tax charges:
Settlement of securities class action
lawsuit $ 18,874 - - - -
Write-off obsolete video game inventory
and related accessories 6,798 - - - -
Failed self-tender offer 4,604 - - - -
Other unusual charges, net of related
income tax effect:
Extraordinary loss on extinguishment
of debt 563 - - - -
Cumulative effect of a change in
accounting principle - - $ 2,560 - -
(2) Pro forma net income eliminates special and/or unusual charges noted above
(see Note 10 and Note 15 to the Consolidated Financial Statements).
(3) Effective January 1, 1995, the Company changed its method of amortizing the
cost of videocassette rental inventory. See Note 4 of Notes to Consolidated
Financial. 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 if the new method had been applied retroactively to
all videocassettes in service at that date.
(4) For 1993, includes a pro forma income tax benefit of $140,000 to reflect
the Company as a C corporation rather than as an S corporation for federal
and state income tax purposes.
18
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations
Summary Results of Operations
The Company's net income for 1997 was $5.0 million, compared to $20.6
million and $9.2 million in 1996 and 1995, respectively. The 1997 and 1995
results included special and/or unusual items as previously noted:
The following table sets forth, for the periods indicated, (i) selected
statement of operations data expressed as a percentage of total revenue; and
(ii) the number of stores open at the end of each such period.
Year Ended December 31,
---------------------------------------------
1997 1996 1995
---------------------------------------------
Revenue:
Rental revenue 83.6% 83.6% 82.9%
Product sales 16.4% 16.4% 17.1%
------------- ------------- -------------
100.0% 100.0% 100.0%
------------- ------------- -------------
Operating costs and expenses:
Cost of product sales (1) 10.2% 10.2% 9.9%
Operating and selling (1) 72.4% 69.1% 70.6%
General and administrative (1) 5.4% 6.0% 5.3%
Amortization of intangibles 1.3% 2.0% 2.5%
------------- ------------- -------------
89.3% 87.3% 88.3%
------------- ------------- -------------
Income from operations 10.7% 12.7% 11.7%
Nonoperating income (expense) (1) -2.7% -1.4% 0.8%
------------- ------------- -------------
Income before income taxes (1) 8.0% 11.3% 12.5%
============= ============= =============
Net income (1) 4.7% 6.8% 7.9%
============= ============= =============
- ----------------------------------------------------------------------------------------------
Number of super stores - end of period 907 551 305
============= ============= =============
(1) Adjusted to exclude the special and/or unusual costs and expenses. See Note
10 and Note 15 to the Consolidated Financial Statements.
Revenue
Revenue increased by $198.2 million, or 66%, in 1997 compared to 1996,
primarily due to the opening of 356 new superstores in 1997. Revenue was also
favorably impacted by an increase of 3% in comparable store revenue in the
current year. Revenue increased by $152.9 million, or 102%, in 1996 compared to
1995, due to the opening of 250 new superstores in 1996 combined with an
increase of 7% in comparable
19
store revenue. The Company ended 1997 with 907 superstores operating in 42
states, compared to 551 stores operating in 29 states at the end of 1996 and 305
stores operating in 23 states at the end of 1995. The Company's pricing of
videocassette rentals and merchandise for sale did not change significantly in
1997.
Operating Costs and Expenses
Cost of Product Sales
The cost of product sales increased from 61.8% in 1996 to 65.2% in 1997 due
to the write-off of obsolete video game inventory and related accessories caused
by advancements in video game technology (see Note 15 to the Consolidated
Financial Statements) and pricing pressures in the fourth quarter of 1997. The
cost of product sales, as adjusted, as a percentage of product sales remained
relatively constant in 1997 compared to 1996. The cost of product sales in 1996
as a percentage of product sales increased from 57.8% in 1995 to 61.8% in 1996.
The gross margin on product sales decreased as the Company 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 and selling expenses as adjusted, which consist principally of
all store expenses, including payroll, occupancy, advertising, depreciation and
rental revenue sharing, increased as a percentage of total revenue to 72.4% in
1997 from 69.1% in 1996. This increase was due to lower average revenues per
store in 1997, resulting primarily from the addition of 606 new superstores
during the last two years, which have lower revenue per store than mature
Hollywood Video stores. Since a portion of store-level operating expenses is
fixed, new stores generally have lower operating margins in the 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 and
will continue to have an adverse impact on the Company's operating margin. At
December 31, 1997, 1996 and 1995, the Company operated 907, 551 and 305
superstores, respectively.
Operating and selling expenses decreased as a percentage of total revenue
to 69.1% in 1996 from 70.6% in 1995, primarily due to lower depreciation and
revenue sharing expense (27.0% in 1996 compared to 29.6% in 1995), partially
offset by an increase in other operating and selling expenses as a percentage of
total revenue resulting from the addition of 442 new superstores in 1996 and
1995, which have lower revenue per store, as discussed above.
General and Administrative
General and administrative expenses, as adjusted, decreased as a percentage
of total revenue to 5.4% in 1997 compared to 6.0% in 1996. This decrease as a
percentage of total revenue was due to the increase in total revenue without a
proportionate increase in corporate overhead.
20
General and administrative expenses increased as a percentage of total
revenue to 6.0% in 1996 from 5.3% in 1995, primarily due to costs incurred for
establishing and staffing the Company's new regional zone offices.
Amortization of Intangibles
Amortization of intangibles increased by $0.7 million in 1997 compared to
1996, primarily due to deferred financing costs associated with the Company's
senior subordinated notes and new revolving credit facility. Amortization of
intangibles increased by $2.2 million in 1996 compared to 1995 primarily due to
the full year impact of amortizing additions to intangible assets resulting from
the Titlewave, Videowatch and other store acquisitions made in 1995.
Nonoperating Income (Expense), Net
Interest expense net of interest income increased in 1997 compared to 1996
and 1995 due to increased levels of borrowings associated with the issuance of
senior subordinated notes in August 1997 (see Note 10 to the Consolidated
Financial Statements), combined with increased borrowings under the revolving
credit facility. In addition the Company incurred a charge of $18.9 million in
1997 for the settlement of the securities litigation (see Note 15 to the
Consolidated Financial Statements).
Income Taxes
The Company's effective tax rate was 40.5% in 1997, 39.8% in 1996 and 36.8%
in 1995 (see Note 11 to the Consolidated Financial Statements).
Liquidity and Capital Resources
The Company generates substantial operating cash flow because most of its
revenue is received in cash. The amount of cash generated from operations in
1997 significantly exceeded the current debt service requirements of the
Company's long-term obligations. The capital expenditures (including purchases
of videocassette rental inventory) of the Company are primarily funded by the
excess operating cash flow and from the proceeds from the debt recapitalization
(see "Cash Provided by Financing Activities"). In addition, the Company has a
$300 million revolving line of credit available to address the timing of certain
working capital and capital expenditure disbursements. The Company believes cash
flow from operations, supplemented by the availability of a revolving line of
credit, will provide the Company with adequate liquidity and the capital
necessary to achieve its planned expansion through at least 1999.
At December 31, 1997, the Company had cash and cash equivalents of $3.9
million and a working capital deficit of $32.4 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
21
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.
Cash Provided by Operating Activities
During 1997, net cash generated by operations was $59.2 million higher than
the prior year. This increase was primarily due to an increase in revenue,
depreciation and amortization expenses and a net favorable change in working
capital accounts, partially offset by lower results of operations (see "Results
of Operations") and a net unfavorable change in deferred income taxes (see Note
11 to the Consolidated Financial Statements). The net favorable change in
working capital accounts was due to a net favorable change in accounts payable,
accrued interest (see "Cash Provided by Operating Activities") and other current
assets and liabilities partially offset by a net unfavorable change in accounts
receivable. The net favorable change in other current assets and liabilities was
due to costs incurred by the Company in the current year with respect to the
failed self-tender offer (see Note 15 to the Consolidated Financial Statements)
and increased advertising accruals due to timing of payments. The increase in
accounts receivable in the current year was due to an increase in certain
marketing allowances and ancillary rental fees attributable to an increase in
the number of stores operated by the Company.
Cash Used in Investing Activities
Net cash used in investing activities increased by $149.0 million from the
prior year primarily due to increased purchases of videocassette rental
inventory for new and existing stores and capital expenditures with respect to
new store construction, remodeling of certain existing stores and for the
continued development of information management systems (see "Capital
Expenditures").
Cash Provided by Financing Activities
Net cash provided by financing activities increased by $98.1 million from
the prior year as a result of the recapitalization of the Company's debt
structure through the issuance of $200 million of 10.625% senior subordinated
notes (the "Notes"), all of the principal of which is due August 15, 2004 with
interest paid semiannually (see Note 10 to the Consolidated Financial
Statements). The proceeds received from the sale of the Notes, net of offering
costs of $6.8 million, were used to repay the entire outstanding indebtedness
under the then existing bank revolving loan. The excess proceeds from the
issuance of the Notes were used to fund capital expenditures (including purchase
of videocassette rental inventory) in the current year. In connection with the
issuance of the Notes, the Company entered into a new senior revolving credit
agreement which provides for the availability of up to $300 million in revolving
credit loans. The Company may utilize the new revolving credit facility as
needed for working capital, capital expenditures and general corporate purposes
(see Note 10 to the Consolidated Financial Statements).
22
Capital Expenditures
The Company's capital expenditures include product for stores, store
equipment and fixtures, remodeling a certain number of existing stores,
implementing and upgrading office and store technology and opening new store
locations. Each new store opening requires initial capital expenditures,
including leasehold improvements, inventory, equipment and costs related to site
location, lease negotiations and construction permits of approximately $0.6
million, excluding leasehold improvements that are customarily paid for by the
property developer. These capital expenditures will be funded primarily by cash
generated from operations, supplemented by the availability of a senior
revolving line of credit or other forms of equipment financing and/or leasing,
if necessary.
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.
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 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."
23
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
None
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 1998 annual meeting of
shareholders (the "1998 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,
1997. 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 1998 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 1998 Proxy Statement.
Item 13. Certain Relationships and Related Transactions
Information required by this Item 13 is hereby incorporated by reference
from the 1998 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
Report of Independent Accountants dated February 27, 1998, on pages F-1 to
F-23 of this report on Form 10-K are filed herewith:
(i) Financial Statements
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1997 and 1996
Consolidated Statements of Operations for the years ended December 31,
1997, 1996 and 1995
Consolidated Statements of Changes in Shareholders' Equity for the years
ended December 31, 1997, 1996 and 1995
Consolidated Statements of Cash Flows for the years ended December 31,
1997, 1996 and 1995
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 1993B Restated Articles of Incorporation, as amended (incorporated
by reference to the Registrant's Registration Statement on Form
S-1 (File No. 33-63042)(the "Form S-1") and by reference to
Exhibit 4 to the Registrant's Registration Statement on Form S-3
(File No. 33-96140)).
3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the Form S-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 Indenture, dated August 13, 1997, between the Registrant and U.S.
Trust Company of California, N.A. (incorporated by reference to
Exhibit 4.1 to the Registration Statement on Form S-4
(No.333-351)(the "1997 S-4").
10.2 Registration Rights Agreement, dated as of August 13, 1997, by and
among the Registrant, Montgomery Securities, Donaldson Lufkin &
Jenrette Securities Corporation, Goldman Sachs & Co. and Societe
Generale Securities Corporation (incorporated by reference to
Exhibit 4.4 to the 1997 S-4).
10.3 1993 Stock Incentive Plan, as amended (incorporated by reference
to Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1997).
10.4 Form of Incentive Stock Option Agreement (incorporated by
reference to Exhibit 10.1 of the Form S-1).
10.5 Form of Nonqualified Stock Option Agreement (incorporated by
reference to Exhibit 10.3 of the Form S-1).
10.6 Revolving Credit Agreement, dated as of September 5, 1997, among
the Registrant, as Borrower, and Societe Generale, DLJ Capital
Funding, Inc. Goldman Sachs Credit Partners L.P. and certain other
financial institutions, as Lenders, and Societe Generale, as Agent
for the Lenders, Donaldson, Lufkin & Jenrette Securities
Corporation, as Administrative Agent, Goldman Sachs Credit
Partners, L.P., as Documentation Agent, and Credit Lyonnais Los
Angeles Branch, Barclays Bank PLC, Deutsche Bank AG, New York
Branch, U.S. Bank National Association and KeyBank National
Association, as Co-Agents (incorporated by reference to Exhibit
10.1 of the 1997 S-4).
27
10.7 Employment letter between the Registrant and Jeffrey B. Yapp,
dated July 31, 1997.
21.1 List of Subsidiaries.
23.1 Consent of Price Waterhouse LLP.
27.1 Financial Data Schedule.
27.2 Restated Financial Data Schedule, year ended December 31, 1996
and 1995.
27.3 Restated Financial Data Schedule first, second and third
quarters 1997.
27.4 Restated Financial Data Schedule 1st, first, second and third
quarters 1996.
- -------------
(b) Reports on Form 8-K:
No reports on Form 8-K were filed by the Company in the three months
ended December 31, 1997.
28
Report of Independent Accountants
To the Board of Directors and Shareholders
of Hollywood Entertainment Corporation
In our opinion, the accompanying consolidated balance sheets 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, 1997
and 1996, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997, 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 4 of the consolidated financial statements, the Company
changed its amortization method for videocassette rental inventory in 1995.
PRICE WATERHOUSE LLP
Portland, Oregon
February 27, 1998
F-1
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(Thousands, except share amounts)
December 31,
------------------------------
1997 1996
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 3,909 $ 12,849
Accounts receivable 39,566 25,785
Merchandise inventories 61,482 45,255
Prepaid expenses and other current assets 6,488 3,232
------------- -------------
Total current assets 111,445 87,121
Videocassette rental inventory, net 226,051 144,264
Property and equipment, net 234,497 115,812
Goodwill, net 93,760 99,229
Deferred income tax 11,334 2,295
Other assets, net 12,036 2,574
------------- -------------
$ 689,123 $ 451,295
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term obligations $ 2,341 $ 205
Accounts payable 103,823 67,207
Accrued expenses 29,423 9,989
Accrued interest 8,256 413
Income taxes payable - 2,914
------------- -------------
Total current liabilities 143,843 80,728
Long-term obligations, less current portion 231,155 82,156
Other liabilities 24,229 13,708
------------- -------------
399,227 176,592
------------- -------------
Commitments and contingencies - -
Shareholders' equity:
Preferred stock, 25,000,000 shares authorized;
no shares issued and outstanding - -
Common stock, no par value, 100,000,000 shares authorized;
36,786,396 and 36,006,201 shares issued
and outstanding 247,950 238,021
Retained earnings 43,988 38,992
Intangible assets, net (2,042) (2,310)
------------- -------------
Total shareholders' equity 289,896 274,703
------------- -------------
$ 689,123 $ 451,295
============= =============
See notes to consolidated financial statements.
F-2
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Year Ended December 31,
-------------------------------------------
1997 1996 1995
------------ ------------ ------------
Revenue:
Rental revenue $ 418,527 $ 252,625 $ 123,894
Product sales 81,974 49,717 25,536
------------ ------------ ------------
500,501 302,342 149,430
------------ ------------ ------------
Operating costs and expenses:
Cost of product sales 53,471 30,707 14,769
Operating and selling 366,960 208,895 105,433
General and administrative 31,698 18,302 7,916
Amortization of intangibles 6,691 6,020 3,775
------------ ------------ ------------
458,820 263,924 131,893
------------ ------------ ------------
Income from operations 41,681 38,418 17,537
Nonoperating income (expense):
Interest income 342 203 1,614
Interest expense (13,806) (4,339) (490)
Litigation settlement (18,874) - -
------------ ------------ ------------
Income before income taxes, extraordinary
item and cumulative effect of a change
in accounting principle 9,343 34,282 18,661
Provision for income taxes 3,784 13,652 6,875
------------ ------------ ------------
Income before extraordinary item and
cumulative effect of a change in accounting
principle 5,559 20,630 11,786
Cumulative effect of a change in accounting
principle - - (2,560)
------------ ------------ ------------
Extraordinary loss on extinguishment of debt
(net of income tax benefit of $372 ) (563) - -
------------ ------------ ------------
Net income $ 4,996 $ 20,630 $ 9,226
============ ============ ============
- ------------------------------------------------------------------------------------------------------------
Net income per share before extraordinary
item and cumulative effect of a change
in accounting principle:
Basic $ 0.15 $ 0.60 $ 0.37
Diluted 0.15 0.59 0.36
- ------------------------------------------------------------------------------------------------------------
Net income per share:
Basic $ 0.14 $ 0.60 $ 0.28
Diluted 0.13 0.59 0.28
- ------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding:
Basic 36,659 34,162 32,230
Diluted 37,718 35,159 32,962
- -------------------------------------------------------------------------------------------------------------
See notes to consolidated financial statements.
F-3
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, 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
Public offering of common stock, net 300,000 4,695 - - 4,695
Issuance of common stock under
option plan 480,195 3,712 - - 3,712
Tax benefit from exercise of stock
options - 1,522 - - 1,522
Amortization of intangible assets - - 268 - 268
Net income - - - 4,996 4,996
---------------- ------------- ------------ ------------ ------------
Balance at December 31, 1997 36,786,396 $ 247,950 $ (2,042) $ 43,988 $ 289,896
================ ============= ============ ============ ============
See notes to consolidated financial statements.
F-4
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year Ended December 31,
-------------------------------------------
1997 1996 1995
------------- ------------ -----------
Operating activities:
Net income $ 4,996 $ 20,630 $ 9,226
Adjustments to reconcile net income to cash
provided by operating activities:
Cumulative effect of a change in accounting principle - - 2,560
Extraordinary loss on extinguishment of debt 563 - -
Depreciation and amortization 140,201 87,115 47,292
Change in deferred rent 3,467 3,083 1,288
Change in deferred income taxes (1,985) 3,350 5,045
Net change in operating assets and liabilities:
Accounts receivable (13,781) (9,631) (11,332)
Merchandise inventories (16,227) (19,264) (13,571)
Accounts payable 36,616 24,429 19,053
Accrued interest 7,843 358 45
Other current assets and liabilities 13,263 5,728 (2,199)
------------- ------------ -----------
Cash provided by operating activities 174,956 115,798 57,407
------------- ------------ -----------
Investing activities:
Purchases of videocassette rental inventory, net (194,273) (124,253) (85,634)
Purchases of property and equipment, net (139,709) (64,038) (54,337)
Investment in businesses acquired - - (16,988)
Increase in intangibles and other assets (4,138) (794) (570)
------------- ------------ -----------
Cash used in investing activities (338,120) (189,085) (157,529)
------------- ------------ -----------
Financing activities:
Proceeds from the issuance of common stock, net 4,695 34,705 95,436
Issuance of long-term obligations 203,159 - 23,500
Repayments of long-term obligations (1,864) (7,610) (29,896)
Tax benefit from exercise of stock options 1,522 473 704
Proceeds from exercise of stock options 3,712 838 1,341
Repurchase of mandatorily redeemable common stock - (54,250) -
(Decrease) increase in revolving loan, net (57,000) 82,000 -
------------- ------------ -----------
Cash provided by financing activities 154,224 56,156 91,085
------------- ------------ -----------
Decrease in cash and cash equivalents (8,940) (17,131) (9,037)
Cash and cash equivalents at beginning of year 12,849 29,980 39,017
------------- ------------ -----------
Cash and cash equivalents at end of year $ 3,909 $ 12,849 $ 29,980
============= ============ ===========
Other Cash Flow Information:
Interest expense paid $ 6,735 $ 4,339 $ 455
Income taxes paid, net of refunds 7,282 6,130 1,953
See notes to consolidated financial statements.
F-5
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
1. Significant Accounting Policies
Corporate Organization and Consolidation
The accompanying financial statements include the amounts of Hollywood
Entertainment Corporation and its wholly owned subsidiaries (the
"Company"). All intercompany transactions have been eliminated.
Nature of the Business
The Company operates a chain of video superstores ("Hollywood Video")
throughout the United States. The Company was incorporated in Oregon on
June 2, 1988 and opened its first store in October 1988. As of December 31,
1997 and 1996, the Company operated 907 stores in 42 states and 551 stores
in 29 states, respectively.
Use of Estimates in the Preparation of Financial Statements
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 as of the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates. Significant estimates relative to the Company include
depreciation and amortization policies.
Cash and Cash Equivalents
The Company considers highly liquid investment instruments, with an
original maturity of three months or less, to be cash equivalents.
Inventories
Merchandise inventories, consisting primarily of prerecorded
videocassettes, concessions, and other accessories held for resale, are
stated at the lower of cost or market. Cost of sales are determined on a
first-in, first-out basis ("FIFO"). 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
4 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.
F-6
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Property, Equipment, Depreciation and Amortization
Property is stated at cost and is depreciated on the straight-line basis
for financial reporting purposes over the estimated useful life of the
assets, which range from approximately five to ten years. Leasehold
improvements are amortized primarily over the lesser of ten years or the
term of the lease.
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.
Long-Lived Assets
The Company adopted Statement of Financial Accounting Standards (SFAS) No.
121, "Accounting for the Impairment of Long-Lived Assets." The statement
establishes accounting standards for the impairment of long-lived assets to
be held and used and for long-lived assets to be disposed. Impairment of
long-lived assets is recognized when events or changes in circumstances
indicate that the carrying amount of the asset or related group of assets
may not be recoverable. Measurement of the amount of the impairment may be
based on the market values of similar assets or estimated discounted future
cash flows resulting from use and ultimate disposition of the asset.
Management has determined that there has been no material impairment to any
long-lived assets as of December 31, 1997 and 1996.
Income Taxes
The Company calculates income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes", which requires recognition of deferred tax
liabilities and assets for the expected future tax consequences of events
that have been included in the financial statements and tax returns.
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.
F-7
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Fair Value of Financial Instruments
In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments", the Company has disclosed the fair value, related carrying
value and method for determining the fair value for the following financial
instruments in the accompanying notes as referenced: cash and cash
equivalents (see Note 1), accounts receivable (see Note 2), and long-term
obligations (see Note 10).
Earnings per Share
The Company adopted SFAS No. 128, "Earnings per Share", effective December
31, 1997, which specifies the computation, presentation, and disclosure
requirements for earnings per share. The statement requires that the
Company disclose both basic and diluted earnings per share on the face of
the income statement and reconcile the numerator and the denominator of the
basic and diluted per-share calculation in the Notes to the Consolidated
Financial Statements (see Note 14).
Advertising
Advertising costs, net of cooperative reimbursements from vendors, are
expensed when incurred.
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 expensed
during the first full month of a store's operation. Incremental costs
incurred by existing stores to prepare and train new employees are expensed
as incurred.
Reclassifications
Certain amounts in the prior years have been reclassified to be consistent
with the 1997 presentation. The reclassifications had no effect on
previously reported net income or shareholders' equity.
F-8
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
2. Accounts Receivable
Accounts receivable as of December 31, 1997 and 1996 consists of:
1997 1996
----------- -----------
(In thousands)
Construction receivables $ 18,906 $ 19,229
Marketing allowances and Other 20,660 6,556
----------- -----------
$ 39,566 $ 25,785
=========== ===========
The carrying amount of accounts receivable approximates fair value
because of the short maturity of those receivables.
3. Videocassette Rental Inventory
Videocassette rental inventory as of December 31, 1997 and 1996 consists
of:
1997 1996
----------- -----------
(In thousands)
Videocassette rental inventory $ 324,727 $ 201,444
Less accumulated amortization (98,676) (57,180)
----------- ----------
$ 226,051 $ 144,264
=========== ==========
Amortization expense related to videocassette inventory was $112.5 million,
$67.1 million and $37.6 million in 1997, 1996 and 1995, 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 FIFO basis applied in the
aggregate based on monthly purchases. Any gain or loss thereon is recorded
in the Company's consolidated statements of operations.
4. 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) 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.
F-9
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
The 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.
5. Property and Equipment
Property and equipment as of December 31, 1997 and 1996 consists of:
1997 1996
------------ ------------
(In thousands)
Fixtures and equipment $ 72,306 $ 35,020
Leasehold improvements 195,203 100,056
Equipment under capital lease 3,426 3,525
Leasehold improvements under capital lease 7,167 -
------------ ------------
278,102 138,601
Less accumulated depreciation and
amortization (43,605) (22,789)
------------ ------------
$ 234,497 $ 115,812
============ ============
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $1.6 million and
$3.0 million at December 31, 1997 and 1996, respectively.
F-10
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
6. Goodwill
Goodwill as of December 31, 1997 and 1996 consists of:
1997 1996
------------ ------------
(In thousands)
Goodwill $ 109,383 $ 109,383
Less accumulated amortization (15,623) (10,154)
------------ ------------
$ 93,760 $ 99,229
============ ============
Goodwill represents the excess of cost over fair value of net assets
purchased and is being amortized on a straight-line basis over 20 years.
The Company assesses the recoverability of these intangibles by determining
whether the amortization of the goodwill over the remaining lives can be
recovered through projected future operating results on an undiscounted
basis. The Company's management believes that there are no materially
impaired intangible assets.
7. Acquisitions
The Company made no acquisitions in 1997 or 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.
Pursuant to the option described above, in January 1996 the Company
repurchased all of the shares issued in the Video Watch acquisition. Of the
F-11
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
aggregate repurchase 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 repurchase 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. 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 year ended
December 31, 1995 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 the year is as follows:
(In thousands, except per share amounts) 1995
----------------------------------------------------------
Total revenue $166,028
Net income 12,275
Net income per share:
Basic 0.38
Diluted 0.36
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.
8. Operating Leases
The Company leases all of its stores, corporate offices, distribution
center and zone offices under non-cancelable operating leases. All of the
Company's stores have an initial operating lease term of five to 15 years
and most have options to renew for between five and 15 additional years.
Most operating leases require payment of property taxes, utilities, common
area maintenance and insurance.
F-12
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
Total rent expense, including related lease-required costs, incurred during
1997, 1996, and 1995 was $96.0 million, $54.1 million and $25.3 million,
respectively.
At December 31, 1997, the future minimum annual rental commitments under
non-cancelable operating leases were as follows:
Operating
Leases
--------------
(In thousands)
Year
-------------
1998 $ 117,432
1999 110,576
2000 107,840
2001 106,258
2002 104,419
Thereafter 534,395
-----------
$ 1,080,920
===========
9. 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 is dependent on future developments, in management's opinion,
recorded reserves are adequate to cover the future payment of claims.
Adjustments, if any, to recorded estimates 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.
F-13
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
10. Long-term Obligations
The Company had the following long-term obligations as of December 31,
1997 and 1996:
1997 1996
----------- -----------
Senior subordinated notes $ 200,000 $ -
Borrowings under bank
revolving credit agreement 24,999 82,000
Capital leases obligations, net
of interest of $1,367 and
$27, respectively 8,497 361
----------- -----------
233,496 82,361
Less current obligations 2,341 205
----------- -----------
$ 231,155 $ 82,156
=========== ===========
In August 1997, the Company issued $200 million principal amount of 10.625%
senior subordinated notes (the "Notes") due August 15, 2004. The proceeds
received from the sale of the Notes, net of offering costs of $6.8 million,
were used to repay the entire outstanding indebtedness under the then
existing bank revolving loan. The Company recorded the charge for the
write-off of the remaining deferred financing costs related to the
indebtedness repaid as an extraordinary loss of $0.6 million, net of
related income tax benefit of $0.4 million, in the current year.
The Notes are redeemable, at the option of the Company, after August 14,
2001 at rates starting at 105.313% of principal amount reduced annually
through August 15, 2003, at which time they become redeemable at 100% of
the principal amount. In addition, at any time prior to August 15, 2000,
the Company may redeem in the aggregate up to 35% of the original principal
amount of the Notes with the proceeds of one or more public equity
offerings, at a redemption price of 110.625% of principal amount. The terms
of the Notes may restrict, among other things, the payment of dividends and
other distributions, investments, the repurchase of capital stock and the
making of certain other restricted payments by the Company, the incurrence
of additional indebtedness by the Company or any of its subsidiaries, and
certain mergers, consolidations and disposition of assets. Additionally, if
a change of control occurs, as defined, each holder of the Notes will have
the right to require the Company to repurchase such holder's Notes at 101%
of principal amount thereof.
The Company is limited in the amount of cash dividends that it can pay and
the amount of common stock and subordinated indebtedness that it may
repurchase by applicable covenants contained in the Notes. As of December
31, 1997, taking
F-14
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
into account such limitations, the Company would not have been able to pay
dividends in excess of $3.5 million.
In September 1997, the Company entered into a senior revolving credit
agreement which provides for the availability of up to $300 million in
aggregate extension of credit. The outstanding balance is due and payable
on September 5, 2002. Revolving credit loans under the credit agreement
bear interest, at the Company's option, at an applicable margin over the
bank's base rate loan or the IBOR rate. The applicable margin is based upon
the ratio of consolidated indebtedness to consolidated adjusted EBITDA, as
defined below. The credit agreement also provides for a commitment fee of
1/2% of any unused portion of the credit agreement. Among other
restrictions, the credit agreement contains financial covenants relating to
specified levels of: indebtedness to income from operations before
depreciation and amortization less 30% of rental revenue after deducting
from such 30% of rental revenue any cash charges associated with the
acquisition of new release videocassettes (adjusted EBITDA); adjusted
EBITDA less taxes paid in cash to interest expense; maintenance of average
store contribution levels; and the maintenance of minimum net worth.
Amounts outstanding under the credit agreement are collateralized by
substantially all of the assets of the Company.
As of December 31, 1997, the fair value of the Notes was $196 million. The
fair value of the Notes was based on quoted market prices as of December
31, 1997. The revolving credit facility is a variable rate loan, and thus,
the fair value approximates the carrying amount as of December 31, 1997.
As of December 31, 1997 maturities on long-term obligations for the next
five years, were as follows:
December 31,
1997
------------
(In thousands)
Year
------------
1998 $ 2,341
1999 2,463
2000 3,693
2001 -
2002 24,999
Thereafter 200,000
------------
$ 233,496
============
F-15
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
11. Income Taxes
The provision for income taxes for the years ended December 31, 1997, 1996
and 1995 consists of:
1997 1996 1995
------------- ------------- ------------
(In thousands)
Current:
Federal $ 1,581 $ 8,052 $ 2,521
State 218 2,250 456
------------- ------------- ------------
Total current 1,799 10,302 2,977
Deferred:
Federal 1,468 2,757 3,302
State 517 593 596
------------- ------------- ------------
Total deferred 1,985 3,350 3,898
------------- ------------- ------------
Total provision $ 3,784 $ 13,652 $ 6,875
============= ============= ============
The Company is subject to minimum state taxes in excess of statutory state
income taxes in many of the states which it operates. These taxes are
included in the current provision for state and local income taxes. A
reconciliation of the statutory federal income tax rate with the Company's
effective income tax rate is as follows:
1997 1996 1995
------------- ------------- ------------
Statutory federal rate 34.0% 35.0% 35.0%
State income taxes, net of
federal income tax benefit 5.5 4.6 3.9
Tax exempt interest income - (0.3) (2.6)
Other, net 1.0 0.5 0.5
------------- ------------- ------------
40.5% 39.8% 36.8%
============= ============= ============
F-16
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
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:
1997 1996
------------- -------------
(In thousands)
Deferred tax assets (liabilities):
Difference between assigned
value and tax basis of
acquired entities $ 690 $ 591
Depreciation and amortization (12,468) (6,165)
Tax loss carryforward 326 192
Deferred rent 3,985 1,225
Financial statement expenses
deferred for tax purposes 1,114 -
Capitalized leases (1,842) (1,091)
Financing leases 2,039 -
Income deferred for financial
statement purposes 634 -
Tax credit carryforward 2,476 -
Other 70 287
------------- -------------
Net deferred liability $ (2,976) $ (4,961)
============= =============
At December 31, 1997, the Company had approximately $0.8 million of
operating loss carry forwards available to reduce future income taxes,
representing operating losses of Title Wave, a company acquired during 1995
through a stock purchase. For tax purposes, the pre-acquisition losses
resulting from a change of ownership of Title Wave are treated as separate
return limiting year losses. The Company expects to fully utilize these
losses in future years and thus no valuation allowance has been recorded.
The carryforward periods expire in years 2008 and 2009.
As of December 31, 1997, the Company had alternative minimum tax credits of
$2.5 million which carryforward indefinitely for federal tax purposes. The
Company may realize tax benefits as a result of the exercise of certain
employee stock options. For financial reporting purposes, any reduction in
income tax obligations as a result of these tax benefits is credited to
shareholders' equity. For financial statement purposes, the benefit of
these credits has been recognized in the deferred income tax assets.
F-17
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
12. Shareholders' Equity
Preferred Stock
At December 31, 1997, 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.
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.
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.
13. Stock Option Plans
In general, the Company's stock option plan provides for the granting of
options to purchase Company shares at the market price of such shares as of
the option grant date. The options generally have a nine year term and
become excercisable on a pro rata basis over five years.
The Company adopted stock option plans in 1993 and 1997 providing for the
granting of non-qualified stock options, stock appreciation rights, bonus
rights
F-18
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
and other incentive grants to employees up to an aggregate of 11,000,000
shares of common stock. The Company granted incentive stock options
pursuant to the 1993 Plan totaling 2,165,513, 2,858,150 and 1,297,594 in
1997, 1996 and 1995, respectively.
As of December 31, 1997, the Company had available for grant under the 1993
Plan 4,728,354 shares of common stock, after considering the lapse of
options previously granted.
The Company has elected to follow APB No. 25; "Accounting for Stock Issued
to Employees" ("APB 25"), and related interpretations in accounting for its
employee stock options. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying
stock on the date of the grant, no compensation expense is recognized. Pro
forma information regarding net income per share is required by SFAS No.
123, "Accounting for Stock-Based Compensation", and has been determined as
if the Company had accounted for its employee stock options under the fair
value method of that statement. The fair value of these options was
estimated at the date of grant using Black-Scholes option pricing model
with the following weighted-average assumptions for 1997, 1996 and 1995:
1997 1996 1995
------- ------- -------
Risk free interest rate 5.7% 6.4% 5.4%
Expected dividend yield 0% 0% 0%
Expected lives 5 years 5 years 5 years
Expected volatility 65% 60% 60%
For the purpose of pro forma disclosures, the estimated fair value of the
options is amortized over the option's vesting period.
The Company's pro forma information is as follows:
December 31,
-------------------------------------------------------------------------
1997 1996 1995
------------------------ ----------------------- -----------------------
Reported Pro forma Reported Pro forma Reported Pro forma
----------- ------------ ----------- ----------- ---------- -----------
Net income $ 4,996 $ 1,459 $ 20,630 $ 18,252 $ 9,226 $ 8,556
Earnings per share:
Basic 0.14 0.04 0.60 0.53 0.28 0.27
Diluted 0.13 0.04 0.59 0.52 0.28 0.26
Options to purchase 1,184,101 shares of common stock were not included in
the computation of pro forma diluted earnings per share for December 31,
1997, as such shares were anti-dilutive.
F-19
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
The pro forma effect on net income for 1997, 1996 and 1995 is not
representative of the pro forma effect on net income in future years
because it does not take into consideration pro forma compensation expense
related to grants made prior to 1995.
A summary of the Company's stock option activity and related information
for 1997, 1996 and 1995 is as follows:
Weighted
Average
Exercise
Shares Price
-------------- --------------
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
Granted 2,165,513 16.35
Exercised (480,195) 7.74
Cancelled (587,217) 11.79
-------------- --------------
Outstanding at December 31, 1997 5,138,288 $12.09
============== ==============
The following table summarizes information about the Company's stock
options outstanding as of December 31, 1997.
Weighted
Weighted Average
Number of Options Average Contractual Life
---------------------------- Exercise Remaining
Grant Price Range Outstanding Exercisable Price (years)
------------------- ------------- ------------ ------------- ----------------
$ 2.340 - $6.500 1,298,425 481,225 $ 5.21 6.25
6.835 - 11.625 1,205,700 296,200 9.83 7.14
11.870 - 17.500 1,291,163 302,483 14.10 7.72
17.750 - 19.120 1,038,000 50,900 18.46 7.97
19.620 - 21.500 305,000 44,400 20.06 8.33
------------ ------------ -------------
5,138,288 1,175,208 $12.09
============ ============ =============
F-20
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
14. Earning per Share
SFAS No. 128, "Earnings per Share" requires current and retroactive
presentation of basic and diluted earnings per share. Basic earnings per
share is calculated based on income available to common shareholders and
the weighted-average number of common shares outstanding during the
reported period. Diluted earnings per share includes additional dilution
from the effect of potential common stock, such as stock issuable pursuant
to the exercise of stock options, warrants outstanding and the conversion
of debt.
The following table is a reconciliation of the basic and diluted earnings
per share computations:
1997 1996 1995
---------------------------- ---------------------------- ----------------------------
(in thousands, except share amounts)
Per Per Per
Share Share Share
Income Shares Amounts Income Shares Amounts Income Shares Amounts
-------- -------- -------- -------- -------- -------- -------- -------- --------
Basic Earnings per Share:
Income before
extraordinary item and
change in accounting
principle $ 5,559 36,659 $ 0.15 $ 20,630 34,162 $ 0.60 $ 11,786 32,230 $ 0.37
Effect of Dilutive Securities:
Stock options - 1,059 - 997 - 732
-------- -------- -------- -------- -------- --------
Dilutive Earning per Share:
Income available to
common shareholders
and assumed conversions $ 5,559 37,718 $ 0.15 $ 20,630 35,159 $ 0.59 $ 11,786 32,962 $ 0.36
======== ======== ======== ======== ======== ======== ======== ======== ========
In 1997, the Company reported a $0.01 per share loss for both basic and
diluted earnings per share for an extraordinary loss on extinguishment of
debt. In 1995, the Company reported a $0.08 per share loss for both basic
and diluted earnings per share due to a change in accounting principle. See
a discussion in Note 10 and Note 4 to the Consolidated Financial
Statements.
15. Special and/or Unusual Items
The Company incurred the following special and/or unusual charges in 1997.
The Company recorded a $6.8 million charge in the fourth quarter of 1997 to
write-off obsolete video game inventory and related accessories caused by
advancements in video game technology. Of the $6.8 million charge, $2.3
million was included in cost of product sales and $4.5 million was included
in operating
F-21
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
and selling expenses on the consolidated statements of operations.
The Company recorded a $4.6 million charge in the fourth quarter of 1997
for costs related to the Company's self-tender offer to acquire shares of
its common stock at $11.00 per share, which failed because the minimum
number of shares required for the transaction was not tendered. This charge
was included in general and administrative expenses on the consolidated
statements of operations.
In March 1997, the Company recorded a $18.9 million charge to the
settlement of the securities litigation initiated in December 1995. The
charge consisted of $14.8 million in damages and $4.1 million in legal and
professional expenses. 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.
16. Commitments and Contingencies
In September 1997 Twentieth Century Fox Home Entertainment, Inc. (FOX)
filed a lawsuit against the Company for hiring Jeffrey Yapp as the
Company's new President, with whom FOX contended it had a binding contract
at the time of such hiring. Without admitting to any of Fox's claims, the
Company settled this litigation in December 1997. The Company believes that
the settlement will not have a material impact on the Company's future
results of operations or financial position.
The Company is involved in legal proceedings which have arisen in the
ordinary course of business. Management does not believe the outcome of
these proceedings will have a material impact on the Company's future
results of operations or financial position.
F-22
Hollywood Entertainment Corporation
Notes to Consolidated Financial Statements (Continued)
17. Quarterly Financial Data
Quarterly financial information is as follows:
Quarter Ended
-----------------------------------------------------------
March June September December
-------------- ------------- ------------- -------------
1997
-------------------------------
Total revenue $110,475 $110,002 $124,621 $155,403
Income from operations 14,329 11,177 12,143 4,032
Net income (3,607) 5,481 4,572 (1,450)
Net income per share:
Basic (0.10) 0.15 0.12 (0.04)
Diluted (0.10) 0.15 0.12 (0.04)
1996
-------------------------------
Total revenue $ 65,073 $ 63,949 $ 75,696 $ 97,624
Income from operations 6,631 5,985 10,957 14,845
Net income 3,727 3,005 5,842 8,056
Net income per share:
Basic 0.11 0.09 0.17 0.23
Diluted 0.11 0.09 0.17 0.23
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 30, 1998.
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 30, 1998.
Signatures Title
---------- -----
MARK J. WATTLES Chairman of the Board of Directors
- ---------------------------------- and Chief Executive Officer
Mark J. Wattles (Principal Executive Officer)
FORREST MARK WOLFINGER Chief Financial Officer
- ---------------------------------- (Principal Financial and Accounting
Forrest Mark Wolfinger Officer)
DONALD J. EKMAN Director
- ----------------------------------
Donald J. Ekman
JAMES N. CUTLER Director
- ----------------------------------
James N. Cutler
RICHARD A. GALANTI Director
- ----------------------------------
Richard A. Galanti
II-1
Exhibit Index
Exhibit Description
Number Page Number
- ------ -----------
3.1 1993B Restated Articles of Incorporation, as amended (incorporated
by reference to the Registrant's Registration Statement on Form S-1
(File No. 33-63042)(the "Form S-1") and by reference to Exhibit 4 to
the Registrant's Registration Statement on Form S-3 (File No.
33-96140)).
3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the Form S-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 Indenture, dated August 13, 1997, between the Registrant and U.S.
Trust Company of California, N.A. (incorporated by reference to
Exhibit 4.1 to the Registration Statement on Form S-4
(No.333-351)(the "1997 S-4").
10.2 Registration Rights Agreement, dated as of August 13, 1997, by and
among the Registrant, Montgomery Securities, Donaldson Lufkin &
Jenrette Securities Corporation, Goldman Sachs & Co. and Societe
Generale Securities Corporation (incorporated by reference to
Exhibit 4.4 to the 1997 S-4).
10.3 1993 Stock Incentive Plan, as amended (incorporated by reference to
Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for
the quarter ended June 30, 1997).
10.4 Form of Incentive Stock Option Agreement (incorporated by reference
to Exhibit 10.1 of the Form S-1).
10.5 Form of Nonqualified Stock Option Agreement (incorporated by
reference to Exhibit 10.3 of the Form S-1).
10.6 Revolving Credit Agreement, dated as of September 5, 1997, among the
Registrant, as Borrower, and Societe Generale, DLJ Capital Funding,
Inc. Goldman Sachs Credit Partners L.P. and certain other financial
institutions, as Lenders, and Societe Generale, as Agent for the
Lenders, Donaldson, Lufkin & Jenrette Securities Corporation, as
Administrative Agent, Goldman Sachs Credit Partners, L.P., as
Documentation Agent, and Credit Lyonnais Los Angeles Branch,
Barclays Bank PLC, Deutsche Bank AG, New York Branch, U.S. Bank
National Association and KeyBank National Association, as Co-Agents
(incorporated by reference to Exhibit 10.1 of the 1997 S-4).
10.7 Employment letter between the Registrant and Jeffrey B. Yapp, dated
July 31, 1997.
21.1 List of Subsidiaries.
23.1 Consent of Price Waterhouse LLP.
27.1 Financial Data Schedule.
27.2 Restated Financial Data Schedule, year ended December 31, 1996
and 1995.
27.3 Restated Financial Data Schedule, first, second and third
quarters 1997.
27.4 Restated Financial Data Schedule, first, second and third
quarters 1996.