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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, 2001
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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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.)
9275 SW Peyton Lane, 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
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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. [X]
On March 15, 2002, the registrant had 58,203,058 shares of Common Stock
outstanding, and on such date, the aggregate market value of the shares of
Common Stock held by non-affiliates of the Registrant was $862,133,594 based
upon the last sale price reported for such date on the Nasdaq National Market.
PART I
ITEM 1. BUSINESS
GENERAL
We are the second largest specialty retailer of rentable home videocassettes,
DVDs and video games in the United States. We operate approximately 1,800
Hollywood Video superstores in 47 states and the District of Columbia and
estimate our share of the domestic videocassette and DVD rental market to be
approximately 10%. For the year ended December 31, 2001, our average store
generated revenue of approximately $766,000. Our total revenue (excluding our
discontinued Reel.com operations) for the years ended December 31, 2000 and
2001 was $1.270 billion and $1.380 billion, respectively, representing
increases of 20.4% and 8.7% over the comparable prior periods. For the year
ended December 31, 2001, approximately 83% of our revenue was derived from the
rental of movies, in both the VHS and DVD format, and games. The remainder of
our revenue was generated from the sale of new and previously-viewed movies and
games and concessions.
Following our inception in 1988, we grew our revenue through new store openings
as well as by increasing our comparable store sales. We opened an average of
306 stores per year from 1996 through 2000. We also produced comparable store
sales increases in 24 of the last 25 quarters, including an 11% increase for
both the third and fourth quarters of 2001 (as compared in each case to the
corresponding quarter of the preceding year).
During the second half of 2000 and in 2001 we made significant improvements to
our management team, including the reinstatement of our founder as President
and the hiring of a new Chief Operating Officer and Chief Financial Officer.
We also discontinued our e-commerce operations and modified our business
strategy to curtail new store openings for a period of time and focus more
intently on the opportunities that exist in our existing stores. Our current
management team is focused on implementing our business strategy through a
disciplined approach to our operational and financial performance and
objectives. After being a net user of cash since our inception, we have been a
net generator of cash since the fourth quarter of 2000.
Our goal is to continue to build a strong national brand and an effective
superstore format that distinguishes us from our competitors. Our branding
strategy is designed to cause consumers to identify us with the entertainment
industry, while our superstore format is designed to encourage multiple rentals
per visit and repeat visits. In each superstore, we focus on providing a
superior selection of movies and video games in an inviting atmosphere that
encourages browsing. Our customer transaction database contains information on
about 34 million household member accounts, enabling us to engage in targeted
marketing based on historical usage patterns.
INDUSTRY OVERVIEW
Industry Data
In this report on Form 10-K, we rely on and refer to information regarding
industry data obtained from market research, publicly available information,
industry publications and other third-party sources. Although we believe the
information is reliable, we cannot guarantee the accuracy or completeness of
the information and have not independently verified it.
Home Video Industry
According to Adams Media Research ("AMR"), the total domestic video retail
industry (consisting of both rentals and sales) grew approximately 11% in 2001,
from $21.1 billion in revenue in 2000 to $23.4 billion in 2001, and is expected
to grow to over $34.0 billion by 2010. According to AMR, the domestic
videocassette and DVD rental industry hit an all-time high of $10.8 billion in
revenue for 2001, while sales of movie videos were approximately $12.5 billion.
We believe the following factors, among others, continue to make video rental a
preferred medium of entertainment for millions of customers.
- - the continued improvement in home entertainment technology (e.g., DVD,
surround sound, HDTV);
- - the opportunity to entertain one or more people at home for a reasonable
price;
- - the opportunity to browse among a very broad selection of movies; and
- - the ability to control the viewing experience, such as the ability to start,
stop, pause, fast-forward and rewind.
According to AMR, VCR penetration now stands at 93.5% of the 102.6 million
domestic television households. In addition, AMR predicts that DVD player
shipments will exceed 13.0 million units in 2001, bringing the total number of
DVD households to 24.8 million, representing penetration of nearly 25% of
domestic television households, and that DVD player penetration will increase
to 45.7 million households, or nearly 50% of domestic television households, by
2003. AMR also reported that the growth rate of DVD player sales in their
first four years of existence has outpaced comparable initial sales growth
rates for CD players and VCRs by multiples of 3 to 1 and 8 to 1, respectively.
The home video rental industry is highly fragmented but has experienced
consolidation in recent years as video store chains have gained significant
market share from independent store operators. Based upon information
published by Video Store Magazine, we estimate that the three largest video
rental store chains (including Hollywood Video) had a 53% market share of all
domestic consumer video rentals in 2000 (including estimated revenues
associated with franchise stores), with the remainder of the market share
largely represented by small independent store operators.
Movie Studio Dependence on Video Retail Industry
According to AMR, the home video industry is the single largest source of
revenue to movie studios and represented approximately $9.5 billion, or 54.8%,
of the $17.4 billion of estimated domestic studio revenue in 2000. Of the many
movies produced by major studios and released in the United States each year,
relatively few are profitable for the studios based on box office revenues
alone. According to the Motion Picture Association of America, in 2000, the
average movie generated approximately $30.0 million in worldwide theater
revenue for studios. Over the past few years, the average total cost to make
and market a movie has increased significantly to over $82.0 million.
Therefore, the average movie loses approximately $50.0 million at the box
office and relies on other sources of revenue, most importantly home video, to
become profitable. Due to the unique browsing characteristics of the retail
environment, a Hollywood Video store's average customer rents slightly over 2.0
movies per transaction-frequently one hit and one non-hit movie. Because of
this, we offer for rental almost all movies produced by the movie studios
regardless of whether they were successful at the box office, including movies
released direct-to-video, thus providing movie studios with a reliable source
of revenue for almost all of their movies.
As a result of the importance of the video retail industry to the movie
studios' revenue base, the home video rental and sales (sell-through) markets
enjoy a period of time in which they have the exclusive rights to distribute a
movie. This period typically begins after a film finishes its domestic
theatrical run (usually five months after its debut) or upon its release to
video (in the case of direct-to-video releases) and lasts for 30 to 90 days
thereafter. This period of exclusivity is intended to maximize revenue to the
movie studio prior to a movie being released to other distribution channels,
including pay-per-view, video-on-demand, pay-TV and broadcast television, and
provides what we believe is a significant competitive advantage.
Trends in Video Rental and Sales
Studios have historically sold videocassettes to video retailers under two
pricing structures, "rental" and "sell-through." Under rental pricing, rental
titles are initially sold by the movie studios at relatively high prices
(typically $60 to $65 wholesale) and promoted primarily for rental, and then
later re-released to retailers for sale to consumers at a lower price
(typically $10 to $15). Certain high-grossing box office films, generally with
box office revenue in excess of $100.0 million, are targeted at the sell-
through market. These titles are released on videocassette at a relatively low
initial price (approximately $12 to $17 wholesale) and are both promoted as a
rental title by video stores and sold directly to consumers through a broad
array of retailers including video stores. Studios elect to release a title
either as rental or sell-through based on which would optimize their income
from the title. Due to the high up-front costs associated with rental pricing,
it was difficult for rental retailers to buy enough copies to satisfy customer
demand in the first few weeks of a title's release.
In 1998, the major studios and several large video retailers, including
Hollywood, began entering into revenue sharing arrangements for VHS
videocassettes as an alternative to the historical "rental" pricing structures.
These arrangements have produced significant benefits for us, including:
- - substantially increasing the volume of newly released videos in our stores;
- - contributing to an increase in revenues resulting from a rise in the total
number of transactions and the number of videocassettes rented per
transaction; and
- - aligning the studios' economic interests more closely with ours because they
share a portion of the rental revenue.
As a result, we currently acquire the majority of all of our VHS videocassettes
from studios under revenue sharing arrangements.
With the introduction of DVD as a new technology for the home video industry,
in November 1998 we introduced DVDs in all of our stores, resulting in the most
successful introduction of a new format in our history. DVDs are our fastest
growing new category in both rental and sales of new and previously-viewed
product due to increased interest in older movie titles as a result of the
substantial improvement in picture and sound quality over VHS and the rapid
adoption and rollout of DVD hardware to domestic households as a result of its
affordable price.
Currently, we acquire the majority of our DVDs for rental inventory from
studios at attractive sell-through prices (typically $17-$18). This pricing
methodology by the movie studios has enabled us to offer depth and selection to
satisfy high consumer demand for DVD rentals. In addition, as consumers
increasingly prefer the DVD medium, we have experienced significant growth in
the sale of previously-viewed DVDs. As a result of the acceptance of DVD by
consumers and the success of VHS revenue sharing for both the video retailers
and the movie studios, we and the movie studios believe that there may be a
benefit to DVD revenue sharing in the future. In August 2001, we announced our
first DVD revenue sharing arrangement with a major studio and entered into our
second DVD revenue sharing arrangement in January 2002. We believe that, with
or without revenue sharing, we will be able to continue strong growth in DVD.
Home Video Game Industry
According to NPD Group, Inc. ("NPD"), the electronic game industry was
approximately a $9.4 billion market in the United States in 2001. Also,
according to International Data Corporation ("IDC"), the home video game
industry is projected to grow by a compound annual growth rate of approximately
45% from 2001 through 2003 as a result of the recent high profile platform
launches of the Sony PlayStation 2, Nintendo GameCube and the Microsoft Xbox.
We expect this growth to positively impact game rentals as a recent survey
conducted by the Sega of America consumer research department illustrated a
strong inclination of game enthusiasts to rent titles before committing to
their purchase, as three out of every five game players rented video games at
least once a month with the average video game enthusiast renting nine
different titles in the past six months. We believe the key factors
contributing to this growth opportunity, which we expect to result in increased
sales and rental of video game products, includes the following:
Hardware platform technology evolution
Video game hardware has evolved significantly from the early products
launched in the 1980s. With the launch of three new gaming systems in 2001,
Nintendo's Gamecube and Game Boy Advance and Microsoft's Xbox, and the
October 2000 launch of Sony's PlayStation 2, IDC expects the total video
game hardware sales in 2002 and 2003 to be approximately $4.2 billion.
According to NPD, next-generation console systems such as Gamecube, Xbox and
Sony PlayStation 2 led to a triple-digit increase of over 120% in revenues
for 2001 versus 2000. Technological advancements have provided significant
improvements in advanced graphics and audio quality, allowing software
developers to create more advanced games, which encourage existing players
to upgrade their hardware platforms and attract new video game players to
purchase an initial system.
Next-generation systems provide multiple capabilities beyond gaming
Many next-generation hardware platforms, including the Sony PlayStation 2
and the Microsoft Xbox, utilize a DVD software format and have the potential
to serve as multi-purpose entertainment centers by doubling as a player for
DVD movies and compact discs. In addition, the Sony PlayStation 2 and the
Microsoft Xbox are expected to provide Internet connectivity.
Introduction of next-generation hardware platforms drives software demand
Sales of video game software generally increase as next-generation platforms
mature and gain wider acceptance. While gaming hardware is very important,
the game software is the driving force of revenue, as the hardware is
relatively useless without the software. Historically, when a new system is
released, a limited number of compatible game titles are immediately
available, but the selection grows rapidly as manufacturers and third-party
publishers develop and release game titles for that new system. IDC's
forecast is that the video game software industry will grow by a compound
annual growth rate of approximately 60% from 2001 through 2003.
Broadening demographic appeal
While the typical electronic game enthusiast is a male between the ages of
14 and 34, the electronic game industry is broadening its appeal. More
females are playing electronic video games, in part due to the development
of video game products that appeal to them. According to Interactive
Digital Software Association ("IDSA"), approximately 43% of all electronic
game players currently are female. Industry experts believe that game
innovation will open up other market opportunities, expanding sales and
bringing in a new base of gamers.
Used Video Game Market
As the installed base of video game hardware platforms has increased and
new hardware platforms are introduced, a growing used video game market has
evolved in the United States. With the abundance of titles available for
each of the three major game platforms, used games are becoming an
increasingly attractive option for video game enthusiasts.
BUSINESS STRATEGY
We are seeking to enhance our position as the nation's second largest specialty
retailer of rentable home videocassettes, DVDs and home video games by focusing
on the following strategies:
Provide Broad Selection and Superior Service
We are committed to providing superior service and satisfying our customers'
movie and video game demands by carrying a broad array of movies and video
games. Our superstores typically carry more than 7,000 movie titles on more
than 16,000 videocassettes and DVDs, together with a large assortment of video
games. In part, through our revenue sharing arrangements with studios, we have
increased the availability of most new movie releases and typically acquire 100
to 200 copies of "hit" movies for each Hollywood Video store. We believe that
this breadth and depth of movie titles, together with our emphasis on superior
customer service, results in a higher average level of rentals per store visit,
creates greater customer satisfaction and encourages repeat visits.
Provide Excellent Entertainment Value
We offer an inexpensive form of entertainment for the family and allow
consumers the opportunity to rent new movie releases, catalog movie titles and
video games for five days in most of our stores. New movie release titles in
the VHS format typically rent for $3.79 and catalog movies for $1.99. All DVDs
rent for $3.79 and video games rent for $4.99 and $5.99, with games for the
newer system platforms renting for the higher amount. We believe movie and
video game rental in general, and our pricing structure and rental terms in
particular, provide consumers convenient entertainment and excellent value.
Capitalize On DVDs
Since its launch, DVD has established itself as a proven rental format. In the
fourth quarter of 2001, DVDs represented an increasing percentage of our total
rental revenue as compared to the fourth quarter of 2000. Furthermore, DVD
penetration is expected to significantly rise between 2002 and 2004, as AMR
predicts that DVD player penetration will approach 50% of domestic television
households by 2003. We expect the percentage mix of DVD rentals will increase
with the expected growth in DVD player penetration. To date, we have
experienced a significant increase in the rental frequency of consumers who
have shifted to DVD technology from VHS, due primarily to the higher quality of
DVD and a desire to see movies previously seen on VHS.
Capitalize On New Game Platform Rollouts
According to International Development Corporation ("IDC"), the home video game
industry is projected to grow by a compound annual growth rate of approximately
45% from 2001 through 2003 as a result of the recent high profile platform
launches of the Sony PlayStation 2, Nintendo GameCube and the Microsoft Xbox.
With approximately $1.0 billion expected to be committed to marketing these new
platforms by their manufacturers, video game rental revenues are expected to
increase significantly following the launch of these new platforms. In the
fourth quarter of 2001, video games represented an increasing percentage of our
total rental revenue as compared to the third quarter of 2001.
In addition to our traditional video game rental business, we are further
developing a business initiative that enables video game enthusiasts to buy,
sell and trade new and used video games. This initiative, called "Game Crazy"
is currently in 66 of our stores and is designed as a store-within-a-store
concept, leveraging a portion of our existing superstore real estate and
capitalizing on the anticipated increase in home video games sales. A typical
"Game Crazy" store-within-a-store generates approximately $393,000 in annual
incremental store revenue. Benefiting from the new hardware launches, Game
Crazy experienced a comparable department sales increase of 34.8% for the
fourth quarter of 2001 (as compared to the fourth quarter of 2000).
Pursue Organic Store Growth
Nearly 95% of our 1,535 video superstores opened since 1995 have been new
stores rather than the acquisition of existing stores. We believe that control
over site selection, discipline in the real estate process and consistency of
store format and design have allowed us to enjoy attractive returns on invested
capital. Our organic store growth strategy is to selectively add Hollywood
superstores in existing markets where we believe the market will successfully
absorb additional Hollywood superstores.
STORES AND STORE OPERATIONS
Store Openings
We opened our first video superstore in October 1988 and grew to 25 superstores
in Oregon and Washington by the end of 1993. In 1994, we significantly
accelerated our store expansion program, adding 88 superstores and expanding
into California, Texas, Nevada, New Mexico, Virginia and Utah. In 1995, we
added 192 superstores and entered major new markets in the midwest, southwest,
east and southeast regions of the United States. Following is a table showing
our superstore growth from 1994 to 2001:
Year Ended December 31,
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1994 1995 1996 1997 1998 1999 2000 2001
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Beginning 25 113 305 551 907 1,260 1,615 1,818
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Opened 33 122 250 356 312 319 208 6
Acquired 55 70 - - 41 43 - -
Closed - - (4) - - (7) (5) (23)
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Ending 113 305 551 907 1,260 1,615 1,818 1,801
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Unlike many video retailers who have grown through acquisitions, we have
focused on organic growth. Of Hollywood's 1,535 video superstores opened since
1995, nearly 95% of these superstores have been opened as new stores. All
sites are chosen through a rigorous site selection process. We have achieved
significant geographic diversification in our store base, which helps insulate
us from potentially detrimental economic, competitive or weather-related
effects in isolated areas of the country. We believe this diversification
helps us deliver more predictable and stable revenue.
We presently intend to seek to open approximately 50 new stores during 2002 and
to increase our store base by approximately 10% per year thereafter.
Superstore Format
Our superstores average approximately 6,800 square feet and are substantially
larger than the stores of most of our competitors. The store exteriors
generally feature large Hollywood Video signs, which make our stores easily
visible to and recognizable by consumers. The interior of each store is clean
and brightly lit. Our superstores are decorated with colorful murals depicting
popular screen stars and walls of video monitors with hi-fi audio accompaniment
to create an exciting Hollywood environment. To assist our customers in
locating movies, DVDs and VHS videocassettes are separately merchandized
by format, and within each format, are organized into categories and arranged
alphabetically by title within each category. New releases are prominently
displayed in easily recognizable locations within each format. Video games are
also located separately in our stores and are further organized in separate
merchandise displays for each major video game hardware platform. We use wall-
mounted and freestanding shelves arranged in wide aisles to provide access to
products and to encourage the movement of customers throughout the store.
Site Selection
We believe the selection of locations for our superstores are critical to the
success of our operations. Prior to 2000, we assembled a new store development
team with broad and significant experience in retail tenant development. The
majority of our new store development personnel were located in the geographic
area for which they were 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 Chairman of the Real Estate Committee of the Board of Directors. 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. We generally seek what we consider the most desirable
locations, typically locating our stores in high-visibility stand-alone
structures or in prominent locations in multi-tenant shopping developments.
All of our stores are located in leased premises; we do not own any real
estate. We size our store development team to meet our anticipated
requirements for store openings for the upcoming year. During 2000, we
downsized our store development team as part of our strategy to curtail store
growth. Based upon our prior experience, we believe that we will be able to
quickly scale our store development team, as needed, to meet future store
growth plans.
PRODUCTS
Rental of Products
Approximately 83% of our revenue is derived from the rental of movies, in both
the VHS and DVD format, and video games. The remainder of our revenue is
generated from the sale of new and previously-viewed movies and video games and
concessions. Our superstores typically carry more than 7,000 movie titles,
consisting of a combination of new releases and an extensive selection of
"catalog" movies, on more than 16,000 videocassettes and DVDs. Excluding new
releases, movie titles are classified into categories, such as "Action,"
"Comedy," "Drama" and "Children," and are displayed alphabetically within those
categories. We do not rent or sell adult movies in any of our stores. In
addition to video rentals, we rent video games licensed by Microsoft, Nintendo,
Sega and Sony. We have significantly expanded our titles to support the recent
launches of Sony's PlayStation 2, Microsoft's Xbox and Nintendo's GameCube.
Each Hollywood Video store offers approximately 550 video game titles.
Sales of Products
The sales of products represented 17% of our total revenue in 2001. We offer
new and previously-viewed movies, in both the VHS and DVD format, and video
games and concessions (e.g., popcorn, sodas and magazines) for sale. We are
experiencing increases in our rental business as a result of the shift from VHS
to DVD. However, we have been capital constrained and had a limited selection
of new DVDs for sale in a limited number of stores and thus have experienced
declines in total new movie sales as consumers have shifted from VHS to DVD.
However, we plan to increase our new DVD inventory for sale during 2002 to take
advantage of the increased penetration of DVD players. While the sales of new
VHS videocassettes have decreased, our sales of previously-viewed movies for
both VHS and DVD have increased significantly due to the increased copy-depth
from revenue sharing arrangements and the typical sell-through pricing
structure for DVD. Moreover, due to DVD's significant advantages in audio and
video quality over VHS, we have experienced tremendous growth in the sale of
previously-viewed DVDs. We expect the market for previously-viewed DVDs to
grow as DVD penetration increases and consumers begin to build their own DVD
catalogs. Our ability to sell previously-viewed movies at lower prices than
new movies provides a competitive advantage over mass market retailers. In the
fourth quarter of 2001, as a result of the new video game platform launches, we
experienced an increase in our video game sales revenue. We also expect this to
continue as consumers become more aware of our "Game Crazy" buy, sell and trade
concept.
REVENUE SHARING
In the fourth quarter of 1998, we began entering into revenue sharing
arrangements directly with the majority of all of the studios with respect to
video tapes. In most cases, these arrangements are currently entered into on a
short-term, title-by-title basis and provide for a rental revenue sharing
period of 26 weeks. In some cases (currently two studios), these arrangements
are entered into on a longer-term basis and are generally applicable to all
titles satisfying specified criteria that are released by the applicable studio
during the term of the arrangement. Under all of these arrangements, in
exchange for acquiring agreed-upon quantities of tapes at reduced or no up-
front cost, we share agreed-upon portions of the revenues that we derive from
the tapes with the applicable studio.
We believe that we are one of the few retailers that have revenue sharing
arrangements with all the major studios, including Buena Vista, Columbia Tri-
Star, DreamWorks, MGM, Paramount, Twentieth Century Fox, Universal Studios, and
Warner. These revenue sharing arrangements provide the following significant
benefits:
- - They provide the opportunity to substantially increase the quantity and
selection of newly released video titles in stock;
- - They contribute to an increase in revenues resulting from a rise in the
total number of transactions and the number of titles rented per
transaction; and
- - They align the studios' economic interests more closely with our interests.
In addition, we believe that revenue sharing has increased the revenues
received on an annual basis by the studios through increased rental activity of
new releases as well as greater distribution of non-hit movies that we might
not otherwise purchase. Consequently, it has been our experience that the
studios with which we enter into revenue sharing arrangements on a tape-by-tape
basis want to engage in revenue sharing arrangements with respect to all of the
titles that they release at rental prices.
Currently, we acquire the majority of our DVDs for rental inventory from
studios at attractive sell-through prices (typically $17-$18). This pricing
methodology by the movie studios has enabled us to offer depth and selection to
satisfy high consumer demand for DVD rentals. In addition, as consumers
increasingly prefer the DVD medium, we have experienced significant growth in
the sale of previously-viewed DVDs. As a result of the acceptance of DVD by
consumers and the success of VHS revenue sharing for both the video retailers
and the movie studios, we believe that there may be a benefit to DVD revenue
sharing in the future. In August 2001, we announced our first DVD revenue
sharing arrangement with a major studio and entered into our second DVD revenue
sharing arrangement in January 2002.
PRICING
We believe that our rental terms and pricing structure provide consumers
convenient entertainment and excellent value. We currently offer a 5-day
rental program on all products in the majority of our stores. We increased our
prices in the majority of our stores in the fourth quarter of 1998 from $1.49
to $1.99 for catalog titles and from $2.99 to $3.49 for new releases. In the
fourth quarter of 1999, we increased our pricing on new releases from $3.49 to
$3.79 in the majority of our stores. Since we began offering DVDs for rental,
DVDs have been priced at $3.79 for five days. Video games rent for five days
for $4.99 and $5.99, with games for the newer system platforms renting for the
higher amount. We did not raise prices in 2000 or in 2001. We are currently
testing higher price points; however, we do not anticipate price increases in
the near term. Customers who fail to return the tapes, DVDs and games within
the initial rental period automatically commence a new rental period of equal
length at the same price.
ADVERTISING AND MARKETING
Our primary goal in advertising is to increase transactions in our superstores,
either from new members or existing members. Prior to 2000, we had
successfully employed a direct mail advertising campaign that efficiently
targeted customers in markets where our superstores were located. In 2000,
however, we experimented with a mass media advertising campaign focused on
corporate branding primarily through television and radio. The campaign was
not successful, and as a result, we have returned to a more cost-effective
direct mail strategy, as successfully employed in the past. In addition, we
also continue to use cooperative movie advertising funds made available by
studios and suppliers to promote certain videos. We will continue to test the
effectiveness of mass media campaigns in select markets, but anticipate our
primary marketing vehicle will continue to be direct mailings. We currently
have a customer transaction database containing information on approximately
34.0 million household member accounts, enabling us to engage in targeted
marketing based on historical usage patterns.
INVENTORY AND INFORMATION MANAGEMENT
Inventory Management
We maintain detailed information on inventory utilization. Our information
systems provide information which enable us to track rental and sell-through
activity by individual videocassette, DVD and video game to determine
appropriate buying, distribution and disposition of inventory, including the
sale of previously-viewed product. Our inventory of videocassettes, DVDs and
video games for rental is prepared according to uniform standards. Each new
videocassette, DVD 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, DVD and video game.
Information Management
We use scalable client-server systems and maintain two distinct systems areas:
a point-of-sale system and a corporate information system. We maintain
information, updated daily, regarding revenue, current and historical rental
and sales activity, demographics of store membership, individual customer
history, and videocassette, DVD and video game rental patterns. This system
allows us 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.
REEL.COM
On October 1, 1998, Hollywood acquired Reel.com, the premier online destination
for film-related content and commerce, for approximately $96.9 million. Prior
to June 2000, Reel.com was a leader in e-commerce as a site which offered for
sale an extensive selection of approximately 50,000 titles on videocassette and
DVD. The website also offered proprietary information about movies, including
descriptions, ratings, critics' reviews, recommendations and links to star
filmographies. Consumers could search through Reel.com's proprietary,
hyperlinked database and preview selected videos.
By June 2000, Reel.com had grown to a run rate of approximately $80.0 million
in annual revenue, but was generating significant cash losses. During 1999 and
2000, we attempted to finance Reel.com with outside capital, including filing a
registration statement for an initial public offering in December 1999. By
June 2000, we recognized that Reel.com would not be able to access outside
capital. Since we were unable to fund its continued losses, we discontinued
Reel.com's e-commerce business on June 12, 2000 and merged it with and into
Hollywood Entertainment Corporation. We laid off substantially all of
Reel.com's employees and closed its corporate office and warehouse in
Emeryville, California.
Today, we operate the Reel.com website as a content-only website containing
information about movies. The retained website is funded primarily through the
sale of advertising on the website and currently operates as a marketing tool
for us. We do not expect the retained website to be a material part of our
business in the future.
COMPETITION
The video retail industry is highly competitive. We compete with local,
regional and national video retail stores, including Blockbuster, and with mass
merchants, specialty retailers, supermarkets, pharmacies, convenience stores,
bookstores, mail order operations and other retailers, as well as with
noncommercial sources, such as libraries. Some of our competitors have
significantly greater financial and marketing resources, market share and name
recognition than we have.
We believe the principal competitive factors in the video retail industry are
price, title selection, rental period, the number of copies of popular titles
available, store location and visibility, customer service and employee
friendliness and convenience of store access and parking. Substantially all of
our stores compete with stores operated by Blockbuster, most in very close
proximity.
We also compete with cable and direct broadcast satellite television systems.
These systems offer both movie channels, for which subscribers pay a
subscription fee for access to movies selected by the provider at times
selected by the provider, and pay-per-view services, for which subscribers pay
a fee to view a particular movie selected by the subscriber. Historically,
pay-per-view services have offered a limited number of channels and movies, and
have offered movies only at scheduled intervals. Over the last few years,
however, advances in digital compression and other developing technologies have
enabled cable and satellite companies to transmit a significantly greater
number of movies to homes at more frequently scheduled intervals throughout the
day. In addition, certain cable companies and others have tested, and are
continuing to test, video-on-demand ("V.O.D.") services in some markets.
Nonetheless, the home video rental market has continued to grow significantly
and we believe that home video rental continues to enjoy significant
competitive advantages over alternative home movie delivery systems. These
advantages include initial periods of exclusivity provided by the studios
before movies are released to these competing distribution channels, broader
arrays of movie titles from which customers can make their selections and the
ability of customers to control the timing and manner of their movie viewing
(including the ability to pause, rewind and fast forward movies without
investing in digital recording systems).
We also believe movie studios have a significant interest in maintaining a
viable home video rental business because revenue generated from the retail
sales and rentals of movies represents the largest source of their revenue.
According to AMR, in 2000 home video represented approximately 55% of the
studios' domestic revenue, while pay-per-view represented only 2%.
Accordingly, the video retail industry provides movie studios with an important
distribution channel and revenue source for direct-to-video and their non-hit
movies as well as their hit movies. In addition, the browsing characteristics
of the retail environment frequently result in consumers concurrently selecting
both hit and non-hit movie titles for rental or purchase. As a result of these
factors, we believe that the movie studios are highly motivated to protect this
significant source of revenue, and accordingly, the home video rental and sell-
through markets enjoy a period of time in which they have the exclusive rights
to distribute a movie. This period of exclusivity typically begins after a
film finishes its domestic theatrical run (usually five months after its
debut), in the case of theatrical releases, or upon its release to video,
in the case of direct-to-video releases, and lasts for 30 to 90 days
thereafter. This period of exclusivity is intended to maximize revenue to the
movie studio prior to a movie being released to other distribution channels,
including pay-per-view, video-on-demand and television, and provides what we
believe is a significant competitive advantage.
In addition, we believe 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 AMR,
approximately 95 million, or 93.5%, of all U.S. television households own a VCR
and more VCR's were sold in 2000 than in any previous year, while AMR predicts
the number of DVD households will reach approximately 50% of all domestic
households by 2003. The studios are experiencing significant growth in
revenues as a result of DVD, which we believe they are highly motivated to
protect. Although we do not believe cable television, V.O.D. or other
distribution channels represent a near-term competitive threat to our business,
technological advances or changes in the manner in which movies are marketed,
including in particular the day and date release of movie titles to pay-per-
view, including direct broadcast satellite (DBS), cable television or other
distribution channels, could make these technologies more attractive and
economical, which could harm our business. See Part II, Item 7, under the
heading "Cautionary Statements" included in this report on Form 10-K.
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. We believe these
seasonality trends will continue.
EMPLOYEES
As of December 31, 2001, we had approximately 22,660 employees, of which 21,685
were in the retail stores and zone offices and the remainder in our corporate
administrative, 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 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
our employees are covered by collective bargaining agreements and employee
relations are considered to be excellent.
SERVICE MARKS
We own United States federal registrations for the service marks "Hollywood
Video", "Hollywood Entertainment", "Hollywood Video Superstores", "Game Crazy"
and "Reel.com." We consider our service marks important to our continued
success. This report on Form 10-K references and depicts certain trademarks,
service marks and trade names of other companies.
ITEM 2. PROPERTIES
As of December 31, 2001, Hollywood's stores by location are as follows:
HOLLYWOOD ENTERTAINMENT
NUMBER OF VIDEO STORES BY STATE
Alabama 13 Nebraska 14
Arizona 57 Nevada 27
Arkansas 9 New Hampshire 1
California 308 New Jersey 31
Colorado 30 New Mexico 10
Connecticut 14 New York 71
Delaware 1 North Carolina 28
Florida 74 North Dakota 3
Georgia 38 Ohio 80
Idaho 12 Oklahoma 21
Illinois 91 Oregon 64
Indiana 38 Pennsylvania 74
Iowa 10 Rhode Island 7
Kansas 14 South Carolina 13
Kentucky 17 South Dakota 3
Louisiana 15 Tennessee 35
Maine 2 Texas 172
Maryland 29 Utah 33
Massachusetts 39 Virginia 40
Michigan 61 Washington 86
Minnesota 38 Washington, D.C. 2
Mississippi 8 West Virginia 1
Missouri 33 Wisconsin 32
Montana 1 Wyoming 1
Total Stores 1,801
Total States (excluding Washington, D.C.) 47
We lease all of our stores, corporate offices, distribution centers and zone
offices under non-cancelable operating leases. All of our 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 of the store leases are "triple
net," requiring us to pay all taxes, insurance and common area maintenance
expenses associated with the properties.
Our corporate headquarters are located at 9275 Southwest Peyton Lane,
Wilsonville, Oregon, and consist of approximately 123,000 square feet of leased
space. The lease expires in November 2008. We have two warehouse facilities.
The first is located at 25600 Southwest Parkway Center Drive, Wilsonville,
Oregon and consists of approximately 175,000 square feet of leased space. The
second is located at 501 Mason Road, LaVergne, Tennessee, and consists of
approximately 98,000 square feet of leased space. These facilities are leased
pursuant to agreements that expire in November 2005 and June 2010,
respectively.
ITEM 3. LEGAL PROCEEDINGS
During 1999, we were named as a defendant in three complaints which have been
coordinated into a single action entitled California Exemption Cases, Case No.
CV779511, in the Superior Court of the State of California in and for the
County of Santa Clara. The plaintiffs are seeking to certify a statewide class
made up of certain current and former employees, which they claim are owed,
compensation for overtime wages, penalties and interest. The plaintiffs are
also seeking attorneys fees and costs. A class has not been certified. We
believe that we have provided adequate reserves in connection with this claim
and intend to vigorously defend the action.
On November 15, 2000, 3PF, a subsidiary of Rentrak Corporation filed a demand
for arbitration with the American Arbitration Association, Case No. 75 181
00413 00 GLO against us and Reel.com, Inc. ("Reel"). 3PF and Reel entered into
a Warehousing and Distribution Agreement on February 7, 2000, under which any
amounts owed by Reel.com were guaranteed by Hollywood under
a separate agreement. 3PF has alleged that Reel is in default under the
Agreement, has failed to perform material obligations under the Agreement, and
has failed to pay amounts due 3PF. 3PF seeks to recover approximately $4.8
million and consequential damages and attorneys fees and costs. We believe
that we have provided adequate reserves in connection with this claim and
intend to vigorously defend the action.
We have been named as a party to various claims, disputes, legal actions and
other proceedings involving contracts, employment and various other matters,
including suits related to amounts charged to customers in connection with
additional rental periods. We believe that we have provided adequate
reserves for these various contingencies and that the outcome of these matters
should not have a material adverse effect on our consolidated financial
condition, results of operations or liquidity.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At our Annual Meeting on December 17, 2001, the holders of the Company's
outstanding Common Stock elected each of Mark J. Wattles, James N. Cutler, Jr.,
Donald J. Ekman, S. Douglas Glendenning and William P. Zebe to our Board of
Directors, by the votes indicated below, to serve for the ensuing year.
Mark J. Wattles
Shares for 38,481,145
Shares withheld 7,546,971
James N. Cutler Jr.
Shares for 45,082,991
Shares withheld 945,125
Donald J. Ekman
Shares for 38,659,966
Shares withheld 7,368,150
S. Douglas Glendenning
Shares for 45,054,504
Shares withheld 973,612
William P. Zebe
Shares for 45,262,028
Shares withheld 766,088
ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning our executive
officers as of December 31, 2001:
Name Age Position
Mark J. Wattles 41 Chairman of the Board, Chief Executive
Officer, President and Director
Donald J. Ekman 49 Executive Vice President of Legal
Affairs, Secretary and Director
F. Bruce Giesbrecht 42 Executive Vice President of Business
Development
James A. Marcum 42 Executive Vice President and Chief
Financial Officer
Roger J. Osborne 49 Executive Vice President of Operations
Scott R. Schultze 47 Executive Vice President and Chief
Operating Officer
- -------------
Mark J. Wattles founded Hollywood in June 1988 and has served as a director,
Chairman of the Board, and Chief Executive Officer since that time. From June
1988 through September 1998, Mr. Wattles also served as President of Hollywood.
From August 1998 through June 2000, Mr. Wattles left his full time position at
Hollywood and served as CEO of Reel.com. In August 2000, Mr. Wattles returned
full time to Hollywood and in January 2001 was re-appointed President of
Hollywood by the Board. Mr. Wattles has been an 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.
Donald J. Ekman became a director of Hollywood in July 1993 and has been the
Executive Vice President of Legal Affairs since August 2000. Before the
appointment to his current position, Mr. Ekman served as the General Counsel of
Hollywood beginning in March 1994 and as a Vice President from 1994 until he
became a Senior Vice President in May 1996. Before joining Hollywood, Mr.
Ekman was in the private practice of law.
F. Bruce Giesbrecht was named Senior Vice President of Product Management in
January 1996, became Senior Vice President of Strategic Planning in January
1998, and Executive Vice President of Business Development in March 2000. He
joined Hollywood in May 1993 as Vice President of Corporate Information Systems
and Chief Information Officer. Mr. Giesbrecht was a founder of RamSoft, Inc.,
a software development company specializing in management systems for the video
industry, and served as its President.
James A. Marcum was appointed Executive Vice President and Chief Financial
Officer in May 2001. From October 2000 to January 2001, Mr. Marcum held the
position of Executive Vice President and Chief Operating Officer of Lids
Incorporated. From June 1995 until May 2000, Mr. Marcum worked for Stage
Stores, Inc., most recently as Vice Chairman and Chief Financial Officer. From
1983 to 1995, he held numerous positions at Melville Corporation, a
conglomerate of specialty retail chains, including Treasurer of the
corporation, his last assignment being Chief Financial Officer of Marshall's
Inc. Prior to 1983, Mr. Marcum was an auditor with Coopers and Lybrand. Mr.
Marcum also serves as a lead director of the Bombay Corporation.
Roger J. Osborne was named Senior Vice President of Operations in January 1999
and became Executive Vice President of Operations in October 2000. Prior to
being named Senior Vice President of Operations, he was the Executive Vice
President of J. Baker, Corporation, a major apparel and footwear retailer, and
President of its Work `N Gear Division since June 1997. Before joining J.
Baker Corporation, Mr. Osborne was Senior Vice President and Zone Director for
Mid-West and East coast markets for Hollywood from November 1996 until May of
1997. From 1993 until 1996, Mr. Osborne worked for J. Baker, Corporation,
serving as Senior Vice President and Director of its licensed shoe department
business from January 1995 to November 1996. Mr. Osborne served in executive
capacities with Bata Shoe Company from 1988 until 1993 and with the Payless
Shoe Store division of May Company from 1975 until 1988.
Scott R. Schultze was named Chief Administrative Officer of Hollywood in July
2000 and became Chief Operating Officer in June 2001. From 1988 until Mr.
Schultze joined Hollywood, he served as Executive Vice President and Chief
Financial Officer for The Limited Stores, a division of the Limited Inc. From
1986 to 1988, Mr. Schultze held the position of Vice President/Controller for
The May Company California and from 1977 to 1986, he held numerous positions at
Meier and Frank, a division of May Company, his last assignment being Vice
President of Finance.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
We have not paid any cash dividends on our common stock since our initial
public offering in July 1993 and anticipate that future earnings will be
retained for the development of our business. Loan covenants contained in our
bank credit facilities and senior subordinated notes limit the amount of
dividends we may pay and the amount of stock we may repurchase (see
Management's Discussion and Analysis of Results of Operations and Financial
Condition under the caption "Liquidity and Capital Resources"). As of December
31, 2001, these covenants effectively prohibited any dividends or stock
repurchases. Our common stock is traded on the Nasdaq National Market
("Nasdaq") under the symbol "HLYW". The following table sets forth the
quarterly high and low bid prices per share, as reported on Nasdaq.
2001 2000
----------------------------------------
Quarter High Low High Low
------- ------- ------ -------- -------
Fourth 16.91 11.61 7.50 0.63
Third 12.85 7.44 9.88 6.38
Second 9.97 1.94 8.38 6.06
First $2.72 $1.00 $15.00 $6.56
As of March 15, 2002, there were 190 holders of record of our common stock, and
no shares of preferred stock were issued and outstanding.
In October 1998, we issued and sold 5,982,537 shares of common stock and
2,380,263 shares of Series A Redeemable Preferred Stock in connection with the
acquisition of Reel.com. 1,982,537 shares of the common stock were issued for
aggregate cash consideration of $26,764,250 and 1,380,263 shares of the Series
A Redeemable Preferred Stock were issued for aggregate cash consideration of
$18,633,551. The balance of the shares of common stock and Series A Redeemable
Preferred Stock were issued in exchange for issued and outstanding shares of
Reel.com. The issuance and sale of these shares was exempt from the
registration requirements of Section 5 of the Securities Act of 1933, as
amended (the "Securities Act"), by virtue of Section 4(2) thereof. These
shares were issued and sold to a limited number of persons to whom disclosure
was provided and from whom "private placement" representations were obtained,
without the use of any general solicitation. In addition, certificates
evidencing these shares bore legends indicating that they were issued without
registration and, accordingly, that resales thereof were restricted. The
exemption provided by Section 4(2) also applied to the common stock issued upon
the conversion of the Series A Redeemable Preferred Shares in December 1998.
On January 24, 2000, we issued 200,000 shares of our common stock to Rentrak
Corporation as part of a litigation settlement. These shares were valued by us
at the time of their issuance at $11.438 per share, or $2,287,600. The issuance
of these shares was exempt from the registration requirements of Section 5 of
the Securities Act by virtue of Section 4(2) thereof. These shares were issued
and sold to a single entity to which disclosure was provided and from whom a
"private placement" representation was obtained, without the use of any general
solicitation. In addition, a certificate evidencing these shares bore a legend
indicating that they were issued without registration and, accordingly, that
resales thereof were restricted.
ITEM 6. SELECTED FINANCIAL DATA
The information presented below for, and as of the end of, each of the fiscal
years in the five-year period ended December 31, 2001 is derived from our
audited financial statements. The following information should be read in
conjunction with "Management's Discussion and Analysis of Results of Operation
and Financial Condition."
Except as otherwise noted, the information in the table below reflects, among
other things, operating losses incurred by Reel.com from October 1, 1998, when
we acquired it, to June 12, 2000, when we discontinued its e-commerce
operations.
Year Ended December 31,
--------------------------------------------------------
2001 2000 1999 1998 1997
---------- ---------- ---------- --------- ---------
OPERATING RESULTS:
Revenue $1,379,503 $1,296,237 $1,096,841 $763,908 $ 500,501
---------- ---------- ---------- --------- ---------
Income (loss) from
operations 119,277 (436,321) (2,513) (36,451) 23,303
---------- ---------- ---------- --------- ---------
Interest expense 56,546 62,302 45,691 33,355 14,302
---------- ---------- ---------- --------- ---------
Income (loss) before
Extraordinary item
and cumulative effect
of a change in
accounting principle 100,416 (530,040) (49,858) (50,464) 5,559
---------- ---------- ---------- --------- ---------
Net income (loss) 100,416 (530,040) (51,302) (50,464) 4,996
---------- ---------- ---------- --------- ---------
Net Income (Loss)
Per Share Before
Extraordinary Item
and Cumulative
Effect of a Change
in Accounting
Principle:
Basic $ 2.05 $(11.48) $(1.09) $(1.30) $0.15
Diluted 1.90 (11.48) (1.09) (1.30) 0.15
---------- ---------- ---------- --------- ---------
Net Income (Loss)
Per Share:
Basic $ 2.05 $(11.48) $(1.13) $(1.30) $0.14
Diluted 1.90 (11.48) (1.13) (1.30) 0.13
---------- ---------- ---------- --------- ---------
- -----------------------------------------------------------------------------
BALANCE SHEET DATA:
Rental inventory, net $191,016 $168,462 $339,912 $259,255 $226,051
Property and
equipment, net 270,586 323,666 382,345 328,182 234,497
Total assets 718,544 665,114 1,053,291 936,330 691,165
Long-term
obligations(1) 514,002 536,401 533,906 392,145 233,496
Shareholders' equity
(deficit) (113,554) (222,377) 304,529 347,591 291,938
- -----------------------------------------------------------------------------
Year Ended December 31,
-------------------------------------------------------
2001 2000 1999 1998 1997
---------- ---------- ---------- --------- --------
OPERATING DATA:
Number of stores at
year end 1,801 1,818 1,615 1,260 907
Weighted average stores
open during the year 1,813 1,751 1,405 1,074 694
Comparable store
revenue increase (2) 6% 2% 12% 8% 3%
- -----------------------------------------------------------------------------
OTHER DATA:
Hollywood superstores
EBITDA (3) 366,453 176,942 265,787 168,158 162,445
Reconciliation to
Adjusted EBITDA (4)
-Add special
charges (5) (7,034) 44,673 26,885 99,910 26,320
-Add non-cash
expenses (6) 88,058 126,260 49,627 51,143 18,022
-Less existing
Store investment
in new release
inventory (7) (252,749) (173,787) (137,794) (189,814) (125,301)
---------- ---------- ---------- -------- --------
Hollywood superstores
Adjusted EBITDA 194,728 174,088 204,505 129,397 81,486
Reel.com EBITDA(8) - (29,834) (46,902) (7,322) -
---------- ---------- ---------- -------- --------
Consolidated Adjusted
EBITDA 194,728 144,254 157,603 122,075 81,486
========== ========== ========== ======== ========
Cash flows generated
from (used in):
Operating activities 273,793 248,871 177,151 246,641 176,478
Investing activities (216,949) (255,822) (320,338) (438,411) (338,120)
Financing activities (21,302) 3,278 146,153 191,836 152,702
- ----------------------------------------------------------------------------
(1) Includes the current portion of long-term obligations.
(2) A store is comparable after it has been open and owned by the Company
for 12 full months. An acquired store converted to the Hollywood Video
name store design is removed from the comparable store base when the
conversion process is initiated and returned 12 full months after
reopening.
(3) EBITDA represents income (loss) from operations, before interest, tax,
depreciation and amortization. EBITDA should not be viewed as a measure
of financial performance under Generally Accepted Accounting Principles
(GAAP) or as a substitute for GAAP measurements, such as net income or
cash flow from operations. This calculation of EBITDA is not necessarily
comparable to reported EBITDA of other companies due to the lack of a
uniform definition of EBITDA. Hollywood superstores EBITDA excludes
Reel.com EBITDA.
(4) Adjusted EBITDA represents income (loss) from operations, before interest,
tax, depreciation and amortization ("EBITDA"), plus certain special
charges, plus non-cash expenses minus, the cost of replenishing new
release rental inventory for existing stores, which is capitalized.
Adjusted EBITDA should not be viewed as a measure of financial performance
under GAAP or as substitute for GAAP measurements such as net income or
cash flow from operations. Our calculation of Adjusted EBITDA is not
necessarily comparable to reported Adjusted EBITDA of other companies due
to the lack of uniform definitions of EBITDA and Adjusted EBITDA.
Hollywood superstores Adjusted EBITDA excludes Reel.com Adjusted EBITDA.
(5) These special charges include:
-2001: $3.3 million reversal of an accrual for restructuring expenses for
the closure of Reel.com and $3.8 million reversal of an accrual for
restructuring expenses related to the 2000 Store Closure Plan.
-2000: $11.1 million accrued for the settlement of revenue sharing
contract disputes, $10.5 million accrued for the settlements of pending
litigation, $9.5 million accrued for lease termination fees, $7.3 million
accrued for store closure costs, $3.5 million for unearned retention
bonuses paid to key members of management and $2.7 million in severance
agreements;
-1999: litigation settlement charges of $25.4 million related to the
settlement of lawsuits with Twentieth Century Fox Home Entertainment and
Rentrak Corporation and a $1.4 million charge for the cumulative effect
of a change in accounting principle (see Note 1 to the Consolidated
Financial Statements);
-1998: an inventory write-down of $99.9 million;
-1997: a litigation settlement of $18.9 million, an inventory write-down
of $2.3 million, $4.6 million related to a failed self-tender offer, and
$.6 million from a loss on early extinguishment of debt.
(6) Expenses which were non-cash in nature including tape loss, the book
cost of previously-viewed movies sold, accounts receivable reserves, net
loss on long-term asset disposals and write-downs of merchandise inventory
to net realizable value.
(7) This represents existing store purchases of new release tapes, games and
DVD's that are considered investing activities on the statement of cash
flows. This is in addition to the cost of product represented by revenue
sharing expense already included in the statement of operations.
(8) The year 2000 excludes the restructuring charge of $67.7 million for the
discontinuation of e-commerce operations (see Note 11 to the Consolidated
Financial Statements).
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with generally accepted accounting principles (GAAP) requires us to make
judgments, assumptions and estimates that affect the amounts reported in the
Consolidated Financial Statements and accompanying notes. Note 1 to the
Consolidated Financial Statements describes the significant accounting policies
and methods used in the preparation of the Consolidated Financial Statements.
Our judgments, assumptions and estimates affect, among other things, the
amounts of: receivables; rental and merchandise inventories; property and
equipment, net; goodwill, net; deferred income tax assets; other liabilities;
revenue; cost of revenue; and operating costs and expenses. We base our
judgments, assumptions and estimates on historical experience and on various
other factors that we believe to be reasonable under the circumstances. Actual
results could differ significantly from amounts based on our judgments,
assumption and estimates. The following critical accounting policies involve
significant judgments, assumptions and estimates, which affect amounts recorded
in the Consolidated Financial Statements.
Revenue Recognition
We recognize revenue upon the rental and sale of our products. Rental revenue
for extended rental periods (when the customer chooses to keep the product
beyond the original rental period) is recognized when the extended rental
period begins. Revenue recorded for extended rental periods is net of estimated
amounts that we do not anticipate collecting based upon historical collection
experience. We continuously monitor actual collections. Estimates are revised
when we believe it is appropriate in light of actual collection rates and other
relevant circumstances. Historically, actual collections have approximated the
related net revenue recorded. However, if actual collections in the future are
less than the related net revenue recorded, our results of operations would be
adversely affected.
Amortization of Rental Inventory
Rental inventory, which includes VHS videocassettes, DVDs and video games, is
stated at cost and amortized over its estimated useful life to an estimated
residual value. Our estimates of useful lives and residual values affect the
amounts of amortization recorded, which in turn affects the carrying value of
our rental inventory and cost of rental (and, upon the transfer of previously
viewed items from rental inventory to merchandise inventory, the carrying value
of our merchandise inventory and cost of product). For new release tapes
acquired for rental under revenue sharing arrangements, the studios' share of
rental revenue is expensed as revenue is earned net of an average estimated
interim residual value. Tapes, DVDs and video games acquired for rental at
fixed prices are amortized to estimated interim residual values in four months
and then to estimated ending residual values over their remaining estimated
useful lives. Purchases of catalog products are amortized on a straight-line
basis over their estimated useful lives to their estimated ending residual
values. Due to the numerous variables associated with the judgments and
assumptions we make in estimating useful lives and residual values of these
items, and the effects of changes in circumstances affecting these estimates
(including the effects of competing products and technologies and actual
selling prices obtainable for previously viewed product), both the precision
and reliability of the resulting estimates are subject to substantial
uncertainties and, as additional information becomes known, we may change our
estimates significantly. For example, in the fourth quarter of 2000, a number
of observations led us to change our estimates of rental inventory lives and
residual values, which resulted in a $164.3 million increase to amortization
expense in that quarter (see Note 5 to the Consolidated Financial Statements).
Impairment of Long-Lived Assets and Goodwill
We review long-lived assets and goodwill for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. We periodically review and monitor our internal management
reports for indicators of impairment. We consider a trend of unsatisfactory
operating results that are not in line with management's expectations to be a
primary indicator of potential impairment. When an indicator of impairment is
noted, assets are evaluated for impairment at the lowest level for which there
are identifiable cash flows (e.g., at the store level). We deem a store to be
impaired if a forecast of undiscounted future operating cash flows directly
related to the store, including estimated disposal value, if any, is less than
the asset carrying amount. If a store is determined to be impaired, the loss
is measured as the amount by which the carrying amount on our balance sheet of
the store exceeds its fair value. Fair value is estimated using a discounted
future cash flow valuation technique similar to that used by management in
making a new investment decision. Considerable management judgment and
assumptions are necessary to estimate discounted future cash flows. Due to the
numerous variables associated with our judgments and assumptions relating to
the valuation of our assets in these circumstances, and the effects of changes
in circumstances affecting these valuations, both the precision and reliability
of the resulting estimates of the related impairment charges are subject to
substantial uncertainties and, as additional information becomes known, our
estimates may change significantly.
Income Taxes
We calculate 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 our financial statements and tax returns. Valuation allowances are
established when necessary to reduce deferred tax assets, including temporary
timing differences and net operating loss carryforwards, to the amount expected
to be realized in the future. In the fourth quarter of 2000, in light of
significant doubt that existed regarding our future income and therefore our
ability to use our net operating loss carryforwards, we recorded a $211.2
million valuation allowance on our $211.2 million net deferred tax asset. In
2001, as a result of our operating performance for the year, as well as
anticipated future operating performance, we determined that it was more likely
than not that certain future tax benefits would be realized. As such, we
reversed $63.4 million of this valuation allowance, which resulted in a $63.4
million increase in net income and a corresponding decrease in our
shareholders' deficit. The valuation allowance of $147.8 million as of December
31, 2001 represents an allowance for the uncertainty as to the future
realization of deferred tax assets based upon our revised expectations. While
changes in the valuation allowance have no effect on the amount of income tax
we pay or on our cash flows, the effects on our reported income and
shareholders' equity may be viewed by some investors and potential lenders as
significant. Due to the numerous variables associated with our judgments,
assumptions and estimates relating to the valuation of our deferred tax assets,
and the effects of changes in circumstances affecting these valuations, both
the precision and reliability of the resulting estimates are subject to
substantial uncertainties and, as additional information becomes known, we may
change our estimates significantly.
Legal Contingencies
Our estimates of our loss contingencies for legal proceedings are based on
various judgments and assumptions regarding the potential resolution or
disposition of the underlying claims and associated costs. Due to the numerous
variables associated with these judgments and assumptions, both the precision
and reliability of the resulting estimates of the related loss contingencies
are subject to substantial uncertainties. We regularly monitor our estimated
exposure to these contingencies and, as additional information becomes known,
may change our estimates significantly.
RESULTS OF OPERATIONS
Summary Results of Operations
Our net income for 2001 was $100.4 million compared to a net loss of $530.0
million in 2000 and a net loss of $51.3 million in 1999. The improvement in
operating results was primarily the result of improved operating performance in
our existing store base, adjustments to our valuation allowance on our net
deferred income tax asset (see Note 17 to the Consolidated Financial
Statements) and closing down the e-commerce operations at Reel.com in June of
2000. The large net loss in 2000 was primarily the result of special charges
summarized in Note 21 to the Consolidated Financial Statements.
The following table sets forth (i) results of operations data expressed as a
percentage of total revenue and (ii) gross margin data.
Year Ended December 31,
------------------------------
2001 2000 1999
-------- -------- --------
Revenue:
Rental revenue 82.7% 82.6% 81.5%
Product sales 17.3% 17.4% 18.5%
-------- -------- --------
100.0% 100.0% 100.0%
-------- -------- --------
Cost of revenue:
Cost of rental 27.2% 44.8% 25.4%
Cost of product 12.3% 15.8% 14.1%
-------- -------- --------
39.5% 60.6% 39.5%
-------- -------- --------
Gross margin 60.5% 39.4% 60.5%
Operating costs and expenses:
Operating and selling 45.0% 55.0% 47.7%
General and administrative 7.0% 8.5% 7.8%
Restructuring charge for closure
of internet business (0.2%) 3.6% -
Restructuring charge for store
closures (0.3%) 1.3% -
Amortization of intangibles 0.4% 4.6% 5.2%
-------- -------- --------
51.9% 73.0% 60.7%
-------- -------- --------
Income (loss) from operations 8.6% (33.6%) (0.2%)
Nonoperating expense (4.0%) (4.8%) (4.2%)
-------- -------- --------
Income (loss) before income taxes
and cumulative effect adjustment 4.6% (38.4%) (4.4%)
(Provision for) benefit from income
taxes 2.7% (2.4%) (0.2%)
-------- -------- --------
Income (loss) before cumulative
effect adjustment 7.3% (40.8%) (4.6%)
Cumulative effect of a change in
accounting principle - - (0.1%)
-------- -------- --------
Net income (loss) 7.3% (40.8%) (4.7%)
======== ======== ========
- ----------------------------------------------------------------------
Other data:
Rental gross margin (1) 67.1% 45.8% 68.8%
Product gross margin (2) 29.0% 9.2% 23.8%
- ----------------------------------------------------------------------
(1) Rental gross margin as a percentage of rental revenues.
(2) Product gross margin as a percentage of product revenues.
REVENUE
Revenue increased by $83.3 million, or 6.4%, in 2001 compared to 2000,
primarily due to an increase of 6% in comparable store revenue. Also favorably
impacting revenue was an additional 62 weighted average number of stores. The
closure of Reel.com in June 2000, which had total revenue of $26.3 million in
2000, unfavorably impacted revenue. Revenue increased by $199.4 million, or
18.2% in 2000 compared to 1999, primarily due to the addition of 203 new
superstores in 2000. Revenue was also favorably impacted by an increase of 2%
in comparable store revenue in 2000. We ended 2001 with 1,801 superstores
operating in 47 states, compared to 1,818 stores operating in 47 states at the
end of 2000 and 1,615 stores operating in 44 states at the end of 1999. We
currently offer a 5-day rental program on all products in the majority of our
stores. New release videos and all DVDs rent for $3.79. Catalog videos rent for
$1.99. Since the fourth quarter of 1999, we have not increased prices on new
release videos, DVDs and catalog videos. Video games rent for $4.99 and $5.99,
with the newer platforms renting for the higher amount. Customers who choose
not to return movies within the applicable rental period are deemed to have
commenced a new rental period of equal length at the same price. Rental
revenue from initial rental periods was $801 million, $937 million and $991
million for 1999, 2000 and 2001, respectively. Rental revenue from extended
rental periods was $93 million, $134 million and $150 million for 1999, 2000
and 2001, respectively.
GROSS MARGIN
Rental Margins
Rental gross margin as a percentage of rental revenue increased to 67.1% in
2001 from 45.8% in 2000. During the fourth quarter of 2000, we made several key
observations that led us to change estimates regarding rental inventory lives
and residual values. As a result of the growing demand for DVDs, the estimated
residual value of catalog VHS cassettes was reduced from $6.00 to $2.00 and the
estimated useful life was reduced from five years to one year. We adopted the
changes in estimate prospectively on October 1, 2000, and recorded a charge of
$164.3 million. By applying these changes prospectively, we also recorded
incremental depreciation expense of approximately $52 million and $18 million
in the fourth quarter of 2000, and in the first three quarters of 2001,
respectively. Excluding the charge and the respective incremental depreciation
expense amounts, margins increased to 68.7% in 2001 from 66.0% in 2000
primarily due to a shift in revenue from VHS to DVDs, which typically have
higher margins.
Rental gross margin as a percentage of rental revenue decreased to 45.8% in
2000 from 68.8% in 1999, primarily due to the charge and incremental
depreciation associated with the change in estimates discussed above.
Product Margins
Product gross margin as a percentage of product sales increased to 29.0% in
2001 from 9.2% in 2000. Product margins in 2000 were negatively impacted by a
$20.8 million charge for the discontinuation of e-commerce operations at
Reel.com and a $8.6 million charge to value the inventory on hand at December
31, 2000 at the lower of cost or net realizable value. Excluding the operations
of Reel.com and the $8.6 million charge, product margins increased to 29.0% in
2001 from 24.4% in 2000, primarily due to improved margins on previously-viewed
movie sales. Compared to 2000, margins on previously-viewed product for 2001
increased due to the depreciation change in estimate, which resulted in lower
residual values being charged to cost of product sales.
Product gross margin as a percentage of product sales decreased to 9.2% in 2000
from 23.8% in 1999, primarily due to the charges noted above. Excluding the
operations of Reel.com and the $8.6 million charge, product margins decreased
to 24.4% in 2000 from 31.8% in 1999, primarily due to a decrease in the average
sales price of previously-viewed movies for sale.
OPERATING COSTS AND EXPENSES
Operating and Selling
Total operating and selling expenses of $621.3 million in 2001 decreased $92.1
million from $713.4 million in 2000. Total operating and selling expenses as a
percentage of total revenues decreased to 45.0% in 2001 from 55.0% in 2000.
Impacting operating and selling expense in 2000 was a $44.3 million charge for
impaired property and equipment (See Note 8 to Consolidated Financial
Statements) and Reel.com operating expenses of $27.4 million. Excluding the
impairment charge and operating expenses of Reel.com, operating and selling
expenses decreased $20.4 million for 2001 as compared to 2000. The decrease was
driven by decreases in advertising expense of $20.5 million, other operating
and selling expenses of $11.9 million and depreciation expense of $8.0 million,
which were partially offset by an increase in store wages of $11.8 million and
occupancy costs of $8.2 million. The decrease in advertising expense was the
result of the discontinuation of a mass media advertising campaign that ran in
2000. In 2001, we returned to a more cost-effective direct mail strategy. The
increases in store wages and occupancy costs were primarily due to the addition
of 62 weighted average stores when compared to the prior year.
Total operating and selling expenses of $713.4 million in 2000 increased $190.7
million from $522.7 million in 1999. Total operating and selling expenses as a
percentage of total revenues increased to 55.0% in 2000 from 47.7% in 1999. The
increase in total operating and selling expenses was due to increases in
depreciation expense of $57.0 million (primarily caused by the impairment
charge noted above), store wages of $44.9 million, occupancy costs of $42.3
million, advertising expenses of $24.4 million, and other store operating
expenses of $33.6 million, which were offset by an $11.4 million decrease in
expenses incurred by Reel.com. The decrease in Reel.com expenses was primarily
due to operating Reel.com for six months in 2000 compared to the entire year in
1999. The increases in store wages, occupancy costs, and other store operating
expenses were primarily due to the increase in the number of superstores
operated by us. We operated 1,818 superstores at December 31, 2000 compared
with 1,615 superstores at the end of 1999. Advertising expense was higher due
to an increase in national television campaigns as compared to prior years.
Restructuring for Closure of Internet Business
On June 12, 2000, we announced that we would close down the e-commerce business
of Reel.com. Although we had developed a leading web-site over the seven
quarters after Reel.com was purchased in October of 1998, Reel.com's business
model of rapid customer acquisition led to large operating losses and required
significant cash funding. Due to market conditions, we were unable to obtain
outside financing for Reel.com, and could not justify continued funding from
our superstore cash flow. On June 13, 2000, we terminated the employment of
approximately 200 of Reel.com's 240 employees, and paid $1.9 million in
involuntary termination benefits. The remaining employees have since been
terminated or integrated into Hollywood Entertainment.
As a result of the discontinuation of Reel.com's e-commerce operations, we
recorded a total charge of $69.3 million in the second quarter of 2000, of
which $48.5 million was classified as a restructuring charge on the
consolidated statement of operations and $20.8 million was included in cost of
product sales. The charge was reduced by $1.6 million to $46.9 million in the
fourth quarter of 2000, and also reduced by $3.3 million to $43.6 million in
the fourth quarter of 2001, because we were able to negotiate termination of
certain obligations and lease commitments more favorably than originally
anticipated.
The restructuring charge line item included $1.9 million of severance and
benefits paid on June 13, 2000, $19.3 million of asset impairment charges, and
$22.4 million (net of reductions) of accrued liabilities. The asset impairment
charges included $14.9 million to write off the remaining goodwill associated
with the acquisition of Reel.com, and $4.4 million to write down equipment,
leasehold improvements, prepaid expenses and accounts receivable to their net
realizable values. Amounts accrued included $17.3 (net of reductions) million
for contractual obligations, lease commitments and anticipated legal claims
against the Company and $5.1 (net of reductions) million for legal, financial,
and other professional services incurred as a direct result of the closure of
Reel.com. As of December 31, 2001, we had paid $7.4 million of the accrued
amounts.
Restructuring charge for store closures
In December 2000, we approved a restructuring plan involving the closure and
disposition of 43 stores that were not operating to our expectations (the
"Restructuring Plan"). In the fourth quarter of 2000, we recorded charges
aggregating $16.9 million, including an $8.0 million write down of property and
equipment, a $1.5 million write down of goodwill and an accrual for store
closing costs of $7.4 million. The established reserve for store closing costs
is for lease termination fees and other store closure costs. We have
liquidated, and plan to continue liquidating, related store inventories through
store closing sales; any remaining product will be used in other stores.
Revenue during the years ended December 31, 2000 and 1999 for the stores
included in the Restructuring Plan was approximately $15.5 million and $13.4
million, respectively. Operating income or loss (defined as income or loss
before interest expense and income taxes) during the years ended December 31,
2000 and 1999 for the stores included in the Restructuring Plan were
approximately $1.8 million loss and $0.5 million loss, respectively. For the
twelve months ended December 31, 2001 these stores recorded a combined
operating loss of $2.5 million that is included in the Consolidated Statement
of Operations.
As of December 31, 2001, we had closed 12 of the 43 scheduled stores that we
included in the Restructuring Plan. We incurred $329,867 in expenses during the
twelve months ended December 31, 2001 related to the closures and received
$450,000 to exit one of the leases.
In December of 2001, we amended the Restructuring Plan and removed 16 stores
from the closure list. We anticipate closing the remaining 15 stores in 2002.
In accordance with the amended plan, and updated estimates of closing costs, we
reversed $3.8 million of the original $16.9 million charge, leaving a $3.7
million accrual balance at December 31, 2001 for store closing costs.
General and Administrative
Total general and administrative expenses of $96.4 million in 2001 decreased
$13.8 million from $110.2 million in 2000. Total general and administrative
expenses as a percentage of total revenue decreased to 7.0% in 2001 compared to
8.5% in 2000. Included in general and administrative expenses in 2000 were
employee loans written off or fully reserved for as doubtful for $17.3 million;
reserves established for pending litigation for $10.5 million and Reel.com
general and administrative expenses of $5.1 million. Included in general and
administrative expenses in 2001 were $4.8 million of non-cash compensation
expense related to a stock grant to our Chief Executive Officer as part of a
three-year employment agreement. Also included was $4.1 million of non-cash
stock compensation associated with other grants under our stock option plans.
Excluding the adjustments noted above, general and administrative expenses
increased as a percentage of revenue to 6.3% in 2001 compared to 6.0% in the
prior year. We made the decision to invest in certain elements of the
business, such as the store field supervision structure, the loss prevention
function and human resources. We believe these investments will have a direct
impact on the business by improving the level of execution.
Total general administrative expenses of $110.2 million increased $24.3 million
from $85.9 million in 1999. Total general and administrative expenses as a
percentage of total revenue increased to 8.5% in 2000 compared to 7.8% in 1999.
Included in general and administrative expenses in 1999 is a special charge of
$25.4 million for legal and settlement charges associated with the settlement
of two lawsuits. Excluding these charges, general and administrative expenses
increased by $49.7 million in 2000, primarily due to employee loans written off
or fully reserved for as doubtful, other payroll and related costs, and
establishing reserves for pending litigation, offset by a $2.1 million decrease
in overhead costs associated with Reel.com. The decrease in Reel.com expenses
was primarily due to operating Reel.com for only six months in 2000 compared to
the entire year in 1999.
Amortization of Intangibles
Amortization of intangibles decreased by $54.9 million in 2001 compared to
2000. The decrease was primarily due to an impairment charge of $30.0 million
taken in the fourth quarter of 2000 related to acquired store goodwill as
discussed in Note 8 to the Consolidated Financial Statements and the closure in
June of 2000 of Reel.com, which had $22.7 million of amortization expense in
the prior year. See Note 11 to the Consolidated Financial Statements for a
discussion of the discontinuation of Reel.com's e-commerce operations and the
resulting charges.
Amortization of intangibles increased by $3.0 million in 2000 compared to 1999,
primarily due to an impairment charge of $30 million related to goodwill on
several acquired stores as discussed in Note 8 to the Consolidated Financial
Statements, as partially offset by a decrease in amortization of goodwill
associated with the Reel.com acquisition.
NON-OPERATING INCOME (EXPENSE), NET
Interest expense, net of interest income, decreased in 2001 compared to 2000,
primarily due to decreased levels of revolving credit borrowings and lower
interest rates. Interest expense, net of interest income, increased in 2000
compared to 1999, due to increased revolving credit borrowings and higher
interest rates and the issuance in June 1999 of an additional $50 million of
10 5/8% senior subordinated notes.
INCOME TAXES
Our effective tax rate was a benefit of 59.0% in 2001 compared to a provision
of 6.3% in 2000 and a provision of 3.9% in 1999 which varies from the federal
statutory rate as a result of non-deductible executive compensation, net non-
deductible option grant compensation, non-deductible goodwill amortization
associated with the Reel.com acquisition, state income taxes and deferred tax
valuation allowances. Valuation allowances reduce deferred income tax balances
to the approximate amount of recoverable income taxes based on assessments of
taxable income within the carryback or carryforward periods for each year.
CHANGE IN EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE
In April 1998, SOP 98-5, "Reporting on the Cost of Start-up Activities" was
finalized, which requires that cost incurred for start-up activities, such as
store openings, be expensed as incurred. We adopted SOP 98-5 effective January
1, 1999. The cumulative effect of the change in accounting principle was to
increase net loss by $1.4 million, net of tax benefit.
LIQUIDITY AND CAPITAL RESOURCES
Overview
During 2000, we experienced a number of significant events with respect to our
liquidity and capital situation. We began the year growing at the average rate
of one store per day, as well as funding significant cash losses at Reel.com.
In order to meet the funding needs to continue at this growth rate, our then-
existing $300.0 million revolving credit facility needed to be expanded or
refinanced. During early 2000, we attempted to refinance this facility. In
March 2000, we received an underwritten commitment from a group of banks for a
new $375.0 million credit facility. However, syndication of this new facility
failed in May 2000 primarily due to market conditions (including lenders'
concerns with losses at Reel.com and the business of Internet companies
generally) and the significant capital needed to fund our aggressive growth.
Without the availability of new funding, we were faced with a requirement to
begin reducing the maximum borrowing capacity under the $300.0 million
revolving credit facility, starting with a $37.5 million reduction on December
5, 2000 and quarterly reductions of $37.5 million in each quarter thereafter,
and to make such payments as would be necessary to cause the borrowings
outstanding under the facility to be less than or equal to the reduced
borrowing capacity. In order to meet this obligation, we needed to make
significant changes to our growth plans.
As part of these changes, in June of 2000, we closed the e-commerce business at
Reel.com, thereby stopping its cash losses. Furthermore, we made the decision
to curtail our new store growth and not sign new leases for the remainder of
the year. We believe that by discontinuing Reel.com's e-commerce operations
(which were losing money at an annual run rate of approximately $60.0 million
in early 2000), and by largely curtailing our new store growth (in which we
were investing at an annual run rate of approximately $140.0 million in early
2000), we have substantially reduced our ongoing uses of cash from that of
early 2000 and before.
On June 8, 2000, we obtained a waiver for non-compliance with certain covenants
under the revolving credit facility, including a leverage ratio covenant and a
covenant regarding loans to affiliated persons. This temporary waiver was
extended on June 20, 2000 and again on July 28, 2000. The revolving credit
facility was amended on August 4, 2000 to permanently amend these covenants. As
consideration for the requested amendment, we agreed to certain new covenants
which, among other things, placed restrictions on capital expenditures and
store growth. These amendments did not affect the amortization schedule of the
revolving credit facility.
As of December 31, 2000, we were in violation of covenants under the revolving
credit facility regarding our tangible net worth ratio, our leverage ratio and
our interest coverage ratio. Although we obtained a waiver for the violations,
the waiver was scheduled to expire on May 5, 2001. Because it was probable we
would incur covenant violations after May 5, 2001 without a restructured
agreement, in accordance with FAS 78, Classification of Obligations That Are
Callable by the Creditor, we reclassified $112.5 million of borrowings under
the revolving credit facility as current liabilities on our consolidated
balance sheet as of December 31, 2000, such that the entire $245.0 million of
borrowings then outstanding under the revolving credit facility were classified
as current liabilities as of that date. As a result of the uncertainty
regarding our ability to negotiate a permanent amendment to the revolving
credit facility and the fact that we had net losses in 2000, 1999, and 1998 and
at December 31, 2000 had a shareholders deficit of $222.4 million, our
independent accountants included a going concern paragraph in their report on
our Consolidated Financial Statements for 2000.
Because it was doubtful that we would be able to meet the scheduled 2001
revolving credit facility amortization of $150.0 million, we began negotiating
a restructured amortization schedule with our lenders. On March 6, 2001, we
made a $6.0 million amortization payment and our lenders agreed to defer $31.5
million of the $37.5 million total due on that date until May 5, 2001. During
the deferral period we and our lenders worked toward a permanent change in the
amortization schedule to better match bank debt pay-down with our business
plan. On May 5, 2001, we made a $1.0 million amortization payment and our
lenders agreed to defer $30.5 until June 5, 2001.
On June 5, 2001, we amended our revolving credit facility and, in connection
therewith, paid to the lenders fees of approximately $3.8 million. The
amendment extended the maturity of the facility from September 5, 2002 to
December 23, 2003, and created a new amortization payment schedule. In
connection with the amendment, $201.5 million of the borrowings outstanding
under the revolving credit facility were reclassified as long-term obligations
on the consolidated balance sheet as of June 30, 2001. As a result of the
amendment, our independent accountants removed the going concern paragraph from
their report. The interest rate applicable to borrowings under the amended
facility was set at IBOR plus 5.0%, subject to reduction upon the achievement
of specified performance targets.
We generate substantial operating cash flow because most of our revenue is
received in cash from the rental and sales of videocassettes, DVDs and games.
The amount of cash generated from operations in 2001 funded our debt service
requirements and all capital expenditures with sufficient cash left over to
reduce accounts payable by $32.9 million. At December 31, 2001 we had $38.8
million of cash and cash equivalents on hand.
On December 7, 2001, we filed with the Securities and Exchange Commission a
shelf registration statement covering up to $110,000,000 of our common stock
(together with up to an additional $16,500,000 of our common stock for purposes
of satisfying any over-allotment options) and up to $300,000,000 of non-
convertible debt securities. On December 10, 2001, we announced that we
received a fully underwritten commitment from UBS Warburg LLC for a new bank
credit facility. On February 14, 2002 the shelf registration statement became
effective.
On March 11, 2002, we completed a public offering of 8,050,000 shares of our
common stock resulting in proceeds of $120.8 million before underwriting fees
and expenses, of which $114 million was applied to the repayment of borrowings
under our prior revolving credit facility.
On March 18, 2002, we obtained new senior bank credit facilities from a
syndicate of lenders led by UBS Warburg LLC consisting of a $150.0 million
senior secured term facility maturing in 2004 and a $25.0 million senior
secured revolving credit facility maturing in 2004. We applied a portion of
initial borrowings thereunder to repay all remaining borrowings under our prior
revolving credit facility (which was then terminated). The maturity of the new
facilities will automatically be extended to 2006 if our existing $250 million
senior subordinated notes are refinanced prior to February 2004 with a maturity
date beyond 2006 (which, subject to market conditions and other relevant
factors, we presently expect to accomplish through the issuance of new senior
subordinated notes in 2002 as contemplated in our shelf registration
statement). As a result of the early retirement of our prior revolving credit
facilities, we anticipate recording an extraordinary charge of approximately
$3.5 million in the first quarter of 2002.
The credit agreement governing the new facilities contains customary
representations, warranties, covenants (including financial covenants) and
events of default. The financial covenants, some of which may become more
restrictive over time, include a (1) maximum debt to adjusted EBITDA ratio, (2)
minimum interest coverage test, and (3) minimum fixed charge coverage test
(determined in each case on the basis of the definitions and other provisions
set forth in such credit agreement). Currently, these financial covenants
require us to maintain (1) a ratio of debt to adjusted EBITDA of 3.0 to 1.0 or
less, (2) a ratio of adjusted EBITDA to interest expense of 3.0 to 1.0 or
greater, and (3) a ratio of adjusted EBITDA, plus rent expense, to fixed
charges of at least 1.0 to 1.0.
We believe that our cash on hand, cash flow from operations, revolving credit
availability and other capital resources will be sufficient to fund the cash
requirements associated with our present operations for the foreseeable future.
We continue to analyze our strategic plan and capital structure and to consider
additional financing transactions, including possible issuances of debt
securities, as sources of incremental liquidity.
Cash Provided by Operating Activities
Net cash flow provided by operating activities increased by $25 million in 2001
compared to 2000. Excluding the effects of changes in accounts payable, our net
cash flow from operations would have increased by $137 million or 81% in 2001.
The increase was due to the discontinuation of e-commerce operations at
Reel.com and improved operating performance in our existing store base. The
increase was partially offset by net pay-downs of accounts payable in 2001 of
$33 million compared to a net increase in accounts payable in 2000 of $79
million.
We lease all of our stores, corporate offices, distribution centers and zone
offices under non-cancelable operating leases. All of our 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. At December 31, 2001, the future
minimum annual rental commitments under non-cancelable operating leases were as
follows:
------------------------------
Operating
Year Ending Leases
December 31, (in thousands)
------------------------------
2002 217,491
2003 215,895
2004 210,362
2005 199,976
2006 179,808
Thereafter 538,020
Cash Used in Investing Activities
Net cash used in investing activities decreased by $39 million, or 15%, from
$256 million in 2000 to $217 million in 2001. The decrease is primarily due to
fewer new store openings in 2001. We opened 208 new stores in 2000 and only
six stores in 2001.
Following is a table summarizing our cash used in investing activities for the
last three years (in thousands):
2001 2000 1999
--------- --------- ---------
Rental Inventory:
New release replenishment $ 252,749 $ 173,787 $ 137,794
New store and other investments 24,401 75,636 93,696
Book value of transfers to merchandise
inventory and loss (74,360) (72,670) (45,613)
--------- --------- ---------
Purchases of rental inventory, net $ 202,790 $ 176,753 $ 185,877
--------- --------- ---------
Purchase of property and
equipment, net 8,802 77,639 112,258
Investment in businesses acquired - - 17,434
Increase in intangibles and other
assets 5,357 1,430 4,769
--------- --------- ---------
Total cash used in investing $ 216,949 $ 255,822 $ 320,338
========= ========= =========
New release replenishment includes the cost of purchases of new release video
tapes, DVDs and games for existing stores and the estimated interim residual
value of video tapes and DVDs acquired under revenue sharing arrangements (see
Note 4 to the Consolidated Financial Statements). It does not include net
revenue sharing expense included in cost of rental on the statement of
operations. Net revenue sharing expense was $191.3 million, $221.8 million and
$165.7 million for the years ended December 31, 2001, 2000 and 1999,
respectively. New store and other investments in rental product includes all
fixed price rental inventories for new store openings, major catalog inventory
enhancement projects, such as an expansion of DVD catalog, and other long-term
investments not considered new release replenishment.
Capital expenditures other than for product include expenditures for equipment,
fixtures, and leasehold improvements for new and existing stores, remodeling
projects, and implementing and upgrading office and store technology. We
anticipate that capital expenditures, other than purchases of rental inventory,
will be approximately $29.4 million in 2002, of which $21.8 million is
anticipated to relate to new, relocated or remodeled stores. The remaining
balance relates to corporate capital expenditures. We presently intend to seek
to open approximately 50 new stores during the remainder of 2002 and to
increase our store base by approximately 10% per year thereafter.
Cash Flow from Financing Activities
In 2001 our cash flow from financing activities was a net use of $21 million
compared to $3 million of net cash provided by financing activities in 2000.
The slowing of store growth coupled with an increase in cash provided by
operations allowed us to operate with internally generated cash flow instead of
outside financing. Over the course of 2001, we repaid $17 million of principal
on capital leases and reduced amounts outstanding under our prior credit
facility by $5 million. At December 31, 2001 the balance outstanding under our
prior revolving credit facility was at $240 million, or $1.5 million under the
maximum availability of $241.5 million. As of March 31, 2002, we had $25.0
million available under our new senior secured revolving credit facility.
Other Financial Measurements: Working Capital
At December 31, 2001, we had cash and cash equivalents of $39 million and a
working capital deficit of $271 million. The working capital deficit is
primarily the result of the accounting treatment of rental inventory as
discussed below. Other factors contributing to the deficit were the current
amounts due under our prior revolving credit facility and significant accrued
expenditures (see Note 13 to the Consolidated Financial Statements). Rental
inventories are accounted for as non-current assets under GAAP 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 our revenue, the classification of these
assets as non-current excludes them from the computation of working capital.
The acquisition cost of rental inventories, however, is reported as a current
liability until paid and, accordingly, included in the computation of working
capital. Consequently, we believe 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
rental inventory as a non-current asset, we will, more likely than not, operate
with a working capital deficit. We believe the current existence of a working
capital deficit does not affect our ability to operate our business and meet
obligations as they come due.
Other Financial Measurements: Adjusted EBITDA and Free Cash Flow
We believe other financial measurements, such as Adjusted EBITDA and Free Cash
Flow, as defined below, are additional measurements that are useful in
understanding our operating results, including our ability to meet our growth
plans and debt service requirements. These measurements should not be viewed as
a measure of financial performance under GAAP or as substitute for GAAP
measurements such as net income or cash flow from operations. Our calculation
of these measurements is not necessarily comparable to those reported by other
companies due to the lack of uniform definitions.
Adjusted EBTIDA represents income (loss) from operations, before interest, tax,
depreciation and amortization ("EBITDA"), plus certain special charges, plus
non-cash expenses, minus the cost of replenishing new release rental inventory
for existing stores, which is capitalized (see Item 6, Selected Financial Data,
for a reconciliation of EBITDA to Adjusted EBITDA). Following is a table
calculating Adjusted EBITDA for 2001 (in millions):
Income from operations $119.3
Depreciation and amortization 247.1
Special charges (accrual reversals) (7.0)
Non-cash expenses 88.0
New release replenishment (252.7)
------
Adjusted EBITDA 194.7
Free Cash Flow represents Adjusted EBITDA, less cash paid for interest, taxes,
investment capital expenditures (new store investments including construction
and product and new product platform rollouts) and maintenance capital
expenditures, other than the cost of replenishing new release rental inventory
for existing stores, which is included in the calculation of Adjusted EBITDA.
Following is a table calculating Free Cash Flow for 2001 (in millions):
Adjusted EBITDA $194.7
Less: cash interest (54.7)
Less: cash taxes paid (0.8)
Less: maintenance capital expenditures (6.4)
-----
Free Cash Flow before investment
capital expenditures 132.8
Less: investment capital expenditures (26.8)
------
Free Cash Flow $106.0
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note 1 to the Consolidated Financial Statements for a discussion of
recently issued accounting standards and the impact they may have on the
financial condition or results of operations.
GENERAL ECONOMIC TRENDS, QUARTERLY RESULTS AND SEASONALITY
We anticipate that our business will be affected by general economic and other
consumer trends. Future operating results may be affected by various factors,
including (i) variations in the number and timing of new store openings, (ii)
the performance of new or acquired stores, (iii) the quality and number of new
release titles available for rental and sale, (iv) additional and existing
competition, (v) marketing programs, (vi) the level of demand for movie and
video game rentals and purchases, (vii) the effects of changing and/or new
technology and intense competition, (viii) the prices for which we are able to
rent or sell our products, (ix) the costs and availability to us of newly-
released movies and video games, (x) changes in other significant operating
costs and expenses, (xi) the effects of our substantial indebtedness and the
limitations imposed by restrictive covenants contained in our debt instruments,
(xii) our ability to manage store expansions and growth, (xiii) acts of God or
public authorities, war, civil unrest, fire, floods, earthquakes, acts of
terrorism, the weather and other matters beyond our control.
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. We believe these
seasonality trends will continue.
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, that involve
substantial risks and uncertainties and which are intended to be covered by the
safe harbors created thereby. These statements can be identified by the fact
that they do not relate strictly to historical information and include the
words "expects", "believes", "anticipates", "plans", "may", "will", "intend",
"estimate", "continue" or other similar expressions. These forward-looking
statements are subject to various risks and uncertainties that could cause
actual results to differ materially from those currently anticipated. These
risks and uncertainties include, but are not limited to, items discussed below
under the heading "Cautionary Statements" and above under the heading "General
Economic Trends, Quarterly Results and Seasonality". Forward-looking
statements speak only as of the date made. We undertake no obligation to
publicly release or update forward-looking statements, whether as a result of
new information, future events or otherwise. You are, however, advised to
consult any further disclosures we make on related subjects in our quarterly
reports on Form 10-Q and any reports made on Form 8-K to the Securities and
Exchange Commission.
CAUTIONARY STATEMENTS
We are subject to a number of risks that are particular to our business and
that may or may not affect our competitors. We describe some of these risks
below. If any of these risks materializes, our business, financial condition,
liquidity and results of operations could be harmed, and the value of our
securities could fall.
We face intense competition and risks associated with technological
obsolescence, and we may be unable to compete effectively.
The home video and home video game industries are highly competitive. We
compete with local, regional and national video retail stores, including those
operated by Blockbuster, Inc., the largest video retailer in the United States,
and with mass merchants, specialty retailers, supermarkets, pharmacies,
convenience stores, bookstores, mail order operations, online stores and other
retailers, as well as with noncommercial sources, such as libraries.
Substantially all of our stores compete with stores operated by Blockbuster,
most in very close proximity. Some of our competitors have significantly
greater financial and marketing resources, market share and name recognition
than Hollywood. As a result of direct competition with Blockbuster and others,
pricing strategies for videos and video games is a significant competitive
factor in our business. Our home video and home video game businesses also
compete with other forms of entertainment, including cinema, television,
sporting events and family entertainment centers. If we do not compete
effectively with competitors in the home video industry or the home video game
industry or with providers of other forms of entertainment, our revenues and/or
our profit margin could decline and our business, financial condition,
liquidity and results of operations could be harmed.
We also compete with cable and direct broadcast satellite television systems.
These systems offer both movie channels, for which subscribers pay a
subscription fee for access to movies selected by the provider at times
selected by the provider, and pay-per-view services, for which subscribers pay
a discrete fee to view a particular movie selected by the subscriber.
Historically pay-per-view services have offered a limited number of channels
and movies, and have offered movies only at scheduled intervals. Today,
however, advances in digital compression and other developing technologies are
enabling cable and satellite companies, and may enable internet service
providers and others, to transmit a significantly greater number of movies to
homes at more frequently scheduled intervals throughout the day. In addition,
certain cable companies, internet service providers and others have tested and
are continuing to test video-on-demand services in some markets. As a concept,
video on demand would provide a subscriber with the ability to view any movie
included in a catalog of titles maintained by the provider at any time of the
day. If video on demand or other alternative movie delivery systems, whether
alone or in conjunction with sophisticated digital recording systems (which
allow viewers to record, pause, rewind and fast forward live broadcasts),
achieve the ability to enable consumers to conveniently view and control the
movies they want to see when they want to see them, such alternative movie
delivery systems could achieve a competitive advantage over the traditional
video rental industry. While we believe that there presently exist substantial
technological, economic and other impediments to alternative movie delivery
systems achieving such a competitive advantage, technological advances and
other developments could enable them to do so, which in turn could harm our
profitability and otherwise harm our business, financial condition, liquidity
and results of operations.
Changes in the way that movie studios price videocassettes and/or DVDs could
adversely affect our revenues and profit margins.
Movie studios use various pricing models to maximize the revenues they receive
for movies released to the home video industry. Historically, these pricing
models have enabled a profitable video rental market to exist and compete
effectively with mass retailers and other sellers of home videos. Initially,
the movie studios adopted a "rental pricing" model under which high initial
wholesale prices are established in order for the studios to maximize revenues
from rental retailers prior to setting prices at levels to create demand from
mass merchants. More recently, movie studios have entered into revenue sharing
arrangements (usually on a title-by-title basis) under which studios provide
movies to video rental retailers at reduced prices in exchange for a share of
rental revenues. Movie studios have also utilized "sell-through" pricing under
which lower wholesale prices generate more consumer demand for home video
purchases, but also result in an increase in profit margins on video rentals.
We can neither control nor predict with certainty whether the studios' pricing
policies will continue to enable us to operate our business as profitably as we
can under current pricing arrangements. If the studios were to significantly
change their pricing policies in a manner that increases our cost of obtaining
movies under revenue sharing arrangements or other arrangements, our revenues
and/or profit margin could decrease, and our business, financial condition,
liquidity and results of operations would be harmed.
We could lose a significant competitive advantage if the movie studios were to
adversely change their current distribution practices.
Currently, video stores receive movie titles approximately 30 to 90 days
earlier than pay-per-view, cable and satellite distribution companies. If
movie studios were to change the current distribution schedule for movie titles
such that video stores were no longer the first major distribution channel to
receive a movie title after its theatrical or direct-to-video release or to
provide for the earlier release of movie titles to competing distribution
channels, we could be deprived of a significant competitive advantage, which
could negatively impact the demand for our products and reduce our revenues and
could harm our business, financial condition, liquidity and results of
operations.
The video store industry could be adversely impacted by conditions affecting
the motion picture industry.
The video store industry is dependent on the continued production and
availability of motion pictures produced by movie studios. Any conditions that
adversely affect the motion picture industry, including constraints on capital,
financial difficulties, regulatory requirements and strikes, work stoppages or
other disruptions involving writers, actors or other essential personnel, could
reduce the number and quality of the new release titles in our stores. This in
turn could reduce consumer demand and negatively impact our revenues, which
would harm our business, financial condition, liquidity and results of
operations.
The failure of video game software and hardware manufacturers to timely
introduce new products could hurt our ability to attract and retain video game
rental customers.
We are dependent on the introduction of new and enhanced video games and game
systems to attract and retain video game rental customers. If manufacturers
fail to introduce or delay the introduction of new games and systems, the
demand for games available to us could decline, negatively impacting our
revenues, and our business, financial condition, liquidity and results of
operations could be harmed.
Expansion of our store base has placed and may place pressure on our operations
and management controls.
We have expanded the size of our store base and the geographic scope of
operations significantly since our inception. Between 1996 and 2000 we opened
an average of 306 stores per year. Although we have currently curtailed new
store openings, we intend to open new stores in the future. This expansion has
placed, and may continue to place, increased pressure on our operating and
management controls. To manage a larger store base, we will need to continue
to evaluate and improve our financial controls, management information systems
and distribution facilities. We may not adequately anticipate or respond to
all of the changing demands of expansion on our infrastructure. In addition,
our ability to open and operate new stores in a profitable manner depends upon
numerous contingencies, many of which are beyond our control. These
contingencies include:
- - our ability under the terms of the instruments governing our existing and
future indebtedness to make capital expenditures associated with new store
openings;
- - our ability to locate suitable store sites, negotiate acceptable lease
terms, and build out or refurbish sites on a timely and cost-effective
basis;
- - our ability to hire, train and retain skilled associates; and
- - our ability to integrate new stores into our existing operations.
We may also open stores in markets where we already have significant operations
in order to maximize our market share within these markets. If we do so, we
cannot assure you that these newly opened stores will not adversely affect the
revenues and profitability of those pre-existing stores in any given market.
We depend on key personnel whom we may not be able to retain; recent management
changes are unproven.
Our future performance depends on the continued contributions of certain key
management personnel. From late 2000 through mid-2001, we made significant
changes to our management personnel, including adding two new outside directors
to the board of directors, reinstating Mark J. Wattles, Hollywood's founder and
Chief Executive Officer, full-time as President, hiring Scott R. Schultze, who
subsequently became Executive Vice President and Chief Operating Officer,
hiring James A. Marcum as Executive Vice President and Chief Financial Officer
and restructuring other executive and senior management positions. These new
members of management may not be able to successfully manage our existing
operations and they may not remain with us. A loss of one or more of these key
management personnel, our inability to attract and retain additional key
management personnel, including qualified store managers, or the inability of
management to successfully manage our operations could prevent us from
implementing our business strategy and harm our business, financial condition,
liquidity or results of operations.
The failure of our management information systems to perform as we anticipate
could harm our business.
The efficient operation of our business is dependent on our management
information systems. In particular, we rely on an inventory utilization system
used by our merchandise organization and in our distribution centers to track
rental activity by individual videocassette, DVD and video game to determine
appropriate buying, distribution and disposition of videocassettes, DVDs and
video games. We use a scalable client-server system to maintain information,
updated daily, regarding revenue, current and historical rental and sales
activity, demographics of store membership, individual customer history, and
videocassette, DVD and video game rental patterns. We rely on these systems as
well as our proprietary point-of-sale and in-store systems to keep our in-store
inventories at optimum levels, to move inventory efficiently and to track and
record our performance. The failure of our management information systems to
perform as we anticipate could impair our ability to manage our inventory and
monitor our performance and harm our business, financial condition, liquidity
and results of operations.
Instruments governing our existing and future indebtedness contain or may
contain covenants that restrict our business.
Instruments governing our new bank credit facility (in which UBS Warburg is
acting as agent for the lenders thereunder, as well as a lender) and our
existing senior subordinated notes due 2004 contain, and our future
indebtedness may contain a number of significant covenants that, among other
things, significantly restrict our ability to:
- - open new stores;
- - incur additional indebtedness;
- - guarantee third-party obligations;
- - enter into capital leases;
- - create liens on assets;
- - dispose of assets;
- - repay indebtedness or amend indebtedness instruments;
- - make capital expenditures;
- - make investments, loans or advances;
- - make acquisitions or engage in mergers or consolidations; and
- - engage in certain transactions with our subsidiaries and affiliates.
We have a substantial amount of indebtedness and debt service obligations,
which could adversely affect our financial and operational flexibility and
increase our vulnerability to adverse conditions.
As of December 31, 2001 we had total consolidated long-term debt, including
capital leases, of approximately $514 million. This level of indebtedness
could increase in the future. Our substantial amount of indebtedness could
have important consequences to you. For example, it could:
- - require us to dedicate a substantial portion of our cash flow to payments
on our indebtedness;
- - limit our ability to borrow additional funds;
- - increase our vulnerability to general adverse economic and industry
conditions;
- - limit our ability to fund future working capital, capital expenditures and
other general corporate requirements;
- - limit our flexibility in planning for, or reacting to, changes in our
business and the industry in which we operate or taking advantage of
potential business opportunities;
- - limit our ability to execute our business strategy successfully; and
- - place us at a competitive disadvantage in our industry.
We and our subsidiaries may incur substantial additional indebtedness in the
future, including indebtedness that would be secured by our assets or those of
our subsidiaries. If new indebtedness is added to our and our subsidiaries'
current indebtedness levels, the related risks that we and they now face could
intensify.
Our ability to satisfy our indebtedness obligations will depend on our
financial and operating performance, which may fluctuate significantly from
quarter to quarter and is subject to economic, industry and market conditions
and to risks related to our business and other factors beyond our control.
We cannot assure you that our business will generate sufficient cash flow from
operations or that future borrowings will be available to us in amounts
sufficient to enable us to pay our indebtedness or to fund our other liquidity
needs. We may need to refinance all or a portion of our indebtedness, on or
before maturity. We cannot assure you that we will be able to refinance any of
our indebtedness, including the debt securities, on commercially reasonable
terms or at all.
Instruments governing our existing and future indebtedness contain or may
contain various covenants, including covenants requiring us to meet specified
financial ratios and tests. Our failure to comply with all applicable
covenants could result in our indebtedness being immediately due and payable.
The instruments governing our existing indebtedness contain various covenants
which, among other things, limit our ability to make capital expenditures and
require us to meet specified financial ratios, which generally become more
stringent over time, including a maximum leverage ratio and a minimum interest
and rent coverage ratio. The instruments governing our future indebtedness may
impose similar or other restrictions and may require us to meet similar or
other financial ratios and tests. Our ability to comply with covenants
contained in the instruments governing our existing and future indebtedness may
be affected by events and circumstances beyond our control. If we breach any
of these covenants, one or more events of default, including cross-defaults
between multiple components of our indebtedness, could result. These events of
default could permit our creditors to declare all amounts owing to be
immediately due and payable, and terminate any commitments to make further
extensions of credit. If we were unable to repay indebtedness owed to our
secured creditors, they could proceed against the collateral securing the
indebtedness owed to them.
We are subject to governmental regulations that impose obligations and
restrictions and may increase our costs.
We are subject to various U.S. federal and state laws that govern, among other
things, the disclosure and retention of our video rental records and access and
use of our video stores by disabled persons, and are subject to various state
and local licensing, zoning, land use, construction and environment
regulations. Furthermore, changes in existing laws, including environmental
and employment laws, new laws or increases in the minimum wage may increase our
costs.
Terrorist attacks, such as the attacks that occurred in New York and
Washington, D.C. on September 11, 2001, and other acts of violence or war may
affect the markets on which our common stock trades, the markets in which we
operate, our operations and our profitability.
Terrorist attacks and other acts of violence or war may negatively affect our
operations and your investment. There can be no assurance that there will not
be further terrorist attacks or other acts of violence or war against the
United States or United States businesses. Also, as a result of terrorism, the
United States has entered into armed conflict. These attacks or armed
conflicts may directly impact our physical facilities or those of our
suppliers. Furthermore, these attacks or armed conflicts may make travel and
the transportation of our supplies and products more difficult and more
expensive and ultimately affect our revenues.
More generally, any of these events could cause consumer confidence and
spending to decrease further or result in increased volatility in the United
States and worldwide financial markets and economy. They also could result in
economic recession in the United States or abroad. Any of these occurrences
could harm our business, financial condition or results of operations, and may
result in the volatility of the market price for our securities and on the
future price of our securities.
Our quarterly operating results will vary, which may affect the value of our
securities in a manner unrelated to our long-term performance.
Our quarterly operating results have varied in the past and we expect that they
will continue to vary in the future depending on a number of factors, many of
which are outside of our control. Factors that may cause our quarterly
operating results to vary include:
- - the level of demand for movie rentals and purchases;
- - existing and future competition from providers of similar products and
alternative forms of entertainment;
- - the prices for which we are able to rent or sell our products;
- - the availability and cost to us of newly-released movies;
- - changes in other significant operating costs and expenses;
- - weather;
- - seasonality;
- - variations in the number and timing of store openings;
- - the performance of newer stores;
- - acquisitions by us of existing video stores;
- - the success of new business initiatives;
- - other factors that may affect retailers in general;
- - changes in movie rental habits resulting from domestic and world events;
- - actual events, circumstances, outcomes and amounts differing from judgments,
assumptions and estimates used in determining the amount of certain assets
(including the amounts of related valuation allowances), liabilities and
other items reflected in our Consolidated Financial Statements; and
- - acts of God or public authorities, war, civil unrest, fire, floods,
earthquakes, acts of terrorism and other matters beyond our control.
Our securities may experience extreme price and volume fluctuations.
The market price of our securities has been and can be expected to be
significantly affected by a variety of factors, including:
- - public announcements concerning us, our competitors or the home video rental
industry;
- - fluctuations in our operating results;
- - introductions of new products or services by us or our competitors;
- - the operating and stock price performance of other comparable companies; and
- - changes in analysts' revenue or earnings estimates.
In addition to the foregoing, the market price of our debt securities may be
significantly affected by change in market rates of interest, yields obtainable
from investments in comparable securities, credit ratings assigned to our debt
securities by third parties and perceptions regarding our ability to pay our
obligations on our debt securities.
In the past, companies that have experienced volatility in the market price of
their securities have been the target of securities class action litigation.
If we were sued in a securities class action, we could incur substantial costs
and suffer from a diversion of our management's attention and resources.
Future sales of shares of our common stock may negatively affect our stock
price.
If we or our shareholders sell substantial amounts of our common stock in the
public market following this offering, the market price of our common stock
could fall. In addition, sales of substantial amounts of our common stock
might make it more difficult for us to sell equity or equity-related securities
in the future.
We do not expect to pay dividends in the foreseeable future.
We have never declared or paid any cash dividends on our common stock and we do
not expect to declare dividends on our common stock in the foreseeable future.
The instruments governing our existing and future indebtedness contain or may
contain provisions prohibiting or limiting the payment of dividends on our
common stock.
Provisions of Oregon law and our articles of incorporation may make it more
difficult to acquire us, even though an acquisition may be beneficial to our
shareholders.
Provisions of Oregon law condition the voting rights that would otherwise be
associated with any shares of our common stock that may be acquired in
specified transactions deemed to constitute a "control share acquisitions" upon
approval by our shareholders (excluding, among other things, the acquiror in
any such transaction). Provisions or Oregon law also restrict, subject to
specified exceptions, the ability of a person owning 15% or more of our common
stock to enter into any "business combination transaction" with us. In
addition, under our articles of incorporation, our Board of Directors has the
authority to issue up to 25.0 million shares of preferred stock and to fix the
rights, preferences, privileges and restrictions of those shares without any
further vote or action by the shareholders. The foregoing provisions of Oregon
law and our articles of incorporation have the effect of delaying, deferring or
preventing a change in control of Hollywood, may discourage bids for our common
stock at a premium over the market price of our common stock and may adversely
affect the market price of, and the voting and other rights of the holders of,
our common stock and the occurrence of a control share acquisition may
constitute an event of default under, or otherwise require us to repurchase or
repay, our indebtedness.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our financial position,
operating results, or cash flows due to adverse changes in financial and
commodity market prices and rates. We have entered into certain market-risk-
sensitive financial instruments for other than trading purposes, principally
short-term and long-term debt. Historically, and as of December 31, 2001, we
have not held derivative instruments or engaged in hedging activities. However,
we may in the future enter into such instruments for the purpose of addressing
market risks, including market risks associated with variable-rate
indebtedness.
The interest payable on our bank credit facility is based on variable interest
rates (IBOR or the prime bank rate at our option), and therefore, affected by
changes in market interest rates. Hypothetically, if variable base rates were
to increase 1% in 2001 as compared to the end of 2000, our interest rate
expense would increase by approximately $2.4 million based on our outstanding
balance on the facility as of December 31, 2001.
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.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information about our directors is incorporated by reference from our
definitive proxy statement, under the caption "Nomination and Election of Board
of Directors," for our 2002 annual meeting of shareholders (the "2002 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, 2001. Information with
respect to our executive officers is included under Item 4A of Part I of this
report.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this Item 11 is incorporated by reference from the 2002
Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required by this Item 12 is incorporated by reference from the 2002
Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this Item 13 is incorporated by reference from the 2002
Proxy Statement.
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 the Registrant's Annual Report on Form 10-K for the year ended
December 31, 2001:
(a)(i), (ii) FINANCIAL STATEMENTS
The following financial statements of the Registrant, together with the Report
of Independent Accountants dated February 19, 2002, except as to Note 25, which
is as of March 18, 2002, are filed herewith:
(i) FINANCIAL STATEMENTS
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 2001 and 2000
Consolidated Statements of Operations for the years ended December 31, 2001,
2000 and 1999
Consolidated Statements of Changes in Shareholders' Equity for the years ended
December 31, 2001, 2000 and 1999
Consolidated Statements of Cash Flows for the years ended December 31, 2001,
2000 and 1999
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.
(a) (iii) Exhibits
The following exhibits are filed with or incorporated by reference into this
Annual Report:
EXHIBIT
NUMBER DESCRIPTION
Items identified with an asterisk (*) are management contracts or
compensatory plans or arrangements.
3.1 1993B Restated Articles of Incorporation, as amended (incorporated
by reference to our Registration Statement on Form S-1 (File No. 33-
63042)(the "Form S-1"), by reference to Exhibit 4 to our Registration
Statement on Form S-3 (File No. 33-96140), and by reference to Exhibit
3.1 to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998.
3.2 1999 Restated Bylaws (incorporated by reference to Exhibit 3.2 to our
Registration Statement on Form S-4 (File No. 333-82937)(the "1999
S-4")).
4.1 Specimen Common Stock certificate (incorporated by reference to
Exhibit 4.1 to our Annual Report on Form 10-K/A for the year ended
December 31, 2000, filed on January 29, 2002).
4.2 Indenture, dated August 13, 1997, between the Registrant and BNY
Western Trust Company, as successor in interest to U.S. Trust Company
of California, N.A., as Trustee (incorporated by reference to Exhibit
4.1 to our Registration Statement on Form S-4 (No.333-35351) (the
"1997 S-4")), as supplemented by the First Supplemental Indenture,
dated as of June 24, 1999, between the Registrant and the Trustee
(incorporated by reference to Exhibit 4.2 of the 1999 S-4), the Second
Supplemental Indenture, dated as of January 20, 2000, between the
Registrant and the Trustee (incorporated by reference to Exhibit 10.1
to our Annual Report on Form 10-K for the year ended December 31,
1999) and the Third Supplemental Indenture, dated as of February 12,
2002, between the Registrant, as Issuer, Hollywood Management Company,
as Subsidiary Guarantor, and the Trustee (incorporated by reference to
Exhibit 4.1 to our Quarterly Report on Form 10-Q/A for the quarter
ended September 30, 2001).
4.3 Indenture dated January 25, 2002 among the Registrant, Hollywood
Management Company, as potential guarantor, and BNY Western Trust
Company as trustee (incorporated by reference to Exhibit 4.1 to our
Registration Statement on Form S-3 (File No. 333-14802)).
10.1 1993 Stock Incentive Plan, as amended (incorporated by reference
to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter
ended June 30, 1997). *
10.2 Form of Incentive Stock Option Agreement (incorporated by
reference to Exhibit 10.1 of the Form S-1). *
10.3 Form of Nonqualified Stock Option Agreement (incorporated by
reference to Exhibit 10.3 of the Form S-1). *
10.4 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1
to our Quarterly Report on Form 10-Q for the quarter ended March 31,
2001). *
10.5 Revolving Credit Agreement, as amended as of August 4, 2000, among the
Registrant, as Borrower, and Societe Generale, Goldman Sachs Credit
Partners L.P. and certain other financial institutions, as Lenders,
and Societe Generale, as Agent for the Lenders, Goldman Sachs Credit
Partners, L.P., as Documentation Agent, and Credit Lyonnais Los
Angeles Branch,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 our Quarterly Report on
Form 10-Q/A for the quarter ended September 30, 2000), as amended by
the Amendment to Credit Agreement dated as of June 5, 2001
(incorporated by reference to Exhibit 10.1 of our Current Report on
Form 8-K filed on June 5, 2001), as amended by the Amendment to Credit
Agreement dated as of November 28, 2001 (incorporated by reference to
Exhibit 10.8 to our Annual Report on Form 10-K/A for the year ended
December 31, 2000, filed on January 29, 2002).
10.6 Credit Agreement dated as of March 18, 2002 among the Registrant, as
Borrower, the several lenders from time to time party thereto, as
Lenders, and UBS AG, Stamford Branch, as administrative agent for the
Lenders.
10.7 Separation and Severance Agreement effective as of October 24, 2000
between the Registrant and Jeffrey B. Yapp (incorporated by reference
to Exhibit 10.6 to the Registrant's Annual Report on Form 10-K for
the year ended December 31, 2000, filed on April 2, 2001). *
10.8 Offer of Employment Term Sheet effective as of January 25, 2001 from
the Registrant to Mark J. Wattles (incorporated by reference
to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for
the year ended December 31, 2000, filed on April 2, 2001). *
10.9 Change of Control Plan for Senior Management dated as of February 3,
2001 (incorporated by reference to Exhibit 10.8 to the Registrant's
Annual Report on Form 10-K for the year ended December 31, 2000, filed
on April 2, 2001). *
10.10 Revenue Sharing Agreement dated March 2, 1998 between the Registrant
and Buena Vista Home Entertainment, Inc (incorporated by reference to
Exhibit 10.13 to our Annual Report on Form 10-K/A for the year ended
December 31, 2000, filed on January 29, 2002). +
10.11 Revenue Sharing Agreement dated July 31, 2001 between the Registrant
and MGM Home Entertainment (incorporated by reference to Exhibit 10.14
to our Annual Report on Form 10-K/A for the year ended December 31,
2000, filed on January 29, 2002). +
10.12 Administrative Services Agreement dated as of January 1, 1998
between Hollywood Management Corporation and Hollywood Entertainment
Corporation (incorporated by reference to Exhibit 10.15 to our Annual
Report on Form 10-K/A for the year ended December 31, 2000, filed on
January 29, 2002).
10.13 Income Tax Allocation Agreement dated as of January 1, 1998 between
Hollywood Management Corporation and Hollywood Entertainment
Corporation (incorporated by reference to Exhibit 10.16 to our Annual
Report on Form 10-K/A for the year ended December 31, 2000, filed on
January 29, 2002).
10.14 Intellectual Property License Agreement between Hollywood
Management Corporation and Hollywood Entertainment Corporation
(incorporated by reference to Exhibit 10.17 to our Annual Report on
Form 10-K/A for the year ended December 31, 2000, filed on January 29,
2002).
21.1 List of Subsidiaries (incorporated by reference to Exhibit 21.1 to
our Annual Report on Form 10-K/A for the year ended December 31, 2000,
filed on January 29, 2002).
23.1 Consent of PricewaterhouseCoopers LLP.
+ Confidential treatment has been requested as to certain portions of these
agreements. Such omitted confidential information has been designated by an
asterisk and has been filed separately with the Securities and Exchange
Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as
amended, pursuant to an application for confidential treatment.
(b) REPORTS ON FORM 8-K:
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,
2001 and 2000, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 2001 in conformity
with accounting principles generally accepted in the United States of America.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, 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 our opinion.
PRICEWATERHOUSECOOPERS LLP
PricewaterhouseCoopers LLP
Portland, Oregon
February 19, 2002, except as to Note 25, which is as of March 18, 2002
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
-------------------------
December 31, December 31,
2001 2000
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 38,810 $ 3,268
Accounts receivable 29,056 23,830
Merchandise inventories 61,585 54,201
Prepaid expenses and other current
assets 10,863 10,099
----------- -----------
Total current assets 140,314 91,398
Rental inventory, net 191,016 168,462
Property and equipment, net 270,586 323,666
Goodwill, net 64,934 69,616
Deferred income tax asset 38,396 -
Other assets, net 13,298 11,972
----------- -----------
$ 718,544 $ 665,114
=========== ===========
LIABILITIES AND SHAREHOLDERS'
EQUITY (DEFICIT)
Current liabilities:
Current maturities of long-term
obligations $ 111,914 $ 261,164
Accounts payable 167,479 200,358
Accrued expenses 112,799 114,633
Accrued interest 13,712 11,817
Income taxes payable 5,266 4,844
----------- ----------
Total current liabilities 411,170 592,816
Long-term obligations, less current
portion 402,088 275,237
Other liabilities 18,840 19,438
----------- ----------
832,098 887,491
Commitments and contingencies (Note 22) - -
Shareholders' equity (deficit):
Preferred stock, no par value,
25,000,000 shares authorized;
no shares issued and outstanding - -
Common stock, no par value, 100,000,000
shares authorized; and 49,428,763
and 46,247,599 shares issued and
outstanding, respectively 375,503 365,441
Unearned compensation (1,655) -
Accumulated deficit (487,402) (587,818)
----------- ----------
Total shareholders' (deficit) (113,554) (222,377)
----------- ----------
$ 718,544 $ 665,114
=========== ===========
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Twelve Months Ended
December 31,
------------------------------------
2001 2000 1999
----------- ----------- -----------
Rental revenue $1,140,730 $1,071,024 $ 893,491
Product sales 238,773 225,213 203,350
----------- ----------- -----------
1,379,503 1,296,237 1,096,841
----------- ----------- -----------
Cost of Revenue:
Cost of rental 375,014 580,849 278,890
Cost of product 169,463 204,401 154,990
----------- ----------- -----------
544,477 785,250 433,880
----------- ----------- -----------
Gross Profit 835,026 510,987 662,961
Operating costs and expenses:
Operating and selling 621,343 713,431 522,682
General and administrative 96,382 110,242 85,873
Restructuring charge for closure
of Internet business (3,256) 46,862 -
Restructuring charge for store
closures (3,778) 16,859 -
Amortization of intangibles 5,058 59,914 56,919
---------- ---------- ----------
715,749 947,308 665,474
---------- ---------- ----------
Income (loss) from operations 119,277 (436,321) (2,513)
Non-operating income (expense):
Interest income 417 175 214
Interest expense (56,546) (62,302) (45,691)
---------- ---------- ----------
Income (loss) before income taxes
and cumulative effect adjustment 63,148 (498,448) (47,990)
(Provision for) benefit from
income taxes 37,268 (31,592) (1,868)
---------- ---------- ----------
Income (loss) before cumulative
effect of a change in accounting
principle 100,416 (530,040) (49,858)
Cumulative effect of a change in
accounting principle (net of
income tax benefit of $983) - - (1,444)
---------- ---------- ----------
Net income (loss) $ 100,416 $(530,040) $ (51,302)
========== ========== ==========
- ------------------------------------------------------------------------
Net income (loss) per share before
cumulative effect of a change
in accounting principle:
Basic $ 2.05 $ (11.48) $ (1.09)
Diluted 1.90 (11.48) (1.09)
- -------------------------------------------------------------------------
Net income (loss) per share:
Basic $ 2.05 $ (11.48) $ (1.13)
Diluted 1.90 (11.48) (1.13)
- -------------------------------------------------------------------------
Weighted average shares outstanding:
Basic 49,101 46,151 45,592
Diluted 52,880 46,151 45,592
- -------------------------------------------------------------------------
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
(In thousands, except share amounts)
Common Stock Unearned Accumu-
------------------- Compen- lated
Shares Amount sation Deficit Total
---------- -------- -------- --------- ---------
Balance at
December 31, 1998 44,933,055 $354,067 - $ (6,476)$ 347,591
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock options exercised 888,482 4,392 - - 4,392
Tax benefit from
stock options - 3,848 - - 3,848
Net loss - - - (51,302) (51,302)
---------- -------- -------- --------- ---------
Balance at
December 31, 1999 45,821,537 362,307 - (57,778) 304,529
---------- -------- -------- --------- ---------
Issuance of common stock:
Legal settlement 200,000 2,288 - - 2,288
Stock options exercised 226,062 783 - - 783
Tax benefit
from stock options - 63 - - 63
Net loss - - - (530,040) (530,040)
---------- -------- -------- --------- ---------
Balance at
December 31, 2000 46,247,599 365,441 - (587,818) (222,377)
---------- -------- -------- --------- ---------
Issuance of common stock:
Compensation grant
(See Note 15) 3,000,000 3,281 - - 3,281
Stock options exercised 181,164 1,097 - - 1,097
Tax impact from
stock options - (61) - - (61)
Stock compensation - 5,745 (1,655) - 4,090
Net income - - - 100,416 100,416
---------- -------- -------- --------- ---------
Balance at
December 31, 2001 49,428,763 $375,503 $ (1,655)$(487,402)$(113,554)
========== ======== ======== ========= =========
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year Ended December 31,
-------------------------------
2001 2000 1999
--------- --------- --------
Operating activities:
Net income (loss) $ 100,416 $(530,040) $(51,302)
Adjustments to reconcile net
income (loss) to cash provided by
operating activities:
Cumulative effect of a change
in accounting principle - - 1,444
Depreciation and amortization 247,176 277,163 222,842
Amortization charge for change in
estimate on rental inventory - 164,306 -
Impairment of long-lived assets - 74,305 -
Amortization of deferred financing costs 3,715 2,665 1,936
Net asset write down for closure of
Internet business - 40,087 -
Net asset write down for store closures - 9,516 -
Loss on other asset dispositions - 10,292 -
Tax impact from exercise of
stock options (61) 63 3,848
Change in deferred rent (598) 1,993 3,565
Change in deferred income taxes (38,396) 25,805 (1,545)
Non-cash stock compensation 7,371 - -
Net change in operating assets
and liabilities:
Accounts receivable (5,226) 18,680 (1,817)
Merchandise inventories (7,384) 16,718 (26,290)
Accounts payable (32,879) 79,378 (385)
Accrued interest 1,895 (48) 2,172
Other current assets
and liabilities (2,236) 57,988 22,683
--------- -------- --------
Cash provided by operating
activities 273,793 248,871 177,151
--------- -------- --------
Investing activities:
Purchases of rental inventory, net (202,790) (176,753) (185,877)
Purchase of property and
equipment, net (8,802) (77,639) (112,258)
Investment in businesses acquired - - (17,434)
Increase in intangibles and other
assets (5,357) (1,430) (4,769)
--------- -------- --------
Cash used in investing
activities (216,949) (255,822) (320,338)
--------- -------- --------
Financing activities:
Issuance of long-term obligations - 12,511 90,162
Repayments of long-term obligations (17,399) (15,016) (8,401)
Proceeds from exercise of stock options 1,097 783 4,392
Increase (decrease) in revolving
loan, net (5,000) 5,000 60,000
--------- --------- --------
Cash (used in) provided by
financing activities (21,302) 3,278 146,153
--------- --------- --------
Increase (decrease) in cash and
cash equivalents 35,542 (3,673) 2,966
Cash and cash equivalents at
beginning of year 3,268 6,941 3,975
--------- --------- --------
Cash and cash equivalents at end
of year $ 38,810 $ 3,268 $ 6,941
========= ========= ========
Other Cash Flow Information:
Interest expense paid $ 54,651 $ 60,702 $ 42,896
Income taxes paid (refunded), net 768 (915) 5,741
Non-cash financing activities
Issuance of common stock as part of
a legal settlement agreement - 2,288 -
See notes to Consolidated Financial Statements
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2001, 2000, 1999
1. SIGNIFICANT ACCOUNTING POLICIES
Corporate Organization and Consolidation
The accompanying financial statements include the accounts of Hollywood
Entertainment Corporation and its wholly owned subsidiaries (the "Company").
The Company's only subsidiary during 2001 was Hollywood Management Company.
During 2000 and 1999, the Company's subsidiaries consisted of Hollywood
Management Company and Reel.com, Inc. All significant inter-company
transactions and accounts have been eliminated.
Nature of the Business
The Company operates a chain of video superstores ("Hollywood Video")
throughout the United States. From October 1998 to June 2000, the Company also
operated an Internet retailer of video only products ("Reel.com")(see Note 11
for a discussion of the discontinuation of Reel.com's e-commerce operations).
The Company was incorporated in Oregon on June 2, 1988 and opened its first
store in October 1988. As of December 31, 2001 and 2000, the Company operated
1,801 stores in 47 states and 1,818 stores in 47 states, respectively.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles (GAAP) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Significant
estimates relative to the Company include revenue recognition, depreciation and
amortization policies, impairment of long-lived assets and goodwill, income
taxes and legal contingencies.
Reclassification of Prior Year Amounts
Certain prior year amounts have been reclassified to conform to the
presentation used for the current year. These reclassifications had no impact
on previously reported net loss or shareholders' equity.
Recently Issued Accounting Standards
In the first quarter of 2001 the Company adopted SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities" issued by the Financial
Accounting Standards Board(FASB) on June 15, 1998. The adoption of SFAS No. 133
did not have an effect on the Company's results of operations or its financial
position.
The Company adopted the provisions of SEC Staff Accounting Bulletin No. 101,
"Revenue Recognition in Financial Statements" in the fourth quarter of 2000.
The Company also adopted Emerging Issues Task Force Issue No. 99-19, "Reporting
Revenues Gross as a Principal versus Net as an agent," in the fourth quarter of
2000. The effect of the adoption of these standards was not material.
In July 2001, the Financial Accounting Standards Board (FASB) issued FASB
Statements Nos. 141 and 142 (SFAS 141 and SFAS 142), "Business Combinations"
and "Goodwill and Other Intangible Assets." SFAS 141 replaces APB 16 and
eliminates pooling-of-interests accounting prospectively. It also provides
guidance on purchase accounting related to the recognition of intangible assets
and accounting for negative goodwill. SFAS 142 changes the accounting for
goodwill from an amortization method to an impairment only approach. Under
SFAS 142, goodwill will be tested annually and whenever events or circumstances
occur indicating that goodwill might be impaired. SFAS 141 and 142 are
effective for all business combinations completed after June 30, 2001. Upon
adoption of SFAS 142, amortization of goodwill recorded for business
combinations consummated prior to July 1, 2001 will cease, and intangible
assets acquired prior to July 1, 2001 that do not meet criteria for recognition
under SFAS 141 will be reclassified to goodwill. Companies are required to
adopt SFAS 142 for fiscal years beginning after December 15, 2001. The Company
will adopt SFAS 142 on January 1, 2002, the beginning of fiscal 2002. In
connection with the adoption of SFAS 142, the Company will be required to
perform a transitional goodwill impairment assessment. The Company has not yet
determined the impact these standards will have on its results of operations
and financial position. As of December 31, 2001, the Company expects a
reduction in annual amortization expense of approximately $5.1 million in 2002
upon adoption of SFAS No. 142.
In July 2001, the FASB issued SFAS No. 143, "Accounting For Asset Retirement
Obligations". SFAS No. 143 requires entities to record the fair value of a
liability for an asset retirement obligation in the period in which it is
incurred. When the liability is initially recorded, the entity is required to
capitalize the cost by increasing the carrying amount of the related long-lived
asset. Over time, the liability is accreted to its present value each period,
and the capitalized cost is depreciated over the useful life of the related
asset. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002
and will be adopted by the Company effective January 1, 2003. The Company
believes adoption of this standard will not have a material effect on its
financial statements.
On October 3, 2001, the FASB issued Statement of Accounting Standards No.
144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS
144"). FAS 144 supercedes FAS 121 "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." FAS 144
applies to all long-lived assets (including discontinued operations) and
consequently amends Accounting Principles Board Opinion No. 30 (APB 30),
Reporting Results of Operations--Reporting the Effects of Disposal of a
Segment of a Business. In general, FAS 144 requires that long-lived assets
that will continue to be operated be measured at the lower of book value or the
undiscounted projected future operating cash flows directly associated with the
asset. FAS 144 requires that long-lived assets that are to be disposed of by
sale be measured at the lower of book value or estimated fair value less
estimated cost to sell. Additionally, FAS 144 expands the scope of
discontinued operations to include all components of an entity with operations
that (1) can be distinguished from the rest of the entity and (2) will be
eliminated from the ongoing operations of the entity in a disposal transaction.
FAS 144 is effective for the Company for all financial statements issued
beginning January 1, 2002. Currently, the management of the Company does not
anticipate disposing of any long-lived assets in 2002, other than the assets
intended to be disposed of pursuant to the store closure plan (see Note 7),
therefore, there should be no affect from the adoption of FAS 144.
Rental Revenue and Merchandise
The Company recognizes revenue upon the rental and sale of its products.
Revenue for extended rental periods (when the customer chooses to keep the
product beyond the original rental period) is recognized when the extended
rental period begins. Revenue recorded for extended rental periods is net of
estimated amounts that the Company does not anticipate collecting based upon
its historical collection experience.
Gift card liability
Gift card liabilities are recorded at the time of sale. Costs of designing,
printing and distributing the cards, and transactional processing costs, are
expensed as incurred. The liability is relieved and revenue is recognized upon
redemption of the gift cards at any Hollywood Video store.
Cost of Rental
Cost of rental includes revenue sharing expense, amortization of
videocassettes, DVDs and games, and book value of inventory loss.
Cash and Cash Equivalents
The Company considers highly liquid investment instruments, with an original
maturity of three months or less, to be cash equivalents. The carrying amounts
of cash and cash equivalents equals fair market value.
Inventories
Merchandise inventories, consisting primarily of prerecorded videocassettes,
concessions, and other accessories held for resale, are stated at the lower of
cost or market (or, in the case of rental inventory, transferred to merchandise
inventory at the carrying value thereof at the time of transfer). Cost of
sales is determined using an average costing method. Rental inventory, which
includes VHS videocassettes, DVDs and video games is stated at cost and
amortized over its estimated useful life to a specified residual value.
Shipping and handling charges related to the rental and sale of inventory are
included in cost of rental and in cost of product. See Notes 4 and 5 for a
discussion of the amortization policy applied to rental inventory.
Property, Equipment, Depreciation and Amortization
Property is stated at cost and is depreciated on a straight-line basis for
financial reporting purposes over the estimated useful life of the assets,
which range from approximately five to ten years. Leasehold improvements are
amortized primarily over ten years, which generally approximates 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. Maintenance and repair costs are charged to
expense as incurred, while improvements that extend the useful life of the
assets are capitalized. As property and equipment is sold or retired, the
applicable cost and accumulated depreciation and amortization are eliminated
from the accounts and any gain or loss thereon is recorded.
In 1998, the Company adopted Statement of Position 98-1 ("SOP 98-1"), which
defines the types of costs that may be capitalized for internally developed
computer software. Accordingly, the Company capitalized $0.3 in 1999. The
Company did not incur costs in 2000 or 2001 that meets the capitalization
requirements.
Long-lived Assets
The Company reviews for impairment long-lived assets and goodwill to be held
and used in the business whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. The Company
periodically reviews and monitors its internal management reports for
indicators of impairment. The Company considers a trend of unsatisfactory
operating results that are not in line with management's expectations to be its
primary indicator of potential impairment. When an indicator of impairment is
noted, assets are evaluated for impairment at the lowest level for which there
are identifiable cash flows (e.g., at the store level). The Company deems a
store to be impaired if a forecast of undiscounted future operating cash flows
directly related to the store, including estimated disposal value, if any, is
less than the asset carrying amount. If a store is determined to be impaired,
the loss is measured as the amount by which the carrying amount of the store
exceeds its fair value. Fair value is estimated using a discounted future cash
flow valuation technique similar to that used by management in making a new
investment decision. Considerable management judgment and assumptions are
necessary to identify indicators of impairment and to estimate discounted
future cash flows. Accordingly, actual results could vary significantly from
such estimates. See Note 8 for estimated impairments at December 31, 2000.
There was no impairment charge in 2001.
Store Closure Reserves
Reserves for store closures are established by calculating the present value of
the remaining lease obligation, adjusted for estimated subtenant agreements or
lease buyouts, if any, and are expensed along with any leasehold improvements.
Store furniture and equipment are either transferred at historical costs to
another location or disposed of and written-off.
Litigation Liabilities
All material litigation loss contingencies, which are judged to be both
probable and estimable, are recorded as liabilities in the Consolidated
Financial Statements in amounts equal to the Company's best estimates of the
costs of resolving or disposing of the underlying claims. These estimates are
based upon judgments and assumptions. The Company regularly monitors its
estimates in light of subsequent developments and changes in circumstances and
adjusts its estimates when additional information causes the Company to believe
that they are no longer accurate. If no particular amount is determined to
constitute the Company's best estimate of a particular litigation loss
contingency, the amount representing the low end of the range of the Company's
estimate of the costs of resolving or disposing of the underlying claims is
recorded as a liability and the range of such estimates is disclosed.
Treasury Stock
In accordance with Oregon law, shares are automatically retired and classified
as available for issuance upon the repurchase of common stock.
Income Taxes
The Company calculates income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes", which requires recognition of deferred tax
liabilities and assets for the expected future tax consequences of events that
have been included in the financial statements and tax returns. Valuation
allowances are established when necessary to reduce deferred tax assets to the
amount expected to be realized.
Deferred Rent
Many of the Company's operating leases contain predetermined fixed increases of
the minimum rental rate during the initial lease term. 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 and is included in other liabilities.
Fair Value of Financial Instruments
In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments", the Company has disclosed the fair value, related carrying value
and method for determining the fair value for the following financial
instruments in the accompanying notes as referenced: cash and cash equivalents
(see above), accounts receivable (see Note 2), and long-term obligations (see
Note 16).
The Company's receivables do not represent significant concentrations of credit
risk at December 31, 2001, due to the wide variety of customers, markets and
geographic areas to which the Company's products are rented and sold.
Comprehensive Income
Comprehensive income (loss) is equal to net income (loss) for all periods
presented.
Advertising
The Company receives cooperative reimbursements from vendors as eligible
expenditures occur relative to the promotion of rental and sales product.
Advertising costs, net of these reimbursements, are expensed as incurred.
Advertising expense was $5.1 million, $25.6 million and $1.2 for 2001, 2000 and
1999, respectively.
Store Pre-opening Costs
Store pre-opening costs, including store employee labor costs and advertising,
incurred prior to the opening of a new store had been expensed during the first
full month of a store's operation. In April 1998, Statement of Position 98-5
(SOP 98-5), "Reporting on the Costs of Start-up Activities" was finalized,
which requires that costs incurred for start-up activities, such as store
openings, be expensed as incurred. The Company adopted SOP 98-5 effective
January 1, 1999. The cumulative effect of the change was to increase net loss
by $1.4 million, net of tax.
2. ACCOUNTS RECEIVABLE
Accounts receivable as of December 31, 2001 and 2000 consists of
(in thousands):
----------------------
2001 2000
---------- ---------
Construction receivables $ 600 $ 1,266
Additional rental fees 18,200 17,425
Marketing 12,253 11,430
Due from employees 2,051 1,866
Licensee receivables 623 -
Other 389 593
---------- ---------
34,116 32,580
Allowance for doubtful accounts (5,060) (8,750)
---------- ---------
29,056 23,830
========== =========
The carrying amount of accounts receivable approximates fair value because of
the short maturity of those receivables. The allowance for doubtful accounts is
primarily for marketing and due from employees.
3. RENTAL INVENTORY
Rental inventory as of December 31, 2001 and 2000 consists of (in thousands):
-------------------------
2001 2000
---------- ----------
Rental inventory $ 675,469 $ 604,715
Less accumulated amortization (484,453) (436,253)
---------- ----------
$ 191,016 $ 168,462
========== ==========
Amortization expense related to rental inventory was $180.2 million, $340.8
million and $107.6 million in 2001, 2000 and 1999, respectively, and is
included in cost of rental. Amortization in 2000 included a $164.3 million
charge for changes in estimated useful lives and salvage values of various
types of rental product (see Note 5). As rental inventory is transferred to
merchandise inventory and sold (previously-viewed product), the applicable cost
and accumulated amortization are eliminated from the accounts, determined on a
first-in-first-out ("FIFO") basis applied in the aggregate to monthly
purchases.
4. RENTAL INVENTORY AMORTIZATION POLICY
For new release tapes acquired under revenue sharing, the studio's share of
rental revenue is expensed net of an average estimated interim residual value
established in rental inventory of $3 per tape. The expense is recorded as
revenue is earned on the respective revenue sharing titles. Tapes that remain
in the Company's rental inventory are amortized to $2 in one year.
New release fixed price purchases of VHS, DVD and game inventories are
amortized to an estimated interim residual value in four months and then to an
estimated ending residual value over the remaining estimated useful life. In
2001 these estimates were as follows:
Interim Ending Useful
Residual Residual Life
-------- -------- --------
VHS $ 3.61 $2 1 year
DVD $ 6.88 $6 5 years
Games $14.16 $5 2 years
Purchases of catalog product, including new store purchases, are amortized on a
straight-line basis to the estimated ending residual values over the estimated
useful lives noted above.
5. AMORTIZATION POLICY CHANGE IN ESTIMATE IN 2000
During the fourth quarter of 2000, the Company made the following key
observations leading management to change estimates regarding rental inventory
lives and residual values.
- - Growth in DVD rental revenue exceeded the Company's original estimates and
has negatively impacted revenue from VHS product.
- - In December 2000, rental revenue from DVD product surpassed rental revenue
from catalog VHS product.
- - The average sales price of previously-viewed VHS movies in fourth quarter of
2000 declined by 24% compared to the third quarter of 2000.
- - The decline in new store openings has caused a build-up of VHS and game
inventory in the Company's warehouse.
Based on the observations noted above, and revised internal estimates on the
growth of DVD rental revenue, the Company's amortization policy with revised
estimates compared to previous estimates is as follows:
- - All catalog VHS product, regardless of the method of acquisition, is
amortized straight-line with an estimated useful life of one year compared to
the previous estimate of five years, and an estimated residual value of $2
compared to the previous estimate of $6.
- - For new release tapes acquired under revenue sharing, the studios share of
rental revenue is expensed net of an average value established in rental
inventory, prior to amortization, of $3 compared to the previous estimate of
$4. Tapes that remain in the Company's rental inventory are amortized to $2 in
one year.
- - New release VHS tapes acquired under methods other than revenue sharing are
amortized to an average value of approximately $4 in the first four months
compared to the previous estimate of $8. Tapes that remain in the Company's
rental inventory are amortized to $2 in one year.
- - DVD rental inventory is amortized on an accelerated basis to an average
value of approximately $7 in the first four months. DVDs that remain in the
Company's rental inventory are amortized to $6 in 60 months. Prior to the
change in estimate, all purchases of DVD rental inventory were amortized
straight-line to a residual value of $6 in 60 months.
- - Game rental inventory is amortized on an accelerated basis to an average
value of approximately $14 in the first four months. Games that remain in the
Company's rental inventory are amortized to $5 in 24 months. Prior to the
change in estimate, Game rental inventory was amortized on an accelerated basis
to an average value of approximately $14.50 in the first twelve months and the
catalog residual value was $8.
The Company adopted these changes in estimate prospectively on October 1, 2000.
The change resulted in a $164.3 million increase to amortization expense in the
fourth quarter of 2000 and is classified as cost of rental on the consolidated
statement of operations. This change in estimate increased net loss by $164.3
million and increased net loss per share by $3.56.
6. PROPERTY AND EQUIPMENT
Property and equipment as of December 31, 2001 and 2000 consists of
(in thousands):
---------------------
2001 2000
--------- ----------
Fixtures and equipment $ 165,723 $ 156,960
Leasehold improvements 360,569 352,245
Equipment under capital lease 15,879 19,578
Leasehold improvements under
capital lease 37,112 44,279
--------- ----------
579,283 573,062
Less accumulated depreciation
and amortization (308,697) (249,396)
--------- ----------
$ 270,586 $ 323,666
========= ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $17.5 million and
$16.4 million at December 31, 2001 and 2000, respectively. Depreciation
expense related to property, plant and equipment was $61.9 million, $114.2
million and $57.2 million in 2001, 2000 and 1999, respectively.
7. STORE CLOSURE RESTRUCTURING
In December 2000, the Company approved a restructuring plan involving the
closure and disposition of 43 stores that were not operating to management's
expectations (the "Restructuring Plan"). In the fourth quarter of 2000, the
Company recorded charges aggregating $16.9 million, including an $8.0 million
write down of property and equipment, a $1.5 million write down of goodwill and
an accrual for store closing costs of $7.4 million. The established reserve
for cash expenditures is for lease termination fees and other store closure
costs. The Company has liquidated and plans to continue liquidating related
store inventories through store closing sales; any remaining product will be
used in other stores.
Revenue during the years ended December 31, 2000 and 1999 for the stores
included in the Restructuring Plan was approximately $15.5 million and $13.4
million, respectively. Operating results (defined as income or loss before
interest expense and income taxes) during the years ended December 31, 2000 and
1999 for the stores included in the Restructuring Plan were approximately $1.8
million loss and $0.5 million loss, respectively. For the twelve months ended
December 31, 2001, these stores recorded a combined net loss of $2.5 million
that is included in the Consolidated Statement of Operations.
As of December 31, 2001, the Company had closed 12 of the 43 scheduled stores
that are included in the Restructuring Plan. The Company incurred $329,867 in
expenses during the twelve months ended December 31, 2001 related to the
closures and received $450,000 to exit one of the leases.
In December of 2001, the Company amended the Restructuring Plan and removed 16
stores from the closure list. The Company anticipates closing the remaining 15
stores in 2002. In accordance with the amended plan, and updated estimates on
closing costs, the Company reversed $3.8 million of the original $16.9 million
charge, leaving a $3.7 million accrual balance at December 31, 2001 for store
closing costs.
8. IMPAIRMENT OF LONG-LIVED ASSETS
In the fourth quarter of 2000, the Company experienced negative same store
sales for the first time in 21 quarters while major competitors experienced
positive same store sales. With a strong slate of new release titles, this
decline in same store sales was unexpected and occurred at a time when the
Company was facing substantial uncertainty with respect to its liquidity. These
changes in circumstance triggered an impairment analysis in accordance with the
Company's policy outlined in Note 1. The Company identified 293 impaired
stores and recorded a charge of $74.3 million. The non-cash charge included
$44.3 million classified as operating and selling expenses in the consolidated
statement of operations that reduced the net carrying amount of property and
equipment, and $30 million classified as amortization of intangibles that
reduced the net carrying amount of goodwill. Property and equipment primarily
consisted of leasehold improvements and fixtures that could not be used in
other locations.
9. GOODWILL
Goodwill as of December 31, 2001 and 2000 consists of:
(in thousands)
--------------------
2001 2000
--------- ---------
Goodwill $ 134,309 $ 134,309
Less accumulated
amortization (69,375) (64,693)
--------- ---------
$ 64,934 $ 69,616
========= =========
Goodwill represents the excess of cost over the fair value of net assets
purchased and has been amortizing on a straight-line basis over two or 20
years. Goodwill in connection with store acquisitions has been amortizing over
20 years. In accordance with Statement of Financial Accounting Standards No.
142, goodwill will no longer be amortized (see Note 1 under the heading
"Recently Issued Accounting Standards" for a discussion of Financial Accounting
Standards No. 142). Goodwill from the Reel.com acquisition was amortized over
two years prior to the discontinuation of Reel.com's e-commerce operations in
June 2000. Amortization expense was $5.1 million, $ 59.9 million and $56.9
million in 2001, 2000 and 1999, respectively. In the second quarter of 2000,
the Company recorded a $69.3 million charge in connection with the
restructuring of Reel.com, including a $14.9 million write-down of goodwill
(see Note 11). During the fourth quarter of 2000, a plan was developed to close
43 stores, of which, 5 were acquired stores. The Company recorded a
restructuring charge of $16.9 million, including a write-down of $1.5 million
of goodwill associated with the acquired stores (see Note 7). The Company also
determined estimated future undiscounted cash flows on several additional
acquired stores were less than the net carrying amount of assets associated
with each store (see Note 8). As required by FAS 121, the Company recorded an
impairment charge of $74.3 million, including a $30 million write-down of
goodwill.
10. STORE ACQUISITIONS
Store growth in 2001 and 2000 did not include any acquired stores.
During 1999, the Company acquired the operations and assets of 49 video
superstores for an aggregate purchase price of $17.4 million. The acquisitions
were accounted for under the purchase method of accounting. Approximately $14.6
million was allocated to goodwill. The results of operations for these
acquisitions do not have a material effect on the consolidated operating
results, and therefore, no pro forma data has been presented.
11. REEL.COM DISCONTINUED E-COMMERCE OPERATIONS
On June 12, 2000, the Company announced that it would discontinue the e-
commerce business of Reel.com. Although the Company had developed a leading
website over the seven quarters after Reel.com was purchased in October of
1998, Reel.com's business model of rapid customer acquisition led to large
operating losses and required significant cash funding. Due to market
conditions, the Company was unable to obtain outside financing for Reel.com,
and could not justify continued funding from its superstore cash flow. On June
13, 2000, the Company terminated the employment of approximately 200 of
Reel.com's 240 employees, and paid $1.9 million in involuntary termination
benefits. The remaining employees have since been terminated or integrated into
Hollywood Entertainment.
As a result of the discontinuation of Reel.com's e-commerce operations, the
Company recorded a total charge of $69.3 million in the second quarter of 2000,
of which $48.5 million was classified as a restructuring charge on the
consolidated statement of operations and $20.8 million was included in cost of
product sales. The charge was reduced by $1.6 million to $46.9 million in the
fourth quarter of 2000, and also reduced by $3.3 million to $43.6 million in
the fourth quarter of 2001, because the Company was able to negotiate
termination of certain obligations and lease commitments more favorably than
originally anticipated.
The restructuring charge line item included $1.9 million of severance and
benefits paid on June 13, 2000, $19.3 million of asset impairment charges, and
$22.4 million (net of reductions) of accrued liabilities. The asset impairment
charges included the write-off of the remaining $14.9 million of goodwill
associated with the acquisition of Reel.com, and $4.4 million to write down
equipment, leasehold improvements, prepaid expenses and accounts receivable to
their net realizable values. Amounts accrued included $17.3 (net of reductions)
million for contractual obligations, lease commitments and anticipated legal
claims against the Company and $5.1 (net of reductions) million for legal,
financial, and other professional services incurred as a direct result of the
closure of Reel.com. As of December 31, 2001, the Company had paid $7.4 million
of the accrued amounts.
The Company used some of the equipment from Reel.com at the distribution center
in Nashville, Tennessee, and at the corporate offices in Wilsonville, Oregon.
Equipment not used by the Company was sold. Proceeds of $250,000 were received
in the third quarter of 2000.
The $20.8 million write down of Reel.com inventory, primarily DVD's, to net
realizable value was charged to cost of product. This represented excess
product for the Hollywood Video segment. The Company liquidated over 85% of
this inventory in 2000. The remaining amount was liquidated or integrated into
Hollywood Video inventory in 2001.
12. 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. Total rent expense, including related lease-required costs,
incurred during 2001, 2000, and 1999 was $253.1 million, $243.9 million and
$201.6 million, respectively.
At December 31, 2001,the future minimum annual rental commitments under non-
cancelable operating leases were as follows (in thousands):
------------------------------
Year Ending Operating
December 31, Leases
------------------------------
2002 $217,491
2003 215,895
2004 210,362
2005 199,976
2006 179,808
Thereafter 538,020
13. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable includes accrued revenue sharing (amounts accrued pursuant to
revenue sharing arrangements in which the Company had not yet received an
invoice). Accrued revenue sharing was $20.6 million and $30.9 at December 31,
2001, and 2000, respectively.
Accrued liabilities as of December 31, 2001 and 2000 consist of
(in thousands):
----------------------
2001 2000
---------- ---------
Payroll and benefits 25,143 19,431
Property taxes and common
area maintenance 10,241 16,340
Gift certificates and coupons 13,940 6,226
Marketing 8,054 14,409
Store closures and lease
terminations 7,977 17,071
Reel.com restructuring 15,000 21,455
Other operating and general
administration 32,444 19,701
---------- ---------
$ 112,799 $ 114,633
========== =========
14. 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 $100,000 and for annual Company claims which exceed
approximately $7.3 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 of the Company's potential claims
liability will be reflected in results of operations for the period in which
such adjustments are determined to be appropriate on the basis of actual
payment experience or other changes in circumstances.
The Company has a 401(k) plan in which eligible employees may elect to
contribute up to 20% of their earnings. Eligible employees are at least 21
years of age, have completed at least one year of service and work at least
1,000 hours in a year. The Company began matching 25% of the employees first 6%
of contributions in January 2000. There were no matching contributions in 1999.
Beginning in April 2000, the Company offered a deferred compensation plan to
certain key employees designated by the Company. The plan allows for the
deferral and investment of current compensation on a pre-tax basis. The
Company has accrued approximately $112,069 and $201,593 related to this plan at
2001 and 2000, respectively.
15. RELATED PARTY TRANSACTIONS
In May 2000, the Company's Board of Directors approved a five-year $15 million
loan to Mr. Mark J. Wattles (with a secondary security interest in the
Company's common stock that he owned), which bore interest at an annual rate
equal to the greater of ten percent or the minimum rate required under the
Internal Revenue Code and regulations thereunder, to avoid imputed interest on
loans to affiliated persons. In December 2000, the Company's Board of
Directors determined that the loan was uncollectable and directed the Company
to write-off the loan.
On January 25, 2001, the Compensation Committee of the Board of Directors of
the Company unanimously approved an employment agreement between the Company
and Mark J. Wattles as President and Chief Executive Officer. Pursuant to the
terms of the agreement, Mr. Wattles received a grant of 3 million shares of
common stock on January 25, 2001. On the date of the grant, the shares had a
market value of $3.28 million.
In July 2001, Boards, Inc. (Boards) opened two Hollywood Video stores as
licensee of the Company pursuant to rights granted by the Company and approved
by the Board of Directors in January 2001. These stores will be operated by
Boards and are not included in the 1,801 stores operated by the Company. Mark
Wattles, the Company's Founder, Chief Executive Officer and President, is the
majority owner of Boards. Under the license arrangement, Boards will pay the
Company $25,000 per store, a royalty of 2% of revenue and may purchase product
and services from the Company. At December 31, 2001, Boards owed the Company
approximately $623,000 for fees, services, and product including rental
inventory to open the stores. On February 15, 2002, Boards paid the Company
$643,953.
16. LONG-TERM OBLIGATIONS AND LIQUIDITY
The Company had the following long-term obligations as of December 31, 2001 and
2000 (in thousands):
December 31,
----------- ----------
2001 2000
----------- ----------
Senior subordinated notes (1) $ 250,000 $ 250,000
Borrowings under revolving credit facility 240,000 245,000
Obligations under capital leases 24,002 41,396
Other - 5
----------- ----------
514,002 536,401
Current portions:
Credit facility 98,500 245,000 (2)
Capital leases & other 13,414 16,164
----------- ----------
111,914 261,164
Total long-term obligations ----------- ----------
net of current portion $ 402,088 $ 275,237
=========== ==========
(1) Coupon payments at 10.625% are due semi-annually in February and August of
each year.
(2) Includes $112.5 million with a scheduled maturity in 2002 that was
reclassified as current portion in accordance with FAS 78, Classification of
Obligations That Are Callable by the Creditor, due to covenant violations that,
as of December 31, 2000, were not waived beyond May 5, 2001.
At December 31, 2001, maturities on long-term obligations for the next five
years were as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2002 $ - $ 98,500 $ 13,414 $ 111,914
2003 - 141,500 10,588 152,088
2004 250,000 - - 250,000
2005 - - - -
2006 - - - -
Thereafter - - - -
----------- ---------- --------- ---------
$ 250,000 $ 240,000 $ 24,002 $ 514,002
----------- ---------- --------- ---------
At December 31, 2001, $250 million of the Company's senior subordinated notes
(the "Notes") due August 15, 2004 were outstanding. The Notes are redeemable,
at the option of the Company, as of 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. 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.
At December 31, 2001 the Company had a total of $241.5 million of borrowing
capacity under its revolving credit facility, of which amount $240.0 million
was outstanding. Revolving credit loans under the facility bear interest, at
the Company's option, at an applicable margin over the bank's base rate loan or
the IBOR rate. At December 31, 2001, the margin over IBOR was at 5% and will
step down if certain performance targets are met. Among other restrictions, the
facility contains financial covenants relating to specified levels of
indebtedness to adjusted net cash EBITDA. Adjusted net cash EBITDA is defined
as income from operations before depreciation and amortization plus non-cash
expenses that reduced EBITDA, less the cost of acquiring new release
videocassettes, game inventory and new store rental inventory which is
capitalized. Other ratios and restrictions include: adjusted net cash EBITDA
less cash taxes paid compared to interest expense; adjusted net cash EBITDA
less cash taxes paid plus rent expense compared to interest expense plus rent
expense; maintenance of average store contribution levels; and the maintenance
of minimum tangible net worth. Amounts outstanding under the credit agreement
are collateralized by substantially all of the assets of the Company.
On December 7, 2001, the Company filed with the Securities and Exchange
Commission a shelf registration statement covering up to $110,000,000 of its
common stock (together with up to an additional $16,500,000 of its common stock
for purposes of satisfying any over-allotment options) and up to $300,000,000
of non-convertible debt securities. On December 10, 2001 the Company announced
that it received a fully underwritten commitment from UBS Warburg LLC for a new
bank credit facility. The credit facility, consisting of a $150.0 million
senior secured term loan maturing in 2004 and a $25.0 million senior secured
revolving credit facility maturing in 2004, is subject to various conditions,
including the sale by the Company of at least $100.0 million of its common
stock and the application of the proceeds of such sale, together with the
initial borrowings under the new bank credit facility, to the repayment of all
borrowings under the Company's existing bank credit facility. The commitment
expires on March 31, 2002.
On February 15, 2002 the Company announced that the shelf registration
statement became effective and that the Company intends to commence an offering
of approximately 7,000,000 shares of its common stock through managing
underwriters UBS Warburg LLC, Bear, Stearns & Co. Inc., Robertson Stephens,
Inc. and Wells Fargo Securities LLC. The Company intends to use the net
proceeds of the offering of common stock to repay a portion of the amounts
outstanding under the existing revolving credit facility and intends to repay
the remaining amounts outstanding with initial borrowings under the new bank
facility described above.
As of December 31, 2001, the fair value of the Notes was $252.5 million. The
fair value of the Notes was based on quoted market prices as of December 31,
2001. The revolving credit facility is a variable rate loan, and thus, the
fair value approximates the carrying amount as of December 31, 2001.
As of December 31, 2001, the Company had $2.1 million of outstanding letters of
credit.
17. INCOME TAXES
The provision for (benefit from) income taxes for the years ended December
31, 2001, 2000 and 1999 consists of: (in thousands)
------------------------------
2001 2000 1999
---------- -------- --------
Current:
Federal $ 312 $ 3,396 $ 2,802
State 816 2,391 1,064
--------- -------- --------
Total current provision 1,128 5,787 3,866
Deferred:
Federal (30,852) 22,523 (2,450)
State (7,544) 3,282 452
--------- -------- --------
Total deferred liability
(benefit) (38,396) 25,805 (1,998)
--------- -------- --------
Total provision (benefit) $(37,268) $ 31,592 $ 1,868
========= ======== ========
The Company is subject to minimum state taxes in excess of statutory state
income taxes in many of the states in which it operates. These taxes are
included in the current provision for state and local income taxes. Certain
acquisitions in 1995 and the Reel.com acquisition in 1998 yielded non-
deductible, goodwill which is reflected in the tax rate reconciliation below.
The tax impact of purchase accounting adjustments is reflected in deferred
taxes. A reconciliation of the statutory federal income tax rate with the
Company's effective tax rate is as follows:
--------------------------
2001 2000 1999
-------- ------- -------
Statutory federal rate
provision (benefit) 34.0% (34.0%) (34.0%)
State income taxes, net of
federal income tax benefit 4.4 (3.5) 2.1
Amortization of non-deductible
goodwill 0.1 2.6 35.7
Net non-deductible expenses 3.8 - -
Unused federal credits (1.2) - -
Increase (decrease)in valuation
allowance (100.5) 41.3 -
Other, net 0.4 (0.1) 0.1
-------- ------- -------
(59.0%) 6.3% 3.9%
======== ======= =======
Deferred income taxes reflect the impact of "temporary differences" between
amounts of assets and liabilities for financial reporting purposes and such
amounts as measured by tax laws. The tax effects of temporary differences that
give rise to significant portions of deferred tax assets and liabilities at
December 31 are as follows: (in thousands)
----------------------
2001 2000
---------- ---------
Deferred tax assets:
Tax loss carryforward $116,200 $122,702
Deferred rent 7,574 7,775
Financial leases 8,270 8,161
Accrued liabilities and reserves 18,991 18,790
Tax credit carryforward 4,836 3,456
Restructure charges 10,360 13,735
Accrued legal settlement 130 522
Inventory valuation 33,470 59,358
Amortization 11,842 14,237
---------- ---------
Total deferred tax assets 211,673 248,736
Valuation allowance (147,790) (211,247)
---------- ---------
Net deferred tax assets 63,883 37,489
---------- ---------
Deferred tax liabilities:
Depreciation and amortization (20,264) (32,843)
Capitalized leases (5,223) (4,646)
---------- ---------
Total deferred tax liabilities (25,487) (37,489)
---------- ---------
Net deferred tax asset (liability) $38,396 $ -
========== =========
The valuation allowance of $147.8 million as of December 31, 2001 represents a
provision for the uncertainty as to the realization of deferred tax assets,
including temporary differences and net operating loss carryforwards. The
Company has determined that it is more likely than not that certain future tax
benefits will be realized as a result of current and future income.
Accordingly, the valuation allowance has been reduced in the current year to
reflect greater anticipated net deferred tax asset utilization. As of December
31, 2001, the Company had approximately $302.2 million of net operating loss
carryforwards available to reduce future income taxes. The carryforward
periods expire in years 2010 through 2020. The Company has federal Alternative
Minimum Tax ("AMT") credit carryforwards of $3.3 million which are available to
reduce future regular taxes in excess of AMT. These credits have no expiration
date. The Company has federal and state tax credit carryforwards of $1.5
million which are available to reduce future taxes. The carryforward periods
expire in years 2018 through 2021, or have no expiration date.
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.
18. SHAREHOLDERS' EQUITY
Preferred Stock
At December 31, 2001, the Company was authorized to issue 25,000,000 shares of
preferred stock in one or more series. With the exception of 3,119,737 shares
which have been designated as "Series A Redeemable Preferred Stock" but have
not been issued, the Board of Directors has authority to designate the
preferences, special rights, limitations or restrictions of such shares.
Common Stock
On January 24, 2000, the Company issued to Rentrak Corporation 200,000 shares
of common stock as part of a litigation settlement.
19. STOCK OPTION PLANS
In general, the Company's stock option plans provide for the granting of
options to purchase Company shares at a fixed price. It has been the Company's
Board of Directors general policy to set the price at the market price of such
shares as of the option grant date. The options generally have a nine year
term and become exercisable on a pro rata basis over three years. The Company
adopted stock option plans in 1993, 1997 and 2001 providing for the granting of
non-qualified stock options, stock appreciation rights, bonus rights and other
incentive grants to employees up to an aggregate of 19,000,000 shares of common
stock. The Company granted non-qualified stock options pursuant to the 1993,
1997 and 2001 Plans totaling 11,063,683, 2,512,650 and 2,804,925 in 2001, 2000
and 1999, respectively.
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 2001, 2000 and 1999:
-----------------------------
2001 2000 1999
-----------------------------
Risk free interest rate 3.87% 4.87% 6.33%
Expected dividend yield 0% 0% 0%
Expected lives 3 years 5 years 5 years
Expected volatility 100% 98% 85%
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options, which have no vesting restrictions and are
fully transferable. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in the Company's opinion, the existing available models do
not necessarily provide a reliable single measure of the fair value of the
Company's employee stock options.
Using the Black-Scholes option valuation model, the weighted average grant date
value of options granted during 2001, 2000 and 1999 (excluding the options
assumed in connection with the Reel.com acquisition) was $1.55, $5.32, and
$9.95 per option, respectively.
For the purpose of pro forma disclosures, the estimated fair value of the
options is amortized over the option's vesting period. The value of options
issued in connection with the Reel.com acquisition are excluded from the pro
forma disclosure as the value of these options was part of the acquisition
purchase price.
The Company's pro forma information is as follows:
(in thousands, except per share amounts)
December 31,
-----------------------------------------------------------
2001 2000 1999
------------------- ------------------- -----------------
Pro Pro Pro
Reported Forma Reported Forma Reported Forma
-------- --------- -------- --------- -------- --------
Net income
(loss) $100,416 $ 97,490 $(530,040)$(538,886) $(51,302)$(57,665)
Earnings (loss)
per Share:
Basic 2.05 1.99 (11.48) (11.68) (1.13) (1.26)
Diluted 1.90 1.84 (11.48) (11.68) (1.13) (1.26)
Due to the Company's losses in 2000 and 1999, a calculation of earnings per
share assuming dilution is not required. In 2000 and 1999 dilutive securities
consisting of options convertible into 5.4 million and 8.2 million shares of
common stock, respectively, were excluded from the reported and pro forma
calculations due to the net loss in each year.
A summary of the Company's stock option activity and related information for
2001, 2000 and 1999 is as follows (in thousands, except per share amounts):
Weighted
Average
Exercise
Shares Price
-------- --------
Outstanding at December 31, 1998 7,460 $ 9.40
Granted 2,805 14.05
Exercised (889) 5.24
Cancelled (1,189) 9.13
-------- --------
Outstanding at December 31, 1999 8,187 11.49
Granted 2,511 7.01
Exercised (226) 3.52
Cancelled (5,050) 11.81
-------- --------
Outstanding as December 31, 2000 5,422 9.45
Granted 11,064 2.05
Exercised (181) 6.24
Cancelled (3,951) 7.39
-------- --------
Outstanding as December 31, 2001 12,354 $ 3.52
======== ========
A summary of options outstanding and exercisable at December 31, 2001 is as
follows (in thousands, except per share amounts):
------------------------------ -------------------
Options Outstanding Options Exercisable
------------------------------ -------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Range of Life Exercise Exercise
Exercise Prices Options (in years) Price Options Price
- --------------- ------- --------- -------- ------- --------
$ 0.56 - $1.56 8,293 8.23 $ 1.17 146 $ 1.07
2.04 - 9.63 2,689 7.26 5.26 561 7.30
9.90 - 15.00 837 6.84 11.70 301 11.17
15.20 - 19.62 535 4.14 18.45 418 18.54
------ --------- -------- ------- --------
12,354 7.75 $ 3.52 1,426 $ 10.78
====== ========= ======== ======= ========
In the first quarter of 2000, the Company granted stock options to
approximately fifty key employees. The grants were for the same number of
shares issued to these employees prior to January 1, 2000. In the third quarter
of 2000, the Company cancelled the stock options that were issued prior to
January 1, 2000 for the fifty employees. The grant and cancellation of the same
number of options for these employees resulted in variable accounting treatment
for the related options for 850,000 shares of the Company's common stock.
Variable accounting treatment will result in unpredictable stock-based
compensation dependent on fluctuations in quoted prices for the Company's
common stock.
The Company recorded compensation expense relating to the variable stock option
plan of $2.5 million in 2001. The Company had no compensation expense recorded
relating to the variable stock compensation plan in 2000 or 1999. The Company
had 482,750 variable options outstanding at December 31, 2001, 850,000 variable
options outstanding at December 31, 2000 and no variable options outstanding at
December 31, 1999.
The Company recorded compensation expense related to certain stock options
issued below the fair market value of the related stock. The Company recorded
compensation expense in the amount of $1.4 million for the year ended December
31, 2001. There was no such compensation expense recorded in 2000 or 1999.
A summary of options granted compared to market price:
Options Granted Shares
-------------------- ------------
Price = Market Value 3,609,550
Price > Market Value 533,000
Price < Market Value 6,921,133
20. EARNINGS PER SHARE
A reconciliation of the basic and diluted per share computations for 2001,
2000 and 1999 is as follows (in thousands, except per share data):
----------------------------------
2001
----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ---------
Income per common share $ 100,416 49,101 $ 2.05
Effect of dilutive securities:
Stock options - 3,779 (0.15)
---------- --------- ---------
Income per share assuming dilution $ 100,416 52,880 $ 1.90
========== ========= =========
----------------------------------
2000
----------------------------------
Weighted Per
Average Share
(Loss) Shares Amount
---------- --------- ---------
Loss per common share $ (530,040) 46,151 $ (11.48)
Effect of dilutive securities:
Stock options - - -
---------- --------- ---------
Loss per share assuming dilution $ (530,040) 46,151 $ (11.48)
========== ========= =========
----------------------------------
1999
----------------------------------
Weighted Per
Average Share
(Loss) Shares Amount
---------- --------- ---------
Loss before cumulative effect
Adjustment $ (49,858) 45,592 $ (1.09)
Cumulative effect of a change in
accounting principle, net of tax (1,444) - (0.04)
---------- --------- ---------
Loss per common share $ (51,302) 45,592 $ (1.13)
Effect of dilutive securities:
Stock options - - -
---------- --------- ---------
Loss per share assuming dilution $ (51,302) 45,592 $ (1.13)
========== ========= =========
Due to the Company's losses in 2000 and 1999, a calculation of earnings per
share assuming dilution is not required. Antidilutive stock options excluded
from the calculation of diluted income (loss) in 2001, 2000, and 1999 was 3.0
million, 5.4 million and 8.2 million, respectively.
21. SPECIAL AND/OR UNUSUAL ITEMS
The Company incurred the following special and/or unusual charges in 2001, 2000
and 1999.
2001
In December of 2001, the Company amended its store closure Restructuring Plan
and removed 16 stores from the closure list. In accordance with the amended
plan, and updated estimates on closing costs, the Company reversed $3.8 million
of the original $16.9 million charge recorded in the fourth quarter of 2000
(Note 7).
In the fourth quarter of 2001, the Company reversed $3.3 million of accrued
liabilities related to the discontinuation of Reel.com's e-commerce operations
because the Company was able to negotiate termination of certain obligations
and lease commitments more favorably than originally anticipated (Note 11).
2000
On June 12 2000, the Company announced that it would close down the e-commerce
business of Reel.com. As a result, the Company recorded a total charge of $67.7
million, of which $46.9 million was classified as a restructuring charge on the
consolidated statement of operations and $20.8 million was included in cost of
product sales (Note 11).
Effective October 1, 2000, the Company changed several estimates regarding
useful lives and salvage values on various types of rental inventory. As a
result, the Company recorded a charge of $164.3 million to cost of rental on
the consolidated statement of operations (Note 5).
In the fourth quarter of 2000, the Company developed a plan to close a group of
stores by the end of 2001. The assets associated with each identified store
were removed from the books and estimated closing costs were accrued resulting
in a $16.9 million charge (Note 7).
In accordance with FASB Statement No. 121, the Company recorded a $74.3 million
charge to properly value long-lived assets at several stores (Note 8). The
charge included a $30 million write-down of goodwill, classified as
amortization of intangibles on the consolidated statement of operations, and a
$44.3 million write-down of property and equipment, classified as operating and
selling.
1999
The Company recorded a $23.1 million charge in connection with a legal
settlement with Rentrak Corporation. On January 24, 2000, the Company and
Rentrak Corporation reached a settlement of their dispute concerning revenue
sharing videocassettes Rentrak had provided to the Company. The settlement
agreement resolves all disputes between the companies and dismisses all claims
against the Company. The settlement included $8.0 million in cash to cover
outstanding invoices and consideration for business disruption to Rentrak; $6.0
million to cover Rentrak's legal fees and costs; and finally, the Company
issued 200,000 shares of its common stock to Rentrak. Additionally, the Company
also incurred $5.8 million in legal fees related to the lawsuit.
On November 1, 1999, the Company and Twentieth Century Fox Home Entertainment
reached a settlement of their dispute. Fox had filed suit alleging fraud and
interference with Fox's contract with Rentrak. The Company incurred $2.3
million in settlement and related legal costs.
22. COMMITMENTS AND CONTINGENCIES
During 1999, Hollywood was named as a defendant in three complaints which have
been coordinated into a single action entitled California Exemption Cases, Case
No. CV779511, in the Superior Court of the State of California in and for the
County of Santa Clara. The plaintiffs are seeking to certify a class made up of
certain exempt current and former employees, which they claim are owed overtime
payments in certain stores in California. The plaintiffs are also seeking
attorneys fees and costs. A class has not been certified. The Company believes
it has provided adequate reserves in connection with this claim and intends to
vigorously defend the action.
On November 15, 2000, 3PF, a subsidiary of Rentrak Corporation filed a demand
for arbitration with the American Arbitration Association, Case No. 75 181
00413 00 GLO against Hollywood and Reel.com, Inc. ("Reel"). 3PF and Reel
entered into a Warehousing and Distribution Agreement on February 7, 2000. 3PF
has alleged that Reel is in default under the Agreement, has failed to perform
material obligations under the Agreement, and has failed to pay amounts due
3PF. 3PF seeks to recover approximately $4.8 million and consequential
damages. The Company believes it has provided adequate reserves in connection
with this claim and continues to vigorously defend the action.
The Company is a party to various claims, disputes, legal actions and other
proceedings involving contracts, employment and various other matters. In the
opinion of management, the outcome of these matters should not have a material
adverse effect on the Company's consolidated financial condition, results of
operations or liquidity.
23. SEGMENT REPORTING
The Company identifies its segments based on management responsibility. The
Company only operated one segment in 2001, the Hollywood Video segment
consisting of the Company's 1,801 retail stores located in 47 states. The
Company operated two segments during the first six months of 2000, the
Hollywood Video segment, consisting of the Company's 1,818 retail stores
located in 47 states, and the Reel.com segment, primarily an e-commerce company
specializing in movies. During the prior year second quarter, the Company
announced the discontinuation of e-commerce operations of Reel.com. This
resulted in a restructuring charge (Note 11). All assets of Reel.com were
transferred to the Hollywood Video segment on June 12, 2000. The Company
measures segment profit as operating income (loss), which is defined as income
(loss) before interest expense and income taxes. Information on segments and a
reconciliation to operating income (loss) are as follows (in thousands):
Year Ended December 31, 2000
-----------------------------------
Hollywood
Video Reel.com Total
---------- ----------- ----------
Revenues $1,269,957 $ 26,280 $1,296,237
Tape amortization (1) 176,459 110 176,569
Other depreciation and
amortization (2) 77,102 23,492 100,594
Gross profit 529,961 (18,974) 510,987
Operating loss (315,238) (121,083) (436,321)
Interest expense, net 57,861 4,266 62,127
Total assets 665,114 - 665,114
Purchase of property and
equipment, net 76,121 1,518 77,639
Year Ended December 31, 1999
-----------------------------------
Hollywood
Video Reel.com Total
---------- ----------- ----------
Revenues $1,054,879 $ 41,962 $1,096,841
Tape amortization 107,127 450 107,577
Other depreciation and
amortization 64,078 51,187 115,265
Gross profit 665,348 (2,387) 662,961
Operating income (loss) 96,025 (98,538) (2,513)
Interest expense, net 41,042 4,435 45,477
Total assets 983,887 69,404 1,053,291
Purchase of property and
equipment, net 108,804 3,454 112,258
(1) Excludes the $164.3 million charge for amortization policy change in
estimate (Note 5).
(2) Excludes the $74.3 million charge for the impairment of long-lived assets
(Note 8).
24. QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data is as follows (in thousands, except per share
data):
Quarter Ended
------------------------------------------
March June September December
2001 --------- --------- --------- ---------
- -------------------------
Total revenue $ 342,245 $ 325,072 $ 344,914 $ 367,272
Gross profit 197,804 197,239 211,605 228,378
Income from
Operations 18,432 20,441 30,310 50,094
Net income 3,526 6,785 15,374 74,731
Net income
per share:
Basic 0.07 0.14 0.31 1.51
Diluted 0.07 0.13 0.28 1.35
Quarter Ended
------------------------------------------
March June September December
2000 --------- --------- --------- ---------
- -------------------------
Total revenue $ 335,322 $ 322,636 $ 306,532 $ 331,747
Gross profit 196,754 174,023 192,083 (51,873)
Income (loss) from
operations 2,735 (70,074) 18,439 (387,421)
Net income (loss) (12,163) (63,044) 716 (455,549)
Net income (loss)
per share:
Basic (0.26) (1.37) 0.02 (9.85)
Diluted (0.26) (1.37) 0.02 (9.85)
Quarter Ended
------------------------------------------
March June September December
1999 --------- --------- --------- ---------
------------------------
Total revenue
As previously reported $ 266,529 $ 250,368 $ 266,319
Adjustments (1) (404) (905) (652)
--------- --------- ---------
As adjusted $ 266,125 $ 249,463 $ 265,667 $ 315,586
========= ========= ========= =========
Gross profit:
As previously reported $ 166,581 $ 155,382 $ 165,177
Adjustments (1) (371) (1,002) (873)
--------- --------- ---------
As adjusted $ 166,210 $ 154,380 $ 164,304 $ 178,067
========= ========= ========= =========
Income from operations
As previously reported $ 13,390 $ 5,707 $ 1,016
Adjustments (1) 204 (1,106) (1,375)
--------- --------- ---------
As adjusted $ 13,594 $ 4,601 $ (359) $ (20,349)
========= ========= ========= =========
Net income (loss)
As previously reported $ (4,221) $ (8,329) $ (11,622)
Adjustments (1) 204 (1,106) (1,375)
--------- --------- ---------
As adjusted $ (4,017) $ (9,435) $ (12,997) $ (24,853)
========= ========= ========= =========
Net income (loss) per
share:
Basic
As previously reported $ (0.09) $ (0.18) $ (0.25)
Adjustments (1) 0.00 (0.03) (0.03)
--------- --------- ---------
As adjusted $ (0.09) $ (0.21) $ (0.28) $ (0.54)
========= ========= ========= =========
Net income (loss) per
share:
Diluted
As previously reported $ (0.09) $ (0.18) $ (0.25)
Adjustments (1) 0.00 (0.03) (0.03)
--------- --------- ---------
As adjusted $ (0.09) $ (0.21) $ (0.28) $ (0.54)
========= ========= ========= =========
(1) During the fourth quarter of 1999, the Reel.com segment of the Company
recorded adjustments primarily related to advertising revenue and product
development costs. The impact of these changes, including related income
tax effects, was to increase previously reported net income by $204,000 for
the quarter ended March 31, 1999 and to decrease net income by $1,106,000
and $1,375,000 for the quarters ended June 30, 1999 and September 30, 1999,
respectively.
25. SUBSEQUENT EVENTS
On March 11, 2002, the Company completed a public offering of 8,050,000 shares
of its common stock, resulting in proceeds of $120.8 million before fees and
expenses, of which $114 million was applied to the repayment of borrowings
under the Company's prior revolving credit facility.
On March 18, 2002, the Company obtained new senior bank credit facilities from
a syndicate of lenders led by UBS Warburg LLC and applied a portion of initial
borrowings thereunder to repay all remaining borrowings under the Company's
prior revolving credit facility (which was then terminated). The new bank
credit facilities consists of a $150.0 million senior secured term facility
maturing in 2004 and a $25.0 million senior secured revolving credit facility
maturing in 2004. The maturity of the new facilities will automatically be
extended to 2006 if the Company's existing $250 million senior subordinated
notes are refinanced prior to February 2004. As a result of the early
retirement of the prior revolving credit facilities, the Company anticipates
recording an extraordinary charge of approximately $3.5 million in the first
quarter of 2002.
The credit agreement governing the facilities contains customary
representations, warranties, covenants (including financial covenants) and
events of default. Hollywood Management Company, and any future subsidiaries of
Hollywood Entertainment Corporation, are guarantors under the credit agreement.
The financial covenants, some of which may become more restrictive over time,
include a (1) maximum debt to adjusted EBITDA, (2) minimum interest coverage
test, and (3) minimum fixed charge coverage test (determined in each case on
the basis of the definitions and other provisions set forth in such credit
agreement). Currently, these financial covenants require the Company to
maintain (1) a ratio of debt to adjusted EBITDA of 3.0 to 1.0 or less, (2) a
ratio of adjusted EBITDA to interest expense of 3.0 to 1.0 or greater, and (3)
a ratio of adjusted EBITDA, plus interest expense, to fixed charges of at least
1.0 to 1.0.
26. CONSOLIDATING FINANCIAL STATEMENTS
Hollywood Entertainment Corporation (HEC) had only one wholly owned subsidiary
as of December 31, 2001, Hollywood Management Company (HMC). HMC is a guarantor
of certain indebtedness of HEC, including the new credit facilities and the
subordinated notes. Prior to June 2000, HEC had a wholly owned subsidiary named
Reel.com (Reel) that was merged with and into HEC in June 2000. The
consolidating condensed financial statements below present the results of
operations and financial position of the subsidiaries of the Company.
Consolidating Condensed Balance Sheet
December 31, 2001
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 1,999 $ 36,811 $ -- $ 38,810
Accounts receivable 19,161 388,895 (379,000) 29,056
Merchandise inventories 61,585 -- -- 61,585
Prepaid expenses and other
current assets 8,377 2,486 -- 10,863
Total current assets 91,122 428,192 (379,000) 140,314
Rental inventory, net 191,016 -- -- 191,016
Property & equipment, net 262,984 7,602 -- 270,586
Goodwill, net 64,934 -- -- 64,934
Deferred income tax asset 38,396 -- -- 38,396
Other assets, net 12,594 4,712 (4,008) 13,298
Total assets $ 661,046 $ 440,506 $ (383,008) $ 718,544
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 111,914 $ -- $ -- $ 111,914
Accounts payable 379,000 167,479 (379,000) 167,479
Accrued expenses 13,935 98,864 -- 112,799
Accrued interest -- 13,712 -- 13,712
Income taxes payable -- 5,266 -- 5,266
Total current liabilities 504,849 285,321 (379,000) 411,170
Long-term obligations, less
current portion 402,088 -- -- 402,088
Other liabilities 18,840 -- -- 18,840
Total liabilities 925,777 285,321 (379,000) 832,098
Preferred stock -- -- -- --
Common stock 373,848 4,008 (4,008) 373,848
Retained earnings
(accumulated deficit) (638,579) 151,177 -- (487,402)
Total shareholders' equity
equity (deficit) (264,731) 155,185 (4,008) (113,554)
Total liabilities and
shareholders equity
(deficit) $ 661,046 $ 440,506 $ (383,008) $ 718,544
Consolidating Condensed Balance Sheet
December 31, 2000
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 1,915 $ 1,353 $ -- $ 3,268
Accounts receivable 19,205 379,665 (375,040) 23,830
Merchandise inventories 54,201 -- -- 54,201
Prepaid expenses and other
current assets 8,169 1,930 -- 10,099
Total current assets 83,490 382,948 (375,040) 91,398
Rental inventory, net 168,462 -- -- 168,462
Property & equipment, net 311,812 11,854 -- 323,666
Goodwill, net 69,616 -- -- 69,616
Other assets, net 11,453 4,527 (4,008) 11,972
Total assets $ 644,833 $ 399,329 $ (379,048) $ 665,114
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 261,164 $ -- $ -- $ 261,164
Accounts payable 375,040 200,358 (375,040) 200,358
Accrued expenses 6,049 108,584 -- 114,633
Accrued interest -- 11,817 -- 11,817
Income taxes payable -- 4,844 -- 4,844
Total current liabilities 642,253 325,603 (375,040) 592,816
Long-term obligations, less
current portion 275,237 -- -- 275,237
Other liabilities 19,438 -- -- 19,438
Total liabilities 936,928 325,603 (375,040) 887,491
Preferred stock
Common stock 365,441 4,008 (4,008) 365,441
Retained earnings
(accumulated deficit) (657,536) 69,718 -- (587,818)
Total shareholders' equity
equity (deficit) (292,095) 73,726 (4,008) (222,377)
Total liabilities and
shareholders equity
(deficit) $ 644,833 $ 399,329 $ (379,048) $ 665,114
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2001
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,382,378 $ 154,075 $(156,950)$1,379,503
Cost of revenue 544,477 -- -- 544,477
Gross profit 837,901 154,075 (156,950) 835,026
Operating costs & expenses:
Operating and selling 610,274 11,069 -- 621,343
General & administrative 204,563 48,769 (156,950) 96,382
Restructuring charges:
Closure of Internet (3,256) -- -- (3,256)
business
Store closures (3,778) -- -- (3,778)
Amortization of intangibles 4,683 375 -- 5,058
Income (loss) from
operations 25,415 93,862 -- 119,277
Interest income -- 35,438 (35,021) 417
Interest expense (91,567) - 35,021 (56,546)
Income (loss) before
income taxes (66,152) 129,300 -- 63,148
(Provision for) income
taxes 85,109 (47,841) -- 37,268
Net income (loss) $ 18,957 $ 81,459 $ -- $ 100,416
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2000
(in thousands)
--------- --------- -------- --------- ---------
HEC HMC Reel Elimin- Consol-
ations idated
--------- --------- -------- --------- ---------
Revenue $1,272,832 $ 134,253 $ 26,280 $(137,128)$1,296,237
Cost of revenue 739,996 -- 45,254 -- 785,250
Gross profit 532,836 134,253 (18,974) (137,128) 510,987
Operating costs & expenses:
Operating and selling 655,164 30,822 27,445 -- 713,431
General & administrative 164,904 77,327 5,139 (137,128) 110,242
Restructuring charges:
Closure of Internet
Business -- -- 46,862 -- 46,862
Store closures 16,859 -- -- -- 16,859
Amortization of intangibles 37,163 88 22,663 -- 59,914
Income (loss) from
Operations (341,254) 26,016 (121,083) -- (436,321)
Interest income -- 26,689 -- (26,514) 175
Interest Expense (84,550) -- (4,266) 26,514 (62,302)
Income (loss) before
Income taxes (425,804) 52,705 (125,349) -- (498,448)
(Provision for) income
taxes (1,061) (19,501) (11,030) -- (31,592)
Net income (loss) $ (426,865)$ 33,204 $(136,379)$ -- $ (530,040)
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 1999
(in thousands)
--------- --------- -------- --------- ---------
HEC HMC Reel Elimin- Consol-
ations idated
--------- --------- -------- --------- ---------
Revenue $1,057,754 $ 61,333 $ 41,962 $ (64,208)$1,096,841
Cost of revenue 389,531 -- 44,349 -- 433,880
Gross profit 668,223 61,333 (2,387) (64,208) 662,961
Operating costs & expenses:
Operating and selling 478,879 4,936 38,867 -- 522,682
General & administrative 110,510 32,310 7,261 (64,208) 85,873
Amortization of intangibles 6,896 -- 50,023 -- 56,919
Income (loss) from
operations 71,938 24,087 (98,538) -- (2,513)
Interest income -- 11,627 -- (11,413) 214
Interest expense (52,669) -- (4,435) 11,413 (45,691)
Income (loss) before income
taxes & cumulative effect
adjustment 19,269 35,714 (102,973) -- (47,990)
(Provision for) benefit
from income taxes (9,054) (13,214) 20,400 -- (1,868)
Income (loss) before cumulative
effect of a change in
accounting principle 10,215 22,500 (82,573) -- (49,858)
Cumulative effect of a
change in accounting
principle (net of income
tax benefit of $983) -- (1,444) -- -- (1,444)
Net income (loss) $ 10,215 $ 21,056 $ (82,573) $ -- $ (51,302)
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2001
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
Operating activities:
Net income $ 18,957 $ 81,459 $ 100,416
Adjustments to reconcile
net income to
cash provided by
operating activities:
Depreciation &
amortization 244,521 6,370 250,891
Non-cash asset write downs
Tax benefit from exercise
of stock options (61) -- (61)
Change in deferred rent (598) -- (598)
Change in deferred income
taxes (38,396) -- (38,396)
Non-cash stock
compensation 7,371 -- 7,371
Net change in operating
assets & liabilities 4,238 (50,068) (45,830)
Cash provided by operating
activities 236,032 37,761 273,793
Investing activities:
Purchases of rental
inventory, net (202,790) -- (202,790)
Purchase of property &
equipment, net (7,063) (1,739) (8,802)
Increase in intangibles
& other assets (4,793) (564) (5,357)
Cash used in investing
activities (214,646) (2,303) (216,949)
Financing activities:
Proceeds from the sale of
common stock, net -- -- --
Issuance of long-term
obligations -- -- --
Repayments of long-term
obligations (17,399) -- (17,399)
Proceeds from exercise
of stock options 1,097 -- 1,097
Increase in revolving
loan, net (5,000) -- (5,000)
Cash provided by financing
activities (21,302) -- (21,302)
Increase (decrease) in cash
and cash equivalents 84 35,458 35,542
Cash and cash equivalents
at beginning of year 1,915 1,353 3,268
Cash and cash equivalents
at end of year $ 1,999 $ 36,811 $ 38,810
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2000
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Reel Consol-
idated
---------- ---------- ---------- ----------
Operating activities:
Net income (loss) $ (426,865) $ 33,204 $ (136,379) $ (530,040)
Adjustments to reconcile
net income (loss) to
cash provided by
operating activities:
Depreciation &
amortization 489,488 5,349 23,602 518,439
Non-cash asset write downs 30,548 3,838 25,509 59,895
Tax benefit from exercise
of stock options 63 -- -- 63
Change in deferred rent 1,993 -- -- 1,993
Change in deferred income
taxes 25,805 -- -- 25,805
Net change in operating
assets & liabilities 121,373 (36,928) 88,271 172,716
Cash provided by operating
activities 242,405 5,463 1,003 248,871
Investing activities:
Purchases of rental
inventory, net (176,926) -- 173 (176,753)
Purchase of property &
equipment, net (67,735) (8,676) (1,228) (77,639)
Increase in intangibles
& other assets (823) (607) -- (1,430)
Cash used in investing
activities (245,484) (9,283) (1,055) (255,822)
Financing activities:
Proceeds from the sale of
common stock, net -- -- -- --
Issuance of long-term
obligations 12,511 -- -- 12,511
Repayments of long-term
obligations (15,016) -- -- (15,016)
Proceeds from exercise
of stock options 783 -- -- 783
Increase in revolving
loan, net 5,000 -- -- 5,000
Cash provided by financing
activities 3,278 -- -- 3,278
Increase (decrease) in cash
and cash equivalents 199 (3,820) (52) (3,673)
Cash and cash equivalents
at beginning of year 1,716 5,173 52 6,941
Cash and cash equivalents
at end of year $ 1,915 $ 1,353 $ -- $ 3,268
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 1999
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Reel Consol-
idated
---------- ---------- ---------- ----------
Operating activities:
Net income (loss) $ 10,215 $ 21,056 $ (82,573) $ (51,302)
Adjustments to reconcile
net income (loss) to
cash provided by
operating activities:
Depreciation &
amortization 169,402 3,739 51,637 224,778
Non-cash asset write downs -- 1,444 -- 1,444
Tax benefit from exercise
of stock options 3,848 -- -- 3,848
Change in deferred rent 3,565 -- -- 3,565
Change in deferred income
taxes (1,545) -- -- (1,545)
Net change in operating
assets & liabilities (22,489) (15,007) 33,859 (3,637)
Cash provided by operating
activities 162,996 11,232 2,923 177,151
Investing activities:
Purchases of rental
inventory, net (185,638) -- (239) (185,877)
Purchase of property &
equipment, net (100,573) (8,231) (3,454) (112,258)
Investment in businesses
acquired (17,434) -- -- (17,434)
Increase in intangibles
& other assets (5,119) -- 350 (4,769)
Cash used in investing
activities (308,764) (8,231) (3,343) (320,338)
Financing activities:
Proceeds from the sale of
common stock, net -- -- -- --
Issuance of long-term
obligations 90,162 -- -- 90,162
Repayments of long-term
obligations (8,401) -- -- (8,401)
Repurchase of common stock --
Proceeds from exercise
of stock options 4,392 -- -- 4,392
Increase in revolving
loan, net 60,000 -- -- 60,000
Cash provided by financing
activities 146,153 -- -- 146,153
Increase (decrease) in cash
and cash equivalents 385 3,001 (420) 2,966
Cash and cash equivalents
at beginning of year 1,331 2,172 472 3,975
Cash and cash equivalents
at end of year $ 1,716 $ 5,173 $ 52 $ 6,941
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 April 1,
2002.
Hollywood Entertainment Corporation
By: /S/ JAMES MARCUM
---------------------------
James Marcum
Executive Vice President
and 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 April 1, 2002.
Signatures Title
/S/ MARK J. WATTLES
- ----------------
Mark J. Wattles Chairman of the Board of Directors,
and Chief Executive Officer
(Principal Executive Officer)
/S/ JAMES MARCUM
- ---------------
James Marcum Executive Vice President
and Chief Financial Officer
(Principal Financial and Accounting Officer)
/S/ DONALD J. EKMAN
- ---------------
Donald J. Ekman Director
/S/ WILLIAM P. ZEBE
- ---------------
William P. Zebe Director
/S/ JAMES N. CUTLER JR.
- -------------------
James N. Cutler Jr. Director
/S/ DOUGLAS GLENDENNING
- -------------------
Douglas Glendenning Director