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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 0-21824
HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in charter)
OREGON 93-0981138
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
9275 S.W. Peyton Lane, Wilsonville, Oregon 97070
(Address of principal executive offices) (zip code)
(503) 570-1600
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such short period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
As of November 8, 2002 there were 59,998,221 shares of the registrant's Common
Stock outstanding.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ ------------------
2002 2001 2002 2001
-------- -------- -------- --------
REVENUE:
Rental product revenue $331,074 $321,172 $ 974,741 $ 940,527
Merchandise sales 37,948 23,741 103,190 71,704
-------- -------- ---------- ----------
369,022 344,913 1,077,931 1,012,231
COST OF REVENUE:
Cost of rental product 112,035 115,017 331,496 350,835
Cost of merchandise 28,562 18,291 78,191 54,748
-------- -------- ---------- ----------
140,597 133,308 409,687 405,583
-------- -------- ---------- ----------
GROSS MARGIN 228,425 211,605 668,244 606,648
OPERATING COSTS AND EXPENSES:
Operating and selling 165,030 156,706 478,080 462,903
General and administrative 20,183 23,313 66,629 70,781
Store opening expenses 1,228 - 1,228 -
Amortization of intangibles - 1,276 - 3,781
Restructuring charge for closure
of internet business - - (12,430) -
-------- -------- ---------- ----------
186,441 181,295 533,507 537,465
-------- -------- ---------- ----------
INCOME FROM OPERATIONS 41,984 30,310 134,737 69,183
Interest expense, net (9,716) (14,602) (31,636) (42,943)
-------- -------- ---------- ----------
Income before income taxes
and extraordinary item 32,268 15,708 103,101 26,240
Provision for income taxes (323) (334) (1,031) (555)
-------- -------- ---------- ----------
Net income before extraordinary item 31,945 15,374 102,070 25,685
Extraordinary loss on retirement
of debt(net of income tax benefit
of $1,308) - - (2,226) -
-------- -------- ---------- ----------
NET INCOME $ 31,945 $ 15,374 $ 99,844 $ 25,685
======== ======== ========== ==========
Net income per share before
extraordinary item:
Basic $ 0.54 $ 0.31 $ 1.81 $ 0.52
Diluted $ 0.50 $ 0.28 $ 1.65 $ 0.50
Net income per share:
Basic $ 0.54 $ 0.31 $ 1.77 $ 0.52
Diluted $ 0.50 $ 0.28 $ 1.62 $ 0.50
Weighted average shares outstanding:
Basic 58,883 49,311 56,431 49,006
Diluted 63,712 54,984 61,797 51,836
The accompanying notes are an integral part of this financial statement
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
September 30, December 31,
------------ -----------
2002 2001
------------ -----------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 19,592 $ 38,810
Receivables 27,079 29,056
Merchandise inventories 96,820 61,585
Prepaid expenses and other current assets 12,665 10,863
----------- -----------
Total current assets 156,156 140,314
Rental inventory, net 237,460 191,016
Property and equipment, net 245,028 270,586
Goodwill 64,934 64,934
Deferred tax asset, net 38,396 38,396
Other assets, net 12,534 13,298
----------- -----------
$ 754,508 $ 718,544
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Current maturities of long-term obligations $ 37,439 $ 111,914
Accounts payable 150,244 167,479
Accrued expenses 90,864 112,799
Accrued interest 3,653 13,712
Income taxes payable 3,570 5,266
----------- -----------
Total current liabilities 285,770 411,170
Long-term obligations, less current portion 350,670 402,088
Other liabilities 17,851 18,840
----------- -----------
654,291 832,098
----------- -----------
Shareholders' equity (deficit):
Preferred stock, 25,000,000 shares
authorized; no shares issued and
outstanding - -
Common stock, 100,000,000 shares authorized;
58,906,865 and 49,428,763 shares issued
and outstanding, respectively 488,639 375,503
Unearned compensation (864) (1,655)
Accumulated deficit (387,558) (487,402)
----------- -----------
Total shareholders' equity (deficit) 100,217 (113,554)
----------- -----------
$ 754,508 $ 718,544
=========== ===========
The accompanying notes are an integral part of this financial statement.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
Nine Months Ended
September 30,
------------------------
2002 2001
---------- ----------
OPERATING ACTIVITIES:
Net income $ 99,844 $ 25,685
Adjustments to reconcile net income
to cash provided by operating activities:
Extraordinary loss on retirement of debt 2,226 -
Amortization of rental product 156,979 135,470
Depreciation and amortization 44,987 50,449
Amortization of deferred financing costs 2,922 2,553
Change in deferred rent (989) (356)
Non-cash stock compensation (1,800) 6,147
Net change in operating assets and liabilities:
Receivables 1,977 (1,871)
Merchandise inventories (35,235) (2,193)
Accounts payable (17,235) (37,750)
Accrued interest (10,059) (4,080)
Other current assets and liabilities (24,169) (4,250)
--------- ---------
Cash provided by operating activities 219,448 169,804
--------- ---------
INVESTING ACTIVITIES:
Purchases of rental inventory, net (203,423) (126,691)
Purchases of property and equipment, net (19,429) (6,222)
Increase in intangibles and other assets (549) (460)
--------- ---------
Cash used in investing activities (223,401) (133,373)
--------- ---------
FINANCING ACTIVITIES:
Proceeds from issuance of common stock 120,750 -
Equity financing costs (7,677) -
Borrowings under new term loan facility 150,000 -
Repayment of prior revolving loan (240,000) -
Increase (decrease) in credit agreements (25,000) (5,000)
Debt financing costs (5,098) (4,035)
Repayments of capital lease obligations (10,894) (12,156)
Proceeds from exercise of stock options 2,654 378
--------- ---------
Cash used in financing activities (15,265) (20,813)
-------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENT (19,218) 15,618
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 38,810 3,268
-------- --------
CASH AND CASH EQUIVALENTS AT END OF THE THIRD
QUARTER $ 19,592 $ 18,886
======== ========
The accompanying notes are an integral part of this financial statement.
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The unaudited Consolidated Financial Statements have been prepared pursuant to
the rules and regulations of the Securities and Exchange Commission.
Certain information and note disclosures normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
(GAAP) have been condensed or omitted pursuant to those rules and regulations,
although the Company believes that the disclosures made are adequate to make
the information presented not misleading. The information furnished reflects
all adjustments which are, in the opinion of management, necessary for a fair
statement of the results for the interim periods presented, and which are of a
normal, recurring nature. These financial statements should be read in
conjunction with the financial statements and the notes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2001 filed
with the Securities and Exchange Commission. Results of operations for interim
periods may not necessarily be indicative of the results that may be expected
for the full year or any other period.
(1) Accounting Policies
The Consolidated Financial Statements included herein have been prepared in
accordance with the accounting policies described in Note 1 to the December 31,
2001 audited Consolidated Financial Statements included in the Company's Annual
Report on Form 10-K. 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 gross margin, net income or shareholders'
equity (deficit).
Effective January 1, 2002, the Company began reporting sales and related costs
of previously viewed rental inventory as rental product revenue and cost of
rental product, respectively. Prior to January 1, 2002, the Company included
sales and related costs of sales of previously viewed rental inventory in
merchandise sales and cost of merchandise sales, respectively. For comparative
purposes, sales and related costs of sales of previously viewed rental
inventory for the three months ended September 30, 2001 and the nine months
ended September 30, 2001 have been reclassified to conform to the presentation
for the current year.
In July 2001, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) Nos. 141 and 142, "Business
Combinations" and "Goodwill and Other Intangible Assets," respectively. SFAS
141 supersedes Accounting Principles Board (APB) Opinion No. 16 and eliminates
pooling-of-interests accounting. It also provides guidance on purchase
accounting related to the recognition of intangible assets and accounting for
negative goodwill. SFAS 142 changes the accounting for goodwill from an
amortization method to an impairment only approach. Under SFAS 142, goodwill
and non-amortizing intangible assets shall be adjusted whenever events or
circumstances occur indicating that goodwill has been impaired. The Company
has completed its impairment testing of the valuation of its goodwill and has
determined that there is no impairment. SFAS 141 and 142 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 ceased, and intangible assets acquired prior to July 1, 2001
that did not meet criteria for recognition under SFAS 141 were reclassified to
goodwill. The Company adopted SFAS 142 on January 1, 2002, the beginning of
fiscal 2002. Application of the non-amortization provisions of SFAS 142 to
goodwill, which had previously been amortized over 20 years, and to the
Company's trade-name right, which had previously been amortized over 15 years,
resulted in an increase in net income of $1.3 million and $3.8 million, net of
tax, for the three and nine months ended September 30, 2002, respectively.
The components of intangible assets are as follows (in thousands):
December 31, September 30,
2001 Additions 2002
------------ --------- ------------
Goodwill $ 64,934 $ - $ 64,934
Trade-name rights 4,612 462 5,074
------------ --------- ------------
$ 69,546 $ 462 $ 70,008
============ ========= ============
The following table summarizes the pro forma impact of excluding amortization
of intangible assets for the three months ended September 2001 and for the nine
months ended September 30, 2001 (in thousands, except per share amounts):
Three Months Nine Months
Ended Ended
September 30, September 30,
2001 2001
------------ ------------
Net income as reported $ 15,374 $ 25,685
Add back: Amortization of
intangible assets, net of tax 1,249 3,701
------------ ------------
Pro forma net income $ 16,623 $ 29,386
============ ============
Basic net income per share:
As reported $ 0.31 $ 0.52
Pro forma net income per share $ 0.34 $ 0.60
Diluted net income per share:
As reported $ 0.28 $ 0.50
Pro forma net income per share $ 0.30 $ 0.57
On October 3, 2001, the FASB issued SFAS 144, "Accounting for the Impairment or
Disposal of Long-lived Assets." SFAS 144 supersedes SFAS 121 "Accounting for
the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed
of." SFAS 144 applies to long-lived assets to be held and used, or to be
disposed of, except for goodwill and non-amortizing intangible assets to be
held and used, as well as goodwill associated with a reporting unit. SFAS 144
supersedes accounting and reporting provisions of the Accounting Principles
Board (APB) Opinion No. 30, "Reporting the Results of Operations, Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions." SFAS 144 develops one
accounting model for long-lived assets that are to be disposed of by sale. SFAS
144 requires that long-lived assets that are to be disposed of by sale be
measured at the lower of book value or fair value less cost to sell.
Additionally, SFAS 144 expands the scope of discontinued operations to include
all components of an entity with operations and cash flows 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. SFAS 144 is
effective for the Company for all financial statements issued beginning January
1, 2002. Currently, 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 2001 amended store closure plan (see note 8). Therefore, the adoption of
SFAS 144 is not expected to have a material impact on its results of
operations, financial position or liquidity.
In May 2002, the FASB issued SFAS 145, "Rescission of FAS Nos. 4, 44 and 64,
Amendment of FAS 13, and Technical Corrections." Among other things, SFAS 145
rescinds various pronouncements regarding the treatment of early extinguishment
of debt as extraordinary unless the provisions of APB Opinion No. 30,
"Reporting the Results of Operations - Reporting the Effect of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions" are met. SFAS 145 provisions regarding early
extinguishment of debt are generally effective for fiscal years beginning after
May 15, 2002. The Company will adopt SFAS 145 on January 1, 2003. The
pronouncement primarily deals with the presentation of these events, and as
such, the Company does not believe the adoption will have a material impact on
its results of operation, financial position or liquidity.
In July 2002, the FASB issued SFAS 146, "Accounting for Costs Associated with
Exit or Disposal". SFAS 146 supersedes EITF 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(Including Certain Costs Incurred in a Restructuring)". This statement applies
to costs that are associated with exit activities that are not covered by SFAS
144, "Accounting for the Impairment of Disposal of Long-Lived Assets," or
entities that are newly acquired in a business combination. The costs that are
covered are one-time termination benefits paid to employees who were
involuntarily terminated, costs to terminate contracts that are not capital
leases and costs to consolidate facilities and relocate employees. The Company
will adopt SFAS 146 on January 1, 2003. Although the Company has not yet
completed an analysis, it does not believe the adoption will have a material
impact on its results of operations, financial position or liquidity.
(2) Rental Amortization Policy
The Company manages its rental inventories of movies under two distinct
categories, new release and catalog. New releases which represent the majority
of all movies acquired are those movies which are primarily purchased on a
weekly basis in large quantities to support demand upon their initial release
by the studios and are generally held for relatively short periods of time.
Catalog, or library, represents an investment in those movies the Company
intends to hold for an indefinite period of time and represents a historic
collection of movies which are maintained on a long- term basis for rental to
customers. In addition to acquiring catalog movies from studios upon their
initial release, the Company acquires previously released or older movies for
catalog inventories to support new store openings and the build up of title
selection for new platforms such as DVD.
Purchases of new release movies are amortized over four months to current
estimated average residual values of approximately $3.16 for VHS and $4.67 for
DVD (net of estimated allowances for losses). Purchases of VHS and DVD catalog
are amortized on a straight-line basis over one year and five years,
respectively, to estimated residual values of $2.00 for VHS and $6.00 for DVD.
For new release movies acquired under revenue sharing arrangements, the
studios' share of rental revenue is charged to cost of rental net of an average
estimated interim residual value which is approximately equal to the residual
values of purchased inventory, as outlined above. The expense is recorded as
revenue is earned on the respective revenue sharing titles.
Games acquired upon their initial release by publishers are amortized over four
months to an estimated interim residual value of approximately $15.00 and then
to $5.00 over the following twenty months. Games the Company expects to keep in
rental inventory for an indefinite period of time are amortized on a straight-
line basis over two years to an estimated residual value of $5.00.
(3) Statements of Changes in Shareholders' Equity (Deficit)
A summary of changes to shareholders' equity (deficit) amounts for the nine
months ended September 30, 2002 is as follows (in thousands, except share
amounts):
Common Stock Unearned
------------------- Compen- Accumulated
Shares Amount sation Deficit Total
---------- -------- -------- --------- ---------
Balance at 12/31/2001 49,428,763 $375,503 $(1,655) $(487,402) $(113,554)
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock issuance 8,050,000 120,750 120,750
Equity offering costs (7,677) (7,677)
Stock options exercised 1,428,102 2,654 2,654
Stock compensation (2,591) 791 (1,800)
Net income 99,844 99,844
---------- -------- -------- --------- ---------
Balance at 9/30/2002 58,906,865 $488,639 $ (864) $(387,558) $ 100,217
========== ======== ======== ========= =========
As of December 31, 2000, the Company recorded a $211.2 million valuation
allowance on its $211.2 million net deferred tax asset, consisting of temporary
timing differences and net operating loss carryforwards. As of September 30,
2002, this valuation allowance was $111.1 million on the Company's $149.5
million net deferred tax asset. Excluding this allowance, as of September 30,
2002 shareholders' equity would have been $211.4 million.
(4) Operating Leases
The Company leases all of its stores, corporate offices, distribution centers
and zone offices under non-cancelable operating leases. All of the Company's
stores have an initial operating lease term of five to fifteen years and most
have options to renew for between five and fifteen additional years. Rent
expense was $53.3 million and $159.4 million for the three months and the nine
months ended September 30, 2002, respectively, compared to $52.9 million and
$159.0 million for the corresponding periods of the prior year. Most operating
leases require payment of additional occupancy costs, including property taxes,
utilities, common area maintenance and insurance. These additional occupancy
costs were $10.7 million and $31.5 million for the three months and the nine
months ended September 30, 2002, respectively, compared to $10.3 million and
$30.7 million for the corresponding periods of the prior year.
(5) Long-term Obligations
The Company had the following long-term obligations as of September 30, 2002
and December 31, 2001 (in thousands):
September 30, December 31,
------------ -----------
2002 2001
------------ -----------
Senior subordinated notes $ 250,000 $ 250,000
Borrowings under credit agreements 125,000 240,000
Obligations under capital leases 13,109 24,002
------------ -----------
388,109 514,002
Current portions:
Credit agreements 26,250 98,500
Capital leases & other 11,189 13,414
------------ -----------
37,439 111,914
Total long-term obligations ------------ -----------
net of current portion $ 350,670 $ 402,088
============ ===========
On December 7, 2001, the Company filed with the Securities and Exchange
Commission a shelf registration statement covering up to $426.5 million of
securities, consisting of $126.5 million of equity securities and $300.0
million of debt securities. The registration statement became effective on
February 14, 2002.
On March 11, 2002, the Company completed a public offering of 8,050,000 shares
of its common stock under its shelf registration statement, 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. The shelf registration statement, as amended on May 20, 2002,
covers the possible issuance of up to an aggregate of $305.8 million in debt
and/or equity securities.
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 the
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 consisted of a $150.0 million senior secured term
facility maturing in March 2004 and a $25.0 million senior secured revolving
credit facility maturing in March 2004. The maturity of the new facilities will
automatically be extended to 2006 if the Company's existing $250 million
10.625% senior subordinated notes due in 2004 (the "Subordinated Notes") are
refinanced prior to February 2004 with a maturity date beyond 2006. The
redemption premium applicable to the existing Subordinated Notes declined from
5.313% to 2.656% on August 15, 2002 and will decline to zero on August 15,
2003.
At September 30, 2002, maturities on long-term obligations for the next five
years are as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December 31, Notes Agreements & Other Total
- ------------ ---------- ---------- --------- ---------
2002 $ - $ - 2,521 $ 2,521
2003 - 35,000 10,588 45,588
2004 250,000 90,000(1) - 340,000
2005 - - - -
2006 - - - -
Thereafter - - - -
---------- ---------- --------- ---------
$ 250,000 $ 125,000 $ 13,109 $ 388,109
---------- ---------- --------- ---------
(1) The maturity of the credit facilities will automatically be extended, such
that $35 million will be due in 2004 and 2005 and $20 million will be due in
2006, if the Subordinated Notes are refinanced prior to February 2004 with a
maturity date beyond 2006.
(6) Earnings per Share
Basic earnings per share are calculated based on income available to common
shareholders and the weighted-average number of common shares outstanding
during the reported period. Diluted earnings per share includes additional
dilution from the effect of potential issuances of common stock, such as stock
issuable pursuant to the exercise of stock options.
The following tables are reconciliations of the basic and diluted earnings per
share computations (in thousands, except per share amounts):
Three Months Ended September 30,
----------------------------------------------------------
2002 2001
--------------------------- -----------------------------
Net Per Share Net Per Share
Income Shares(1) Amounts Income Shares(1) Amounts
------- --------- ------- -------- --------- --------
Basic income
per share: $31,945 58,883 $ 0.54 $ 15,374 49,311 $ 0.31
Effect of dilutive ======= =======
securities:
Stock options - 4,829 - 5,673
------- --------- -------- ---------
Diluted income
per share: $31,945 63,712 $ 0.50 $ 15,374 54,984 $ 0.28
======= ========= ======= ======== ========= ========
(1) Represents weighted average shares outstanding.
Antidilutive stock options excluded from the calculation of diluted income per
share were 0.9 million shares and 1.7 million shares in the three months ended
September 30, 2002 and 2001, respectively.
Nine Months Ended September 30,
-----------------------------------------------------------
2002 2001
---------------------------- -----------------------------
Net Per Share Net Per Share
Income Shares(1) Amounts Income Shares(1) Amounts
------- --------- -------- -------- ------- ----------
Basic income
per share: $99,844 56,431 $ 1.77 $ 25,685 49,006 $ 0.52
Effect of dilutive ======= =========
securities:
Stock options - 5,366 - 2,830
------- --------- -------- -------
Diluted income
per share: $99,844 61,797 $ 1.62 $ 25,685 51,836 $ 0.50
======= ========= ======== ======== ======= =========
(1) Represents weighted average shares outstanding.
Antidilutive stock options excluded from the calculation of diluted income per
share were 0.7 million shares and 4.8 million shares in the nine months ended
September 30, 2002 and 2001, respectively.
(7) Reel.com Discontinued E-commerce Operations
On June 12, 2000, the Company announced that it would discontinue the e-
commerce business of Reel.com, Inc. (Reel.com). Although the Company believes
it 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 retail
stores' cash flow. As a result of the discontinuation of Reel.com's e-commerce
operations, the Company recorded a restructuring charge of $69.3 million in the
second quarter of 2000 that included $22.4 million of accrued liabilities (net
of $4.9 million of reductions). Amounts accrued included $17.3 million for
contractual obligations, lease commitments and anticipated legal claims against
the Company and $5.1 million for legal, financial, and other professional
services incurred as a direct result of the closure of Reel.com. Since June
2000, the Company has paid $10.0 million of the $22.4 million of accrued
liabilities, inclusive of legal and legal related costs in settlement of all
claims with 3PF. As a result, the remaining accrual balance for such claims
was reversed to a zero balance at June 30, 2002, resulting in a $12.4 million
accrual reversal.
(8) Store Closure Restructuring
In December of 2001, the Company amended its store closure restructuring plan
and continues to pursue the closing of the remaining 15 stores. In accordance
with the amended plan and revised estimates on closing costs, the Company has a
$3.7 million accrual balance as of September 30, 2002 for store closing costs.
The Company did not close any of the 15 stores in the first nine months of
2002.
(9) Legal Proceedings
During 1999, the Company 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 were seeking to certify a class made
up of certain exempt employees, who they claim are owed overtime payments for
work performed in certain stores in California. The parties have since entered
into a settlement agreement, which was given preliminary approval by the court
on August 5, 2002. The class consists of only those individuals employed by
Hollywood Entertainment within the State of California as salaried store
managers in Hollywood Video stores during the period from January 25, 1995 to
March 31, 2002, and only those employed by Hollywood Entertainment within the
State of California as salaried assistant managers in Hollywood Video stores
during the period from January 25, 1995 to December 31, 1999, who do not opt-
out of the settlement. The Company believes, based upon the agreement, it has
provided adequate reserves in connection with the settlement agreement.
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. 3PF and Reel.com entered into a
Warehousing and Distribution Agreement (Agreement) on February 7, 2000. 3PF
alleged that, as a result of the discontinuation of Reel.com operations,
Reel.com was in default under the Agreement, failed to perform material
obligations under the Agreement, and failed to pay amounts due 3PF. On May 15,
2002, the Company, 3PF and Rentrak Corporation entered into a settlement
agreement encompassing all claims between the two parties including
counterclaims and causes of action that were asserted or could have been
asserted and agreed to the dismissal of the arbitration case.
The Company has been named 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
extended rental periods. The Company believes it has provided adequate
reserves for these various contingencies and that the outcome of these matters
should not have a material adverse effect on the Company's consolidated results
of operation, financial condition or liquidity.
(10) Related Party Transactions
In the nine months ended September 30, 2002, Boards, Inc. (Boards) opened three
Hollywood Video stores as a licensee of the Company pursuant to rights granted
by the Company and approved by the Board of Directors as part of an employment
agreement with Mark Wattles, the Company's founder, Chief Executive Officer and
President, in January 2001 to open and operate 20 licensed stores. Boards now
operates five stores, which are not included in the 1,804 stores operated by
the Company. Mark Wattles is the majority owner of Boards. Under the license
arrangement, Boards will pay the Company $25,000 per store as a license fee,
royalty payments of 2% of revenue and may purchase product and services from
the Company. The Company supplies products and services for all five stores,
including the store opening inventory. As a result, the receivable from Boards
was approximately $1.1 million as of September 30, 2002. The Company expects
this receivable to fluctuate throughout the remainder of the year and in 2003
depending on the number of stores recently opened by Boards in which the
Company supplies the opening inventory. The Company does not anticipate this
receivable exceeding $1.5 million at any given point in time.
(11) Consolidating Financial Statements
Hollywood Entertainment Corporation (HEC) had one subsidiary, Hollywood
Management Company (HMC), during the nine months ended September 30, 2002. HMC
is wholly owned and a guarantor of the subordinated notes of HEC. The
consolidating condensed financial statements below present the results of
operations, financial position and liquidity of HEC and HMC.
Consolidating Condensed Statement of Operations
Three months ended September 30, 2002
(in thousands)
---------- -------- --------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- -------- --------- ----------
REVENUE $ 369,740 $ 40,946 $ (41,664) $ 369,022
COST OF REVENUE 140,597 -- -- 140,597
GROSS MARGIN 229,143 40,946 (41,664) 228,425
OPERATING COSTS & EXPENSES:
Operating and selling 161,430 3,600 -- 165,030
General & administrative 47,155 14,692 (41,664) 20,183
Store Opening Expenses 1,228 -- -- 1,228
Restructuring charge for
closure of internet
business -- -- -- --
INCOME FROM OPERATIONS 19,330 22,654 -- 41,984
Interest income -- 8,830 (8,741) 89
Interest expense (18,546) -- 8,741 (9,805)
Income before income
taxes 784 31,484 -- 32,268
Benefit from (provision for)
income taxes 11,326 (11,649) -- (323)
NET INCOME $ 12,110 $ 19,835 $ -- $ 31,945
Consolidating Condensed Statement of Operations
Nine months ended September 30, 2002
(in thousands)
---------- -------- --------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- -------- --------- ----------
REVENUE $1,080,087 $115,877 $(118,033) $1,077,931
COST OF REVENUE 409,687 -- -- 409,687
GROSS MARGIN 670,400 115,877 (118,033) 668,244
OPERATING COSTS & EXPENSES:
Operating and selling 469,938 8,142 -- 478,080
General & administrative 148,805 35,857 (118,033) 66,629
Store Opening Expenses 1,228 -- -- 1,228
Restructuring charge for
closure of internet
business (12,430) -- -- (12,430)
INCOME FROM OPERATIONS 62,859 71,878 -- 134,737
Interest income -- 23,271 (22,979) 292
Interest expense (54,907) -- 22,979 (31,928)
Income before income
taxes and extraordinary
item 7,952 95,149 -- 103,101
Benefit from (provision for)
income taxes 35,148 (36,179) -- (1,031)
Net income before
extraordinary item 43,100 58,970 -- 102,070
Extraordinary loss on
retirement of debt (net
of income tax benefit of
$1,308) (2,226) -- -- (2,226)
NET INCOME $ 40,874 $ 58,970 $ -- $ 99,844
Consolidating Condensed Balance Sheet
September 30, 2002
(in thousands)
---------- -------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
---------- -------- --------- ---------
ASSETS
Cash and cash equivalents $ 2,013 $ 17,579 $ -- $ 19,592
Receivables 17,830 407,744 (398,495) 27,079
Merchandise inventories 96,820 -- -- 96,820
Prepaid expenses and other
current assets 9,863 2,802 -- 12,665
Total current assets 126,526 428,125 (398,495) 156,156
Rental inventory, net 237,460 -- -- 237,460
Property & equipment, net 227,095 17,933 -- 245,028
Goodwill, net 64,934 -- -- 64,934
Deferred tax assets, net 38,396 -- -- 38,396
Other assets, net 11,343 5,199 (4,008) 12,534
Total Assets $ 705,754 $451,257 $(402,503) $ 754,508
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 37,439 $ -- $ -- $ 37,439
Accounts payable 398,495 150,244 (398,495) 150,244
Accrued expenses 11,228 79,636 -- 90,864
Accrued interest -- 3,653 -- 3,653
Income taxes payable -- 3,570 -- 3,570
Total current liabilities 447,162 237,103 (398,495) 285,770
Long-term obligations, less
current portion 350,670 -- -- 350,670
Other liabilities 17,851 -- -- 17,851
Total liabilities 815,683 237,103 (398,495) 654,291
Common stock 488,639 4,008 (4,008) 488,639
Unearned compensation (864) -- -- (864)
Retained earnings
(accumulated deficit) (597,704) 210,146 -- (387,558)
Total shareholders'
equity (deficit) (109,929) 214,154 (4,008) 100,217
Total liabilities and
shareholders' equity
(deficit) $ 705,754 $451,257 $(402,503) $ 754,508
Consolidating Condensed Statement of Cash Flows
Nine months ended September 30, 2002
(in thousands)
---------- -------- ----------
HEC HMC Consol-
idated
---------- -------- ----------
OPERATING ACTIVITIES:
Net income $ 40,874 $ 58,970 $ 99,844
Adjustments to reconcile
net income to
cash provided by
operating activities:
Extraordinary item 2,226 -- 2,226
Depreciation &
amortization 200,339 4,549 204,888
Change in deferred rent (989) -- (989)
Non cash stock compensation (1,800) -- (1,800)
Net change in operating
assets & liabilities (6,807) (77,914) (84,721)
Cash provided by (used in)
Operating activities 233,843 (14,395) 219,448
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (203,423) -- (203,423)
Purchase of property &
equipment, net (15,081) (4,348) (19,429)
Increase in intangibles
& other assets (60) (489) (549)
Cash used in investing
activities (218,564) (4,837) (223,401)
FINANCING ACTIVITIES:
Proceeds from the sale of
common stock, net 113,073 -- 113,073
Repayments of capital lease
obligations (10,894) -- (10,894)
Proceeds from exercise
of stock options 2,654 -- 2,654
Increase in revolving
loans, net (120,098) -- (120,098)
Cash used in financing
activities (15,265) -- (15,265)
Decrease in cash
and cash equivalents 14 (19,232) (19,218)
Cash and cash equivalents
at beginning of year 1,999 36,811 38,810
Cash and cash equivalents at
the end of the second quarter $ 2,013 $ 17,579 $ 19,592
ITEM 2 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 audited
Consolidated Financial Statements included in our Annual Report on Form 10-K
for the year ended December 31, 2001, and Note 1 to the Consolidated Financial
Statements contained in this Quarterly Report on Form 10-Q, 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; 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, assumptions and estimates. Certain critical accounting policies
that involve significant judgments, assumptions and estimates which affect
amounts recorded in the Consolidated Financial Statements are discussed in our
Annual Report on Form 10-K for the year ended December 31, 2001 in Management's
Discussion and Analysis of Results of Operations and Financial Condition under
the heading "Critical Accounting Policies."
For a discussion of new accounting pronouncements, refer to Note 1, "Accounting
Policies," to the Consolidated Financial Statements.
RESULTS OF OPERATIONS
Summary Results of Operations
Our net income for the three months and nine months ended September 30, 2002
was $31.9 million and $99.8 million, respectively, compared with net income of
$15.4 million and $25.7 million for the three months and nine months ended
September 30, 2001, respectively. Net income in all periods presented
benefited from a reduction in our valuation allowance on our deferred income
tax asset, resulting in an effective tax rate of 1.0% in the three months and
nine months ending September 30, 2002 and 2.1% in the three months and nine
months ending September 30, 2001. The Company believes a 40.5% effective tax
rate is more representative of a normalized provision for income taxes when the
valuation allowance reductions are excluded. Income before income taxes and
extraordinary item for the three months and the nine months ended September 30,
2002 was $32.3 million and $103.1 million, respectively, compared to $15.7
million and $26.2 million for the three months and nine months ended September
30, 2001, respectively. Included in income before income taxes and
extraordinary item in the three months ended September 30, 2002 was $4.5
million of income resulting from variable plan accounting for certain
compensatory stock options. Included in income before income taxes and
extraordinary item in the nine months ended September 30, 2002 was a $12.4
million reversal of an accrual associated with the resolution of certain claims
associated with the closure of Reel.com. Excluding these items, and assuming a
normalized effective tax rate of 40.5%, our net income for the three months and
the nine months ended September 30, 2002 would have been $16.5 million and
$51.3 million, respectively, compared to $9.3 million and $15.6 million for the
three months and nine months ended September 30, 2001, respectively. The
improvement was primarily the result of improved operating performance in our
existing store base, in which comparable store sales rose 7% for both the three
months and nine months ended September 30, 2002. Other items attributing to the
improvement were intangible assets no longer amortizing and incremental
amortization charges on rental product taken in the prior year.
The following table sets forth (i) selected results of operations data,
expressed as a percentage of total revenue; (ii) other financial data; and
(iii) selected operating data.
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
(Unaudited)
REVENUE:
Rental product revenue 89.7% 93.1% 90.4% 92.9%
Merchandise sales 10.3 6.9 9.6 7.1
---------- ---------- ---------- ----------
100.0 100.0 100.0 100.0
---------- ---------- ---------- ----------
GROSS MARGIN 61.9 61.4 62.0 59.9
OPERATING COSTS AND EXPENSES:
Operating and selling 44.7 45.4 44.4 45.7
General and administrative 5.5 6.8 6.2 7.0
Store opening expenses 0.3 0.0 0.1 0.0
Amortization of intangibles 0.0 0.4 0.0 0.4
Restructuring charge for
closure of internet business 0.0 0.0 (1.2) 0.0
---------- ---------- ---------- ----------
50.5 52.6 49.5 53.1
---------- ---------- ---------- ----------
INCOME FROM OPERATIONS 11.4 8.8 12.5 6.8
Interest expense, net (2.6) (4.2) (2.9) (4.2)
---------- ---------- ---------- ----------
Income before income taxes
and extraordinary item 8.7 4.6 9.6 2.6
Provision for income taxes (0.1) (0.1) (0.1) (0.1)
---------- --------- ---------- ----------
Net income before
extraordinary item 8.6 4.5 9.5 2.5
---------- --------- ---------- ----------
Extraordinary loss on
retirement of debt, net 0.0 0.0 (0.2) 0.0
---------- --------- ---------- ----------
NET INCOME 8.6% 4.5% 9.3% 2.5%
---------- --------- ---------- ----------
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
OTHER FINANCIAL DATA:
Rental product gross margin (1) 66.2% 64.2% 66.0% 62.7%
Merchandise gross margin (2) 24.7% 23.0% 24.2% 23.6%
EBITDA (in thousands)(3) $ 52,397 $ 51,053 $165,494 $143,780
Cash flow from:(in thousands)
Operating activities $ 86,655 $ 68,470 $219,448 $169,804
Investing activities (80,570) (55,595) (223,401) (133,373)
Financing activities (3,877) (13,756) (15,265) (20,813)
OPERATING DATA:
Number of stores at quarter end 1,804 1,809 1,804 1,809
Weighted average stores open
during the period 1,804 1,812 1,801 1,815
Comparable store revenue
increase (4) 7% 11% 7% 4%
- ---------------------------------
(1) Rental product gross margin as a percentage of rental revenue.
(2) Merchandise sales gross margin as a percentage of merchandise sales.
(3) EBITDA represents income from operations before special charges and certain
accrual reversals, depreciation and amortization (excluding amortization of
rental product) adjusted for significant non-cash expense/income items such as
expense associated with certain stock option grants. See "Other Financial
Measurements: EBITDA and Free Cash Flow" in our discussion of Liquidity and
Capital Resources for a calculation of EBITDA. EBITDA should not be viewed as a
measure of financial performance under GAAP or as a substitute for GAAP
measurements such as net income or cash flow from operations. The calculation
of EBITDA is not necessarily comparable to reported EBITDA of other companies
due to the lack of uniform definition of EBITDA. Effective with the third
quarter 2002 financial results and this Quarterly Report on Form 10-Q, we have
adopted the methodology of our most significant competitor to calculate EBITDA
(as disclosed in our Quarterly Report on Form 10-Q for the period ending June
30, 2002). While the methodologies used in calculating this EBITDA and our
previously reported Adjusted EBITDA differ, we believe that any differences in
the methodologies are immaterial in the long term. EBITDA for the year 2001
under our new method would have been $204.6 million compared to Adjusted EBITDA
under the old method of $194.7 million. While each methodology has benefits, we
believe the new methodology more accurately takes into account any timing
affects of new release titles that may positively or negatively impact EBITDA
for any specific quarter and thus provides a more accurate view of our cash
earnings power on a quarter to quarter basis.
(4) A store is comparable after it has been open and owned by the Company for
12 full months.
REVENUE
Revenue increased by $24.1 million, or 7.0%, in the three months ended
September 30, 2002 compared to the three months ended September 30, 2001, due
to a 7% increase in comparable store revenue, offset by a net reduction of 8
weighted average stores. Revenue increased by $65.7 million, or 6.5%, in the
nine months ended September 30, 2002 compared to the nine months ended
September 30, 2001, due to a 7% increase in comparable store revenue, offset by
a net reduction of 14 weighted average stores. At September 30, 2002, we had
1,804 stores operating in 47 states compared to 1,809 stores operating in 47
states at September 30, 2001. We currently offer a 5-day rental program on all
products in the majority of our stores. In most of our stores, new release
videos and DVDs (both new release and catalog) rent for $3.79 and catalog
videos rent for $1.99. Since the fourth quarter of 1999, other than test
pricing, 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 and games
within the initial rental period are deemed to have commenced a new rental
period of equal length at the same price (extended rental periods). Rental
revenue from extended rental periods for the three months and for the nine
months ended September 30, 2002 were $37.4 million and $115.7 million,
respectively, compared to $36.5 million and $110.6 million in the corresponding
periods of the prior year.
Effective January 1, 2002, we began reporting sales and related costs of
previously viewed rental inventory as rental product revenue and cost of rental
product, respectively. Prior to January 1, 2002, we included sales and related
costs of sales of previously viewed rental inventory in merchandise sales and
cost of merchandise sales, respectively. For comparative purposes, sales and
related costs of sales of previously viewed rental inventory for the three
months ended September 30, 2001 and the nine months ended September 30, 2001
have been reclassified to conform to the presentation for the current year.
GROSS MARGIN
Rental Product Margins
Rental product gross margin as a percentage of rental product revenue increased
to 66.2% and 66.0% in the three months and nine months ended September 30,
2002, respectively, from 64.2% and 62.7% in the three months and nine months
ended September 30, 2001, respectively. Rental product margins in the three
months and nine months ended September 30, 2001 were negatively impacted by $2
million and $18 million, respectively, in incremental depreciation expense
associated with changes in estimated rental inventory lives and residual values
that were adopted on a prospective basis on October 1, 2000. 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. Excluding the incremental depreciation expense, margins
increased to 66.2% and 66.0% in the three months and nine months ended
September 30, 2002, respectively, from 64.8% and 64.6% in the three months and
nine months, ended September 30, 2001, respectively. The increases were
primarily due to a shift in revenue from VHS product to DVD product, which
typically has higher margins.
Merchandise Sales Margins
Merchandise sales gross margin as a percentage of merchandise sales increased
to 24.7% and 24.2% in the three months and nine months ended September 30,
2002, respectively, from 23.0% and 23.6% in the three months and nine months
ended September 30, 2001, respectively. The increase was primarily the result
of an increase in the percentage of merchandise sales from our Game Crazy
departments, which typically have higher margins than merchandise sales in our
video stores.
OPERATING COSTS AND EXPENSES
Operating and Selling
Total operating and selling expense in the three months ended September 30,
2002 decreased as a percentage of revenue to 44.7% compared to 45.4% in the
corresponding period of the prior year. The percentage decrease is primarily
the result of leverage on increased revenue. Total operating and selling
expense in the three months ended September 30, 2002 increased $8.3 million to
$165.0 million from $156.7 million in the three months ended September 30,
2001. The increase was primarily the result of increased variable costs
associated with increased store sales volume. Payroll and related expenses
increased by $7.2 million and other operating and selling expenses increased by
$1.1 million in the three months ended September 30, 2002 when compared to the
corresponding period of the prior year.
Total operating and selling expense in the nine months ended September 30, 2002
decreased as a percentage of revenue to 44.4% compared to 45.7% in the
corresponding period of the prior year. The percentage decrease is primarily
the result of leverage on increased revenue. Total operating and selling
expense in the nine months ended September 30, 2002 increased $15.2 million to
$478.1 million from $462.9 million in the nine months ended September 30, 2001.
The increase was primarily the result of increased variable costs associated
with increased store sales volume. Payroll and related expenses increased by
$13.0 million and other operating and selling expenses increased by $2.2
million in the nine months ended September 30, 2002 when compared to the
corresponding period of the prior year.
General and Administrative
General and administrative expenses in the three months ended September 30,
2002 decreased $3.1 million to $20.2 million from $23.3 million in the three
months ended September 30, 2001. General and administrative expenses decreased
as a percentage of total revenue to 5.5%, compared to 6.8% in the corresponding
period of the prior year. General and administrative expenses for the three
months ended September 30, 2002 benefited from the recognition of approximately
$4.5 million of non-cash income associated with variable stock options, as a
result of the closing stock price at September 30, 2002 and a reduction of
variable options outstanding as a result of cancellations. Excluding this
adjustment, general and administrative expenses increased $1.4 million to $24.7
million or 6.7% of total revenue.
General and administrative expenses in the nine months ended September 30, 2002
decreased $4.2 million to $66.6 from $70.8 million in the nine months ended
September 30, 2001. General and administrative expenses for the nine months
ended September 30, 2002 benefited from the recognition of approximately $4.5
million of non-cash income associated with variable stock options, primarily as
a result of the closing stock price at September 30, 2002 and a reduction of
options outstanding as a result of cancellations. Included in general and
administrative expenses in the nine months ended September 30, 2001 was $5.6
million in compensation expense related to a stock grant to our Chief Executive
Officer. Excluding the income associated with the variable stock options in
the nine months ended September 30, 2002, and the expense related to the stock
grant in the nine months ended September 30, 2001, general and administrative
expenses increased $5.4 million when compared to the corresponding period of
the prior year, and increased as a percentage of revenue to 6.5% for the nine
months ended September 30, 2002, compared to 6.4% for the prior year. The
increase is the result of our investment in certain elements of our business
such as the store field supervision structure, the loss prevention function and
human resources. We believe these investments have had, and will continue to
have, a direct impact on our business by improving our level of execution.
Store opening expenses
Store opening expenses were $1.2 million in the three months and nine months
ended September 30, 2002. The store opening expenses are primarily expenses
related to relocation and recruiting of new field employees, store employee
training labor and grand-opening advertising expenses. We will continue to
report these store opening expenses as a separate component of our operating
expenses in the future.
Amortization of Intangibles
We adopted SFAS 142 as of January 1, 2002, and as a result we had no
amortization expense in the three months or the nine months ended September 30,
2002 compared to $1.3 million and $3.8 of amortization expense for the three
months and the nine months ended September 30, 2001, respectively. Had we not
adopted SFAS 142, we would have had $1.3 million and $3.8 million of
amortization expense in the three months ended and nine months ended September
30, 2002, respectively.
Restructuring charge for closure of internet business
On June 12, 2000, we announced that we would discontinue the e-commerce
business of Reel.com. Although we believe that we 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, we were unable to obtain outside financing for Reel.com, and could
not justify continued funding from our retail stores' cash flow. As a result of
the discontinuation of Reel.com's e-commerce operations, we recorded a
restructuring charge of $69.3 million in the second quarter of 2000 that
included $22.4 million of accrued liabilities (net of $4.9 million of
reductions). Amounts accrued included $17.3 million for contractual
obligations, lease commitments and anticipated legal claims against us and $5.1
million for legal, financial, and other professional services incurred as a
direct result of the closure of Reel.com. Since June 2000, we have paid $10.0
million of the $22.4 million of accrued liabilities including legal and legal
related costs in settlement of all claims with 3PF. As a result, the remaining
accrual balance for such claims was reversed to a zero balance at June 30, 2002
resulting in a $12.4 accrual reversal.
INTEREST EXPENSE, NET
Interest expense, net of interest income, decreased by $4.9 million and $11.3
million in the three months and nine months ended September 30, 2002,
respectively, compared to the corresponding periods of the prior year. The
decrease is due to decreased borrowings under our revolving credit facilities
and lower interest rates.
INCOME TAXES
Our effective tax rate was a provision of 1.0% for the three months and nine
months ended September 30, 2002, compared to a provision of 2.1% in the
corresponding periods in the prior year. The rate varies from the federal
statutory rate as a result of minimum state taxes in excess of statutory state
income taxes and a reduction in the deferred tax valuation allowance as a
result of the utilization of net deferred tax assets, primarily net operating
loss carryforwards, based upon taxable income earned in the current periods.
The reduction of the valuation allowance reduced our federal income tax
effective rate in each period presented.
As of December 31, 2000, we had recorded a $211.2 million valuation allowance
on our $211.2 million net deferred tax asset, consisting of temporary timing
differences and net operating loss carryforwards. As of September 30, 2002,
this valuation allowance was $111.1 million on our $149.5 million net deferred
tax asset. Excluding this allowance, as of September 30, 2002 shareholders'
equity would have been $211.4 million.
EXTRAORDINARY CHARGE ON RETIREMENT OF DEBT
As a result of the early retirement of our prior revolving credit facility, we
recorded an extraordinary charge of $2.2 million in the three months ended
March 31, 2002 (net of an income tax benefit of $1.3 million) to write-off
deferred financing costs.
RENTAL INVENTORY
Analysis of rental inventory and investment in rental product
We manage our rental inventories of movies under two distinct categories, new
release and catalog. New releases which represent the majority of all movies
acquired are those movies which are primarily purchased on a weekly basis in
large quantities to support demand upon their initial release by the studios
and are generally held for relatively short periods of time. Catalog, or
library, represents an investment in those movies we intend to hold for an
indefinite period of time and represents a historic collection of movies which
are maintained on a long- term basis for rental to customers. In addition to
acquiring catalog movies from studios upon their initial release, we acquire
previously released or older movies for catalog inventories to support new
store openings and the build up of title selection for new platforms such as
DVD. During the year, we significantly increased the amount of DVDs to be held
in our catalog inventories by investing approximately $48.9 million.
Purchases of new release movies are amortized over four months to current
estimated average residual values of approximately $3.16 for VHS and $4.67 for
DVD (net of estimated allowances for losses). Purchases of VHS and DVD catalog
are amortized on a straight-line basis over one year and five years,
respectively, to estimated residual values of $2.00 for VHS and $6.00 for DVD.
Games acquired upon their initial release by publishers are amortized over four
months to an estimated interim residual value of approximately $15.00 and then
to $5.00 over the following twenty months. Games the Company expects to keep in
rental inventory for an indefinite period of time are amortized on a straight-
line basis over two years to an estimated residual value of $5.00.
When analyzing our rental inventory purchase activity, it is important to
consider that we acquire new releases of movies under two different pricing
structures, "revenue sharing" and "sell-through." These methods will impact the
amount of new releases held as rental inventory on our consolidated balance
sheet. Under revenue sharing, in exchange for acquiring agreed-upon quantities
of tapes or DVDs at reduced or no up-front costs, we share agreed-upon portions
of the revenue that we derive from the tapes or DVDs with the applicable
studio. The studio's share of rental revenue is expensed, net of an estimated
residual value, as revenue is earned on the revenue sharing titles. The
resulting revenue sharing expense is considered a direct cost of sales rather
than an investment in rental inventory. Under sell-through pricing, we purchase
movies from the studios with no obligation for future payments to the studios
based upon revenue performance of the title. Sell-through purchases are
recognized as an investment in rental inventory, which is then amortized to
cost of sales over its estimated useful life. Purchases of rental inventories,
as shown on our consolidated statement of cash flows, are not reflective of the
total costs of acquiring movies for rental and are impacted by the mix of
movies acquired under these pricing structures. The following table summarizes
our total acquisition costs of new releases (in thousands):
Nine Months Ended
September 30,
--------------------
2002 2001
--------- ---------
New release replenishment $ 234,056 $ 166,001
Revenue sharing expense 103,059 156,260
--------- ---------
Total new release purchases $ 337,115 $ 322,261
New release replenishment includes sell-through purchases of movies and games
and the residual value of revenue sharing purchases. Currently, we acquire the
majority of our DVDs under the sell-through pricing structure. As the
percentage of new release purchases represented by DVD grows, so does the
percentage of purchases represented by the sell-through pricing structure. The
migration from revenue sharing to sell-through pricing appears as an increase
in purchases of rental inventory, net on the consolidated statement of cash
flows.
As of September 30, 2002, net rental inventory was $237.5 million compared to
$191.0 million as of December 31, 2001, an increase of $46.5 million. The
following table summarizes the related balance sheet activity (in thousands):
Balance at December 31, 2001 $ 191,016
New release replenishment 234,056
New stores and catalog DVD and games 38,823
Book value of transfers to merchandise
inventory and tape loss (1) (69,456)
---------
Purchases of rental inventory, net 203,423
Less rental inventory amortization (156,979)
---------
Balance at September 30, 2002 $ 237,460
---------
(1) Book value of transfers to merchandise inventory represents the residual
book value of movies and games that are transferred from rental inventory to
merchandise inventory to be sold as previously viewed product. When the
previously viewed product is sold, the residual book value is recognized as
expense. Tape loss represents the residual book value of certain movies and
games that are lost, stolen or damaged during the period.
MERCHANDISE INVENTORY
Merchandise inventory includes new VHS and DVD movies for sale, concessions and
accessory items for sale, Game Crazy merchandise inventory and the residual
book value of movies and games that are transferred from rental inventory to
merchandise inventory to be sold as previously viewed product. Merchandise
inventory increased $35.2 million to $96.8 million as of September 30, 2002,
from $61.6 million as of December 31, 2001 due to the expansion of our Game
Crazy departments and an increase in new DVD movies for sale.
LIQUIDITY AND CAPITAL RESOURCES
Overview
We generate substantial operating cash flow from the rental and sales of
videocassettes, DVDs and games. The amount of cash generated from operations in
the nine months ended September 30, 2002 funded the majority of our debt
service requirements and maintenance capital expenditures with sufficient cash
left over to make strategic investments in DVD catalog product and open 103 new
Game Crazy departments in existing store locations. At September 30, 2002, we
had $19.6 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 $426.5 million of securities,
consisting of $126.5 million of equity securities and $300.0 million of debt
securities. The registration statement became effective on February 14, 2002.
On March 11, 2002, we completed a public offering of 8,050,000 shares of our
common stock under our shelf registration statement, resulting in proceeds of
$120.8 million before fees and expenses, of which $114 million was applied to
the repayment of borrowings under our prior revolving credit facility. The
shelf registration statement, as amended May 20, 2002, allows the issuance of
up to an aggregate of $305.8 million of debt and equity securities.
On March 18, 2002, we 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 our prior
revolving credit facility, which was then terminated. The new bank credit
facilities consisted 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 our existing $250 million 10.625% senior subordinated notes due in 2004
(the "Subordinated Notes") are refinanced prior to February 2004 with a
maturity date beyond 2006.
We believe that cash flow from operations, increased flexibility under our new
credit facilities, cash on hand and trade credit will provide adequate
liquidity and capital resources to execute our business plan for the next
twelve months. With respect to our longer term cash requirements and desire for
increased financial and operating flexibility, taking into account the maturity
of our credit facilities and our outstanding subordinated notes due in 2004, we
will likely need to effect additional capital and/or financing transactions.
Accordingly, we continue to analyze our capital structure and from time to time
may consider additional capital and/or financing transactions as a source of
incremental liquidity. Although we believe that we will be able to timely
effect additional capital and/or financing transactions on acceptable terms,
any failure to do so could impair our ability to execute our business plan
and/or satisfy our other cash requirements over the longer term.
Cash Provided by Operating Activities
Net cash provided by operating activities increased by $49.6 million or 29.2%
in the nine months ended September 30, 2002 compared to the nine months ended
September 30, 2001. The increase was primarily due to improved operating
performance in our existing store base.
Cash Used in Investing Activities
Net cash used in investing activities increased by $90.0 million, or 67.5%, to
$223.4 million in the nine months ended September 30, 2002 from $133.4 million
in the nine months ended September 30, 2001. The increase was the result of
the shift in product mix from VHS to DVD, resulting in a shift in product
acquisition from revenue sharing to sell-through pricing, investments in DVD
catalog product, and investments in new stores and Game Crazy departments.
Cash Used in Financing Activities
Net cash used in financing activities decreased $5.5 million to $15.3 million
in the nine months ended September 30, 2002, compared to $20.8 million in the
corresponding period of the prior year. In the first quarter of 2002, we sold
8,050,000 shares of our common stock resulting in proceeds of $120.8 million
before underwriting fees and expenses. We also obtained new senior bank credit
facilities consisting of a $150.0 million senior secured term facility and a
$25.0 million senior secured revolving credit facility. Net proceeds from the
sale of common stock and initial borrowings under the senior secured term
facility were used to repay all amounts outstanding under our prior revolving
credit facility. As a result of the strength of our cash flow in 2002, during
the second quarter, we elected to prepay our remaining 2002 amortization
payments and on November 14, 2002, also elected to prepay the scheduled
amortization payments for the first and second quarters of 2003. As a result we
have no mandatory amortization requirements for our term loan until September
30, 2003. At September 30, 2002 the balance owed under our new senior secured
term facility was $125 million and we had $25.0 million of borrowings available
under our new revolving credit facility.
At September 30, 2002, 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 $ - $ - $ 2,521 $ 2,521
2003 - 35,000 10,588 45,588
2004 250,000 90,000(1) - 340,000
2005 - - - -
2006 - - - -
Thereafter - - - -
---------- ---------- --------- ---------
$ 250,000 $ 125,000 $ 13,109 $ 388,109
---------- ---------- --------- ---------
(1) The maturity of the credit facilities will automatically be extended, such
that $35 million will be due in 2004 and 2005, and $20 million will be due in
2006, if the Subordinated Notes are refinanced prior to February 2004 with a
maturity date beyond 2006.
Other Financial Measurements: Working Capital
At September 30, 2002, we had cash and cash equivalents of $19.6 million and a
working capital deficit of $129.6 million. The working capital deficit is
primarily the result of the accounting treatment of rental inventory. 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: EBITDA and Free Cash Flow
We believe other financial measurements, such as 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.
EBITDA represents income from operations before special charges and certain
accrual reversals plus depreciation and amortization (excluding amortization of
rental product) plus/minus non-cash expense/income. Following is a table
calculating EBITDA (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
Income from operations $ 41,984 $ 30,310 $ 134,737 $ 69,183
Depreciation and amortization(1) 14,926 17,176 44,987 50,449
Non-cash expenses(2) (4,513) 1,567 (1,800) 6,148
Special charges(3) - 2,000 (12,430) 18,000
---------- ---------- ---------- ----------
EBITDA $ 52,397 $ 51,053 $ 165,494 $143,780
========== ========== ========== ==========
(1)Represents depreciation and amortization of property and equipment, and
amortization of intangibles. It does not include amortization of rental
product.
(2) Expenses that are non-cash in nature consisting primarily of compensation
associated with certain stock option grants.
(3) The special charge for the nine months ended September 30, 2002 of $12.4
million represented an accrual reversal of restructuring charges related to the
closure of Reel.com. Special charges were $2.0 million and $18.0 million for
the three months and nine months ended September 30, 2001. These charges
represent incremental depreciation expense associated with changes in estimated
rental inventory lives and residual values that were adopted on a prospective
basis October 1, 2000.
Free Cash Flow represents EBITDA, less cash paid for interest and taxes,
maintenance capital expenditures and discretionary investment capital
expenditures. Discretionary Free Cash Flow represents Free Cash Flow before
discretionary investments in capital expenditures that are not required to
maintain existing stores (e.g. investment in new store openings and new product
platform rollouts). We believe Discretionary Free Cash Flow and Free Cash Flow
are useful measurements in determining our ability to meet our growth plans,
satisfy working capital demands and meet our debt service requirements.
Following is a table calculating Discretionary Free Cash Flow and Free Cash
Flow (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- ------------------
2002 2001 2002 2001
-------- -------- -------- --------
EBITDA $ 52,397 $ 51,053 $165,494 $143,780
Less: Cash interest paid (15,600) (20,909) (39,065) (47,341)
Cash taxes paid (473) (192) (1,334) (795)
Maintenance capital
expenditures (1) (3,562) (2,911) (8,359) (3,930)
-------- -------- -------- --------
Discretionary Free Cash Flow 32,762 27,041 116,736 91,714
Less discretionary investment
capital expenditures:
rental product,
equipment & leasehold
improvements (2) (17,464) (14,636) (49,893) (17,459)
-------- -------- -------- --------
Free Cash Flow 15,298 12,405 66,843 74,255
======== ======== ======== ========
(1) Maintenance capital expenditures represents expenditures that we believe
are necessary to maintain the existing store operations, including equipment,
fixtures, leasehold improvements, remodeling projects, and implementing and
upgrading office and store technology. We anticipate that maintenance capital
expenditures will be approximately $10 million in 2002.
(2) Discretionary investment capital expenditures in the nine months ended
September 30, 2002 were for an expansion of our DVD non-new release catalog
selections in certain stores and investments in our expansion strategies for
Game Crazy departments and new video stores. In the nine months ended September
30, 2001, discretionary investment capital expenditures were primarily related
an expansion of our DVD non-new release catalog selections. We anticipate that
discretionary investment capital expenditures will be approximately $75.8
million in 2002, which includes approximately 200 new Game Crazy departments
and 40 new video stores and our DVD non-new release catalog expansion.
As a result of the strength of our cash flow in 2002, during the second
quarter, we elected to prepay our remaining 2002 amortization payments and on
November 14, 2002, also elected to prepay the scheduled amortization payments
for the first and second quarters of 2003. As a result we have no mandatory
amortization requirements for our term loan until September 30, 2003.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risk represents the risk of loss that may impact our financial position,
operating results, or cash flows due to adverse changes in financial and
commodity market prices and rates. Our short-term and long-term debt represents
market-risk-sensitive financial instruments. Historically, and as of September
30, 2002, we have not held derivative instruments for the purpose of addressing
market risks, including market risks associated with variable rate
indebtedness.
The interest payable on our senior credit facilities is based on variable
interest rates (LIBOR or the prime bank rate at our option) and is, therefore,
affected by changes in market interest rates. Hypothetically, if variable base
rates were to increase 1% in 2002 as compared to the rates at September 30,
2002, our interest rate expense would increase by approximately $1.3 million
based on our outstanding balance on the facilities as of September 30, 2002.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Within the 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of our management,
including our Chief Executive Officer and our Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934.
Based on the evaluation of our disclosure controls and procedures, our Chief
Executive Officer and the Chief Financial Officer have concluded that our
disclosure controls and procedures are effective in timely alerting them to
material information relating to the Company that is required to be included in
our periodic SEC filings.
Internal Controls and Procedures
There have been no significant changes in our internal controls or in other
factors that could significantly affect internal controls subsequent to the
date we carried out our evaluation.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934 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", "intends", "estimates", "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 in the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 2001 under the heading
"Cautionary Statements" and 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.
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 are testing or
offering video-on-demand services. As a concept, video-on-demand provides 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 and receive the movies from the studios at the same time
video stores do, 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.
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 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.
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. Also, in the third quarter of 2002 we began
an accelerated roll out of our Game Crazy departments, departments within our
video stores that specialize in selling and trading video games, opening 101
new departments. We presently intend to open 400 additional Game Crazy
departments as well as over 200 new video stores in the next five quarters.
This expansion has placed, and may continue to place, increased pressure on our
operating and management controls. To manage a larger store base and
additional Game Crazy departments, 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 but not limited to:
- - 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 bank credit facility and our 10.625% senior
subordinated notes due 2004 contain, and our future indebtedness may contain,
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 September 30, 2002, we had total consolidated long-term debt, including
capital leases, of approximately $388.1 million. 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. 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.
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 currently have $340 million of indebtedness maturing in 2004
including $250 million of subordinated notes. We plan to refinance the
subordinated notes 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 new release movie titles;
- - 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.
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, 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 acquirer 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.
PART II OTHER INFORMATION
ITEM 1. 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 class made up of
certain exempt employees, who they claim are owed overtime payments for work
performed in certain stores in California. We have since entered into a
settlement agreement which was given preliminary approval by the court on
August 5, 2002. The class consists of only those individuals who do not opt
out of the settlement who were employed by us within the State of California as
salaried Hollywood Video store managers during the period from January 25, 1995
to March 31, 2002, and as salaried assistant Hollywood Video store managers
during the period from January 25, 1995 to December 31, 1999. We believe we
have provided adequate reserves in connection with the settlement agreement.
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. 3PF and Reel.com entered into a
Warehousing and Distribution Agreement (Agreement) on February 7, 2000. 3PF
alleged that, as a result of the discontinuation of Reel.com operations,
Reel.com was in default under the Agreement, failed to perform material
obligations under the Agreement, and failed to pay amounts due 3PF. On May 15,
2002, the Company, 3PF and Rentrak Corporation entered into a settlement
agreement encompassing all claims between the two parties including
counterclaims and causes of action that were asserted or could have been
asserted and agreed to the dismissal of the arbitration case.
The Company has been named 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
extended rental periods. The Company believes it has provided adequate
reserves for these various contingencies and that the outcome of these matters
should not have a material adverse effect on the Company's consolidated results
of operation, financial condition or liquidity.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
3.1 1993B Restated Articles of Incorporation, as amended (incorporated by
reference to the Registrant's Registration Statement on Form S-1 (File No. 33-
63042), by reference to Exhibit 4 to the Registrant's Registration Statement on
Form S-3 (File No. 33-96140), and by reference to Exhibit 3.1 to the
Registrant's 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 the
Registrant's Registration Statement on Form S-4 (File No. 333-82937) (the
"1999 S-4")).
4.1 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 the Registration
Statement on Form S-4 (No. 333-35351)), 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 the
Registrant's 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
Registrant, as Issuer, Hollywood Management Company, as Subsidiary Guarantor,
and Trustee (incorporated by reference to Exhibit 4.1 to the Registrant's
Quarterly Report on Form 10-Q/A for the quarter ended September 30, 2001).
99.1 Certification of Chief Executive Officer and Chief Financial Officer of
Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
On August 12, 2002, we filed a current report on Form 8-K under "Item 9.
Regulation FD Disclosure" reporting that each of the principal executive
officer and principal financial officer of the Company submitted to the
Securities and Exchange Commission the statements under oath in accordance with
the Commission's Order No 4-460 requiring the filing of sworn statements
pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HOLLYWOOD ENTERTAINMENT CORPORATION
(Registrant)
November 14, 2002 /S/James A. Marcum
- ------------------ -------------------------------------------------
(Date) James A. Marcum
Executive Vice President and Chief Financial Officer
(Authorized Officer and Principal Financial and
Accounting Officer of the Registrant)
CERTIFICATIONS
I, Mark J. Wattles, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Hollywood
Entertainment Corp.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Mark J. Wattles
---------------------------
Mark J. Wattles
Chief Executive Officer
I, James A. Marcum, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Hollywood
Entertainment Corp.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ James A. Marcum
---------------------------
James A. Marcum
Chief Financial Officer