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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2002
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission file number 0-21824
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HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in its charter)
Oregon 93-0981138
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(State or other jurisdiction of (IRS Employer
incorporation or organization) identification No.)
9275 SW Peyton Lane, Wilsonville, OR 97070
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(Address of principal executive offices) (Zip Code)
(503) 570-1600
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Title of Each Class Name of Each Exchange on
- ----------------------- Which Registered
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Common Stock Nasdaq National Market
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period than the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
On June 28, 2002 (the last business day of the registrant's most recently
completed second fiscal quarter), the aggregate market value of the shares of
Common Stock held by non-affiliates of the Registrant was $1,125,171,316 based
upon the last sale price reported for such date on the Nasdaq National Market.
Shares of Common Stock held by executive officers and directors of the
registrant are not included in the computation. However, the registrant has
made no determination that such individuals are "affiliates" within the meaning
of Rule 405 under the Securities Act of 1933.
On March 19, 2003, the registrant had 60,010,816 shares of Common Stock
outstanding
PART I
ITEM 1. BUSINESS
GENERAL
We are the second largest specialty retailer of rentable home videocassettes,
DVDs and video games in the United States. We opened our first video superstore
in October 1988 and completed our initial public offering in July 1993. As of
December 31, 2002, we operated 1,831 Hollywood Video superstores in 47 states
and the District of Columbia, and estimate our share of the domestic
videocassette and DVD rental market to be approximately 11%. Of our 1,831
superstores, at December 31, 2002, 273 have been remerchandised to include an
in-store game department, Game Crazy, that allows game enthusiasts to buy, sell
and trade used and new video game hardware, software and accessories. A Game
Crazy department is an area of the existing video store that occupies
approximately 700 to 900 square feet, carries from 1,400 to 2,000 video game
titles and is designed to satisfy the preferences or our growing customer base.
Our total revenue and EBITDA were $1.490 billion and $233.8 million,
respectively, for the year ended December 31, 2002 and $1.380 billion and
$204.6 million, respectively, for the year ended December 31, 2001. Revenue
from rental products, including VHS, DVD and video games, represented
approximately 89% of our revenue for the year ended December 31, 2002. The
remainder of our revenue is generated from the sale of new VHS and DVD movies,
concessions and video game products through our Game Crazy departments.
Our goal is to continue to build a strong national brand and an effective
superstore format that distinguishes us from our competitors. Our branding
strategy is designed to cause consumers to identify us with the entertainment
industry, while our superstore format is designed to encourage multiple rentals
per visit and repeat visits. Our superstores are typically strategically
situated in high-traffic, high-visibility and convenient locations. More than
300 million customers visit our superstores every year, while an average of
more than 50 million vehicles pass by the distinctive Hollywood Video signage
every day. In each superstore, we focus on providing a superior selection of
movies and video games in an inviting atmosphere that encourages browsing. We
believe that movie rentals in general, and our pricing structure and rental
terms in particular, provide consumers convenient entertainment and excellent
value. In addition, we believe that our rental of video games combined with our
in-store game departments provide us with an increased level of differentiation
from our competitors.
We file annual reports, quarterly reports, proxy statements and other
information with the Securities and Exchange Commission (SEC). You may read and
copy any materials we file with the SEC at the SEC's Public Reference Room at
450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
The SEC maintains an Internet site that contains our reports, proxy statements,
and other information. The SEC's Internet address is http://www.sec.gov.
We also make available free of charge through our Internet website the
company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K and, if applicable, amendments to those reports as soon as
reasonably practical after we file such materials with the SEC
(http://www.shareholder.com/hlyw/Edgar.cfm).
INDUSTRY OVERVIEW
Home Video Industry
According to Adams Media Research ("AMR"), the total domestic video retail
industry (consisting of both rentals and sales) grew from $11.7 billion in
revenue in 1990 to $22.3 billion in 2002, and is expected to grow to
approximately $30.1 billion by 2007. According to AMR, the total domestic video
retail industry grew approximately 9% in 2002. During 2002, certain industry
analysts reported that the rental portion of the video retail industry may be
declining. We experienced growth in our rental business during 2002 and believe
that the industry did as well based on the 2002 year-end reported results of
other major retail chains. The following factors, among others, continue to
make video rental a preferred medium of entertainment for millions of
customers:
- - the continued improvement in home entertainment technology (e.g. DVD,
surround sound, HDTV) which encourages consumers to spend more time watching
movies at home;
- - the opportunity to entertain one or more people at home for a reasonable
price;
- - the opportunity to browse among a very broad selection of movies at a
retail location; and
- - the ability to control the viewing experience, such as the ability to
start, stop, pause, fast-forward and rewind.
According to AMR, at the end of 2002 VCR penetration stood at approximately
90.2% of the 107.0 million domestic television households, while DVD player
penetration was 36.2%. AMR predicts that DVD player penetration will surpass
50% of domestic television households by 2004, which we believe will lead to
significant increases in both DVD rentals and product sales. The growth rate of
DVD player sales in their first four years of existence has outpaced comparable
initial sales growth rates for CD players and VCRs by multiples of 3 to 1 and 7
to 1, respectively.
Highly Fragmented Rental Industry
The home video rental industry is highly fragmented but has experienced
consolidation in recent years as video store chains have gained significant
market share from independent store operators. The three largest video rental
store chains, including us, had an approximately 50% market share of all
domestic consumer video rentals in 2002 (including estimated revenues
associated with franchise stores), with the remainder of the market share
largely represented by small independent store operators. We believe that there
are several competitive advantages to being a large home video chain,
particularly in this highly fragmented industry. These advantages include the
enhanced ability to benefit from strong studio relationships, access to more
copies of individual movie titles through direct revenue sharing arrangements,
sophisticated information systems, greater access to prime real estate
locations, greater access to managerial resources, greater marketing
efficiencies, greater access to capital and competitive pricing made possible
by size and operating efficiencies.
Movie Studio Dependence on Video Retail Industry
According to AMR, the home video industry is the single largest source of
revenue to movie studios and represented approximately $12.3 billion, or 59%,
of the $20.8 billion of estimated domestic studio revenue in 2002. Of the many
movies produced by major studios and released in the United States each year,
relatively few are profitable for the studios based on box office revenues
alone. According to the Motion Picture Association of America, in 2002, the
average movie generated approximately $32.5 million in worldwide theater
revenue for studios. Over the past few years, the average total cost to make
and market a movie has increased significantly to over $82 million. Therefore,
the average movie loses approximately $50 million at the box office and relies
on other sources of revenue, most importantly home video, to become profitable.
Due to the unique browsing characteristics of the retail environment, our
superstore's average customer rents approximately 2.0 movies per transaction-
frequently one hit and one non-hit movie. Because of this, we acquire almost
all movies produced by the studios regardless of whether or not they were
successful at the box office, including movies released direct-to-video, thus
providing movie studios with a reliable source of revenue for almost all of
their movies. In 2002, of the 772 new release movie titles that we acquired for
rental, 707, or 92%, represented low-grossing box office releases (less than
$40.0 million in revenue) or direct-to-video releases. These low-grossing box
office and direct-to-video titles accounted for approximately 52% of our rental
revenue in 2002. Without home video, the movie studios would generate
substantially less revenue from these low grossing and direct-to-video movies.
Exclusive Rental Window
As a result of the importance of the video retail industry to the movie
studios' revenue base, the home video rental and sell-through markets enjoy a
period of time in which they have the exclusive rights to distribute a movie.
This period of exclusivity has been in place since the mid 1980s. The period
typically begins after a film finishes its domestic theatrical run (usually
five months after its debut) or upon its release to video, in the case of
direct-to-video releases, and lasts for 30 to 60 days thereafter. This period
of exclusivity is intended to maximize revenue to the movie studio prior to a
movie being released to other distribution channels, including pay-per-view,
video-on-demand and television, and provides what we believe is a significant
competitive advantage.
Trends in Video Rental and Sales
Studios have historically sold videocassettes to video retailers under two
pricing structures, "rental" and "sell-through." Rental titles were
historically initially sold at relatively high prices (as high as $60 to $65
wholesale) and promoted primarily for rental, and then later re-released for
sale to consumers at a lower price (typically $10 to $15 wholesale). Certain
high-grossing box office films, generally with box office revenue in excess of
$100 million, are targeted at the rental and sell-through markets for both
video rental stores and traditional mass merchants. These titles are released
on videocassette at a relatively low initial price (approximately $12 to $17
wholesale) and are both promoted as a rental title by video stores and sold
directly to consumers through a broad array of retailers including video
stores. Studios elect to release a title either as rental or sell-through based
on which would optimize their income from the title. Due to the high up-front
costs, it was difficult for retailers to buy enough copies under rental pricing
to satisfy customer demand in the first few weeks of a title's release.
In 1998, the major studios and several large video retailers, including us,
began entering into revenue sharing arrangements for VHS videocassettes as an
alternative to the historical rental pricing structures, which required video
retailers to purchase titles for either rental or sale. These arrangements have
produced significant benefits for us, including: (i) substantially increasing
the number of newly released videos in our superstores thereby decreasing the
in-store copy depth problems that have plagued the video rental industry for
years; (ii) contributing to an increase in revenues resulting from a rise in
the total number of videocassettes rented; and (iii) aligning the studios'
economic interests more closely with ours because they share a portion of the
rental revenue.
With the introduction of DVD as a new technology for the home video industry,
in November 1998, we introduced DVDs in all of our superstores, resulting in
the most successful introduction of a new format in our history. DVDs are our
fastest growing new product category due to increased interest in older movie
titles as a result of the substantial improvement in picture and sound quality
over VHS and the rapid adoption and rollout of DVD hardware to domestic
households as a result of its affordable price.
In 2002, we acquired approximately 60% of our new release DVD rental inventory
from studios at sell-through pricing (typically $16 to $17 wholesale) and 40%
through revenue sharing. Because of the low wholesale pricing of DVD, we do not
need revenue sharing arrangements to offer a large number of copies to our
customers. We do however believe there may still be some advantages to DVD
revenue sharing and will continue to consider DVD revenue sharing on a studio
by studio basis. We believe that, with or without revenue sharing, we will be
able to continue strong growth in DVD rentals.
HOME VIDEO GAME INDUSTRY
Expanding Video Game Hardware Market
According to NPD Group, Inc. ("NPD"), the video game industry was an
approximately $10.2 billion market in the United States in 2002, with video
game hardware accounting for $4.2 billion. In 2000 and 2001, Nintendo's
GameCube, Sony's PlayStation 2 and Microsoft's Xbox, three new-generation
hardware technology products, were introduced. These new platforms have
substantially increased the installed base of video game hardware units and
have driven significant growth in the video game software segment. As with
previous new platforms, consumers have increased both their purchase of games
and rental frequency.
Increased Video Game Software Selection
According to NPD, the video game software industry grew to approximately $6.0
billion or 31% in 2002 over 2001, and is projected to grow 20% to $7.2 billion
in 2003. Growth in the overall number of titles available for game platforms
has been rapid. Between July and December in 2002, for example, an estimated
548 new titles were released. In addition, the significant expansion and
adoption of new game platforms is driving consumers to become more economical
by renting video games or buying previously played titles. This proliferation
of game titles is also causing growth in the "trade-in" market, where consumers
can exchange their games for new games or other used games. Based on our
experience, the greater the number of available titles in the market, the more
consumers will be inclined to rent and/or trade games. Game rental product
revenue has increased 16% in the twelve months ended December 31, 2002,
compared to the prior year. We offer video game rentals in all of our stores,
and, as of December 31, 2002, 273 of our 1,831 stores had in-store game
departments.
Widening Demographic Trends
Because of advancing technologies, enhanced functionality and the aging of the
gamer population, the video game market has steadily broadened its demographic
appeal over the past two decades. These changing demographics are not limited
to age, as approximately 43% of players are now female. According to
Interactive Digital Software Association, 57% of gamers are over 18 years old,
with 36% between the ages of 18 and 35. We believe these broadening demographic
trends will benefit concepts like Game Crazy and traditional video game rental
retailers, which generate traffic of all types of video game players-avid,
casual and value-oriented.
Viable and Growing Used Games Market
Pre-owned games is becoming one of the fastest growing categories in the video
game industry. As the installed base of video game hardware platforms has
increased, with new platforms introduced, a growing used video game market has
evolved, extending the life of older platforms for the video game user who has
access to additional software titles through the used market. According to NPD
Funworld, the installed base of older, "legacy" video game hardware in the US
totaled roughly 110 million units in 2001. These transactions provide video
game retailers with a highly profitable inventory of used video game products.
Margins on these used video game products are significantly higher than those
for new products. The introduction of three new platforms beginning in 2000 and
the significant increase in software should create a significant supply and
demand of used product thus attracting the "core game" customers. The high
price points of new games also increases the perceived value of old game
software, facilitating the trading in of old games previously purchased and
buying additional ones at discounted prices. Additionally, the used video game
market should increase as consumers look to increasingly maximize and realize
the value for their used products when purchasing new hardware and software.
BUSINESS STRATEGY
We are committed to enhancing our position as the nation's second largest
specialty retailer of rentable home videocassettes, DVDs and home video games
by focusing on the following strategies:
Provide Broad Selection and Superior Service
We are committed to providing superior service and satisfying customers' movie
and video game demands by carrying a broad array of movies and video games. Our
superstores typically carry more than 8,000 movie titles on more than 18,000
videocassettes and DVDs, together with a large assortment of video games.
Through our revenue sharing arrangements with studios and lower wholesale
prices on DVDs, we have increased the availability of most new movie releases
and typically acquire 100 to 200 copies of "hit" movies for each superstore.
This breadth and depth of movie titles, together with our emphasis on superior
customer service, results in a higher average level of rentals per store visit,
creates greater customer satisfaction and encourages repeat visits. We have
continued to expand our availability of game titles for rental and sale in
order to satisfy consumer demand and to position us to capitalize on the fast-
growing new and used video game market.
Provide Excellent Entertainment Value
We offer an inexpensive form of entertainment for the family and allow
consumers the opportunity to rent new movie releases, older "catalog" movie
titles and video games for five days in most of our superstores. New movie
release titles in the VHS format typically rent for $3.79 and older catalog
movies for $1.99. DVDs typically rent for $3.79 and video games typically rent
for $4.99 or $5.99, with games for the newer system platforms renting for the
higher amount. We also offer a large selection of used movies and games at
attractive prices. Our combination of game rental sections and Game Crazy
departments provides consumers with a compelling economic alternative to buying
new video games at price points as high as $49.99.
Capitalize On DVDs
Since its launch, DVD has established itself as a proven rental format. During
the fourth quarter of 2002, DVDs represented approximately 45% of our movie
rental revenue, compared to approximately 10% in the fourth quarter of 2000.
Furthermore, DVD penetration is expected to significantly rise between 2002 and
2004; AMR predicts that DVD player penetration will surpass 50% of domestic
television households by 2004. We expect the percentage mix of DVD rentals will
increase with the expected growth in DVD player penetration. In addition, we
have experienced an increase in the rental spending of consumers who have
shifted to DVD technology from VHS, due primarily to the higher quality of DVD
and a desire to see movies previously seen on VHS.
Capitalize On Video Game Platform Rollouts
We are taking advantage of the significant growth in the home video game
industry caused by the successful launches of the Sony PlayStation 2, Nintendo
GameCube and the Microsoft Xbox, by having games available to consumers to rent
and own. With a significant amount of money spent marketing these platforms by
their manufacturers, together with a record number of new release titles, video
game rental product revenues have increased 16% in the twelve months ended
December 31, 2002, compared to the corresponding period of the prior year.
Furthermore, currently there is the largest number of video game titles
available to consumers in the history of the video game industry, which we
believe is driving consumers to become more economical by renting video games.
In addition, as the number of game titles has proliferated and the availability
of software for older platforms has decreased, the used video game market has
grown significantly. A large part of our game strategy targets the rental
tendencies of game enthusiasts who prefer to rent games prior to purchasing
them due to the recent, rapid increase in the number of available titles. We
have been renting games to our customers since our first store was opened in
1988. A recent survey conducted by the Sega of America consumer research
department illustrated the strong inclination of game enthusiasts to rent
titles before committing to their purchase, as three out of every five gamers
rented video games at least once a month with the average video game enthusiast
renting nine different titles in the past six months.
Continue Rollout of Remerchandising Initiative and Remodel Program
In addition to our traditional video game rental business, we have developed
Game Crazy, a department within our existing stores that enables video game
enthusiasts to buy, sell and trade new and used video games. We have achieved
excellent results in our 66 Game Crazy departments that have been in operation
since 1999. In 2002, these stores generated over $500,000 and $60,000 in annual
incremental store revenue and EBITDA, respectively, and comparable department
sales increased 36%. In its first twelve months we expect a Game Crazy
department to generate $400,000 in incremental store revenue and greater than
$50,000 in EBITDA. Based on these expected results, the average remerchandised
store increases its revenues by approximately 50% and individual store level
EBITDA by 28%.
The addition of a Game Crazy department is very similar to our prior
remerchandising efforts and is accomplished with minimal store disruption. The
addition of a Game Crazy department costs approximately $100,000 to $110,000
including construction, fixtures, inventory and opening expenses. During a Game
Crazy remerchandising effort, we typically remodel the existing store
simultaneously, without substantially interfering with the base video store,
leaving us with a fully remodeled and remerchandised store. During 2002, we
remerchandised 203 stores to include a Game Crazy (while simultaneously
remodeling all of those stores) and anticipate adding at least 300 additional
Game Crazy departments in 2003. In total, we have identified more than 1,000
Hollywood Video superstores that can accommodate this remerchandising
initiative. We expect to roll out this remerchandising initiative on a market-
by-market basis. As a result, we will be able to manage operational
efficiencies and focus on filling in markets.
Generate Comparable Store Sales Increases
We have generated comparable store sales increases in 28 of the last 29
quarters. We have been leading our major competitors in the industry in
comparable store sales over the last seven quarters, including an 11% increase
in both the third and fourth quarters of 2001, a 7% increase for each of the
first, second and third quarters of 2002 and a 12% increase in the fourth
quarter of 2002. We believe that we are well positioned to generate same store
sales increases in the future due to expected continued increases in DVD rental
revenue, the remerchandising program, game rental and sales revenue from the
recent rollout of the latest video game platforms and continued improvement in
execution of operations and marketing by management.
Pursue Organic Store Growth
To maintain and enhance our estimated 11% market share and number two position
in the video rental industry, we will prudently pursue organic store growth
while remaining focused on maintaining our strong financial results.
Approximately 95% of the 1,576 video superstores that we have opened since 1996
have been done so through internal site selection and development rather than
the acquisition of existing stores. We believe that control over site
selection, discipline in the real estate process and consistency of store
format and design have allowed us to enjoy strong returns on invested capital.
Our organic store growth strategy is to selectively add Hollywood superstores
in existing markets where we believe the market will successfully absorb
additional Hollywood superstores. We anticipate growing our store base by up to
10% per year. The superstores that we plan to add in the future may include
Game Crazy departments, depending on factors such as geographic location and
site selection.
STORES AND STORE OPERATIONS
Video Store Openings
We opened our first video superstore in October 1988 and grew to 25 superstores
in Oregon and Washington by the end of 1993. In 1994, we significantly
accelerated our store expansion program, adding 88 superstores and expanding
into California, Texas, Nevada, New Mexico, Virginia and Utah. In 1995, we
added 192 superstores and entered major new markets in the midwest, southwest,
east and southeast regions of the United States. Following is a table showing
superstore growth from 1994:
Year Ended December 31,
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1994 1995 1996 1997 1998 1999 2000 2001 2002
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Beginning 25 113 305 551 907 1,260 1,615 1,818 1,801
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Opened 33 122 250 356 312 319 208 6 41
Acquired 55 70 - - 41 43 - - -
Closed - - (4) - - (7) (5) (23) (11)
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Ending 113 305 551 907 1,260 1,615 1,818 1,801 1,831
=========================================================
Unlike many video retailers who have grown through acquisitions, we have
focused primarily on organic growth through internal site selection. We believe
that control over site selection and discipline in the real estate process have
been among our key competitive advantages. We have achieved significant
geographic diversification in our store base, which helps insulate us from
potentially detrimental economic, competitive or weather-related effects in
isolated areas of the country. This diversification helps us deliver more
predictable and stable revenue.
Site Selection
We believe that the selection of locations for our superstores is critical to
the success of our operations. We have assembled a new store development team
with broad and significant experience in retail tenant development. The
majority of the new store development personnel has expertise in and reside in
the geographic area for which they were responsible, but all final site
approval takes place at the corporate office, where new sites are approved by a
committee of senior management personnel. Final approval of all new sites is
the responsibility of the Chairman of the Real Estate Committee of the Board of
Directors. Important criteria for the location of a superstore include density
of local residential population, traffic count on roads immediately adjacent to
the store location, visibility and accessibility of the store, availability of
ample parking and competition. Management generally seeks what it considers the
most desirable locations, typically locating superstores in high-visibility,
stand-alone structures or in prominent locations in multi-tenant shopping
developments. All of our superstores are located in leased premises; we do not
own any real estate. Our real estate and store development team is scaled to
meet our contemplated store growth needs in the future.
PRODUCTS
Rental of Products
Revenue from rental products, including rental and sale of previously viewed
VHS, DVD and video games, represented approximately 89% of our revenue for the
year ended December 31, 2002. While the sales of new VHS videocassettes has
decreased, sales of previously viewed movies in both the VHS and DVD format has
increased significantly due to the increased copy-depth resulting from revenue
sharing arrangements and the typical sell-through pricing structure for DVD.
Moreover, due to DVD's significant advantages in audio and video quality over
VHS, we have experienced significant growth in the sale of previously viewed
DVDs. Our ability to sell previously viewed movies at lower prices than new
movies provides a competitive advantage over mass-market retailers. We expect
the market for previously viewed DVDs to experience strong growth as DVD
penetration increases and consumers begin to build their own DVD libraries.
Furthermore, previously viewed DVDs do not suffer from the quality degradation
that VHS tapes do, making them an attractive option for consumers looking to
build their personal movie libraries.
Our superstores typically carry more than 8,000 movie titles, consisting of a
combination of new releases and an extensive selection of older "catalog"
movies, on more than 18,000 videocassettes and DVDs. Excluding new releases,
movie titles are classified into categories, such as "Action," "Comedy,"
"Drama" and "Children," and are displayed alphabetically within those
categories. We do not rent or sell adult movies. In addition to video rentals,
we rent video games licensed primarily by Microsoft, Nintendo and Sony. We have
significantly expanded our titles to support Sony's PlayStation 2, Microsoft's
Xbox and Nintendo's Game Cube. Each superstore offers approximately 580 video
game titles.
Sales of Products
The sales of video game hardware, software and accessories through our Game
Crazy departments, new VHS and DVD movies, and concessions (e.g., popcorn,
sodas, candy and magazines) represent approximately 11% of our total revenue
for the year ended December 31, 2002. During 2002, as a result of the recent
video game platform launches and our recent rollout of Game Crazy departments
in our stores, we experienced an increase in both new and used video game sales
revenue and expect this to continue as consumers continue to buy new games as
well as utilize the Game Crazy concept of buy, sell and trade. We also expanded
our new movie assortments to include DVD for sale in all stores to take
advantage of the increased penetration of DVD players.
REVENUE SHARING
In the fourth quarter of 1998, we began entering into video rental revenue
sharing arrangements directly with the majority of all of the studios. In most
cases, these arrangements are currently entered into on a short-term, title-by-
title basis and provide for a rental revenue sharing period of 26 weeks. In
some cases, these arrangements are entered into on a longer-term basis and are
generally applicable to titles satisfying specified criteria that are released
by the applicable studio during the term of the arrangement. Under all of these
arrangements, in exchange for acquiring agreed-upon quantities of tapes at
reduced or no up-front cost, we share agreed-upon portions of the revenues that
we derive from the tapes with the applicable studio.
We believe that we are one of the few retailers who have revenue sharing
arrangements with all the major studios, including Buena Vista, Columbia Tri-
Star, DreamWorks, MGM, Paramount, Twentieth Century Fox, Universal Studios, and
Warner. These revenue sharing arrangements provide the following significant
benefits:
- - They provide the opportunity to substantially increase the quantity
and selection of newly released video titles in stock;
- - They contribute to an increase in revenues resulting from a rise in the
total number of transactions and the number of titles rented per
transaction; and
- - They align the studios' economic interest more closely with ours.
In addition, revenue sharing has increased the revenues received on an annual
basis by the studios through increased rental activity of new releases as well
as greater distribution of non-hit movies that might not otherwise have been
purchased. Consequently, it has been our experience that the studios with which
we have entered into revenue sharing arrangements on a title-by-title basis
want to do so with respect to all of the titles that they release at rental
prices.
As a result, we currently acquire the majority of our VHS titles from studios
under revenue sharing arrangements, while we acquire the majority of our DVDs
for rental inventory from studios at attractive sell-through prices (typically
$17-18). The sell-through pricing methodology for DVDs by the movie studios has
enabled us to offer depth and selection to satisfy high consumer demand for DVD
rentals without revenue sharing. We do however believe there may still be some
advantages to DVD revenue sharing and will continue to consider DVD revenue
sharing on a studio by studio basis. We believe that, with or without revenue
sharing, we will be able to continue strong growth in DVD rentals.
PRICING
Our rental terms and pricing structure provide consumers convenient
entertainment and excellent value. We currently offer a 5-day rental program on
all products in the majority of our stores. We increased our prices in the
majority of our stores in the fourth quarter of 1998 from $1.49 to $1.99 for
VHS catalog titles and from $2.99 to $3.49 for new releases VHS. In the fourth
quarter of 1999, we increased our pricing on new releases from $3.49 to $3.79
in the majority of our stores. Since we began offering DVDs for rental, DVDs
have typically been priced at $3.79 for 5-day rentals. Video games rent for
five days, typically for $4.99 and $5.99, with games for the newer system
platforms renting for the higher amount. We did not raise prices in 2000, 2001
or in 2002. We are currently testing higher price points; however, we do not
anticipate price increases in the near term. Customers who do not return the
movies within the applicable rental period are deemed to have commenced a new
rental period of equal length at the same price.
ADVERTISING AND MARKETING
Our primary goal in advertising is to increase transactions in our superstores,
either from new members or existing members. Historically, we had successfully
employed a direct mail advertising campaign that efficiently targeted customers
in markets where superstores were located. In 2000, however, we experimented
with a mass media advertising campaign focused on corporate branding primarily
through television and radio. The campaign was not successful and as a result
we have returned to a more cost-effective direct mail strategy, as successfully
employed in the past. In addition, we also continue to use cooperative movie
advertising funds made available by studios and suppliers to promote certain
videos. We will continue to test the effectiveness of mass media campaigns in
select markets, but anticipate that our primary marketing vehicle will continue
to be direct mailings. We believe that our current marketing strategy is the
most productive and cost effective manner to increase customer visits. We
currently have a customer transaction database containing information on
approximately 34.0 million household member accounts, enabling us to engage in
targeted marketing based on historical usage patterns.
INVENTORY AND INFORMATION MANAGEMENT
Inventory Management
We maintain detailed information on inventory utilization. Our information
systems enables us to track rental activity by individual videocassette, DVD
and video game to determine appropriate buying, distribution and disposition of
inventory, including the sale of previously-viewed product. Our inventory of
videocassettes, DVDs and video games for rental is prepared according to
uniform standards. Each new videocassette, DVD and video game is removed from
its original carton and placed in a rental case with a magnetic security device
and bar coding is affixed to each videocassette, DVD and video game. Our Game
Crazy departments utilize their own independent inventory system. Game Crazy's
point-of-sale system provides us with sufficient detail to manage our breadth
of titles and maintain in-stock positions with frequent replenishment cycles.
The inventory system also permits us to match up supply with demand title by
title, adjust ordering, transfer inventories from one store location to another
and actively manages new and used title pricing.
Information Management
We use a scalable client-server systems and maintain two distinct system areas:
a point-of-sale system and a corporate information system. We maintain
information, updated daily, regarding revenue, current and historical rental
and sales activity, demographics of store membership, individual customer
history, and videocassette, DVD and video game rental patterns. This system
allows for the comparison of current performance against historical performance
and the current year's budget, manage inventory, make purchasing decisions on
new releases and manage labor costs. This system has the ability to continue to
improve customer service, operational efficiency, and management's ability to
monitor critical performance factors.
COMPETITION
The video retail industry is highly competitive. We compete with local,
regional and national video retail stores, including Blockbuster, and with
supermarkets, pharmacies, convenience stores, bookstores, mass merchants, mail
order operations and other retailers, as well as with non-commercial sources
such as libraries.
We believe that the principal competitive factors in the video retail industry
are price, title selection, rental period, the number of copies of popular
titles available, superstore location and visibility, customer service and
employee friendliness and convenience of store access and parking.
Substantially all of our superstores compete with stores operated by
Blockbuster, most in very close proximity.
We also compete with cable, satellite, and pay-per-view television systems, in
which subscribers pay a fee to see a movie selected by the subscriber. As
digital cable and digital satellite services have continued to increase
penetration, consumers have been given more choices in their viewing of pay-
per-view movies and in some cases video-on-demand. We estimate that digital
cable or satellite is available in approximately 50 million households. These
systems offer approximately 50 channels dedicated to pay-per-view and in some
cases video-on-demand, allowing for companies to transmit a significantly
greater number of movies to homes at more frequently scheduled intervals
throughout the day. Contrary to previous forecasts however, during the same
period that digital cable and digital satellite have grown rapidly, home video
has also grown significantly. According to AMR, approximately 90.2% of all U.S.
television households own a VCR and the number of DVD households is projected
to surpass 50% by the end of 2004. In addition, video stores represented
approximately 59% of the studios' domestic revenue, while pay-per-view
represented only 2%. According to the movie studios, movies are, and will
continue for the foreseeable future, to be available on pay-per-view and video-
on-demand only after the home video's exclusive window has expired. A window
has been used historically to protect each distribution channel from downstream
channels. Principally protecting theaters from home video, home video from
pay-per-view or video-on-demand and pay-per-view or video-on-demand from
premium channels. The exclusive home video window protects both mass merchants
who sell videos and video retailers that rent videos. We do not believe that
pay-per-view or video-on-demand pose a serious competitive threat for the
foreseeable future.
We also compete with Internet-based mail-delivery video rental subscription
services, such as Netflix. However, given our belief that consumers generally
make the decision to rent, as well as which movie(s) to rent, within a few
hours of completing a rental transaction, we do not believe these services pose
a significant threat for the foreseeable future. In addition, we have tested
both in-store subscription services, as well as internet-based mail-delivery
rental services, and believe that such experience positions us to offer
multiple forms of subscription rental models, such as in-store, via the mail,
or a combination of both, if we were to conclude that such a service would be
attractive to customers and good for shareholders.
The video game industry is highly fragmented, with no major player holding more
than a 20% share of the market, leaving a significant opportunity for our Game
Crazy departments to rapidly gain market share. Video game software and
hardware is typically sold through retail channels, including specialty
retailers, mass merchants, like Wal-Mart and Target, toy retail chains,
consumer electronic retailers, computer stores, regional chains, wholesale
clubs, via the Internet and through mail order. In addition, the used market is
offered in specialty retail chains that feature an educated game staff such as
GameStop and Electronics Boutique. We believe our superstores will
differentiate themselves from our competitors' as being the only significant
retailer to feature both rentals and sales of new and used video games staffed
by video game enthusiasts. Furthermore, we believe our Game Crazy departments
have a competitive advantage because of our existing store base and existing
traffic.
EMPLOYEES
As of December 31, 2002, we had approximately 25,900 employees, of whom 24,800
were in the retail stores and zone offices and the remainder in our corporate,
administrative and warehousing operations.
Superstore managers report to district managers, who supervise the operations
of the stores. The district managers report to regional managers, who report
directly to the Vice President of Operations for each zone office. The
corporate support staff periodically has meetings with zone personnel, regional
managers, district managers and superstore managers to review operations. None
of our employees are covered by collective bargaining agreements. We consider
our employee relations to be excellent.
Despite that Game Crazy is only a department within our superstores, we have
created a solid management infrastructure including district managers for Game
Crazy, who report to the regional managers, and store level operators. We have
made a concerted effort to hire sales associates who are game enthusiasts
through our established recruiting and training process. This is particularly
important in the video game industry, which requires product knowledge on a
large and ever-changing number of titles. We have attracted a staff of
dedicated gamers for our Game Crazy departments who provide attentive customer
service and possess knowledge of the industry.
SERVICE MARKS
We own United States federal registrations for the service marks "Hollywood
Video", "Hollywood Entertainment", "Hollywood Video Superstores" and "Game
Crazy". We consider our service marks important to our continued success.
ITEM 2. PROPERTIES
As of December 31, 2002, Hollywood's stores by location are as follows:
HOLLYWOOD ENTERTAINMENT
NUMBER OF VIDEO STORES BY STATE
Alabama 13 Nebraska 14
Arizona 57 Nevada 28
Arkansas 9 New Hampshire 2
California 312 New Jersey 33
Colorado 31 New Mexico 10
Connecticut 14 New York 72
Delaware 2 North Carolina 28
Florida 74 North Dakota 3
Georgia 36 Ohio 81
Idaho 12 Oklahoma 23
Illinois 92 Oregon 65
Indiana 38 Pennsylvania 74
Iowa 12 Rhode Island 8
Kansas 14 South Carolina 14
Kentucky 17 South Dakota 3
Louisiana 15 Tennessee 35
Maine 2 Texas 175
Maryland 29 Utah 34
Massachusetts 41 Virginia 39
Michigan 62 Washington 88
Minnesota 38 Washington, D.C. 2
Mississippi 9 West Virginia 1
Missouri 34 Wisconsin 34
Montana 1 Wyoming 1
Total Stores 1,831
Total States (excluding Washington, D.C.) 47
We lease all of our stores, corporate offices, distribution centers and zone
offices under non-cancelable operating leases. All of our stores have an
initial operating lease term of five to 15 years and most have options to renew
for between five and 15 additional years. Most of the store leases are "triple
net," requiring us to pay all taxes, insurance and common area maintenance
expenses associated with the properties.
Our corporate headquarters are located at 9275 Southwest Peyton Lane,
Wilsonville, Oregon, and consist of approximately 123,000 square feet of leased
space. The lease expires in November 2008. We have two warehouse facilities.
The first is located at 25600 Southwest Parkway Center Drive, Wilsonville,
Oregon and consists of approximately 175,000 square feet of leased space. The
second is located at 501 Mason Road, LaVergne, Tennessee, and consists of
approximately 98,000 square feet of leased space. These facilities are leased
pursuant to agreements that expire in November 2005 and June 2010,
respectively.
ITEM 3. LEGAL PROCEEDINGS
In 1999, Hollywood Entertainment Corporation was named as a defendant in three
complaints that have been consolidated 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
sought to certify a class of former and current California salaried Store
Managers and Assistant Managers alleging that Hollywood engaged in unlawful
conduct by improperly designating its salaried Store Managers and Assistant
Store Managers as "exempt" from California's overtime compensation requirements
in violation of the California Labor Code. Hollywood maintains that its
California Store Managers and Assistant Store Managers were properly designated
as exempt from overtime and therefore disputes all claims for damages and other
relief made in the lawsuit. The parties have since entered into a settlement
agreement, which was given final approval by the court on January 28, 2003.
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 did not opt-out of the
settlement. Our established reserves at December 31, 2002 are adequate to cover
amounts in 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 Entertainment Corporation 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, Hollywood, 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.
Hollywood Entertainment Corporation has been named in several purported class
action lawsuits alleging various causes of action, including claims regarding
its membership application and extended rental period charges. Hollywood has
vigorously defended these actions and maintains that the terms of its extended
rental charge policy are fair and legal. (Some of Hollywood's major
competitors have settled similar litigation by agreeing, in addition to other
remedies, to modify their extended rental policies to conform very closely to
Hollywood's existing policy.) Hollywood has been successful in obtaining
dismissal of three of the actions filed against it. Two of the lawsuits have
been consolidated in a nationwide class action entitled, George Curtis and Karl
G. Anuta, on behalf of themselves and the class of similarly situated customers
of Hollywood Video, Plaintiffs, and Michael DeLong, Intervenor-Plaintiff v.
Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8
SEA, in the Superior Court of King County, Washington. Hollywood and the
plaintiffs in this nationwide class action have entered into a settlement
agreement and are seeking preliminary approval from the King County Superior
Court. Final approval of this settlement would fully and finally resolve all
class actions with regard to Hollywood's membership application and extended
rental period charges. (An individual plaintiff can opt out of the class and
bring an action in his or her own name but could not bring a class action.) We
believe, based upon the settlement agreement, we have provided adequate
reserves in connection with these lawsuits. In addition, we do not believe the
pending settlement will have any material effect on our methods of operating or
on our future results of operations.
We have been named in various claims, disputes, legal actions and other
proceedings involving contracts, employment and various other matters. We
believe we have provided adequate reserves for these various contingencies and
that the outcome of these matters should not have a material adverse effect on
our consolidated results of operation, financial condition or liquidity.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no submissions of matters to a vote of security holders in the
fourth quarter of 2002.
ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning our executive
officers as of December 31, 2002:
Name Age Position
Mark J. Wattles 42 Chairman of the Board, Chief Executive
Officer, President and Director
Donald J. Ekman 50 Executive Vice President of Legal
Affairs, Secretary and Director
F. Bruce Giesbrecht 43 Executive Vice President of Business
Development
James A. Marcum 43 Executive Vice President and Chief
Financial Officer
Roger J. Osborne 50 Executive Vice President of Operations
- -------------
Mark J. Wattles founded Hollywood in June 1988 and has served as a director,
Chairman of the Board, and Chief Executive Officer since that time. From June
1988 through September 1998, Mr. Wattles also served as President of Hollywood.
From August 1998 through June 2000, Mr. Wattles left his full time position at
Hollywood and served as CEO of Reel.com. In August 2000, Mr. Wattles returned
full time to Hollywood and in January 2001 was re-appointed President of
Hollywood by the Board. Mr. Wattles has been an owner and operator in the
video rental industry since 1985. In 2001 Mr. Wattles was appointed to the
National Advisory Council of the Marriot Business School at Brigham Young
University.
Donald J. Ekman became a director of Hollywood in July 1993 and has been the
Executive Vice President of Legal Affairs since August 2000. Before the
appointment to his current position, Mr. Ekman served as the General Counsel of
Hollywood beginning in March 1994 and as a Vice President from 1994 until he
became a Senior Vice President in May 1996. Before joining Hollywood, Mr.
Ekman was in the private practice of law.
F. Bruce Giesbrecht was named Senior Vice President of Product Management in
January 1996, became Senior Vice President of Strategic Planning in January
1998, and Executive Vice President of Business Development in March 2000. He
joined Hollywood in May 1993 as Vice President of Corporate Information Systems
and Chief Information Officer. Mr. Giesbrecht was a founder of RamSoft, Inc.,
a software development company specializing in management systems for the video
industry, and served as its President.
James A. Marcum was appointed Executive Vice President and Chief Financial
Officer in May 2001. From October 2000 to January 2001, Mr. Marcum held the
position of Executive Vice President and Chief Operating Officer of Lids
Incorporated. From June 1995 until May 2000, Mr. Marcum worked for Stage
Stores, Inc., most recently as Vice Chairman and Chief Financial Officer. From
1983 to 1995, he held numerous positions at Melville Corporation, a
conglomerate of specialty retail chains, including Treasurer of the
corporation, his last assignment being Chief Financial Officer of Marshall's
Inc. Prior to 1983, Mr. Marcum was an auditor with Coopers and Lybrand. Mr.
Marcum also served as a lead director and Chairman of the Audit Committee of
the Bombay Corporation until February 2003.
Roger J. Osborne was named Senior Vice President of Operations in January 1999
and became Executive Vice President of Operations in October 2000. Prior to
being named Senior Vice President of Operations, he was the Executive Vice
President of J. Baker, Corporation, a major apparel and footwear retailer, and
President of its Work `N Gear Division since June 1997. Before joining J.
Baker Corporation, Mr. Osborne was Senior Vice President and Zone Director for
Mid-West and East coast markets for Hollywood from November 1996 until May of
1997. From 1993 until 1996, Mr. Osborne worked for J. Baker, Corporation,
serving as Senior Vice President and Director of its licensed shoe department
business from January 1995 to November 1996. Mr. Osborne served in executive
capacities with Bata Shoe Company from 1988 until 1993 and with the Payless
Shoe Store division of May Company from 1975 until 1988.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
We have not paid any cash dividends on our common stock since our initial
public offering in July 1993 and anticipate that future earnings will be
retained for the development of our business. Loan covenants contained in our
bank credit facilities and senior subordinated notes limit the amount of
dividends we may pay and the amount of stock we may repurchase (see
Management's Discussion and Analysis of Results of Operations and Financial
Condition under the caption "Liquidity and Capital Resources"). Our common
stock is traded on the Nasdaq National Market ("Nasdaq") under the symbol
"HLYW". The following table sets forth the quarterly high and low sales prices
per share, as reported on Nasdaq.
2002 2001
----------------------------------------
Quarter High Low High Low
------- ------- ------ -------- -------
Fourth $20.19 $14.30 $16.91 $11.61
Third 20.15 12.83 12.85 7.44
Second 20.72 17.08 9.97 1.94
First 17.70 11.35 2.72 1.00
As of March 19, 2003, there were 184 holders of record of our common stock, and
no shares of preferred stock were issued and outstanding.
In October 1998, we issued and sold 5,982,537 shares of common stock and
2,380,263 shares of Series A Redeemable Preferred Stock in connection with the
acquisition of Reel.com. 1,982,537 shares of the common stock were issued for
aggregate cash consideration of $26,764,250 and 1,380,263 shares of the Series
A Redeemable Preferred Stock were issued for aggregate cash consideration of
$18,633,551. The balance of the shares of common stock and Series A Redeemable
Preferred Stock were issued in exchange for issued and outstanding shares of
Reel.com. The issuance and sale of these shares was exempt from the
registration requirements of Section 5 of the Securities Act of 1933, as
amended (the "Securities Act"), by virtue of Section 4(2) thereof. These
shares were issued and sold to a limited number of persons to whom disclosure
was provided and from whom "private placement" representations were obtained,
without the use of any general solicitation. In addition, certificates
evidencing these shares bore legends indicating that they were issued without
registration and, accordingly, that resales thereof were restricted. The
exemption provided by Section 4(2) also applied to the common stock issued upon
the conversion of the Series A Redeemable Preferred Shares in December 1998.
On January 24, 2000, we issued 200,000 shares of our common stock to Rentrak
Corporation as part of a litigation settlement. These shares were valued by us
at the time of their issuance at $11.438 per share, or $2,287,600. The issuance
of these shares was exempt from the registration requirements of Section 5 of
the Securities Act by virtue of Section 4(2) thereof. These shares were issued
and sold to a single entity to which disclosure was provided and from whom a
"private placement" representation was obtained, without the use of any general
solicitation. In addition, a certificate evidencing these shares bore a legend
indicating that they were issued without registration and, accordingly, that
resales thereof were restricted.
On March 11, 2002, we sold 8,050,000 shares of our common stock resulting in
proceeds of $120.8 million before underwriting fees and expenses. Net proceeds
from the sale of common stock were used to partially repay amounts outstanding
under our prior revolving credit facility.
On December 18, 2002, we completed the sale of $225 million principal amount of
9.625% Senior Subordinated Notes due 2011. We used the net proceeds from the
sale of subordinated notes, along with initial borrowings under our new credit
facility, to repay amounts outstanding under our existing credit facilities
which were due in 2004 and redeem the 10.625% Senior Subordinated Notes due
2004 and for general corporate purposes.
ITEM 6. SELECTED FINANCIAL DATA
The information presented below for, and as of the end of, each of the fiscal
years in the five-year period ended December 31, 2002 is derived from our
audited financial statements. The following information should be read in
conjunction with "Management's Discussion and Analysis of Results of Operation
and Financial Condition."
Except as otherwise noted, the information in the table below reflects, among
other things, operating losses incurred by Reel.com from October 1, 1998, when
we acquired it, to June 12, 2000, when we discontinued its e-commerce
operations.
Year Ended December 31,
--------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- --------- ---------
OPERATING RESULTS:
Revenue $1,490,066 $1,379,503 $1,296,237 $1,096,841 $763,908
---------- ---------- ---------- --------- ---------
Income (loss) from
operations 189,327 119,277 (436,321) (2,513) (36,451)
---------- ---------- ---------- --------- ---------
Interest expense, net 42,057 56,129 62,127 45,477 33,214
---------- ---------- ---------- --------- ---------
Income (loss) before
Extraordinary item
and cumulative effect
of a change in
accounting principle 244,071 100,416 (530,040) (49,858) (50,464)
---------- ---------- ---------- --------- ---------
Net income (loss)(1) 241,845 100,416 (530,040) (51,302) (50,464)
---------- ---------- ---------- --------- ---------
Net Income (Loss)
Per Share Before
Extraordinary Item
and Cumulative
Effect of a Change
in Accounting
Principle:
Basic $ 4.27 $ 2.05 $(11.48) $(1.09) $(1.30)
Diluted 3.91 1.90 (11.48) (1.09) (1.30)
---------- ---------- ---------- --------- ---------
Net Income (Loss)
Per Share:
Basic $ 4.23 $ 2.05 $(11.48) $(1.13) $ (1.30)
Diluted 3.88 1.90 (11.48) (1.13) (1.30)
---------- ---------- ---------- --------- ---------
- ------------------------------------------------------------------------------
BALANCE SHEET DATA:
Rental inventory, net $ 260,190 $191,016 $168,462 $339,912 $259,255
Property and
equipment, net 255,497 270,586 323,666 382,345 328,182
Total assets 1,146,376 718,544 665,114 1,053,291 936,330
Long-term
obligations(2) 388,746 514,002 536,401 533,906 392,145
Shareholders' equity
(deficit) 257,149 (113,554) (222,377) 304,529 347,591
- ------------------------------------------------------------------------------
Year Ended December 31,
-------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- --------- --------
OPERATING DATA:
Number of stores at
year end 1,831 1,801 1,818 1,615 1,260
Weighted average stores
open during the year 1,805 1,813 1,751 1,405 1,074
Comparable store
revenue increase (3) 8% 6% 2% 12% 8%
- ----------------------------------------------------------------------------
OTHER FINANCIAL DATA
(in thousands):
Calculation of EBITDA (4)
Income (loss) from
operations 189,327 119,277 (436,321) (2,513) (36,451)
Exclude Reel.com
operating losses - - 121,083 98,538 20,000
Exclude special
charges (5) - - 330,068 25,441 101,834
Exclude reversal of
accruals (6) (13,258) (7,034) - - -
------- ------- ------- ------- -------
Adjusted income from
operations 176,069 112,243 14,830 121,466 85,383
Add back depreciation
and amortization (7) 59,343 66,940 77,102 64,078 47,592
Adjust for non-cash
items (8) (1,633) 25,371 52,000 - -
------- ------- ------- ------- -------
EBITDA 233,779 204,554 143,932 185,544 132,975
======= ======= ======= ======= =======
Cash flows generated
from (used in):
Operating activities 361,991 273,793 248,871 177,151 246,641
Investing activities (552,051) (212,293) (255,822) (320,338) (438,411)
Financing activities 184,395 (25,958) 3,278 146,153 191,836
- ----------------------------------------------------------------------------
(1) We adopted Statement of Financial Accounting Standards No. 142 on
January 1, 2002, and concurrently ceased to amortize goodwill recorded in
connection with prior business combinations and our trade name rights,
which had the effect of increasing our net income for 2002 by $3.2
million. See Note 10 to the Consolidated Financial Statements. Excluding
amortization of these intangible assets would have reduced our net loss or
increased our net income by $3.1 million, $29.9 million, $54.7 million and
$16.4 million, respectively, for the years ended December 31, 2001, 2000,
1999 and 1998.
(2) Includes the current portion of long-term obligations. For the year ended
December 31, 2002, excludes $203.9 million of our 10.625% senior
subordinated notes that were called on December 18, 2002 and redeemed on
January 17, 2003.
(3) A store is comparable after it has been open and owned by the Company
for 12 full months. An acquired store converted to the Hollywood Video
name store design is removed from the comparable store base when the
conversion process is initiated and returned 12 full months after
reopening.
(4) EBITDA represents income from operations before operating losses of
Reel.com, special charges, certain accrual reversals, depreciation and
amortization (excluding amortization of rental product) and significant
non-cash expense/income items such as expense/income associated with
certain stock option grants. 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, 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 ended 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. 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.
(5) 2000 includes an inventory write-down of $164.3 million associated with
modifications to rental product amortization estimates; a $74.3 million
charge for the impairment of long-lived assets and the goodwill related to
those assets; a $17.3 million charge for doubtful employee receivables; a
$16.9 million charge related to the planned closing of 43 stores in 2001;
a $13.2 million charge to write-down specific rental and merchandise
inventories to net realizable value; a $11.1 million charge for settlement
of revenue sharing contract disputes; a $10.5 million charge for pending
legal settlements; a $9.5 million charge for lease termination fees; a
$6.8 million charge for doubtful cooperative advertising receivables; a
$3.5 million charge for an unearned bonus payout; and a $2.7 million
charge related to severance liabilities. 1999 represents litigation
settlement charges. 1998 includes a $99.9 million charge related to the
valuation of our rental inventory and a $1.9 million charge related to
purchased in-process research and development.
(6) Represents reversals of accruals for restructuring charges for the
discontinuation of Reel.com e-commerce operations and store closures as
show on separate line items on our Consolidated Statement of Operations.
(7) Excludes amortization of rental product and depreciation and amortization
from our former Reel.com subsidiary of $23.6 million, $51.6 million and
$12.7 million for the periods ended December 31, 2000, 1999 and 1998,
respectively.
(8) Represents stock compensation and incremental rental amortization charges
associated with changes in estimated rental inventory lives and residual
values that were adopted on a prospective basis on October 1, 2000.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with generally accepted accounting principles (GAAP) requires us to make
judgments, assumptions and estimates that affect the amounts reported in the
Consolidated Financial Statements and accompanying notes. Note 1 to the
Consolidated Financial Statements describes the significant accounting policies
and methods used in the preparation of the Consolidated Financial Statements.
Our judgments, assumptions and estimates affect, among other things, the
amounts of: receivables; rental and merchandise inventories; property and
equipment, net; goodwill; deferred income tax assets; other liabilities;
revenue; cost of revenue; and operating costs and expenses. We base our
judgments, assumptions and estimates on historical experience and on various
other factors that we believe to be reasonable under the circumstances. Actual
results could differ significantly from amounts based on our judgments,
assumption and estimates. The following critical accounting policies involve
significant judgments, assumptions and estimates, which affect amounts recorded
in the Consolidated Financial Statements.
Revenue Recognition
We recognize revenue upon the rental and sale of our products. Rental revenue
for extended rental periods (when the customer chooses to keep the product
beyond the original rental period) is recognized when the extended rental
period begins. Revenue recorded for extended rental periods is net of estimated
amounts that we do not anticipate collecting based upon historical collection
experience. We continuously monitor actual collections. Estimates are revised
when we believe it is appropriate in light of actual collection rates and other
relevant circumstances. Historically, actual collections have approximated the
related net revenue recorded. However, if actual collections in the future are
less than the related net revenue recorded, our results of operations would be
adversely affected.
Merchandise Inventory Valuation
Merchandise inventories, consisting primarily of video games, prerecorded
videocassettes and DVDs, concessions, and accessories held for resale, are
stated at the lower of cost or market. Due to the numerous variables associated
with the judgments and assumptions we make in estimating market values, and the
effects of changes in circumstances affecting these estimates (including the
effects of competing products and technologies), both the precision and
reliability of the resulting estimates are subject to substantial uncertainties
and, as additional information becomes known, we may change our estimates
significantly.
Amortization of Rental Inventory
Rental inventory, which includes VHS videocassettes, DVDs and video games, is
stated at cost and amortized over its estimated useful life to an estimated
residual value. Our estimates of useful lives and residual values affect the
amounts of amortization recorded, which in turn affects the carrying value of
our rental inventory and cost of rental product (and, upon the transfer of
previously viewed items from rental inventory to merchandise inventory, the
carrying value of our merchandise inventory). For new release movies acquired
for rental under revenue sharing arrangements, the studios' share of rental
revenue is expensed as revenue is earned net of average estimated residual
values. Tapes, DVDs and video games acquired for rental at fixed prices are
amortized to estimated residual values in periods ranging from four months to
five years. Due to the numerous variables associated with the judgments and
assumptions we make in estimating useful lives and residual values of these
items, and the effects of changes in circumstances affecting these estimates
(including the effects of competing products and technologies and actual
selling prices obtainable for previously viewed product), both the precision
and reliability of the resulting estimates are subject to substantial
uncertainties and, as additional information becomes known, we may change our
estimates significantly. For example, in the fourth quarter of 2000, a number
of observations led us to change our estimates of rental inventory lives and
residual values, which resulted in a $164.3 million increase to amortization
expense in that quarter (see Note 6 to the Consolidated Financial Statements).
Impairment of Long-Lived Assets and Goodwill
We review long-lived assets and goodwill for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. We periodically review and monitor our internal management
reports for indicators of impairment. We consider a trend of unsatisfactory
operating results that are not in line with management's expectations to be a
primary indicator of potential impairment. When an indicator of impairment is
noted, assets are evaluated for impairment at the lowest level for which there
are identifiable cash flows (e.g., at the store level). We deem a store to be
impaired if a forecast of undiscounted future operating cash flows directly
related to the store, including estimated disposal value, if any, is less than
the asset carrying amount. If a store is determined to be impaired, the loss
is measured as the amount by which the carrying amount on our balance sheet of
the store exceeds its fair value. Fair value is estimated using a discounted
future cash flow valuation technique similar to that used by management in
making a new investment decision. Considerable management judgment and
assumptions are necessary to estimate discounted future cash flows. Due to the
numerous variables associated with our judgments and assumptions relating to
the valuation of our assets in these circumstances, and the effects of changes
in circumstances affecting these valuations, both the precision and reliability
of the resulting estimates of the related impairment charges are subject to
substantial uncertainties and, as additional information becomes known, our
estimates may change significantly.
Income Taxes
We calculate income taxes in accordance with SFAS No. 109, "Accounting for
Income Taxes," which requires recognition of deferred tax liabilities and
assets for the expected future tax consequences of events that have been
included in our financial statements and tax returns. Valuation allowances are
established when necessary to reduce deferred tax assets, including temporary
timing differences and net operating loss carryforwards, to the amount expected
to be realized in the future. In the fourth quarter of 2000, in light of
significant doubt that existed regarding our future income and therefore our
ability to use our net operating loss carryforwards, we recorded a $211.2
million valuation allowance on our $211.2 million net deferred tax asset. In
2001 and 2002, as a result of our operating performance for each year, as well
as anticipated future operating performance, we determined that it was more
likely than not that certain future tax benefits would be realized. As such we
reversed $63.4 million and $147.8 million of this valuation allowance in 2001
and 2002, respectively, which resulted in a corresponding increases in net
income and corresponding increases/decreases in our shareholders'
equity/deficit. While changes in the valuation allowance have no effect on the
amount of income tax we pay or on our cash flows, the effects on our reported
income and shareholders' equity may be viewed by some investors and potential
lenders as significant. Due to the numerous variables associated with our
judgments, assumptions and estimates relating to the valuation of our deferred
tax assets, and the effects of changes in circumstances affecting these
valuations, both the precision and reliability of the resulting estimates are
subject to substantial uncertainties and, as additional information becomes
known, we may change our estimates significantly.
Legal Contingencies
Our estimates of our loss contingencies for legal proceedings are based on
various judgments and assumptions regarding the potential resolution or
disposition of the underlying claims and associated costs. Due to the numerous
variables associated with these judgments and assumptions, both the precision
and reliability of the resulting estimates of the related loss contingencies
are subject to substantial uncertainties. We regularly monitor our estimated
exposure to these contingencies and, as additional information becomes known,
may change our estimates significantly.
RESULTS OF OPERATIONS
Summary Results of Operations
Our net income for 2002 was $241.8 million compared to $100.4 million in 2001
and a net loss of $530.0 million in 2000. The improvement in operating results
was primarily the result of improved operating performance in our existing
store base, adjustments to our valuation allowance on our net deferred income
tax asset (see Note 17 to the Consolidated Financial Statements) and the
closing of the e-commerce operations at Reel.com in June of 2000. The large net
loss in 2000 was primarily the result of special charges summarized in Note 21
to the Consolidated Financial Statements. In our press release on February 20,
2003, we announced net income in 2002 of $246.5 million reflecting the
recognition of $111.1 million in deferred tax assets which were previously
unrecognized. Actual deferred tax assets recognized were $106.4 million and
have been reflected accordingly in these financial statements.
Summary Results of Operations
The following table sets forth (i) results of operations data expressed as a
percentage of total revenue and (ii) gross margin data.
Year Ended December 31,
------------------------------
2002 2001 2000
-------- -------- --------
Revenue:
Rental product revenue 88.9% 92.2% 88.7%
Merchandise sales 11.1% 7.8% 11.3%
-------- -------- --------
100.0% 100.0% 100.0%
-------- -------- --------
Cost of revenue:
Cost of rental product 30.0% 33.3% 49.5%
Cost of merchandise 8.5% 6.2% 11.1%
-------- -------- --------
38.5% 39.5% 60.6%
-------- -------- --------
Gross margin 61.5% 60.5% 39.4%
Operating costs and expenses:
Operating and selling 43.5% 45.0% 55.0%
General and administrative 6.0% 7.0% 8.5%
Store opening expense 0.2% - -
Restructuring charge for closure
of internet business (0.8%) (0.2%) 3.6%
Restructuring charge for store
closures (0.1%) (0.3%) 1.3%
Amortization of intangibles - 0.4% 4.6%
-------- -------- --------
48.8% 51.9% 73.0%
-------- -------- --------
Income (loss) from operations 12.7% 8.6% (33.6%)
Interest expense, net (2.8%) (4.0%) (4.8%)
-------- -------- --------
Income (loss) before income taxes
and extraordinary loss 9.9% 4.6% (38.4%)
(Provision for) benefit from income
taxes 6.5% 2.7% (2.4%)
-------- -------- --------
Income (loss) before extraordinary
loss 16.4% 7.3% (40.8%)
Extraordinary loss on retirement
of debt, net (0.2%) - -
-------- -------- --------
Net income (loss) 16.2% 7.3% (40.8%)
======== ======== ========
Year Ended December 31,
---------------------------
2002 2001 2000
-------- ------ -------
Other data:
Rental product gross margin (1) 66.2% 63.9% 44.3%
Merchandise sales gross margin (2) 24.0% 21.0% 1.4%
- -------------------------------------------------------------
(1) Rental product gross margin as a percentage of rental product revenue.
(2) Merchandise sales gross margin as a percentage of merchandise sales.
REVENUE
Revenue increased by $110.6 million, or 8.0%, in 2002 compared to 2001,
primarily due to an increase of 8% in comparable store revenue. Revenue
increased by $83.3 million, or 6.4%, in 2001 compared to 2000, primarily due to
an increase of 6% in comparable store revenue. Also favorably impacting
revenue in 2001 was the addition, on a weighted average basis, of 62 stores.
The closure of Reel.com in June 2000, which had total revenue of $26.3 million
in 2000, unfavorably impacted revenue. We ended 2002 with 1,831 superstores
operating in 47 states, compared to 1,801 superstores operating in 47 states at
the end of 2001 and 1,818 stores operating in 47 states at the end of 2000. We
currently offer a 5-day rental program on all products in the majority of our
stores. New release videos and all DVDs typically rent for $3.79. Catalog
videos typically rent for $1.99. Since the fourth quarter of 1999, we have not
increased prices on new release videos, DVDs or catalog videos. Video games
rent for $4.99 and $5.99, with games designed for the newer platforms renting
for the higher amount. Customers who choose not to return movies within the
applicable rental period are deemed to have commenced a new rental period of
equal length at the same price. Revenue recorded for extended rental periods is
net of estimated amounts that we do not anticipate collecting based upon
historical collection experience. Rental revenue from initial rental periods
was $1,167 million, $1,121 million and $1,016 million for 2002, 2001 and 2000,
respectively. Rental revenue from extended rental periods was $157 million,
$150 million and $134 million for 2002, 2001 and 2000, respectively. Our
policies with respect to these extended rental periods have been the subject of
litigation. See "Item 3. Legal Proceedings."
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 2001 and 2000
have been reclassified to conform to the presentation for the current year.
GROSS MARGIN
Rental Product Margins
Rental gross margin as a percentage of rental revenue increased to 66.2% in
2002 from 63.9% in 2001 and 44.3% in 2000. The Company regularly evaluates and
updates rental inventory accounting estimates. Effective October 1, 2002,
estimated average residual values on new release movies was reduced from $3.16
to $2.00 for VHS and from $4.67 to $4.00 for DVD. In addition, the estimated
residual value of catalog DVD inventory was reduced from $6.00 to $4.00. These
changes resulted in a $4.1 million increase in cost of rental product in 2002.
We also made several key observations that led us to change estimates regarding
rental inventory lives and residual values during the fourth quarter of 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. We adopted the changes in
estimate prospectively on October 1, 2000, and recorded a charge of $164.3
million. By applying these changes prospectively, we also recorded incremental
depreciation expense of approximately $52 million and $18 million in the fourth
quarter of 2000 and in the first three quarters of 2001, respectively.
Excluding the impact of these changes in estimate, margins increased to 66.5%
in 2002 from 65.3% in 2001 and 63.1% in 2000 primarily due to a shift in
revenue from VHS to DVD, which typically has higher margins.
Merchandise Sales Margins
Merchandise sales gross margin as a percentage of merchandise sales increased
to 24.0% in 2002 from 21.0% in 2001 and 1.4% in 2000. The increase in 2002
margins compared to 2001 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. The
low margin in 2000 was primarily the result of operations of our former
internet subsidiary, Reel.com, including a $20.8 million charge for the
discontinuation of their e-commerce operations, and a $8.6 million charge in
our video stores to value the inventory on hand at December 31, 2000 at the
lower of cost or net realizable value.
OPERATING COSTS AND EXPENSES
Operating and Selling
Total operating and selling expenses as a percentage of total revenue decreased
to 43.5% in 2002 from 45.0% in 2001. The percentage decrease is primarily the
result of leverage on increased revenue. Total operating and selling expenses
of $647.8 million in 2002 increased $26.5 million from $621.3 million in 2001.
The increase was primarily the result of increased variable costs associated
with increased store sales volume and an increase of an additional 207 Game
Crazy departments in 2002. Salary and wages increased $23.1 million and other
operating and selling expenses increased by $3.4 million in 2002 compared to
the prior year.
Total operating and selling expenses of $621.3 million in 2001 decreased $92.1
million from $713.4 million in 2000. Total operating and selling expenses as a
percentage of total revenues decreased to 45.0% in 2001 from 55.0% in 2000.
Impacting operating and selling expense in 2000 was a $44.3 million charge for
impaired property and equipment (See Note 9 to Consolidated Financial
Statements) and Reel.com operating expenses of $27.4 million. Excluding the
impairment charge and operating expenses of Reel.com, operating and selling
expenses decreased $20.4 million for 2001 as compared to 2000. The decrease was
driven by decreases in advertising expense of $20.5 million, other operating
and selling expenses of $11.9 million and depreciation expense of $8.0 million,
which were partially offset by an increase in store wages of $11.8 million and
occupancy costs of $8.2 million. The decrease in advertising expense was the
result of the discontinuation of a mass media advertising campaign that ran in
2000. In 2001, we returned to a more cost-effective direct mail strategy. The
increases in store wages and occupancy costs were primarily due to the addition
of 62 weighted average stores compared to the prior year.
Restructuring for Closure of Internet Business
On June 12, 2000, we announced that we would close down the e-commerce business
of Reel.com. Although we had developed a leading web-site over the seven
quarters after Reel.com was purchased in October of 1998, Reel.com's business
model of rapid customer acquisition led to large operating losses and required
significant cash funding. Due to market conditions, we were unable to obtain
outside financing for Reel.com, and could not justify continued funding from
our superstore cash flow. As a result of the discontinuation of Reel.com's e-
commerce operations, we recorded a total charge of $69.3 million in the second
quarter of 2000, of which $48.5 million was classified as a restructuring
charge on the consolidated statement of operations and $20.8 million was
included in merchandise sales. The $48.5 million charge included $27.3 million
of accrued liabilities for contractual obligations, lease commitments,
anticipated legal claims, legal fees, financial consulting, and other
professional services incurred as a direct result of the closure of Reel.com.
The charge was reduced by $1.6 million to $46.9 million in the fourth quarter
of 2000, and also reduced by $3.3 million and $12.4 million in 2001 and 2002,
respectively, because we were able to negotiate termination of certain
obligations and lease commitments more favorably than originally anticipated.
As of December 31, 2002, we had paid for all accrued liabilities (net of
reductions) and do not anticipate further adjustments.
Restructuring charge for store closures
In December 2000, we approved a restructuring plan involving the closure and
disposition of 43 stores that were not operating to our expectations (the
"Restructuring Plan"). In the fourth quarter of 2000, we recorded charges
aggregating $16.9 million, including an $8.0 million write down of property and
equipment, a $1.5 million write down of goodwill and an accrual for store
closing costs of $7.4 million. The established reserve for cash expenditures
is for lease termination fees and other store closure costs. We have liquidated
and plan to continue liquidating related store inventories through store
closing sales; any remaining product will be used in other stores.
Revenue for the stores subject to the store closure plan was $6.3 million,
$13.8 million and $15.5 million in 2002, 2001 and 2000, respectively. Operating
results (defined as income or loss before interest expense and income taxes)
was $.9 million loss, $2.5 million loss and $1.8 million in 2002, 2001 and
2000, respectively. The operating results for the stores in the closure plan
were included in the Consolidated Statement of Operations.
During the twelve months ended December 31, 2001, we closed 12 of the stores
included in the plan and incurred $329,867 in expenses related to the closures
and received $450,000 to exit one of the leases. During the twelve months ended
December 31, 2002, we closed one store included in the plan and incurred
$90,000 in closure expenses.
In December of 2001 and 2002, we amended the Restructuring Plan and removed 16
stores and 2 stores from the closure list, respectively. In accordance with the
amended plans, and updated estimates on closing costs, we reversed $3.8 million
and $0.8 million of the original $16.9 million charge, leaving a $3.7 million
and $2.8 million accrual balance at December 31, 2001 and 2002, respectively,
for store closing costs. At December 31, 2002, twelve stores remained to be
closed under the Restructuring Plan.
General and Administrative
Total general and administrative expenses of $89.6 million in 2002 decreased
$6.8 million from $96.4 million in 2001. Total general and administrative
expenses as a percentage of total revenue decreased to 6.0% in 2002 compared to
7.0% in 2001. General and administrative expenses in 2002 benefited from the
reversal of a legal accrual in the amount of $1.6 million as a result of the
final confirmation of the settlement of our California exempt/non-exempt class
action lawsuit for an amount less than anticipated. The reversal of non-cash
stock compensation of $1.6 million also benefited 2002 general and
administrative expenses. Included in general and administrative expenses in
2001 were $4.8 million of non-cash compensation expense related to a stock
grant to our Chief Executive Officer as part of a three-year employment
agreement. Also included was $4.1 million of non-cash stock compensation
associated with other grants under our stock option plans. Excluding the
adjustments noted above, general and administrative expenses would have been
$92.8 million, or 6.2% of revenue in the current year compared to $87.5 million
or 6.3% in the prior year.
Total general and administrative expenses of $96.4 million in 2001 decreased
$13.8 million from $110.2 million in 2000. Total general and administrative
expenses as a percentage of total revenue decreased to 7.0% in 2001 compared to
8.5% in 2000. Included in general and administrative expenses in 2000 were
employee loans written off or fully reserved for as doubtful for $17.3 million;
reserves established for pending litigation for $10.5 million and Reel.com
general and administrative expenses of $5.1 million. Included in general and
administrative expenses in 2001 were $4.8 million of non-cash compensation
expense related to a stock grant to our Chief Executive Officer as part of a
three-year employment agreement. Also included was $4.1 million of non-cash
stock compensation associated with other grants under our stock option plans.
Excluding the adjustments noted above, general and administrative expenses
increased as a percentage of revenue to 6.3% in 2001 compared to 6.0% in the
prior year. We made the decision to invest in certain elements of the
business, such as the store field supervision structure, the loss prevention
function and human resources. We believe these investments have had and will
continue to have a direct impact on the business by improving the level of
execution.
Amortization of Intangibles
We adopted SFAS 142 as of January 1, 2002, and as a result we had no
amortization expense in 2002 compared to $5.1 million in 2001. SFAS 142 changes
the accounting for goodwill and certain intangible assets from an amortization
method to an impairment only approach. Under SFAS 142, goodwill and non-
amortizing intangible assets are adjusted whenever events or circumstances
occur indicating that goodwill has been impaired. When we evaluate goodwill and
intangible assets for possible impairment, we compare the present value of
estimated future cash flows of our 1,831 video stores (our reporting unit) to
the asset recorded. An impairment charge would be recorded to the extent that
the asset recorded exceeds the present value of estimated future cash flows. We
did not recognize an impairment charge in 2002.
Amortization of intangibles decreased by $54.9 million in 2001 compared to
2000. The decrease was primarily due to an impairment charge of $30.0 million
taken in the fourth quarter of 2000 related to acquired store goodwill as
discussed in Note 9 to the Consolidated Financial Statements and the closure in
June of 2000 of Reel.com, which had $22.7 million of amortization expense in
the prior year.
NON-OPERATING INCOME (EXPENSE), NET
Interest expense, net of interest income, decreased in 2002 compared to 2001 by
$14.1 million. The reduction was primarily due to decreased levels of revolving
credit borrowings and lower interest rates offset by incremental interest for
bonds issued on December 18, 2002. On March 11, 2002, we completed a public
offering of 8,050,000 shares of our common stock, resulting in proceeds of
$120.8 million before fees and expenses, of which $114 million was applied to
the repayment of borrowings under our prior revolving credit facility. Interest
expense, net of interest income, decreased in 2001 compared to 2000, primarily
due to decreased levels of revolving credit borrowings and lower interest
rates.
INCOME TAXES
Our effective tax rate was a benefit of 65.7% in 2002 compared to a benefit of
59.0% in 2001 and a provision of 6.3% in 2000 which varies from the federal
statutory rate as a result of adjustments to deferred tax asset valuation
allowances, non-deductible executive compensation, non-deductible goodwill
amortization associated with the Reel.com acquisition and state income taxes.
In the fourth quarter of 2000, in light of significant doubt that existed
regarding our future income and therefore our ability to use our net operating
loss carryforwards, we recorded a $211.2 million valuation allowance on our
$211.2 million net deferred tax asset. In 2002 and 2001, as a result of our
operating performance for each year, as well as anticipated future operating
performance, we determined that it was more likely than not that certain future
tax benefits would be realized. As such, we benefited by the reversal of $147.8
million and $63.4 million of the valuation allowance in 2002 and 2001,
respectively.
EXTRAORDINARY LOSS 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 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 that 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 that
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 2002, we significantly increased the amount of DVDs to be held in
our catalog inventories by investing approximately $62.9 million in DVD
catalog.
Purchases of new release movies are amortized over four months to current
estimated average residual values of approximately $2.00 for VHS and $4.00 for
DVD (net of estimated allowances for losses). Purchases of VHS and DVD catalog
are amortized on a straight-line basis over one year and five years,
respectively, to estimated residual values of $2.00 for VHS and $4.00 for DVD.
We regularly evaluate and update rental inventory accounting estimates.
Effective October 1, 2002, estimated average residual values on new release
movies was reduced from $3.16 to $2.00 for VHS and from $4.67 to $4.00 for DVD.
In addition, the estimated residual value of catalog DVD inventory was reduced
from $6.00 to $4.00.
For new release movies acquired under revenue sharing arrangements, the
studios' share of rental revenue is charged to cost of rental net of average
estimated residual values, which are 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.
The majority of games purchased are amortized over four months to an average
residual value below $5.00. Games that the Company expects to keep in rental
inventory for an indefinite period of time are amortized on a straight-line
basis over two years to a current estimated residual value of $5.00.
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.
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):
Twelve Months Ended
December 31,
--------------------
2002 2001
--------- ---------
New release purchases $ 287,365 $ 207,055
Revenue sharing expense 130,356 191,340
--------- ---------
Total new release investment 417,721 398,395
Book value of transfers to merchandise
inventory and tape loss (84,624) (74,360)
--------- ---------
Total new release investment, net $ 333,097 $ 324,035
New release purchases include purchases of movies and games, as defined by our
amortization policy, and the residual value of revenue sharing product
acquired. We acquired the majority of our DVDs under the sell-through pricing
structure.
As of December 31, 2002, net rental inventory was $260.2 million compared to
$191.0 million as of December 31, 2001, an increase of $69.2 million. The
following table summarizes the related balance sheet activity (in thousands):
--------- ---------
2002 2001
--------- ---------
Balance at beginning of year $ 191,016 $ 168,462
New release purchases 287,365 207,056
Book value of transfers to merchandise
inventory and tape loss (1) (84,624) (74,360)
--------- ---------
New release purchases, net 202,741 132,696
New stores and catalog (2) 85,338 70,095
--------- ---------
Purchases of rental inventory, net 288,079 202,791
Less rental inventory amortization (218,905) (180,237)
--------- ---------
Balance at year end $ 260,190 $ 191,016
--------- ---------
(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.
(2) Catalog represents an investment in rental inventory that we intend to hold
for an indefinite period of time. We significantly increased the amount of DVDs
to be held in our catalog inventories by investing approximately $62.9 million
and $37.9 million in 2002 and 2001, respectively.
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 $35.7 million to $97.3 million as of December 31, 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
Our primary source of operating cash flow is generated from the rental and
sales of videocassettes, DVDs and games. The amount of cash generated from
operations in the twelve months ended December 31, 2002 funded the majority of
our debt service requirements and maintenance capital expenditures with
sufficient cash left over to remodel and remerchandise 203 stores to include
Game Crazy departments, open 41 new video stores and continue strategic
investments in DVD catalog product. At December 31, 2002, we had $33.1 million
of cash and cash equivalents on hand (excluding cash held by trustee for
refinancing).
During 2002 and early 2003, we completed several refinancing transactions that
lengthened maturities on our long-term debt, lowered our effective interest
rate and increased working capital availability (see cash "Cash Flow From
Financing Activities" below). 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 foreseeable future. However, we continue to analyze our
capital structure and our business plan and from time to time may consider
additional capital and/or financing transactions as a source of incremental
liquidity.
Cash Provided by Operating Activities
Net cash provided by operating activities increased by $88.2 million or 32.2%
in the twelve months ended December 31, 2002 compared to the twelve months
ended December 31, 2001. The increase was primarily due to improved operating
performance in our existing store base.
We lease all of our stores, corporate offices, distribution centers and zone
offices under non-cancelable operating leases. All of our stores have an
initial operating lease term of five to 15 years and most have options to renew
for between five and 15 additional years. At December 31, 2002, the future
minimum annual rental commitments under non-cancelable operating leases were as
follows:
------------------------------
Operating
Year Ending Leases
December 31, (in thousands)
------------------------------
2003 224,354
2004 219,712
2005 209,430
2006 189,884
2007 159,919
Thereafter 417,361
Cash Used in Investing Activities
Net cash used in investing activities increased by $339.8 million, or 160.0%,
to $552.1 million in the twelve months ended December 31, 2002, from $212.3
million in the twelve months ended December 31, 2001. On December 18, 2002, we
completed the sale of $225 million 9.625% senior subordinated notes due 2011
and delivered net proceeds of $218.5 million to the indenture trustee to redeem
$203.9 million of the $250 million 10.625% senior subordinated notes due 2004.
Excluding the cash held by the indenture trustee, our cash used in investing
activities increased by $121.2 million, or 57.1%. The increase was the result
of investments in new stores and Game Crazy departments and the shift in
product mix from VHS to DVD, resulting in a shift in product acquisition from
revenue sharing to sell-through pricing. In 2002, we opened 41 video stores and
207 Game Crazy departments compared to 6 video stores and no Game Crazy
departments in 2001.
Cash Flow from Financing Activities
Net cash flow from financing activities was a $184.4 million source of cash in
the twelve months ended December 31, 2002, compared to a $26.0 million use of
cash in the corresponding period of the prior year. As of December
31, 2002, we had $218.5 million of cash held by the indenture trustee that was
used to redeem $203.9 million of our $250.0 million 10.625% senior subordinated
notes on January 17, 2003. If the $203.9 million had been paid prior to
December 31, 2002, cash flow from financing activities would have been a $19.5
million net use of cash.
On March 11, 2002, we completed a public offering of 8,050,000 shares of our
common stock, resulting in proceeds of $120.8 million before fees and expenses,
of which $114 million was applied to the repayment of borrowings under our
prior revolving credit facility.
On March 18, 2002, we obtained 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 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 interest
payable on the credit facilities is based on variable interest rates (LIBOR or
the prime bank rate at our option). At December 31, 2002 we had a total of
$107.5 million outstanding under the senior secured term facility, no
outstanding balance on the $25.0 million senior secured revolving credit
facility and we were in compliance with all financial covenants.
On December 18, 2002, we completed the sale of $225 million 9.625% senior
subordinated notes due 2011. We delivered the net proceeds to the indenture
trustee to redeem $203.9 million of the $250 million 10.625% senior
subordinated notes due 2004, including accrued interest and the required call
premium. At December 31, 2002, the trustee was holding $218.5 million and we
continued to carry the $250 million 10.625% senior subordinated notes on our
balance sheet, $203.9 million of which was classified as a current liability
titled "Subordinated notes to be retired by trustee." On January 17, 2003, the
redemption of $203.9 million of the notes was completed.
The senior subordinated notes due 2011 are redeemable, at our option, beginning
March 15, 2007, at rates starting at 104.8% of the principal amount. Rates
reduce annually through March 15, 2009, at which time the notes become
redeemable at 100% of the principal amount. The terms of the notes may
restrict, among other things, payment of dividends and other distributions,
investments, the repurchase of capital stock or subordinated indebtedness, the
making of certain other restricted payments, the incurrence of additional
indebtedness or liens by the Company or any of its subsidiaries, and certain
mergers, consolidations and disposition of assets. Additionally, if a change
of control occurs, as defined, each holder of the notes will have the right to
require us to repurchase the holder's notes at 101% of the principal amount.
On January 16, 2003, we obtained new senior secured credit facilities from a
syndicate of lenders led by UBS Warburg LLC. The new facilities consist of a
$200.0 million term loan facility and a $50.0 million revolving credit
facility, each maturing in 2008. We used the net proceeds from the transaction
to repay amounts outstanding under our existing credit facilities which were
due in 2004, redeem the remaining $46.1 million principal amount of our 10.625%
senior subordinated notes due 2004 that were outstanding as of December 31,
2002, and for general corporate purposes. We completed the redemption of the
10.625% senior subordinated notes on February 18, 2003.
Revolving credit loans under the new facility bear interest, at our option, at
an applicable margin over the bank's base rate loan or the LIBOR rate. The
initial margin over LIBOR was 3.5% for the term loan facility and will step
down if certain performance targets are met. The credit facility contains
financial covenants (determined in each case on the basis of the definitions
and other provisions set forth in such credit agreement), some of which may
become more restrictive over time, that include a (1) maximum debt to adjusted
EBITDA test, (2) minimum interest coverage test, and (3) minimum fixed charge
coverage test. Amounts outstanding under the credit agreement are
collateralized by substantially all of our assets. Hollywood Management
Company, and any future subsidiaries of Hollywood Entertainment Corporation,
are guarantors under the credit agreement.
After giving effect to all the transactions described above, maturities on
long-term obligations at December 31, 2002 for the next five years would have
been as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2003 - 15,000 10,178 25,178
2004 - 20,000 - 20,000
2005 - 20,000 - 20,000
2006 - 20,000 - 20,000
2007 - 20,000 - 20,000
Thereafter 225,000 105,000 - 330,000
----------- ---------- --------- ---------
$ 225,000 $ 200,000 $ 10,178 $ 435,178
----------- ---------- --------- ---------
Other Financial Measurements: Working Capital
At December 31, 2002, we had cash and cash equivalents of $33.1 million
(excluding cash held by trustee for refinancing) and a working capital deficit
of $111.9 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 Discretionary Free Cash Flow
We believe other financial measurements, such as EBITDA and Discretionary 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):
Twelve Months Ended
December 31,
----------------------
2002 2001
---------- ----------
Income from operations $ 189,327 $ 119,277
Reversal of accruals (1) (13,258) (7,034)
Depreciation and amortization(2) 59,343 66,940
Non-cash items (3) (1,633) 25,371
---------- ----------
EBITDA $ 233,779 $ 204,554
========== ==========
(1) Represents reversals of accruals for restructuring charges for the
discontinuation of Reel.com e-commerce operations and store closures as shown
on separate line items on our Consolidated Statement of Operations.
(2) Represents depreciation and amortization of property and equipment, and
amortization of intangibles. Does not include amortization of rental product.
(3) Expense(income) items that are non-cash in nature including compensation
associated with certain stock option grants of $(1.6) million and $7.4 million
in 2002 and 2001, respectively, and in 2001, $18.0 million of incremental
depreciation expense associated with changes in estimated rental inventory
lives and residual values that were adopted on a prospective basis October 1,
2000.
Discretionary Free Cash Flow represents EBITDA, less cash paid for interest and
taxes, less maintenance capital expenditures, but before discretionary
investments in 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 is a useful measurement 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 (in thousands):
Twelve Months Ended
December 31,
--------------------
2002 2001
-------- --------
EBITDA $233,779 $204,554
Less: Cash interest paid (41,415) (54,651)
Cash taxes paid (2,613) (768)
Maintenance capital
expenditures (1) (9,622) (6,441)
-------- --------
Discretionary Free Cash Flow (2) 180,129 142,694
(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 store, office and distribution systems. We anticipate that
maintenance capital expenditures will be approximately $20 million in 2003.
(2) Discretionary Free Cash Flow is used for debt service and discretionary
investment expenditures including construction, equipment, fixtures, inventory,
supplies and opening costs for new stores and Game Crazy departments and long-
term investments in rental inventory such as the expansion of DVD catalog. In
2002, discretionary investment expenditures were approximately $88.4 million
and included remerchandising 203 stores to include a Game Crazy department, 41
new video store openings and continued investment in DVD catalog product. In
2001, discretionary investment expenditures were approximately $26.8 million
primarily related to an expansion of our DVD catalog selections. We anticipate
that discretionary investment capital expenditures will be approximately $125
million in 2003 primarily from our planned store openings and Game Crazy
expansion.
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note 1 and Note 10 to the Consolidated Financial Statements for a
discussion of recently issued accounting standards and the impact they may have
on the financial condition or results of operations.
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, that involve
substantial risks and uncertainties and which are intended to be covered by the
safe harbors created thereby. These statements can be identified by the fact
that they do not relate strictly to historical information and include the
words "expects", "believes", "anticipates", "plans", "may", "will", "intend",
"estimate", "continue" or other similar expressions. These forward-looking
statements are subject to various risks and uncertainties that could cause
actual results to differ materially from those currently anticipated. These
risks and uncertainties include, but are not limited to, items discussed below
under the heading "Cautionary Statements." Forward-looking statements speak
only as of the date made. We undertake no obligation to publicly release or
update forward-looking statements, whether as a result of new information,
future events or otherwise. You are, however, advised to consult any further
disclosures we make on related subjects in our quarterly reports on Form 10-Q
and any reports made on Form 8-K to the Securities and Exchange Commission.
CAUTIONARY STATEMENTS
We are subject to a number of risks that are particular to our business and
that may or may not affect our competitors. We describe some of these risks
below. If any of these risks materializes, our business, financial condition,
liquidity and results of operations could be harmed, and the value of our
securities could fall.
We face intense competition and risks associated with technological
obsolescence, and we may be unable to compete effectively.
The home video and home video game industries are highly competitive. We
compete with local, regional and national video retail stores, including those
operated by Blockbuster, Inc., the largest video retailer in the United States,
and with mass merchants, specialty retailers, supermarkets, pharmacies,
convenience stores, bookstores, mail order operations, online stores and other
retailers, as well as with noncommercial sources, such as libraries.
Substantially all of our stores compete with stores operated by Blockbuster,
most in very close proximity. Some of our competitors have significantly
greater financial and marketing resources, market share and name recognition
than Hollywood. As a result of direct competition with Blockbuster and others,
pricing strategies for videos and video games is a significant competitive
factor in our business. Our home video and home video game businesses also
compete with other forms of entertainment, including cinema, television,
sporting events and family entertainment centers. If we do not compete
effectively with competitors in the home video industry or the home video game
industry or with providers of other forms of entertainment, our revenues and/or
our profit margin could decline and our business, financial condition,
liquidity and results of operations could be harmed.
We also compete with cable and direct broadcast satellite television systems.
These systems offer both movie channels, for which subscribers pay a
subscription fee for access to movies selected by the provider at times
selected by the provider, and pay-per-view services, for which subscribers pay
a discrete fee to view a particular movie selected by the subscriber.
Historically, pay-per-view services have offered a limited number of channels
and movies, and have offered movies only at scheduled intervals. Over the past
five years, however, advances in digital compression and other developing
technologies have enabled 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 that 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 they 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, if they did, our business and financial condition could
suffer materially.
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. 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 60 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. In 2002 we began an accelerated rollout of
our Game Crazy departments, departments within our video stores that specialize
in selling and trading video games, opening 207 new departments. We intend to
open at least 300 additional Game Crazy departments and grow our video store
base by up to 10% in 2003. 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 are 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.
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 reinstatement of Mark J.
Wattles, Hollywood's founder and Chief Executive Officer, full-time as
President, and hiring or restructuring other executive and senior management
positions. 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 facilities and our senior subordinated
notes 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 December 31, 2002, we had total consolidated long-term debt, including
capital leases, of approximately $388.7 million (excluding subordinated notes
to be retired with cash held by trustee) and on January 16, 2003, we completed
the refinancing of our senior secured credit facilities. 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 we increase our indebtedness, the related risks that we 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.
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. At December 31, 2002, we were in compliance with all
covenants contained within our debt agreements.
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.
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 could also impact consumer television
viewing habits and may reduce the amount of time available for watching rented
movies, which could adversely impact our revenue. They also could result in an
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.
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.
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 and related acquisitions;
- - other factors that may affect retailers in general;
- - changes in movie rental habits resulting from domestic and world events;
- - actual events, circumstances, outcomes and amounts differing from judgments,
assumptions and estimates used in determining the amount of certain assets
(including the amounts of related valuation allowances), liabilities and
other items reflected in our Consolidated Financial Statements; and
- - acts of God or public authorities, war, civil unrest, fire, floods,
earthquakes, acts of terrorism and other matters beyond our control.
Our securities may experience extreme price and volume fluctuations.
The market price of our securities has been and can be expected to be
significantly affected by a variety of factors, including:
- - public announcements concerning us, our competitors or the home video rental
industry;
- - fluctuations in our operating results;
- - introductions of new products or services by us or our competitors;
- - the operating and stock price performance of other comparable companies; and
- - changes in analysts' revenue or earnings estimates.
In addition to the foregoing, the market price of our debt securities may be
significantly affected by change in market rates of interest, yields obtainable
from investments in comparable securities, credit ratings assigned to our debt
securities by third parties and perceptions regarding our ability to pay our
obligations on our debt securities.
In the past, companies that have experienced volatility in the market price of
their securities have been the target of securities class action litigation.
If we were sued in a securities class action, we could incur substantial costs
and suffer from a diversion of our management's attention and resources.
Future sales of shares of our common stock may negatively affect our stock
price.
If we or our shareholders sell substantial amounts of our common stock in the
public market, 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.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our financial position,
operating results, or cash flows due to adverse changes in financial and
commodity market prices and rates. We have entered into certain market-risk-
sensitive financial instruments for other than trading purposes, principally
short-term and long-term debt. Historically, and as of December 31, 2002, we
have not held derivative instruments or engaged in hedging activities. However,
we may in the future enter into such instruments for the purpose of addressing
market risks, including market risks associated with variable-rate
indebtedness.
The interest payable on our bank credit facility is based on variable interest
rates equal to a specified Eurodollar rate or base rate and is therefore
affected by changes in market interest rates. If variable base rates had
increased 1% in 2002 compared to the end of 2001, our interest expense would
have increased by approximately $1.1 million based on our outstanding balance
on the facility as of December 31, 2002.
The fair market value of long-term fixed interest rate debt is also subject to
interest rate risk. Generally, the fair market value of fixed interest rate
debt will increase as interest rates fall and decrease as interest rates rise.
The estimated fair value of our long-term fixed interest rate debt at December
31, 2002 was $486.2 million including $256.7 million of our 10.625% senior
subordinated notes that were redeemed after December 31, 2002, but before the
date of this filing. We believe the effect of an estimated 1% change in
interest rates would not have a material impact on our future operating results
or cash flows with respect to our fixed interest rate debt. Fair values were
determined from quoted market prices.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Incorporated by reference to Item 15 of this report on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information about our directors is incorporated by reference from our
definitive proxy statement, under the caption "Nomination and Election of Board
of Directors," for our 2003 annual meeting of shareholders (the "2003 Proxy
Statement") to be filed pursuant to Regulation 14A under the Securities
Exchange Act of 1934, which proxy statement we expect to file no later than 120
days after the end of our fiscal year ended December 31, 2002. Information
with respect to our executive officers is included under Item 4A of Part I of
this report.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this Item 11 is incorporated by reference from the 2003
Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Part of the information required by this Item 12 is incorporated by reference
from the 2003 Proxy Statement.
The following table summarizes information with respect to options under the
Company's stock option plans at December 31, 2002:
Options Outstanding Options
--------------------- remaining
Weighted available
average for future
exercise issuance under
Options price the plans
---------- -------- --------------
Stock option plans
approved by security
holders 8,490,846 $5.18 3,004,309
Stock option plans
not approved by
security holders 2,656,884 $8.48 1,467,726
---------- -------- --------------
11,147,730 $5.96 4,472,035
========== ======== ==============
The stock option plans not approved by security holders have generally the same
features as those approved by security holders. For further information
regarding the Company's stock option plans, see Note 19 to the Consolidated
Financial Statements.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this Item 13 is incorporated by reference from the 2003
Proxy Statement.
ITEM 14. 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.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
Listed below are all financial statements, notes, schedules and exhibits filed
as part of the Registrant's Annual Report on Form 10-K for the year ended
December 31, 2002:
(a)(i), (ii) FINANCIAL STATEMENTS
The following financial statements of the Registrant, together with the Report
of Independent Accountants dated March 21, 2003, are filed herewith:
(i) FINANCIAL STATEMENTS
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 2002 and 2001
Consolidated Statements of Operations for the years ended December 31, 2002,
2001 and 2000
Consolidated Statements of Changes in Shareholders' Equity for the years ended
December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the years ended December 31, 2002,
2001 and 2000
Notes to Consolidated Financial Statements
(ii) FINANCIAL SCHEDULES
All financial schedules are omitted as the required information is inapplicable
or the information is presented in the respective Consolidated Financial
Statements or related notes.
(a) (iii) EXHIBITS
The following exhibits are filed with or incorporated by reference into this
Annual Report:
EXHIBIT
NUMBER DESCRIPTION
Items identified with an asterisk (*) are management contracts or
compensatory plans or arrangements.
3.1 1993B Restated Articles of Incorporation, as amended (incorporated
by reference to our Registration Statement on Form S-1 (File No. 33-
63042)(the "Form S-1"), by reference to Exhibit 4 to our Registration
Statement on Form S-3 (File No. 33-96140), and by reference to Exhibit
3.1 to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998.
3.2 1999 Restated Bylaws (incorporated by reference to Exhibit 3.2 to our
Registration Statement on Form S-4 (File No. 333-82937)(the "1999
S-4")).
4.1 Indenture, dated August 13, 1997, between the Registrant and BNY
Western Trust Company, as successor in interest to U.S. Trust Company
of California, N.A., as Trustee (incorporated by reference to Exhibit
4.1 to our Registration Statement on Form S-4 (No.333-35351) (the
"1997 S-4")), as supplemented by the First Supplemental Indenture,
dated as of June 24, 1999, between the Registrant and the Trustee
(incorporated by reference to Exhibit 4.2 of the 1999 S-4), the Second
Supplemental Indenture, dated as of January 20, 2000, between the
Registrant and the Trustee (incorporated by reference to Exhibit 10.1
to our Annual Report on Form 10-K for the year ended December 31,
1999) and the Third Supplemental Indenture, dated as of February 12,
2002, between the Registrant, as Issuer, Hollywood Management Company,
as Subsidiary Guarantor, and the Trustee (incorporated by reference to
Exhibit 4.1 to our Quarterly Report on Form 10-Q/A for the quarter
ended September 30, 2001).
4.2 Indenture dated January 25, 2002 among the Registrant, Hollywood
Management Company, as potential guarantor, and BNY Western Trust
Company as trustee (incorporated by reference to Exhibit 4.1 to our
Registration Statement on Form S-3 (File No. 333-14802)).
4.3 First Supplemental Indenture dated as of December 18, 2002 among the
Registrant and Hollywood Management Company and BNY Western Trust
Company as Trustee.
10.1 1993 Stock Incentive Plan, as amended (incorporated by reference
to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter
ended June 30, 1997). *
10.2 Form of Incentive Stock Option Agreement (incorporated by
reference to Exhibit 10.1 of the Form S-1). *
10.3 Form of Nonqualified Stock Option Agreement (incorporated by
reference to Exhibit 10.3 of the Form S-1). *
10.4 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1
to our Quarterly Report on Form 10-Q for the quarter ended March 31,
2001). *
10.5 Credit Agreement dated as of January 16, 2003 between the Registrant,
UBS Warburg LLC as Lead Arranger, UBS AG, Stamford Branch as
Administrative Agent and Bank of America, N.A., as Documentation
Agent.
10.6 Offer of Employment Term Sheet effective as of January 25, 2001 from
the Registrant to Mark J. Wattles (incorporated by reference
to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for
the year ended December 31, 2000, filed on April 2, 2001). *
10.7 Change of Control Plan for Senior Management dated as of February 3,
2001 (incorporated by reference to Exhibit 10.8 to the Registrant's
Annual Report on Form 10-K for the year ended December 31, 2000, filed
on April 2, 2001). *
10.8 Revenue Sharing Agreement dated March 2, 1998 between the Registrant
and Buena Vista Home Entertainment, Inc (incorporated by reference to
Exhibit 10.13 to our Annual Report on Form 10-K/A for the year ended
December 31, 2000, filed on January 29, 2002). +
10.9 Revenue Sharing Agreement dated July 31, 2001 between the Registrant
and MGM Home Entertainment (incorporated by reference to Exhibit 10.14
to our Annual Report on Form 10-K/A for the year ended December 31,
2000, filed on January 29, 2002). +
10.10 1997 Employee Nonqualified Stock Option Plan, as amended. *
10.11 Separation and Severance Agreement between Scott Schultze and the
Registrant. *
10.12 License Agreement, effective as of January 25, 2001, between the
Registrant and Boards, Inc. *
10.13 Product and Support Agreement, effective as of January 25, 2001,
between the Registrant and Boards, Inc. *
21.1 List of Subsidiaries (incorporated by reference to Exhibit 21.1 to
our Annual Report on Form 10-K/A for the year ended December 31, 2000,
filed on January 29, 2002).
23.1 Consent of PricewaterhouseCoopers LLP.
99.1 Certifications of Chief Executive Officer and Chief Financial Officer
Pursuant to Section 1350 of Title 18 of the United States Code, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Acct of 2002.
+ Confidential treatment has been requested as to certain portions of these
agreements. Such omitted confidential information has been designated by an
asterisk and has been filed separately with the Securities and Exchange
Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as
amended, pursuant to an application for confidential treatment.
(b) REPORTS ON FORM 8-K:
No reports on Form 8-K were filed in the quarterly period ended December 31,
2002.
Report of Independent Accountants
To the Board of Directors and Shareholders of Hollywood Entertainment
Corporation:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in shareholders' equity and
of cash flows present fairly, in all material respects, the financial position
of Hollywood Entertainment Corporation and its subsidiaries at December 31,
2002 and 2001, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 2002 in conformity
with accounting principles generally accepted in the United States of America.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As discussed in Notes 1 and 10 to the consolidated financial statements, the
Company changed its method of accounting for goodwill in 2002.
PricewaterhouseCoopers LLP
Portland, Oregon
March 21, 2003
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
-------------------------
December 31, December 31,
2002 2001
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 33,145 $ 38,810
Cash held by trustee for refinancing 218,531 -
Accounts receivable, net 34,996 29,056
Merchandise inventories 97,307 61,585
Prepaid expenses and other current
assets 14,772 10,863
----------- -----------
Total current assets 398,751 140,314
Rental inventory, net 260,190 191,016
Property and equipment, net 255,497 270,586
Goodwill 64,934 64,934
Deferred income tax asset, net 147,813 38,396
Other assets 19,191 13,298
----------- -----------
$ 1,146,376 $ 718,544
=========== ===========
LIABILITIES AND SHAREHOLDERS'
EQUITY (DEFICIT)
Current liabilities:
Current maturities of long-term
obligations $ 27,678 $ 111,914
Subordinated notes to be retired with
cash held by trustee (including accrued
interest of $8.1 million) 212,080 -
Accounts payable 158,423 167,479
Accrued expenses 108,432 112,799
Accrued interest 2,923 13,712
Income taxes payable 1,151 5,266
----------- ----------
Total current liabilities: 510,687 411,170
Long-term obligations, less current
portion 361,068 402,088
Other liabilities 17,472 18,840
----------- ----------
889,227 832,098
Commitments and contingencies (Note 22) - -
Shareholders' equity (deficit):
Preferred stock, 25,000,000 shares
authorized; no shares issued and
outstanding - -
Common stock, 100,000,000 shares
authorized; 59,796,573 and
49,428,763 shares issued and
outstanding, respectively 503,403 375,503
Unearned compensation (697) (1,655)
Accumulated deficit (245,557) (487,402)
----------- ----------
Total shareholders' equity(deficit) 257,149 (113,554)
----------- ----------
$ 1,146,376 $ 718,544
=========== ===========
See notes to Consolidated Financial Statements
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Twelve Months Ended
December 31,
------------------------------------
2002 2001 2000
----------- ----------- -----------
Rental product revenue $1,324,017 $1,271,394 $1,149,780
Merchandise sales 166,049 108,109 146,457
----------- ----------- -----------
1,490,066 1,379,503 1,296,237
----------- ----------- -----------
Cost of Revenue:
Cost of rental product 447,278 459,071 640,805
Cost of merchandise 126,251 85,406 144,445
----------- ----------- -----------
573,529 544,477 785,250
----------- ----------- -----------
Gross Profit 916,537 835,026 510,987
Operating costs and expenses:
Operating and selling 647,773 621,343 713,431
General and administrative 89,602 96,382 110,242
Store opening expenses 3,093 - -
Restructuring charge for closure
of internet business (12,430) (3,256) 46,862
Restructuring charge for store
closures (828) (3,778) 16,859
Amortization of intangibles - 5,058 59,914
---------- ---------- ----------
727,210 715,749 947,308
---------- ---------- ----------
Income (loss) from operations 189,327 119,277 (436,321)
Non-operating expense:
Interest expense, net (42,057) (56,129) (62,127)
---------- ---------- ----------
Income (loss) before income taxes
and extraordinary item 147,270 63,148 (498,448)
(Provision for) benefit from
income taxes 96,801 37,268 (31,592)
---------- ---------- ----------
Income (loss) before extraordinary
item 244,071 100,416 (530,040)
Extraordinary loss on
extinguishment of debt (net of
income tax benefit of $1,308) (2,226) - -
---------- ---------- ----------
Net income (loss) $ 241,845 $ 100,416 $(530,040)
========== ========== ==========
- ------------------------------------------------------------------------
Net income (loss) per share before
Extraordinary item:
Basic $ 4.27 $ 2.05 $ (11.48)
Diluted 3.91 1.90 (11.48)
- -------------------------------------------------------------------------
Net income (loss) per share:
Basic $ 4.23 $ 2.05 $ (11.48)
Diluted 3.88 1.90 (11.48)
- -------------------------------------------------------------------------
Weighted average shares outstanding:
Basic 57,202 49,101 46,151
Diluted 62,390 52,880 46,151
- -------------------------------------------------------------------------
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
(In thousands, except share amounts)
Common Stock Unearned Accumu-
------------------- Compen- lated
Shares Amount sation Deficit Total
---------- -------- -------- --------- ---------
Balance at
December 31, 1999 45,821,537 $362,307 $ - $ (57,778)$ 304,529
---------- -------- -------- --------- ---------
Issuance of common stock:
Legal settlement 200,000 2,288 - - 2,288
Stock options exercised 226,062 783 - - 783
Tax benefit
from stock options - 63 - - 63
Net loss - - - (530,040) (530,040)
---------- -------- -------- --------- ---------
Balance at
December 31, 2000 46,247,599 365,441 - (587,818) (222,377)
---------- -------- -------- --------- ---------
Issuance of common stock:
Compensation grant
(See Note 15) 3,000,000 3,281 - - 3,281
Stock options exercised 181,164 1,097 - - 1,097
Tax impact from
stock options - (61) - - (61)
Stock compensation - 5,745 (1,655) - 4,090
Net income - - - 100,416 100,416
---------- -------- -------- --------- ---------
Balance at
December 31, 2001 49,428,763 375,503 (1,655) (487,402) (113,554)
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock issuance 8,050,000 120,750 - - 120,750
Equity offering costs - (7,677) - - (7,677)
Stock options exercised 2,317,810 4,604 - - 4,604
Stock option tax benefit - 12,814 - - 12,814
Stock compensation - (2,591) 958 - (1,633)
Net income - - - 241,845 241,845
---------- -------- -------- --------- ---------
Balance at
December 31, 2002 59,796,573 $503,403 $ (697)$(245,557)$ 257,149
========== ======== ======== ========= =========
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year Ended December 31,
-------------------------------
2002 2001 2000
--------- --------- ---------
Operating activities:
Net income (loss) $ 241,845 $ 100,416 $(530,040)
Adjustments to reconcile net
income (loss) to cash provided by
operating activities:
Extraordinary loss on extinguishment
of debt 2,226 - -
Amortization of rental product 218,905 180,237 176,569
Depreciation and amortization 59,343 66,939 100,594
Amortization of deferred financing costs 3,785 3,715 2,665
Amortization charge for change in
estimate on rental inventory - - 164,306
Impairment of long-lived assets - - 74,305
Net asset write down for closure of
Internet business - - 40,087
Net asset write down for store closures - - 9,516
Loss on other asset dispositions - - 10,292
Tax impact from exercise of
stock options 12,814 (61) 63
Change in deferred rent (1,368) (598) 1,993
Change in deferred income taxes (109,417) (38,396) 25,805
Non-cash stock compensation (1,633) 7,371 -
Net change in operating assets
and liabilities:
Accounts receivable (5,940) (5,226) 18,680
Merchandise inventories (35,722) (7,384) 16,718
Accounts payable (9,056) (32,879) 79,378
Accrued interest (2,649) 1,895 (48)
Other current assets
and liabilities (11,142) (2,236) 57,988
--------- -------- --------
Cash provided by operating
activities 361,991 273,793 248,871
--------- -------- --------
Investing activities:
Purchases of rental inventory, net (288,079) (202,790) (176,753)
Purchase of property and
equipment, net (44,254) (8,802) (77,639)
Increase in intangibles and other
assets (1,187) (701) (1,430)
Net proceeds from issuance of subordinated
notes delivered to indenture trustee (218,531) - -
--------- -------- --------
Cash used in investing
activities (552,051) (212,293) (255,822)
--------- -------- --------
Financing activities:
Proceeds from the issuance of
common stock 120,750 - -
Equity financing costs (7,677) - -
Issuance of subordinated debt 225,000 - -
Borrowings under new term loan 150,000 - -
Repayment of prior revolving loan (240,000) - -
Increase (decrease) in credit facilities (42,500) (5,000) 5,000
Debt financing costs (11,966) (4,656) -
Issuance of long-term obligations - - 12,511
Repayments of capital lease
obligations (13,816) (17,399) (15,016)
Proceeds from exercise of stock options 4,604 1,097 783
--------- --------- --------
Cash (used in) provided by
financing activities 184,395 (25,958) 3,278
--------- --------- --------
Increase (decrease) in cash and
cash equivalents (5,665) 35,542 (3,673)
Cash and cash equivalents at
beginning of year 38,810 3,268 6,941
--------- --------- --------
Cash and cash equivalents at end
of year $ 33,145 $ 38,810 $ 3,268
========= ========= ========
Other Cash Flow Information:
Interest expense paid $ 41,415 $ 54,651 $ 60,702
Income taxes paid (refunded), net 2,613 768 (915)
Non-cash financing activities
Issuance of common stock as part of
a legal settlement agreement - - 2,288
See notes to Consolidated Financial Statements
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001, 2000
1. SIGNIFICANT ACCOUNTING POLICIES
Corporate Organization and Consolidation
The accompanying financial statements include the accounts of Hollywood
Entertainment Corporation and its wholly owned subsidiaries (the "Company").
The Company's only subsidiary during 2002 and 2001 was Hollywood Management
Company. During 2000, the Company's subsidiaries consisted of Hollywood
Management Company and Reel.com, Inc. All significant inter-company
transactions and accounts have been eliminated.
Nature of the Business
The Company operates a chain of video superstores ("Hollywood Video")
throughout the United States. The Company was incorporated in Oregon on June 2,
1988 and opened its first store in October 1988. As of December 31, 2002 and
2001, the Company operated 1,831 stores in 47 states and 1,801 stores in 47
states, respectively. From October 1998 to June 2000, the Company also operated
an Internet retailer of video only products ("Reel.com")(see Note 11 for a
discussion of the discontinuation of Reel.com's e-commerce operations).
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles (GAAP) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Significant
estimates relative to the Company include revenue recognition, depreciation and
amortization policies, impairment of long-lived assets and goodwill, income
taxes and legal contingencies.
Reclassification of Prior Year Amounts
Certain prior year amounts have been reclassified to conform to the
presentation used for the current year. These reclassifications had no impact
on previously reported net income (loss) 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 2001 and 2000 have been reclassified to conform to the
presentation for the current year.
Recently Issued Accounting Standards
In July 2001, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 143, "Accounting For Asset
Retirement Obligations". SFAS No. 143 requires entities to record the fair
value of a liability for an asset retirement obligation in the period in which
it is incurred. When the liability is initially recorded, the entity is
required to capitalize the cost by increasing the carrying amount of the
related long-lived asset. Over time, the liability is accreted to its present
value each period, and the capitalized cost is depreciated over the useful life
of the related asset. SFAS No. 143 is effective for fiscal years beginning
after June 15, 2002 and will be adopted by the Company effective January 1,
2003. The Company has not completed its evaluation of the impact the standard
will have in its results of operations, financial position or liquidity.
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-amortized 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
Infrequent 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 management of the Company does not anticipate
disposing of any long-lived assets in 2003, other than the assets intended to
be disposed of pursuant to the 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 December 2002, the FASB issued the Statement of Financial Accounting
Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based Compensation -
Transition and Disclosure - An Amendment of FASB Statement No. 123." SFAS 148
amends Statement of Financial Accounting Standards No. 123 ("SFAS 123"),
"Accounting for Stock-Based Compensation," to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. SFAS 148 amends the disclosure
requirements of SFAS 123 to require prominent disclosures both in annual and
interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results.
The Company has included the disclosures required by SFAS 148 in Note 1 -
"Significant Accounting Policies" and Note 19 - "Stock Option Plans."
In May 2002, the FASB issued SFAS 145, "Rescission of SFAS Nos. 4, 44 and 64,
Amendment of SFAS 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. The Company does not believe the
adoption will have a material impact on its results of operations, financial
position or liquidity.
In November 2002, the EITF reached a consensus on Issue 02-16, addressing the
accounting of cash consideration received by a customer from a vendor,
including vendor rebates and refunds. The consensus reached states that
consideration received should be presumed to be a reduction of the prices of
the vendor's products or services and should therefore be shown as a reduction
of cost of sales in the income statement of the customer. The presumption
could be overcome if the vendor receives an identifiable benefit in exchange
for the consideration or the consideration represents a reimbursement of a
specific incremental identifiable cost incurred by the customer in selling the
vendor's product or service. If one of these conditions is met, the cash
consideration should be characterized as a reduction of those costs in the
income statement of the customer. The consensus reached also concludes that if
rebates or refunds can be reasonably estimated, such rebates or refunds should
be recognized as a reduction of the cost of sales based on a systematic and
rational allocation of the consideration to be received relative to the
transactions that mark the progress of the customer toward earning the rebate
or refund. The provisions of this consensus will be applied prospectively. The
Company is evaluating its agreements with vendors to determine the appropriate
presentation of certain considerations, primarily cooperative advertising.
In November 2002, the FASB issued Interpretation No. 45 (FIN 45),
"Guarantor's Accounting and Disclosure Requirements for Guarantees." FIN
45 requires a guarantor to recognize, at the inception of a guarantee, a
liability for the fair value of the obligation it has undertaken in issuing the
guarantee. The Company will apply FIN 45 to guarantees, if any, issued after
December 31, 2002. In addition, FIN 45 also requires guarantors to disclose
certain information for guarantees, including product warranties, outstanding
at December 31, 2002. The Company is currently evaluating the impact adoption
will have on its financial statements and related disclosures.
In January 2003,FASB issued Interpretation No. 46, "Consolidation of Variable
Interest Entities," ("FIN 46") to clarify the conditions under which assets,
liabilities and activities of another entity should be consolidated into the
financial statements of a company. SFAS 46 requires the consolidation of a
variable interest entity (including a special purpose entity such as that
utilized in an accounts receivable securitization transaction) by a company
that bears that majority of the risk of loss from the variable interest
entity's activities, is entitled to receive a majority of the variable interest
entity's residual returns or both. The provisions of FIN 46 are required to be
adopted by the Company in fiscal 2003. The Company believes that the adoption
of FIN 46 will not have any affect on the Company's results of operations or
its financial position.
Rental Revenue and Merchandise
The Company recognizes revenue upon the rental and sale of its products.
Revenue for extended rental periods (when the customer chooses to keep the
product beyond the original rental period) is recognized when the extended
rental period begins. Revenue recorded for extended rental periods is net of
estimated amounts that the Company does not anticipate collecting based upon
its historical collection experience.
Gift Card Liability
Gift card liabilities are recorded at the time of sale. Costs of designing,
printing and distributing the cards, and transactional processing costs, are
expensed as incurred. The liability is relieved and revenue is recognized upon
redemption of the gift cards at any Hollywood Video store.
Cost of Rental Product
Cost of rental product includes revenue sharing expense, amortization of
videocassettes, DVDs and games, the book value of previously viewed movies and
games and the book value of rental inventory loss.
Cash and Cash Equivalents
The Company considers highly liquid investment instruments, with an original
maturity of three months or less, to be cash equivalents. The carrying amounts
of cash and cash equivalents equals fair value.
Inventories
Merchandise inventories, consisting primarily of video games, new movies for
sale, concessions, and accessories held for resale, are stated at the lower of
cost or market (or, in the case of rental inventory transferred to merchandise
inventory at the carrying value thereof at the time of transfer). Cost of sales
is determined using an average costing method.
Rental inventory, which includes VHS videocassettes, DVDs and video games is
stated at cost and amortized over its estimated useful life to a specified
residual value. Shipping and handling charges related to rental and
merchandise inventory are included in the cost of such inventory. See Notes 4
through 6 for a discussion of the amortization policy applied to rental
inventory.
Property, Equipment, Depreciation and Amortization
Property is stated at cost and is depreciated on a straight-line basis for
financial reporting purposes over the estimated useful life of the assets,
which range from approximately five to ten years. Leasehold improvements are
amortized primarily over ten years, which generally approximates the term of
the lease.
Additions to property and equipment are capitalized and include acquisitions of
property and equipment, costs incurred in the development and construction of
new stores, major improvements to existing property and major improvements in
management information systems including certain costs incurred for internally
developed computer software. Maintenance and repair costs are charged to
expense as incurred, while improvements that extend the useful life of the
assets are capitalized. As property and equipment is sold or retired, the
applicable cost and accumulated depreciation and amortization are eliminated
from the accounts and any gain or loss thereon is recorded.
Long-lived Assets
The Company reviews for impairment of long-lived assets to be held and used in
the business whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. The Company periodically
reviews and monitors its internal management reports for indicators of
impairment. The Company considers a trend of unsatisfactory operating results
that are not in line with management's expectations to be its primary indicator
of potential impairment. When an indicator of impairment is noted, assets are
evaluated for impairment at the lowest level for which there are identifiable
cash flows (e.g., at the store level). The Company deems a store to be
impaired if a forecast of undiscounted future operating cash flows directly
related to the store, including estimated disposal value, if any, is less than
the asset carrying amount. If a store is determined to be impaired, the loss is
measured as the amount by which the carrying amount of the store exceeds its
fair value. Fair value is estimated using a discounted future cash flow
valuation technique similar to that used by management in making a new
investment decision. Considerable management judgment and assumptions are
necessary to identify indicators of impairment and to estimate discounted
future cash flows. Accordingly, actual results could vary significantly from
such estimates. There were no impairment charges in 2002 or 2001. See Note 9
for estimated impairments at December 31, 2000.
The Company reviews goodwill and intangible assets on an annual basis or
whenever events or circumstances occur indicating that goodwill may be
impaired. When the Company is evaluating for possible impairment of goodwill,
it compares the present value of future cash flows of its reporting unit, which
is defined as the Companies 1,831 video stores, to the goodwill recorded. If
this indicates that the goodwill is impaired, the Company would record a charge
to the extent that the goodwill balance would be adjusted to that of the
present value of future cash flows.
Store Closure Reserves
Reserves for store closures were established by calculating the present value
of the remaining lease obligation, adjusted for estimated subtenant agreements
or lease buyouts, if any, and were expensed along with any leasehold
improvements. Store furniture and equipment was either transferred at
historical costs to another location or disposed of and written-off.
Litigation Liabilities
All material litigation loss contingencies, which are judged to be both
probable and estimable, are recorded as liabilities in the Consolidated
Financial Statements in amounts equal to the Company's best estimates of the
costs of resolving or disposing of the underlying claims. These estimates are
based upon judgments and assumptions. The Company regularly monitors its
estimates in light of subsequent developments and changes in circumstances and
adjusts its estimates when additional information causes the Company to believe
that they are no longer accurate. If no particular amount is determined to
constitute the Company's best estimate of a particular litigation loss
contingency, the amount representing the low end of the range of the Company's
estimate of the costs of resolving or disposing of the underlying claim is
recorded as a liability and the range of such estimates is disclosed.
Treasury Stock
In accordance with Oregon law, shares of common stock are automatically retired
and classified as available for issuance upon repurchase.
Income Taxes
The Company calculates income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes", which requires recognition of deferred tax
liabilities and assets for the expected future tax consequences of events that
have been included in the financial statements and tax returns. Valuation
allowances are established when necessary to reduce deferred tax assets to the
amount expected to be realized.
Deferred Rent
Many of the Company's operating leases contain predetermined fixed increases of
the minimum rental rate during the initial lease term. For these leases, the
Company recognizes the related rental expense on a straight-line basis and
records the difference between the amount charged to expense and the rent paid
as deferred rent and is included in other liabilities.
Fair Value of Financial Instruments
In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments", the Company has disclosed the fair value, related carrying value
and method for determining the fair value for the following financial
instruments in the accompanying notes as referenced: cash and cash equivalents
(see above), accounts receivable (see Note 2), and long-term obligations (see
Note 16).
The Company's receivables do not represent significant concentrations of credit
risk at December 31, 2002, due to the wide variety of customers, markets and
geographic areas to which the Company's products are rented and sold.
Accounting for Stock-based Compensation
At December 31, 2002, the Company had three stock-based compensation plans,
which are described more fully in Note 19. The Company accounts for those
plans under the recognition and measurement principles of APB Opinion No. 25,
"Accounting for Stock Issued to Employees, and related Interpretations." The
following table illustrates the effect on net income and earnings per share if
the Company had applied the fair value recognition provisions of SFAS 123,
"Accounting for Stock-Based Compensation."
Year Ended December 31,
--------------------------------------------------------
2002 2001 2000
---------------- ------------------- -----------------
Net income (loss)
as reported $241,845 $100,416 $(530,040)
Add: Stock-based
compensation expense
included in reported
net income, net of
tax related tax
effects 596 2,378 --
Deduct: Total stock-
based employee
compensation expense
under fair value
based method for all
awards, net of
related tax effects (7,941) (4,180) (8,846)
-------- -------- ---------
Pro forma net income $234,500 $ 98,614 $(538,886)
======== ======== =========
Earnings (loss)
per Share:
Basic--as reported $ 4.23 $ 2.05 $ (11.48)
Basic--pro forma 4.10 2.01 (11.68)
Diluted--as reported 3.88 1.90 (11.48)
Diluted--pro forma 3.87 1.93 (11.68)
See Note 19 for the assumptions and methodologies used to determine the fair
value of stock-based compensation.
Comprehensive Income
Comprehensive income (loss) is equal to net income (loss) for all periods
presented.
Advertising
The Company receives cooperative reimbursements from vendors as eligible
expenditures are incurred relative to the promotion of rental and sales
product. Advertising costs, net of these reimbursements, are expensed as
incurred. Advertising expense was $4.5 million, $5.1 million and $25.6 million
for 2002, 2001 and 2000, respectively.
2. ACCOUNTS RECEIVABLE
Accounts receivable as of December 31, 2002 and 2001 consists of
(in thousands):
----------------------
2002 2001
---------- ---------
Construction receivables $ 2,079 $ 600
Additional rental fees 18,450 18,200
Marketing 14,399 12,253
Due from employees 533 2,051
Licensee receivables 631 623
Other 1,360 389
---------- ---------
37,452 34,116
Allowance for doubtful accounts (2,456) (5,060)
---------- ---------
$ 34,996 $ 29,056
========== =========
The carrying amount of accounts receivable approximates fair value because of
the short maturity of those receivables. The allowance for doubtful accounts is
primarily for marketing and due from employees.
3. RENTAL INVENTORY
Rental inventory as of December 31, 2002 and 2001 consists of (in thousands):
-------------------------
2002 2001
---------- ----------
Rental inventory $ 722,582 $ 675,469
Less accumulated amortization (462,392) (484,453)
---------- ----------
$ 260,190 $ 191,016
========== ==========
Amortization expense related to rental inventory was $218.9 million, $180.2
million and $340.8 million in 2002, 2001 and 2000, respectively, and is
included in cost of rental product. Amortization in 2000 included a $164.3
million charge for changes in estimated useful lives and salvage values of
various types of rental product (see Note 6). As rental inventory is
transferred to merchandise inventory and sold as previously-viewed product, the
applicable cost and accumulated amortization are eliminated from the accounts,
determined on a first-in-first-out ("FIFO") basis applied in the aggregate to
monthly purchases.
4. RENTAL INVENTORY AMORTIZATION POLICY
The Company manages its rental inventories of movies as 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, primarily for new platforms such as DVD.
Beginning October 1, 2002, purchases of new release movies are amortized over
four months to current estimated average residual values of approximately $2.00
for VHS and $4.00 for DVD (net of estimated allowances for losses). Purchases
of VHS and DVD catalog are amortized on a straight-line basis over twelve
months and sixty months, respectively, to estimated residual values of $2.00
for VHS and $4.00 for DVD (see Note 5).
For new release movies acquired under revenue sharing arrangements, the
studios' share of rental revenue is charged to cost of rental net of average
estimated residual values which are 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.
The majority of games purchased are amortized over four months to an average
residual value below $5.00. Games that the Company expects to keep in rental
inventory for an indefinite period of time are amortized on a straight-line
basis over two years to a current estimated residual value of $5.00.
5. CHANGE IN ACCOUNTING ESTIMATE FOR RENTAL INVENTORY - 2002
The Company regularly evaluates and updates rental inventory accounting
estimates. Effective October 1, 2002, estimated average residual values on new
release movies was reduced from $3.16 to $2.00 for VHS and from $4.67 to $4.00
for DVD. In addition, the estimated residual value of catalog DVD inventory was
reduced from $6.00 to $4.00. As a result of these changes in estimate, cost of
rental product revenue in 2002 was $4.1 million higher and net income per share
(basic and diluted) was $0.04 lower.
6. CHANGE IN ACCOUNTING ESTIMATE FOR RENTAL INVENTORY - 2000
Prior to the change in estimate effective October 1, 2002 (see Note 5) the
Company previously made the following changes in estimate effective October 1,
2000 (see Note 4 for our current estimates):
Catalog VHS product began to amortize over an estimated useful life of one year
compared to the previous estimate of five years to an estimated residual value
of $2 compared to the previous estimate of $6. For new release tapes acquired
under revenue sharing, the studios share of rental revenue was expensed, net of
an average value established in rental inventory of $3 compared to the previous
estimate of $4. New release VHS purchases were amortized to an average value of
approximately $4 in the first four months compared to the previous estimate of
$8. DVD purchases defined as new release began to depreciate over four months.
Prior to the change in estimate, all purchases of DVD rental inventory were
amortized straight-line to a residual value of $6 in 60 months. Game inventory
residual value was reduced from $8 to $5.
The change resulted in a $164.3 million increase to amortization expense in the
fourth quarter of 2000 and is classified as cost of rental on the consolidated
statement of operations. This change in estimate increased net loss by $164.3
million and increased net loss per share (basic and diluted) by $3.56.
7. PROPERTY AND EQUIPMENT
Property and equipment as of December 31, 2002 and 2001 consists of
(in thousands):
---------------------
2002 2001
--------- ----------
Fixtures and equipment $ 187,300 $ 165,723
Leasehold improvements 380,047 360,569
Equipment under capital lease 15,784 15,879
Leasehold improvements under
capital lease 37,112 37,112
--------- ----------
620,243 579,283
Less accumulated depreciation
and amortization (364,746) (308,697)
--------- ----------
$ 255,497 $ 270,586
========= ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $24.4 million and
$17.5 million at December 31, 2002 and 2001, respectively. Depreciation
expense related to property, plant and equipment was $59.3 million, $61.9
million and $114.2 million in 2002, 2001 and 2000, respectively.
8. STORE CLOSURE RESTRUCTURING
In December 2000, the Company approved a restructuring plan involving the
closure and disposition of 43 stores that were not operating to management's
expectations (the "Restructuring Plan"). In the fourth quarter of 2000, the
Company recorded charges aggregating $16.9 million, including an $8.0 million
write down of property and equipment, a $1.5 million write down of goodwill and
an accrual for store closing costs of $7.4 million. The established reserve
for cash expenditures is for lease termination fees and other store closure
costs. The Company has liquidated and plans to continue liquidating related
store inventories through store closing sales; any remaining product will be
used in other stores.
Revenue for the stores under the Restructuring Plan was $6.3 million, $13.8
million and $15.5 million in 2002, 2001 and 2000, respectively. Operating
results (defined as income or loss before interest expense and income taxes)
was $.9 million loss, $2.5 million loss and $1.8 million in 2002, 2001 and
2000, respectively. The operating results for the stores in the Restructuring
Plan were included in the Consolidated Statement of Operations.
During the twelve months ended December 31, 2001, the Company closed 12 of the
stores included in the plan and incurred $329,867 in expenses related to the
closures and received $450,000 to exit one of the leases. During the twelve
months ended December 31, 2002, the Company closed one store included in the
plan and incurred $90,000 in closure expenses.
In December of 2001 and 2002, the Company amended the Restructuring Plan and
removed 16 stores and 2 stores from the closure list, respectively. In
accordance with the amended plans, and updated estimates on closing costs, the
Company reversed $3.8 million and $0.8 million of the original $16.9 million
charge, leaving a $3.7 million and $2.8 million accrual balance at December 31,
2001 and 2002, respectively, for store closing costs. At December 31, 2002,
twelve stores remained to be closed under the Restructuring Plan.
9. IMPAIRMENT OF LONG-LIVED ASSETS
In the fourth quarter of 2000, the Company experienced negative same store
sales for the first time in 21 quarters while major competitors experienced
positive same store sales. With a strong slate of new release titles, this
decline in same store sales was unexpected and occurred at a time when the
Company was facing substantial uncertainty with respect to its liquidity. These
changes in circumstance triggered an impairment analysis in accordance with the
Company's policy outlined in Note 1. The Company identified 293 impaired
stores and recorded a charge of $74.3 million. The non-cash charge included
$44.3 million classified as operating and selling expenses in the consolidated
statement of operations that reduced the net carrying amount of property and
equipment, and $30 million classified as amortization of intangibles that
reduced the net carrying amount of goodwill. Property and equipment primarily
consisted of leasehold improvements and fixtures that could not be used in
other locations.
10. GOODWILL AND INTANGIBLE ASSETS
Goodwill was $64.9 million as of December 31, 2002 and 2001 and represents the
excess of cost over the fair value of net assets purchased net of accumulated
amortization and impairment charges recorded prior to the adoption of FAS 142.
In July 2001, the FASB issued SFAS Nos. 141 and 142, "Business Combinations"
and "Goodwill and Other Intangible Assets," respectively. SFAS 141 supersedes
Accounting Principles Board (APB) Opinion 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 and to the Company's trade-name right resulted in an increase in net
income of $3.2 million for the year ended December 31, 2002. Had the non-
amortization provisions of SFAS 142 been in place in the years ended December
31, 2001 and 2000, net income would have been $3.1 million and $29.9 million
higher, respectively.
The components of intangible assets are as follows (in thousands):
December 31, December 31,
2001 Additions 2002
------------ --------- ------------
Goodwill $ 64,934 $ - $ 64,934
Trade-name rights 4,612 733 5,345
------------ --------- ------------
$ 69,546 $ 733 $ 70,279
============ ========= ============
The following table summarizes the pro forma impact of excluding amortization
of intangible assets for the years ended December 31, 2002, 2001 and 2000 (in
thousands, except per share amounts):
Year Ended December 31,
-------- -------- ---------
2002 2001 2000
-------- -------- ---------
Net income(loss), as reported $241,845 $100,416 $(530,040)
Add back: Amortization of
intangible assets, net of tax - 3,116 29,904
-------- -------- ---------
Pro forma net income(loss) $241,845 $103,532 $(500,136)
======== ======== =========
Basic net income(loss) per share:
As reported $ 4.23 $ 2.05 $ (11.48)
Pro forma net income(loss) per share $ 4.23 $ 2.11 $ (10.84)
Diluted net income(loss) per share:
As reported $ 3.88 $ 1.90 $ (11.48)
Pro forma net income(loss) per share $ 3.88 $ 1.96 $ (10.84)
11. REEL.COM DISCONTINUED E-COMMERCE OPERATIONS
On June 12, 2000, the Company announced that it would close down the e-commerce
business of Reel.com. Although the Company had developed a leading web-site
over the seven quarters after Reel.com was purchased in October of 1998,
Reel.com's business model of rapid customer acquisition led to large operating
losses and required significant cash funding. Due to market conditions, the
Company was unable to obtain outside financing for Reel.com, and could not
justify continued funding from its superstore cash flow. As a result of the
discontinuation of Reel.com's e-commerce operations, the Company recorded a
total charge of $69.3 million in the second quarter of 2000, of which $48.5
million was classified as a restructuring charge on the consolidated statement
of operations and $20.8 million was included in merchandise sales. The $48.5
million charge included $27.3 million of accrued liabilities for contractual
obligations, lease commitments, anticipated legal claims, legal fees, financial
consulting, and other professional services incurred as a direct result of the
closure of Reel.com. The charge was reduced by $1.6 million to $46.9 million in
the fourth quarter of 2000, and also reduced by $3.3 million and $12.4 million
in 2001 and 2002, respectively, because the Company was able to negotiate
termination of certain obligations and lease commitments more favorably than
originally anticipated. As of December 31, 2002, the Company had paid for all
accrued liabilities, net of reductions, and does not anticipate further
adjustments.
12. OPERATING LEASES
The Company leases all of its stores, corporate offices, distribution centers
and zone offices under non-cancelable operating leases. The Company's stores
generally have an initial operating lease term of five to fifteen years and
most have options to renew for between five and fifteen additional years. Rent
expense was $213.2 million, $212.7 million and $206.1 million for the years
ended December 31, 2002, 2001 and 2000, respectively. Most operating leases
require payment of additional occupancy costs, including property taxes,
utilities, common area maintenance and insurance. These additional occupancy
costs were $42.1 million, $40.4 million and $37.4 million for the years ended
December 31, 2002, 2001 and 2002, respectively.
At December 31, 2002, the future minimum annual rental commitments under non-
cancelable operating leases were as follows (in thousands):
------------------------------
Year Ending Operating
December 31, Leases
------------------------------
2003 $224,354
2004 219,712
2005 209,430
2006 189,884
2007 159,919
Thereafter 417,361
13. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable includes accrued revenue sharing (amounts accrued pursuant to
revenue sharing arrangements in which the Company had not yet received an
invoice). Accrued revenue sharing was $15.9 million and $20.6 million at
December 31, 2002, and 2001, respectively.
Accrued liabilities as of December 31, 2002 and 2001 consist of
(in thousands):
----------------------
2002 2001
---------- ---------
Payroll and benefits $ 24,136 $ 25,143
Property taxes and common
area maintenance 9,313 10,241
Gift cards and coupons 15,672 13,940
Marketing 5,815 8,054
Store closures and lease
terminations 4,453 7,977
Reel.com restructuring - 15,000
Property plant and equipment 10,531 2,961
Other operating and general
administration 38,512 29,483
---------- ---------
$ 108,432 $ 112,799
========== =========
14. EMPLOYEE BENEFIT PLANS
The Company is self-insured for employee medical benefits under the Company's
group health plan. The Company maintains stop loss coverage for individual
claims in excess of $100,000 and for annual Company claims that exceed
approximately $8.7 million in the aggregate. While the ultimate amount of
claims incurred is dependent on future developments, in management's opinion,
recorded reserves are adequate to cover the future payment of claims.
Adjustments, if any, to recorded estimates of the Company's potential claims
liability will be reflected in results of operations for the period in which
such adjustments are determined to be appropriate on the basis of actual
payment experience or other changes in circumstances.
The Company has a 401(k) plan in which eligible employees may elect to
contribute up to 20% of their earnings. Eligible employees are at least 21
years of age, have completed at least one year of service and work at least
1,000 hours in a year. The Company currently matches 25% of the employee's
first 6% of contributions.
Beginning in April 2000, the Company offered a deferred compensation plan to
certain key employees designated by the Company. The plan allows for the
deferral and investment of current compensation on a pre-tax basis. The
Company has accrued approximately $140,660 and $112,069 related to this plan at
December 31, 2002 and 2001, respectively.
Beginning in January 2002, the Company offered a 401(k) supplemental plan that
allows our highly compensated employees the ability to receive the full 25%
employer match on the first 6% of contributions that is not available under the
Company's 401(k) plan. The plan allows for the deferral and investment of
current compensation on a pre-tax basis. The Company has accrued approximately
$373,829 in the year ended December 31, 2002.
15. RELATED PARTY TRANSACTIONS
In May 2000, the Company's Board of Directors approved a five-year $15 million
loan to Mr. Mark J. Wattles (with a secondary security interest in the
Company's common stock that he owned), which bore interest at an annual rate
equal to the greater of ten percent or the minimum rate required under the
Internal Revenue Code and regulations thereunder, to avoid imputed interest on
loans to affiliated persons. In December 2000, the Company's Board of
Directors determined that because the Company's common stock that Mr. Wattles
owned was worth less than the primary security interest (which was ahead of the
Company's secondary security interest) the loan was uncollectable and directed
the Company to write-off the loan.
On January 25, 2001, the Compensation Committee of the Board of Directors of
the Company unanimously approved an employment agreement between the Company
and Mark J. Wattles as President and Chief Executive Officer. Pursuant to the
terms of the agreement, on January 25, 2001, Mr. Wattles received a grant of
$3.28 million in common stock (3 million shares).
In July 2001, Boards, Inc. (Boards) began to open Hollywood Video stores as
licensee of the Company pursuant to rights granted by the Company and approved
by the Board of Directors in connection with Mark J. Wattles employment
agreement in January 2001. These stores are operated by Boards and are not
included in the 1,831 stores operated by the Company. Mark Wattles, the
Company's Founder, Chief Executive Officer and President, is the majority owner
of Boards. Under the license arrangement, Boards pays the Company an initial
license fee of $25,000 per store, a royalty of 2% of revenue and may purchase
product and services from the Company. As of December 31, 2002, Boards operated
nine stores. Under the arrangement, Boards has 30 day payment terms and has
incurred license fees, royalties, and purchased product and services from the
Company totaling $5.0 million, of which, $4.4 has been paid in full as of
December 31, 2002, leaving an outstanding balance due to the Company of $0.6
million.
16. LONG-TERM OBLIGATIONS AND LIQUIDITY
The Company had the following long-term obligations as of December 31, 2002 and
2001 (in thousands):
December 31,
----------- ----------
2002 2001
----------- ----------
Borrowings under credit facilities $ 107,500 $ 240,000
Senior subordinated notes due 2011 (1) 225,000 -
Senior subordinated notes due 2004 (2) 250,000 250,000
Obligations under capital leases 10,178 24,002
----------- ----------
592,678 514,002
Current portions:
Credit facilities 17,500 98,500
Capital leases 10,178 13,414
----------- ----------
27,678 111,914
Subordinated notes to be retired
with cash held by trustee 203,932 -
Total long-term obligations
net of current portion and notes to ----------- ----------
be retired with cash held by trustee $ 361,068 $ 402,088
=========== ==========
(1) Coupon payments at 9.625% are due semi-annually in March and September.
(2) On December 18, 2002, the Company called $203.9 million of the notes, which
were redeemed on January 17, 2003. The remaining $46.1 million was called on
January 17, 2003 and redeemed on February 18, 2003.
On March 11, 2002, the Company completed a public offering of 8,050,000 shares
of its common stock, resulting in proceeds of $120.8 million before fees and
expenses, of which $114 million was applied to the repayment of borrowings
under the Company's prior revolving credit facility.
On March 18, 2002, the Company obtained senior bank credit facilities from a
syndicate of lenders led by UBS Warburg LLC and applied a portion of initial
borrowings thereunder to repay all remaining borrowings under the Company's
prior revolving credit facility, which was then terminated. The bank credit
facilities consist 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 interest payable on the credit facilities is based on variable
interest rates (LIBOR or the prime bank rate at our option). At December 31,
2002 the Company had a total of $107.5 million outstanding under the senior
secured term facility, no outstanding balance on the $25.0 million senior
secured revolving credit facility and was in compliance with all financial
covenants.
On December 18, 2002, the Company completed the sale of $225 million 9.625%
senior subordinated notes due 2011. The Company delivered the net proceeds to
an indenture trustee to redeem $203.9 million of the $250 million 10.625%
senior subordinated notes due 2004 including accrued interest and the required
call premium. At December 31, 2002, the trustee was holding $218.5 million and
the Company continued to carry the $250 million 10.625% senior subordinated
notes on its balance sheet. On January 17, 2003, the redemption of $203.9
million of the notes was completed.
The senior subordinated notes due 2011 are redeemable, at the option of the
Company, beginning in March 15 2007, at rates starting at 104.8% of principal
amount reduced annually through March 15, 2009, at which time they become
redeemable at 100% of the principal amount. The terms of the notes may
restrict, among other things, payment of dividends and other distributions,
investments, the repurchase of capital stock or subordinated indebtedness, the
making of certain other restricted payments, the incurrence of additional
indebtedness or liens by the Company or any of its subsidiaries, and certain
mergers, consolidations and disposition of assets. Additionally, if a change of
control occurs, as defined, each holder of the notes will have the right to
require the Company to repurchase such holder's notes at 101% of principal
amount thereof.
On January 16, 2003, the Company completed the closing of new senior secured
credit facilities from a syndicate of lenders led by UBS Warburg LLC. The new
facilities consist of a $200.0 million term loan facility and a $50.0 million
revolving credit facility, each maturing in 2008. The Company used the net
proceeds from the transaction to repay amounts outstanding under the Company's
existing credit facilities which were due in 2004, redeem the remaining $46.1
million outstanding principal amount of the Company's 10.625% senior
subordinated notes due 2004 and for general corporate purposes. The Company
completed the redemption of the 10.625% senior subordinated notes on February
18, 2003.
Revolving credit loans under the new facility bear interest, at the Company's
option, at an applicable margin over the bank's base rate loan or the LIBOR
rate. The initial margin over LIBOR was 3.5% for the term loan facility and
will step down if certain performance targets are met. The credit facility
contains financial covenants (determined in each case on the basis of the
definitions and other provisions set forth in such credit agreement), some of
which may become more restrictive over time, that include a (1) maximum debt to
adjusted EBITDA test, (2) minimum interest coverage test, and (3) minimum fixed
charge coverage test. Amounts outstanding under the credit agreement are
collateralized by substantially all of the assets of the Company. Hollywood
Management Company, and any future subsidiaries of Hollywood Entertainment
Corporation, are guarantors under the credit agreement.
After giving effect to all the transactions described above, maturities on
long-term obligations at December 31, 2002 for the next five years would have
been as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2003 - 15,000 10,178 25,178
2004 - 20,000 - 20,000
2005 - 20,000 - 20,000
2006 - 20,000 - 20,000
2007 - 20,000 - 20,000
Thereafter 225,000 105,000 - 330,000
----------- ---------- --------- ---------
$ 225,000 $ 200,000 $ 10,178 $ 435,178
----------- ---------- --------- ---------
As of December 31, 2002, the fair value of the 10.625% senior subordinated
notes due 2004 was $256.7 million and the fair value of the 9.625% senior
subordinated notes due 2011 was $229.5 million. The fair value of the notes was
based on quoted market prices as of December 31, 2002. The revolving credit
facility is a variable rate loan, and thus, the fair value approximates the
carrying amount as of December 31, 2002.
As of December 31, 2002, the Company had $1.1 million of outstanding letters of
credit.
17. INCOME TAXES
The provision for (benefit from) income taxes from continuing operations for
the years ended December 31, 2002, 2001 and 2000 consists of (in thousands):
------------------------------
2002 2001 2000
---------- -------- --------
Current:
Federal $ (3,507) $ 312 $ 3,396
State 2,107 816 2,391
--------- -------- --------
Total current provision
(benefit) (1,400) 1,128 5,787
Deferred:
Federal (81,076) (30,852) 22,523
State (14,325) (7,544) 3,282
--------- -------- --------
Total deferred liability
(benefit) (95,401) (38,396) 25,805
--------- -------- --------
Total provision (benefit) $ (96,801) $(37,268) $ 31,592
========= ======== ========
The Company is subject to minimum state taxes in excess of statutory state
income taxes in many of the states in which it operates. These taxes are
included in the current provision for state and local income taxes. Certain
acquisitions in 1995 and the Reel.com acquisition in 1998 yielded non-
deductible goodwill which is reflected in the tax rate reconciliation below.
The tax impact of purchase accounting adjustments is reflected in deferred
taxes. The difference between the tax provision at the statutory federal income
tax rate and the tax provision attributable to income (loss) from continuing
operations before income taxes for the three years ended December 31 is
analyzed below:
--------------------------
2002 2001 2000
-------- ------- -------
Statutory federal rate
provision (benefit) 34.0% 34.0% (34.0%)
State income taxes, net of
federal income tax benefit 3.9 4.4 (3.5)
Amortization of non-deductible
Goodwill - 0.1 2.6
Net non-deductible expenses 0.4 3.8 -
Unused federal credits (0.6) (1.2) -
Increase (decrease)in valuation
allowance (103.4) (100.5) 41.3
Other, net - 0.4 (0.1)
-------- ------- -------
(65.7%) (59.0%) 6.3%
======== ======= =======
Deferred income taxes reflect the impact of "temporary differences" between
amounts of assets and liabilities for financial reporting purposes and such
amounts as measured by tax laws. The tax effects of temporary differences that
give rise to significant portions of deferred tax assets and liabilities from
continuing operations at December 31 are as follows (in thousands):
----------------------
2002 2001
---------- ---------
Deferred tax assets:
Tax loss carryforward $102,131 $116,200
Deferred rent 7,027 7,574
Accrued liabilities and reserves 13,957 18,991
Tax credit carryforward 6,623 4,836
Restructure charges 3,505 10,360
Accrued legal settlement 101 130
Inventory valuation 20,803 33,470
Amortization 5,640 11,842
---------- ---------
Total deferred tax assets 159,787 203,403
Valuation allowance - (147,790)
---------- ---------
Net deferred tax assets 159,787 55,613
---------- ---------
Deferred tax liabilities:
Depreciation and amortization (8,104) (13,425)
Capitalized and financing leases (3,870) (3,792)
---------- ---------
Total deferred tax liabilities (11,974) (17,217)
---------- ---------
Net deferred tax asset $147,813 $38,396
========== =========
The Company believes that it is more likely than not that certain future tax
benefits will be realized as a result of current and anticipated future income.
Accordingly, the valuation allowance was reduced by $147.8 million in 2002 and
$63.4 million in 2001 to reflect anticipated net deferred tax asset
utilization. As of December 31, 2002, the Company had approximately $259.0
million of net operating loss carryforwards available to reduce future income
taxes. The carryforward periods expire in years 2019 through 2021. The
Company has federal Alternative Minimum Tax ("AMT") credit carryforwards of
$4.3 million which are available to reduce future regular taxes in excess of
AMT. These credits have no expiration date. The Company has federal and state
tax credit carryforwards of $2.3 million which are available to reduce future
taxes. The carryforward periods expire in years 2018 through 2022, or have no
expiration date.
The Company realized a tax benefit in the amount of $12.8 million in 2002 as a
result of the exercise of employee stock options. For financial reporting
purposes, the impact of this tax benefit is credited directly to shareholders'
equity.
Certain contingencies related to income taxes are discussed in Note 22,
"Contingencies and Other Commitments."
18. SHAREHOLDERS' EQUITY
Preferred Stock
At December 31, 2002, the Company was authorized to issue 25,000,000 shares of
preferred stock in one or more series. With the exception of 3,119,737 shares
which have been designated as "Series A Redeemable Preferred Stock" but have
not been issued, the Board of Directors has authority to designate the
preferences, special rights, limitations or restrictions of such shares.
Common Stock
On March 11, 2002, the Company completed a public offering of 8,050,000 shares
of its common stock.
On January 24, 2000, the Company issued to Rentrak Corporation 200,000 shares
of common stock as part of a litigation settlement.
19. STOCK OPTION PLANS
In general, the Company's stock option plans provide for the granting of
options to purchase Company shares at a fixed price. It has been the Company's
Board of Directors general policy to set the price at the market price of such
shares as of the option grant date. The options generally have a nine year
term and become exercisable on a pro rata basis over the first three years or
at such other periods as determined by the Board. The Company adopted stock
option plans in 1993, 1997 and 2001 providing for the granting of non-qualified
stock options, stock appreciation rights, bonus rights and other incentive
grants to employees up to an aggregate of 21,000,000 shares of common stock.
The Company granted non-qualified stock options pursuant to the 1993, 1997 and
2001 Plans totaling 3,311,368, 11,063,683 and 2,510,650 in 2002, 2001 and 2000,
respectively. The Company cancelled 2.2 million, 4.0 million and 5.1 million of
stock options in 2002, 2001 and 2000, respectively.
The Company has elected to follow APB No. 25; "Accounting for Stock Issued to
Employees" ("APB 25"), and related interpretations in accounting for its
employee stock options. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying
stock on the date of the grant, no compensation expense is recognized upon the
date of grant. Pro forma information regarding net income per share is
required by SFAS No. 123, "Accounting for Stock-Based Compensation", and has
been determined as if the Company had accounted for its employee stock options
under the fair value method of that statement. The fair value of these options
was estimated at the date of grant using Black-Scholes option pricing model
with the following weighted-average assumptions for 2002, 2001 and 2000:
-----------------------------
2002 2001 2000
-----------------------------
Risk free interest rate 2.17% 3.87% 4.87%
Expected dividend yield 0% 0% 0%
Expected lives 4 years 3 years 5 years
Expected volatility 108% 100% 98%
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options, which have no vesting restrictions and are
fully transferable. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in the Company's opinion, the existing available models do
not necessarily provide a reliable single measure of the fair value of the
Company's employee stock options.
Using the Black-Scholes option valuation model, the weighted average grant date
value of options granted during 2002, 2001 and 2000 (excluding the options
assumed in connection with the Reel.com acquisition) was $8.82, $1.55, and
$5.32 per share subject to the option, respectively.
For the purpose of pro forma disclosures, the estimated fair value of the
options is amortized over the option's vesting period. The value of options
issued in connection with the Reel.com acquisition are excluded from the pro
forma disclosure as the value of these options was part of the acquisition
purchase price.
The Company's pro forma information is as follows (in thousands, except per
share amounts):
Year Ended December 31,
--------------------------------------------------------
2002 2001 2000
---------------- ------------------- -----------------
Net income (loss)
as reported $241,845 $100,416 $(530,040)
Add: Stock-based
compensation expense
included in reported
net income, net of
tax related tax
effects 596 2,378 --
Deduct: Total stock-
based employee
compensation expense
under fair value
based method for all
awards, net of
related tax effects (7,941) (4,180) (8,846)
-------- -------- ---------
Pro forma net income $234,500 $ 98,614 $(538,886)
======== ======== =========
Earnings (loss)
per Share:
Basic--as reported $ 4.23 $ 2.05 $ (11.48)
Basic--pro forma 4.10 2.01 (11.68)
Diluted--as reported 3.88 1.90 (11.48)
Diluted--pro forma 3.87 1.93 (11.68)
Pro forma diluted shares were 60,662,392 and 51,095,451 in 2002 and 2001,
respectively, and are different from diluted shares as reported because of the
pro forma unamortized stock option compensation at the end of each period that
would result in a reduction of diluted shares. Due to the Company's loss in
2000, a calculation of earnings per share assuming dilution is not required. In
2000 dilutive securities consisting of options exercisable for 5.4 million
shares of common stock were excluded from the reported and pro forma
calculations due to the net loss.
A summary of the Company's stock option activity and related information for
2002, 2001 and 2000 is as follows (in thousands, except per share amounts):
Weighted
Average
Exercise
Shares Price
-------- --------
Outstanding at December 31, 1999 8,187 $ 11.49
Granted 2,511 7.01
Exercised (226) 3.52
Cancelled (5,050) 11.81
-------- --------
Outstanding as December 31, 2000 5,422 9.45
Granted 11,064 2.05
Exercised (181) 6.24
Cancelled (3,951) 7.39
-------- --------
Outstanding as December 31, 2001 12,354 3.52
Granted 3,311 13.47
Exercised (2,318) 2.39
Cancelled (2,199) 7.32
-------- --------
Outstanding as December 31, 2002 11,148 $ 5.96
======== ========
The 3.3 million options granted in 2002 were granted with an exercise price
equal to market value.
A summary of options outstanding and exercisable at December 31, 2002 is as
follows (in thousands, except per share amounts):
------------------------------ -------------------
Options Outstanding Options Exercisable
------------------------------ -------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Range of Life Exercise Exercise
Exercise Prices Options (in years) Price Options Price
- ---------------- ------- --------- -------- ------- --------
$ 1.000 - $1.090 5,243 7.24 $ 1.09 1,102 $ 1.09
1.094 - 1.563 1,007 7.22 1.50 146 1.24
2.040 - 12.000 2,997 7.72 9.43 268 6.79
12.010 - 20.390 1,901 6.49 16.29 599 17.65
------ --------- -------- ------- --------
11,148 7.24 $ 5.96 2,115 $ 6.51
====== ========= ======== ======= ========
In the first quarter of 2000, the Company granted stock options to
approximately fifty key employees. The grants were for the same number of
shares issued to these employees prior to January 1, 2000. In the third quarter
of 2000, the Company cancelled the stock options that were issued prior to
January 1, 2000 for the fifty employees. The grant and cancellation of the same
number of options for these employees resulted in variable accounting treatment
for the related options for 850,000 shares of the Company's common stock.
Variable accounting treatment resulted in unpredictable stock-based
compensation dependent on fluctuations in quoted prices for the Company's
common stock. In 2002, the variable options were canceled and the Company
reversed expense that was recognized in 2001 on the canceled options. Options
subject to variable accounting outstanding at December 31, 2002, 2001 and 2000
were 0, 482,750 and 850,000, respectively. The Company reversed compensation
expense in 2002 of $2.6 million relating to the variable stock options compared
to compensation expense of $2.7 million in 2001. No compensation expense was
recorded relating to the variable options in 2000.
The Company recorded compensation expense related to certain stock options
issued below the fair market value of the related stock. The Company recorded
compensation expense in the amount of $1.0 million and $1.4 million for the
year ended December 31, 2002 and 2001, respectively. There was no such
compensation expense recorded in 2000.
20. EARNINGS PER SHARE
A reconciliation of the basic and diluted per share computations for 2002,
2001 and 2000 is as follows (in thousands, except per share data):
----------------------------------
2002
----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ---------
Income before extraordinary item $ 244,071 57,202 $ 4.27
Extraordinary loss on extinguishment
of debt(net of income tax benefit
of $1,308) (2,226) (.04)
---------- --------- ---------
Income per common share $ 241,845 57,202 $ 4.23
Effect of dilutive securities:
Stock options - 5,188 (.35)
---------- --------- ---------
Income per share assuming dilution $ 241,845 62,390 $ 3.88
========== ========= =========
----------------------------------
2001
----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ---------
Income per common share $ 100,416 49,101 $ 2.05
Effect of dilutive securities:
Stock options - 3,779 (0.15)
---------- --------- ---------
Income per share assuming dilution $ 100,416 52,880 $ 1.90
========== ========= =========
----------------------------------
2000
----------------------------------
Weighted Per
Average Share
(Loss) Shares Amount
---------- --------- ---------
Loss per common share $ (530,040) 46,151 $ (11.48)
Effect of dilutive securities:
Stock options - - -
---------- --------- ---------
Loss per share assuming dilution $ (530,040) 46,151 $ (11.48)
========== ========= =========
Due to the Company's loss in 2000, a calculation of earnings per share assuming
dilution is not required. Shares subject to antidilutive stock options excluded
from the calculation of diluted income (loss) in 2002, 2001, and 2000 were .8
million, 3.0 million and 5.4 million, respectively.
21. SPECIAL AND/OR UNUSUAL ITEMS
The Company incurred the following special and/or unusual charges in 2002, 2001
and 2000.
2002 and 2001
In December of 2002 and 2001, the Company amended its store closure
Restructuring Plan by removing stores from the closure list. In accordance with
the amended plans, and updated estimates on closing costs, the Company reversed
$0.8 million and $3.8 million, respectively, of the original $16.9 million
charge recorded in the fourth quarter of 2000 (Note 8).
In the second quarter of 2002, and in the fourth quarter of 2001, the Company
reversed $12.4 million and $3.3 million, respectively, of accrued liabilities
related to the discontinuation of Reel.com's e-commerce operations because the
Company was able to negotiate termination of certain obligations, lease
commitments and legal contingencies more favorably than originally anticipated
(Note 11).
2000
On June 12, 2000, the Company announced that it would close down the e-commerce
business of Reel.com. As a result, the Company recorded a total charge of $67.7
million, of which $46.9 million was classified as a restructuring charge on the
consolidated statement of operations and $20.8 million was included in cost of
product sales (Note 11).
Effective October 1, 2000, the Company changed several estimates regarding
useful lives and salvage values on various types of rental inventory. As a
result, the Company recorded a charge of $164.3 million to cost of rental on
the consolidated statement of operations (Note 6).
In the fourth quarter of 2000, the Company developed a plan to close a group of
stores by the end of 2001. The assets associated with each identified store
were removed from the books and estimated closing costs were accrued resulting
in a $16.9 million charge (Note 8).
In accordance with FASB Statement No. 121, the Company recorded a $74.3 million
charge to properly value long-lived assets at several stores (Note 9). The
charge included a $30 million write-down of goodwill, classified as
amortization of intangibles on the consolidated statement of operations, and a
$44.3 million write-down of property and equipment, classified as operating and
selling.
22. COMMITMENTS AND CONTINGENCIES
In 1999, Hollywood Entertainment Corporation was named as a defendant in three
complaints, which have been consolidated 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
sought to certify a class of former and current California salaried Store
Managers and Assistant Managers alleging that Hollywood engaged in unlawful
conduct by improperly designating its salaried Store Managers and Assistant
Store Managers as "exempt" from California's overtime compensation requirements
in violation of the California Labor Code. Hollywood maintains that its
California Store Managers and Assistant Store Managers were properly designated
as exempt from overtime and therefore disputes all claims for damages and other
relief made in the lawsuit. The parties have since entered into a settlement
agreement, which was given final approval by the court on January 28, 2003.
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 did 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 Entertainment Corporation 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, Hollywood, 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 under examination by the Internal Revenue Service (IRS)
for the tax years 1994 through 1997. In connection with those examinations,
the IRS proposed adjustments for tax years 1994 through 1997, which the Company
did not agree with at the exam or appeals level. In April 2001, the IRS issued
a Notice of Deficiency (the Notice) for tax years 1994 through 1997 with
respect to various issues. In July 2001, the Company filed a petition in
United States Tax Court requesting a re-determination of the proposed
deficiency. In January 2003, the IRS and the Company reached a tentative
settlement agreement related to the various issues and established deferred tax
assets in the amount of $3.1 million.
Hollywood Entertainment Corporation has been named in several purported class
action lawsuits alleging various causes of action, including claims regarding
its membership application and extended rental period charges. Hollywood has
vigorously defended these actions and maintains that the terms of its extended
rental charge policy are fair and legal. (Some of Hollywood's major
competitors have settled similar litigation by agreeing, in addition to other
remedies, to modify their extended rental policies to conform very closely to
Hollywood's existing policy.) Hollywood has been successful in obtaining
dismissal of three of the actions filed against it. Two of the lawsuits have
been consolidated in a nationwide class action entitled, George Curtis and Karl
G. Anuta, on behalf of themselves and the class of similarly situated customers
of Hollywood Video, Plaintiffs, and Michael DeLong, Intervenor-Plaintiff v.
Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8
SEA, in the Superior Court of King County, Washington. Hollywood and the
plaintiffs in this nationwide class action have entered into a settlement
agreement and are seeking preliminary approval from the King County Superior
Court. Final approval of this settlement would fully and finally resolve all
class actions with regard to Hollywood's membership application and extended
rental period charges. (An individual plaintiff can opt out of the class and
bring an action in his or her own name but could not bring a class action.)
The Company believes, based upon the settlement agreement, it has provided
adequate reserves in connection with these lawsuits. In addition, the Company
does not believe the pending settlement will have any material effect on its
methods of operating or on its future results of operations.
The Company has been named to various claims, disputes, legal actions and other
proceedings involving contracts, employment and various other matters. 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 its consolidated results of operation, financial condition or
liquidity.
23. SEGMENT REPORTING
The Company identifies its segments based on management responsibility. The
Company only operated one segment in 2002 and 2001, the Hollywood Video segment
consisting of the Company's 1,831 and 1,801 retail stores, respectively,
located in 47 states. The Company operated two segments during the first six
months of 2000, the Hollywood Video segment, consisting of the Company's 1,818
retail stores located in 47 states, and the Reel.com segment, primarily an e-
commerce company specializing in movies. During June 2000, the Company
announced the discontinuation of e-commerce operations of Reel.com (Note 11).
All assets of Reel.com were transferred to the Hollywood Video segment on June
12, 2000. The Company measures segment profit as operating income (loss), which
is defined as income (loss) before interest expense and income taxes.
Information on segments and reconciliation to operating income (loss) are as
follows (in thousands):
Year Ended December 31, 2000
-----------------------------------
Hollywood
Video Reel.com Total
---------- ----------- ----------
Revenues $1,269,957 $ 26,280 $1,296,237
Tape amortization (1) 176,459 110 176,569
Other depreciation and
amortization (2) 77,102 23,492 100,594
Gross profit 529,961 (18,974) 510,987
Operating loss (315,238) (121,083) (436,321)
Interest expense, net 57,861 4,266 62,127
Total assets 665,114 - 665,114
Purchase of property and
equipment, net 76,121 1,518 77,639
(1) Excludes the $164.3 million charge for amortization policy change in
estimate (Note 6).
(2) Excludes the $74.3 million charge for the impairment of long-lived assets
(Note 9).
24. QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data is as follows (in thousands, except per share
data):
Quarter Ended
------------------------------------------
March June September December
2002 --------- --------- --------- ---------
- -------------------------
Total revenue $ 363,648 $ 345,261 $ 369,022 $ 412,135
Gross profit 223,009 216,810 228,425 248,293
Income from
operations 40,935 51,818 41,984 54,590
Net income before
extraordinary loss 28,669 51,818 41,984 54,590
Net income 26,443 41,456 31,945 142,001
Net income before
extraordinary loss
per share:
Basic 0.56 0.71 0.54 2.39
Diluted 0.50 0.64 0.50 2.21
Net income
per share:
Basic 0.51 0.71 0.54 2.39
Diluted 0.46 0.64 0.50 2.21
Quarter Ended
------------------------------------------
March June September December
2001 --------- --------- --------- ---------
- -------------------------
Total revenue $ 342,245 $ 325,072 $ 344,914 $ 367,272
Gross profit 197,804 197,239 211,605 228,378
Income from
Operations 18,432 20,441 30,310 50,094
Net income 3,526 6,785 15,374 74,731
Net income
per share:
Basic 0.07 0.14 0.31 1.51
Diluted 0.07 0.13 0.28 1.35
Quarter Ended
------------------------------------------
March June September December
2000 --------- --------- --------- ---------
- -------------------------
Total revenue $ 335,322 $ 322,636 $ 306,532 $ 331,747
Gross profit 196,754 174,023 192,083 (51,873)
Income (loss) from
operations 2,735 (70,074) 18,439 (387,421)
Net income (loss) (12,163) (63,044) 716 (455,549)
Net income (loss)
per share:
Basic (0.26) (1.37) 0.02 (9.85)
Diluted (0.26) (1.37) 0.02 (9.85)
25. CONSOLIDATING FINANCIAL STATEMENTS
Hollywood Entertainment Corporation (HEC) had only one wholly owned subsidiary
as of December 31, 2002, Hollywood Management Company (HMC). HMC is a guarantor
of certain indebtedness of HEC, including the obligations under the new credit
facilities and the 9.625% senior subordinated notes due 2011. Prior to June
2000, HEC had a wholly owned subsidiary, Reel.com (Reel), that was merged with
and into HEC in June 2000. The consolidating condensed financial statements
below present the results of operations and financial position of the
subsidiaries of the Company.
Consolidating Condensed Balance Sheet
December 31, 2002
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,045 $ 31,100 $ -- $ 33,145
Cash held by trustee for
Refinancing 218,531 218,531
Accounts receivable, net 20,529 218,517 (204,050) 34,996
Merchandise inventories 97,307 -- -- 97,307
Prepaid expenses and other
current assets 11,995 2,777 -- 14,772
Total current assets 131,876 470,925 (204,050) 398,751
Rental inventory, net 260,190 -- -- 260,190
Property & equipment, net 234,964 20,533 -- 255,497
Goodwill, net 64,934 -- -- 64,934
Deferred income tax asset 147,813 -- -- 147,813
Other assets, net 17,361 5,838 (4,008) 19,191
Total assets $ 857,138 $ 497,296 $ (208,058) $1,146,376
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 27,678 $ -- $ -- $ 27,678
Subordinated notes to be
Retired with cash held by
Trustee (including accrued
Interest of $8.1 million) 203,940 8,140 -- 212,080
Accounts payable 204,050 158,423 (204,050) 158,423
Accrued expenses 16,852 91,580 -- 108,432
Accrued interest -- 2,923 -- 2,923
Income taxes payable -- 1,151 -- 1,151
Total current liabilities 452,520 262,217 (204,050) 510,687
Long-term obligations, less
current portion 361,068 -- -- 361,068
Other liabilities 17,472 -- -- 17,472
Total liabilities 831,060 262,217 (204,050) 889,227
Preferred stock -- -- -- --
Common stock 503,403 4,008 (4,008) 503,403
Unearned compensation (697) -- -- (697)
Retained earnings
(accumulated deficit) (476,628) 231,071 -- (245,557)
Total shareholders' equity
equity (deficit) 26,078 235,079 (4,008) 257,149
Total liabilities and
shareholders equity
(deficit) $ 857,138 $ 497,296 $ (208,058) $1,146,376
Consolidating Condensed Balance Sheet
December 31, 2001
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 1,999 $ 36,811 $ -- $ 38,810
Accounts receivable, net 19,161 388,895 (379,000) 29,056
Merchandise inventories 61,585 -- -- 61,585
Prepaid expenses and other
current assets 8,377 2,486 -- 10,863
Total current assets 91,122 428,192 (379,000) 140,314
Rental inventory, net 191,016 -- -- 191,016
Property & equipment, net 262,984 7,602 -- 270,586
Goodwill, net 64,934 -- -- 64,934
Deferred income tax asset 38,396 -- -- 38,396
Other assets, net 12,594 4,712 (4,008) 13,298
Total assets $ 661,046 $ 440,506 $ (383,008) $ 718,544
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 111,914 $ -- $ -- $ 111,914
Accounts payable 379,000 167,479 (379,000) 167,479
Accrued expenses 13,935 98,864 -- 112,799
Accrued interest -- 13,712 -- 13,712
Income taxes payable -- 5,266 -- 5,266
Total current liabilities 504,849 285,321 (379,000) 411,170
Long-term obligations, less
current portion 402,088 -- -- 402,088
Other liabilities 18,840 -- -- 18,840
Total liabilities 925,777 285,321 (379,000) 832,098
Preferred stock -- -- -- --
Common stock 373,848 4,008 (4,008) 373,848
Retained earnings
(accumulated deficit) (638,579) 151,177 -- (487,402)
Total shareholders' equity
equity (deficit) (264,731) 155,185 (4,008) (113,554)
Total liabilities and
shareholders equity
(deficit) $ 661,046 $ 440,506 $ (383,008) $ 718,544
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2002
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,492,941 $ 156,057 $(158,932)$1,490,066
Cost of revenue 573,529 -- -- 573,529
Gross profit 919,412 156,057 (158,932) 916,537
Operating costs & expenses:
Operating and selling 637,739 10,034 -- 647,773
General & administrative 199,254 49,280 (158,932) 89,602
Store opening expenses 3,093 -- -- 3,093
Restructuring charges:
Closure of Internet
business (12,430) -- -- (12,430)
Store closures (828) -- -- (828)
Income from
operations 92,584 96,743 -- 189,327
Interest income -- 31,619 (31,125) 494
Interest expense (73,676) -- 31,125 (42,551)
Income before
income taxes 18,908 128,362 -- 147,270
(Provision for) income
taxes 145,269 (48,468) -- 96,801
Net income before
extraordinary item 164,177 79,894 -- 244,071
Extraordinary loss on
extinguishment of debt, net (2,226) -- -- (2,226)
Net income $ 161,951 $ 79,894 -- $ 241,845
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2001
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,382,378 $ 154,075 $(156,950)$1,379,503
Cost of revenue 544,477 -- -- 544,477
Gross profit 837,901 154,075 (156,950) 835,026
Operating costs & expenses:
Operating and selling 610,274 11,069 -- 621,343
General & administrative 204,563 48,769 (156,950) 96,382
Restructuring charges:
Closure of Internet
business (3,256) -- -- (3,256)
Store closures (3,778) -- -- (3,778)
Amortization of intangibles 4,683 375 -- 5,058
Income from
operations 25,415 93,862 -- 119,277
Interest income -- 35,438 (35,021) 417
Interest expense (91,567) - 35,021 (56,546)
Income(loss) before
income taxes (66,152) 129,300 -- 63,148
(Provision for) income
taxes 85,109 (47,841) -- 37,268
Net income $ 18,957 $ 81,459 $ -- $ 100,416
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2000
(in thousands)
--------- --------- -------- --------- ---------
HEC HMC Reel Elimin- Consol-
ations idated
--------- --------- -------- --------- ---------
Revenue $1,272,832 $ 134,253 $ 26,280 $(137,128)$1,296,237
Cost of revenue 739,996 -- 45,254 -- 785,250
Gross profit 532,836 134,253 (18,974) (137,128) 510,987
Operating costs & expenses:
Operating and selling 655,164 30,822 27,445 -- 713,431
General & administrative 164,904 77,327 5,139 (137,128) 110,242
Restructuring charges:
Closure of Internet
business -- -- 46,862 -- 46,862
Store closures 16,859 -- -- -- 16,859
Amortization of intangibles 37,163 88 22,663 -- 59,914
Income (loss) from
operations (341,254) 26,016 (121,083) -- (436,321)
Interest income -- 26,689 -- (26,514) 175
Interest Expense (84,550) -- (4,266) 26,514 (62,302)
Income (loss) before
Income taxes (425,804) 52,705 (125,349) -- (498,448)
(Provision for) income
taxes (1,061) (19,501) (11,030) -- (31,592)
Net income (loss) $ (426,865)$ 33,204 $(136,379)$ -- $ (530,040)
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2002
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
Operating activities:
Net income $ 161,951 $ 79,894 $ 241,845
Adjustments to reconcile
net income to
cash provided by
operating activities:
Extraordinary loss on
Extinguishment of debt 2,226 -- 2,226
Depreciation &
amortization 276,505 5,528 282,033
Tax benefit from exercise
of stock options 12,814 -- 12,814
Change in deferred rent (1,368) -- (1,368)
Change in deferred income
taxes (109,417) -- (109,417)
Non-cash stock
compensation (1,633) -- (1,633)
Net change in operating
assets & liabilities (200,961) 136,452 (64,509)
Cash provided by operating
activities 140,117 221,874 361,991
Investing activities:
Purchases of rental
inventory, net (288,079) -- (288,079)
Purchase of property &
equipment, net (36,326) (7,928) (44,254)
Increase in intangibles
& other assets (61) (1,126) (1,187)
Refinancing proceeds -- (218,531) (218,531)
Cash used in investing
activities (324,466) (227,585) (552,051)
Financing activities:
Proceeds from the sale of
common stock, net 113,073 -- 113,073
Issuance of subordinated
debt 225,000 -- 225,000
Repayments of capital
lease obligations (13,816) -- (13,816)
Proceeds from exercise
of stock options 4,604 -- 4,604
Decrease in revolving loans,
net (144,466) -- (144,466)
Cash provided by financing
activities 184,395 -- 184,395
Increase in cash
and cash equivalents 46 (5,711) (5,665)
Cash and cash equivalents
at beginning of year 1,999 36,811 38,810
Cash and cash equivalents
at end of year $ 2,045 $ 31,100 $ 33,145
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2001
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
Operating activities:
Net income $ 18,957 $ 81,459 $ 100,416
Adjustments to reconcile
net income to
cash provided by
operating activities:
Depreciation &
amortization 244,521 6,370 250,891
Non-cash asset write downs
Tax benefit from exercise
of stock options (61) -- (61)
Change in deferred rent (598) -- (598)
Change in deferred income
taxes (38,396) -- (38,396)
Non-cash stock
compensation 7,371 -- 7,371
Net change in operating
assets & liabilities 4,238 (50,068) (45,830)
Cash provided by operating
activities 236,032 37,761 273,793
Investing activities:
Purchases of rental
inventory, net (202,790) -- (202,790)
Purchase of property &
equipment, net (7,063) (1,739) (8,802)
Increase in intangibles
& other assets (4,793) (564) (5,357)
Cash used in investing
activities (214,646) (2,303) (216,949)
Financing activities:
Proceeds from the sale of
common stock, net -- -- --
Issuance of long-term
obligations -- -- --
Repayments of long-term
obligations (17,399) -- (17,399)
Proceeds from exercise
of stock options 1,097 -- 1,097
Increase in revolving
loan, net (5,000) -- (5,000)
Cash provided by financing
activities (21,302) -- (21,302)
Increase in cash
and cash equivalents 84 35,458 35,542
Cash and cash equivalents
at beginning of year 1,915 1,353 3,268
Cash and cash equivalents
at end of year $ 1,999 $ 36,811 $ 38,810
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2000
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Reel Consol-
idated
---------- ---------- ---------- ----------
Operating activities:
Net income (loss) $ (426,865) $ 33,204 $ (136,379) $ (530,040)
Adjustments to reconcile
net income (loss) to
cash provided by
operating activities:
Depreciation &
amortization 489,488 5,349 23,602 518,439
Non-cash asset write downs 30,548 3,838 25,509 59,895
Tax benefit from exercise
of stock options 63 -- -- 63
Change in deferred rent 1,993 -- -- 1,993
Change in deferred income
taxes 25,805 -- -- 25,805
Net change in operating
assets & liabilities 121,373 (36,928) 88,271 172,716
Cash provided by operating
activities 242,405 5,463 1,003 248,871
Investing activities:
Purchases of rental
inventory, net (176,926) -- 173 (176,753)
Purchase of property &
equipment, net (67,735) (8,676) (1,228) (77,639)
Increase in intangibles
& other assets (823) (607) -- (1,430)
Cash used in investing
activities (245,484) (9,283) (1,055) (255,822)
Financing activities:
Proceeds from the sale of
common stock, net -- -- -- --
Issuance of long-term
obligations 12,511 -- -- 12,511
Repayments of long-term
obligations (15,016) -- -- (15,016)
Proceeds from exercise
of stock options 783 -- -- 783
Increase in revolving
loan, net 5,000 -- -- 5,000
Cash provided by financing
activities 3,278 -- -- 3,278
Increase (decrease) in cash
and cash equivalents 199 (3,820) (52) (3,673)
Cash and cash equivalents
at beginning of year 1,716 5,173 52 6,941
Cash and cash equivalents
at end of year $ 1,915 $ 1,353 $ -- $ 3,268
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, as of March 27,
2003.
Hollywood Entertainment Corporation
By: /S/ JAMES MARCUM
---------------------------
James Marcum
Executive Vice President
and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities indicated as of March 27, 2003.
Signatures Title
/S/ MARK J. WATTLES
- ----------------
Mark J. Wattles Chairman of the Board of Directors,
and Chief Executive Officer
(Principal Executive Officer)
/S/ JAMES MARCUM
- ---------------
James Marcum Executive Vice President
and Chief Financial Officer
(Principal Financial and Accounting Officer)
/S/ DONALD J. EKMAN
- ---------------
Donald J. Ekman Director
/S/ WILLIAM P. ZEBE
- ---------------
William P. Zebe Director
/S/ JAMES N. CUTLER JR.
- -------------------
James N. Cutler Jr. Director
/S/ DOUGLAS GLENDENNING
- -------------------
Douglas Glendenning Director
CERTIFICATIONS
I, Mark J. Wattles, certify that:
1. I have reviewed this annual report on Form 10-K of Hollywood Entertainment
Corp.;
2. Based on my knowledge, this annual 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 annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 annual 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 annual
report (the "Evaluation Date"); and
c) presented in this annual 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
annual 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: March 27, 2003
/s/ Mark J. Wattles
---------------------------
Mark J. Wattles
Chief Executive Officer
I, James A. Marcum, certify that:
1. I have reviewed this annual report on Form 10-K of Hollywood Entertainment
Corp.;
2. Based on my knowledge, this annual 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 annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 annual 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 annual
report (the "Evaluation Date"); and
c) presented in this annual 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
annual 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: March 27, 2003
/s/ James A. Marcum
---------------------------
James A. Marcum
Chief Financial Officer