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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 0-21824
HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in charter)
OREGON 93-0981138
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
9275 S.W. Peyton Lane, Wilsonville, Oregon 97070
(Address of principal executive offices) (zip code)
(503) 570-1600
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such short period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
As of October 13, 2003 there were 60,831,051 shares of the registrant's Common
Stock outstanding.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ --------------------
2003 2002 2003 2002
-------- -------- ---------- ---------
REVENUE:
Rental product revenue $337,306 $331,074 $1,031,784 $ 974,741
Merchandise sales 64,652 37,948 177,208 103,190
-------- -------- ---------- ---------
401,958 369,022 1,208,992 1,077,931
COST OF REVENUE:
Cost of rental product 104,641 112,035 327,408 331,496
Cost of merchandise 46,672 28,562 128,222 78,191
-------- -------- ---------- ---------
151,313 140,597 455,630 409,687
-------- -------- ---------- ---------
GROSS MARGIN 250,645 228,425 753,362 668,244
OPERATING COSTS AND EXPENSES:
Operating and selling 181,791 165,030 531,328 478,080
General and administrative 25,650 20,183 81,200 66,629
Store opening expenses 1,219 1,228 3,942 1,228
Restructuring charge for closure
of internet business - - - (12,430)
-------- -------- ---------- ---------
208,660 186,441 616,470 533,507
-------- -------- ---------- ---------
INCOME FROM OPERATIONS 41,985 41,984 136,892 134,737
Interest expense, net (7,879) (9,716) (25,715) (31,636)
Early debt retirement - - (12,467) (3,534)
-------- -------- ---------- ---------
Income before income taxes 34,106 32,268 98,710 99,567
Provision for income taxes (13,636) (323) (39,484) 277
-------- -------- ---------- ---------
NET INCOME $ 20,470 $ 31,945 $ 59,226 $ 99,844
======== ======== ========== =========
Net income per share:
Basic $ 0.34 $ 0.54 $ 0.98 $ 1.77
Diluted $ 0.32 $ 0.50 $ 0.92 $ 1.62
Weighted average shares outstanding:
Basic 60,942 58,883 60,482 56,431
Diluted 64,624 63,712 64,414 61,797
The accompanying notes are an integral part of this financial statement
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
September 30, December 31,
------------ -----------
2003 2002
------------ -----------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 39,941 $ 33,145
Cash held by trustee for refinancing - 218,531
Receivables, net 24,539 34,996
Merchandise inventories 128,321 97,307
Prepaid expenses and other current assets 12,397 14,772
----------- -----------
Total current assets 205,198 398,751
Rental inventory, net 254,026 260,190
Property and equipment, net 280,620 255,497
Goodwill 65,217 64,934
Deferred tax asset, net 120,119 147,813
Other assets, net 19,931 19,191
----------- -----------
$ 945,111 $ 1,146,376
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term obligations $ 2,368 $ 27,678
Subordinated notes to be retired with
cash held by trustee (including accrued
interest of $8.1 million) - 212,080
Accounts payable 137,062 158,423
Accrued expenses 98,575 108,432
Accrued interest 950 2,923
Income taxes payable 1,500 1,151
----------- -----------
Total current liabilities 240,455 510,687
Long-term obligations, less current portion 370,000 361,068
Other liabilities 16,325 17,472
----------- -----------
626,780 889,227
----------- -----------
Shareholders' equity:
Preferred stock, 25,000,000 shares
authorized; no shares issued and
outstanding - -
Common stock, 100,000,000 shares authorized;
60,769,201 and 59,796,573 shares issued
and outstanding, respectively 504,928 503,403
Unearned compensation (266) (697)
Accumulated deficit (186,331) (245,557)
----------- -----------
Total shareholders' equity 318,331 257,149
----------- -----------
$ 945,111 $ 1,146,376
=========== ===========
The accompanying notes are an integral part of this financial statement.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
Nine Months Ended
September 30,
-----------------------
2003 2002
--------- ---------
OPERATING ACTIVITIES:
Net income $ 59,226 $ 99,844
Adjustments to reconcile net income
to cash provided by operating activities:
Write-off of deferred financing costs 5,827 2,226
Amortization of rental product 158,552 156,979
Depreciation 45,675 44,987
Amortization of deferred financing costs 1,910 2,922
Tax benefit from exercise of stock options 7,485 -
Change in deferred rent (1,146) (989)
Change in deferred taxes 27,694 -
Non-cash stock compensation 431 (1,800)
Net change in operating assets and liabilities:
Receivables 10,457 1,977
Merchandise inventories (31,014) (35,235)
Accounts payable (21,361) (17,235)
Accrued interest (10,113) (10,059)
Other current assets and liabilities (7,141) (24,169)
--------- ---------
Cash provided by operating activities 246,482 219,448
--------- ---------
INVESTING ACTIVITIES:
Purchases of rental inventory, net (152,388) (203,423)
Purchases of property and equipment, net (70,798) (19,429)
Increase in intangibles and other assets (1,299) (549)
Proceeds from indenture trustee 218,531 -
--------- ---------
Cash used in investing activities (5,954) (223,401)
--------- ---------
FINANCING ACTIVITIES:
Proceeds from issuance of common stock - 120,750
Equity financing costs - (7,677)
Extinguishment of subordinated debt (250,000)
Borrowings under new term loan facility 200,000 150,000
Repayment of prior revolving loan (107,500) (240,000)
Decrease in credit agreements (55,000) (25,000)
Debt financing costs (7,454) (5,098)
Repayments of capital lease obligations (7,818) (10,894)
Repurchase of common stock (9,412) -
Proceeds from exercise of stock options 3,452 2,654
--------- ---------
Cash used in financing (233,732) (15,265)
--------- ---------
INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS 6,796 (19,218)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 33,145 38,810
--------- ---------
CASH AND CASH EQUIVALENTS AT END OF THIRD QUARTER $ 39,941 $ 19,592
========= =========
The accompanying notes are an integral part of this financial statement.
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The unaudited Consolidated Financial Statements have been prepared pursuant to
the rules and regulations of the Securities and Exchange Commission. Certain
information and note disclosures normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
(GAAP) have been condensed or omitted pursuant to those rules and regulations,
although Hollywood Entertainment Corporation (the "Company") believes that the
disclosures made are adequate to make the information presented not misleading.
The information furnished reflects all adjustments that are, in the opinion of
management, normal and recurring and necessary to provide a fair statement of
the results for the interim periods presented. These financial statements
should be read in conjunction with the financial statements and the notes
thereto included in the Company's Annual Report on Form 10-K for the fiscal
year ended December 31, 2002 filed with the Securities and Exchange Commission.
Results of operations for interim periods may not necessarily be indicative of
the results that may be expected for the full year or any other period.
(1) Accounting Policies
The Consolidated Financial Statements included herein have been prepared in
accordance with the accounting policies described in Note 1 to the December 31,
2002 audited Consolidated Financial Statements included in the Company's Annual
Report on Form 10-K. Certain prior year amounts have been reclassified to
conform to the presentation used for the current year. These reclassifications
had no impact on previously reported gross margin, net income or shareholders'
equity.
The Company accounts for its stock option plans under the recognition and
measurement principles of Accounting Principal Board opinion No. 25,
"Accounting for Stock Issued to Employees, and related Interpretations."
Pursuant to the disclosure requirements of Statement of Financial Accounting
Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation" and
Statement of Financial Accounting Standards No. 148, "Accounting for Stock-
Based Compensation - Transition and Disclosure - an Amendment of SFAS 123." 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.
(in thousands, except per share amounts)
Three Months Nine Months
Ended September 30, Ended September 30,
-------- -------- -------- --------
2003 2002 2003 2002
-------- -------- -------- --------
Net income, as reported $ 20,470 $ 31,945 $ 59,226 $ 99,844
Add: Stock-based compensation
expense included in reported
net income, net of tax 80 103 259 470
Deduct: Total stock-based employee
compensation expense under
fair value based method for
all awards, net of tax (1,723) (1,682) (6,206) (5,695)
-------- -------- -------- --------
Pro forma net income $ 18,827 $ 30,366 $ 53,279 $ 94,619
======== ======== ======== ========
Earnings per Share:
Basic--as reported $ 0.34 $ 0.54 $ 0.98 $ 1.77
Basic--pro forma 0.31 0.52 0.88 1.68
Diluted--as reported 0.32 0.50 0.92 1.62
Diluted--pro forma $ 0.30 $ 0.49 $ 0.85 $ 1.58
In July 2001, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards No. 143 (SFAS 143), "Accounting for Asset
Retirement Obligations." SFAS 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 143 is effective for fiscal years beginning after June 15, 2002 and
was adopted by the Company on January 1, 2003. Adoption of the standard did not
impact the Company's results of operations, financial position or liquidity in
the nine months ended September 30, 2003.
In May 2002, the FASB issued Statement of Financial Accounting Standards No.
145 (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 an
extraordinary item 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. In
the first quarter of 2003, the Company redeemed its $250 million 10.625% senior
subordinated notes due 2004 and retired its prior credit facility due 2004,
resulting in a pre-tax charge of $12.5 million that was not considered an
extraordinary item. Additionally, in the first quarter of 2002, the Company
retired its credit facility in place at that time, resulting in a $3.5 million
pre-tax charge that was considered an extraordinary item in the Company's
Consolidated Statement of Operations in its Quarterly Report on Form 10-Q for
the period ended March 31, 2002. In accordance with SFAS 145, this charge has
been reclassified to conform to the presentation of the current period.
In July 2002, the FASB issued Statement of Financial Accounting Standards No.
146 (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)." SFAS 146 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 adopted SFAS 146 on
January 1, 2003. Adoption of the standard did not have a material impact on the
Company's results of operations, financial position or liquidity.
In November 2002, the FASB's Emerging Issues Task Force reached a consensus on
Issue 02-16 (EITF 02-16) addressing the accounting of cash consideration
received by a customer from a vendor, including vendor rebates and refunds.
The Company implemented the provisions of EITF 02-16 on January 1, 2003 to
account for payments and credits it receives from its vendors primarily related
to co-operative advertising arrangements. Pursuant to the provisions of EITF
02-16, vendor consideration which represents a reimbursement of specific,
incremental, identifiable costs is included in operating and selling costs and
expenses on the consolidated statements of operations, along with the related
costs, in the period the promotion takes place. Any consideration that exceeds
such costs is now classified as a reduction of the cost of product purchased,
resulting in an increase in net advertising expense and a reduction in
inventory cost, thereby reducing cost of revenue when the product is rented or
sold. As a result, the change could impact the timing of recognition of these
specific considerations. Implementation of EITF 02-16 did not have a material
impact on the Company's results of operation, financial position or liquidity
in the nine months ended September 30, 2003.
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 does not have significant guarantees that
require liability recognition or disclosure.
(2) Rental Amortization Policy
The Company manages its rental inventories of movies as two distinct
categories, new releases 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, the Company acquires catalog inventories to support new
store openings and to build-up its title selection, primarily as it relates to
new formats such as DVD.
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 currently 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.
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.
(3) Statements of Changes in Shareholders' Equity
A summary of changes to shareholders' equity amounts for the nine months ended
September 30, 2003 is as follows (in thousands, except share amounts):
Common Stock Unearned
------------------- Compen- Accumulated
Shares Amount sation Deficit Total
---------- -------- -------- --------- --------
Balance at 12/31/2002 59,796,573 $503,403 $ (697) $(245,557) $257,149
---------- -------- -------- --------- --------
Issuance of common stock:
Stock options exercised 1,505,628 3,452 3,452
Stock options tax benefit 7,485 7,485
Stock compensation - 431 431
Repurchase of common stock (533,000) (9,412) (9,412)
Net income 59,226 59,226
---------- -------- -------- --------- --------
Balance at 09/30/2003 60,769,201 $504,928 $ (266) $(186,331) $318,331
========== ======== ======== ========= ========
(4) Operating Leases
The Company leases all of its stores, corporate offices and distribution
centers under non-cancelable operating leases. All of the Company's stores
have an initial operating lease term of five to fifteen years and most have
options to renew for additional terms between five and fifteen years. Rent
expense was $56.7 million and $167.5 million for the three months and the nine
months ended September 30, 2003, respectively, compared to $53.3 million and
$159.4 million for the corresponding periods of the prior year. Most operating
leases require payment of additional occupancy costs, including property taxes,
utilities, common area maintenance and insurance. These additional occupancy
costs were $11.3 million and $34.4 million for the three months and the nine
months ended September 30, 2003 compared to $10.7 million and $31.5 million for
the corresponding periods of the prior year.
(5) Long-term Obligations
The Company had the following long-term obligations as of September 30, 2003
and December 31, 2002 (in thousands):
September 30, December 31,
------------- ------------
2003 2002
--------- ---------
Borrowings under credit facilities $ 145,000 $ 107,500
Senior subordinated notes due 2011 (1) 225,000 225,000
Senior subordinated notes due 2004 (2) - 250,000
Obligations under capital leases 2,368 10,178
--------- ---------
372,368 592,678
Current portions:
Credit facilities - 17,500
Capital leases 2,368 10,178
--------- ---------
2,368 27,678
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 $ 370,000 $ 361,068
========= =========
(1) Interest 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 December 18, 2002, the Company completed the sale of $225.0 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 $250.0 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 $250.0 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.
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 principle amount of the Company's 10.625% senior
subordinated notes due 2004 on February 18, 2003 and for general corporate
purposes.
On February 28, 2003, the Company prepaid the required 2003 term loan facility
principle payments of $15.0 million. On July 16, 2003, the Company prepaid the
required 2004 principle payments of $20.0 million and on September 9, 2003 the
Company prepaid the required 2005 principle payments of $20.0 million.
At September 30, 2003, maturities on long-term obligations for the next five
years are as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2003 $ - $ - $ 2,368 $ 2,368
2004 - - - -
2005 - - - -
2006 - 20,000 - 20,000
2007 - 20,000 - 20,000
Thereafter 225,000 105,000 - 330,000
---------- ---------- --------- ---------
$ 225,000 $ 145,000 $ 2,368 $ 372,368
---------- ---------- --------- ---------
(6) Earnings per Share
Earnings per basic share are calculated based on income available to common
shareholders and the weighted-average number of common shares outstanding
during the reported period. Earnings per diluted share include additional
dilution from the effect of potential issuances of common stock, such as stock
issuable pursuant to the exercise of stock options.
The following tables are reconciliations of the earnings per basic and diluted
share computations (in thousands, except per share amounts):
Three Months Ended September 30,
----------------------------------------------------------
2003 2002
--------------------------- -----------------------------
Net Per Share Net Per Share
Income Shares(1) Amounts Income Shares(1) Amounts
------- --------- ------- -------- --------- --------
Income per
basic share: $ 20,470 60,942 $ 0.34 $ 31,945 58,883 $ 0.54
Effect of dilutive ======= =======
securities:
Stock options - 3,682 - 4,829
------- --------- -------- ---------
Income per
diluted share: $ 20,470 64,624 $ 0.32 $ 31,945 63,712 $ 0.50
======= ========= ======= ======== ========= ========
(1) Represents weighted average shares outstanding.
Antidilutive stock options excluded from the calculation of income per diluted
share were 1.1 million shares and 0.9 million shares for the three months ended
September 30, 2003 and 2002, respectively.
Nine Months Ended September 30,
-----------------------------------------------------------
2003 2002
---------------------------- -----------------------------
Net Per Share Net Per Share
Income Shares(1) Amounts Income Shares(1) Amounts
------- --------- -------- -------- ------- ----------
Income per
basic share: $59,226 60,482 $ 0.98 $ 99,844 56,431 $ 1.77
Effect of dilutive ======= =========
securities:
Stock options - 3,932 - 5,366
------- --------- -------- -------
Income per
diluted share: $59,226 64,414 $ 0.92 $ 99,844 61,797 $ 1.62
======= ========= ======== ======== ======= =========
(1) Represents weighted average shares outstanding.
Antidilutive stock options excluded from the calculation of income per diluted
share were 1.2 million shares and 0.7 million shares in the nine months ended
September 30, 2003 and 2002, respectively.
(7) Store Closure Restructuring
At September 30, 2003, twelve stores remained to be closed pursuant to the
Company's store closure plan adopted in December of 2000 and amended in
December of 2001 and 2002. In accordance with the plan and the updated
estimates of closing costs as of September 30, 2003, the Company had an accrual
of $2.8 million related to the closures.
(8) Legal Proceedings
In 1999, the Company 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 the Company 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. The Company maintains that its California Store Managers and
Assistant Store Managers were properly designated as exempt from overtime. The
parties entered into a settlement agreement, which was given final approval by
the court on January 28, 2003. A third party claims administrator was hired to
process claims and distribute funds to the class. All claims submitted have
been processed, and verified claims have been paid. The Company has satisfied
its obligations under the settlement agreement and a final Case Management
Conference took place on August 12, 2003. Plaintiffs' counsel submitted final
requests for dismissal and the parties are awaiting an entry by the court.
Reserves established prior to the beginning of fiscal 2003 were adequate to
cover amounts in the settlement agreement.
The Company has been named in several purported class action lawsuits alleging
various causes of action, including claims regarding its membership application
and additional rental period charges. The Company has vigorously defended these
actions and maintains that the terms of its additional rental charge policy are
fair and legal. The Company has been successful in obtaining dismissal of three
of the actions filed against it. A statewide class action entitled George
Curtis v. Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No.
01-2-36007-8 SEA was certified on June 14, 2002 in the Superior Court of King
County, Washington. On May 20, 2003, a nationwide class action entitled George
DeFrates v. Hollywood Entertainment Corporation, No. 02 L 707 was certified in
the Circuit Court of St. Clair County, Twentieth Judicial Circuit, State of
Illinois. The Company believes it has provided adequate reserves in connection
with these lawsuits.
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 April 2003, the IRS and the Company reached a settlement
agreement related to the various issues and the Company established a deferred
tax asset in the amount of $3.1 million. The settlement did not impact the
Company's provision for income taxes in the three months and nine months ended
September 30, 2003.
The Company has been named to various other 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.
(9) Related Party Transactions
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 1,864 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 2.0% of revenue and also
purchases products and services from the Company at the Company's cost. From
July 2001 through September 30, 2003, Boards has incurred license fees and
royalties, and purchased products and services from the Company totaling $12.1
million, of which, $11.4 million has been paid as of September 30, 2003. Boards
is in compliance with the 30 day payment terms under the arrangement. The
outstanding balance of $0.7 million due the Company is related to current
activity. In the three months ended September 30, 2003, Boards incurred charges
of $2.5 million and made $2.3 million in payments. As of September 30, 2003,
Boards operated 18 stores.
(10) Consolidating Financial Statements
Hollywood Entertainment Corporation (HEC) had one subsidiary, Hollywood
Management Company (HMC), during the nine months ended September 30, 2003. HMC
is wholly owned and a guarantor of the subordinated notes of HEC. The
consolidating condensed financial statements below present the results of
operations, financial position and liquidity of HEC and HMC.
Consolidating Condensed Statement of Operations
Nine months ended September 30, 2003
(Unaudited, in thousands)
---------- -------- --------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- -------- --------- ----------
REVENUE $1,211,149 $109,590 $(111,747) $1,208,992
COST OF REVENUE 455,630 - - 455,630
GROSS MARGIN 755,519 109,590 (111,747) 753,362
OPERATING COSTS & EXPENSES:
Operating and selling 518,218 13,110 - 531,328
General & administrative 161,079 31,868 (111,747) 81,200
Store Opening Expenses 3,942 - - 3,942
Restructuring charge for
closure of internet
business - - - -
INCOME FROM OPERATIONS 72,280 64,612 - 136,892
Interest income - 26,915 (26,185) 730
Interest expense (52,630) - 26,185 (26,445)
Early retirement of debt (12,467) - - (12,467)
Income before income
taxes 7,183 91,527 - 98,710
Provision for
income taxes (2,704) (36,780) - (39,484)
NET INCOME $ 4,479 $ 54,747 $ - $ 59,226
Consolidating Condensed Statement of Operations
Nine months ended September 30, 2002
(in thousands)
---------- -------- --------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- -------- --------- ----------
REVENUE $1,080,087 $115,877 $(118,033) $1,077,931
COST OF REVENUE 409,687 - - 409,687
GROSS MARGIN 670,400 115,877 (118,033) 668,244
OPERATING COSTS & EXPENSES:
Operating and selling 469,938 8,142 - 478,080
General & administrative 148,805 35,857 (118,033) 66,629
Store Opening Expenses 1,228 - - 1,228
Restructuring charge for
closure of internet
business (12,430) - - (12,430)
INCOME FROM OPERATIONS 62,859 71,878 - 134,737
Interest income - 23,271 (22,979) 292
Interest expense (54,907) - 22,979 (31,928)
Early retirement of debt (3,534) - - (3,534)
Income before income taxes 4,418 95,149 - 99,567
Benefit from (provision for)
income taxes 36,456 (36,179) - 277
NET INCOME $ 40,874 $ 58,970 $ - $ 99,844
Consolidating Condensed Balance Sheet
September 30, 2003
(Unaudited, in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,223 $ 37,718 $ - $ 39,941
Receivables 19,092 446,437 (440,990) 24,539
Merchandise inventories 128,321 - - 128,321
Prepaid expenses and other
current assets 10,993 1,404 - 12,397
Total current assets 160,629 485,559 (440,990) 205,198
Rental inventory, net 254,026 - - 254,026
Property & equipment, net 258,915 21,705 - 280,620
Goodwill, net 65,217 - - 65,217
Deferred tax assets, net 120,119 - - 120,119
Other assets, net 17,183 6,756 (4,008) 19,931
Total Assets $ 876,089 $ 514,020 $(444,998) $ 945,111
LIABILITIES & SHAREHOLDERS'
EQUITY
Current maturities of
long-term obligations $ 2,368 $ - $ - $ 2,368
Accounts payable 440,990 137,062 (440,990) 137,062
Accrued expenses 13,892 84,683 - 98,575
Accrued interest - 950 - 950
Income taxes payable - 1,500 - 1,500
Total current liabilities 457,250 224,195 (440,990) 240,455
Long-term obligations, less
current portion 370,000 - - 370,000
Other liabilities 16,325 - - 16,325
Total liabilities 843,575 224,195 (440,990) 626,780
Common stock 504,928 4,008 (4,008) 504,928
Unearned compensation (266) - - (266)
Retained earnings
(accumulated deficit) (472,148) 285,817 - (186,331)
Total shareholders'
equity 32,514 289,825 (4,008) 318,331
Total liabilities and
shareholders' equity $ 876,089 $ 514,020 $(444,998) $ 945,111
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
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 26,078 235,079 (4,008) 257,149
Total liabilities and
shareholders equity $ 857,138 $ 497,296 $(208,058) $1,146,376
Consolidating Condensed Statement of Cash Flows
Nine months ended September 30, 2003
(unaudited, in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 4,479 $ 54,747 $ 59,226
Adjustments to reconcile
net income to
cash provided by
operating activities:
Write-off of deferred
financing costs 5,827 - 5,827
Depreciation &
amortization 200,371 5,766 206,137
Tax benefit from exercise
of stock options 7,485 - 7,485
Change in deferred tax asset 27,694 - 27,694
Change in deferred rent (1,146) - (1,146)
Non cash stock compensation 431 - 431
Net change in operating
assets & liabilities 204,722 (263,894) (59,172)
Cash provided by (used in)
operating activities 449,863 (203,381) 246,482
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (152,388) - (152,388)
Purchase of property &
equipment, net (63,186) (7,612) (70,798)
Increase in intangibles
& other assets (380) 217,612 217,232
Cash provided by (used in)
investing activities (215,954) 210,000 (5,954)
FINANCING ACTIVITIES:
Repayments of capital lease
obligations (7,818) - (7,818)
Proceeds from exercise
of stock options 3,452 - 3,452
Repurchase of Common
Stock (9,412) - (9,412)
Increase in revolving
loans, net (219,954) - (219,954)
Cash used in financing
activities (233,732) - (233,732)
Increase in cash
and cash equivalents 177 6,619 6,796
Cash and cash equivalents
at beginning of year 2,045 31,100 33,145
Cash and cash equivalents at
the end of the third quarter $ 2,222 $ 37,719 $ 39,941
Consolidating Condensed Statement of Cash Flows
Nine months ended September 30, 2002
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 40,874 $ 58,970 $ 99,844
Adjustments to reconcile
net income to
cash provided by
operating activities:
Write off deferred
financing costs 2,226 - 2,226
Depreciation &
amortization 200,339 4,549 204,888
Change in deferred rent (989) - (989)
Non cash stock compensation (1,800) - (1,800)
Net change in operating
assets & liabilities (6,807) (77,914) (84,721)
Cash provided by (used in)
Operating activities 233,843 (14,395) 219,448
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (203,423) - (203,423)
Purchase of property &
equipment, net (15,081) (4,348) (19,429)
Increase in intangibles
& other assets (60) (489) (549)
Cash used in investing
activities (218,564) (4,837) (223,401)
FINANCING ACTIVITIES:
Proceeds from the sale of
common stock, net 113,073 - 113,073
Repayments of capital lease
obligations (10,894) - (10,894)
Proceeds from exercise
of stock options 2,654 - 2,654
Increase in revolving
loans, net (120,098) - (120,098)
Cash used in financing
activities (15,265) - (15,265)
Increase (decrease) in cash
and cash equivalents 14 (19,232) (19,218)
Cash and cash equivalents
at beginning of year 1,999 36,811 38,810
Cash and cash equivalents at
the end of the third quarter $ 2,013 $ 17,579 $ 19,592
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with generally accepted accounting principles (GAAP) requires us to make
judgments, assumptions and estimates that affect the amounts reported in the
Consolidated Financial Statements and accompanying notes. Note 1 to the audited
Consolidated Financial Statements included in our Annual Report on Form 10-K
for the year ended December 31, 2002 and Note 1 to the Consolidated Financial
Statements contained in this Quarterly Report on Form 10-Q describe 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,
net; other liabilities; revenue; cost of revenue; and operating costs and
expenses. We base our judgments, assumptions and estimates on historical
experience and on various other factors that we believe to be reasonable under
the circumstances. Actual results could differ significantly from amounts based
on our judgments, assumptions and estimates. Certain critical accounting
policies that involve significant judgments, assumptions and estimates which
affect amounts recorded in the Consolidated Financial Statements are discussed
in our Annual Report on Form 10-K for the year ended December 31, 2002 in
Management's Discussion and Analysis of Results of Operations and Financial
Condition under the heading "Critical Accounting Policies."
For a discussion of new accounting pronouncements, refer to Note 1, "Accounting
Policies," to the Consolidated Financial Statements.
RESULTS OF OPERATIONS
Summary Results of Operations
Our net income for the three months and nine months ended September 30, 2003
was $20.5 million and $59.2 million, respectively, compared with net income of
$31.9 million and $99.8 million for the three months and nine months ended
September 30, 2002. The decrease in net income was primarily the result of a
change in our provision for income taxes. Net income for the three months and
nine months ended September 30, 2002 benefited from a reduction in our
valuation allowance on our deferred income tax assets, resulting in an
effective tax rate of 1.0% (excluding a $1.3 million income tax benefit
recorded in the first quarter due to a charge of $3.5 million for early debt
retirement). We believe that an effective tax rate of 40.5% would have
represented a normalized provision for income taxes excluding the valuation
allowance. The effective tax rate for the three months and nine months ended
September 30, 2003 was 40.0%. Also contributing to the decrease in net income
for the nine months ended September 30, 2003 was a $12.5 million charge
recorded in the first quarter of 2003 for early debt retirement compared to a
early debt retirement charge in the first quarter of 2002 of $3.5 million.
The following table sets forth (i) selected results of operations data,
expressed as a percentage of total revenue; (ii) other financial data; and
(iii) selected operating data.
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
(Unaudited)
REVENUE:
Rental product revenue 83.9% 89.7% 85.3% 90.4%
Merchandise sales 16.1 10.3 14.7 9.6
---------- ---------- ---------- ----------
100.0 100.0 100.0 100.0
---------- ---------- ---------- ----------
GROSS MARGIN 62.4 61.9 62.3 62.0
OPERATING COSTS AND EXPENSES:
Operating and selling 45.2 44.7 44.0 44.4
General and administrative 6.4 5.5 6.7 6.2
Store opening expenses 0.3 0.3 0.3 0.1
Restructuring charge for
closure of internet business 0.0 0.0 0.0 (1.2)
---------- ---------- ---------- ----------
51.9 50.5 51.0 49.5
---------- ---------- ---------- ----------
INCOME FROM OPERATIONS 10.5 11.4 11.3 12.5
Interest expense, net (2.0) (2.6) (2.1) (2.9)
Early debt retirement 0.0 0.0 (1.0) (0.3)
---------- ---------- ---------- ----------
Income before income taxes 8.5 8.8 8.2 9.3
Provision for income taxes (3.4) (0.1) (3.3) 0.0
---------- --------- ---------- ----------
Net income 5.1 8.7 4.9 9.3
---------- --------- ---------- ----------
OTHER FINANCIAL DATA:
Rental product gross margin (1) 69.0% 66.2% 68.3% 66.0%
Merchandise gross margin (2) 27.8% 24.7% 27.6% 24.2%
OPERATING DATA:
Number of stores at quarter end 1,864 1,804 1,864 1,804
Weighted average stores open
during the period 1,851 1,804 1,842 1,801
Same store revenue
increase (3) 7% 7% 10% 7%
- ---------------------------------
(1) Rental product gross margin as a percentage of rental revenue.
(2) Merchandise sales gross margin as a percentage of merchandise sales.
(3) A store is comparable (same store) after it has been open and owned by
the Company for 12 full months.
REVENUE
Revenue increased by $32.9 million, or 9%, for the three months ended September
30, 2003 compared to the three months ended September 30, 2002, due to a 7%
increase in same store revenue and a net increase of 47 weighted average
stores. Revenue increased by $131.1 million, or 12%, for the nine months ended
September 30, 2003 compared to the nine months ended September 30, 2002, due to
a 10% increase in same store revenue and a net increase of 41 weighted average
stores. At September 30, 2003, we had 1,864 stores operating in 47 states
compared to 1,804 stores operating in 47 states at September 30, 2002. In most
of our stores, we currently offer 5-day rentals on all products with new
release videos and all DVDs typically renting for $3.79 and catalog videos
typically renting for $1.99. Since the fourth quarter of 1999, other than test
pricing, we have not increased prices on new release or catalog videos and
DVDs. Video games rent for $4.99 and $5.99, with games for the newer platforms
typically renting for the higher amount. Customers who choose not to return
movies within the initial rental period are deemed to have commenced a new
rental period (an extended rental period) that is equal in length and price to
the initial rental period. The percentage of rental revenues generated from
extended rental periods has not changed significantly in several years.
GROSS MARGIN
Rental Product Margins
Rental product gross margin as a percentage of rental product revenue increased
to 69.0% and 68.3% for the three months and nine months ended September 30,
2003, respectively, from 66.2% and 66.0% for the three months and nine months
ended September 30, 2002, respectively. The increase was primarily due to a
shift in revenue from VHS product to DVD product, which typically has higher
gross margins.
Merchandise Sales Margins
Merchandise sales gross margin as a percentage of merchandise sales revenue
increased to 27.8% and 27.6% for the three months and nine months ended
September 30, 2003, respectively, from 24.7% and 24.2% for the three months and
nine months ended September 30, 2002, respectively. The increase was primarily
the result of an increase in the percentage of merchandise sales from our Game
Crazy departments, which typically have higher margins than merchandise sales
from our video departments, and an improvement in our concession sales.
OPERATING COSTS AND EXPENSES
Operating and Selling Expenses
Total operating and selling expenses for the three months ended September 30,
2003 increased as a percentage of revenue to 45.2% from 44.7% in the
corresponding period of the prior year primarily due to an increase in payroll
and benefits. Total operating and selling expense in the three months ended
September 30, 2003 increased $16.8 million to $181.8 million from $165.0
million in the three months ended September 30, 2002. The increase was
primarily the result of increased variable costs associated with increased
store revenue, an increase of 47 weighted-average stores compared to the
corresponding period of the prior year and an increase in operating and selling
expenses associated with the expansion of our Game Crazy departments from 169
departments as of September 30, 2002 to 577 departments as of September 30,
2003. Payroll and related expenses increased by $9.6 million, rent and related
expense increased by $3.8 million, and other operating and selling expenses
increased by $3.4 million in the three months ended September 30, 2003, when
compared to the corresponding period of the prior year.
Total operating and selling expenses for the nine months ended September 30,
2003 decreased as a percentage of revenue to 43.9% from 44.4% in the
corresponding period of the prior year. The percentage decrease is primarily
the result of leverage from increased revenue. Total operating and selling
expense in the nine months ended September 30, 2003 increased $53.2 million to
$531.3 million from $478.1 million in the nine months ended September 30, 2002.
The increase was primarily the result of increased variable costs associated
with increased store revenue, an increase of 41 weighted-average stores
compared to the corresponding period of the prior year and an increase in
operating and selling expenses associated with the expansion of our Game Crazy
departments. Payroll and related expenses increased by $32.2 million, rent and
related expenses increased by $10.8 million, and other operating and selling
expenses increased by $10.2 million for the nine months ended September 30,
2003 when compared to the corresponding period of the prior year.
General and Administrative Expenses
General and administrative expenses for the three months ended September 30,
2003 increased $5.5 million to $25.7 million, or 6.4% of total revenue, from
$20.2 million, or 5.5% of total revenue for three months ended September 30,
2002. General and administrative expenses for the three months ended September
30, 2002 benefited from the recognition of approximately $4.5 million of non-
cash income associated with variable plan accounting on the cancellation of
stock options. Excluding this benefit, general and administrative expenses as a
percentage of total revenue were lower for the three months ended September 30,
2003 compared to three months ended September 30, 2002.
General and administrative expenses for the nine months ended September 30,
2003 increased $14.6 million to $81.2 million, or 6.7% of total revenue, from
$66.6 million, or 6.2% of total revenue for the nine months ended September 30,
2002. Included in general and administrative expenses for the nine months ended
September 30, 2003 was a $1.7 million charge recognized in the first quarter to
adjust a class action litigation settlement reserve related to extended rental
periods. General and administrative expenses for the nine months ended
September 30, 2002 benefited from the recognition of approximately $4.5 million
of non-cash income associated with variable plan accounting on the cancellation
of stock options. Excluding these items, general and administrative expenses as
a percentage of total revenue were consistent for the nine months ended
September 30, 2003 and 2002.
Store opening expenses
Store opening expenses were $1.2 million and $3.9 million for the three months
and nine months ended September 30, 2003, respectively, compared to $1.2
million for both corresponding periods of the prior year. Store opening
expenses are primarily expenses related to relocating, recruiting and training
new field employees and grand-opening advertising expenses for new video stores
and new Game Crazy departments.
INTEREST EXPENSE, NET
Interest expense, net of interest income, was $7.9 million and $25.7 million
for the three months and nine months ended September 30, 2003, respectively,
compared to $9.7 million and $31.6 million for the corresponding periods of the
prior year. The respective three months and nine months decrease of $1.8
million and $5.9 million was primarily due to lower interest rates.
EARLY DEBT RETIREMENT
In the first quarter of 2003, we redeemed the outstanding $250 million 10.625%
senior subordinated notes due 2004 and retired our prior credit facility due
2004. As a result, we recorded a charge of $12.5 million that included the
early redemption premium of $6.6 million and the write-off of deferred
financing costs. In the first quarter of 2002, we paid all amounts outstanding
and retired our credit facility in place at that time, resulting in a $3.5
million charge to write-off deferred financing costs.
INCOME TAXES
Our effective tax rate was a provision of 40.0% for the three months and nine
months ended September 30, 2003. For the three months and nine months ended
September 30, 2002, our tax provision included reductions in our valuation
allowance on our deferred income tax assets. The allowance was reduced based
upon taxable income earned during the period as a result of the utilization of
net deferred tax assets, primarily net operating loss carryforwards. This
resulted in an effective rate of 1.0% for the three months ended September 30,
2002. In addition to the valuation allowance adjustment, the income tax benefit
of $0.3 million in the nine months ended September 30, 2002 included a $1.3
million benefit recorded in the first quarter of 2002 due to a $3.5 million
charge for early debt retirement. Our effective tax rate varies from the
federal statutory rate as a result of minimum state taxes in excess of
statutory state income taxes and the reduction in the deferred tax valuation
allowance.
RENTAL INVENTORY
Analysis of rental inventory and investment in rental product
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 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 studio. The
studio's share of rental revenue is expensed, net of an estimated residual
value, as revenue is earned on 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 to an estimated
residual value. Therefore, 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. Cost of rental product included revenue sharing
expense of $18.8 million and $70.4 million for the three and nine months ended
September 30, 2003, respectively, compared to $31.0 million and $103.1 million
in the three and nine months ended September 30, 2002, respectively. The
decline in revenue sharing expense is primarily the result of an increase in
the percentage of movies acquired in the DVD format compared to VHS, as we
currently have fewer DVD revenue sharing arrangements than VHS revenue sharing
arrangements.
MERCHANDISE INVENTORY
Merchandise inventory includes new VHS and DVD movies for sale, concessions,
accessories, 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 $31.0 million to $128.3 million as of September 30, 2003, from $97.3
million as of December 31, 2002 primarily due to the expansion of our Game
Crazy departments. In the nine months ended September 30, 2003, we
remerchandised 294 stores to include a Game Crazy department and opened ten
stores that included a Game Crazy department.
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 nine months ended September 30, 2003 funded our debt service
requirements and maintenance capital expenditures and provided the capital
required to remodel and remerchandise 294 of our stores to include Game Crazy
departments as well as to open 42 new video stores. At September 30, 2003, we
had $39.9 million of cash and cash equivalents on hand.
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 Used in
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. 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 was $246.5 million and $219.4 million
for the nine months ended September 30, 2003 and 2002, respectively. The
increase of $27.1 million or 12.4% was primarily due to improved operating
performance in our existing store base and a decrease in receivables.
Cash Used in Investing Activities
Net cash used in investing activities was $6.0 million and $223.4 million for
the nine months ended September 30, 2003 and 2002, respectively. Net cash used
in investing activities for the nine months ended September 30, 2003 included a
$218.5 million source of cash related to a financing transaction. 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. The delivery of the proceeds to the indenture
trustee and the subsequent use of the proceeds to redeem the notes in the first
quarter of 2003 were classified as investing activities. In the nine months
ended September 30, 2003, we opened 42 video stores and remerchandised 294
stores to include a Game Crazy department compared to opening eight video
stores and remerchandising 103 stores to include Game Crazy departments in the
nine months ended September 30, 2002. For the year 2003, we currently
anticipate investing approximately $125 million in new video store openings,
Game Crazy expansion and maintenance capital expenditures in property and
equipment.
Cash Used in Financing Activities
Net cash flow from financing activities was a $233.7 million use of cash for
the nine months ended September 30, 2003 compared to a $15.3 million use of
cash in the corresponding period of the prior year. The $233.7 million use of
cash reflects the redemption of $250.0 million senior subordinated notes and
the retirement of our prior credit facility of $107.5 million with $218.5
million in proceeds from the indenture trustee and $200.0 million of initial
borrowings under our new credit facility. The use of cash also reflects the
repurchase of 533,000 shares of common stock for $9.4 million and $55.0 million
for prepayment of term loan facility principle payments through 2005.
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 $114.0 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.
On December 18, 2002, we completed the sale of $225.0 million 9.625% senior
subordinated notes due 2011. We delivered the net proceeds from the transaction
to the indenture trustee to redeem $203.9 million of the $250.0 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 with cash held by trustee." On January
17, 2003, the redemption of $203.9 million of the notes was completed.
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 borrowings under the term loan
facility to repay amounts outstanding under our existing credit facilities
which were due in 2004, redeem the remaining $46.1 million principle amount of
our 10.625% senior subordinated notes due 2004 on February 18, 2003 and for
general corporate purposes. We have prepaid $55.0 million of the term loan
facility principle payments due through 2005. On February 28, 2003, we prepaid
the 2003 required payments of $15.0 million, on July 16, 2003, we prepaid the
required 2004 payments of $20.0 million and on September 9, 2003, we prepaid
the required 2005 payments of $20.0 million.
Instruments governing our indebtedness contain various covenants, including
covenants requiring us to meet specified financial ratios and tests and
covenants that restrict our business. At September 30, 2003, we were in
compliance with all covenants contained within our debt agreements.
At September 30, 2003, maturities on long-term obligations for the next five
years are as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2003 $ - $ - $ 2,368 $ 2,368
2004 - - - -
2005 - - - -
2006 - 20,000 - 20,000
2007 - 20,000 - 20,000
Thereafter 225,000 105,000 - 330,000
---------- ---------- --------- ---------
$ 225,000 $ 145,000 $ 2,368 $ 372,368
---------- ---------- --------- ---------
Other Financial Measurements: Working Capital
At September 30, 2003, we had cash and cash equivalents of $39.9 million and a
working capital deficit of $35.3 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 and the majority of this
inventory has a relatively short useful life (as evidenced by our amortization
policies), 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 rental 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 our obligations as they
come due.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risk represents the risk of loss that may impact our financial position,
operating results, or cash flows due to adverse changes in financial and
commodity market prices and rates. 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 September 30, 2003, 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 Euro rate or base rate and is therefore affected by
changes in market interest rates. If variable base rates had increased 1.0%
during the twelve months ended September 30, 2003 our interest expense would
have increased by approximately $1.5 million based on our outstanding balance
on the facility as of September 30, 2003.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We evaluated, under the supervision and with the participation of our
management, including our Chief Executive Officer and our Chief Financial
Officer, the effectiveness of our disclosure controls and procedures as of the
end of the period covered by this report pursuant to Rule 13a-15(b) under the
Securities Exchange Act of 1934. Based on the evaluation, our Chief Executive
Officer and the Chief Financial Officer have concluded that our disclosure
controls and procedures are effective in ensuring that information required to
be disclosed is recorded, processed, summarized and reported in a timely
manner.
Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting that
occurred during our last fiscal quarter that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, that are
subject to 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
customers.
We are dependent on the introduction of new and enhanced video games and game
systems to attract and retain video game 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. In the nine
months ended September 30, 2003, we added 304 Game Crazy departments and opened
42 video stores and we anticipate opening approximately 50 additional video
stores in the fourth quarter of 2003. We intend to open at least 300 additional
Game Crazy departments and grow our video store base by up to 10% in 2004. 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.
We have a substantial amount of indebtedness and debt service obligations,
which could adversely affect our financial and operational flexibility and
increase our vulnerability to adverse conditions.
As of September 30, 2003, we had total consolidated long-term debt, including
capital leases, of approximately $372.4 million. We and our subsidiaries could
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 potential 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 and covenants that restrict our business. 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 September 30, 2003, we were in compliance with
all covenants contained within our debt agreements.
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;
- - repurchase shares of our common stock;
- - guarantee third-party obligations;
- - enter into capital leases;
- - create liens on assets;
- - dispose of assets;
- - repay indebtedness or amend debt instruments;
- - make capital expenditures;
- - make investments, loans or advances;
- - pay dividends;
- - make acquisitions or engage in mergers or consolidations; and
- - engage in certain transactions with our subsidiaries and affiliates.
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 and game 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 movies and games;
- - 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. These provisions of Oregon law and
our articles of incorporation have the effect of delaying, deferring or
preventing a change in control of Hollywood, may discourage bids for our common
stock at a premium over the market price of our common stock and may adversely
affect the market price of, and the voting and other rights of the holders of,
our common stock and the occurrence of a control share acquisition may
constitute an event of default under, or otherwise require us to repurchase or
repay, our indebtedness.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In 1999, we were 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
we engaged in unlawful conduct by improperly designating our salaried Store
Managers and Assistant Store Managers as "exempt" from California's overtime
compensation requirements in violation of the California Labor Code. We
maintain that our California Store Managers and Assistant Store Managers were
properly designated as exempt from overtime. The parties entered into a
settlement agreement, which was given final approval by the court on January
28, 2003. A third party claims administrator was hired to process claims and
distribute funds to the class. All claims submitted have been processed, and
verified claims have been paid. We have satisfied our obligations under the
Settlement Agreement and a final Case Management Conference took place on
August 12, 2003. Plaintiffs' counsel submitted final requests for dismissal and
the parties are awaiting entry by the court. Reserves established prior to the
beginning of fiscal 2003 were adequate to cover amounts in the settlement
agreement.
We have been named in several purported class action lawsuits alleging various
causes of action, including claims regarding our membership application and
additional rental period charges. We have vigorously defended these actions and
maintain that the terms of our additional rental charge policy are fair and
legal. We have been successful in obtaining dismissal of three of the actions
filed against us. A statewide class action entitled George Curtis v. Hollywood
Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was
certified on June 14, 2002 in the Superior Court of King County, Washington. On
May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood
Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of
St. Clair County, Twentieth Judicial Circuit, State of Illinois. We believe we
have provided adequate reserves in connection with these lawsuits.
We have 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 we 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, we filed a petition in United States Tax Court
requesting a re-determination of the proposed deficiency. In April 2003, the
parties reached a settlement agreement related to the various issues and we
established a deferred tax asset in the amount of $3.1 million. The settlement
did not impact our provision for income taxes in the three months and nine
months ended September 30, 2003.
We have been named to various other 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 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
3.1 1993B Restated Articles of Incorporation, as amended (incorporated by
reference to the Registrant's Registration Statement on Form S-1 (File No. 33-
63042), by reference to Exhibit 4 to the Registrant's Registration Statement on
Form S-3 (File No. 33-96140), and by reference to Exhibit 3.1 to the
Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30,
1998).
3.2 1999 Restated Bylaws (incorporated by reference to Exhibit 3.2 to the
Registrant's Registration Statement on Form S-4 (File No. 333-82937) (the
"1999 S-4")).
4.1 Indenture dated 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)) as supplemented by the First Supplemental Indenture
dated as of December 18, 2002 among the Registrant and Hollywood Management
Company and BNY Western Trust Company as Trustee (incorporated by reference to
Exhibit 4.3 to our Annual Report on Form 10-K for the year ended December 31,
2002).
10.1 Amendment to Credit Agreement dated as of dated as of August 13, 2003
among the Registrant, an Oregon corporation, as borrower, UBS AG, Stamford
Branch, as administrative agent and the lenders from time to time party
thereto.
31.1 Certification of Chief Executive Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002
31.2 Certification of Chief Financial Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002
32.1 Certification of Chief Executive Officer and Chief Financial Officer of
Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
On July 2, 2003 we filed a current report on Form 8-K under "Item 12. Results
of Operation and Financial Condition" reporting that on July 2, 2003, we issued
a press release announcing our same store sales for the quarter ended June 30,
2003. Our press release was attached to the report as Exhibit 99.1.
On July 15, 2003 we filed a current report on Form 8-K under "Item 12. Results
of Operation and Financial Condition" reporting that on July 15, 2003, we
issued a press release announcing our financial results for the quarter ended
June 30, 2003. Our press release was attached to the report as Exhibit 99.1.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HOLLYWOOD ENTERTAINMENT CORPORATION
(Registrant)
October 29, 2003 /S/Timothy R. Price
- ------------------ -------------------------------------------------
(Date) Timothy R. Price
Chief Financial Officer
(Authorized Officer and Principal Financial and
Accounting Officer of the Registrant)