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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission file number 0-21824
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HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in its charter)
Oregon 93-0981138
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(State or other jurisdiction of (IRS Employer
incorporation or organization) identification No.)
9275 SW Peyton Lane, Wilsonville, OR 97070
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(Address of principal executive offices) (Zip Code)
(503) 570-1600
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Title of Each Class Name of Each Exchange on
- ----------------------- Which Registered
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Common Stock Nasdaq National Market
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period than the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of the Form 10-
K or any amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
On June 30, 2003 (the last business day of the registrant's most recently
completed second fiscal quarter), the aggregate market value of the shares
of Common Stock held by non-affiliates of the Registrant was $986,093,237
based upon the last sale price reported for such date on the Nasdaq National
Market. Shares of Common Stock held by executive officers and directors of
the registrant are not included in the computation. However, the registrant
has made no determination that such individuals are "affiliates" within the
meaning of Rule 405 under the Securities Act of 1933.
On March 9, 2004, the registrant had 59,801,579 shares of Common Stock
outstanding
PART I
ITEM 1. BUSINESS
OUR BUSINESS
We are the second largest rental retailer of DVDs, videocassettes and video
games in the United States. We opened our first video store in October 1988
and, as of December 31, 2003, we operated 1,920 Hollywood Video stores in 47
states and the District of Columbia. As of December 31, 2003, we also operated
595 Game Crazy stores, which are game specialty stores where game enthusiasts
can buy, sell and trade new and used video game hardware, software and
accessories. A typical Game Crazy store carries over 2,500 video game titles
and occupies an area of approximately 700 to 900 square feet adjacent to a
Hollywood Video store.
Our total revenue and cash provided by operating activities were $1.683 billion
and $390.8 million, respectively, for the year ended December 31, 2003 and
$1.490 billion and $361.6 million, respectively, for the year ended December
31, 2002. Revenue from our Hollywood Video stores represented approximately 89%
of our revenue for the year ended December 31, 2003 consisting of approximately
92% from rental products and 8% from the sale of new DVD and VHS movies and
concessions. Revenue from our Game Crazy stores for the year ended December 31,
2003 represented approximately 11% of our total revenue.
Our strategy is to successfully build and operate two separately managed
national chains, each with a retail model designed to compete favorably against
the primary competitors in its segment of the entertainment industry. The
Hollywood Video retail model, including the types of real estate sites we
pursue, the store design, employee hiring and training practices, and inventory
and merchandising standards, is designed to maximize the number of customers
per store, as well as the frequency of customer visits and the amount that
consumers spend per visit. Hollywood Video stores are typically located in
high-traffic, high-visibility locations with convenient access and parking.
Inside the store, we focus on providing a superior selection of movies and
video games for rent, in a friendly and inviting atmosphere that encourages
browsing. We believe that consumers view movie rentals in general, and our
pricing structure and rental terms in particular, as a convenient form of
entertainment and an excellent value. Our Game Crazy retail model, including
the core concept of allowing consumers to buy, sell and trade new and used
merchandise, combined with store design, employee selection and training, and
our inventory selection and merchandising presentation, is designed to appeal
to both "hard-core" and casual game consumers. Remerchandising a Hollywood
Video in order to accommodate a Game Crazy, including reducing its size, does
not cannibalize Hollywood Video revenue. Further, we believe that there is
significant customer overlap, enabling the Hollywood Video and Game Crazy
retail models to complement each other, allowing each of the concepts to have a
competitive advantage versus its primary competitor.
HOME VIDEO MOVIES - INDUSTRY OVERVIEW
Consumer Spending
According to Adams Media Research ("AMR"), the total domestic video retail
industry (consisting of both rentals and sales) grew from $16.4 billion in
revenue in 1998 to an estimated $24.4 billion in 2003, and is expected to grow
to approximately $30.7 billion by 2007. AMR estimates that the total domestic
video retail industry grew approximately 10% in 2003. Total video rental
spending, according to AMR, has remained fairly flat from 1998 to 2003
increasing from $9.7 billion in 1998 to $9.9 billion in 2003 and AMR estimates
that rental spending declined by 1% in 2003 from 2002. The following factors,
among others, continue to make video rental an attractive medium of
entertainment for millions of customers:
- - the continued improvement in home entertainment technology (e.g. DVD,
surround sound, HDTV) which encourages consumers to spend more time watching
movies at home;
- - the opportunity to entertain one or more people at home for a reasonable
price;
- - the opportunity to browse among a very broad selection of movies at a
retail location; and
- - the ability to control the viewing experience, such as the ability to
start, stop, pause, fast-forward and rewind.
According to AMR, at the end of 2003 VCR penetration stood at approximately
87.6% of the 108.9 million domestic television households, while DVD player
penetration was 49.3%.
Movie Studio Dependence on Video Retail Industry
We believe the home video industry is the single largest source of revenue to
movie studios. According to AMR, the home video industry represented
approximately $12.3 billion, or 59%, of the $20.8 billion of estimated domestic
studio revenue in 2002. As a result, the movie studios are highly motivated to
protect this significant source of revenue. A majority of all movies that are
produced by movie studios are either released directly to video and generate no
box office revenues or are unprofitable based on box office revenues alone.
Accordingly, the video retail industry provides movie studios with an important
distribution channel and revenue source for their direct-to-video and non-hit
movies as well as their hit movies. In addition, the browsing characteristics
of the retail environment frequently results in consumers selecting more than
one movie, which based on our experience typically includes both hit and non-
hit movie titles, for rental or purchase. As a result, we believe that the
movie studios are highly motivated to protect this significant source of
revenue.
Exclusive Rental Window
As a result of the importance of the video retail industry to the movie
studios' revenue base, the home video rental and sell-through markets enjoy a
period of time during which they have the exclusive rights to distribute a
movie. This period of exclusivity has been in place since the mid 1980s. The
period typically begins after a film finishes its domestic theatrical run
(usually five months after its debut) or upon its release to video in the case
of direct-to-video releases, and lasts for 30 to 60 days thereafter. This
period of exclusivity is intended to maximize revenue to the movie studio prior
to a movie being released to other distribution channels, including pay-per-
view, video-on-demand, premium or pay cable and other television distribution,
and provides what we believe is a significant competitive advantage for the
rental retail channel. Exclusive windows have been used historically to protect
each distribution channel from downstream channels, principally protecting
theaters from home video, home video from pay-per-view or video-on-demand and
pay-per-view or video-on-demand from premium cable and other television
channels. The exclusive home video window protects both mass merchants who
sell videos and video retailers who rent videos.
New Release Movie Pricing to Home Video Retailers
Studios are currently offering substantially all new release DVD titles to
rental retailers and mass merchant retailers at low, "sell-through", prices
(typically under $18 wholesale). This is a departure from the historical VHS
pricing model in which a majority of the new release titles were purchased by
rental retailers at high "rental" prices (typically $60 to $65 wholesale) and
promoted primarily for rental. Then later (approximately six months) these
titles would be re-released for sale to consumers at a lower price (typically
$10 to $15 wholesale). However, even under this historical VHS pricing model,
prominent children's titles and certain high-grossing box office films were
simultaneously targeted at the rental and consumer sell-through markets, in
which case those titles were priced at the lower "sell-through" level upon
initial release.
In 1998, the major studios and several large video retailers, including us,
began entering into VHS revenue sharing arrangements as an alternative to
purchasing at the historically high "rental" prices (typically $60 to $65).
Under revenue sharing arrangements, rental retailers were able to acquire
significantly more copies of movies in order to satisfy consumer demand faster
and improve overall consumer satisfaction. In exchange for receiving more
copies of movies at significantly reduced or no up-front cost, rental
retailers, including us, agreed to share a pre-determined portion of the
revenues derived from the those movies during the revenue sharing period
(generally 26 weeks). We believe that VHS revenue sharing produced significant
benefits for us, including: (i) substantially increasing the availability of
newly released videos in our stores; (ii) improving customer satisfaction as
more consumers have been able to get the movie they want; (iii) increasing
revenue and same store sales; and (iv) aligning the studios' economic interests
more closely with our economic interests.
Nearly all DVDs are being initially released at "sell-through" pricing. Because
of the lower wholesale pricing, the benefits of entering into revenue sharing
arrangements for DVDs are not as significant as they were for VHS, we believe
there are advantages to revenue sharing on DVDs, especially the ability to
improve availability and thus customer satisfaction. We have DVD revenue
sharing arrangements with a number of studios, with approximately half of our
new release DVD rental product revenue in 2003 occurring under revenue sharing
arrangements. We are in discussions regarding additional revenue sharing
arrangements and believe that additional revenue sharing would have a positive
impact on our business.
VIDEO GAMES - INDUSTRY OVERVIEW
Consumer Spending
According to NPD Group, Inc. ("NPD"), the video game industry was an
approximately $10.0 billion market in the United States in 2003, with software
accounting for $5.8 billion and hardware and accessories accounting for $4.2
billion. In 2000 and 2001, Nintendo's GameCube, Sony's PlayStation 2 and
Microsoft's Xbox, three new-generation hardware technology products, were
introduced. These platforms have substantially increased the installed base of
video game hardware units and have driven significant growth in the video game
software segment. As with the introduction of previous new platforms, consumers
have increased both their purchase and rental of games.
Hardware Platform Technology
Hardware platform technology continues to evolve. The early products launched
in the 1980's had only 8-bit processing speeds compared to the hardware
available today, Sony Playstation 2, Microsoft Xbox and Nintendo Game Cube,
which have 128-bit processing speeds. Advancements in processing speed and data
storage provide for significant improvements in graphics and audio quality that
software developers utilize to create more exciting games. In addition, new
hardware technology is available with capabilities beyond gaming, such as
playing DVD movies and providing internet connectivity. These advancements
encourage existing game players to upgrade their systems and can attract new
game players.
Increased Video Game Software Selection
Production of video game software generally increases with the introduction of
next-generation hardware as video game publishers attempt to capitalize on the
excitement generated by new technology. According to NPD, the video game
software industry grew 5% to approximately $5.8 billion in 2003 compared to
2002, and is projected to grow 8% to $6.2 billion in 2004. Growth in the
overall number of titles available for game platforms has been rapid, with an
estimated 830 new titles were released in 2003.
Widening Demographic Trends
Because of advancing technologies, enhanced functionality and the aging of the
gamer population, the video game market has steadily broadened its demographic
appeal over the past two decades. According to a poll released in August 2003
by the Entertainment Software Association and conducted by Peter D. Hart
Research Associates, Inc., game players over the age of 50 now account for 17%
of game players, up from 13% in 2000. The data also shows women who are 18 and
over now make up a larger percentage of game players (26%) than boys ages 6 to
17 (21%). We believe these broadening demographic trends will benefit our Game
Crazy stores.
Viable and Growing Used Games Market
The buying, selling and trading of used games by consumers is relatively new
and has caused the used game category to grow rapidly for certain specialty
retailers. The total installed base of video game hardware has increased with
the introduction of new platforms, which has increased the used game market by
extending the life of older platforms and enabling game consumers access to
additional software titles in the used market. Used titles compatible with
legacy hardware provide video game retailers with a highly profitable category,
as margins on used games are significantly higher than on new games. The
introduction of the three new platforms and the significant increase in new
titles has created a greater supply and demand of used product. At the same
time, the high price of new games for the latest platforms has increased the
perceived value of used game software. As a result, we believe the used video
game market will increase as consumers increasingly look to realize the "in-
store currency" value of products they already own when making new purchases.
BUSINESS STRATEGY - HOLLYWOOD VIDEO
We are committed to enhancing our position as the nation's second largest
rental retailer of DVDs, videocassettes and video games by focusing on the
following strategies:
Provide Broad Selection and Superior Service
We are committed to providing superior service and satisfying customers' movie
and video game demands by carrying a broad array of titles for rent. Our stores
typically carry more than 10,000 movie and game titles on more than 25,000
DVDs, videocassettes and video games. Through our revenue sharing arrangements
with studios and lower wholesale prices on DVDs, we have increased the
availability of most new movie releases and typically acquire 100 to 250 copies
of "hit" movies for each store. This breadth and depth of movie titles,
together with our emphasis on superior customer service, results in a higher
average level of rentals per store visit, creates greater customer satisfaction
and encourages repeat visits.
Provide Entertainment Convenience and Value
We offer an inexpensive and convenient form of entertainment by allowing
consumers to rent new movie releases, older "catalog" movie titles and video
games for five days in most of our stores. Both new release and catalog DVDs
typically rent for $3.79 and new movie release titles in the VHS format
typically rent for $3.79 while older VHS catalog movies rent for $1.99. We
often offer a $1.00 rebate for early return on select new release titles in
their first few weeks of release. In addition, we focus our movie sales efforts
on the sale of previously viewed movies, which we believe offer a better value
than new movies for those consumers who choose to purchase as opposed to rent
movies. Video games typically rent for $4.99 or $5.99, with games for the
newer system platforms renting for the higher amount. We also offer used games
for sale in Hollywood Video stores that do not have an adjacent Game Crazy.
Capitalize on Continued Industry Consolidation
Hollywood Video grew its revenue from $17 million in 1993 to $1.5 billion in
2003, which management believes is primarily attributable to taking market
share in a fragmented industry. The home video rental industry has experienced
consolidation in recent years, as the larger video store chains have taken
market share from independent store operators, but the industry still remains
fragmented. In 2003, we estimated the share of the three largest video rental
store chains, including us, to represent approximately half of the domestic
consumer video rental market. The remainder of the market share is divided
amongst a relatively large number of smaller independent and regional
operators. We believe our size is a competitive advantage with respect to
smaller operators because it allows us to benefit from strong studio
relationships, access to more copies of individual movie titles through direct
revenue sharing arrangements, sophisticated information systems, greater access
to prime real estate locations, greater access to managerial resources, greater
marketing efficiencies, greater access to capital, greater flexibility setting
competitive prices and other operating efficiencies made possible by size.
Pursue Organic Store Growth
To maintain and enhance our market share and number two position in the video
rental industry, we will pursue organic store growth. Unlike many video
retailers who have grown through acquisitions, we have focused primarily on
organic growth through internal site selection. Approximately 95% of the 1,678
video stores that we have opened since 1996 have been the result of internal
site selection and development rather than the acquisition of existing stores.
We believe that control over site selection and discipline in the real estate
process have been among our key competitive advantages. Our organic store
growth strategy is to selectively add Hollywood stores in existing markets
where we believe the market will successfully absorb additional Hollywood
stores. We are targeting long-term growth of our store base of between 5% and
10% per year.
BUSINESS STRATEGY - GAME CRAZY
Game Crazy has performed below our expectations to date, generating significant
operating losses for the Company. While we anticipate continued losses through
at least 2004, we believe Game Crazy represents a compelling long-term
opportunity. We believe in the game industry and are committed to increasing
our share of the growing market for new and used video game hardware, software
and accessories. As part of our strategy, we will continue to maintain a
separate organizational structure that oversees all aspects of Game Crazy's
existing operations as well as new store growth.
Provide Broad Selection and Superior Service
Our Game Crazy stores typically offer our customers over 2,500 video game
titles on all major hardware systems. This extensive selection is continuously
updated as software publishers release new titles. We believe our breadth of
product selection and deep availability of newly released titles appeals to the
hard-core game enthusiast as well as the casual game player and seasonal gift
buyer. In addition, we seek to hire knowledgeable and passionate sales
associates who are generally "gamers" themselves, and then train them to create
exceptional shopping experiences for our customers.
Destination Location for Game Consumers
We believe our combination of product selection, knowledgeable sales staff,
exceptional customer service, exciting merchandising presentation, convenient
location, and availability of games for rental in our video stores will compel
game consumers of all types to recognize Game Crazy as the destination location
for video games. Our merchandising presentation includes interactive game
terminals where customers can try games before they purchase and where our
sales staff can demonstrate tricks and strategies to win games. Our Game Crazy
stores benefit from the quality of the real estate in which our video stores
are located, typically in high-visibility, stand-alone structures or prominent
locations within multi-tenant shopping developments, with convenient
accessibility to the store and availability of ample parking.
We believe the significant expansion and adoption of new game platforms is
driving consumers to become more economical by purchasing and trading-in used
games, as well as by renting more games. The proliferation of game titles is
also causing growth in the "trade-in" market, where consumers exchange their
games for new games or other used games. Based on our experience, the greater
the number of available titles in the market, the more consumers are inclined
to trade and/or rent games. We believe our broad selection of used video games
in combination with our rental selection in our video stores will differentiate
us from our competitors and be a significant factor in a customer's decision on
where to shop for video games.
Continue Opening New Game Crazy Stores
We opened 67 Game Crazy stores in 1999 and had 69 stores in operation at the
end of 2000. In 2002, we began opening additional Game Crazy stores, adding 207
new stores in 2002 and 319 new stores in 2003. Stores opened prior to 2002
("mature stores") generated average annual revenue of approximately $540,000 in
2003. Although stores opened since 2002 have experienced lower volumes than
mature stores, we are optimistic about our ability to increase revenue per
store. In addition, we believe the game industry will experience significant
growth with the anticipated release of new hardware platforms in 2006, and we
seek to be a major player in the game industry when this occurs. As such, we
plan to continue our expansion of Game Crazy and anticipate adding
approximately 150 new stores in 2004.
The opening of a Game Crazy and the remerchandising of the adjacent Hollywood
Video store is typically accomplished with minimal disruption and results in
higher Hollywood Video revenue once the remerchandising is complete. The cost
of a Game Crazy and simultaneous remerchandising of the Hollywood Video store
is approximately $200,000 including construction, fixtures, inventory and
opening expenses. We expect to continue the expansion of Game Crazy on a
market-by-market basis in order to obtain marketing, management and other
operational efficiencies.
STORES AND STORE OPERATIONS
Video Store Openings
We opened our first video store in October 1988 and grew to 25 stores in Oregon
and Washington by the end of 1993. In 1994, we significantly accelerated our
store expansion program, adding 88 stores and expanding into California, Texas,
Nevada, New Mexico, Virginia and Utah. In 1995, we added 192 stores and entered
major new markets in the Midwest, Southwest, East and Southeast regions of the
United States. The following table shows store growth from 1994.
Year Ended December 31,
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1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
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Beginning 25 113 305 551 907 1,260 1,615 1,818 1,801 1,831
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Opened 33 122 250 356 312 319 208 6 41 96
Acquired 55 70 - - 41 43 - - - 6
Closed - - (4) - - (7) (5) (23) (11) (13)
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Ending 113 305 551 907 1,260 1,615 1,818 1,801 1,831 1,920
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Site Selection
We believe that the selection of locations for our stores is critical to the
success of our operations. We have assembled a store development team with
broad and significant experience in retail tenant development. Most of our new
store development personnel have expertise in and reside in the geographic area
for which they are responsible, but all final site approval takes place at the
corporate office where new sites are approved by a committee of senior
management personnel. Final approval of all new sites is the responsibility of
the Chairman of the Real Estate Committee of the Board of Directors. Important
criteria for the location of a store include density of local residential
population, traffic count on roads immediately adjacent to the store location,
visibility and accessibility of the store, availability of ample parking and
proximity of competition. Management generally seeks what it considers the most
desirable locations, typically locating stores in high-visibility, stand-alone
structures or in prominent locations in multi-tenant shopping developments. All
of our stores are located in leased premises; we do not own any real estate.
Our real estate and store development team is scaled to meet our planned store
growth.
PRODUCTS
Hollywood Video
Our video stores typically carry more than 10,000 movie and game titles on
25,000 units of DVDs, VHS and games, consisting of a combination of new
releases and an extensive selection of older "catalog" movies. Excluding new
releases, movie titles are classified into categories, such as "Action,"
"Comedy," "Drama" and "Children," and are displayed alphabetically within those
categories. We do not rent or sell adult movies. In addition to video rentals,
we rent video games primarily for Sony Playstation 1 & 2, Microsoft Xbox and
Nintendo Game Cube.
Hollywood video stores contributed 89% of our consolidated revenue in 2003.
Revenue from rental products, including rental and sale of previously viewed
DVD, VHS and video games, represented approximately 92% of video store revenue
for 2003. In addition to the growth of DVD rentals, we have experienced
significant growth in the sale of previously viewed DVDs. Our ability to sell
previously viewed movies at lower prices than new movies provides a competitive
advantage over mass-market retailers. We expect the market for previously
viewed DVDs to experience strong growth as DVD player penetration increases and
consumers begin to build their own DVD libraries. Furthermore, previously
viewed DVDs do not suffer from the quality degradation that VHS tapes do,
making them an attractive option for consumers looking to build their personal
movie libraries.
The remaining approximately 8% of video store revenue was from the sale of new
DVDs and videocassettes and concessions (e.g., popcorn, sodas, candy and
magazines).
Game Crazy
Game Crazy offers new and used video game software, hardware and accessories.
Each Game Crazy typically carries over 2,500 video game titles that can be
played on all major new and legacy game systems. We offer new and used Sony
Playstation 2, Microsoft Xbox, Nintendo Game Cube, Game Boy Advance and Game
Boy hardware systems as well a broad selection of used legacy hardware systems.
In addition, we offer new and used game accessories such as controllers, memory
cards and game media such as strategy guides. Revenue from new and used
software represented 68% of Game Crazy revenue for 2003, while 32% was from new
and used hardware and accessories.
SUPPLIERS AND PURCHASING ARRANGEMENTS
We purchase the majority of our movies directly from the studios through
revenue sharing arrangements or other direct purchasing methods, and we
purchase a majority of our video games directly from video game publishers,
except for used games which are purchased from our customers with in-store
credit.
ADVERTISING AND MARKETING
Our primary goal in advertising is to increase transactions in our stores from
both new and existing members. Our primary focus is on cost-effective direct
mail strategies and in-store marketing efforts. In addition, we continue to use
cooperative movie advertising funds made available by studios and suppliers to
promote certain titles. We occasionally test the effectiveness of mass media
campaigns in select markets, but anticipate that our primary marketing vehicle
will continue to be direct mailings. We believe that our current marketing
strategy is the most productive and cost effective manner to increase customer
visits. We currently have a customer transaction database containing
information on approximately 36.0 million household member accounts, which
enables targeted marketing based on historical usage patterns.
Beginning in the fourth quarter of 2003, we increased our advertising budget
for Game Crazy stores in an attempt to capture market share and to support the
new stores. A majority of our Game Crazy advertising is in mass mail
distributions and newspaper free-standing inserts.
INVENTORY AND INFORMATION MANAGEMENT
Inventory Management
We maintain detailed information on inventory utilization. Our information
systems enable us to track rental activity by individual videocassette, DVD and
video game to determine appropriate buying, distribution, pricing and
disposition of inventory, including the sale of previously viewed product. Our
inventory of videocassettes, DVDs and video games for rental is prepared
according to uniform standards. Each new DVD, videocassette and video game is
removed from its original carton, bar coded, and placed in a rental case with a
magnetic security device. Our Game Crazy stores utilize their own independent
inventory system with enhanced functionality that allows us to manage used
product trade-in credit values and retail pricing based upon multiple factors
such as age and current inventory levels. Game Crazy's point-of-sale system
provides us with sufficient detail to manage our breadth of titles and maintain
in-stock positions with frequent replenishment cycles. The inventory system
also permits us to match supply with demand title by title, adjust ordering,
transfer inventories from one store location to another and actively manages
new and used title pricing.
Information Management
We use a scalable client-server system and maintain three distinct system
areas: point-of-sale systems for Hollywood Video and Game Crazy and a corporate
information system. We maintain information, updated daily, regarding revenue,
current and historical rental and sales activity, demographics of store
membership, individual customer history, as well as DVD, videocassette and
video game rental patterns. This system allows us to measure our current
performance, manage inventory, make purchasing decisions and manage labor
costs. This system has the ability to continue to improve customer service,
operational efficiency, and management's ability to monitor critical
performance factors.
COMPETITION
The video retail industry is highly competitive. We compete with local,
regional and national video retail stores, including Blockbuster and Movie
Gallery, and with mass merchants, mail-delivery video rental subscription
services, such as Netflix, supermarkets, pharmacies, convenience stores,
bookstores and other retailers, as well as with non-commercial sources such as
libraries.
We believe that the principal competitive factors in the video rental industry
are price, title selection, rental period, the number of copies of popular
titles available, store location and visibility, customer service and employee
friendliness, and convenience of store access and parking. Substantially all of
our stores compete with stores operated by Blockbuster, most in very close
proximity.
We also compete with cable, satellite, and pay-per-view television systems, in
which subscribers pay a fee to see a movie selected by the subscriber. As
digital cable and digital satellite services have continued to increase
penetration, consumers have been given more choices in their viewing of pay-
per-view movies and in some cases video-on-demand. We estimate that cable or
satellite is available in over 90 million households. These systems can offer
multiple channels dedicated to pay-per-view and in some cases video-on-demand,
allowing for companies to transmit a significantly greater number of movies to
homes at more frequently scheduled intervals throughout the day.
The video game industry is highly fragmented. With the possible exception of
Wal-Mart, we believe no major player holds more than a 20% share of the market,
leaving a significant opportunity for our Game Crazy stores to rapidly gain
market share. Video game software and hardware is typically sold through retail
channels, including specialty retailers, mass merchants, toy retail chains,
consumer electronic retailers, computer stores, regional chains, wholesale
clubs, via the Internet and through mail order. In addition, the used market is
offered in specialty retail chains that feature an educated game staff such as
GameStop and Electronics Boutique.
EMPLOYEES
As of December 31, 2003, we had approximately 27,900 employees, of whom 26,800
were in the retail stores and zone offices and the remainder in our corporate,
administrative and distribution centers. None of our employees are covered by
collective bargaining agreements. We consider our employee relations to be
excellent.
Video store managers report to district managers, who supervise the operations
of the stores. The district managers report to regional managers, who report
directly to the Vice President of Operations for each zone. The corporate
support staff periodically has meetings with zone personnel, regional managers,
district managers and store managers to review operations.
We have created a separate management infrastructure for Game Crazy including
store level operators who report to district managers, who in turn report to
regional managers. We have made a concerted effort to hire sales associates who
are game enthusiasts through our established recruiting and training process.
This is particularly important in the video game industry, which requires
product knowledge on a large and growing number of titles. We have attracted a
staff of dedicated gamers for our Game Crazy stores who provide attentive
customer service and possess knowledge of the industry.
SERVICE MARKS
We own United States federal registrations for the service marks "Hollywood
Video", "Hollywood Entertainment", "Hollywood Video Stores" and "Game Crazy".
We consider our service marks important to our continued success.
HISTORICAL INFORMATION
We file annual reports, quarterly reports, proxy statements and other
information with the Securities and Exchange Commission (SEC). You may read and
copy any materials we file with the SEC at the SEC's Public Reference Room at
450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
The SEC maintains an Internet site that contains our reports, proxy statements,
and other information. The SEC's Internet address is http://www.sec.gov.
We also make available free of charge through our Internet website our annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K and, if applicable, amendments to those reports as soon as reasonably
practical after we file such materials with the SEC
(http://hollywoodvideo.com/investors/SECfilings).
ITEM 2. PROPERTIES
As of December 31, 2003, Hollywood's stores by state are as follows:
HOLLYWOOD ENTERTAINMENT
NUMBER OF HOLLYWOOD VIDEO (HV)
AND GAME CRAZY (GC) STORES BY STATE
HV GC HV GC
--- --- --- ---
Alabama 13 - Nebraska 14 -
Arizona 57 32 Nevada 28 13
Arkansas 9 - New Hampshire 2 -
California 326 140 New Jersey 35 12
Colorado 36 14 New Mexico 11 -
Connecticut 16 3 New York 75 20
Delaware 2 - North Carolina 32 -
Florida 84 - North Dakota 3 1
Georgia 36 - Ohio 82 33
Idaho 14 4 Oklahoma 23 -
Illinois 90 51 Oregon 67 19
Indiana 41 16 Pennsylvania 76 18
Iowa 13 - Rhode Island 9 3
Kansas 14 - South Carolina 16 -
Kentucky 17 2 South Dakota 3 -
Louisiana 18 - Tennessee 37 15
Maine 2 - Texas 190 69
Maryland 31 12 Utah 37 13
Massachusetts 44 5 Virginia 42 19
Michigan 64 16 Washington 91 34
Minnesota 37 19 Washington, D.C. 2 -
Mississippi 9 - West Virginia 1 -
Missouri 35 5 Wisconsin 34 7
Montana 1 - Wyoming 1 -
Total Stores 1,920 595
Total States (excluding Washington, D.C.) 47 27
We lease all of our stores, corporate offices, distribution centers and zone
offices under non-cancelable operating leases. All of our stores have an
initial operating lease term of five to 15 years and most have options to renew
for between five and 15 additional years. Most of the store leases are "triple
net," requiring us to pay all taxes, insurance and common area maintenance
expenses associated with the properties.
Our corporate headquarters are located at 9275 Southwest Peyton Lane,
Wilsonville, Oregon, and consist of approximately 123,000 square feet of leased
space. The lease expires in November 2008. We currently lease space in three
distribution centers, two to primarily support Hollywood Video and a separate
facility to support Game Crazy. The Hollywood Video distribution centers are
located at 25600 Southwest Parkway Center Drive, Wilsonville, Oregon
(approximately 175,000 square feet) and at 501 Mason Road, LaVergne, Tennessee
(approximately 98,000 square feet). The Game Crazy facility is located at 9445
SW Ridder Road, Wilsonville, Oregon (approximately 84,000 square feet). All of
these facilities are leased pursuant to agreements that expire in November
2005, June 2010 and February 2008, respectively.
ITEM 3. 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. 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 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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no submissions of matters to a vote of security holders in the
fourth quarter of 2003.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning our executive
officers as of December 31, 2003:
Name Age Position
- ---------------------- --- ----------------------------------------
Mark J. Wattles 43 Chairman of the Board, Chief Executive
Officer, President and Director
F. Bruce Giesbrecht 44 General Manager of Corporate Operations
Roger J. Osborne 51 General Manager of Store Operations
Timothy R. Price 45 Chief Financial Officer
- ----------------------
Mark J. Wattles founded Hollywood in June 1988 and has served as a director,
Chairman of the Board, and Chief Executive Officer since that time. From June
1988 through September 1998, Mr. Wattles also served as President of Hollywood.
From August 1998 through June 2000, Mr. Wattles left his full time position at
Hollywood and served as CEO of Reel.com. In August 2000, Mr. Wattles returned
full time to Hollywood and in January 2001 was re-appointed President of
Hollywood by the Board. Mr. Wattles has been an owner and operator in the
video rental industry since 1985. In 2001, Mr. Wattles was appointed to the
National Advisory Council of the Marriot Business School at Brigham Young
University.
F. Bruce Giesbrecht was announced as the Company's President and Chief
Operating Officer on January 29, 2004. Mr. Giesbrecht was named Executive Vice
President of Business Development in March 2000 and became General Manager of
Corporate Operations in July 2003. Mr. Giesbrecht joined Hollywood in May 1993
as Vice President of Corporate Information Systems and Chief Information
Officer, was named Senior Vice President of Product Management in January 1996
and became Senior Vice President of Strategic Planning in January 1998. Prior
to joining Hollywood Mr. Giesbrecht was a founder of RamSoft, Inc., a software
development company specializing in management systems for the video industry,
and served as its President.
Roger J. Osborne was named Executive Vice President of Operations in October
2000 and became General Manager of Store Operations in July 2003. Prior to
being named Senior Vice President of Operations at Hollywood in January 1999,
he was the Executive Vice President of J. Baker, Corporation, a major apparel
and footwear retailer, and President of its Work `N Gear Division since June
1997. Before rejoining J. Baker Corporation, Mr. Osborne was Senior Vice
President and Zone Director for Mid-West and East coast markets for Hollywood
from November 1996 until May of 1997. From 1993 until 1996, Mr. Osborne worked
for J. Baker, Corporation, serving as Senior Vice President and Director of its
licensed shoe department business from January 1995 to November 1996. Mr.
Osborne served in executive capacities with Bata Shoe Company from 1988 until
1993 and with the Payless Shoe Store division of May Company from 1975 until
1988.
Timothy R. Price joined Hollywood in January 2003 as Senior Vice President of
Finance and was named Chief Financial Officer in July 2003. Prior to joining
Hollywood, Mr. Price was with May Company for four years holding the positions
of Chief Financial Officer for Robinson's-May from 2000 to 2002 and Vice
President and Controller of Hecht's from 1998 to 2000. Prior to the May
Company, Mr. Price served as Vice President and Controller of Kohl's from 1996
to 1998 and held a variety of financial executive positions at the Limited from
1988 to 1996.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
We have not paid any cash dividends on our common stock since our initial
public offering in July 1993 and anticipate that future earnings will be
retained for the development of our business. Loan covenants contained in our
bank credit facilities and senior subordinated notes limit the amount of
dividends we may pay and the amount of stock we may repurchase (see
Management's Discussion and Analysis of Results of Operations and Financial
Condition under the caption "Liquidity and Capital Resources"). Our common
stock is traded on the Nasdaq National Market ("Nasdaq") under the symbol
"HLYW". The following table sets forth the quarterly high and low sales prices
per share, as reported on Nasdaq.
2003 2002
----------------------------------------
Quarter High Low High Low
------- ------- ------ -------- -------
Fourth $17.97 $12.35 $20.19 $14.30
Third 18.65 15.60 20.15 12.83
Second 18.18 15.75 20.72 17.08
First 16.26 12.59 17.70 11.35
As of March 9, 2004, there were 177 holders of record of our common stock, and
no shares of preferred stock were issued and outstanding.
ITEM 6. SELECTED FINANCIAL DATA
The information presented below for, and as of the end of, each of the fiscal
years in the five-year period ended December 31, 2003 is derived from our
audited financial statements. The following information should be read in
conjunction with "Management's Discussion and Analysis of Results of Operation
and Financial Condition," including a discussion of critical accounting
policies that require significant management estimates, judgments and
assumptions.
Except as otherwise noted, the information in the table below reflects, among
other things, operating losses incurred by Reel.com in 1999 through June 12,
2000, when we discontinued its e-commerce operations.
Year Ended December 31,
---------------------------------------------------------
2003 2002 2001 2000 1999
--------- ---------- ---------- ---------- ----------
OPERATING RESULTS:
Revenue $1,682,548 $1,490,066 $1,379,503 $1,296,237 $1,096,841
--------- ---------- ---------- ---------- ----------
Income (loss) from
operations 185,094 189,327 119,277 (436,321) (2,513)
--------- ---------- ---------- ---------- ---------
Interest expense, net 35,507 42,057 56,129 62,127 45,477
--------- ---------- ---------- ---------- ---------
Income (loss) before
cumulative effect
of a change in
accounting principle 82,272 241,845 100,416 (530,040) (49,858)
--------- ---------- ---------- ---------- ---------
Net income (loss)(1) 82,272 241,845 100,416 (530,040) (51,302)
--------- ---------- ---------- ---------- ---------
Net income (loss)
per share before
cumulative effect
of a change in
accounting principle:
Basic $ 1.36 $ 4.23 $ 2.05 $(11.48) $(1.09)
Diluted 1.28 3.88 1.90 (11.48) (1.09)
---------- ---------- ---------- --------- ---------
Net income (loss)
per share:
Basic $ 1.36 $ 4.23 $ 2.05 $(11.48) $(1.13)
Diluted 1.28 3.88 1.90 (11.48) (1.13)
---------- ---------- ---------- --------- ---------
- ------------------------------------------------------------------------------
BALANCE SHEET DATA:
Rental inventory, net $268,748 $260,190 $191,016 $168,462 $339,912
Property and
equipment, net 288,857 255,497 270,586 323,666 382,345
Total assets 997,457 1,146,376 718,544 665,114 1,053,291
Long-term
obligations(2) 371,316 388,746 514,002 536,401 533,906
Shareholders' equity
(deficit) 325,829 257,149 (113,554) (222,377) 304,529
- ------------------------------------------------------------------------------
Year Ended December 31,
-------------------------------------------------------
2003 2002 2001 2000 1999
---------- ---------- ---------- --------- --------
OPERATING DATA:
Number of stores at
year end 1,920 1,831 1,801 1,818 1,615
Weighted average stores
open during the year 1,852 1,805 1,813 1,751 1,405
Number of Game Crazy
stores at year end 595 276 69 69 67
Weighted average Game
Crazy stores open
during the year 469 97 69 68 20
Same store
revenue increase (3) 11% 8% 6% 2% 12%
- ----------------------------------------------------------------------------
(1) We adopted Statement of Financial Accounting Standards No. 142 on
January 1, 2002, and concurrently ceased to amortize goodwill recorded in
connection with prior business combinations and our trade name rights.
See Note 8 to the Consolidated Financial Statements. Excluding
amortization of these intangible assets would have reduced our net loss or
increased our net income by $3.1 million, $29.9 million and $54.7 million,
respectively, for the years ended December 31, 2001, 2000 and 1999.
(2) Includes the current portion of long-term obligations. For the year ended
December 31, 2002, excludes $203.9 million of our 10.625% senior
subordinated notes that were called on December 18, 2002 and redeemed on
January 17, 2003.
(3) A store is comparable after it has been open and owned by the Company
for 12 full months. An acquired store converted to the Hollywood Video
name store design is removed from the comparable store base when the
conversion process is initiated and returned 12 full months after
reopening. In the fourth quarter of 2003, the Company began to report
comparable revenue increases for each of its two segments, Hollywood Video
and Game Crazy. For 2003, same store sales for Hollywood Video was 3%
while same store sales for Game Crazy was 16%.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
ABOUT HOLLYWOOD ENTERTAINMENT
We are the second largest rental retailer of DVDs, videocassettes and video
games in the United States. We opened our first video store in October 1988
and, as of December 31, 2003, we operated 1,920 Hollywood Video stores in 47
states and the District of Columbia. As of December 31, 2003, we also operated
595 Game Crazy stores, which are game specialty stores where game enthusiasts
can buy, sell and trade new and used video game hardware, software and
accessories. A typical Game Crazy store carries over 2,500 video game titles
and occupies an area of approximately 700 to 900 square feet adjacent to a
Hollywood Video store. Hollywood Video stores accounted for 89% of consolidated
revenue in 2003 while Game Crazy contributed 11%.
Hollywood Video derives 92% of its revenue from rentals of DVD and VHS movies
and video games and from the sale of previously viewed movies and games. The
remaining 8% of Hollywood Video's revenue is from the sale of new DVD and VHS
movies and concessions. Although domestic consumer rental spending has remained
fairly flat over the past five years, Hollywood Video stores have been able to
generate positive same store sales by taking market share. We believe we can
continue to take market share as the rental industry is still highly
fragmented. We estimate approximately half of the market share remains divided
amongst a relatively large number of smaller independent and regional
operators. The studio's current movie distribution practice provides an
exclusive window for DVD and VHS retail channels before the movies are
available to pay-per view, video-on-demand and other distribution channels.
Changes in the studio distribution practice or changes in pricing of movies
could negatively impact our business. For a discussion of risks inherent to
rental retailers in general and Hollywood video in particular, please see
"Cautionary Statements".
Game Crazy generates revenue from the sale of new and used game software,
hardware and accessories. The video game industry, an approximately $10 billion
market in the United States in 2003 according to NPD Group, Inc., has
historically experienced peaks and valleys in consumer spending dependent upon
the availability of new technology. In 2000 and 2001, Sony's PlayStation 2,
Nintendo's GameCube and Microsoft's Xbox, three new-generation hardware
technology products, were introduced. These platforms have substantially
increased the installed base of video game hardware units and have driven
significant growth in the video game software segment. As with the introduction
of previous new platforms, consumers have increased both their purchase and
rental of games. Buying, selling and trading used games is relatively new and
has caused the used game category to grow rapidly for certain specialty
retailers. Each new platform introduction has increased trade-ins of used
titles compatible with legacy hardware, which in turn extends the life of older
platforms by enabling the game consumer access to additional software titles
through the used market.
Our strategy is to successfully build and operate two separately managed
national chains, each with a retail model designed to compete favorably against
the primary competitors in its segment of the entertainment industry. The
Hollywood Video retail model, including the types of real estate sites we
pursue, the store design, employee hiring and training practices, and inventory
and merchandising standards, is designed to maximize the number of customers
per store, as well as the frequency of customer visits and the amount that
consumers spend per visit. Hollywood Video stores are typically located in
high-traffic, high-visibility locations with convenient access and parking.
Inside the store, we focus on providing a superior selection of movies and
video games for rent, in a friendly and inviting atmosphere that encourages
browsing. We believe that consumers view movie rentals in general, and our
pricing structure and rental terms in particular, as a convenient form of
entertainment and an excellent value. Our Game Crazy retail model, including
the core concept of allowing consumers to buy, sell and trade new and used
merchandise, combined with store design, employee selection and training, and
our inventory selection and merchandising presentation, is designed to appeal
to both "hard-core" and casual game consumers. Remerchandising a Hollywood
Video in order to accommodate a Game Crazy, including reducing its size, does
not cannibalize Hollywood Video revenue. Further, we believe that there is
significant customer overlap, enabling the Hollywood Video and Game Crazy
retail models to complement each other, allowing each of the concepts to have a
competitive advantage versus its primary competitor.
We analyze operating results by segment, Hollywood Video and Game Crazy. Key
indicators used in running our business include total revenue growth, same
store sales, gross margin rates, inventory levels, and operating expenses in
dollars and as percentage of revenue. We also assess rental revenue performance
by product type, DVD, VHS and games. Our operating results are subject to the
application of critical accounting policies as discussed in "Critical
Accounting Policies and Estimates." These policies require management to make
significant estimates, judgements and assumptions that are subject to
uncertainties that may change as additional information becomes known.
RESULTS OF OPERATIONS
Summary Results of Operations
Our income from operations for 2003 was $185.1 million compared to $189.3
million for 2002. The decrease was primarily due to operating losses incurred
by Game Crazy for 2003 and a $12.4 million reversal of an accrual related to
the closure of our former internet business, Reel.com, that benefited income
from operations for 2002. For 2003, Hollywood Video generated $205.1 million in
income from operations while Game Crazy generated a net loss from operations of
$20.0 million.
Our net income for 2003 was $82.3 million compared with net income of $241.8
million and $100.4 million for 2002 and 2001, respectively. The decrease in net
income was primarily the result of a change in our provision for income taxes.
Net income for 2002 and 2001 benefited from a reduction in our valuation
allowance on our deferred income tax assets, resulting in an income tax benefit
of $98.1 million and $37.3 million, respectively. We believe that an effective
tax rate of 40.5% would have represented a normalized provision for income
taxes excluding the valuation allowance reductions. The effective tax rate for
2003 was 40.0%. Also contributing to the decrease in net income for 2003 was a
$12.5 million charge recorded in the first quarter of 2003 for early debt
retirement compared to an early debt retirement charge in the first quarter of
2002 of $3.5 million.
Results of Operation Expressed as a Percentage of Revenue
The following table sets forth (i) results of operations data expressed as a
percentage of total revenue and (ii) gross margin data.
Year Ended December 31,
------------------------------
2003 2002 2001
-------- -------- --------
Revenue:
Rental product revenue 82.4% 88.9% 92.2%
Merchandise sales 17.6% 11.1% 7.8%
-------- -------- --------
100.0% 100.0% 100.0%
-------- -------- --------
Gross margin 60.5% 61.5% 60.5%
Operating costs and expenses:
Operating and selling 43.0% 43.5% 45.0%
General and administrative 6.3% 6.0% 7.0%
Store opening expense 0.3% 0.2% -
Restructuring charge for closure
of internet business 0.0% (0.8%) (0.2%)
Restructuring charge for store
closures (0.1%) (0.1%) (0.3%)
Amortization of intangibles - - 0.4%
-------- -------- --------
49.5% 48.8% 51.9%
-------- -------- --------
Income from operations 11.0% 12.7% 8.6%
Interest expense, net (2.1%) (2.8%) (4.0%)
Early debt retirement (0.7%) (0.2%) -
-------- -------- --------
Income before income taxes 8.2% 9.7% 4.6%
(Provision for) benefit from income
taxes (3.3%) 6.5% 2.7%
-------- -------- --------
Net income 4.9% 16.2% 7.3%
======== ======== ========
Year Ended December 31,
---------------------------
2003 2002 2001
-------- ------- -------
Other data:
Rental product gross margin (1) 68.2% 66.2% 63.9%
Merchandise sales gross margin (2) 24.4% 24.0% 21.0%
- -------------------------------------------------------------
(1) Rental product gross margin as a percentage of rental product revenue.
(2) Merchandise sales gross margin as a percentage of merchandise sales.
REVENUE
Revenue increased by $192.5 million, or 12.9%, for 2003 compared to 2002. The
increase was primarily due to a 3% increase in Hollywood Video same store
sales, the addition of 102 Hollywood Video stores and 319 Game Crazy stores and
a 16% increase in Game Crazy same store sales. Revenue increased by $110.6
million, or 8.0%, for 2002 compared to 2001. The increase was primarily due to
a 6% increase in Hollywood Video same store sales and the addition of 41
Hollywood Video stores and 207 Game Crazy stores.
The following is a summary of revenue by product category and operating segment
(in thousands):
---------- ---------- ----------
2003 2002 2001
---------- ---------- ----------
DVD rental product revenue $ 763,352 $ 480,177 $ 228,245
VHS rental product revenue 504,181 727,347 942,056
Game rental product revenue 119,057 116,493 101,093
---------- ---------- ----------
Total rental product revenue 1,386,590 1,324,017 1,271,394
---------- ---------- ----------
Video store merchandise revenue 115,826 109,382 81,143
Game Crazy revenue 180,132 56,667 26,966
---------- ---------- ----------
Total merchandise revenue 295,958 166,049 108,109
---------- ---------- ----------
---------- ---------- ----------
Total revenue $1,682,548 $1,490,066 $1,379,503
========== ========== ==========
Rental revenue is generated from the rental of DVD and VHS movies and video
games and from the eventual sale of previously viewed movies and games. We
currently offer a 5-day rental program on all products in the majority of our
stores. All DVDs and new release VHS movies typically rent for $3.79. Catalog
VHS movies typically rent for $1.99. Since the fourth quarter of 1999, we have
not increased prices on DVDs, new release VHS or catalog VHS. Video games rent
for $4.99 and $5.99, with games designed for the newer platforms renting for
the higher amount. Customers who choose not to return movies within the
applicable rental period are deemed to have commenced a new rental period of
equal length at the same price. Revenue recorded for extended rental periods is
net of estimated amounts that we do not anticipate collecting based upon
historical collection experience. The percentage of rental revenues generated
from extended rental periods has not changed significantly in several years.
Game Crazy revenue represented 60.9% of consolidated merchandise revenue for
2003. Game Crazy revenue is generated from the sale of new and used video game
hardware, software and accessories. The remaining 39.1% of merchandise revenue
was generated in Hollywood Video stores through the sale of new DVD and VHS
movies and concessions.
GROSS MARGIN
Rental Product Margins
Rental gross margin as a percentage of rental revenue increased to 68.2% for
2003 from 66.2% for 2002 and 63.9% for 2001. The increase for 2003 compared to
2002 was primarily due to a shift in revenue from VHS product to DVD product,
which typically has higher gross margins. The increase for 2002 compared to
2001 also benefited from increased DVD revenue as well as the absence of
incremental amortization that was recorded in 2001 associated with an
amortization change in estimate. The Company regularly evaluates and updates
rental inventory accounting estimates. Effective October 1, 2002, estimated
average residual values on new release movies was reduced from $4.67 to $4.00
for DVD and from $3.16 to $2.00 for VHS. In addition, the estimated residual
value of catalog DVD inventory was reduced from $6.00 to $4.00. These changes
resulted in a $4.1 million increase in cost of rental product in 2002. We also
made several key observations that led us to change estimates regarding rental
inventory lives and residual values during the fourth quarter of 2000. As a
result of the growing demand for DVDs, the estimated residual value of catalog
VHS cassettes was reduced from $6.00 to $2.00 and the estimated useful life was
reduced from five years to one year. We adopted the changes in estimate
prospectively on October 1, 2000, and recorded a charge of $164.3 million. By
applying these changes prospectively, we also recorded incremental depreciation
expense of approximately $52 million and $18 million in the fourth quarter of
2000 and in the first three quarters of 2001, respectively.
Merchandise Sales Margins
Merchandise sales gross margin as a percentage of merchandise sales increased
to 24.4% for 2003 from 24.0% for 2002 and 21.0% for 2001. The increase is
primarily the result of an increase in the percentage of merchandise sales from
Game Crazy and Hollywood Video's concessions business, which typically have
higher margins than new movie sales in Hollywood Video. In 2003, Game Crazy
revenue accounted for 60.9% of consolidated merchandise revenue with a gross
margin rate of 24.7%, while Hollywood Video accounted for the remainder with a
gross margin rate of 24.0%.
OPERATING COSTS AND EXPENSES
Operating and Selling Expenses
Total operating and selling expenses for 2003 decreased as a percentage of
revenue to 43.0% from 43.5% for 2002. The percentage decrease was primarily the
result of leverage from increased revenue. Total operating and selling expense
for 2003 increased $76.4 million to $724.1 million from $647.8 million for
2002. The increase was primarily the result of increased variable costs
associated with increased store revenue, an increase of 47 weighted-average
stores and an increase in operating and selling expenses associated with the
expansion of our Game Crazy stores. Payroll and related expenses increased by
$40.0 million, rent and related expenses increased by $15.4 million,
advertising increased by $11.7 million, and other operating and selling
expenses increased by $9.3 million for 2003 compared to 2002.
Total operating and selling expenses for 2002 decreased as a percentage of
revenue to 43.5% from 45.0% for 2001. The percentage decrease was primarily the
result of leverage from increased revenue. Total operating and selling expense
for 2002 increased $26.5 million to $647.8 million from $621.3 million for
2001. The increase was primarily the result of increased variable costs
associated with increased store revenue and an increase in operating and
selling expenses associated with the expansion of Game Crazy stores. Payroll
and related expenses increased by $23.1 million and other operating and selling
expenses increased by $3.4 million for 2002 compared to 2001.
General and Administrative Expenses
General and administrative expenses for 2003 increased $16.4 million to $106.0
million, or 6.3% of total revenue, from $89.6 million, or 6.0% of total revenue
for 2002. Included in general and administrative expenses for 2003 was a $1.7
million charge recognized in the first quarter to increase a class action
litigation settlement reserve related to extended rental periods. General and
administrative expenses for 2002 benefited from the net reversal of
approximately $1.6 million of non-cash stock option expense. The $1.6 million
benefit reflects stock option expense of $2.9 million recorded in the first,
second and fourth quarters and a net reversal of expense of $4.5 million
recorded in the third quarter primarily associated with the cancellation of
stock options subject to variable plan accounting. General and administrative
expenses for 2002 also benefited from the reversal of a legal accrual in the
amount of $1.6 million, as a result of the final confirmation of the settlement
of our California exempt/non-exempt class action lawsuit for an amount less
than anticipated. Excluding these items, general and administrative expenses as
a percentage of total revenue were consistent for 2003 and 2002.
General and administrative expenses for 2002 decreased $6.8 million to $89.6
million, or 6.0% of total revenue, from $96.4 million, or 7.0% of total revenue
for 2001. General and administrative expenses for 2002 benefited from the net
reversal of approximately $1.6 million of non-cash stock option expense and
also benefited from a $1.6 million reversal of a legal accrual. Included in
general and administrative expenses in 2001 were $4.8 million of non-cash
compensation expense related to a stock grant to our Chief Executive Officer as
part of a three-year employment agreement. Also included was $4.1 million of
non-cash stock compensation associated with other grants under our stock option
plans. Excluding these items, general and administrative expenses as a
percentage of total revenue declined slightly in 2002 as compared 2001.
NON-OPERATING INCOME (EXPENSE), NET
Interest Expense
Interest expense, net of interest income, decreased in 2003 as compared to 2002
by $6.6 million. The reduction was primarily due to decreased borrowing levels
and lower interest rates (see Note 13 to our consolidated financial statements
for a description of our outstanding debt). Interest expense, net of interest
income, decreased in 2002 as compared to 2001 by $14.1 million. The reduction
was primarily due to decreased levels of revolving credit borrowings and lower
interest rates offset by incremental interest for bonds issued on December 18,
2002.
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 an 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% in 2003, compared to a benefit
of 68.3% in 2002 and a benefit of 59.0% in 2001, which varies from the federal
statutory rate as a result of adjustments to deferred tax asset valuation
allowances, non-deductible executive compensation, non-deductible goodwill
amortization associated with the Reel.com acquisition and state income taxes.
We anticipate an effective tax rate of 40.0% for 2004. In the fourth quarter of
2000, in light of significant doubt that existed regarding our future income
and therefore our ability to use our net operating loss carryforwards, we
recorded a $211.2 million valuation allowance on our $211.2 million net
deferred tax asset. In 2002 and 2001, as a result of our operating performance
for each year, as well as anticipated future operating performance, we
determined that it was more likely than not that certain future tax benefits
would be realized. Consequently, we benefited by the reversal of $147.8 million
and $63.4 million of the valuation allowance in 2002 and 2001, respectively. In
the fourth quarter of 2003 we applied for a change in accounting method with
the Internal Revenue Service (IRS) to accelerate the deduction of store pre-
opening supplies and the amortization of DVD and VHS movies and video games.
The application is under review by the IRS. Based on internal forecasts and
utilization of our net operating loss carryforwards, we do not anticipate
significant cash tax payments until 2005.
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
dollar amount of new releases held as rental inventory on our consolidated
balance sheet. Under revenue sharing, in exchange for acquiring agreed-upon
quantities of DVDs or tapes at reduced or no up-front costs, we share agreed-
upon portions of the revenue that we derive from the DVDs or tapes 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 rental product 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 $88.8 million for 2003, compared to $130.4 million
for 2002 and $191.3 million for 2001. 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 in Hollywood Video stores consists of new DVD and VHS
movies for sale, concessions and accessory items for sale, 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 in our Game Crazy stores consist of new and used game software,
hardware and accessories.
Consolidated merchandise inventory increased $32.6 million to $129.9 million as
of December 31, 2003, from $97.3 million as of December 31, 2002. The increase
was primarily due to the addition of 319 Game Crazy stores in 2003 and an
increase in the breadth and depth of games at existing Game Crazy stores.
LIQUIDITY AND CAPITAL RESOURCES
Overview
Our primary source of operating cash flow is generated from the rental and
sales of DVDs, videocassettes and games. The amount of cash generated from our
video store operations in 2003 funded our debt service requirements,
maintenance capital expenditures, and Game Crazy operating losses and provided
the capital required to add 319 Game Crazy stores and 102 Hollywood Video
stores. At December 31, 2003, we had $74.1 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 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, including our expansion plans discussed below in
"Cash Used in Investing Activities." 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 $390.8 million and $361.6 million
for 2003 and 2002, respectively. The increase of $29.2 million or 8.1% was
primarily due to an increase in income from operations in our Hollywood Video
stores and favorable changes in working capital accounts, offset by operating
losses incurred by our Game Crazy stores.
Cash Used in Investing Activities
Net cash used in investing activities was $98.8 million and $551.6 million for
2003 and 2002, respectively. Net cash used in investing activities for 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 2003, we opened 102
Hollywood Video stores, of which 20 included a Game Crazy, and remerchandised
299 stores to include a Game Crazy compared to opening 41 Hollywood Video
stores and remerchandising 203 stores to include Game Crazy in 2002. We
currently anticipate investing approximately $105 million in 2004 to open 150
Hollywood Video stores, of which approximately 40 may include a Game Crazy, to
remerchandise 110 existing Hollywood Video stores to include a Game Crazy, and
for maintenance capital expenditures in property and equipment. We regularly
consider new business initiatives that would enhance, expand, or complement our
position in the entertainment industry. Some of those under consideration, such
as in-store subscription services and mail delivery rental services, are
closely related to our existing business. Any initiative undertaken could
require significant capital investment, could be unsuccessful, or, even if
successful, could have a short-term adverse impact on our financial condition
and operating results.
Cash Used in Financing Activities
Net cash flow from financing activities was a $251.0 million use of cash for
2003 compared to a $184.4 million source of cash in the corresponding period of
the prior year. The $251.0 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 1,746,173 shares of common
stock for $26.3 million and $55.0 million for prepayment of term loan facility
principal payments through 2005. In January 2004, we paid an additional $20
million on the term loan facility, and are now prepaid through 2006 and we also
repurchased 295,139 shares of common stock for $3.7 million.
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 principal amount of
our 10.625% senior subordinated notes due 2004 on February 18, 2003 and for
general corporate purposes. We have prepaid $75.0 million of the term loan
facility principal payments due through 2006, including a $20.0 million payment
made on January 5, 2004.
Instruments governing our indebtedness contain various covenants, including
covenants requiring us to meet specified financial ratios and tests and
covenants that restrict our business including our ability to pay dividends and
limitations on the amount of common stock we can repurchase. At December 31,
2003, we were in compliance with all covenants contained within our debt
agreements.
At December 31, 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
- ------------ ---------- ---------- --------- ---------
2004 $ - $ - $ 647 $ 647
2005 - - 454 454
2006 - 20,000(1) 215 20,215
2007 - 20,000 - 20,000
2008 - 105,000 - 105,000
Thereafter 225,000 - - 225,000
---------- ---------- --------- ---------
$ 225,000 $ 145,000 $ 1,316 $ 371,316
---------- ---------- --------- ---------
(1)Paid on January 5, 2004.
Contractual Obligations
Our contractual obligations consist of long-term debt, operating leases
(primarily store leases) and capital leases. We lease all of our stores,
corporate offices, distribution centers and zone offices under non-cancelable
operating leases. All of our stores have an initial operating lease term of
five to 15 years and most have options to renew for between five and 15
additional years. Contractual obligations as of December 31, 2003 are as
follows (in thousands):
Contractual 2-3 4-5 More than
Obligations Total 1 Year Years Years 5 Years
- --------------- ---------- -------- -------- -------- ---------
Long-term Debt $ 370,000 $ - $ 20,000 $125,000 $ 225,000
Capital Leases 1,316 647 669 - -
Operating Leases 1,355,531 237,821 438,057 318,519 361,134
---------- -------- -------- -------- ---------
Total $1,726,847 $238,468 $458,726 $443,519 $ 586,134
---------- -------- -------- -------- ---------
Other Financial Measurements: Working Capital
At December 31, 2003, we had cash and cash equivalents of $74.1 million and a
working capital deficit of $33.6 million. The working capital deficit is
primarily the result of the accounting treatment of rental inventory. Rental
inventories are accounted for as non-current assets under GAAP because they are
not assets that 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.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Revenue Recognition
We recognize revenue upon the rental and sale of our products. Rental revenue
for extended rental periods (when the customer chooses to keep the product
beyond the original rental period) is recognized when the extended rental
period begins. Revenue recorded for extended rental periods is net of estimated
amounts that we do not anticipate collecting based upon historical collection
experience. We continuously monitor actual collections. Estimates are revised
when we believe it is appropriate in light of actual collection rates and other
relevant circumstances. Historically, actual collections have approximated the
related net revenue recorded. However, if actual collections in the future are
less than the related net revenue recorded, our results of operations would be
adversely affected.
Merchandise Inventory Valuation
Merchandise inventories, consisting primarily of new and used video game
software and hardware, new DVD and VHS movies and concessions, are stated at
the lower of cost or market. We consider several factors in our assessment of
market value including age and inventory turns. Due to the numerous variables
associated with the judgments and assumptions we make in estimating market
values, and the effects of changes in circumstances affecting these estimates
(including the effects of competing products and technologies), both the
precision and reliability of the resulting estimates are subject to substantial
uncertainties and, as additional information becomes known, we may change our
estimates significantly.
Amortization of Rental Inventory
Rental inventory, which includes DVD and VHS movies and video games, is stated
at cost and amortized over its estimated useful life to an estimated residual
value. We analyze several metrics to validate our estimates such as inventory
turns, previously viewed product sales and average inventory levels per store
among many other variables. Our estimates of useful lives and residual values
affect the amounts of amortization recorded, which in turn affects the carrying
value of our rental inventory and cost of rental product (and, upon the
transfer of previously viewed items from rental inventory to merchandise
inventory, the carrying value of our merchandise inventory). For new release
movies acquired for rental under revenue sharing arrangements, the studios'
share of rental revenue is expensed as revenue is earned net of average
estimated residual values. DVDs, tapes and video games acquired for rental at
fixed prices are amortized to estimated residual values in periods ranging from
four months to five years for DVD library. Due to the numerous variables
associated with the judgments and assumptions we make in estimating useful
lives and residual values of these items, and the effects of changes in
circumstances affecting these estimates (including the effects of competing
products and technologies and actual selling prices obtainable for previously
viewed product), both the precision and reliability of the resulting estimates
are subject to substantial uncertainties and, as additional information becomes
known, we may change our estimates significantly. For example, in the fourth
quarter of 2000, a number of observations led us to change our estimates of
rental inventory lives and residual values, which resulted in a $164.3 million
increase to amortization expense in that quarter. More recently, in the fourth
quarter of 2002, our updated estimates resulted in a $4.1 million increase in
cost of rental.
Impairment of Long-Lived Assets and Goodwill
We review long-lived assets and goodwill for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. We periodically review and monitor our internal management
reports for indicators of impairment. We consider a trend of unsatisfactory
operating results that are not in line with management's expectations to be a
primary indicator of potential impairment. When an indicator of impairment is
noted, assets are evaluated for impairment at the lowest level for which there
are identifiable cash flows (e.g. at the store level). We deem a store to be
impaired if a forecast of undiscounted future operating cash flows directly
related to the store, including estimated disposal value, if any, is less than
the asset carrying amount. If a store is determined to be impaired, the loss is
measured as the amount by which the carrying amount on our balance sheet of the
store exceeds its fair value. Fair value is estimated using a discounted future
cash flow valuation technique similar to that used by management in making a
new investment decision. Considerable management judgment and assumptions are
necessary to estimate discounted future cash flows. Due to the numerous
variables associated with our judgments and assumptions relating to the
valuation of our assets in these circumstances, and the effects of changes in
circumstances affecting these valuations, both the precision and reliability of
the resulting estimates of the related impairment charges are subject to
substantial uncertainties and, as additional information becomes known, our
estimates may change significantly.
Income Taxes
We calculate income taxes in accordance with SFAS No. 109, "Accounting for
Income Taxes," which requires recognition of deferred tax assets and
liabilities for the expected future tax consequences of events that have been
included in our financial statements and tax returns. Valuation allowances are
established when necessary to reduce deferred tax assets, including temporary
timing differences and net operating loss carryforwards, to the amount expected
to be realized in the future. Deferred assets and liabilities are measured
using enacted tax rates in effect for the year in which those temporary
differences are expected to be recovered or settled. In the fourth quarter of
2000, in light of significant doubt that existed regarding our future income
and therefore our ability to use our net operating loss carryforwards, we
recorded a $211.2 million valuation allowance on our $211.2 million net
deferred tax asset. In 2001 and 2002, as a result of our operating performance
for each year, as well as anticipated future operating performance, we
determined that it was more likely than not that certain future tax benefits
would be realized. We therefore reversed $63.4 million and $147.8 million of
this valuation allowance in 2001 and 2002, respectively, which resulted in a
corresponding increase in net income and corresponding increases/decreases in
our shareholders' equity/deficit. While changes in the valuation allowance have
no effect on the amount of income tax we pay or on our cash flows, the effects
on our reported income and shareholders' equity may be viewed by some investors
and potential lenders as significant. Due to the numerous variables associated
with our judgments, assumptions and estimates relating to the valuation of our
deferred tax assets, and the effects of changes in circumstances affecting
these valuations, both the precision and reliability of the resulting estimates
are subject to substantial uncertainties and, as additional information becomes
known, we may change our estimates significantly.
Legal Contingencies
Our estimates of our loss contingencies for legal proceedings are based on
various judgments and assumptions regarding the potential resolution or
disposition of the underlying claims and associated costs. Due to the numerous
variables associated with these judgments and assumptions, both the precision
and reliability of the resulting estimates of the related loss contingencies
are subject to substantial uncertainties. We regularly monitor our estimated
exposure to these contingencies with formal meetings between our Chief
Financial Officer and internal legal counsel and, as additional information
becomes known, we may change our estimates significantly.
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note 1 to the Consolidated Financial Statements for a discussion of
recently issued accounting standards and the impact they may have on the
financial condition or results of operations.
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, that involve
substantial risks and uncertainties and which are intended to be covered by the
safe harbors created thereby. These statements can be identified by the fact
that they do not relate strictly to historical information and include the
words "expects", "believes", "anticipates", "plans", "may", "will", "intend",
"estimate", "continue" or other similar expressions. These forward-looking
statements are subject to various risks and uncertainties that could cause
actual results to differ materially from those currently anticipated. These
risks and uncertainties include, but are not limited to, items discussed below
under the heading "Cautionary Statements." Forward-looking statements speak
only as of the date made. We undertake no obligation to publicly release or
update forward-looking statements, whether as a result of new information,
future events or otherwise. You are, however, advised to consult any further
disclosures we make on related subjects in our quarterly reports on Form 10-Q
and any reports made on Form 8-K to the Securities and Exchange Commission.
CAUTIONARY STATEMENTS
We are subject to a number of risks that are particular to our business and
that may or may not affect our competitors. We describe some of these risks
below. If any of these risks materialize, 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. We also
compete with Internet-based mail-delivery video rental subscription services,
such as Netflix. 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 DVDs and/or videocassettes could
adversely affect our revenues and profit margins.
Movie studios use various pricing models to maximize the revenues they receive
from the home video industry. Historically, these pricing models have enabled a
profitable video rental market to exist and compete effectively with mass
merchant 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 or other arrangements, or decreases
wholesale prices leading consumers to purchase movies instead of renting
movies, our revenues and/or profit margin could decrease, and our business,
financial condition, liquidity and results of operations could 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. We currently anticipate
that hardware manufactures will release new products with enhanced features
some time in 2006. 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 and new business initiatives have placed and may
continue to 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 the second half of 2002 we began an
accelerated rollout of our Game Crazy stores, stores within our Hollywood Video
stores that specialize in selling and trading video games, opening 207 new
stores. In 2003 we added 319 Game Crazy stores and opened 102 Hollywood Video
stores and we anticipate adding additional Game Crazy stores and opening
additional Hollywood Video stores in 2004 and beyond. 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
stores, 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 also regularly consider new business initiatives that would enhance, expand,
or complement our position in the entertainment industry. Some of those under
consideration, such as in-store subscription services and mail delivery rental
services, are closely related to our existing business. Any initiative
undertaken could require significant capital investment, could be unsuccessful,
or, even if successful, could have a short-term adverse impact on our financial
condition and operating results.
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 DVD, videocassette and video game to determine
appropriate buying, distribution and disposition of DVDs, videocassettes and
video games. In addition, our Game Crazy point-of-sale system is used to
determine appropriate used game trade-in values and used game prices. 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 DVD, videocassette 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 December 31, 2003, we had total consolidated long-term debt, including
capital leases, of approximately $371.3 million. We and our subsidiary could
incur substantial additional indebtedness in the future, including indebtedness
that would be secured by our assets or those of our subsidiary. 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 December 31, 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 Hollywood 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, games and game
hardware;
- - 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;
- - initial investments in and 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 and video game 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 these factors, 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.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our financial position,
operating results, or cash flows due to adverse changes in financial and
commodity market prices and rates. We have entered into certain market-risk-
sensitive financial instruments for other than trading purposes, principally
short-term and long-term debt. Historically, and as of December 31, 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 Eurodollar rate or base rate and is therefore
affected by changes in market interest rates. If variable base rates had
increased 1% in 2003 compared to the end of 2002, our interest expense would
have increased by approximately $1.5 million based on our outstanding balance
on the facility as of December 31, 2003.
The fair market value of long-term fixed interest rate debt is also subject to
interest rate risk. Generally, the fair market value of fixed interest rate
debt will increase as interest rates fall and decrease as interest rates rise.
The estimated fair value of our long-term fixed interest rate debt at December
31, 2003 was $243.6. We believe the effect of an estimated 1% change in
interest rates would not have a material impact on our future operating results
or cash flows with respect to our fixed interest rate debt. Fair values were
determined from quoted market prices.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Incorporated by reference to Item 15 of this report on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. 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.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information about our directors is incorporated by reference from our
definitive proxy statement, under the caption "Nomination and Election of Board
of Directors," for our 2004 annual meeting of shareholders (the "2004 Proxy
Statement") to be filed pursuant to Regulation 14A under the Securities
Exchange Act of 1934, which proxy statement we expect to file no later than 120
days after the end of our fiscal year ended December 31, 2003. Information
with respect to our executive officers is included under Item 4A of Part I of
this report.
We have adopted a Business and Ethics Code of Conduct for the guidance of our
directors, officers, and partners, including our principal executive, financial
and accounting officers and our controller. Our code of conduct, along with
other corporate governance documents, is posted on our website at
http://www.hollywoodvideo.com/investors under the link Corporate Governance.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this Item 11 is incorporated by reference from the 2004
Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Part of the information required by this Item 12 is incorporated by reference
from the 2004 Proxy Statement.
The following table summarizes information with respect to options under the
Company's stock option plans at December 31, 2003:
Options Outstanding Options
--------------------- remaining
Weighted available
average for future
exercise issuance under
Options price the plans
---------- -------- --------------
Stock option plans
approved by security
holders 7,640,005 $6.44 2,797,766
Stock option plans
not approved by
security holders 2,090,846 $11.29 1,475,201
---------- -------- --------------
9,730,851 $ 7.48 4,272,967
========== ======== ==============
The stock option plans not approved by security holders have generally the same
features as those approved by security holders. For further information
regarding the Company's stock option plans, see Note 17 to the Consolidated
Financial Statements.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this Item 13 is incorporated by reference from the 2004
Proxy Statement.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information required by this Item 14 is incorporated by reference from the 2004
Proxy Statement.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
Listed below are all financial statements, notes, schedules and exhibits filed
as part of the Registrant's Annual Report on Form 10-K for the year ended
December 31, 2003:
(a)(i), (ii) FINANCIAL STATEMENTS
The following financial statements of the Registrant, together with the Report
of Independent Accountants dated February 16, 2004, are filed herewith:
(i) FINANCIAL STATEMENTS
Report of Independent Auditors
Consolidated Balance Sheets as of December 31, 2003 and 2002
Consolidated Statements of Operations for the years ended December 31, 2003,
2002 and 2001
Consolidated Statements of Changes in Shareholders' Equity for the years ended
December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the years ended December 31, 2003,
2002 and 2001
Notes to Consolidated Financial Statements
(ii) FINANCIAL SCHEDULES
All financial schedules are omitted as the required information is inapplicable
or the information is presented in the respective Consolidated Financial
Statements or related notes.
(a) (iii) EXHIBITS
The following exhibits are filed with or incorporated by reference into this
Annual Report:
EXHIBIT
NUMBER DESCRIPTION
Items identified with an asterisk (*) are management contracts or
compensatory plans or arrangements.
3.1 1993B Restated Articles of Incorporation, as amended (incorporated
by reference to our Registration Statement on Form S-1 (File No. 33-
63042)(the "Form S-1"), by reference to Exhibit 4 to our Registration
Statement on Form S-3 (File No. 33-96140), and by reference to Exhibit
3.1 to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998).
3.2 1999 Restated Bylaws (incorporated by reference to Exhibit 3.2 to our
Registration Statement on Form S-4 (File No. 333-82937)(the "1999
S-4")).
4.1 Indenture dated 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 1993 Stock Incentive Plan, as amended (incorporated by reference
to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter
ended June 30, 1997). *
10.2 Form of Incentive Stock Option Agreement (incorporated by
reference to Exhibit 10.1 of the Form S-1). *
10.3 Form of Nonqualified Stock Option Agreement (incorporated by
reference to Exhibit 10.3 of the Form S-1). *
10.4 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1
to our Quarterly Report on Form 10-Q for the quarter ended March 31,
2001). *
10.5 Credit Agreement dated as of January 16, 2003 between the Registrant,
UBS Warburg LLC as Lead Arranger, UBS AG, Stamford Branch as
Administrative Agent and Bank of America, N.A., as Documentation
Agent (incorporated by reference to Exhibit 10.5 to our Annual Report
on Form 10-K for the year ended December 31, 2002), amended by the
Credit Agreement Amendment 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 (incorporated by reference to Exhibit 10.1 to our
Quarterly Report on Form 10-Q for the quarter ended September 30,
2003).
10.6 Offer of Employment Term Sheet effective as of January 25, 2001 from
the Registrant to Mark J. Wattles (incorporated by reference
to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for
the year ended December 31, 2000, filed on April 2, 2001). *
10.7 Change of Control Plan for Senior Management dated as of February 3,
2001 (incorporated by reference to Exhibit 10.8 to the Registrant's
Annual Report on Form 10-K for the year ended December 31, 2000, filed
on April 2, 2001). *
10.8 Revenue Sharing Agreement dated March 2, 1998 between the Registrant
and Buena Vista Home Entertainment, Inc (incorporated by reference to
Exhibit 10.13 to our Annual Report on Form 10-K/A for the year ended
December 31, 2000, filed on January 29, 2002). +
10.9 Revenue Sharing Agreement dated July 31, 2001 between the Registrant
and MGM Home Entertainment (incorporated by reference to Exhibit 10.14
to our Annual Report on Form 10-K/A for the year ended December 31,
2000, filed on January 29, 2002). +
10.10 1997 Employee Nonqualified Stock Option Plan, as amended (incorporated
by reference to Exhibit 10.10 to our Annual Report on Form 10-K for
the year ended December 31, 2002). *
10.12 License Agreement, effective as of January 25, 2001, between the
Registrant and Boards, Inc (incorporated by reference to Exhibit 10.12
to our Annual Report on Form 10-K for the year ended December 31,
2002). *
10.13 Product and Support Agreement, effective as of January 25, 2001,
between the Registrant and Boards, Inc. (incorporated by reference to
Exhibit 10.13 to our Annual Report on Form 10-K for the year ended
December 31, 2002). *
21.1 List of Subsidiaries (incorporated by reference to Exhibit 21.1 to
our Annual Report on Form 10-K/A for the year ended December 31, 2000,
filed on January 29, 2002).
23.1 Consent of PricewaterhouseCoopers LLP.
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
+ Confidential treatment has been requested as to certain portions of these
agreements. Such omitted confidential information has been designated by an
asterisk and has been filed separately with the Securities and Exchange
Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as
amended, pursuant to an application for confidential treatment.
(b) REPORTS ON FORM 8-K:
On October 20, 2003 we filed a current report on Form 8-K under "Item 12.
Results of Operation and Financial Condition" reporting that on October 13,
2003, we issued a press release announcing our financial results for the
quarter ended September 30, 2003. Our press release was attached to the report
as Exhibit 99.1.
Report of Independent Auditors
To the Board of Directors and Shareholders of Hollywood Entertainment
Corporation:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in shareholders' equity and
of cash flows present fairly, in all material respects, the financial position
of Hollywood Entertainment Corporation and its subsidiaries at December 31,
2003 and December 31, 2002, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2003 in
conformity with accounting principles generally accepted in the United States
of America. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
As discussed in Note 8 to the consolidated financial statements, the Company
changed its method of accounting for goodwill in 2002.
/S/PricewaterhouseCoopers LLP
Portland, Oregon
February 16, 2004
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
-------------------------
December 31, December 31,
2003 2002
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 74,133 $ 33,145
Cash held by trustee for refinancing - 218,531
Receivables, net 33,987 34,996
Merchandise inventories 129,864 97,307
Prepaid expenses and other current
assets 13,233 14,772
----------- -----------
Total current assets 251,217 398,751
Rental inventory, net 268,748 260,190
Property and equipment, net 288,857 255,497
Goodwill 66,678 64,934
Deferred income tax asset, net 104,302 147,813
Other assets 17,655 19,191
----------- -----------
$ 997,457 $ 1,146,376
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term
obligations $ 647 $ 27,678
Subordinated notes to be retired with
cash held by trustee (including accrued
interest of $8.1 million) - 212,080
Accounts payable 159,586 158,423
Accrued expenses 117,867 108,432
Accrued interest 6,467 2,923
Income taxes payable 284 1,151
----------- ----------
Total current liabilities 284,851 510,687
Long-term obligations, less current
portion 370,669 361,068
Other liabilities 16,108 17,472
----------- ----------
671,628 889,227
Commitments and contingencies - -
Shareholders' equity:
Preferred stock, 25,000,000 shares
authorized; no shares issued and
outstanding - -
Common stock, 100,000,000 shares
authorized; 59,666,347 and
59,796,573 shares issued and
outstanding, respectively 489,247 503,403
Unearned compensation (133) (697)
Accumulated deficit (163,285) (245,557)
----------- ----------
Total shareholders' equity 325,829 257,149
----------- ----------
$ 997,457 $ 1,146,376
=========== ===========
See notes to Consolidated Financial Statements
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Twelve Months Ended
December 31,
------------------------------------
2003 2002 2001
---------- ---------- ----------
REVENUE:
Rental product revenue $1,386,590 $1,324,017 $1,271,394
Merchandise sales 295,958 166,049 108,109
---------- ---------- ----------
1,682,548 1,490,066 1,379,503
---------- ---------- ----------
COST OF REVENUE:
Cost of rental product 441,034 447,278 459,071
Cost of merchandise 223,598 126,251 85,406
---------- ---------- ----------
664,632 573,529 544,477
---------- ---------- ----------
GROSS PROFIT 1,017,916 916,537 835,026
Operating costs and expenses:
Operating and selling 724,136 647,773 621,343
General and administrative 106,024 89,602 96,382
Store opening expenses 4,768 3,093 -
Restructuring charge for closure
of internet business - (12,430) (3,256)
Restructuring charge for store
closures (2,106) (828) (3,778)
Amortization of intangibles - - 5,058
---------- ---------- ----------
832,822 727,210 715,749
---------- ---------- ----------
INCOME FROM OPERATIONS 185,094 189,327 119,277
Non-operating expense:
Interest expense, net (35,507) (42,057) (56,129)
Early debt retirement (12,467) (3,534) -
----------- ----------- ----------
Income before income taxes 137,120 143,736 63,148
Benefit (provision)
for income taxes (54,848) 98,109 37,268
----------- ----------- ----------
NET INCOME $ 82,272 $ 241,845 $ 100,416
=========== =========== ==========
- ----------------------------------------------------------------------
Net income per share:
Basic $ 1.36 $ 4.23 $ 2.05
Diluted 1.28 3.88 1.90
- ----------------------------------------------------------------------
Weighted average shares outstanding:
Basic 60,439 57,202 49,101
Diluted 64,180 62,390 52,880
- ----------------------------------------------------------------------
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
(In thousands, except share amounts)
Common Stock Unearned Accumu-
------------------- Compen- lated
Shares Amount sation Deficit Total
---------- -------- -------- --------- ---------
Balance at
December 31, 2000 46,247,599 365,441 - (587,818) (222,377)
---------- -------- -------- --------- ---------
Issuance of common stock:
Compensation grant 3,000,000 3,281 - - 3,281
Stock options exercised 181,164 1,097 - - 1,097
Tax impact from
stock options - (61) - - (61)
Stock compensation - 5,745 (1,655) - 4,090
Net income - - - 100,416 100,416
---------- -------- -------- --------- ---------
Balance at
December 31, 2001 49,428,763 375,503 (1,655) (487,402) (113,554)
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock issuance 8,050,000 120,750 - - 120,750
Equity offering costs - (7,677) - - (7,677)
Stock options exercised 2,317,810 4,604 - - 4,604
Stock option tax benefit - 12,814 - - 12,814
Stock compensation - (2,591) 958 - (1,633)
Net income - - - 241,845 241,845
---------- -------- -------- --------- ---------
Balance at
December 31, 2002 59,796,573 503,403 (697) (245,557) 257,149
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock options exercised 1,615,947 4,066 - - 4,066
Stock option tax benefit - 8,053 - - 8,053
Stock compensation - - 564 - 564
Repurchase of common stock (1,746,173) (26,275) - - (26,275)
Net income - - - 82,272 82,272
---------- -------- -------- --------- ---------
Balance at
December 31, 2003 59,666,347 $489,247 $ (133)$(163,285)$ 325,829
========== ======== ======== ========= =========
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year Ended December 31,
-------------------------------
2003 2002 2001
--------- --------- ---------
Operating activities:
Net income $ 82,272 $ 241,845 $ 100,416
Adjustments to reconcile net income to cash
provided by operating activities:
Write-off deferred financing costs 5,827 2,226 -
Amortization of rental product 211,806 218,905 180,237
Depreciation 60,762 59,343 66,939
Amortization of deferred financing costs 4,481 3,785 3,715
Tax benefit from exercise of stock options 8,053 12,814 (61)
Change in deferred rent (1,364) (1,368) (598)
Change in deferred taxes 43,512 (109,417) (38,396)
Non-cash stock compensation 564 (1,633) 7,371
Net change in operating assets and liabilities:
Receivables 1,010 (5,940) (5,226)
Merchandise inventories (32,557) (35,722) (7,384)
Accounts payable 1,163 (9,056) (32,879)
Accrued interest 3,544 (2,649) 1,895
Other current assets and liabilities 1,718 (11,544) (2,146)
--------- -------- --------
Cash provided by operating activities 390,791 361,589 273,883
--------- -------- --------
Investing activities:
Purchases of rental inventory, net (220,364) (288,079) (202,790)
Purchase of property and equipment, net (94,123) (44,254) (8,802)
Increase in intangibles and other assets (2,816) (785) (791)
Proceeds from indenture trustee 218,531 (218,531) -
--------- -------- --------
Cash used in investing activities (98,772) (551,649) (212,383)
--------- -------- --------
Financing activities:
Proceeds from issuance of common stock - 120,750 -
Equity financing costs - (7,677) -
Issuance of subordinated debt - 225,000 -
Repayment of subordinated debt (250,000) - -
Borrowings under new term loan 200,000 150,000 -
Repayment of prior revolving loan (107,500) (240,000) -
Decrease in credit facilities (55,000) (42,500) (5,000)
Debt financing costs (7,453) (11,966) (4,656)
Repayments of capital lease obligations (10,291) (13,816) (17,399)
Repurchase of common stock (26,275) - -
Proceeds from capital lease obligation 1,422 - -
Proceeds from exercise of stock options 4,066 4,604 1,097
--------- --------- --------
Cash (used in) provided by
financing activities (251,031) 184,395 (25,958)
--------- --------- --------
Increase (decrease) in cash and
cash equivalents 40,988 (5,665) 35,542
Cash and cash equivalents at
beginning of year 33,145 38,810 3,268
--------- --------- --------
Cash and cash equivalents at end of year $ 74,133 $ 33,145 $ 38,810
========= ========= ========
Other Cash Flow Information:
Interest expense paid $ 36,381 $ 41,415 $ 54,651
Income taxes paid, net 4,157 2,613 768
See notes to Consolidated Financial Statements
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003, 2002, 2001
1. SIGNIFICANT ACCOUNTING POLICIES
Corporate Organization and Consolidation
The accompanying financial statements include the accounts of Hollywood
Entertainment Corporation and its wholly owned subsidiaries (the "Company").
The Company's only subsidiary during 2003, 2002 and 2001 was Hollywood
Management Company.
Nature of the Business
The Company operates a chain of video stores ("Hollywood Video") throughout the
United States. The Company was incorporated in Oregon on June 2, 1988 and
opened its first store in October 1988. As of December 31, 2003, 2002 and
2001, the Company operated 1,920 stores in 47 states, 1,831 stores in 47 states
and 1,801 stores in 47 states, respectively. In 2003, the Company began
reporting operating results for two segments, Hollywood Video, as described
above, and Game Crazy, game specialty stores where game enthusiasts can buy,
sell and trade new and used video game hardware, software and accessories. A
Game Crazy typically occupies an area of approximately 700 to 900 square feet
within a Hollywood Video store. As of December 31, 2003, the Company operated
595 Game Crazy stores in 27 states
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles (GAAP) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Significant
estimates relative to the Company include revenue recognition, depreciation and
amortization policies, impairment of long-lived assets and goodwill, income
taxes and legal contingencies.
Reclassification of Prior Year Amounts
Certain prior year amounts have been reclassified to conform to the
presentation used for the current year. These reclassifications had no impact
on previously reported net income or shareholders' equity.
Recently Issued Accounting Standards
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
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 were 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 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.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" (FIN 46). FIN 46 requires the consolidation of
variable interest entities in which an enterprise absorbs a majority of the
entity's expected losses, receives a majority of the entity's expected residual
returns, or both, as a result of ownership, contractual or other financial
interests in the entity. Application of this interpretation is required in
financial statements of public entities that have interests in variable
interest entities or potential variable interest entities commonly referred to
as special-purpose entities for periods ending after December 15,
2003. Application by public entities for all other types of entities is
required in financial statements for periods ending after March 15,
2004. The adoption of this interpretation did not have, and is not expected to
have, a material impact on the Company's financial position or results of
operations.
Rental Revenue and Merchandise
The Company recognizes revenue upon the rental and sale of its products.
Revenue for extended rental periods (when the customer chooses to keep the
product beyond the original rental period) is recognized when the extended
rental period begins. Revenue recorded for extended rental periods is net of
estimated amounts that the Company does not anticipate collecting based upon
its historical collection experience.
Revenue generated from subscription sales or similar programs where a customer
receives free rentals, reduced rental prices or discounted game prices (MVP
cards in Game Crazy) in exchange for an up-front payment is recognized as
revenue evenly over the time period the customer receives the benefit. Upon the
sale of a subscription or MVP card, a liability is recorded that is amortized
to revenue over the applicable time period.
Gift Card and Gift Certificate Liability
Gift card and gift certificate liabilities are recorded at the time of sale.
Costs of designing, printing and distributing the cards and certificates, and
transactional processing costs, are expensed as incurred. The liability is
relieved and revenue is recognized upon redemption of the gift cards or gift
certificate for rental or purchase at any Hollywood Video store.
Cost of Rental Product
Cost of rental product includes revenue sharing expense, amortization of DVD
and VHS movies, games, capitalized shipping and handling, the book value of
previously viewed movies and games, disk repair and the book value of rental
inventory loss.
Cost of Merchandise Sales
Cost of merchandise sales is determined using an average costing method for
groups with similar product characteristics for Hollywood Video and at an item
level for Game Crazy. Cost of merchandise sales includes product shipping and
handling and valuation adjustments or markdowns that are necessary to record
inventory at the lower of cost or market.
Cash and Cash Equivalents
The Company considers highly liquid investment instruments, with an original
maturity of three months or less, to be cash equivalents. The carrying amounts
of cash and cash equivalents equals fair value.
Inventories
Merchandise inventories, consisting primarily of video games, new movies for
sale, previously viewed movies for sale, concessions, and accessories held for
resale, are stated at the lower of cost or market (or, in the case of rental
inventory transferred to merchandise inventory at the carrying value thereof at
the time of transfer). Used video game inventory includes games accepted as
trade-ins from customers. Games are accepted from customers in exchange for
in-store credit. At the time of trade-in, the inventory is recorded as well as
the corresponding liability for the trade credit. The liability is relieved
when the trade credit is redeemed.
Rental inventory, which includes VHS videocassettes, DVDs and video games is
stated at cost and amortized over its estimated useful life to a specified
residual value. Shipping and handling charges related to rental and
merchandise inventory are included in the cost of such inventory. See Notes 4
and 5 for a discussion of the amortization policy applied to rental inventory.
Property, Equipment, Depreciation and Amortization
Property is stated at cost and is depreciated on a straight-line basis for
financial reporting purposes over the estimated useful life of the assets,
which range from approximately five to ten years. Leasehold improvements are
amortized primarily over ten years, which generally approximates the term of
the lease.
Additions to property and equipment are capitalized and include acquisitions of
property and equipment, costs incurred in the development and construction of
new stores, major improvements to existing property and major improvements in
management information systems including certain costs incurred for internally
developed computer software. Maintenance and repair costs are charged to
expense as incurred, while improvements that extend the useful life of the
assets are capitalized. As property and equipment is sold or retired, the
applicable cost and accumulated depreciation and amortization are eliminated
from the accounts and any gain or loss thereon is recorded.
Long-lived Assets
The Company reviews for impairment of long-lived assets to be held and used in
the business whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. The Company periodically
reviews and monitors its internal management reports for indicators of
impairment. The Company considers a trend of unsatisfactory operating results
that are not in line with management's expectations to be its primary indicator
of potential impairment. When an indicator of impairment is noted, assets are
evaluated for impairment at the lowest level for which there are identifiable
cash flows (e.g., at the store level). The Company deems a store to be
impaired if a forecast of undiscounted future operating cash flows directly
related to the store, including estimated disposal value, if any, is less than
the asset carrying amount. If a store is determined to be impaired, the loss is
measured as the amount by which the carrying amount of the store exceeds its
fair value. Fair value is estimated using a discounted future cash flow
valuation technique similar to that used by management in making a new
investment decision. Considerable management judgment and assumptions are
necessary to identify indicators of impairment and to estimate discounted
future cash flows. Accordingly, actual results could vary significantly from
such estimates. There were no impairment charges in 2003 or 2002.
Goodwill & Intangible Assets
The Company reviews goodwill and intangible assets on an annual basis or
whenever events or circumstances occur indicating that goodwill may be
impaired. When the Company is evaluating for possible impairment of goodwill,
it compares the present value of future cash flows of its reporting unit, which
is defined as the Company's 1,920 video stores, to the goodwill recorded. If
this indicates that the goodwill is impaired, the Company would record a charge
to the extent that the goodwill balance would be adjusted to that of the
present value of future cash flows.
Store Closure Reserves
Reserves for store closures were established by calculating the present value
of the remaining lease obligation, adjusted for estimated subtenant agreements
or lease buyouts, were expensed along with any leasehold improvements. Store
furniture and equipment was either transferred at historical costs to another
location or disposed of and written-off.
Litigation Liabilities
All material litigation loss contingencies, which are judged to be both
probable and estimable, are recorded as liabilities in the Consolidated
Financial Statements in amounts equal to the Company's best estimates of the
costs of resolving or disposing of the underlying claims. These estimates are
based upon judgments and assumptions. The Company regularly monitors its
estimates in light of subsequent developments and changes in circumstances and
adjusts its estimates when additional information causes the Company to believe
that they are no longer accurate. If no particular amount is determined to
constitute the Company's best estimate of a particular litigation loss
contingency, the amount representing the low end of the range of the Company's
estimate of the costs of resolving or disposing of the underlying claim is
recorded as a liability and the range of such estimates is disclosed.
Treasury Stock
In accordance with Oregon law, shares of common stock are automatically retired
and classified as available for issuance upon repurchase.
Income Taxes
We calculate income taxes in accordance with SFAS No. 109, "Accounting for
Income Taxes," which requires recognition of deferred tax assets and
liabilities for the expected future tax consequences of events that have been
included in our financial statements and tax returns. Valuation allowances are
established when necessary to reduce deferred tax assets, including temporary
timing differences and net operating loss carryforwards, to the amount expected
to be realized in the future. Deferred assets and liabilities are measured
using enacted tax rates in effect for the year in which those temporary
differences are expected to be recovered or settled. In the fourth quarter of
2000, in light of significant doubt that existed regarding our future income
and therefore our ability to use our net operating loss carryforwards, we
recorded a $211.2 million valuation allowance on our $211.2 million net
deferred tax asset. In 2001 and 2002, as a result of our operating performance
for each year, as well as anticipated future operating performance, we
determined that it was more likely than not that certain future tax benefits
would be realized. We therefore reversed $63.4 million and $147.8 million of
this valuation allowance in 2001 and 2002, respectively, which resulted in an
increase in net income and a corresponding increase/decrease in our
shareholders' equity/deficit. While changes in the valuation allowance have no
effect on the amount of income tax we pay or on our cash flows, the effects on
our reported income and shareholders' equity may be viewed by some investors
and potential lenders as significant. Due to the numerous variables associated
with our judgments, assumptions and estimates relating to the valuation of our
deferred tax assets, and the effects of changes in circumstances affecting
these valuations, both the precision and reliability of the resulting estimates
are subject to substantial uncertainties and, as additional information becomes
known, we may change our estimates significantly
Deferred Rent
Many of the Company's operating leases contain predetermined fixed increases of
the minimum rental rate during the initial lease term. For these leases, the
Company recognizes the related rental expense on a straight-line basis and
records the difference between the amount charged to expense and the rent paid
as deferred rent and is included in other liabilities.
Fair Value of Financial Instruments
In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments", the Company has disclosed the fair value, related carrying value
and method for determining the fair value for the following financial
instruments in the accompanying notes as referenced: cash and cash equivalents
(see above), accounts receivable (see Note 2), and long-term obligations (see
Note 13).
The Company's receivables do not represent significant concentrations of credit
risk at December 31, 2003, due to the wide variety of customers, markets and
geographic areas to which the Company's products are rented and sold.
Accounting for Stock Based Compensation
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.
Year Ended December 31,
----------------------------
2003 2002 2001
-------- -------- --------
Net income as reported $ 82,272 $241,845 $100,416
Add: Stock-based compensation
expense included in reported
net income, net of tax 339 596 2,378
Deduct: Total stock- based
Employee compensation expense
under fair value based method
for all awards, net tax (8,295) (7,941) (4,180)
-------- -------- --------
Pro forma net income $74,316 $234,500 $ 98,614
======== ======== ========
Earnings per share:
Basic--as reported $ 1.36 $ 4.23 $ 2.05
Basic--pro forma 1.23 4.10 2.01
Diluted--as reported 1.28 3.88 1.90
Diluted--pro forma 1.19 3.87 1.93
Comprehensive Income
Comprehensive income is equal to net income for all periods presented.
Advertising
The Company receives cooperative reimbursements from vendors as eligible
expenditures are incurred relative to the promotion of rental and sales
product. Advertising costs, net of these reimbursements, are expensed as
incurred. Advertising expense was $16.2 million, $4.5 million and $5.1 million
for 2003, 2002 and 2001, respectively. The increase in 2003 was related to an
increase in advertising for Game Crazy and the adoption of EITF 02-16 that
reclassified certain credits from concession vendors to cost of merchandise
revenue.
2. RECEIVABLES
Accounts receivable as of December 31, 2003 and 2002 consists of
(in thousands):
----------------------
2003 2002
---------- ---------
Construction receivables $ 4,826 $ 2,079
Additional rental fees, net 19,970 18,450
Marketing 8,468 14,399
Due from employees 244 533
Licensee receivables 1,509 631
Other 785 1,360
---------- ---------
35,802 37,452
Allowance for doubtful accounts (1,815) (2,456)
---------- ---------
$ 33,987 $ 34,996
========== =========
The carrying amount of accounts receivable approximates fair value because of
the short maturity of those receivables. The allowance for doubtful accounts is
primarily for marketing.
3. RENTAL INVENTORY
Rental inventory as of December 31, 2003 and 2002 consists of (in thousands):
-------------------------
2003 2002
---------- ----------
Rental inventory $ 773,953 $ 722,582
Less accumulated amortization (505,205) (462,392)
---------- ----------
$ 268,748 $ 260,190
========== ==========
Number of stores 1,920 1,831
Inventory/store 140 142
Amortization expense related to rental inventory was $211.8 million, $218.9
million and $180.2 million in 2003, 2002 and 2001, respectively, and is
included in cost of rental product. As rental inventory is transferred to
merchandise inventory and sold as previously-viewed product, the applicable
cost and accumulated amortization are eliminated from the accounts, determined
on a first-in-first-out ("FIFO") basis applied in the aggregate to monthly
purchases.
4. RENTAL INVENTORY AMORTIZATION POLICY
The Company manages its rental inventories of movies as two distinct
categories, new 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.
5. CHANGE IN ACCOUNTING ESTIMATE FOR RENTAL INVENTORY - 2002
The Company regularly evaluates and updates rental inventory accounting
estimates. Effective October 1, 2002, estimated average residual values on new
release movies was reduced from $3.16 to $2.00 for VHS and from $4.67 to $4.00
for DVD. In addition, the estimated residual value of catalog DVD inventory was
reduced from $6.00 to $4.00. As a result of these changes in estimate, cost of
rental product revenue in 2002 was $4.1 million higher and net income per share
(basic and diluted) was $0.04 lower.
6. PROPERTY AND EQUIPMENT
Property and equipment as of December 31, 2003 and 2002 consists of (in
thousands):
---------------------
2003 2002
--------- ----------
Fixtures and equipment $ 232,379 $ 187,300
Leasehold improvements 465,874 380,047
Equipment under capital lease 4,644 15,784
Leasehold improvements under
capital lease 6,725 37,112
--------- ----------
709,622 620,243
Less accumulated depreciation
and amortization (420,765) (364,746)
--------- ----------
$ 288,857 $ 255,497
========= ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $6.4 million and
$24.4 million at December 31, 2003 and 2002, respectively. Depreciation
expense related to property, plant and equipment was $56.7 million, $59.3
million and $61.9 million in 2003, 2002 and 2001, respectively.
7. STORE CLOSURE RESTRUCTURING
In December 2000, we approved a restructuring plan involving the closure and
disposition of 43 stores that were not operating to our expectations (the
"Restructuring Plan"). In the fourth quarter of 2000, we recorded charges
aggregating $16.9 million, including an $8.0 million write down of property and
equipment, a $1.5 million write down of goodwill and an accrual for store
closing costs of $7.4 million. The established reserve for cash expenditures
is for lease termination fees and other store closure costs. We have liquidated
and plan to continue liquidating related store inventories through store
closing sales; any remaining product will be used in other stores.
Revenue for the stores subject to the store Restructuring Plan was $6.0
million, $6.3 million, $13.8 million and $15.5 million in 2003, 2002, 2001 and
2000, respectively. Operating results (defined as income or loss before
interest expense and income taxes) was $0.3 million loss, $0.9 million loss,
$2.5 million loss and $1.8 million loss in 2003, 2002, 2001 and 2000,
respectively. The operating results for the stores in the closure plan were
included in the Consolidated Statement of Operations.
During the twelve months ended December 31, 2001, we closed 12 of the stores
included in the plan and incurred $329,867 in expenses related to the closures
and received $450,000 to exit one of the leases. During the twelve months ended
December 31, 2002, we closed one store included in the plan and incurred
$90,000 in closure expenses.
In December of 2001, 2002 and 2003, we amended the Restructuring Plan and
removed 16 stores, 2 stores and 9 stores from the closure list, respectively.
In accordance with the amended plans, and updated estimates on closing costs,
we reversed $3.8 million, $0.8 million and $2.1 of the original $16.9 million
charge, leaving a $3.7 million, $2.8 million and $0.7 million accrual balance
at December 31, 2001, 2002 and 2003, respectively, for store closing costs. At
December 31, 2003, 3 stores remained to be closed under the Restructuring Plan,
one of which closed in January 2004.
8. GOODWILL AND INTANGIBLE ASSETS
Goodwill was $66.7 as of December 31, 2003 and $64.9 million as of December 31,
2002 and 2001 and represents the excess of cost over the fair value of net
assets purchased net of impairment charges and accumulated amortization
recorded prior to the adoption of FAS 142.
The increase in Goodwill was the result of six stores acquired in four separate
transactions during the year ended December 31, 2003. The aggregate purchase
price was $2.0 million, of which, $1.7 million was allocated to Goodwill. The
remaining purchase price represented the fair market value of the assets
acquired that were allocated to store inventory and leasehold improvements.
In July 2001, the FASB issued SFAS Nos. 141 and 142, "Business Combinations"
and "Goodwill and Other Intangible Assets," respectively. SFAS 141 supersedes
Accounting Principles Board (APB) Opinion No. 16 and eliminates pooling-of-
interests accounting. It also provides guidance on purchase accounting related
to the recognition of intangible assets and accounting for negative goodwill.
SFAS 142 changes the accounting for goodwill from an amortization method to an
impairment only approach. Under SFAS 142, goodwill and non-amortizing
intangible assets shall be adjusted whenever events or circumstances occur
indicating that goodwill has been impaired. The Company has completed its
impairment testing of the valuation of its goodwill and has determined that
there is no impairment. SFAS 141 and 142 were effective for all business
combinations completed after June 30, 2001. Upon adoption of SFAS 142,
amortization of goodwill recorded for business combinations consummated prior
to July 1, 2001 ceased, and intangible assets acquired prior to July 1, 2001
that did not meet criteria for recognition under SFAS 141 were reclassified to
goodwill. The Company adopted SFAS 142 on January 1, 2002, the beginning of
fiscal 2002.
The components of intangible assets are as follows (in thousands):
December 31, December 31,
2002 Additions 2003
------------ --------- ------------
Goodwill $ 64,934 $ 1,744 $ 66,678
Trade-name rights 5,345 879 6,224
------------ --------- ------------
$ 70,279 $ 2,623 $ 72,902
============ ========= ============
The following table summarizes the pro forma impact of excluding amortization
of intangible assets for the years ended December 31, 2003, 2002 and 2001 (in
thousands, except per share amounts):
Year Ended December 31,
-------- -------- ---------
2003 2002 2001
-------- -------- ---------
Net income, as reported $ 82,272 $241,845 $ 100,416
Add back: Amortization of
intangible assets, net of tax - - 3,116
-------- -------- ---------
Pro forma net income $ 82,272 $241,845 $ 103,532
======== ======== =========
Basic net income per share:
As reported $ 1.36 $ 4.23 $ 2.05
Pro forma net income per share $ 1.36 $ 4.23 $ 2.11
Diluted net income per share:
As reported $ 1.28 $ 3.88 $ 1.90
Pro forma net income per share $ 1.28 $ 3.88 $ 1.96
9. REEL.COM DISCONTINUED E-COMMERCE OPERATIONS
On June 12, 2000, the Company announced that it would close down the e-commerce
business of Reel.com. Although the Company had developed a leading web-site
over the seven quarters after Reel.com was purchased in October of 1998,
Reel.com's business model of rapid customer acquisition led to large operating
losses and required significant cash funding. Due to market conditions, the
Company was unable to obtain outside financing for Reel.com, and could not
justify continued funding from its video store cash flow. As a result of the
discontinuation of Reel.com's e-commerce operations, the Company recorded a
total charge of $69.3 million in the second quarter of 2000, of which $27.3
million was accrued liabilities for contractual obligations, lease commitments,
anticipated legal claims, legal fees, financial consulting, and other
professional services incurred as a direct result of the closure of Reel.com.
The accrual was reduced by $1.6 million, $3.3 million and $12.4 million in
2000, 2001 and 2002, respectively, because the Company was able to negotiate
termination of certain obligations and lease commitments more favorably than
originally anticipated. The Company has paid for all accrued liabilities, net
of reductions, and does not anticipate further adjustments.
10. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable includes accrued revenue sharing (amounts accrued pursuant to
revenue sharing arrangements in which the Company had not yet received an
invoice). Accrued revenue sharing was $23.6 million and $15.9 million at
December 31, 2003, and 2002, respectively.
Accrued liabilities as of December 31, 2003 and 2002 consist of
(in thousands):
----------------------
2003 2002
---------- ---------
Payroll and benefits $ 26,456 $ 24,136
Property taxes and common
area maintenance 11,045 9,313
Gift cards and discount cards 22,908 15,672
Marketing 5,709 5,815
Store closures and lease
terminations 1,127 4,453
Property, plant and equipment 5,050 10,531
Accrued insurance 5,425 3,332
Accrued sales tax 13,320 11,433
Other operating and general
administration 26,827 23,747
---------- ---------
$ 117,867 $ 108,432
========== =========
11. EMPLOYEE BENEFIT PLANS
The Company is self-insured for employee medical benefits under the Company's
group health plan. The Company maintains stop loss coverage for individual
claims in excess of $125,000. While the ultimate amount of claims incurred is
dependent on future developments, in management's opinion, recorded reserves
are adequate to cover the future payment of claims. Adjustments, if any, to
recorded estimates of the Company's potential claims liability will be
reflected in results of operations for the period in which such adjustments are
determined to be appropriate on the basis of actual payment experience or other
changes in circumstances.
The Company has a 401(k) plan in which eligible employees may elect to
contribute up to 20% of their earnings. Eligible employees are at least 21
years of age, have completed at least one year of service and work at least
1,000 hours in a year. The Company matched 25% of the employee's first 6% of
contributions until June 30, 2003, when the company elected to end the match.
Beginning in April 2000, the Company offered a deferred compensation plan to
certain key employees designated by the Company. The plan allows for the
deferral and investment of current compensation on a pre-tax basis. The
Company has accrued $247,923 and $140,660 related to this plan at December 31,
2003 and 2002, respectively.
Beginning in January 2002, the Company offered a 401(k) supplemental plan that
allowed our highly compensated employees the ability to receive the full 25%
employer match on the first 6% of contributions (through June 30, 2003 when the
company elected to end the match) that were not available to them under the
Company's 401(k) plan. The plan allows for the deferral and investment of
current compensation on a pre-tax basis. The Company has accrued approximately
$738,326 and $373,829 related to this plan at December 31, 2003 and 2002,
respectively.
12. RELATED PARTY TRANSACTIONS
On January 25, 2001, the Compensation Committee of the Board of Directors of
the Company unanimously approved an employment agreement between the Company
and Mark J. Wattles as President and Chief Executive Officer. Pursuant to the
terms of the agreement, on January 25, 2001, Mr. Wattles received a grant of
$3.28 million in common stock (3 million shares).
In July 2001, Boards, Inc. (Boards) began to open Hollywood Video stores as
licensee of the Company pursuant to rights granted by the Company and approved
by the Board of Directors in connection with Mark J. Wattles' employment
agreement in January 2001. These stores are operated by Boards and are not
included in the 1,920 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 December 31, 2003, Boards has incurred license fees and
royalties, and purchased products and services from the Company totaling $16.0
million, of which, $14.5 million has been paid as of December 31, 2003. Boards
is in compliance with the 30 day payment terms under the arrangement. The
outstanding balance of $1.5 million due the Company is related to current
activity. In the twelve months ended December 31, 2003, Boards incurred charges
of $11.0 million and made $10.2 million in payments. As of December 31, 2003,
Boards operated 20 stores.
13. LONG-TERM OBLIGATIONS AND LIQUIDITY
The Company had the following long-term obligations as of December 31, 2003 and
2002 (in thousands):
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 1,316 10,178
----------- ----------
371,316 592,678
Current portions:
Credit facilities - 17,500
Capital leases 647 10,178
----------- ----------
647 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 $ 370,669 $ 361,068
=========== ==========
(1) Coupon payments at 9.625% are due semi-annually in March and September.
(2) On December 18, 2002, the Company called $203.9 million of the notes, which
were redeemed on January 17, 2003. The remaining $46.1 million was called on
January 17, 2003 and redeemed on February 18, 2003.
On December 18, 2002, the Company completed the sale of $225 million 9.625%
senior subordinated notes due 2011. The Company delivered the net proceeds to
an indenture trustee to redeem $203.9 million of the $250 million 10.625%
senior subordinated notes due 2004 including accrued interest and the required
call premium. At December 31, 2002, the trustee was holding $218.5 million and
the Company continued to carry the $250 million 10.625% senior subordinated
notes on its balance sheet. On January 17, 2003, the redemption of $203.9
million of the notes was completed.
The senior subordinated notes due 2011 are redeemable, at the option of the
Company, beginning in March 15, 2007, at rates starting at 104.8% of principal
amount reduced annually through March 15, 2009, at which time they become
redeemable at 100% of the principal amount. The terms of the notes may
restrict, among other things, payment of dividends and other distributions,
investments, the repurchase of capital stock or subordinated indebtedness, the
making of certain other restricted payments, the incurrence of additional
indebtedness or liens by the Company or any of its subsidiaries, and certain
mergers, consolidations and disposition of assets. Additionally, if a change of
control occurs, as defined, each holder of the notes will have the right to
require the Company to repurchase such holder's notes at 101% of principal
amount thereof. At December 31, 2003, the company was in compliance with the
restrictions, and other terms of the notes.
On January 16, 2003, the Company completed the closing of new senior secured
credit facilities from a syndicate of lenders led by UBS Warburg LLC. The new
facilities consist of a $200.0 million term loan facility and a $50.0 million
revolving credit facility, each maturing in 2008. The Company used the net
proceeds from the transaction to repay amounts outstanding under the Company's
existing credit facilities which were due in 2004, redeem the remaining $46.1
million outstanding principal amount of the Company's 10.625% senior
subordinated notes due 2004 and for general corporate purposes. The Company
completed the redemption of the 10.625% senior subordinated notes on February
18, 2003. The Company has prepaid $75 million of the term loan facility
principal payments due through 2006, including a $20 million payment made on
January 5, 2004.
Revolving credit loans under the new facility bear interest, at the Company's
option, at an applicable margin over the bank's base rate loan or the LIBOR
rate. The initial margin over LIBOR was 3.5% for the term loan facility and
will step down if certain performance targets are met. The credit facility
contains financial covenants (determined in each case on the basis of the
definitions and other provisions set forth in such credit agreement), some of
which may become more restrictive over time, that include a (1) maximum debt to
adjusted EBITDA test, (2) minimum interest coverage test, and (3) minimum fixed
charge coverage test. Amounts outstanding under the credit agreement are
collateralized by substantially all of the assets of the Company. Hollywood
Management Company, and any future subsidiaries of Hollywood Entertainment
Corporation, are guarantors under the credit agreement. At December 31, 2003,
the Company was in compliance with all covenants contained within the
agreement.
Maturities on long-term obligations at December 31, 2003 for the next five
years is as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2004 - - 647 647
2005 - - 454 454
2006 - 20,000(1) 215 20,215
2007 - 20,000 - 20,000
2008 - 105,000 - 105,000
Thereafter 225,000 - - 225,000
----------- ---------- --------- ---------
$ 225,000 $ 145,000 $ 1,316 $ 371,316
----------- ---------- --------- ---------
(1) Paid on January 5, 2004.
The fair value of the 9.625% senior subordinated notes due 2011 was $243.6
million and $229.5 million as of December 31, 2003 and 2002, respectively,
based on quoted market prices. The revolving credit facility is a variable rate
loan, and thus, the fair value approximates the carrying amount as of December
31, 2003 and 2002.
As of December 31, 2003, the Company had $5.1 million of outstanding letters of
credit issued upon the revolving credit facility.
14. OFF BALANCE SHEET ARRANGEMENTS
The Company leases all of its stores, corporate offices, distribution centers
and zone offices under non-cancelable operating leases. The Company's stores
generally have an initial operating lease term of five to fifteen years and
most have options to renew for between five and fifteen additional years. Rent
expense was $225.0 million, $213.2 million and $212.7 million for the years
ended December 31, 2003, 2002 and 2001, respectively. Most operating leases
require payment of additional occupancy costs, including property taxes,
utilities, common area maintenance and insurance. These additional occupancy
costs were $46.2 million, $42.1 million and $40.4 million for the years ended
December 31, 2003, 2002 and 2001, respectively.
At December 31, 2003, the future minimum annual rental commitments under non-
cancelable operating leases were as follows (in thousands):
------------------------------
Year Ending Operating
December 31, Leases
------------------------------
2004 $237,821
2005 228,986
2006 209,071
2007 178,674
2008 139,845
Thereafter 361,134
15. INCOME TAXES
The provision for (benefit from) income taxes from continuing operations for
the years ended December 31, 2003, 2002 and 2001 consists of (in thousands):
------------------------------
2003 2002 2001
---------- -------- --------
Current:
Federal $ 2,265 $ (3,507) $ 312
State 1,018 2,107 816
--------- -------- --------
Total current provision
(benefit) 3,283 (1,400) 1,128
Deferred:
Federal 42,785 (82,243) (30,852)
State 8,780 (14,466) (7,544)
--------- -------- --------
Total deferred liability
(benefit) 51,565 (96,709) (38,396)
--------- -------- --------
Total provision (benefit) $ 54,848 $(98,109) $(37,268)
========= ======== ========
The Company is subject to minimum state taxes in excess of statutory state
income taxes in many of the states in which it operates. These taxes are
included in the current provision for state and local income taxes. Certain
acquisitions in 1995 and the Reel.com acquisition in 1998 yielded non-
deductible goodwill which is reflected in the tax rate reconciliation below.
The tax impact of purchase accounting adjustments is reflected in deferred
taxes. The difference between the tax provision at the statutory federal income
tax rate and the tax provision attributable to income from continuing
operations before income taxes for the three years ended December 31 is
analyzed below:
--------------------------
2003 2002 2001
-------- ------- -------
Statutory federal rate
provision 35.0% 34.0% 34.0%
State income taxes, net of
federal income tax benefit 4.6 3.9 4.4
Amortization of non-deductible
Goodwill - - 0.1
Net non-deductible expenses 0.5 0.4 3.8
Federal credits & adjustments 1.4 (0.6) (1.2)
Decrease in valuation allowance - (103.4) (100.5)
Change in Deferred Tax Rate (2.6) - -
Other, net 1.1 - 0.4
-------- ------- -------
40.0% (65.7%) (59.0%)
======== ======= =======
Deferred income taxes reflect the impact of "temporary differences" between
amounts of assets and liabilities for financial reporting purposes and such
amounts as measured by tax laws. The tax effects of temporary differences that
give rise to significant portions of deferred tax assets and liabilities from
continuing operations at December 31 are as follows (in thousands):
----------------------
2003 2002
---------- ---------
Deferred tax assets:
Tax loss carryforward $117,953 $102,131
Deferred rent 6,319 7,027
Accrued liabilities and reserves 11,300 14,081
Tax credit carryforward 6,820 6,623
Restructure charges 2,604 3,526
Inventory valuation 23,957 35,038
Amortization 1,474 5,944
---------- ---------
Total deferred tax assets 170,427 174,370
Deferred tax liabilities:
Depreciation and amortization (62,638) (22,648)
Capitalized and financing leases (3,487) (3,909)
---------- ---------
Total deferred tax liabilities (66,125) (26,557)
---------- ---------
Net deferred tax asset $104,302 $147,813
========== =========
The Company believes that it is more likely than not that certain future tax
benefits will be realized as a result of current and anticipated future income.
Accordingly, the valuation allowance was reduced by $147.8 million in 2002 to
reflect anticipated net deferred tax asset utilization. As of December 31,
2003, the Company had approximately $304.3 million of net operating loss
carryforwards available to reduce future income taxes. The carryforward
periods expire in years 2019 through 2021. The Company has federal Alternative
Minimum Tax ("AMT") credit carryforwards of $3.0 million which are available to
reduce future regular taxes in excess of AMT. These credits have no expiration
date. The Company has federal and state tax credit carryforwards of $3.8
million which are available to reduce future taxes. The carryforward periods
expire in years 2018 through 2023, or have no expiration date.
The Company realized a tax benefit in the amount of $8.1 million and $12.8 in
2003 and 2002, respectively, as a result of the exercise of employee stock
options. For financial reporting purposes, the impact of this tax benefit is
credited directly to shareholders' equity.
16. SHAREHOLDERS' EQUITY
Preferred Stock
At December 31, 2003, the Company was authorized to issue 25,000,000 shares of
preferred stock in one or more series. With the exception of 3,119,737 shares
which have been designated as "Series A Redeemable Preferred Stock" but have
not been issued, the Board of Directors has authority to designate the
preferences, special rights, limitations or restrictions of such shares.
Common Stock
During the third and fourth quarters of 2003, the Company repurchased a total
of 1,746,173 shares of its common stock for an aggregate purchase price of
$26.3 million.
On March 11, 2002, the Company completed a public offering of 8,050,000 shares
of its common stock.
17. STOCK OPTION PLANS
In general, the Company's stock option plans provide for the granting of
options to purchase Company shares at a fixed price. It has been the Company's
Board of Directors general policy to set the price at the market price of such
shares as of the option grant date. The options generally have a nine year
term and become exercisable on a pro rata basis over the first three years or
at such other periods as determined by the Board. The Company adopted stock
option plans in 1993, 1997 and 2001 providing for the granting of non-qualified
stock options, stock appreciation rights, bonus rights and other incentive
grants to employees up to an aggregate of 21,000,000 shares of common stock.
The Company granted non-qualified stock options pursuant to the 1993, 1997 and
2001 Plans totaling 1,485,667, 3,311,368, and 11,063,683 in 2003, 2002 and
2001, respectively. The Company cancelled 1.3 million, 2.2 million, and 4.0
million of stock options in 2003, 2002 and 2001, respectively.
The Company has elected to follow APB Opinion 25; "Accounting for Stock Issued
to Employees" ("APB 25"), and related interpretations in accounting for its
employee stock options. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying
stock on the date of the grant, no compensation expense is recognized upon the
date of grant. Pro forma information regarding net income per share is
required by SFAS No. 123, "Accounting for Stock-Based Compensation", and has
been determined as if the Company had accounted for its employee stock options
under the fair value method of that statement. The fair value of these options
was estimated at the date of grant using Black-Scholes option pricing model
with the following weighted-average assumptions for 2003, 2002 and 2001:
-----------------------------
2003 2002 2001
-----------------------------
Risk free interest rate 2.33% 2.17% 3.87%
Expected dividend yield 0% 0% 0%
Expected lives 5 years 4 years 3 years
Expected volatility 96.9% 108% 100%
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options, which have no vesting restrictions and are
fully transferable. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in the Company's opinion, the existing available models do
not necessarily provide a reliable single measure of the fair value of the
Company's employee stock options.
Using the Black-Scholes option valuation model, the weighted average grant date
value of options granted during 2003, 2002 and 2001 was $10.70, $10.03, and
$1.55 per share subject to the option, respectively.
For the purpose of pro forma disclosures, the estimated fair value of the
options is amortized over the option's vesting period. The Company's pro forma
information is as follows (in thousands, except per share amounts):
Year Ended December 31,
----------------------------
2003 2002 2001
-------- -------- --------
Net income as reported $ 82,272 $241,845 $100,416
Add: Stock-based compensation
expense included in reported
net income, net of tax 339 596 2,378
Deduct: Total stock- based
employee compensation expense
under fair value based method
for all awards, net of tax (8,295) (7,941) (4,180)
-------- -------- --------
Pro forma net income $74,316 $234,500 $ 98,614
======== ======== ========
Earnings per Share:
Basic--as reported $ 1.36 $ 4.23 $ 2.05
Basic--pro forma 1.23 4.10 2.01
Diluted--as reported 1.28 3.88 1.90
Diluted--pro forma 1.19 3.87 1.93
A summary of the Company's stock option activity and related information for
2003, 2002 and 2001 is as follows (in thousands, except per share amounts):
Weighted
Average
Exercise
Shares Price
-------- --------
Outstanding as December 31, 2000 5,422 9.45
Granted 11,064 2.05
Exercised (181) 6.24
Cancelled (3,951) 7.39
-------- --------
Outstanding as December 31, 2001 12,354 3.52
Granted 3,311 13.47
Exercised (2,318) 2.39
Cancelled (2,199) 7.32
-------- --------
Outstanding as December 31, 2002 11,148 $ 5.96
Granted 1,486 14.73
Exercised (1,616) 2.96
Cancelled (1,287) 8.35
-------- --------
Outstanding as December 31, 2003 9,731 7.48
======== ========
The 1.5 million options granted in 2003 were granted with an exercise price
equal to market value.
A summary of options outstanding and exercisable at December 31, 2003 is as
follows (in thousands, except per share amounts):
------------------------------ -------------------
Options Outstanding Options Exercisable
------------------------------ -------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Range of Life Exercise Exercise
Exercise Prices Options (in years) Price Options Price
- ---------------- ------- --------- -------- ------- --------
$ 1.000 - $1.090 4,371 6.24 $ 1.09 2,440 $ 1.09
1.094 - 1.563 549 6.21 1.47 187 1.31
2.040 - 12.000 1,878 6.95 11.17 147 8.79
12.010 - 20.390 2,933 6.66 15.78 853 17.55
------ --------- -------- ------- --------
9,731 6.50 $ 7.48 3,627 $ 5.32
====== ========= ======== ======= ========
In the first quarter of 2000, the Company granted stock options to
approximately fifty key employees. The grants were for the same number of
shares issued to these employees prior to January 1, 2000. In the third quarter
of 2000, the Company cancelled the stock options that were issued prior to
January 1, 2000 for the fifty employees. The grant and cancellation of the same
number of options for these employees resulted in variable accounting treatment
for the related options for 850,000 shares of the Company's common stock.
Variable accounting treatment resulted in unpredictable stock-based
compensation dependent on fluctuations in quoted prices for the Company's
common stock. In 2002, the variable options were canceled and the Company
reversed expense that was recognized in 2001 on the canceled options. Options
subject to variable accounting outstanding at December 31, 2003, 2002 and 2001
were 0, 0 and 482,750, respectively. The Company reversed compensation expense
in 2002 of $2.6 million relating to the variable stock options compared to
compensation expense of $2.7 million in 2001.
The Company recorded compensation expense related to certain stock options
issued below the fair market value of the related stock in the amount of $0.6
million, $1.0 million and $1.4 million for the year ended December 31, 2003,
2002 and 2001, respectively.
18. EARNINGS PER SHARE
A reconciliation of the basic and diluted per share computations for 2003,
2002 and 2001 is as follows (in thousands, except per share data):
----------------------------------
2003
----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ---------
Income per common share $ 82,272 60,439 $ 1.36
Effect of dilutive securities:
Stock options - 3,741 (.08)
---------- --------- ---------
Income per share assuming dilution $ 82,272 64,180 $ 1.28
========== ========= =========
----------------------------------
2002
----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ---------
Income per common share $ 241,845 57,202 $ 4.23
Effect of dilutive securities:
Stock options - 5,188 (0.35)
---------- --------- ---------
Income per share assuming dilution $ 241,845 $ 62,390 3.88
========== ========= =========
----------------------------------
2001
----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ---------
Income per common share $ 100,416 49,101 $ 2.05
Effect of dilutive securities:
Stock options - 3,779 (0.15)
---------- --------- ---------
Income per share assuming dilution $ 100,416 52,880 $ 1.90
========== ========= =========
Shares subject to antidilutive stock options excluded from the calculation of
diluted income in 2003, 2002, and 2001 were 1.3 million, 0.8 million and 3.0
million, respectively.
19. COMMITMENTS AND CONTINGENCIES
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. 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 the Company's membership
application and additional rental period charges. The Company has vigorously
defended these actions and maintains that the terms of our 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 parties 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 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 the Company's consolidated results of operations, financial
condition or liquidity.
20. SEGMENT REPORTING
The Company's management regularly evaluates the performance of two segments,
Hollywood Video and Game Crazy, in its assessment of performance and in
deciding how to allocate resources. Hollywood Video represents the Company's
1,920 video stores excluding the operations of Game Crazy. Game Crazy
represents 595 in-store departments that allows game enthusiasts to buy, sell,
and trade used and new video game hardware, software and accessories. The
Company measures segment profit as operating income (loss), which is defined as
income (loss) before interest expense and income taxes. Information on
segments and reconciliation to operating income (loss) are as follows (in
thousands):
Year Ended December 31, 2003
-----------------------------------
Hollywood Game
Video Crazy Total
---------- ----------- ----------
Revenues $1,502,416 $ 180,132 $1,682,548
Depreciation 56,699 4,063 60,762
Income (loss) from operations 205,080 (19,986) 185,094
Total assets 888,030 109,427 997,457
Purchases of property and
equipment 65,769 28,354 94,123
Game Crazy's loss from operations includes an overhead allocation of 1% of Game
Crazy revenue for information support services, treasury and accounting
functions, and other general and administrative services. Game Crazy revenue
for 2002 was $56.7 million. Information regarding Game Crazy's results of
operations, total assets and purchases of property and equipment as reported
above for 2003 is not available for prior periods due to Game Crazy's smaller
scale prior to 2003 when costs were not segregated and captured.
21. QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data is as follows (in thousands, except per share
data):
Quarter Ended
------------------------------------------
March June September December
2003 --------- --------- --------- ---------
- -------------------------
Total revenue $ 417,592 $ 389,443 $ 401,958 $ 473,555
Gross profit 261,900 240,818 250,645 264,553
Income from
operations 55,036 39,871 41,985 48,201
Net income 19,578 19,178 20,469 23,046
Net income
per share:
Basic 0.33 0.32 0.34 0.38
Diluted 0.31 0.30 0.32 0.36
Quarter Ended
------------------------------------------
March June September December
2002 --------- --------- --------- ---------
- -------------------------
Total revenue $ 363,648 $ 345,261 $ 369,022 $ 412,135
Gross profit 223,009 216,810 228,425 248,293
Income from
operations 40,935 51,818 41,984 54,590
Net income 26,443 41,456 31,945 142,001
Net income
per share:
Basic 0.51 0.71 0.54 2.39
Diluted 0.46 0.64 0.50 2.21
Quarter Ended
------------------------------------------
March June September December
2001 --------- --------- --------- ---------
- -------------------------
Total revenue $ 342,245 $ 325,072 $ 344,914 $ 367,272
Gross profit 197,804 197,239 211,605 228,378
Income from
Operations 18,432 20,441 30,310 50,094
Net income 3,526 6,785 15,374 74,731
Net income
per share:
Basic 0.07 0.14 0.31 1.51
Diluted 0.07 0.13 0.28 1.35
22. CONSOLIDATING FINANCIAL STATEMENTS
Hollywood Entertainment Corporation (HEC) had only one wholly owned subsidiary
as of December 31, 2003, Hollywood Management Company (HMC). HMC is a guarantor
of certain indebtedness of HEC, including the obligations under the new credit
facilities and the 9.625% senior subordinated notes due 2011. Prior to June
2000, HEC had a wholly owned subsidiary, Reel.com (Reel), that was merged with
and into HEC in June 2000. The consolidating condensed financial statements
below present the results of operations and financial position of the
subsidiaries of the Company.
Consolidating Condensed Balance Sheet
December 31, 2003
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,259 $ 71,874 $ - $ 74,133
Cash held by trustee for
Refinancing - -
Accounts receivable, net 24,796 461,250 (452,059) 33,987
Merchandise inventories 129,864 - - 129,864
Prepaid expenses and other
current assets 10,041 3,192 - 13,233
Total current assets 166,960 536,316 (452,059) 251,217
Rental inventory, net 268,748 - - 268,748
Property & equipment, net 265,257 23,600 - 288,857
Goodwill, net 66,678 - - 66,678
Deferred income tax asset 104,302 - - 104,302
Other assets, net 14,469 7,194 (4,008) 17,655
Total assets $ 886,414 $ 567,110 $ (456,067) $ 997,457
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 647 $ - $ - $ 647
Subordinated notes to be
Retired with cash held by
Trustee (including accrued
Interest of $8.1 million) - - - -
Accounts payable 452,059 159,586 (452,059) 159,586
Accrued expenses 22,907 94,960 - 117,867
Accrued interest - 6,467 - 6,467
Income taxes payable - 284 - 284
Total current liabilities 475,613 261,297 (452,059) 284,851
Long-term obligations, less
current portion 370,669 - - 370,669
Other liabilities 16,108 - - 16,108
Total liabilities 862,390 261,297 (452,059) 671,628
Common stock 489,247 4,008 (4,008) 489,247
Unearned compensation (133) - - (133)
Retained earnings
(accumulated deficit) (465,090) 301,805 - (163,285)
Total shareholders' equity
equity (deficit) 24,024 305,813 (4,008) 325,829
Total liabilities and
shareholders equity
(deficit) $ 886,414 $ 567,110 $ (456,067) $ 997,457
Consolidating Condensed Balance Sheet
December 31, 2002
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,045 $ 31,100 $ - $ 33,145
Cash held by trustee for
Refinancing - 218,531 - 218,531
Accounts receivable, net 20,529 218,517 (204,050) 34,996
Merchandise inventories 97,307 - - 97,307
Prepaid expenses and other
current assets 11,995 2,777 - 14,772
Total current assets 131,876 470,925 (204,050) 398,751
Rental inventory, net 260,190 - - 260,190
Property & equipment, net 234,964 20,533 - 255,497
Goodwill, net 64,934 - - 64,934
Deferred income tax asset 147,813 - - 147,813
Other assets, net 17,361 5,838 (4,008) 19,191
Total assets $ 857,138 $ 497,296 $ (208,058) $1,146,376
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 27,678 $ - $ - $ 27,678
Subordinated notes to be
Retired with cash held by
Trustee (including accrued
Interest of $8.1 million) 203,940 8,140 - 212,080
Accounts payable 204,050 158,423 (204,050) 158,423
Accrued expenses 16,852 91,580 - 108,432
Accrued interest - 2,923 - 2,923
Income taxes payable - 1,151 - 1,151
Total current liabilities 452,520 262,217 (204,050) 510,687
Long-term obligations, less
current portion 361,068 - - 361,068
Other liabilities 17,472 - - 17,472
Total liabilities 831,060 262,217 (204,050) 889,227
Common stock 503,403 4,008 (4,008) 503,403
Unearned compensation (697) - - (697)
Retained earnings
(accumulated deficit) (476,628) 231,071 - (245,557)
Total shareholders' equity
equity (deficit) 26,078 235,079 (4,008) 257,149
Total liabilities and
shareholders equity
(deficit) $ 857,138 $ 497,296 $ (208,058) $1,146,376
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2003
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,685,424 $ 151,186 $(154,062)$1,682,548
Cost of revenue 664,632 - - 664,632
Gross profit 1,020,792 151,186 (154,062) 1,017,916
Operating costs & expenses:
Operating and selling 700,477 23,659 - 724,136
General & administrative 211,914 48,172 (154,062) 106,024
Store opening expenses 4,768 - - 4,768
Restructuring charges:
Closure of Internet
business - - - -
Store closures (2,106) - - (2,106)
Income from
operations 105,739 79,355 - 185,094
Interest income - 38,818 (38,059) 759
Interest expense (74,325) - 38,059 (36,266)
Early debt retirement (12,467) - - (12,467)
Income before
income taxes 18,947 118,173 - 137,120
(Provision for) income
taxes (7,409) (47,439) - (54,848)
Net income $ 11,538 $ 70,734 - $ 82,272
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2002
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,492,941 $ 156,057 $(158,932)$1,490,066
Cost of revenue 573,529 - - 573,529
Gross profit 919,412 156,057 (158,932) 916,537
Operating costs & expenses:
Operating and selling 637,739 10,034 - 647,773
General & administrative 199,254 49,280 (158,932) 89,602
Store opening expenses 3,093 - - 3,093
Restructuring charges:
Closure of Internet
business (12,430) - - (12,430)
Store closures (828) - - (828)
Income from
operations 92,584 96,743 - 189,327
Interest income - 31,619 (31,125) 494
Interest expense (73,676) - 31,125 (42,551)
Early debt retirement (3,534) - (3,534)
Income before
income taxes 15,374 128,362 - 143,736
(Provision for) income
taxes 146,577 (48,468) - 98,109
Net income $ 161,951 $ 79,894 - $ 241,845
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2001
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,382,378 $ 154,075 $(156,950)$1,379,503
Cost of revenue 544,477 - - 544,477
Gross profit 837,901 154,075 (156,950) 835,026
Operating costs & expenses:
Operating and selling 610,274 11,069 - 621,343
General & administrative 204,563 48,769 (156,950) 96,382
Restructuring charges:
Closure of Internet
business (3,256) - - (3,256)
Store closures (3,778) - - (3,778)
Amortization of intangibles 4,683 375 - 5,058
Income from
operations 25,415 93,862 - 119,277
Interest income - 35,438 (35,021) 417
Interest expense (91,567) - 35,021 (56,546)
Income(loss) before
income taxes (66,152) 129,300 - 63,148
(Provision for) income
taxes 85,109 (47,841) - 37,268
Net income $ 18,957 $ 81,459 $ - $ 100,416
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2003
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
Operating activities:
Net income $ 11,539 $ 70,733 $ 82,272
Adjustments to reconcile
net income to
cash provided by
operating activities:
Depreciation &
amortization 275,404 7,472 282,876
Tax benefit from exercise
of stock options 8,053 - 8,053
Change in deferred rent (1,364) - (1,364)
Change in deferred income
taxes 43,512 - 43,512
Non-cash stock
compensation 564 - 564
Net change in operating
assets & liabilities 218,729 (243,851) (25,122)
Cash provided by operating
activities 556,437 (165,646) 390,791
Investing activities:
Purchases of rental
inventory, net (220,364) - (220,364)
Purchase of property &
equipment, net (82,909) (11,214) (94,123)
Increase in intangibles
& other assets (1,917) (899) (2,816)
Refinancing proceeds - 218,531 218,531
Cash used in investing
activities (305,190) 206,418 (98,772)
Financing activities:
Proceeds from the sale of
common stock, net - - -
Issuance of subordinated
debt - - -
Extinguishment of
Subordinated debt (250,000) - (250,000)
Repayments of capital
lease obligations (8,869) - (8,869)
Repurchase of common stock (26,275) - (26,275)
Proceeds from exercise
of stock options 4,066 - 4,066
Decrease in revolving loans,
net 30,047 - 30,047
Cash provided by financing
activities (251,031) - (251,031)
Increase in cash
and cash equivalents 216 40,772 40,988
Cash and cash equivalents
at beginning of year 2,045 31,100 33,145
Cash and cash equivalents
at end of year $ 2,261 $ 71,872 $ 74,133
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2002
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
Operating activities:
Net income $ 161,951 $ 79,894 $ 241,845
Adjustments to reconcile
net income to
cash provided by
operating activities:
Extraordinary loss on
Extinguishment of debt 2,226 - 2,226
Depreciation &
amortization 276,505 5,528 282,033
Tax benefit from exercise
of stock options 12,814 - 12,814
Change in deferred rent (1,368) - (1,368)
Change in deferred income
taxes (109,417) - (109,417)
Non-cash stock
compensation (1,633) - (1,633)
Net change in operating
assets & liabilities (200,961) 136,050 (64,911)
Cash provided by operating
activities 140,117 221,472 361,589
Investing activities:
Purchases of rental
inventory, net (288,079) - (288,079)
Purchase of property &
equipment, net (36,326) (7,928) (44,254)
Increase in intangibles
& other assets (61) (724) (785)
Refinancing proceeds - (218,531) (218,531)
Cash used in investing
activities (324,466) (227,183) (551,649)
Financing activities:
Proceeds from the sale of
common stock, net 113,073 - 113,073
Issuance of subordinated
debt 225,000 - 225,000
Repayments of capital
lease obligations (13,816) - (13,816)
Proceeds from exercise
of stock options 4,604 - 4,604
Decrease in revolving loans,
net (144,466) - (144,466)
Cash provided by financing
activities 184,395 - 184,395
Increase in cash
and cash equivalents 46 (5,711) (5,665)
Cash and cash equivalents
at beginning of year 1,999 36,811 38,810
Cash and cash equivalents
at end of year $ 2,045 $ 31,100 $ 33,145
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2001
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
Operating activities:
Net income $ 18,957 $ 81,459 $ 100,416
Adjustments to reconcile
net income to
cash provided by
operating activities:
Depreciation &
amortization 244,521 6,370 250,891
Non-cash asset write downs
Tax benefit from exercise
of stock options (61) - (61)
Change in deferred rent (598) - (598)
Change in deferred income
taxes (38,396) - (38,396)
Non-cash stock
compensation 7,371 - 7,371
Net change in operating
assets & liabilities 4,238 (49,978) (45,740)
Cash provided by operating
activities 236,032 37,851 273,883
Investing activities:
Purchases of rental
inventory, net (202,790) - (202,790)
Purchase of property &
equipment, net (7,063) (1,739) (8,802)
Increase in intangibles
& other assets (137) (654) (791)
Cash used in investing
activities (209,990) (2,393) (212,383)
Financing activities:
Debt financing costs (4,656) - (4,656)
Repayments of long-term
obligations (17,399) - (17,399)
Proceeds from exercise
of stock options 1,097 - 1,097
Increase in revolving
loan, net (5,000) - (5,000)
Cash provided by financing
activities (25,958) - (25,958)
Increase in cash
and cash equivalents 84 35,458 35,542
Cash and cash equivalents
at beginning of year 1,915 1,353 3,268
Cash and cash equivalents
at end of year $ 1,999 $ 36,811 $ 38,810
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, as of March 12,
2004.
Hollywood Entertainment Corporation
By: /S/ TIMOTHY R. PRICE
---------------------------
Timothy R. Price
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities indicated as of March 12, 2004
Signatures Title
/S/ MARK J. WATTLES
- -----------------------
Mark J. Wattles Chairman of the Board of Directors,
and Chief Executive Officer
(Principal Executive Officer)
/S/ F. BRUCE GIESBRECHT
- -----------------------
F. Bruce Giesbrecht President and Chief Operating Officer
and Director
/S/ TIMOTHY R. PRICE
- -----------------------
Timothy R. Price Chief Financial Officer
(Principal Financial and Accounting Officer)
/S/ WILLIAM P. ZEBE
- -----------------------
William P. Zebe Director
/S/ JAMES N. CUTLER JR.
- -----------------------
James N. Cutler Jr. Director
/S/ DOUGLAS GLENDENNING
- -----------------------
Douglas Glendenning Director