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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 0-21824
HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in charter)
OREGON 93-0981138
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
9275 S.W. Peyton Lane, Wilsonville, Oregon 97070
(Address of principal executive offices) (zip code)
(503) 570-1600
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such short period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
As of April 19, 2004 there were 60,463,345 shares of the registrant's Common
Stock outstanding.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)
Three Months Ended
March 31,
--------------------------
2004 2003
---------- ----------
REVENUE:
Rental product revenue $ 359,517 $ 364,547
Merchandise sales 83,274 53,045
---------- ----------
442,791 417,592
---------- ----------
COST OF REVENUE:
Cost of rental product 108,934 116,610
Cost of merchandise 63,331 39,082
---------- ----------
172,265 155,692
---------- ----------
GROSS PROFIT 270,526 261,900
Operating costs and expenses:
Operating and selling 192,500 175,086
General and administrative 32,116 30,393
Store opening expenses 326 1,385
---------- ----------
224,942 206,864
---------- ----------
INCOME FROM OPERATIONS 45,584 55,036
Non-operating expense:
Interest expense, net (7,754) (9,664)
Early debt retirement - (12,467)
----------- -----------
Income before income taxes 37,830 32,905
Provision
for income taxes (15,132) (13,327)
---------- ----------
NET INCOME $ 22,698 $ 19,578
=========== ===========
- -----------------------------------------------------------
Net income per share:
Basic $ 0.38 $ 0.33
Diluted 0.36 0.31
- -----------------------------------------------------------
Weighted average shares outstanding:
Basic 59,647 59,867
Diluted 62,312 63,898
- -----------------------------------------------------------
The accompanying notes are an integral part of this financial statement
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except share amounts)
-------------------------
March 31, December 31,
2004 2003
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 70,529 $ 74,133
Receivables, net 31,459 33,987
Merchandise inventories 119,718 129,864
Prepaid expenses and other current
assets 12,643 13,233
----------- -----------
Total current assets 234,349 251,217
Rental inventory, net 263,835 268,748
Property and equipment, net 282,446 288,857
Goodwill 66,678 66,678
Deferred income tax asset, net 93,070 104,302
Other assets 16,902 17,655
----------- -----------
$ 957,280 $ 997,457
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term
obligations $ 497 $ 647
Accounts payable 123,043 159,586
Accrued expenses 114,851 117,867
Accrued interest 1,064 6,467
Income taxes payable 2,652 284
----------- ----------
Total current liabilities 242,107 284,851
Long-term obligations, less current
portion 350,913 370,669
Other liabilities 15,979 16,108
----------- ----------
608,999 671,628
Commitments and contingencies - -
Shareholders' equity:
Preferred stock, 25,000,000 shares
authorized; no shares issued and
outstanding - -
Common stock, 100,000,000 shares
authorized; 60,006,080 and
59,666,347 shares issued and
outstanding, respectively 488,868 489,247
Unearned compensation - (133)
Accumulated deficit (140,587) (163,285)
----------- ----------
Total shareholders' equity 348,281 325,829
----------- ----------
$ 957,280 $ 997,457
=========== ===========
The accompanying notes are an integral part of this financial statement.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
Three Months ended
March 31,
--------------------
2004 2003
--------- ---------
Operating activities:
Net income $ 22,698 $ 19,578
Adjustments to reconcile net income to cash
provided by operating activities:
Write-off deferred financing costs - 5,827
Amortization of rental product 51,596 58,536
Depreciation 17,223 14,969
Amortization of deferred financing costs 888 698
Tax benefit from exercise of stock options 2,457 1,219
Change in deferred rent (129) (355)
Change in deferred taxes 11,232 9,363
Non-cash stock compensation 133 167
Net change in operating assets and liabilities:
Receivables 2,528 1,484
Merchandise inventories 10,145 (8,152)
Accounts payable (36,542) (18,658)
Accrued interest (5,403) (8,215)
Other current assets and liabilities (773) (2,628)
--------- ---------
Cash provided by operating activities 76,053 73,833
--------- ---------
Investing activities:
Purchases of rental inventory, net (46,682) (57,565)
Purchase of property and equipment, net (10,812) (18,566)
Increase in intangibles and other assets 694 (209)
Proceeds from indenture trustee - 218,531
--------- ---------
Cash (used in) provided by
investing activities (56,800) 142,191
--------- ---------
Financing activities:
Extinguishment of subordinated debt - (250,000)
Borrowings under new term loan - 200,000
Repayment of prior revolving loan - (107,500)
Decrease in credit facilities (20,000) (15,000)
Debt financing costs (114) (6,915)
Repayments of capital lease obligations (140) (5,359)
Repurchase of common stock (3,665) -
Proceeds from capital lease obligation 233 -
Proceeds from exercise of stock options 829 773
--------- ---------
Cash used in financing activities (22,857) (184,001)
--------- ---------
Increase (decrease) in cash and
cash equivalents (3,604) 32,023
Cash and cash equivalents at
beginning of year 74,133 33,145
--------- ---------
Cash and cash equivalents
at end of first quarter $ 70,529 $ 65,168
========= =========
The accompanying notes are an integral part of this financial statement.
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The unaudited Consolidated Financial Statements have been prepared pursuant to
the rules and regulations of the Securities and Exchange Commission. Certain
information and note disclosures normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
(GAAP) have been condensed or omitted pursuant to those rules and regulations,
although Hollywood Entertainment Corporation (the "Company") believes that the
disclosures made are adequate to make the information presented not misleading.
The information furnished reflects all adjustments (consisting of normal
recurring adjustments) that are, in the opinion of management, necessary to
provide a fair statement of the results for the interim periods presented.
These financial statements should be read in conjunction with the financial
statements and the notes thereto included in the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities
and Exchange Commission. Results of operations for interim periods may not
necessarily be indicative of the results that may be expected for the full year
or any other period.
(1) Accounting Policies
The Consolidated Financial Statements included herein have been prepared in
accordance with the accounting policies described in Note 1 to audited
Consolidated Financial Statements included in the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 2003. Certain prior year
amounts have been reclassified to conform to the presentation used for the
current year. These reclassifications had no impact on previously reported
gross profit, net income or shareholders' equity.
The Company accounts for its stock option plans under the recognition and
measurement principles of Accounting Principles Board opinion No. 25,
"Accounting for Stock Issued to Employees, and related Interpretations."
Pursuant to the disclosure requirements of Statement of Financial Accounting
Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation" and
Statement of Financial Accounting Standards No. 148, "Accounting for Stock-
Based Compensation - Transition and Disclosure - an Amendment of SFAS 123." The
following table illustrates the effect on net income and earnings per share if
the Company had applied the fair value recognition provisions of SFAS 123.
(in thousands, except per share amounts)
Three Months
Ended March 31,
-------- --------
2004 2003
-------- --------
Net income, as reported $ 22,698 $ 19,578
Add: Stock-based compensation
expense included in reported
net income, net of tax 80 103
Deduct: Total stock-based employee
compensation expense under
fair value based method for
all awards, net of tax (1,681) (2,117)
-------- --------
Pro forma net income $ 21,097 $ 17,564
======== ========
Earnings per Share:
Basic--as reported $ 0.38 $ 0.33
Basic--pro forma 0.35 0.29
Diluted--as reported 0.36 0.31
Diluted--pro forma $ 0.35 $ 0.29
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 a material impact on the
Company's financial position or results of operations.
(2) Merger Agreement
On March 28, 2004 the Company signed a definitive merger agreement with Carso
Holdings Corporation ("Carso"), an affiliate of Leonard Green & Partners, L.P.
If the merger is completed, Hollywood Entertainment shareholders will receive
$14.00 per share in cash. Mark Wattles, Hollywood's founder, Chairman and Chief
Executive Officer, will continue in his current capacities following the merger
and will own 50% of the common stock and 52% of the junior preferred stock of
Carso. Green Equity Investors IV, LP will own 50% of the common stock of
Carso, 48% of the junior preferred stock of Carso, and all of the senior
preferred stock of Carso. The Company entered into the merger agreement
following the unanimous recommendation of a special committee comprised of the
independent directors of the Company's Board of Directors (the "Special
Committee"). The Special Committee and the Board of Directors received a
fairness opinion from Lazard Freres & Company, LLC.
The closing of the merger is subject to terms and conditions customary for
transactions of this type, including shareholder approval, receipt of antitrust
clearance and the completion of financing. The Company will solicit shareholder
approval by means of a proxy statement, which will be mailed to Hollywood
shareholders upon the completion of the required Securities and Exchange
Commission filing and review process. The parties currently anticipate
consummating the transaction in the third calendar quarter of 2004.
The Company filed a current report on Form 8-K on March 29, 2004 that included
the merger agreement and debt financing commitment letters as exhibits. The
proxy statement that the Company plans to file with the Securities and Exchange
Commission and mail to its shareholders will contain information about the
proposed merger and related matters.
(3) 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 that are primarily purchased
on a weekly basis in large quantities to support demand upon their initial
release by the studios and are generally held for relatively short periods of
time. Catalog, or library, represents an investment in those movies 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.
(4) Statements of Changes in Shareholders' Equity
A summary of changes to shareholders' equity amounts for the three months ended
March 31, 2004 is as follows (in thousands, except share amounts):
Common Stock Unearned
------------------- Compen- Accumulated
Shares Amount sation Deficit Total
---------- -------- -------- --------- --------
Balance at 12/31/2003 59,666,347 $489,247 $ (133) $(163,285) $325,829
---------- -------- -------- --------- --------
Issuance of common stock:
Stock options exercised 634,872 829 829
Stock options tax benefit 2,457 2,457
Stock compensation - 133 133
Repurchase of common stock (295,139) (3,665) (3,665)
Net income 22,698 22,698
---------- -------- -------- --------- --------
Balance at 03/31/2004 60,006,080 $488,868 $ - $(140,587) $348,281
========== ======== ======== ========= ========
(5) 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 $59.1 million and $55.0 million for the three months ended March
31, 2004 and 2003, respectively. Most operating leases require payment of
additional occupancy costs, including property taxes, utilities, common area
maintenance and insurance. These additional occupancy costs were $12.2 million
and $11.6 million for the three months ended March 31, 2004 and 2003,
respectively.
At December 31, 2003, the last fiscal year-end date, 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
(6) LONG-TERM OBLIGATIONS AND LIQUIDITY
The Company had the following long-term obligations as of March 31, 2004 and
December 31, 2003 (in thousands):
March 31, December 31,
----------- ----------
2004 2003
----------- ----------
Borrowings under credit facilities $ 125,000 $ 145,000
Senior subordinated notes due 2011 (1) 225,000 225,000
Obligations under capital leases 1,410 1,316
----------- ----------
351,410 371,316
Current portion:
Capital leases 497 647
----------- ----------
497 647
Total long-term obligations
net of current portion and notes to ----------- ----------
be retired with cash held by trustee $ 350,913 $ 370,669
=========== ==========
(1) Coupon payments at 9.625% are due semi-annually in March and September.
Upon consummation of the merger agreement disclosed in Note 2, the Company's
capital structure will change significantly. The senior subordinated notes due
2011 and the current term loan credit facility will be retired and replaced
with new financing arrangements. The new arrangements will substantially
increase the long-term obligations of the Company. Information regarding the
merger agreement and related financing can be found in the Company's current
report on Form 8-K filed on March 29, 2004.
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 indenture
governing 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 the holder's
notes at 101% of principal amount thereof. At December 31, 2003, the Company
was in compliance with the restrictions, covenants, and other terms of the
indenture. Hollywood Management Company, and any future subsidiaries of
Hollywood Entertainment Corporation, are guarantors under the credit agreement.
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 March 31, 2004, the
Company was in compliance with all covenants contained within the agreement.
Maturities on long-term obligations at March 31, 2004 for the next five years
are as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2004 $ - $ - $ 392 $ 392
2005 - - 510 510
2006 - - 490 490
2007 - 20,000 17 20,017
2008 - 105,000 - 105,000
Thereafter 225,000 - - 225,000
---------- ---------- --------- ---------
$ 225,000 $ 125,000 $ 1,409 $ 351,409
---------- ---------- --------- ---------
(7) Earnings per Share
Earnings per basic share are calculated based on income available to common
shareholders and the weighted-average number of common shares outstanding
during the reported period. Earnings per diluted share include additional
dilution from the effect of potential issuances of common stock, such as stock
issuable pursuant to the exercise of stock options.
The following tables are reconciliations of the earnings per basic and diluted
share computations (in thousands, except per share amounts):
Three Months Ended March 31,
----------------------------------------------------------
2004 2003
--------------------------- -----------------------------
Net Per Share Net Per Share
Income Shares(1) Amounts Income Shares(1) Amounts
------- --------- ------- -------- --------- --------
Income per
basic share: $ 22,698 59,647 $ 0.38 $ 19,578 59,867 $ 0.33
Effect of dilutive ======= =======
securities:
Stock options - 2,665 - 4,031
------- --------- -------- ---------
Income per
diluted share: $ 22,698 62,312 $ 0.36 $ 19,578 63,898 $ 0.31
======= ========= ======= ======== ========= ========
(1) Represents weighted average shares outstanding.
Antidilutive stock options excluded from the calculation of income per diluted
share were 4.3 million shares and 1.4 million shares for the three months ended
March 31, 2004 and 2003, respectively.
(8) Store Closure Restructuring
At March 31, 2004, one store remained to be closed pursuant to the Company's
store closure plan adopted in December of 2000 and amended in December of 2001,
2002 and 2003. In the first quarter of 2004, the Company closed two stores. In
accordance with the plan and the updated estimates of closing costs as of March
31, 2004, the Company had an accrual of $0.2 million related to the closure.
(9) Commitments and Contingencies
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 is currently involved in settlement discussions and
expects this case to be resolved in 2004. The Company believes it has provided
adequate reserves in connection with these lawsuits.
The Company and the members of its Board of Directors are defendants in seven
putative class action lawsuits filed in the circuit courts of Clackamas and
Multnomah counties, Oregon, related to the Agreement and Plan of Merger Among
Hollywood Entertainment Corporation, Carso Holdings Corporation and Cosar
Corporation dated as of March 28, 2004 (the "Merger Agreement"). The first of
the lawsuits was filed on March 30, 2004, the three most recent were filed on
April 6, 2004. The lawsuits allege generally that in approving the Merger
Agreement the members of the Board breached fiduciary duties owed to the
Company's shareholders. Each lawsuit seeks a court order enjoining the Company
from completing the merger, damages in an unstated amount allegedly suffered by
the shareholders by reason of the Merger Agreement and the payment of costs and
attorneys' fees to the plaintiffs' lawyers. The response of the Company and
Board members to the first of the lawsuits is due on April 29, 2004. The
Company's articles and bylaws include indemnification provisions with respect
to its directors and, in addition to payment of its own legal costs and fees,
the Company may be required to advance the payment of legal fees and costs
incurred in these lawsuits by the Board members.
In 2003, the Company was named as a defendant in two complaints regarding wage
and hour claims in California. In 2004, an additional suit was filed with
substantially similar claims. The plaintiffs are seeking to certify a class
action alleging that certain California employees were denied meal and rest
periods. There are several additional related wage and hours claims for unpaid
overtime, late payment of wages and off the clock work. At this time, the
Company and plaintiffs have agreed to stay these cases pending consolidation
and mediation. The Company believes it has provided adequate reserves in
connection with these lawsuits.
In addition, 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
contingencies and that the outcome of these matters should not have a material
adverse effect on its consolidated results of operations, financial condition
or liquidity.
(10) Related Party Transactions
In July 2001, Boards, Inc. (Boards) began to open Hollywood Video stores as
licensee of the Company pursuant to rights granted by the Company and approved
by the Board of Directors in connection with Mark J. Wattles' employment
agreement in January 2001. These stores are operated by Boards and are not
included in the 1,935 stores operated by the Company. Mark Wattles, the
Company's founder and Chief Executive Officer, 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. Boards is in compliance
with the 30 day payment terms under the arrangement. The outstanding balance of
$0.4 million due the Company is related to current activity. As of March 31,
2004, Boards operated 20 stores.
The following table reconciles the net receivable balance due from Boards, Inc
(in thousands):
2004 2003
-------- --------
Receivable Balance Beginning of Year $ 1,509 $ 631
-------- --------
License fee - 100
(2%)Royalty fee 132 57
Products & Services 1,904 2,156
------- --------
Expenses - First Quarter 2,036 2,313
Payments - First Quarter (3,101) (2,545)
------- --------
Receivable Balance Ending March 31 $ 444 $ 399
======== ========
(11) Segment Reporting
The Company operates two primary business segments, Hollywood Video and Game
Crazy. Hollywood Video represents the Company's 1,935 video superstores. Game
Crazy represents the Company's 608 game specialty stores, where game
enthusiasts can buy, sell, and trade new and used 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):
Three Months Ended
March 31, 2004
---------------------------------
Hollywood Game
Video Crazy Total
---------- ----------- ----------
Revenues $ 385,423 $ 57,368 $ 442,791
Depreciation 15,251 1,972 17,223
Overhead allocation (574) 574 -
Income (loss)
from operations 50,236 (4,652) 45,584
Total assets 853,140 104,140 957,280
Purchases of property
and equipment, net 9,543 1,269 10,812
Three Months Ended
March 31, 2003
---------------------------------
Hollywood Game
Video Crazy Total
---------- ----------- ----------
Revenues $ 393,742 $ 23,850 $ 417,592
Depreciation 14,301 668 14,969
Overhead allocation (238) 238 -
Income (loss)
from operations 59,000 (3,964) 55,036
Total assets 941,415 56,042 997,457
Purchases of property
and equipment, net 10,363 8,203 18,566
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 but does not include a
charge for occupancy.
(12) Consolidating Financial Statements
Hollywood Entertainment Corporation (HEC) had only one wholly owned subsidiary
as of March 31, 2004, Hollywood Management Company (HMC). HMC is a guarantor of
certain indebtedness of HEC, consisting of the obligations under the credit
facilities and the 9.625% senior subordinated notes due 2011. The consolidating
condensed financial statements below present the results of operations and
financial position of the subsidiaries of the Company.
Consolidating Condensed Balance Sheet
March 31, 2004
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,290 $ 68,239 $ - $ 70,529
Accounts receivable, net 24,450 443,984 (436,975) 31,459
Merchandise inventories 119,718 - - 119,718
Prepaid expenses and other
current assets 10,196 2,447 - 12,643
Total current assets 156,654 514,670 (436,975) 234,349
Rental inventory, net 263,835 - - 263,835
Property & equipment, net 258,917 23,529 - 282,446
Goodwill, net 66,678 - - 66,678
Deferred income tax asset 93,070 - - 93,070
Other assets, net 13,410 7,500 (4,008) 16,902
Total assets $ 852,564 $ 545,699 $ (440,983) $ 957,280
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 497 $ - $ - $ 497
Subordinated notes to be
Retired with cash held by
Trustee (including accrued
Interest of $8.1 million) - - - -
Accounts payable 436,975 116,691 (436,975) 116,691
Accrued expenses 19,829 95,022 - 114,851
Accrued Revenue Sharing 6,353 6,353
Accrued interest - 1,064 - 1,064
Income taxes payable - 2,652 - 2,652
Total current liabilities 457,301 221,782 (436,975) 242,108
Long-term obligations, less
current portion 350,912 - - 350,912
Other liabilities 15,979 - - 15,979
Total liabilities 824,192 221,782 (436,975) 608,999
Common stock 488,744 - 488,744
Unearned compensation 124 - - 124
Retained earnings
(accumulated deficit) (460,496) 323,917 (4,008) (140,587)
Total shareholders'
equity (deficit) 28,372 323,917 (4,008) 348,281
Total liabilities and
shareholders equity
(deficit) $ 852,564 $ 545,699 $ (440,983) $ 957,280
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 (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 Statement of Operations
Three Months ended March 31, 2004
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $ 443,509 $ 39,758 $ (40,476) $ 442,791
Cost of revenue 172,265 - - 172,265
Gross profit 271,244 39,758 (40,476) 270,526
Operating costs & expenses:
Operating and selling 187,921 4,579 - 192,500
General & administrative 57,615 14,977 (40,476) 32,116
Store opening expenses 326 - - 326
Income from
operations 25,382 20,202 - 45,584
Interest income - 9,974 (9,894) 80
Interest expense (17,728) - 9,894 (7,834)
Income before
income taxes 7,654 30,176 - 37,830
(Provision for) income
taxes (3,062) (12,070) - (15,132)
Net income $ 4,592 $ 18,106 $ - $ 22,698
Consolidating Condensed Statement of Operations
Three months ended March 31, 2003
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $ 418,311 $ 43,030 $ (43,749) $417,592
Cost of revenue 155,692 - - 155,692
Gross profit 262,619 43,030 (43,749) 261,900
Operating costs & expenses:
Operating and selling 170,437 4,649 - 175,086
General & administrative 58,937 15,205 (43,749) 30,393
Store opening expenses 1,385 - - 1,385
Restructuring charges:
Closure of Internet
business - - - -
Store closures - - - -
Income from
operations 31,860 23,176 - 55,036
Interest income - 8,196 (7,875) 321
Interest expense (17,860) - 7,875 (9,985)
Early debt retirement (12,467) - - (12,467)
Income before
income taxes 1,533 31,372 - 32,905
(Provision for) income
taxes (1,562) (11,765) - (13,327)
Net income $ (29) $ 19,607 $ - $ 19,578
Consolidating Condensed Statement of Cash Flows
Three months ended March 31, 2004
(in thousands)
----------- ---------- ----------
HEC HMC Consol-
idated
----------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 4,593 $ 18,105 $ 22,698
Adjustments to reconcile
net income to
cash provided by
operating activities:
Depreciation &
amortization 69,168 538 69,706
Tax benefit from exercise
of stock options 2,457 2,457
Change in deferred rent (129) - (129)
Change in deferred income
taxes 11,232 - 11,232
Non-cash stock
compensation 133 - 133
Net change in operating
assets & liabilities (7,826) (22,218) (30,044)
Cash provided by operating
activities 79,628 (3,575) 76,053
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (46,682) - (46,682)
Purchase of property &
equipment, net (10,344) (468) (10,812)
Proceeds from indenture
trustee 285 409 694
Cash used in investing
activities (56,741) (59) (56,800)
FINANCING ACTIVITIES:
Proceeds from the sale of
common stock, net - - -
Issuance of subordinated
debt - - -
Extinguishment of
Subordinated debt - - -
Repayments of capital
lease obligations (140) - (140)
Repurchase of common stock (3,665) - (3,665)
Proceeds from exercise
of stock options 829 - 829
Decrease in credit facility (20,000) - (20,000)
Proceeds from capital lease
Obligations 233 - 233
Debt financing costs (114) - (114)
Cash provided by financing
activities (22,857) - (22,857)
Increase in cash
and cash equivalents 30 (3,634) (3,604)
Cash and cash equivalents
at beginning of year 2,259 71,874 74,133
Cash and cash equivalents at
the end of the first quarter $ 2,289 $ 68,240 $ 70,529
Consolidating Condensed Statement of Cash Flows
Three months ended March 31, 2003
(in thousands)
---------- ---------- ----------
HEC HMC Consol-
idated
---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ (29) $ 19,607 $ 19,578
Adjustments to reconcile
net income to
cash provided by
operating activities:
Write-off of deferred
financing costs 5,827 - 5,827
Depreciation &
amortization 72,450 1,753 74,203
Tax benefit from exercise
of stock options 1,219 - 1,219
Change in deferred tax asset 9,363 - 9,363
Change in deferred rent (355) - (355)
Non cash stock compensation 167 - 167
Net change in operating
assets & liabilities 170,490 (206,657) (36,167)
Cash provided by (used in)
Operating activities 259,132 (185,297) 73,835
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (57,565) - (57,565)
Purchase of property &
equipment, net (17,559) (1,007) (18,566)
Increase in intangibles
& other assets 57 218,263 218,320
Cash used in investing
activities (75,067) 217,256 142,189
FINANCING ACTIVITIES:
Proceeds from the sale of
common stock, net - - -
Repayments of capital lease
obligations (5,359) - (5,359)
Proceeds from exercise
of stock options 773 - 773
Increase in revolving
loans, net (179,415) - (179,415)
Cash used in financing
activities (184,001) - (184,001)
Increase in cash
and cash equivalents 64 31,959 32,023
Cash and cash equivalents
at beginning of year 2,045 31,100 33,145
Cash and cash equivalents at
the end of the first quarter $ 2,109 $ 63,059 $ 65,168
ITEM 2. 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 March 31, 2004, we operated 1,935 Hollywood Video stores in 47
states and the District of Columbia. As of March 31, 2004, we also operated 608
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 87% of consolidated revenue in the
three months ended March 31, 2004 while Game Crazy contributed 13%.
In the three months ended March 31, 2004, Hollywood Video derived 81% 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 19% of Hollywood Video's
revenue was 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 generated increased revenue through opening
new stores and taking market share. We estimate approximately half of the
market share remains divided among 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, has
not cannibalized or otherwise adversely affected Hollywood Video revenue. In
fact, 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.
Merger Agreement
On March 28, 2004 we signed a definitive merger agreement with Carso Holdings
Corporation ("Carso"), an affiliate of Leonard Green & Partners, L.P. If the
merger is completed, Hollywood Entertainment shareholders will receive $14.00
per share in cash. Mark Wattles, Hollywood's founder, Chairman and Chief
Executive Officer, will continue in his current capacities following the merger
and will own 50% of the common stock and 52% of the junior preferred stock of
Carso. Green Equity Investors IV, LP will own 50% of the common stock of
Carso, 48% of the junior preferred stock of Carso, and all of the senior
preferred stock of Carso. We entered into the merger agreement following the
unanimous recommendation of a special committee comprised of the independent
directors of the Company's Board of Directors (the "Special Committee"). The
Special Committee and the Board of Directors received a fairness opinion from
Lazard Freres & Company, LLC.
The closing of the merger is subject to terms and conditions customary for
transactions of this type, including shareholder approval, receipt of antitrust
clearance and the completion of financing. We will solicit shareholder approval
by means of a proxy statement, which will be mailed to Hollywood shareholders
upon the completion of the required Securities and Exchange Commission filing
and review process. We anticipate consummating the transaction in the third
calendar quarter of 2004. Hollywood and Carso Holdings Corporation estimate
that the total amount of funds necessary to complete the merger and related
transactions and to pay related fees and expenses will be approximately $115
million. In addition, if the merger is not completed for reasons specified in
the merger agreement, we may have to reimburse Carso for its expenses up to
$3.0 million. In some circumstances, for example if we accept an offer we
believe is superior to Carso's, we would also have to pay a transaction
termination fee of $26.5 million.
We filed a current report on form 8-K on March 29, 2004 that included the
merger agreement and debt financing commitment letters as exhibits. The proxy
statement that we plan to file with the Securities and Exchange Commission and
mail to our shareholders will contain information about the proposed merger and
related matters.
RESULTS OF OPERATIONS
Summary Results of Operations
Total revenue for Hollywood Entertainment Corporation for the first quarter
2004 was $442.8 million compared to $417.6 million for the first quarter of
2003. The increase is primarily attributable to more Hollywood Video stores
and more Game Crazy stores open during the quarter and positive same store
sales at Game Crazy, partially offset by negative same store sales at Hollywood
Video. For the first quarter, revenue and same store sales for Hollywood Video
was $385.4 million and negative 6% respectively. For the first quarter,
revenue and same store sales for Game Crazy was $57.4 million and 30%
respectively.
Our income from operations for the three months ended March 31, 2004 was $45.6
million compared to $55.0 million for the three months ended March 31, 2003.
The decrease was primarily due to operating losses incurred by Game Crazy and a
decrease in video same store sales. For the three months ended March 31, 2004,
Hollywood Video generated $50.3 million in income from operations while Game
Crazy generated a net loss from operations of $4.7 million.
Our net income for the three months ended March 31, 2004 was $22.7 million
compared with net income of $19.6 million for 2003.
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.
Three Months Ended
March 31,
-------------------
2004 2003
-------- --------
Revenue:
Rental product revenue 81.2% 87.3%
Merchandise sales 18.8% 12.7%
-------- --------
100.0% 100.0%
-------- --------
Gross margin 61.1% 62.7%
Operating costs and expenses:
Operating and selling 43.5% 41.9%
General and administrative 7.2% 7.3%
Store opening expense 0.1% 0.3%
-------- --------
50.8% 49.5%
-------- --------
Income from operations 10.3% 13.2%
Interest expense, net (1.8%) (2.3%)
Early debt retirement - (3.0%)
-------- --------
Income before income taxes 8.5% 7.9%
Provision for income taxes (3.4%) (3.2%)
-------- --------
Net income 5.1% 4.7%
======== ========
Other data:
Rental product gross margin (1) 69.7% 68.0%
Merchandise sales gross margin (2) 23.9% 26.3%
- ----------------------------------------------------
(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 $25.2 million, or 6.0%, for the three months ended March
31, 2004 compared to the three months ended March 31, 2003. The increase was
primarily due to an increase, on a weighted average basis, of 294 Game Crazy
stores and 92 Hollywood Video stores plus a 30% increase in Game Crazy same
store sales, partially offset by a 6% decrease in Hollywood Video same store
sales.
The following is a summary of revenue by product category and operating segment
(in thousands):
---------- ----------
Q1 2004 Q1 2003
---------- ----------
DVD rental product revenue $ 237,630 $ 181,509
VHS rental product revenue 91,541 151,651
Game rental product revenue 30,346 31,387
---------- ----------
Total rental product revenue 359,517 364,547
---------- ----------
Video store merchandise revenue 25,906 29,195
Game Crazy revenue 57,368 23,850
---------- ----------
Total merchandise revenue 83,274 53,045
---------- ----------
---------- ----------
Total revenue $ 442,791 $ 417,592
========== ==========
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 68.9% and 45.0% of consolidated merchandise
revenue for the three months ended March 31, 2004 and 2003, respectively. Game
Crazy revenue is generated from the sale of new and used video game hardware,
software and accessories. Hollywood Video contributed the remaining 31.1% and
55.0% of consolidated merchandise revenue for the three months ended March 31,
2004 and 2003, respectively, 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 69.7% for
the three months ended March 31, 2004 from 68.0% for the three months ended
March 31, 2003. The increase was primarily due to a shift in revenue from VHS
product to DVD product, which typically has higher gross margins.
Merchandise Sales Margins
Merchandise sales gross margin as a percentage of merchandise sales decreased
to 23.9% for the three months ended March 31, 2004 from 26.3% for the three
months ended March 31, 2003. The decrease was the result of lower gross margin
rates for both Hollywood Video and Game Crazy. For Hollywood Video, the
decrease was the result of lower gross margin rates for new movie sales,
including markdowns on slow moving and older VHS titles. For Game Crazy, the
decrease was the result of a shift in revenue from used product to new product,
which typically has lower gross margins. The decrease was partially offset by
an increase in the percentage of merchandise sales from Game Crazy, which
typically have higher margins than new movie sales in Hollywood Video.
OPERATING COSTS AND EXPENSES
Operating and Selling Expenses
Total operating and selling expenses for the three months ended March 31, 2004
increased as a percentage of revenue to 43.5% from 41.9% for the three months
ended March, 31 2003. The percentage increase was primarily the result of
higher labor and other fixed and variable expense rates, due to the 6% decrease
in same store Hollywood Video sales, and an increase of 92 weighted average
Hollywood Video stores. Total operating and selling expense for the three
months ended March 31, 2004 increased $17.4 million to $192.5 million from
$175.1 million for 2003. The increase was primarily the result of increased
variable costs associated with increased total revenue, an increase of 92
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 $9.0 million, rent and related expenses increased by $4.7
million, advertising increased by $1.1 million, and other operating and selling
expenses increased by $2.6 million for the three months ended March 31, 2004
compared to the three months ended March 31, 2003.
General and Administrative Expenses
General and administrative expenses for the three months ended March 31, 2004
increased $1.7 million to $32.1 million, or 7.2% of total revenue, from $30.4
million, or 7.3% of total revenue for the three months ended March 31, 2003.
Included in the general and administrative expenses for March 31, 2004 was a
$1.9 million charge to increase the settlement reserve for wage and hour class
action litigation as well as $1.0 million paid to Lazard Freres & Company, LLC
for services incurred in connection with its delivery of a fairness opinion
related to the merger agreement. Included in general and administrative
expenses for the three months ended March 31, 2003 was a $1.7 million charge to
increase a class action litigation settlement reserve related to extended
rental periods.
NON-OPERATING INCOME (EXPENSE), NET
Interest Expense
Interest expense, net of interest income, decreased in the three months ended
March 31, 2004 compared to the three months ended March 31, 2003 by $1.9
million. The reduction was primarily due to the new debt structure, prepayment
resulting in decreased borrowing levels and lower interest rates (see Note 5 to
see a detailed table of long-term obligations).
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.
INCOME TAXES
Our effective tax rate was a provision of 40.0% for the three months ended
March 31, 2004 compared to a provision of 40.5% for the three months ended
March 31, 2003. Our effective tax rate varies from the federal statutory rate
as a result of nondeductible officer's compensation, other permanent items and
minimum state income taxes. 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, but excluding any impact of the proposed merger, 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 $20.2 million for the three months ended March 31,
2004 compared to $28.9 million for the three months ended March 31, 2003. 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 decreased $10.2 million to $119.7 million
for the three months ended March 31, 2004, from $129.9 million as of December
31, 2003. The decrease was primarily the result of a normal seasonal decline
from the fourth quarter and new movie returns of slow moving and older VHS
titles.
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 2004 funded our debt service requirements,
maintenance capital expenditures, and Game Crazy operating losses and provided
the capital required to add 13 Game Crazy stores and 19 Hollywood Video stores.
At March 31, 2004, we had $70.5 million of cash and cash equivalents on hand.
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." However, upon consummation of the merger disclosed
above under the heading "Merger Agreement," our capital structure will change
significantly. The financing required to complete the merger transaction will
require a substantial increase in our long-term obligations, which will
increase our debt service requirements. Information regarding the merger
agreement and related financing can be found in the Company's current report on
Form 8-K filed on March 29, 2004.
Cash Provided by Operating Activities
Net cash provided by operating activities increased by $2.3 million, or 3.0%,
to $76.1 million for the three months ended March 31, 2004 compared to $73.8
million for the corresponding period of the prior year. The increase was the
result of a decrease in income from operations offset by a decrease in interest
payments, a decrease in payments related to debt retirement and favorable
changes in working capital accounts.
Cash Used in Investing Activities
Net cash used in investing activities was $56.8 million for the three months
ended March 31, 2004, including the cost to open 19 Hollywood Video stores and
13 Game Crazy stores. Our investment in rental inventory decreased 19% for the
three months ended March 31, 2004 compared to the three months ended March 31,
2003. The decease was primarily due to a shift in purchases from VHS to DVD,
which is generally less expensive and results in higher gross margins, as well
as a decrease in units purchased due to a weaker slate of new release titles.
In the three months ended March 31, 2003, investing activities resulted in a
$142.2 million source of cash. The source of cash was primarily the result of
proceeds delivered to subordinated note holders on our behalf by the indenture
trustee. The delivery of the proceeds to the indenture trustee and the
subsequent use of the proceeds to redeem the notes in the first quarter of 2003
were classified as investing activities. In the three months ended March 31,
2003 we opened 11 Hollywood Video stores and 84 Game Crazy stores.
We currently anticipate investing approximately $105 million in 2004 to open
150 Hollywood Video stores and 150 Game Crazy stores 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, liquidity and operating
results.
Cash Used in Financing Activities
Net cash flow from financing activities was a $22.9 million use of cash for the
three months ended March 31, 2004 that included a $20 million prepayment on our
term loan facility, which is now prepaid through 2006, and the repurchase of
295,139 shares of common stock for $3.7 million. Net cash flow from financing
activities was a $184.0 million use of cash for the three months ended March
31, 2003. The use of cash reflected the redemption of $250.0 million of 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.
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 March 31, 2004,
we were in compliance with all covenants contained within our debt agreements.
At March 31, 2004, 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 $ - $ - $ 392 $ 392
2005 - - 510 510
2006 - - 490 490
2007 - 20,000 17 20,017
2008 - 105,000 - 105,000
Thereafter 225,000 - - 225,000
---------- ---------- --------- ---------
$ 225,000 $ 125,000 $ 1,409 $ 351,409
---------- ---------- --------- ---------
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, the last
fiscal year-end date, 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 March 31, 2004, we had cash and cash equivalents of $70.5 million and a
working capital deficit of $7.8 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
The preparation of financial statements and related disclosures in conformity
with generally accepted accounting principles (GAAP) requires us to make
judgments, assumptions and estimates that affect the amounts reported in the
Consolidated Financial Statements and accompanying notes. Note 1 to the audited
Consolidated Financial Statements included in our Annual Report on Form 10-K
for the year ended December 31, 2003 and Note 1 to the Consolidated Financial
Statements contained in this Quarterly Report on Form 10-Q describe the
significant accounting policies and methods used in the preparation of the
Consolidated Financial Statements. Our judgments, assumptions and estimates
affect, among other things: the amounts of receivables; rental and merchandise
inventories; property and equipment, net; goodwill; deferred income tax assets,
net; other liabilities; revenue; cost of revenue; and operating costs and
expenses. We base our judgments, assumptions and estimates on historical
experience and on various other factors that we believe to be reasonable under
the circumstances. Actual results could differ significantly from amounts based
on our judgments, assumptions and estimates. Certain critical accounting
policies that involve significant judgments, assumptions and estimates which
affect amounts recorded in the Consolidated Financial Statements are discussed
in our Annual Report on Form 10-K for the year ended December 31, 2003 in
Management's Discussion and Analysis of Results of Operations and Financial
Condition under the heading "Critical Accounting Policies."
For a discussion of new accounting pronouncements, refer to Note 1, "Accounting
Policies," to the Consolidated Financial Statements.
ITEM 3. 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 March 31, 2004, 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% during the twelve months ended March 31, 2004 our interest expense
would have increased by approximately $1.3 million based on our outstanding
balance on the facility as of March 31, 2004.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We evaluated, under the supervision and with the participation of our
management, including our Chief Executive Officer and our Chief Financial
Officer, the effectiveness of our disclosure controls and procedures as of the
end of the period covered by this report pursuant to Rule 13a-15(b) under the
Securities Exchange Act of 1934. Based on the evaluation, our Chief Executive
Officer and the Chief Financial Officer have concluded that our disclosure
controls and procedures are effective in ensuring that information required to
be disclosed is recorded, processed, summarized and reported in a timely
manner.
Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting that
occurred during our last fiscal quarter that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, that 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.
Failure to complete our proposed merger could negatively impact the market
price of our common stock. If the merger is terminated and our board of
directors seeks another merger or business combination, shareholders cannot be
certain that we will be able to find a partner willing to pay an equivalent or
better price than the price to be paid in the merger.
We signed a definitive merger agreement with Carso Holdings Corporation
("Carso"), an affiliate of Leonard Green & Partners, L.P., on March 28, 2004.
Completion of the merger is subject to a number of contingencies, including
approval by a majority of our shareholders, receipt of regulatory approvals and
other customary closing conditions. Seven class action lawsuits have been
filed naming us, the members of our board of directors, one of our executive
officers and Leonard Green & Partners. The lawsuits seek to enjoin the
completion of the merger.
Unless or until the merger agreement is terminated, subject to specified
exceptions, Hollywood is restricted from entering into or soliciting,
initiating or encouraging any inquiries or proposals that may lead to a
proposal or offer for a merger, consolidation, business combination, sale of
substantial assets, tender offer, sale of shares of capital stock or other
similar transactions with any person or entity other than Carso. As a result of
these restrictions, Hollywood may not be able to enter into an alternative
transaction at a more favorable price, if at all, without incurring potentially
significant liability to Carso.
Uncertainties associated with the proposed merger may cause Hollywood to lose
key personnel.
If the merger is not completed for any reason, Hollywood will be subject to a
number of risks, including:
- - the market price of Hollywood common stock may decline to the extent that
the current market price of such shares reflects a market assumption that
the merger will be completed;
- - costs related to the merger, such as legal and accounting fees and
portion of the investment banking fees and, in certain circumstances,
termination and expense reimbursement fees, must be paid even if the
merger is not completed and will be expensed in the fiscal period in
which termination occurs;
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. In the first quarter of 2004 we opened 19 Hollywood Video stores and
added 13 Game Crazy stores. We anticipate continuing to add 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 March 31, 2004, we had total consolidated long-term debt, including
capital leases, of approximately $351.4 million. We and our subsidiary could
incur substantial additional indebtedness in the future, including the
financing required to complete the merger, which will substantially increase
our indebtedness. An increase in our indebtedness could intensify the related
risks that we now face. 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 March 31, 2004, 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. We
are aware of seven putative class action lawsuits related to the merger
agreement. We may incur substantial costs related to our defense and we may
suffer from a diversion of our management's attention and resources.
Future sales of shares of our common stock may negatively affect our stock
price.
If we or our shareholders sell substantial amounts of our common stock in the
public market, the market price of our common stock could fall. In addition,
sales of substantial amounts of our common stock might make it more difficult
for us to sell equity or equity-related securities in the future.
We do not expect to pay dividends in the foreseeable future.
We have never declared or paid any cash dividends on our common stock and we do
not expect to declare dividends on our common stock in the foreseeable future.
The instruments governing our existing and future indebtedness contain or may
contain provisions prohibiting or limiting the payment of dividends on our
common stock.
Provisions of Oregon law and our articles of incorporation may make it more
difficult to acquire us, even though an acquisition may be beneficial to our
shareholders.
Provisions of Oregon law condition the voting rights that would otherwise be
associated with any shares of our common stock that may be acquired in
specified transactions deemed to constitute a "control share acquisitions" upon
approval by our shareholders (excluding, among other things, the acquirer in
any such transaction). Provisions or Oregon law also restrict, subject to
specified exceptions, the ability of a person owning 15% or more of our common
stock to enter into any "business combination transaction" with us. In
addition, under our articles of incorporation, our Board of Directors has the
authority to issue up to 25.0 million shares of preferred stock and to fix the
rights, preferences, privileges and restrictions of those shares without any
further vote or action by the shareholders. These provisions of Oregon law and
our articles of incorporation have the effect of delaying, deferring or
preventing a change in control of Hollywood, may discourage bids for our common
stock at a premium over the market price of our common stock and may adversely
affect the market price of, and the voting and other rights of the holders of,
our common stock and the occurrence of a control share acquisition may
constitute an event of default under, or otherwise require us to repurchase or
repay, our indebtedness.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
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 is currently involved in settlement discussions and
expects this case to be resolved in 2004. The Company believes it has provided
adequate reserves in connection with these lawsuits.
The Company and the members of its Board of Directors are defendants in seven
putative class action lawsuits filed in the circuit courts of Clackamas and
Multnomah counties, Oregon, related to the Agreement and Plan of Merger Among
Hollywood Entertainment Corporation, Carso Holdings Corporation and Cosar
Corporation dated as of March 28, 2004 (the "Merger Agreement"). The first of
the lawsuits was filed on March 30, 2004, the three most recent were filed on
April 6, 2004. The lawsuits allege generally that in approving the Merger
Agreement the members of the Board breached fiduciary duties owed to the
Company's shareholders. Each lawsuit seeks a court order enjoining the Company
from completing the merger, damages in an unstated amount allegedly suffered by
the shareholders by reason of the Merger Agreement and the payment of costs and
attorneys' fees to the plaintiffs' lawyers. The response of the Company and
Board members to the first of the lawsuits is due on April 29, 2004. The
Company's articles and bylaws include indemnification provisions with respect
to its directors and, in addition to payment of its own legal costs and fees,
the Company may be required to advance the payment of legal fees and costs
incurred in these lawsuits by the Board members.
In 2003, the Company was named as a defendant in two complaints regarding wage
and hour claims in California. In 2004, an additional suit was filed with
substantially similar claims. The plaintiffs are seeking to certify a class
action alleging that certain California employees were denied meal and rest
periods. There are several additional related wage and hours claims for unpaid
overtime, late payment of wages and off the clock work. At this time, the
Company and plaintiffs have agreed to stay these cases pending consolidation
and mediation. The Company believes it has provided adequate reserves in
connection with these lawsuits.
In addition, 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
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 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
A summary of our purchases of shares of our common stock for the three months
ended March 31, 2004 is as follows (in thousands , except share amounts):
ISSUER PURCHASES OF EQUITY SECURITIES
------------------------------------------------------------
Period Total Average Total Maximum
Number of Price Paid Number of Number (or
Shares per Share Shares Approximate
Purchased (1) Purchased as Dollar
Part of Value)
Publicly of Shares
Announced that May
Plans or Yet Be
Programs Purchased
Under the
Plans or
Programs (2)
--------- --------- --------- ---------
January 1-31 295,139 $ 12.42 295,139 $ 675
February 1-29 - - - 675
March 1-31 - - - 27,212
--------- --------- ---------
Total 295,139 $ 12.42 295,139
========= ========= =========
(1) All share purchases were open-market purchases made under a repurchase
plan publicly announced in a press release dated August 27, 2003. Hollywood's
board of directors authorized the purchase of the maximum number of shares
allowed under the Company's bank credit facility and terms of the indenture.
The purchase satisfied the conditions of the safe harbor of SEC Rule 10b-18.
(2) Hollywood's ability to purchase shares under its publicly announced plan
is limited by its bank credit facility. The Company does not intend to make
further purchases under the plan while its proposed merger transaction is
pending.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
2.1 Agreement and Plan of Merger dated March 28, 2004 by and among the
Registrant, Carso Holdings Corporation and Cosar Corporation (incorporated by
reference to Exhibit 2.1 to the Registrant's current report on Form 8-K filed
March 29, 2004).
3.1 1993B Restated Articles of Incorporation, as amended (incorporated by
reference to the Registrant's Registration Statement on Form S-1 (File No. 33-
63042), by reference to Exhibit 4 to the Registrant's Registration Statement on
Form S-3 (File No. 33-96140), and by reference to Exhibit 3.1 to the
Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30,
1998).
3.2 1999 Restated Bylaws (incorporated by reference to Exhibit 3.2 to the
Registrant's Registration Statement on Form S-4 (File No. 333-82937) (the
"1999 S-4")).
4.1 Indenture dated January 25, 2002 among the Registrant, Hollywood Management
Company, as potential guarantor, and BNY Western Trust Company as trustee
(incorporated by reference to Exhibit 4.1 to our Registration Statement on Form
S-3 (File No. 333-14802)) as supplemented by the First Supplemental Indenture
dated as of December 18, 2002 among the Registrant and Hollywood Management
Company and BNY Western Trust Company as Trustee (incorporated by reference to
Exhibit 4.3 to our Annual Report on Form 10-K for the year ended December 31,
2002).
31.1 Certification of Chief Executive Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002
31.2 Certification of Chief Financial Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002
32.1 Certification of Chief Executive Officer and Chief Financial Officer of
Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
On January 6, 2004, Hollywood Entertainment Corporation (the "Company") issued
a press release announcing its same store sales results for the quarter ended
December 31, 2003. The Company's press release is attached to the Form 8-K.
On January 29, 2004, Hollywood Entertainment Corporation (the "Company") issued
a press release announcing its financial results for the quarter and year ended
December 31, 2003. The Company's press release is attached to the Form 8-K.
On March 28, 2004, Hollywood Entertainment Corporation (the "Company") entered
into an agreement and plan of merger (the "Merger Agreement") with Carso
Holdings Corporation ("Holdings") and its wholly owned subsidiary. Holdings is
a wholly owned subsidiary of Leonard Green & Partners, L.P. ("LGP"), a private
equity firm that manages more than $3.6 billion of private equity capital. A
copy of the Merger Agreement is attached as exhibit 2.1. If the Merger
Agreement is approved by the Company's shareholders at a special shareholder
meeting and if the other conditions in the Merger Agreement are met, Holding's
wholly owned subsidiary will merge into the Company, with the Company
surviving, and each share of Company common stock will be converted into the
right to receive $14.00. The Company's March 29, 2004 press release announcing
its entry into the Merger Agreement is attached to the Form 8-K. The equity
financing necessary for the transaction has been fully committed by a wholly
owned subsidiary of LGP and the debt financing necessary for the transaction
has been fully committed by affiliates of UBS AG. The commitment letter from
UBS is attached to the Form 8-K.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HOLLYWOOD ENTERTAINMENT CORPORATION
(Registrant)
April 22, 2004 /S/Timothy R. Price
- ------------------ -------------------------------------------------
(Date) Timothy R. Price
Chief Financial Officer
(Authorized Officer and Principal Financial and
Accounting Officer of the Registrant)
37
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