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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 June 30, 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 July 28, 2004 there were 60,761,968 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 Six Months Ended
June 30, June 30,
------------------ -------------------
2004 2003 2004 2003
-------- -------- --------- ---------
REVENUE:
Rental product revenue $344,009 $329,932 $ 703,526 $ 694,479
Merchandise sales 79,120 59,511 162,393 112,556
-------- -------- --------- ---------
423,129 389,443 865,919 807,035
COST OF REVENUE:
Cost of rental product 105,765 106,157 214,699 222,767
Cost of merchandise 59,144 42,468 122,475 81,550
-------- -------- --------- ---------
164,909 148,625 337,174 304,317
-------- -------- --------- ---------
GROSS MARGIN 258,220 240,818 528,745 502,718
Operating costs and expenses:
Operating and selling 189,242 174,453 381,741 349,539
General and administrative 27,244 25,156 59,360 55,549
Store opening expenses 711 1,338 1,037 2,723
Restructuring charges
for store closures (190) - (190) -
------- -------- --------- ---------
217,007 200,947 441,948 407,811
------- -------- --------- ---------
INCOME FROM OPERATIONS 41,213 39,871 86,797 94,907
Non-operating expense:
Interest expense, net (7,505) (8,171) (15,259) (17,835)
Early debt retirement - - - (12,467)
-------- -------- --------- ---------
Income before income taxes 33,708 31,700 71,538 64,605
Provision for income taxes (13,483) (12,522) (28,615) (25,849)
-------- -------- --------- ---------
NET INCOME $ 20,225 $ 19,178 $ 42,923 $ 38,756
======== ======== ========= =========
- -------------------------------------------------------------------------------
Net income per share:
Basic $ 0.33 $ 0.32 $ 0.71 $ 0.64
Diluted $ 0.32 $ 0.30 $ 0.69 $ 0.60
- -------------------------------------------------------------------------------
Weighted average shares outstanding:
Basic 60,607 60,626 60,127 60,249
Diluted 62,902 64,655 62,595 64,291
- -------------------------------------------------------------------------------
The accompanying notes are an integral part of this financial statement
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
-------------------------
June 30, December 31,
2004 2003
----------- -----------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 117,211 $ 74,133
Receivables, net 28,453 33,987
Merchandise inventories 117,610 129,864
Prepaid expenses and other current
assets 11,112 13,233
----------- -----------
Total current assets 274,386 251,217
Rental inventory, net 265,333 268,748
Property and equipment, net 280,762 288,857
Goodwill 66,678 66,678
Deferred income tax asset, net 83,704 104,302
Other assets 16,313 17,655
----------- -----------
$ 987,176 $ 997,457
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term
obligations $ 583 $ 647
Accounts payable 120,661 159,586
Accrued expenses 116,957 117,867
Accrued interest 6,426 6,467
Income taxes payable 3,405 284
----------- ----------
Total current liabilities 248,032 284,851
Long-term obligations, less current
portion 350,803 370,669
Other liabilities 15,742 16,108
----------- ----------
614,577 671,628
Commitments and contingencies - -
Shareholders' equity:
Preferred stock, 25,000,000 shares
authorized; no shares issued and
outstanding - -
Common stock, 100,000,000 shares
authorized; 60,711,661 and
59,666,347 shares issued and
outstanding, respectively 492,961 489,247
Unearned compensation - (133)
Accumulated deficit (120,362) (163,285)
----------- ----------
Total shareholders' equity 372,599 325,829
----------- ----------
$ 987,176 $ 997,457
=========== ===========
The accompanying notes are an integral part of this financial statement.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
Six Months ended
June 30,
--------------------
2004 2003
--------- ---------
Operating activities:
Net income $ 42,923 $ 38,756
Adjustments to reconcile net income to cash
provided by operating activities:
Write-off deferred financing costs - 5,827
Amortization of rental product 99,549 108,035
Depreciation 31,882 30,007
Amortization of deferred financing costs 1,647 1,302
Tax benefit from exercise of stock options 5,409 5,274
Change in deferred rent (365) (762)
Change in deferred taxes 20,598 18,401
Non-cash stock compensation 133 299
Net change in operating assets and liabilities:
Receivables 5,534 5,915
Merchandise inventories 12,254 (22,073)
Accounts payable (38,925) (30,759)
Accrued interest (42) (2,935)
Other current assets and liabilities 4,206 (14,968)
--------- ---------
Cash provided by operating activities 184,803 142,319
--------- ---------
Investing activities:
Purchases of rental inventory, net (96,134) (97,512)
Purchase of property and equipment, net (23,787) (45,385)
Increase in intangibles and other assets (179) (598)
Proceeds from indenture trustee - 218,531
--------- ---------
Cash (used in) provided by
investing activities (120,100) 75,036
--------- ---------
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 - (6,989)
Repayments of capital lease obligations (227) (6,620)
Repurchase of common stock (3,665) -
Proceeds from capital lease obligation 297 -
Proceeds from exercise of stock options 1,970 1,991
--------- ---------
Cash used in financing activities (21,625) (184,118)
--------- ---------
Increase in cash and
cash equivalents 43,078 33,237
Cash and cash equivalents at
beginning of year 74,133 33,145
--------- ---------
Cash and cash equivalents
at end of second quarter $ 117,211 $ 66,382
========= =========
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 Six Months
Ended June 30, Ended June 30,
-------- -------- -------- --------
2004 2003 2004 2003
-------- -------- -------- --------
Net income, as reported $ 20,225 $ 19,178 $ 42,923 $ 38,756
Add: Stock-based compensation
expense included in reported
net income, net of tax 0 76 80 180
Deduct: Total stock-based employee
compensation expense under
fair value based method for
all awards, net of tax (1,012) (2,366) (2,693) (4,482)
-------- -------- -------- --------
Pro forma net income $ 19,213 $ 16,888 $ 40,310 $ 34,454
======== ======== ======== ========
Earnings per Share:
Basic--as reported $ 0.33 $ 0.32 $ 0.71 $ 0.64
Basic--pro forma 0.32 0.28 0.67 0.57
Diluted--as reported 0.32 0.30 0.69 0.60
Diluted--pro forma $ 0.31 $ 0.27 $ 0.66 $ 0.56
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 as contemplated by the merger agreement, Hollywood
Entertainment shareholders, except for Mark Wattles, the Company's founder,
Chairman and Chief Executive Officer, and other members of senior management
who will acquire Carso common stock, will receive $14.00 per share in cash. Mr.
Wattles 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 its type, including shareholder approval and the completion of
financing. On August 6, 2004, the Company filed a current report on Form 8-K
announcing that Leonard Green & Partners, L.P. had informed us that, due to
industry and market conditions, Leonard Green & Partners, L.P. believes the
financing condition to the completion of the merger will not be satisfied. The
Company and the Special Committee are considering Hollywood's alternatives to
determine the course of action that would be in the best interests of our
shareholders. The Company does not assure you that a merger with Carso will be
completed, or if completed, that it would be completed on terms that do not
differ materially from those in the merger agreement.
(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
newer 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 six months ended
June 30, 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 1,340,453 1,970 1,970
Stock options tax benefit 5,409 5,409
Stock compensation - 133 133
Repurchase of common stock (295,139) (3,665) (3,665)
Net income 42,923 42,923
---------- -------- -------- --------- --------
Balance at 06/30/2004 60,711,661 $492,961 $ - $(120,362) $372,599
========== ======== ======== ========= ========
(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 $59.8 million and $118.9 million for the three months and the six
months ended June 30, 2004, respectively, compared to $55.8 million and $110.8
million for the corresponding periods of the prior year. Most operating leases
require payment of additional occupancy costs, including property taxes,
utilities, common area maintenance and insurance. These additional occupancy
costs were $12.4 million and $24.6 million for the three months and the six
months ended June 30, 2004, respectively, compared to $11.6 million and $23.2
million for the corresponding periods of the prior year.
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 June 30, 2004 and
December 31, 2003 (in thousands):
June 30, 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 1,386 1,316
---------- ----------
351,386 371,316
Current portion:
Capital leases 583 647
---------- ----------
583 647
Total long-term obligations
net of current portion ---------- ----------
$ 350,803 $ 370,669
========== ==========
(1) Coupon payments at 9.625% are due semi-annually in March and September.
If the merger described in Note 2 is completed, the Company's capital structure
is expected to change significantly. If the merger is completed, the Company
anticipates 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 would 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 reports on Form 8-K filed on March 29,
2004, June 8, 2004, and August 6, 2004, and in the Company's preliminary proxy
statement filed on July 8, 2004.
The senior subordinated notes due 2011 are redeemable, at the option of the
Company, beginning 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 June 30, 2004, 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 the senior secured
credit facilities from a syndicate of lenders led by UBS Warburg LLC. The
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
prior credit facilities that 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 specified 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 June 30, 2004, the
Company was in compliance with all covenants contained in the agreement.
Maturities on long-term obligations at June 30, 2004 for the next five years
are as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2004 $ - $ - $ 322 $ 322
2005 - - 529 529
2006 - - 509 509
2007 - 20,000 26 20,026
2008 - 105,000 - 105,000
Thereafter 225,000 - - 225,000
---------- ---------- --------- ---------
$ 225,000 $ 125,000 $ 1,386 $ 351,386
---------- ---------- --------- ---------
(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 June 30,
----------------------------------------------------------
2004 2003
--------------------------- -----------------------------
Net Per Share Net Per Share
Income Shares(1) Amounts Income Shares(1) Amounts
------- --------- ------- -------- --------- --------
Income per
basic share: $ 20,225 60,607 $ 0.33 $ 19,178 60,626 $ 0.32
Effect of dilutive ======= =======
securities:
Stock options - 2,295 - 4,029
------- --------- -------- ---------
Income per
diluted share: $ 20,225 62,902 $ 0.32 $ 19,178 64,655 $ 0.30
======= ========= ======= ======== ========= ========
(1) Represents weighted average shares outstanding.
Antidilutive stock options excluded from the calculation of income per diluted
share were 2.0 million shares and 1.0 million shares for the three months ended
June 30, 2004 and 2003, respectively.
Six Months Ended June 30,
-----------------------------------------------------------
2004 2003
---------------------------- -----------------------------
Net Per Share Net Per Share
Income Shares(1) Amounts Income Shares(1) Amounts
------- --------- -------- -------- ------- ----------
Income per
basic share: $42,923 60,127 $ 0.71 $ 38,756 60,249 $ 0.64
Effect of dilutive ======= =========
securities:
Stock options - 2,468 - 4,042
------- --------- -------- -------
Income per
diluted share: $42,923 62,595 $ 0.69 $ 38,756 64,291 $ 0.60
======= ========= ======== ======== ======= =========
(1) Represents weighted average shares outstanding.
Antidilutive stock options excluded from the calculation of income per diluted
share were 2.8 million shares and 1.1 million shares in the six months ended
June 30, 2004 and 2003, respectively.
(8) Store Closure Restructuring
At June 30, 2004, there were no remaining stores 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. As a result, the remaining balance of $0.2
million was reversed in the second quarter of 2004.
(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 eight
putative class action lawsuits filed in the circuit courts of Clackamas and
Multnomah counties, Oregon, related to the Merger Agreement described in Note
2. 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 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. On July 8, 2004, the Company filed a current
report on Form 8-K announcing a tentative settlement had been reached. The
Company believes it has provided adequate reserves in connection with these
lawsuits and tentative settlement.
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. A mediation is scheduled for September 9, 2004. 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 a
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 1,954 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
$985 thousand due the Company is related to current activity. As of June 30,
2004, Boards operated 21 stores, but has since closed a store.
The following table reconciles the net receivable balance due from Boards, Inc.
(in thousands): --------------------- -------------------
2004 2003
--------------------- -------------------
2nd Qtr Yr-To-Date 2nd Qtr Yr-To-Date
-------- -------- -------- --------
Beginning Receivable Balance $ 444 $ 1,509 $ 399 $ 631
-------- -------- -------- --------
License fee 25 25 75 175
(2%)Royalty fee 131 263 75 132
Products & Services 3,141 5,046 2,195 4,351
-------- -------- -------- --------
Expenses 3,297 5,334 2,345 4,658
Payments (2,756) (5,858) (2,276) (4,821)
-------- -------- -------- --------
Ending Balance June 30 $ 985 $ 985 $ 468 $ 468
======== ======== ======== ========
(11) Segment Reporting
In 2003, in an effort to ensure the creation of a "gamer" culture within its
game departments, the Company began managing its business as two separate
segments, Hollywood Video and Game Crazy, wherein the Hollywood Video segment
represents the Hollywood Video stores and the Game Crazy segment represents the
in-store game departments. Beginning with the 2003 annual report filed on Form
10-K, the Company chose to present its financial results pursuant to the
guidelines for segment reporting under FAS 131, including the presentation of
operating income by segment. When calculating operating income by segment, in
addition to any direct costs incurred as a result of operating the game
departments, the Company also allocated a portion of the Company's total
corporate overhead based on 1% of the game departments' budgeted revenue in
order to assign costs associated with information technology support, treasury
and accounting functions and other general and administrative services.
Three Months Ended Three Months Ended
June 30, 2004 June 30, 2003
---------------------------- ----------------------------
Hollywood Game Hollywood Game
Video Crazy Total Video Crazy Total
---------- -------- -------- ---------- -------- --------
Revenues $ 370,169 $ 52,960 $423,129 $ 358,000 $ 31,443 $389,443
Depreciation 13,630 1,029 14,659 14,057 981 15,038
Overhead
Allocation (519) 519 - (314) 314 -
Income (loss)
from operations 47,107 (5,894) 41,213 45,327 (5,456) 39,871
Total assets 883,566 103,610 987,176 890,105 71,668 961,773
Purchases of
property and
equipment, net 11,573 1,402 12,975 16,983 9,835 26,818
Six Months Ended Six Months Ended
June 30, 2004 June 30, 2003
---------------------------- ----------------------------
Hollywood Game Hollywood Game
Video Crazy Total Video Crazy Total
---------- -------- -------- ---------- -------- --------
Revenues $ 755,590 $110,329 $865,919 $ 751,742 $ 55,293 $807,035
Depreciation 28,881 3,001 31,882 28,357 1,650 30,007
Overhead
Allocation (1,093) 1,093 - (553) 553 -
Income (loss)
from operations 97,343 (10,546) 86,797 104,272 (9,365) 94,907
Total assets 883,566 103,610 987,176 890,105 71,668 961,773
Purchases of
property and
equipment, net 21,116 2,671 23,787 27,347 18,038 45,385
(12) Consolidating Financial Statements
Hollywood Entertainment Corporation (HEC) had one subsidiary, Hollywood
Management Company (HMC), during the six months ended June 30, 2004. HMC is
wholly owned and a guarantor of the senior subordinated notes of HEC. The
consolidating condensed financial statements below present the results of
operations, financial position and liquidity of HEC and HMC.
Consolidating Condensed Statement of Operations
Six months ended June 30, 2004
(unaudited, in thousands)
---------- ---------- --------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- --------- ----------
REVENUE $ 867,356 $ 74,882 $(76,319) $ 865,919
COST OF REVENUE 337,174 - - 337,174
GROSS MARGIN 530,182 74,882 (76,319) 528,745
OPERATING COSTS & EXPENSES:
Operating and selling 369,935 11,806 - 381,741
General & administrative 108,370 27,309 (76,319) 59,360
Store Opening Expenses 1,037 - - 1,037
Restructuring charge for
Store closure (190) - - (190)
INCOME FROM OPERATIONS 51,030 35,767 - 86,797
Interest income - 17,956 (17,656) 300
Interest expense (33,215) - 17,656 (15,559)
Early debt retirement - -
Equity Earnings in Subsidiary 32,427 - (32,427) -
Income before income
taxes 50,242 53,723 (32,427) 71,538
Benefit from (provision for)
income taxes (7,319) (21,296) - (28,615)
NET INCOME $ 42,923 $ 32,427 $(32,427) $ 42,923
Consolidating Condensed Statement of Operations
Six months ended June 30, 2003
(unaudited, in thousands)
---------- ---------- --------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- --------- ----------
REVENUE $ 808,473 $ 77,735 $(79,173) $ 807,035
COST OF REVENUE 304,317 - - 304,317
GROSS MARGIN 504,156 77,735 (79,173) 502,718
OPERATING COSTS & EXPENSES:
Operating and selling 341,895 7,644 - 349,539
General & administrative 109,931 24,791 (79,173) 55,549
Store Opening Expenses 2,723 - - 2,723
Restructuring charge for
Store closure - - - -
INCOME FROM OPERATIONS 49,607 45,300 - 94,907
Interest income - 17,476 (16,929) 547
Interest expense (35,311) - 16,929 (18,382)
Equity in Earnings 37,659 - (37,659) -
Of Subsidiary
Early debt retirement (12,467) - - (12,467)
Income before income
taxes 39,488 62,776 (37,659) 64,605
Benefit from (provision for)
income taxes (732) (25,117) - (25,849)
NET INCOME $ 38,756 $ 37,659 $(37,659) $ 38,756
Consolidating Condensed Balance Sheet
June 30, 2004
(unaudited, in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,328 $ 114,883 $ - $ 117,211
Receivables 23,413 415,516 (410,476) 28,453
Merchandise inventories 117,610 - - 117,610
Prepaid expenses and other 8,480 2,632 - 11,112
current assets
Total current assets 151,831 533,031 (410,476) 274,386
Rental inventory, net 265,333 - - 265,333
Property & equipment, net 256,570 24,192 - 280,762
Goodwill, net 66,678 - - 66,678
Deferred tax assets, net 83,704 - - 83,704
Other assets, net 8,638 7,675 - 16,313
Investment in Subsidiary 338,238 - (338,238) -
Total Assets $1,170,992 $ 564,898 $ (748,714)$ 987,176
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 583 $ - $ - $ 583
Accounts payable 410,476 120,661 (410,476) 120,661
Accrued expenses 20,789 96,168 - 116,957
Accrued interest - 6,426 - 6,426
Income taxes payable - 3,405 - 3,405
Total current liabilities 431,848 226,660 (410,476) 248,032
Long-term obligations, less
current portion 350,803 - - 350,803
Other liabilities 15,742 - - 15,742
Total liabilities 798,393 226,660 (410,476) 614,577
Common stock 492,961 4,008 (4,008) 492,961
Unearned compensation - - - -
Retained earnings
(accumulated deficit) (120,362) 334,230 (334,230) (120,362)
Total shareholders'
equity (deficit) 372,599 338,238 (338,238) 372,599
Total liabilities and
shareholders' equity
(deficit) $1,170,992 $ 564,898 $(748,714)$ 987,176
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 10,461 7,194 - 17,655
Investment in Subsidiary 305,813 - (305,813) -
Total assets $1,188,219 $ 567,110 $ (757,872) $ 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) (163,285) 301,805 (301,805) (163,285)
Total shareholders'
equity (deficit) 325,829 305,813 (305,813) 325,829
Total liabilities and
shareholders equity
(deficit) $1,188,219 $ 567,110 $(757,872) $ 997,457
Consolidating Condensed Statement of Cash Flows
Six months ended June 30, 2004
(unaudited, in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ation idated
---------- ---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 42,923 $ 32,427 $(32,427) $ 42,923
Equity Earnings in Subsidiary (32,427) - 32,427 -
Adjustments to reconcile
net income to
cash provided by
operating activities:
Write-off of deferred
financing costs - - - -
Depreciation &
amortization 130,856 2,222 - 133,078
Tax benefit from exercise
of stock options 5,409 - - 5,409
Change in deferred tax asset 20,598 - - 20,598
Change in deferred rent (365) - - (365)
Non cash stock compensation 133 - - 133
Net change in operating
assets & liabilities (28,504) 11,531 - (16,973)
Cash provided by (used in)
Operating activities 138,623 46,180 - 184,803
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (96,134) - - (96,134)
Purchase of property &
equipment, net (20,972) (2,815) - (23,787)
Increase in intangibles
& other assets - - - -
Refinancing Proceeds 177 (356) - (179)
Cash used in investing
activities (116,929) (3,171) - (120,100)
FINANCING ACTIVITIES:
Proceeds from the sale of
common stock, net - - - -
Repayments of capital lease
obligations (227) - - (227)
Repurchase of Common Stock (3,665) - - (3,665)
Proceeds from exercise
of stock options 1,970 - - 1,970
Decrease in Credit Facility (20,000) - - (20,000)
Proceeds from Capital lease
Obligations 297 - - 297
Cash used in financing
activities (21,625) - - (21,625)
Increase in cash
and cash equivalents 69 43,007 - 43,078
Cash and cash equivalents
at beginning of year 2,259 71,874 - 74,133
Cash and cash equivalents at
the end of the second
quarter $ 2,328 $ 114,883 - $ 117,211
Consolidating Condensed Statement of Cash Flows
Six months ended June 30, 2003
(unaudited, in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ation idated
---------- ---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 38,756 $ 37,659 (37,659) $ 38,756
Equity Earnings in Subsidiary (37,659) - 37,659 -
Adjustments to reconcile
net income to
cash provided by
operating activities:
Write-off of deferred
financing costs 5,827 - - 5,827
Depreciation &
amortization 135,663 3,681 - 139,344
Tax benefit from exercise
of stock options 5,274 - - 5,274
Change in deferred tax asset 18,401 - - 18,401
Change in deferred rent (762) - - (762)
Non cash stock compensation 299 - - 299
Net change in operating
assets & liabilities 157,118 (221,938) - (64,820)
Cash provided by (used in)
Operating activities 322,917 (180,598) - 142,319
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (97,512) - - (97,512)
Purchase of property &
equipment, net (41,336) (4,049) - (45,385)
Increase in intangibles
& other assets 167 (765) - (598)
Net Proceeds from indenture
trustee - 218,531 - 218,531
Cash used in investing
activities (138,681) 213,717 - 75,036
FINANCING ACTIVITIES:
Proceeds from the sale of
common stock, net - - - -
Repayments of capital lease
obligations (6,620) - - (6,620)
Proceeds from exercise
of stock options 1,991 - - 1,991
Increase in revolving
loans, net (179,489) - - (179,489)
Cash used in financing
activities (184,118) - - (184,118)
Increase in cash
and cash equivalents 118 33,119 - 33,237
Cash and cash equivalents
at beginning of year 2,045 31,100 - 33,145
Cash and cash equivalents at
the end of the second
quarter $ 2,163 $ 64,219 $ - $ 66,382
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 movies and video games in the
United States. We opened our first Hollywood Video store in October 1988 and,
as of June 30, 2004, we operated 1954 Hollywood Video stores in 47 states and
the District of Columbia, of which 646 included an in-store game
department("Game Crazy"), where game enthusiasts can buy, sell and trade new
and used video game hardware, software and accessories. A typical Game Crazy
department carries over 2,500 video game titles and occupies an area of
approximately 700 to 900 square feet within the store.
For the six months ended June 30, 2004, we derived 81.3% of our revenue from
movie and game rental products, 12.7% from the sale of new and used game
hardware, software and accessories in our game departments, and 6.0% from the
sale of new movies, concessions and video accessories.
Although domestic rental spending has remained fairly flat over the past five
years and appears to be declining in 2004, we have increased revenue through
opening new stores, taking market share and selling more used movies. We
estimate approximately half of the rental industry's market share remains
divided among a relatively large number of smaller independent and regional
operators. The studios' 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 our
industry in general and Hollywood video in particular, please see "Cautionary
Statements".
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 attributable to the release of new technology
platforms for game play. 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 video game software. As with the introduction of previous new platforms,
consumers have increased both their purchase and rental of games. In addition,
the emergence and acceptance of buying, selling and trading used games has
caused used game sales to grow rapidly for certain retailers who sell used
games, including us.
Our strategy is to make Hollywood Video stores a total home entertainment
destination. 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. Our 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
games for rent as well as new and used movies and games for sale, in a friendly
and inviting atmosphere that encourages browsing. We believe that consumers
view movie and game rentals in general, and our pricing structure and rental
terms in particular, as a convenient form of entertainment and an excellent
value. As it relates to movie sales, our focus is primarily on used movies
which we believe offer a better value to those consumers who choose to purchase
as opposed to rent. As it relates to game sales, our approach is to build
dedicated departments within the store. This approach, combined with the core
concept of buy, sell and trade, along with our employee hiring and training,
and inventory selection and merchandising presentation, is designed to appeal
to both "hard-core" and casual game consumers.
Remerchandising a Hollywood Video to include a game department allows us to
leverage our real estate investment and customer traffic, and even though we
reduce the area dedicated to movie merchandising in order to make room for a
game department, increases rental membership, customer traffic and movie-
related revenue and total transactions. Moreover, we believe that there is
significant customer overlap, and that our integrated approach provides a
competitive advantage by enabling us to offer consumers a total home
entertainment destination.
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 use key indicators that are non-
GAAP including EBITDA, Adjusted EBITDA, free cash flow and return on
investment. 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,
judgments 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 as contemplated by the merger agreement, our shareholders,
except for Mark Wattles, our founder, Chairman and Chief Executive Officer, and
other members of senior management who will acquire Carso common stock, will
receive $14.00 per share in cash. Mr. Wattles 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 its type, including shareholder approval and the completion of
financing. On August 6, 2004, we filed a current report on Form 8-K announcing
that Leonard Green & Partners, L.P. had informed us that, due to industry and
market conditions, Leonard Green & Partners, L.P. believes the financing
condition to the completion of the merger will not be satisfied. We and the
Special Committee are considering Hollywood's alternatives to determine the
course of action that would be in the best interests of our shareholders. We
do not assure you that a merger with Carso will be completed, or if completed,
that it would be completed on terms that do not differ materially from those in
the merger agreement.
RESULTS OF OPERATIONS
Summary Results of Operations
Total revenue for the three months and six months ended June 30, 2004 was
$423.1 million and $865.9 million, respectively, compared to $389.4 million and
$807.0 million for the corresponding periods of the prior year. The increase
was primarily attributable to more Hollywood Video stores, more game
departments and positive same store sales.
Our income from operations for the three months ended June 30, 2004 was $41.2
million compared to $39.9 million for the three months ended June 30, 2003. The
increase was attributable to expense leverage on higher revenue partially
offset by merger-related expenses of $2.4 million. Income from operations for
the six months ended June 30, 2004 was $86.8 million compared to $94.9 million
for the six months ended June 30, 2003. The decrease was attributable to a
shift in the mix of revenue coming from merchandise sales, which has a lower
profit margin than rental product revenue, as well as merger-related expenses.
Our net income for the three months ended June 30, 2004 was $20.2 million
compared to net income of $19.2 million for the three months ended June 30,
2003. The increase was attributable to expense leverage on higher revenue
partially offset by merger-related expenses of $2.4 million. Our net income for
the six months ended June 30, 2004 was $42.9 million compared to net income of
$38.8 million for the six months ended June 30, 2003. The increase was
attributable to a $12.5 million expense for early debt retirement in the first
quarter of 2003, causing a year-over-year increase in net income of the same
amount for the six months ended June 30 2004, partially offset by merger-
related expenses of $3.6 million.
Results of Operation Expressed as a Percentage of Revenue
The following table sets forth (i) results of operations data expressed as a
percentage of total revenue and (ii) gross margin data.
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
2004 2003 2004 2003
-------- -------- -------- --------
Revenue:
Rental product revenue 81.3% 84.7% 81.2% 86.1%
Merchandise sales 18.7% 15.3% 18.8% 13.9%
-------- -------- -------- --------
100.0% 100.0% 100.0% 100.0%
-------- -------- -------- --------
Gross margin 61.0% 61.8% 61.1% 62.3%
Operating costs and expenses:
Operating and selling 44.7% 44.8% 44.1% 43.3%
General and administrative 6.4% 6.5% 6.9% 6.9%
Store opening expense 0.2% 0.3% 0.1% 0.3%
Restructuring Charges for Store
Closure 0.0% 0.0% 0.0% 0.0%
-------- -------- -------- --------
51.3% 51.6% 51.1% 50.5%
-------- -------- -------- --------
Income from operations 9.7% 10.2% 10.0% 11.8%
Interest expense, net (1.7%) (2.1%) (1.7%) (2.2%)
Early debt retirement 0.0% 0.0% 0.0% (1.6%)
-------- -------- -------- --------
Income before income taxes 8.0% 8.1% 8.3% 8.0%
Provision for income taxes (3.2%) (3.2%) (3.3%) (3.2%)
-------- -------- -------- --------
Net income 4.8% 4.9% 5.0% 4.8%
======== ======== ======== ========
Other data:
Rental product gross margin (1) 69.3% 67.8% 69.5% 67.9%
Merchandise sales gross margin (2) 25.2% 28.6% 24.6% 27.5%
- --------------------------
(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 $33.7 million, or 8.6%, and $58.9 million, or 7.3%, for
the three months and six months ended June 30, 2004, respectively, compared to
the three months and six months ended June 30, 2003. The increases were
primarily due to opening new Hollywood Video stores, additional game
departments and an increase in same store sales. We opened 20 and 39 Hollywood
Video stores and added 38 and 51 game departments for the three months and six
months ended June 30, 2004, respectively. Total revenue also benefited from
increased same store sales of 4% and 3% in the three months and six months
ended June 30, 2004, respectively. Increased same store sales were primarily
the result of same store increases for our game departments of 24% and 27% for
the three months and six months ended June 30, 2004. The increases more than
offset rental product revenue decreases of 1% and 3% on a same store basis for
the three months and six months ended June 30, 2004.
The following is a summary of revenue by product category (in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
2004 2003 2004 2003
--------- --------- --------- ---------
DVD rental product revenue $ 236,444 $ 176,042 $ 474,074 $ 357,551
VHS rental product revenue 79,883 125,604 171,424 277,255
Game rental product revenue 27,682 28,286 58,028 59,673
--------- --------- --------- ---------
Total rental product revenue 344,009 329,932 703,526 694,479
--------- --------- --------- ---------
Game Crazy departments 52,960 31,443 110,329 55,293
New movies, concessions
and accessories 26,160 28,068 52,064 57,263
--------- --------- --------- ---------
Total merchandise sales 79,120 59,511 162,393 112,556
--------- --------- --------- ---------
--------- --------- --------- ---------
Total revenue $ 423,129 $ 389,443 $ 865,919 $ 807,035
========= ========= ========= =========
Rental product revenue is generated from the rental of movies and games and
from the sale of used movies and games no longer needed as rental inventory. We
currently offer a 5-day rental term 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
typically 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 amounts that we do not anticipate collecting. The percentage of
rental product revenues generated from extended rental periods has not changed
significantly in several years.
Merchandise sales are generated from the sale of new and used game hardware,
software and accessories, new movies, concessions and miscellaneous video
accessory items. Revenue from our game departments increased 68.4% and 99.5% in
the three months and six months ended June 30, 2004, respectively, compared to
the three months and six months ended June 30, 2003. The increase was primarily
due to the addition of 160 new departments and favorable year-over-year
increases for existing departments.
GROSS MARGIN
Rental Product Margins
Rental product gross margin as a percentage of rental product revenue increased
to 69.3% and 69.5% for the three months and the six months ended June 30, 2004,
respectively, from 67.8% and 67.9% for the three months and the six months
ended June 30, 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 25.2% and 24.6% for the three months and the six months ended June 30, 2004,
respectively, from 28.6% and 27.5% for the three months and the six months
ended June 30, 2003. The decrease was primarily the result of an increase in
the mix of revenue from new game sales, which typically have lower gross
margins than other product categories, such as used games, accessories and
concessions.
OPERATING COSTS AND EXPENSES
Operating and Selling Expenses
Total operating and selling expenses for the three months ended June 30, 2004
decreased slightly as a percentage of revenue to 44.7% from 44.8% for the three
months ended June,30 2003. Total operating and selling expense for the three
months ended June 30, 2004 increased $14.7 million to $189.2 million from
$174.5 million for 2003. The increase was primarily the result of increased
variable costs associated with increased total revenue, an increase of 101
weighted-average stores and an increase in operating and selling expenses
associated with the expansion of our Game Crazy initiative, including operating
an additional 179 weighted-average game departments. Payroll and related
expenses increased by $4.8 million, rent and related expenses increased by $4.8
million, advertising increased by $4.5 million, and other operating and selling
expenses increased by $0.6 million for the three months ended June 30, 2004
compared to the corresponding period of the prior year.
Total operating and selling expenses for the six months ended June 30, 2004
increased as a percentage of revenue to 44.1% from 43.3% for the six months
ended June 30, 2003. Total operating and selling expense for the six months
ended June 30, 2004 increased $32.2 million to $381.7 million from $349.5
million for 2003. The increase was primarily the result of increased variable
costs associated with increased total revenue, an increase of 97 weighted-
average stores and an increase in operating and selling expenses associated
with the expansion of our Game Crazy initiative, including operating an
additional 236 weighted-average game departments. Payroll and related expenses
increased by $13.8 million, rent and related expenses increased by $9.5
million, advertising increased by $5.6 million, and other operating and selling
expenses increased by $3.3 million for the six months ended June 30, 2004
compared to the corresponding period of the prior year.
General and Administrative Expenses
General and administrative expenses for the three months ended June 30, 2004
increased $2.0 million to $27.2 million, or 6.4% of total revenue, from $25.2
million, or 6.5% of total revenue for the three months ended June 30, 2003.
Included in the general and administrative expenses for three months ended June
30, 2004 was a $1.0 million charge for the anticipated settlement of the
shareholder lawsuit related to the pending merger and $1.4 million in other
merger-related expenses.
General and administrative expenses for the six months ended June 30, 2004
increased $3.9 million to $59.4 million, or 6.9% of total revenue, from $55.5
million, or 6.9% of total revenue for the six months ended June 30, 2003.
The increase was primarily due to merger-related expenses for the six months
ended June 30, 2004 of $3.6 million.
NON-OPERATING INCOME (EXPENSE), NET
Interest Expense
Interest expense, net of interest income, was $7.5 million and $15.3 million
for the three months and six months ended June 30, 2004, respectively compared
to $8.2 million and $17.8 million for the corresponding periods of the prior
year. The reduction was primarily due to 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 non-cash write-off of deferred
financing costs.
INCOME TAXES
Our effective tax rate was a provision of 40% for the three months and six
months ended June 30, 2004 compared to a provision of 39.5% and 40%,
respectively, for the three months and six months ended June 30, 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 videocassettes at reduced or no up-front costs, we share
with the studio agreed-upon portions of the revenue that we derive from those
DVDs or videocassettes. The studio's share of the 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 revenue
rather than an investment in rental inventory. Under sell-through pricing, we
purchase movies from the studios with no further obligation to make payments to
the studios for those movies. 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
$13.8 million and $33.9 million for the three months and six months ended June
30, 2004 compared to $22.7 million and $51.6 for the three months and six
months ended June 30, 2003. The decline in revenue sharing expense is primarily
the result of an increase in the percentage of movies acquired on DVD compared
to VHS, as we currently have fewer DVD revenue sharing arrangements than VHS
revenue sharing arrangements, and the continued decline in the mix of VHS
purchases relative to total purchases.
MERCHANDISE INVENTORY
Merchandise inventory consists of new and used game software, hardware and
accessories, new 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 used.
Consolidated merchandise inventory decreased $12.3 million to $117.6 million as
of June 30, 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
the return to studios of slow selling, older titles of movies acquired for
sale.
LIQUIDITY AND CAPITAL RESOURCES
Overview
Our primary source of operating cash flow is generated from the rental and
sales of movies on DVD and VHS, video game hardware and software, video game
and movie accessories, and concessions. The amount of cash generated from
operations in 2004 funded our debt service requirements, maintenance capital
expenditures, and provided the capital required to open 39 Hollywood Video
stores and add 51 game departments. At June 30, 2004, we had $117.2 million of
cash and cash equivalents on hand.
We believe that cash flow from operations, flexibility under our 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." If the merger disclosed above under the heading "Merger
Agreement" is completed, our capital structure will change significantly. The
financing required to complete the merger transaction will substantially
increase 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 reports on Form 8-K filed on March 29,
2004, June 8, 2004, and August 6, 2004, and in the Company's preliminary proxy
statement filed on July 8, 2004.
Cash Provided by Operating Activities
Net cash provided by operating activities increased by $42.4 million, or 29.9%,
to $184.8 million for the six months ended June 30, 2004 compared to $142.3
million for the corresponding period of the prior year. The increase was
partially attributable to a decrease in interest payments, a decrease in
expenses related to debt retirement and favorable changes in working capital
accounts.
Cash Used in Investing Activities
Net cash used in investing activities was $120.1 million for the six months
ended June 30, 2004, including the cost to open 39 Hollywood Video stores and
to add 51 game departments. In the six months ended June 30, 2003 we opened 21
Hollywood Video stores and added 210 game departments. 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.
We currently anticipate investing between $80 million and $105 million in 2004
to open between 100 and 150 Hollywood Video stores, to add between 100 and 150
game departments, and for maintenance capital expenditures. In addition, 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 $21.6 million use of cash for the
six months ended June 30, 2004 and included a $20 million prepayment on our
term loan facility, which is now prepaid through 2006, as well as the
repurchase of 295,139 shares of common stock for $3.7 million. Net cash flow
from financing activities was a $184.1 million use of cash for the six months
ended June 30, 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 June 30,
2004, we were in compliance with all covenants contained within our debt
agreements.
At June 30, 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 $ - $ - $ 322 $ 322
2005 - - 529 529
2006 - - 509 509
2007 - 20,000 26 20,026
2008 - 105,000 - 105,000
Thereafter 225,000 - - 225,000
---------- ---------- --------- ---------
$ 225,000 $ 125,000 $ 1,386 $ 351,386
---------- ---------- --------- ---------
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. Our stores generally 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 June 30, 2004, we had cash and cash equivalents of $117.2 million and a
positive working capital balance of $26.4 million. In prior quarters we had
operated with a working capital deficit. The positive working capital balance
was primarily due to the discontinuation of prepayments on our term facility
and the cessation of all activity related to our share repurchase program. The
prior quarter working capital deficits were 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 may be 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 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 June 30, 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 June 30, 2004 our interest expense
would have increased by approximately $1.3 million based on our outstanding
balance on the facility as of June 30, 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,
the completion of the financing, and other customary closing conditions.
Leonard Green & Partners, L.P. has informed us that, due to industry and market
conditions, Leonard Green & Partners, L.P. believes the financing condition to
the completion of the merger will not be satisfied. We and the Special
Committee are considering Hollywood's alternatives to determine the course of
action that would be in the best interests of our shareholders. We do not
assure you that a merger with Carso will be completed, or if completed, that it
would be completed on terms that do not differ materially from those in the
merger agreement. In addition, eight 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
the current market price reflects an assumption that the merger will be
completed; and
- - 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 in the rental and sale of our products.
The home video and video game industries are fragmented and highly competitive.
We compete for the rental and sale of our products with:
- - local, regional and national video retail stores, including those
operated by Blockbuster, Inc., the largest video retailer in the United
States, and Movie Gallery;
- - mass merchants, including Wal-Mart;
- - specialty retailers, including GameStop, Electronics Boutique and
Suncoast;
- - supermarkets, pharmacies, convenience stores, bookstores and other
retailers that rent or sell our products as a component, rather than the
focus, of their overall business;
- - Internet-based mail-delivery home video rental subscription services,
such as Netflix;
- - mail order operations and online stores, including Amazon.com; and
- - noncommercial sources, such as libraries.
In particular, substantially all of our stores compete with stores operated by
Blockbuster, most in very close proximity. Some of our competitors, including
Blockbuster, have significantly greater financial and marketing resources,
market share and name recognition than Hollywood. In addition, some retailers
sell DVDs and videocassettes at lower prices in order to increase overall
traffic to their stores or businesses, and mass merchants may be more willing
to sell at lower, or even below wholesale, prices because of the variety of
their inventory. As a result of direct competition with Blockbuster and
others, pricing strategies for movies and video games is a significant
competitive factor in our business.
If we do not compete effectively with competitors in the home video industry or
the video game industry, our revenues and/or our profit margins could decline
and our business, financial condition, liquidity and results of operations
could be harmed.
New technologies could create competitive advantages for our competitors.
Advances in technologies that benefit our competitors may materially adversely
effect our business. For example, advances in cable and direct broadcast
satellite technologies, including high definition digital television
transmissions offered through those systems, may adversely affect public demand
for video store rentals. Expanded content available through these media,
including movies, specialty programming and sporting events could result in
fewer movies being rented. In addition, higher quality resolution and sound
offered through these services and technologies could require us to increase
capital expenditures: for example, to upgrade our DVD inventory to provide
movies in high definition.
Cable and direct broadcast satellite technologies 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. Certain cable companies, Internet service providers and
others are also 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 pay-per-view, video-on-demand or other alternative movie delivery systems
achieve the ability to enable consumers to conveniently view and control the
movies they want to see when they want to see them, such alternative movie
delivery systems could achieve a competitive advantage over the traditional
home video rental industry. This risk would be exacerbated if these
competitors receive the movies from the studios at the same time video stores
do and by the increased popularity and availability of personal digital
recording systems (such as TiVo) that allow viewers to record, pause, rewind
and fast forward live broadcasts and create their own personal library of
movies.
In addition, we may compete in the future with other distribution or
entertainment technologies that are either in their developmental or testing
phases now or that may be developed in the future. For example, some retailers
have begun to rent or sell DVDs through kiosks or vending machines.
Additionally, the technology exists to offer disposable DVDs which would allow
a consumer to view a DVD an unlimited number of times during a specified period
of time, at the end of which the DVD becomes unplayable. We cannot predict the
impact that future technologies will have on our business.
If any of the technologies described above create a competitive advantage for
our competitors, our business, financial condition, liquidity and results of
operations could be harmed.
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 home video rental market to exist and compete effectively with
mass merchant retailers and other sellers of home movies. 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 margins 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. If the studios were
to significantly change their pricing policies in a manner that increases our
cost of obtaining movies under revenue sharing arrangements or other
arrangements, our revenues and/or profit margins could decrease, and our
business, financial condition, liquidity and results of operations could be
harmed.
We could lose a significant competitive advantage if the movie studios were to
adversely change their current distribution practices.
Currently, Hollywood Video stores and other retail outlets 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 and other retail
outlets 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 home video 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 Hollywood Video
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 video
game systems to attract and retain video game customers. We currently
anticipate that hardware manufactures will release new products with enhanced
features some time within the next few years. If manufacturers fail to
introduce or delay the introduction of new video games and systems, the demand
for video games available to us could decline, negatively impacting our
revenues, and our business, financial condition, liquidity and results of
operations could be harmed. In addition, although past introductions of new
hardware platforms have expanded sales and rentals, we cannot be certain that
the next generation will provide similar benefits to our business.
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 resumed
opening Hollywood Video stores and began a significant remerchandising
initiative to add Game Crazy departments to existing Hollywood Video stores,
opening 41 new Hollywood Video stores and adding 207 Game Crazy departments.
In 2003, we opened 102 Hollywood Video stores and added 319 Game Crazy
departments. In 2004, we anticipate opening between 100 and 150 new Hollywood
Video stores and adding between 100 and 150 new Game Crazy departments. This
expansion has placed, and may continue to place, increased pressure on our
operating and management controls. To manage a larger store base and a growing
video game buy, sell and trade business, 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, these
newly opened stores could adversely affect the revenues and profitability of
the 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 and senior management
involvement, 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, including Mark J. Wattles, our founder, chairman and
chief executive officer. These key management personnel may not be able to
continue 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 movies 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 June 30, 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 June 30, 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 home video rental records and
access and use of 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 eight 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.
We are party to various legal proceedings with respect to which a negative
outcome could have a material adverse effect on our operations.
We have been named in several purported class action lawsuits alleging various
causes of action, including claims regarding our membership application and
additional rental period charges. We have been successful in obtaining
dismissal of three of the actions filed against us. A statewide class action
entitled George Curtis v. Hollywood Entertainment Corp., dba Hollywood Video,
Defendant, No. 01-2-36007-8 SEA was certified on June 14, 2002 in the Superior
Court of King County, Washington. On May 20, 2003, a nationwide class action
entitled George DeFrates v. Hollywood Entertainment Corporation, No. 02 L 707
was certified in the Circuit Court of St. Clair County, Twentieth Judicial
Circuit, State of Illinois.
In 2003, we were 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.
In addition, we have been named to various other claims, disputes, legal
actions and other proceedings involving contracts, employment and various other
matters.
A negative outcome in any of the foregoing actions could harm our business,
financial condition, liquidity or results of operations and could cause us to
vary aspects of our operations. In addition, prolonged litigation, regardless
of which party prevails, could be costly, divert management attention or result
in increased costs of doing business.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We have been named in several purported class action lawsuits alleging various
causes of action, including claims regarding our membership application and
additional rental period charges. We have vigorously defended these actions and
maintain that the terms of its additional rental charge policy are fair and
legal. We have 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. We are
currently involved in settlement discussions and expect this case to be
resolved in 2004. We believe we have provided adequate reserves in connection
with these lawsuits.
We and the members of our Board of Directors are defendants in eight putative
class action lawsuits filed in the circuit courts of Clackamas and Multnomah
counties, Oregon, related to the merger agreement described in Note 2. The
lawsuits allege generally that in approving the Merger Agreement the members of
the Board breached fiduciary duties owed to our shareholders. Each lawsuit
seeks a court order enjoining us 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. Our articles and bylaws include indemnification provisions with
respect to our directors and, in addition to payment of our own legal costs and
fees, we may be required to advance the payment of legal fees and costs
incurred in these lawsuits by the Board members. On July 8, 2004, we filed a
current report on Form 8-K announcing a tentative settlement had been reached.
We believe we have provided adequate reserves in connection with these lawsuits
and tentative settlement.
In 2003, we were 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, we have agreed with the
plaintiffs to stay these cases pending consolidation and mediation. A mediation
is scheduled for September 9, 2004. We believe we have provided adequate
reserves in connection with these lawsuits.
In addition, we have been named to various other claims, disputes, legal
actions and other proceedings involving contracts, employment and various other
matters. We believe we have provided adequate reserves for 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.
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 June 30, 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 Purchased as Dollar
Part of Value)
Publicly of Share
Announced that May
Plans or Yet Be
Programs Purchased
Under the
Plans or
Programs(1)
--------- --------- --------- ---------
April 1-30 - $ - - $ 27,212
May 1-31 - - - 19,821
June 1-30 - - - 19,821
--------- --------- ---------
Total - $ - -
========= ========= =========
(1) Hollywood's ability to purchase shares under its publicly announced plan
is limited by its bank credit facility. The calculation is outlined in our
amended credit facility as exhibit 10.1 in our quarterly report on Form 10-Q
for the period ended September 30, 2003. We do 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).
2.1(a) First Amendment to Agreement and Plan of Merger by and among the
Registrant, Carso Holdings Corporation and Cosar Corporation dated June 4, 2004
(incorporated by reference to Exhibit 2.1 to the Registrant's current report on
Form 8-K filed June 8, 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 April 2, 2004, we filed a current report on Form 8-K under "Item 5. Other
Events" reporting that the members of the Company's Board of Directors and an
executive officer of the Company had been named in a purported class action
lawsuit in connection with the proposed acquisition of the Company in a
transaction between the Company and an affiliate of Leonard Green & Partners,
L.P. Our press release was attached to the report as Exhibit 99.1.
On June 8, 2004, we filed a current report on Form 8-K under "Item 5. Other
Events" reporting that Hollywood Entertainment Corporation (the "Company"),
Carso Holdings Corporation ("Holdings") and a wholly owned subsidiary of
Holdings have entered into the First Amendment, dated as of June 4, 2004 (the
"Amendment"), to the Agreement and Plan of Merger, dated as of March 28,
2004, among such parties (the "Original Merger Agreement"). The Original
Merger Agreement was previously filed as an exhibit to a Current Report
on Form 8-K on March 29, 2004.
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)
August 6, 2004 /S/Timothy R. Price
- ------------------ -------------------------------------------------
(Date) Timothy R. Price
Chief Financial Officer
(Authorized Officer and Principal Financial and
Accounting Officer of the Registrant)