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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2004
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission file number 0-21824
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HOLLYWOOD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in its charter)
Oregon 93-0981138
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(State or other jurisdiction of (IRS Employer
incorporation or organization) identification No.)
9275 SW Peyton Lane, Wilsonville, OR 97070
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(Address of principal executive offices) (Zip Code)
(503) 570-1600
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Title of Each Class Name of Each Exchange on
- ----------------------- Which Registered
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Common Stock Nasdaq National Market
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period than the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
On June 30, 2004 (the last business day of the registrant's most recently
completed second fiscal quarter), the aggregate market value of the shares of
Common Stock held by non-affiliates of the Registrant was $787,404,506 based
upon the last sale price reported for such date on the Nasdaq National Market.
Shares of Common Stock held by executive officers and directors of the
registrant are not included in the computation. However, the registrant has
made no determination that such individuals are "affiliates" within the meaning
of Rule 405 under the Securities Act of 1933.
On March 11, 2005, the registrant had 64,081,787 shares of Common Stock
outstanding
PART I
ITEM 1. BUSINESS
OUR BUSINESS
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 December 31, 2004 we operated 2,006 Hollywood Video stores in 47 states
and the District of Columbia. Our stores, which average approximately 6,600
square feet, 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 video games for sale, in a friendly and inviting atmosphere that encourages
browsing.
Our strategy is to make each Hollywood Video store a total home entertainment
destination. We believe that many consumers continue to view movie and video
game rentals as a convenient form of entertainment and an excellent value. As
it relates to movie sales, our focus is primarily on the sale of used movies,
which we believe offer a better value to those consumers who choose to purchase
as opposed to rent. In addition, we benefit from being able to offer a large
inventory of used titles no longer needed for our rental business. Our
approach to video game sales is primarily to build dedicated game retail
departments within our Hollywood Video stores. As of December 31, 2004, 695
Hollywood Video stores included an in-store "Game Crazy" department 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. In addition, we had 20 free-standing Game Crazy stores as of December
31, 2004.
Our total revenue and cash provided by operating activities were $1.782 billion
and $400.7 million, respectively, for the year ended December 31, 2004 and
$1.683 billion and $391.5 million, respectively, for the year ended December
31, 2003. Revenue from our Hollywood Video stores represented approximately 84%
of our revenue for the year ended December 31, 2004 consisting of approximately
78% from rental products and 6% from the sale of new DVD and VHS movies and
concessions. Revenue from our Game Crazy departments for the year ended
December 31, 2004 represented approximately 16% of our total revenue.
HOME VIDEO MOVIES - INDUSTRY OVERVIEW
The home video retail industry includes the sale and rental of DVD and
videocassette movies by traditional video store retailers, online retailers,
subscription rental retailers, mass merchants and other retailers. The
introduction of retail-priced DVD and videocassette movies has led to a growing
trend of consumers buying movies rather than renting. This trend is expected to
continue to present challenges for traditional video store retailers, such as
Hollywood, that depend on revenues generated by the rental of DVD and
videocassette movies. With relatively low wholesale pricing, the market shift
to DVD movies has presented Hollywood and the rest of the movie rental industry
with the opportunity to improve gross margins and copy depth.
The studios' current movie distribution practice provides an exclusive window
for DVD and videocassette movie retail channels before a movie is available to
pay-per view, video-on-demand and other distribution channels. Because we
believe the home video retail industry represents the single largest source of
revenue to movie studios, we expect studios to continue to release movies to
retail channels before they are available to other distribution channels, which
we believe reduces the threat to our business posed by these channels.
Although the movie rental industry is facing increased competition from other
forms of entertainment, including retail DVD sales, subscription services and
video on demand, we believe there continue to be significant opportunities for
industry growth for the following reasons:
Exclusive Rental Window
As a result of the importance of the video retail industry to the movie
studios' revenue base, the home video rental and sell-through markets enjoy a
period of time during which they have the exclusive rights to distribute a
movie. This period of exclusivity has been in place since the mid 1980s. The
period typically begins after a film finishes its domestic theatrical run
(usually five months after its debut) or upon its release to video in the case
of direct-to-video releases, and lasts for 30 to 60 days thereafter. This
period of exclusivity is intended to maximize revenue to the movie studio prior
to a movie being released to other distribution channels, including pay-per-
view, video-on-demand, premium or pay cable and other television distribution,
and provides what we believe is a significant competitive advantage for the
rental retail channel. Exclusive windows have been used historically to protect
each distribution channel from downstream channels, principally protecting
theaters from home video, home video from pay-per-view or video-on-demand and
pay-per-view or video-on-demand from premium cable and other television
channels. The exclusive home video window protects both mass merchants who
sell videos and video retailers who rent videos.
New Release Movie Pricing to Home Video Retailers
In 1998, the major studios and several large home video retailers, including
Hollywood, began entering into revenue sharing arrangements as an alternative
to the historical rental pricing structures, which required home video
retailers to purchase all titles for rental or sell-through. Under these
arrangements, we pay movie studios a significantly reduced price per copy and
in return share with the studios an agreed percentage of our rental revenue for
a limited period of time, usually 26 weeks. We believe that there are
considerable advantages to revenue sharing, including the ability to improve
availability and thus customer satisfaction. We have revenue sharing
arrangements with a number of studios, with more than half of our new movie
release rental revenue in 2004 having been generated under revenue sharing
arrangements. We are in discussions regarding additional revenue sharing
arrangements and believe that additional revenue sharing would have a positive
impact on our business.
VIDEO GAMES - INDUSTRY OVERVIEW
Consumer Spending
According to NPD Group, Inc. ("NPD"), the video game industry was an
approximately $9.9 billion market in the United States in 2004, with software
accounting for $6.2 billion and hardware and accessories accounting for $3.7
billion.
Hardware and Software
In 2000 and 2001, three new-generation hardware platforms, Nintendo's GameCube,
Sony's PlayStation 2 and Microsoft's Xbox, were introduced. The popularity of
these platforms has substantially increased the number of video game hardware
units in use and has driven significant growth in the video game software
segment. According to NPD, the video game software industry grew 7% to
approximately $6.2 billion in 2004 compared to 2003. Hardware sales, according
to NPD, were down 27 percent for 2004 due to price cuts and widespread
inventory shortages during the holiday shopping season. We expect next
generation hardware to be introduced in late 2005 and in 2006, and that this
introduction will drive further growth in software sales and rentals.
Hardware Platform Technology
Hardware platform technology continues to evolve. The early products launched
in the 1980's had only 8-bit processing speeds compared to the hardware
available today, Sony Playstation 2, Microsoft Xbox and Nintendo Game Cube,
which have 128-bit processing speeds. Advances in processing speed and data
storage significantly improved graphics and audio quality, which has led to the
creation of more exciting games. In addition, new hardware technology is
available with capabilities beyond gaming, such as playing DVD movies and
providing internet connectivity. These advances attracted new game players and
encouraged existing game players to upgrade their systems.
Viable and Growing Used Games Market
Hollywood and other specialty retailers have benefited from the rapid growth of
the used video game market over the last few years. Used titles are highly
profitable because margins on used video games are significantly higher than on
new video games. The introduction of the three new platforms has created a
greater supply and demand of used legacy games as some gamers switch to the new
platforms and trade in legacy games, while others seek to extend the lives of
legacy systems by purchasing used legacy games. At the same time, the high
price of new video games for the latest platforms has increased the perceived
value of used game software compatible with the new systems. As a result, we
believe the used video game market will increase as consumers increasingly look
to realize the trade-in value of products they already own when making new
purchases.
BUSINESS STRATEGY
In the last year, we have engaged in negotiations for the sale of Hollywood,
initially to a private equity fund and more recently to Movie Gallery, Inc.,
with whom we have signed a merger agreement subject to shareholder approval.
Subsequently, Blockbuster Inc. has made an unsolicited tender offer for all of
our securities. Despite our efforts to sell the company, we remain focused on
operating our business to enhance our position as the nation's second largest
rental retailer of movies and video games by focusing on the following
strategies:
Increase Rental Market Share
Hollywood grew its revenue from $17.0 million in 1993 to $1.8 billion in 2004,
which management believes is primarily attributable to taking market share in a
fragmented industry. The home video rental industry has experienced
consolidation in recent years, as the larger video store chains have taken
market share from independent operators, but the industry remains highly
fragmented. In 2004, we estimate the share of the three largest home video
rental store chains, including us, represented approximately half of the
domestic consumer home video rental market. In 2004, we estimate that our
market share was 12% of the domestic consumer home video rental market. The
remainder of the market share is divided among a relatively large number of
smaller independent and regional operators. We believe our size provides us
with a competitive advantage over smaller operators because it allows us to
benefit from strong studio relationships, access to more copies of individual
movie titles through direct revenue sharing arrangements, sophisticated
information systems, greater access to prime real estate locations, greater
access to managerial resources, greater marketing efficiencies, greater access
to capital, greater flexibility setting competitive prices and other operating
efficiencies made possible by size.
Provide Customers with a Destination for Home Entertainment
We are committed to providing superior service and satisfying customers' movie
and video game needs by carrying a broad array of titles for rent. We offer an
inexpensive and convenient form of entertainment by allowing consumers to rent
new movie releases, older "catalog" movie titles and video games for five days
in most Hollywood Video stores. Hollywood Video stores typically carry more
than 10,000 movie and video game titles on more than 25,000 units of DVD,
videocassette and video game formats. Both new release and catalog DVDs
typically rent for $3.79 and new movie release titles in the videocassette
format typically rent for $3.79 while older videocassette catalog movies rent
for $1.99. Video games typically rent for $4.99 or $5.99, with video games for
the newer hardware platforms renting for the higher amount.
We believe we are well positioned to capitalize on the growing trend of
consumers purchasing movies. We focus our movie sales efforts on used DVD and
videocassette movies, which we believe offer a better value than new products
to our customers. Our DVD and videocassette movie rental inventory provides a
continuous source of used DVD and videocassette movies and, to a lesser extent,
video games for sale when such products are no longer needed as rental
inventory. Although our focus is primarily on used movies, we offer
approximately 400 of the top-selling new titles on DVD in every store to
satisfy our customers who choose to purchase new DVD movies.
Our Game Crazy departments benefit from the prime real estate in which
Hollywood Video stores are typically located. We believe our combination of
product selection, knowledgeable sales staff, exceptional customer service,
exciting merchandising presentation, convenient location and availability of
video games for rent in Hollywood Video stores will encourage video game
consumers to recognize Hollywood Video stores as a destination location. Our
merchandising presentation within each Game Crazy department includes
interactive game terminals where customers can try video games before they
purchase and where our sales staff can demonstrate tricks and strategies to
improve game play.
We believe our broad product offering and focus on delivering superior customer
service creates greater customer satisfaction and thereby increases the number
of customers per store, the number of visits per customer and the average
transaction size per customer visit.
Continue to Pursue Compelling Initiatives
We continuously evaluate new developments in our industry and consider
initiatives closely related to our existing business that will provide an
opportunity to grow revenue and profitability.
For example, in the third quarter of 2004 we began to offer nationally the
Movie Value Pass, or MVP, an in-store movie rental subscription service that
allows customers to rent an unlimited number of most new release movies and all
catalog movies during the term of the pass, subject to a limit on the number of
movies that can be out at one time.
As an example of a potential future initiative, we believe that movie trading
represents a significant potential source of incremental revenue. Similar to
the strategy that we have pursued within our Game Crazy departments, we believe
that a movie trading business will enable us to capitalize on our customers'
desire to realize the "currency" value of their home video library. As a result
of our significant used movie business and our considerable experience with the
buy, sell, trade model in our Game Crazy departments, we believe that we are
well positioned to develop a successful movie trading business.
STORES AND STORE OPERATIONS
Video Store Openings
We opened our first video store in October 1988 and grew to 25 stores in Oregon
and Washington by the end of 1993. In 1994, we significantly accelerated our
store expansion program, adding 88 stores and expanding into California, Texas,
Nevada, New Mexico, Virginia and Utah. In 1995, we added 203 stores and entered
major new markets in the Midwest, Southwest, East and Southeast regions of the
United States. The following table shows store growth from 1995.
Year Ended December 31,
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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
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Beginning 113 305 551 907 1,260 1,615 1,818 1,801 1,831 1,920
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Opened 122 250 356 312 319 208 6 41 96 96
Acquired 70 - - 41 43 - - - 6 4
Closed - (4) - - (7) (5) (23) (11) (13) (14)
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Ending 305 551 907 1,260 1,615 1,818 1,801 1,831 1,920 2,006
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Site Selection
We believe the selection of locations for our stores is critical to the success
of our operations. We have assembled a store development team with broad and
significant experience in retail tenant development. Most of our new store
development personnel have expertise in and reside in the geographic area for
which they are responsible, but all final site approval takes place at the
corporate office where new sites are approved by a committee of senior
management personnel. Final approval of all new sites is the responsibility of
the Chairman of the Real Estate Committee of the Board of Directors. Important
criteria for the location of a store include density of local residential
population, traffic count on roads immediately adjacent to the store location,
visibility and accessibility of the store, availability of ample parking and
proximity of competition. Management generally seeks what it considers the most
desirable locations, typically locating stores in high-visibility, stand-alone
structures or in prominent locations in multi-tenant shopping developments. All
of our store locations are leased: we do not own any real estate. Our real
estate and store development team is scaled to meet our planned store growth.
PRODUCTS
Hollywood Video
Our video stores typically carry more than 10,000 movie and game titles on
25,000 units of DVDs, VHS and games, consisting of a combination of new
releases and an extensive selection of older "catalog" movies and games.
Excluding new releases, movie titles are classified into categories, such as
"Action," "Comedy," "Drama" and "Children," and are displayed alphabetically
within those categories. We do not rent or sell adult movies. In addition to
video rentals, we rent video games primarily for Sony Playstation 1 & 2,
Microsoft Xbox and Nintendo Game Cube.
Hollywood video stores contributed 84% of total revenue in 2004. Revenue from
rental products, including rental and sale of previously viewed DVD, VHS and
video games, represented approximately 78% of total revenue for 2004. In
addition to the growth of DVD rentals, we have experienced significant growth
in the sale of previously viewed DVDs. Our ability to sell previously viewed
movies at lower prices than new movies provides a competitive advantage over
mass-market retailers. We expect the market for previously viewed DVDs to
experience strong growth as DVD player penetration increases and consumers
begin to build their own DVD libraries. Furthermore, previously viewed DVDs do
not suffer from the quality degradation that VHS tapes do, making them an
attractive option for consumers looking to build their personal movie
libraries.
The remaining approximately 6% of total revenue was from the sale of new DVDs
and videocassettes and concessions (e.g., popcorn, sodas, candy and magazines).
Game Crazy
Game Crazy, which consist primarily of in-store game departments where
consumers buy, sell and trade new and used video game software, hardware and
accessories, contributed 16% of our total revenue for 2004. Each Game Crazy
typically carries over 2,500 video game titles that can be played on all major
new and legacy game systems. We offer new and used Sony Playstation 2,
Microsoft Xbox, Nintendo Game Cube, Game Boy Advance and Game Boy hardware
systems as well a broad selection of used legacy hardware systems. In addition,
we offer new and used game accessories such as controllers, memory cards and
game media such as strategy guides. Revenue from new and used software
represented 67% of Game Crazy revenue for 2004, while 31% was from new and used
hardware and accessories.
SUPPLIERS AND PURCHASING ARRANGEMENTS
We purchase the majority of our movies directly from the studios through
revenue sharing arrangements or other direct purchasing methods, and we
purchase a majority of our video games directly from video game publishers,
except for used games which are received on trade directly from our customers.
ADVERTISING AND MARKETING
Our primary marketing focus is on cost-effective direct mail strategies, free-
standing newspaper inserts and in-store marketing efforts. In addition, we
continue to use cooperative movie advertising funds made available by studios
and suppliers to promote certain titles. We occasionally test the effectiveness
of mass media campaigns in select markets, but anticipate that our primary
marketing vehicle will continue to be direct mailings. We believe that our
current marketing strategy is the most productive and cost effective manner to
increase customer visits. We currently have a customer transaction database
containing information on over 36 million household member accounts, which
enables targeted marketing based on historical usage patterns.
INVENTORY AND INFORMATION MANAGEMENT
Inventory Management
We maintain detailed information on inventory utilization. Our information
systems enable us to track rental activity by individual videocassette, DVD and
video game to determine appropriate buying, distribution, pricing and
disposition of inventory, including the sale of previously viewed product. Our
inventory of videocassettes, DVDs and video games for rental is prepared
according to uniform standards. Each new DVD, videocassette and video game is
removed from its original carton, bar coded, and placed in a rental case with a
magnetic security device. Our Game Crazy departments utilize their own
independent inventory system with enhanced functionality that allows us to
manage used product trade-in credit values and retail pricing based upon
multiple factors such as age and current inventory levels. Game Crazy's point-
of-sale system provides us with sufficient detail to manage our breadth of
titles and maintain in-stock positions with frequent replenishment cycles. The
inventory system also permits us to match supply with demand title by title,
adjust ordering, transfer inventories from one store location to another and
manage new and used title pricing.
Information Management
We use a scalable client-server system and maintain distinct point-of-sale
systems for Hollywood Video and Game Crazy and a corporate information system.
We maintain information, updated daily, regarding revenue, current and
historical rental and sales activity, store membership demographics, individual
customer histories, and DVD, videocassette and video game rental patterns. This
system allows us to measure our current performance, manage inventory, make
purchasing decisions and manage labor costs; it also enables us to continue to
improve customer service, operational efficiency, and management's ability to
monitor critical performance factors.
COMPETITION
The video retail industry is highly competitive. We compete with local,
regional and national video retail stores, including Blockbuster and Movie
Gallery; mail-delivery video rental subscription services, such as Netflix;
mass merchants, supermarkets, pharmacies, convenience stores, bookstores and
other retailers; and non-commercial sources such as libraries.
We believe that the principal competitive factors in the video rental industry
are price, title selection, rental period, the number of copies of popular
titles available, store location and visibility, customer service and employee
friendliness, and convenience of store access and parking. Substantially all of
our stores compete with stores operated by Blockbuster, most in very close
proximity.
We also compete with cable, satellite, and pay-per-view television systems.
Digital cable and digital satellite services have continued to increase
penetration: we estimate that cable or satellite is available in over 90
million households. These systems offer multiple channels dedicated to pay-per-
view and in some cases, video-on-demand, and allow some of our competitors to
transmit a significant number of movies to homes at frequent intervals.
The video game industry is highly fragmented. With the possible exception of
Wal-Mart, we believe no major player holds more than a 20% share of the market,
leaving a significant opportunity for our Game Crazy departments to rapidly
gain market share. Video game software and hardware is typically sold through
retail channels, including specialty retailers, mass merchants, toy retail
chains, consumer electronic retailers, computer stores, regional chains,
wholesale clubs, via the Internet and through mail order. Specialty retail
chains that feature an educated game staff, such as GameStop and Electronics
Boutique, are our chief competitors in the used game market.
EMPLOYEES
As of December 31, 2004, we had approximately 30,616 employees, of whom 29,601
were in the retail stores and zone offices and the remainder in our corporate,
administrative and distribution centers. None of our employees are covered by
collective bargaining agreements. We consider our employee relations to be
good.
Video store managers report to district managers, who supervise the operations
of the stores. The district managers report to regional managers, who report
directly to the Vice President of Operations for each zone. The corporate
support staff periodically has meetings with zone personnel, regional managers,
district managers and store managers to review operations.
We have created a separate management infrastructure for Game Crazy including
store level operators who report to district managers, who in turn report to
regional managers. We have made a concerted effort through our established
recruiting and training process to hire sales associates who are game
enthusiasts. This is particularly important in the video game industry, which
requires product knowledge on a large and growing number of titles. We have
attracted a staff of dedicated gamers for our Game Crazy departments who
provide attentive customer service and possess knowledge of the industry.
SERVICE MARKS
We own United States federal registrations for the service marks "Hollywood
Video", "Hollywood Entertainment", "Hollywood Video Superstores" and "Game
Crazy". We consider our service marks important to our continued success.
HISTORICAL INFORMATION
We file annual reports, quarterly reports, proxy statements and other
information with the Securities and Exchange Commission (SEC). You may read and
copy any materials we file with the SEC at the SEC's Public Reference Room at
450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
The SEC maintains an Internet site that contains our reports, proxy statements,
and other information. The SEC's Internet address is http://www.sec.gov.
We also make available free of charge through our Internet website our annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K and, if applicable, amendments to those reports as soon as reasonably
practical after we file such materials with the SEC
(http://hollywoodvideo.com/investors/SECfilings).
ITEM 2.
As of December 31, 2004, Hollywood's stores by state were as follows:
HOLLYWOOD ENTERTAINMENT
NUMBER OF HOLLYWOOD VIDEO (HV)
AND GAME CRAZY (GC) STORES BY STATE
HV GC HV GC
--- --- --- ---
Alabama 13 1 Nebraska 14 -
Arizona 59 35 Nevada 31 13
Arkansas 9 1 New Hampshire 4 -
California 335 150 New Jersey 35 12
Colorado 39 19 New Mexico 11 -
Connecticut 17 5 New York 82 23
Delaware 3 - North Carolina 39 7
Florida 88 - North Dakota 3 1
Georgia 39 - Ohio 84 42
Idaho 15 6 Oklahoma 23 5
Illinois 91 53 Oregon 70 28
Indiana 42 20 Pennsylvania 76 21
Iowa 13 1 Rhode Island 10 5
Kansas 15 - South Carolina 18 3
Kentucky 17 3 South Dakota 4 -
Louisiana 19 - Tennessee 39 18
Maine 3 - Texas 198 86
Maryland 32 15 Utah 42 15
Massachusetts 44 6 Virginia 45 19
Michigan 64 21 Washington 93 39
Minnesota 40 20 Washington, D.C. 2 -
Mississippi 9 - West Virginia 1 -
Missouri 39 11 Wisconsin 33 11
Montana 2 - Wyoming 2 -
Total Stores 2,006 715
Total States (excluding Washington, D.C.) 47 33
We lease all of our stores, corporate offices, distribution centers and zone
offices under non-cancelable operating leases. All of our stores have an
initial operating lease term of five to 15 years and most have options to renew
for between five and 15 additional years. Most of the store leases are "triple
net," requiring us to pay all taxes, insurance and common area maintenance
expenses associated with the properties.
Our corporate headquarters are located at 9275 Southwest Peyton Lane,
Wilsonville, Oregon, and consist of approximately 123,000 square feet of leased
space. The lease expires in November 2008. We currently lease space in three
distribution centers, two to primarily support Hollywood Video and a separate
facility to support Game Crazy. The Hollywood Video distribution centers are
located at 25600 Southwest Parkway Center Drive, Wilsonville, Oregon
(approximately 175,000 square feet) and at 501 Mason Road, LaVergne, Tennessee
(approximately 98,000 square feet). The Game Crazy facility is located at 9445
SW Ridder Road, Wilsonville, Oregon (approximately 84,000 square feet). All of
these facilities are leased pursuant to agreements that expire in December
2011, June 2010 and February 2008, respectively.
ITEM 3. LEGAL PROCEEDINGS
On January 3, 2005, we received a letter from The Nasdaq Stock Market, Inc.
indicating that our securities were subject to delisting from The Nasdaq
National Market because we failed to comply with Marketplace Rules 4350(e) and
4350(g), which require that we hold an annual shareholder meeting and
distribute a proxy statement and solicit proxies for the meeting. We requested
and received a hearing before a Nasdaq Listing Qualifications Panel to review
the staff determination. On February 15, 2005, the Panel informed us that our
securities would be delisted at the opening of business on February 17, 2005.
We requested that the Panel reconsider its decision, which it did. The Panel
has agreed to continue listing our securities under specified conditions,
including that we hold an annual meeting on or before March 30, 2005. We have
set a March 30, 2005 annual meeting date.
We have been named in several purported class action lawsuits alleging various
causes of action, including claims regarding our membership application and
additional rental period charges. We have vigorously defended these actions and
maintain that the terms of our additional rental charge policy are fair and
legal. We have been successful in obtaining dismissal of three of the actions
filed against us. A statewide class action entitled George Curtis v. Hollywood
Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was
certified on June 14, 2002 in the Superior Court of King County, Washington. On
May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood
Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of
St. Clair County, Twentieth Judicial Circuit, State of Illinois. We reached a
nationwide settlement with the plaintiffs. This settlement encompasses all of
the claims asserted in each of the related actions. Preliminary approval of
settlement was granted on August 10, 2004. We have agreed to pay plaintiffs'
legal counsel $2.7 million and to give class members a rent-one-get-one coupons
on a claims made basis with a guaranteed total redemption of $9 million along
with other remedial relief. A hearing to obtain final court approval of the
settlement is set for June 24, 2005. Notice to class members began on October
10, 2004 and will last for six months. Coupons will likely be distributed to
the class beginning in the fall of 2005 and payment will be made to plaintiffs'
legal counsel following final court approval in June 2005. We believe we have
provided adequate reserves in connection with these lawsuits.
We are aware of eight lawsuits filed in the circuit courts of Oregon for the
counties of Clackamas and Multnomah related to the proposed merger of the
Company with an affiliate of Leonard Green & Partners, L.P. (LGP) pursuant to
the initial Agreement and Plan of Merger, dated as of March 28, 2004, among
Hollywood Entertainment and affiliates of LGP (the "March 28 Merger
Agreement"). These purported class action and derivative suits each seek a
court order enjoining completion of the Merger, and costs and attorneys' fees
to the plaintiffs' lawyers. Some of the suits additionally request damages in
an unstated amount allegedly suffered by our shareholders by reason of the
March 28 Merger Agreement. The Clackamas County suits were consolidated and, on
July 28, 2004, the parties to the Clackamas and Multnomah County suits entered
into a memorandum of understanding regarding a potential settlement of claims.
We described, in a current report on Form 8-K filed July 8, 2004, the terms of
the proposed settlement, which included additional disclosure in our proxy
statement regarding the merger, modifications to the termination fee and
shareholder approval requirements in the March 28 Merger Agreement, covenants
from an affiliate of LGP regarding the future sale of Hollywood Entertainment,
and payment of $995,000 of the plaintiff's attorney fees. We have provided a
reserve for this litigation that we believe is adequate. We entered into an
amended and restated merger agreement with LGP affiliates on October 13, 2004.
Plaintiffs in the consolidated cases previously informed us of their intent to
file a consolidated complaint that includes allegations regarding the amended
and restated merger agreement.
On December 22, 2004, JDL Partners filed a purported class action lawsuit
naming us and our directors, claiming that our directors breached fiduciary
duties to our shareholders in the way they conducted negotiations with
Blockbuster, Inc. and Movie Gallery, Inc. for an acquisition of Hollywood
following our entering into the amended and restated merger agreement with LGP.
On January 9, 2005, we terminated the amended and restated merger agreement and
entered into a merger agreement with Movie Gallery, Inc. and its wholly owned
subsidiary. It is not clear what effect the new merger agreement will have on
the settlement negotiations regarding the old merger agreement, and there is no
assurance that a settlement will be effected or that current reserves for this
litigation will be adequate. It is also unclear what effect the new merger
agreement will have on the complaint filed by JDL Partners.
On February 18, 2005, co-lead counsel in the consolidated Clackamas County
actions filed a First Amended Consolidated Shareholder Class Action And
Derivative Complaint (the "First Amended Consolidated Complaint") against
Hollywood, the members of the Board of Directors of Hollywood, the members of
the Special Committee of the Board of Directors, LGP and UBS.
The First Amended Consolidated Complaint seeks an injunction preventing
Hollywood from completing its merger with Movie Gallery, unspecified
compensatory damages, punitive damages and attorneys' fees and costs.
Hollywood and the members of the Board of Directors and Special Committee
intend to vigorously contest the claims in the First Amended Consolidated
Complaint. However, there is no assurance that that current reserves for this
litigation will be adequate.
In 2003 we were named as a defendant in three actions asserting wage and hour
claims in California. The plaintiffs sought to certify a statewide class action
alleging that certain California employees were denied meal and rest periods.
There were several additional related claims for unpaid overtime, unpaid off
the clock work, and penalties for late payment of wages and record keeping
violations. A mediation took place on September 9, 2004 and the parties reached
a settlement of all claims alleged in each of the actions. Pursuant to the
settlement, two of the actions were dismissed and all claims asserted by
plaintiffs were alleged in a single action. We received preliminary approval of
the settlement on January 10, 2005. Notice was sent directly to class members
on February 4, 2005. Final approval is scheduled for hearing on April 21, 2005.
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
our consolidated results of operations, financial condition or liquidity. At
December 31, 2004, the legal contingencies reserve was $13.3 million. At
December 31, 2003, the legal contingencies reserve was $6.8 million.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no submissions of matters to a vote of security holders in the
fourth quarter of 2004.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning our executive
officers as of March 15, 2005:
Name Age Position
- ---------------------- --- ----------------------------------------
F. Bruce Giesbrecht 45 Chief Executive Officer, President,
Chief Operating Officer and Director
Timothy R. Price 46 Chief Financial Officer
- ----------------------
On February 3, 2005 we announced that Mark Wattles resigned as director, Chief
Executive Officer and Chairman of the Board of Directors and that the Board of
Directors appointed F. Bruce Giesbrecht as Chief Executive Officer. No
replacement has been named to serve as Chairman of the Board of Directors.
F. Bruce Giesbrecht was announced as the Company's President and Chief
Operating Officer on January 29, 2004. Mr. Giesbrecht was named Executive Vice
President of Business Development in March 2000 and became General Manager of
Corporate Operations in July 2003. Mr. Giesbrecht joined Hollywood in May 1993
as Vice President of Corporate Information Systems and Chief Information
Officer, was named Senior Vice President of Product Management in January 1996
and became Senior Vice President of Strategic Planning in January 1998. Prior
to joining Hollywood Mr. Giesbrecht was a founder of RamSoft, Inc., a software
development company specializing in management systems for the video industry,
and served as its President.
Timothy R. Price joined Hollywood in January 2003 as Senior Vice President of
Finance and was named Chief Financial Officer in July 2003. Prior to joining
Hollywood, Mr. Price was with May Company for four years holding the positions
of Chief Financial Officer for Robinson's-May from 2000 to 2002 and Vice
President and Controller of Hecht's from 1998 to 2000. Prior to the May
Company, Mr. Price served as Vice President and Controller of Kohl's from 1996
to 1998 and held a variety of financial executive positions at the Limited from
1988 to 1996.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK, RELATED SHAREHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
We have never paid any cash dividends on our common stock and anticipate that
future earnings will be retained for the development of our business. Loan
covenants contained in our bank credit facilities and senior subordinated notes
limit the amount of dividends we may pay and the amount of stock we may
repurchase (see Management's Discussion and Analysis of Results of Operations
and Financial Condition under the caption "Liquidity and Capital Resources").
Our common stock is traded on the Nasdaq National Market ("Nasdaq") under the
symbol "HLYW". The following table sets forth the quarterly high and low sales
prices per share, as reported on Nasdaq.
2004 2003
----------------------------------------
Quarter High Low High Low
------- ------- ------ -------- -------
Fourth $13.20 $ 9.29 $17.97 $12.35
Third 13.22 9.42 18.65 15.60
Second 13.56 12.64 18.18 15.75
First 14.10 10.58 16.26 12.59
As of March 14, 2005 there were 166 holders of record of our common stock, and
no shares of preferred stock were issued and outstanding. The source for this
information is American Stock Transfer and Trust.
The following table summarizes information with respect to options under our
stock option plans at December 31, 2004:
Options Outstanding Options
--------------------- remaining
Weighted available
average for future
exercise issuance under
Options price the plans
---------- -------- --------------
Stock option plans
approved by security
holders 6,240,835 $6.95 3,113,501
Stock option plans
not approved by
security holders 1,190,879 $14.04 1,859,706
---------- -------- --------------
7,431,714 $ 8.08 4,973,207
========== ======== ==============
The stock option plans not approved by security holders have generally the same
features as those approved by security holders. For further information
regarding the Company's stock option plans, see Note 19 to the Consolidated
Financial Statements.
ITEM 5C. CHANGES IN SECURITIES AND USE OF PROCEEDS
Our ability to purchase shares of our common stock under our publicly announced
plan is limited by our 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 did not repurchase shares in the
fourth quarter of fiscal 2004 and we do not intend to make further purchases
under the plan while our proposed merger transaction is pending.
ITEM 6. SELECTED FINANCIAL DATA
Like many other publicly traded retail companies, we recently reviewed our
accounting practices with respect to store operating leases and concluded that
we needed to correct certain technical errors in our accounting for leases and
restate prior periods as discussed in Item 7 under the heading "Restatement of
Prior Periods" and in to our consolidated financial statements.
Revision of Classification
We also reviewed our accounting practices with respect to balance sheet
classification of auction rate securities. Auction rate securities are
variable rate bonds tied to short term interest rates with maturities on the
face of the securities in excess of 90 days. Auction rate securities have
interest rate resets through a modified Dutch auction at predetermined short
term intervals, usually every 7, 28 or 35 days. They trade at par and are
callable at par on any interest payment date at the option of the issuer.
Interest paid during a given period is based upon the interest rate determined
during the prior auction. Although these securities are issued and rated as
long term bonds, they are priced and traded as short term instruments because
of the liquidity provided through the interest rate reset. We had historically
classified these instruments as cash equivalents if the period between interest
rate resets was 90 days or less, which was based on the ability to either
liquidate the holdings or roll the investment over to the next reset period.
Based on our re-evaluation of the maturity dates associated with the underlying
bonds, we have revised our classification our auction rate securities,
previously classified as cash equivalents, as marketable securities in
accordance with FAS 95 for each of the periods presented in the accompanying
consolidated balance sheet. We have classified these investments as available
for sale investments and consider them to be current assets based on the
availability of these assets to fund current operations. The purchase and sale
of marketable securities are now displayed in the investing section of the cash
flow statement. As of December 31, 2004 and 2003, we were in violation of
certain covenants restricting our investments in cash equivalents and
marketable securities under our credit facility and our indenture for senior
subordinated notes because we invested in AAA-rated marketable securities with
maturities beyond those allowed under our credit facility. The lenders have
waived the default through March 31, 2005; if we correct the violation by that
time, we will not need a waiver from holders of our senior subordinated notes.
We expect to correct the violation and be in compliance with our credit
facility and indenture covenants by March 31, 2005.
The information presented below for, and as of the end of, each of the fiscal
years in the five-year period ended December 31, 2004 is derived from our
audited financial statements, adjusted for the restatement of 2000 through
2004. The following information should be read in conjunction with
"Management's Discussion and Analysis of Results of Operation and Financial
Condition," including a discussion of critical accounting policies that require
significant management estimates, judgments and assumptions.
Except as otherwise noted, the information in the table below reflects, among
other things, operating losses incurred by Reel.com in 1999 through June 12,
2000, when we discontinued its operations.
Year Ended December 31,
---------------------------------------------------------
2004 2003(1) 2002(1) 2001(1) 2000(1)
Restated Restated Restated Restated
--------- ---------- ---------- ---------- ----------
OPERATING RESULTS:
Revenue $1,782,364 $1,682,548 $1,490,066 $1,379,503 $1,296,237
--------- ---------- ---------- ---------- ----------
Income (loss) from
operations 146,488 182,206 189,617 121,321 (435,830)
--------- ---------- ---------- ---------- ---------
Interest expense, net 29,993 35,507 42,057 56,129 62,127
--------- ---------- ---------- ---------- ---------
--------- ---------- ---------- ---------- ---------
Net income (loss)(2) 71,288 80,070 259,745 102,460 (548,286)
--------- ---------- ---------- ---------- ---------
Net income (loss)
per share:
Basic $ 1.18 $ 1.32 $ 4.54 $ 2.09 $(11.88)
Diluted 1.14 1.25 4.16 1.94 (11.88)
---------- ---------- ---------- --------- ---------
- ------------------------------------------------------------------------------
BALANCE SHEET DATA:
Rental inventory, net $289,144 $268,748 $260,190 $191,016 $168,462
Property and
equipment, net 227,824 243,413 215,461 233,642 281,658
Total assets 1,119,527 1,006,055 1,163,686 727,333 677,365
Long-term
obligations(3) 351,256 371,316 388,746 514,002 536,401
Shareholders' equity
(deficit) 373,632 297,212 230,734 (157,869) (268,736)
- ------------------------------------------------------------------------------
Year Ended December 31,
-------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- --------- --------
OPERATING DATA:
Number of stores at
year end 2,006 1,920 1,831 1,801 1,819
Weighted average stores
open during the year 1,953 1,852 1,805 1,813 1,751
Number of Game Crazy
departments at year end 715 595 276 69 69
Weighted average Game
Crazy departments open
during the year 647 469 118 69 68
Same store
revenue increase (4) 2% 11% 8% 6% 2%
- ----------------------------------------------------------------------------
(1) Following is a table of the selected financial data as previously
reported.
Year Ended December 31,
---------------------------------------------
2003 As 2002 As 2001 As 2000 As
Reported Reported Reported Reported
---------- ---------- ---------- ----------
OPERATING RESULTS:
Income (loss) from
operations 185,094 189,327 119,277 (436,321)
---------- ---------- ---------- ---------
Net income (loss) 82,272 241,845 100,416 (530,040)
---------- ---------- ---------- ---------
Net income (loss)
per share:
Basic $ 1.36 $ 4.23 $ 2.05 $(11.48)
Diluted 1.28 3.88 1.90 (11.48)
------------------------------------------------------------------
BALANCE SHEET DATA:
Property and
equipment, net 288,857 255,497 270,586 323,666
Total assets 997,457 1,146,376 718,544 665,114
Shareholders' equity
(deficit) 325,829 257,149 (113,554) (222,377)
------------------------------------------------------------------
(2) We adopted Statement of Financial Accounting Standards No. 142 on
January 1, 2002 and concurrently ceased to amortize goodwill recorded in
connection with prior business combinations and our trade name rights.
See Note 10 to the Consolidated Financial Statements. Excluding
amortization of these intangible assets would have reduced our net loss or
increased our net income by $3.1 million and $29.9 million,
respectively, for the years ended December 31, 2001 and 2000.
(3) Includes the current portion of long-term obligations. For the year ended
December 31, 2002, excludes $203.9 million of our 10.625% senior
subordinated notes that were called on December 18, 2002 and redeemed on
January 17, 2003.
(4) A store is comparable after it has been open and owned by us for 12 full
months. An acquired store converted to the Hollywood Video
name store design is removed from the same store base when the
conversion process is initiated and returned 12 full months after
reopening. For 2004, same store sales for video stores decreased 5%
and same store sales for Game Crazy increased 22%.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
ABOUT HOLLYWOOD ENTERTAINMENT
We are the second largest rental retailer of movies and video games in the
United States. We opened our first video store in October 1988 and, as of
December 31, 2004, we operated 2,006 Hollywood Video stores in 47 states and
the District of Columbia, of which 695 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. In addition, we had 20 free-standing Game
Crazy stores.
For 2004, we derived 77.9% of our revenue from movie and game rental products,
16.1% 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 have declined in 2004, we have increased our total 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, see "Cautionary
Statements".
The video game industry, an approximately $9.9 billion market in the United
States in 2004 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.
In the last year, we have engaged in negotiations for the sale of Hollywood,
initially to a private equity fund and more recently to Movie Gallery, Inc.,
with whom we have signed a merger agreement subject to shareholder approval.
Subsequently, Blockbuster Inc. has made an unsolicited tender offer for all of
our securities. Despite efforts to sell the Company, we remain focused on
operating our business to enhance our position as the nation's second largest
rental retailer of movies and video games.
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 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 the sale of used
movies, which we believe offer a better value to those consumers who choose to
purchase instead of rent. As it relates to video game sales, our approach is
primarily to build dedicated game retail departments within our Hollywood Video
stores. 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.
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 measures 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 January 9, 2005 we signed a definitive merger agreement with Movie Gallery,
Inc. and its wholly owned subsidiary, TG Holdings, Inc., which provides for the
merger of TG Holdings into Hollywood, with Hollywood surviving the merger as a
wholly owned subsidiary of Movie Gallery. Under the terms of the merger
agreement, our shareholders will be entitled to receive $13.25 per share in
cash upon the completion of the merger.
We had previously entered into an amended and restated merger agreement, dated
as of October 13, 2004, with Carso Holdings Corporation ("Carso") and Hollywood
Merger Corp., both affiliates of Leonard Green & Partners, L.P. Under the
terms of this amended and restated merger agreement, our shareholders were to
receive $10.25 per share in cash upon completion of the merger contemplated by
the amended and restated merger agreement. By a termination agreement dated
January 9, 2005, between us, Carso and its affiliates, and related documents,
we terminated the amended and restated merger agreement. The termination of
the merger agreement with Carso required our payment of Carso's transaction
expenses of $4.0 million.
We terminated the agreement with Carso and entered into the merger agreement
with Movie Gallery following a unanimous recommendation in favor of these
actions by a special committee of our board of directors consisting of the
independent directors of our board of directors. The special committee and our
board of directors received a fairness opinion from Lazard Freres & Company,
LLC as to the consideration to be received by our shareholders pursuant to the
merger agreement with Movie Gallery.
The closing of the merger with TG Holdings is subject to terms and conditions
customary for transactions of its type, including shareholder approval,
antitrust clearance and the completion of financing. The parties to the merger
agreement anticipate completing the merger in the second quarter of 2005.
Blockbuster, Inc. has commenced unsolicited tender offers for all of our
outstanding shares of common stock and for all of our outstanding 9.625% Senior
Subordinated Notes due 2011. Blockbuster has also made filings under federal
antitrust laws seeking clearance for a possible acquisition of Hollywood. Our
board of directors has recommended to shareholders that they not tender their
shares of common stock to Blockbuster, based in large part on the uncertainty
of completing a transaction with Blockbuster. The board has taken no position
with respect to the tender of outstanding senior subordinated notes. Our board
may change its views depending on whether or not Blockbuster is cleared by
federal agencies to acquire Hollywood and if so on what conditions. In
addition to antitrust clearance, Blockbuster's tender offers are subject to a
number of other contingencies, including the tender of at least a majority of
Hollywood's shares, and they may not be completed.
RESTATEMENT OF PRIOR PERIODS
Like many other publicly traded retail companies, we reviewed our accounting
practices with respect to store operating leases. This review was triggered in
part by the February 7, 2005 letter issued from the Office of the Chief
Accountant of the Securities and Exchange Commission ("SEC") to the American
Institute of Certified Public Accountants expressing the SEC's views regarding
proper accounting for certain operating lease matters under GAAP. We concluded
that we needed to correct certain errors in our accounting for leases and
restate prior periods.
Classification of Store Build-out Costs
We coordinate and directly pay for a varying amount of the construction of new
stores based upon executed lease agreements. For some stores we are responsible
for overseeing the construction while in others the lessor may be fully
responsible for building the store to our specification. In all cases,
however, we are reimbursed by the lessor for most of the construction costs.
Historically, we accounted for the unreimbursed portion of the construction as
leasehold improvement assets that depreciated over 10 years, which approximated
the term of the lease. Upon further review of the applicable accounting
guidance, we have determined that the amount of assets recorded as leasehold
improvements depends upon a number of factors, including the nature of the
assets and the amount of construction risk we have during the construction
period.
Nature of the assets: Store build-out costs have been segregated between
structural elements that benefit the lessor beyond the term of the lease and
assets that are considered normal tenant improvements. In accordance with EITF
96-21 "Implementation Issues in Accounting for Leasing Transactions involving
Special-Purpose Entities", payments made by us for structural elements that are
not reimbursed by the lessor should be considered a prepayment of rent that
should be amortized as rent expense over the term of the lease.
Construction risk: In store construction projects where we either pay directly
for a portion of the construction cost of a new store that are not reimbursed
by the lessor and/or we are responsible for cost overruns, we may be deemed the
owner of all store assets during construction under the provisions of EITF 97-
10 "The Effect of Lessee Involvement in Asset Construction." Upon completion
of construction, if we comply with the provisions of FAS 98, we are considered
to have sold and leased back the asset from the lessor. We have analyzed all of
the projects in which we were deemed the owner under the provisions of EITF 97-
10 and have concluded that we complied with the provision of FAS 98 for sale-
leaseback treatment upon completion of the project.
Classification of Tenant Improvement Allowances
We historically accounted for tenant improvement allowances as a reduction to
the related leasehold improvement assets. We have concluded that certain
allowances should be considered lease incentives as discussed in Financial
Accounting Standards Board Technical Bulletin No. 88-1, "Issues Relating to
Accounting for Leases," (FTB 88-1). For allowances determined to be incentives,
FTB 88-1 requires lease incentives to be recorded as deferred rent liabilities
on the balance sheet, a reduction in rent expense on the statement of
operations and as a component of operating activities on the consolidated
statements of cash flows.
Rent Holidays
We historically recognized rent on a straight-line basis over the lease term
commencing with the store opening date. Upon re-evaluating FASB Technical
Bulletin No. 85-3, "Accounting for Operating Leases with Scheduled Rent
Increases," we have determined that the lease term should commence on the date
that the property is ready for normal tenant improvements.
Depreciation of Leasehold Improvements
Historically, we depreciated leasehold improvements over 10 years, which
approximates the contractual term of the lease. We also depreciated leasehold
improvements acquired subsequent to store opening, such as remodels, over 10
years. We have concluded that such leasehold improvements should be amortized
over the lesser of the assets economic life of 10 years or the contractual term
of the lease. Optional renewal periods are included in the contractual term of
the lease if renewal is reasonably assured at the time the asset is placed in
service.
Lease Incentive
During 1996 to 2000, certain landlords reimbursed a portion of our grand
opening events and advertising expenses. We historically recorded these
marketing allowances received for grand opening costs as a reduction of our
advertising expense in the period that the marketing allowance was received. We
now believe that these allowances should be considered lease incentives as
discussed in Financial Accounting Standards Board Technical Bulletin No. 88-1,
"Issues Relating to Accounting for Leases," (FTB 88-1). FTB 88-1 requires
lease incentives to be recorded as deferred rent liabilities on the balance
sheet, and amortized against rent expense over the term of the lease.
See note 3 to the consolidated financial statements for a comparison of
previously reported financial statements to restated financial statements.
Revision of Classification
Marketable Securities
We also reviewed our accounting practices with respect to balance sheet
classification of auction rate securities. Auction rate securities are variable
rate bonds tied to short term interest rates with maturities on the face of the
securities in excess of 90 days. Auction rate securities have interest rate
resets through a modified Dutch auction, at predetermined short term intervals,
usually every 7, 28 or 35 days. They trade at par and are callable at par on
any interest payment date at the option of the issuer. Interest paid during a
given period is based upon the interest rate determined during the prior
auction. Although these securities are issued and rated as long term bonds,
they are priced and traded as short term instruments because of the liquidity
provided through the interest rate reset. We had historically classified these
instruments as cash equivalents if the period between interest rate resets was
90 days or less, which was based the ability to either liquidate the holdings
or roll the investment over to the next reset period. Based upon our re-
evaluation of the maturity dates associated with the underlying bonds, we have
revised our classification our auction rate securities, previously classified
as cash equivalents, as marketable securities in accordance with FAS 95 for
each of the periods presented in the accompanying consolidated balance sheet.
We have classified these investments as available for sale investments and
consider them to be current assets based on the availability of these assets to
fund current operations. The purchase and sale of marketable securities are now
displayed in the investing section of the cash flow statement. As of December
31, 2004 and 2003, we were in violation of certain covenants restricting our
investments in cash equivalents and marketable securities under our credit
facility and our indenture for senior subordinated notes because we invested in
AAA-rated marketable securities with maturities beyond those allowed under our
credit facility. The lenders have waived the default through March 31, 2005; if
we correct the violation by that time, we will not need a waiver from holders
of our senior subordinated notes. We expect to correct the violation and be in
compliance with our credit facility and indenture covenants by March 31, 2005.
RESULTS OF OPERATIONS
Summary Results of Operations
Total revenue for 2004 was $1,782.4 million compared to $1,682.5 million for
2003. The increase was primarily attributable to the addition of 100 Hollywood
Video stores and 120 game departments, and the positive same store sales for
game departments, which more than offset the negative same store revenue from
the video stores.
Total revenue for 2003 was $1,682.5 million compared to $1,490.1 million for
2002. The increase was primarily due to a 3% increase in Hollywood Video same
store sales, a 16% increase in Game Crazy same store sales, and the addition of
102 Hollywood Video stores and 319 game departments.
Our income from operations for 2004 was $146.5 million compared to $182.2
million for 2003. The decrease was attributable to increased operating and
selling expenses of $66.3 million and increased general and administrative
expenses of $17.9 million, partially offset by increased gross margin of $47.8
million and a reduction in store opening expenses of $2.6 million. The increase
in operating and selling expenses was driven by increased labor of $23.2
million due to an increased number of video stores and game departments, higher
rent and related costs of $22.5 million and a $13.8 million charge for the
impairment of long-lived assets as discussed below. The increase in general and
administrative expenses was driven by an increase in professional services of
$12.7 million, which included $9.4 million in merger related expenses, and a
$4.4 million increase in the loss on disposals of fixed assets due to the non-
cash write-off of capitalized systems development that will not be placed in
service. For 2004, Hollywood Video generated $168.0 million in income from
operations while Game Crazy generated a net loss from operations of $21.6
million.
Our income from operations for 2003 was $182.2 million compared to $189.6
million for 2002. The decrease was primarily due to operating losses incurred
by Game Crazy for 2003 and a $12.4 million reversal of an accrual related to
the closure of our former internet business, Reel.com, that benefited income
from operations for 2002. For 2003, Hollywood Video generated $206.9 million in
income from operations while Game Crazy generated a net loss from operations of
$24.7 million.
Our net income for 2004 was $71.3 million compared with net income of $80.1
million for 2003. The decrease was attributable to increased gross margin of
$47.8 million, as well as a $12.5 million expense for early debt retirement in
the first quarter of 2003, which causes net income to increase year-over-year
by the same amount, offset by the $66.3 million increase in operating and
selling expenses.
Our net income for 2003 was $80.1 million compared with net income of $259.7
million for 2002. The decrease in net income was primarily the result of a
change in our provision for income taxes. Net income for 2002 benefited from a
reduction in our valuation allowance on our deferred income tax assets,
resulting in an income tax benefit of $115.7 million. We believe that an
effective tax rate of 40.5% would have represented a normalized provision for
income taxes excluding the valuation allowance reductions. The effective tax
rate for 2003 was 40.3%. Also contributing to the decrease in net income for
2003 was a $12.5 million charge recorded in the first quarter of 2003 for early
debt retirement compared to an early debt retirement charge in the first
quarter of 2002 of $3.5 million.
Impairment Charge
We review long-lived assets and goodwill for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. We periodically review and monitor our internal management
reports for indicators of impairment. We consider a trend of unsatisfactory
operating results that are not in line with management's expectations to be a
primary indicator of potential impairment. In the fourth quarter of 2004 our
video store same store sales decreased 3%. These results were not in line with
earlier management expectations and management felt that the recent trend of
negative video store same store sales could continue. Accordingly, we evaluated
our store assets and determined that certain stores had a forecast of
undiscounted future operating cash flows that were less than the carrying
amount of the stores respective assets. We considered these stores impaired and
recorded a $13.8 million non-cash impairment charge. The charge was calculated
as the amount by which the carrying value of the assets exceeded our estimate
of the stores fair value.
Results of Operation Expressed as a Percentage of Revenue
Year Ended December 31,
------------------------------
2004 2003 2002
Restated Restated
-------- -------- --------
Revenue:
Rental product revenue 77.9% 82.4% 88.9%
Merchandise sales 22.1% 17.6% 11.1%
-------- -------- --------
100.0% 100.0% 100.0%
-------- -------- --------
Gross margin 59.8% 60.5% 61.5%
Operating costs and expenses:
Operating and selling 44.5% 43.2% 43.5%
General and administrative 7.0% 6.3% 6.0%
Store opening expense 0.1% 0.3% 0.2%
Restructuring charge for closure
of internet business 0.0% 0.0% (0.8%)
Restructuring charge for store
closures 0.0% (0.1%) (0.1%)
-------- -------- --------
51.6% 49.7% 48.8%
-------- -------- --------
Income from operations 8.2% 10.8% 12.7%
Interest expense, net (1.7%) (2.1%) (2.8%)
Early debt retirement 0.0% (0.7%) (0.2%)
-------- -------- --------
Income before income taxes 6.5% 8.0% 9.7%
(Provision for) benefit from income
taxes (2.5%) (3.2%) 7.7%
-------- -------- --------
Net income 4.0% 4.8% 17.4%
======== ======== ========
Year Ended December 31,
---------------------------
2004 2003 2002
------- ------- -------
Other data:
Rental product gross margin (1) 69.9% 68.2% 66.2%
Merchandise sales gross margin (2) 24.1% 24.4% 24.0%
- --------------------------------------------------------------
(1) Rental product gross margin as a percentage of rental product revenue.
(2) Merchandise sales gross margin as a percentage of merchandise sales.
REVENUE
Revenue increased by $99.8 million, or 5.9%, for 2004 compared to 2003. The
increase was primarily due to opening new Hollywood Video stores and additional
game departments and a 2% increase in same store sales. We operated an
additional 101 weighted-average Hollywood Video stores and 178 additional
weighted-average game departments. A decrease in same store sales from our
video stores of 5% was offset by a 22% increase in same store sales from Game
Crazy.
Revenue increased by $192.5 million, or 12.9%, for 2003 compared to 2002. The
increase was primarily due to opening new Hollywood Video stores and additional
game departments and an 11% increase in same store sales. We operated an
additional 47 weighted-average Hollywood Video stores and 351 additional
weighted-average game departments. Same store sales from our Hollywood Video
stores increased 3% and same store sales from Game Crazy increased 16%.
The following is a summary of revenue by product category and operating segment
(in thousands):
---------- ---------- ----------
2004 2003 2002
---------- ---------- ----------
DVD rental product revenue $ 966,062 $ 763,352 $ 480,177
VHS rental product revenue 305,514 504,181 727,347
Game rental product revenue 116,722 119,057 116,493
---------- ---------- ----------
Total rental product revenue 1,388,298 1,386,590 1,324,017
---------- ---------- ----------
Video store merchandise revenue 107,532 115,826 109,382
Game Crazy revenue 286,534 180,132 56,667
---------- ---------- ----------
Total merchandise revenue 394,066 295,958 166,049
---------- ---------- ----------
---------- ---------- ----------
Total revenue $1,782,364 $1,682,548 $1,490,066
========== ========== ==========
Rental revenue is generated from the rental of DVD and VHS movies and video
games and from the sale of previously viewed movies and games. We currently
offer a 5-day rental program on all products in the majority of our stores. All
DVDs and new release VHS movies typically rent for $3.79. Catalog VHS movies
typically rent for $1.99. Video games rent for $4.99 and $5.99, with games
designed for the newer platforms renting for the higher amount. Customers who
choose not to return movies within the applicable rental period are deemed to
have commenced a new rental period of equal length at the same price. Revenue
recorded for extended rental periods was $170.6 million, $165.6 million and
$157.3 million in 2004, 2003 and 2002, respectively, and is net of estimated
amounts that we do not anticipate collecting.
In the third quarter of 2004 we began to offer nationally the Movie Value Pass
(MVP), an in-store movie rental subscription service that allows customers to
rent an unlimited number of most new release movies and all catalog movies
during the term of the pass, subject to a limit on the number of movies that
can be out at one time. Subscription fees are paid up-front and recognized as
rental product revenue on a straight-line basis over the applicable term of the
pass, typically one month.
Merchandise sales are generated from the sale of new and used game hardware,
software and accessories, new movies, concessions and miscellaneous video
accessory items.
GROSS MARGIN
Rental Product Margins
Rental product gross profit as a percentage of rental product revenue ("gross
margin") increased to 69.9% for 2004 from 68.2% for 2003 and 66.2% for 2002.
The increases were 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 decreased to 24.1% for 2004 from 24.4% for 2003.
The decrease was primarily the result of an increase in the percentage of
revenue from new game sales, which typically have lower gross margins than
other product categories, such as used games, accessories and concessions.
Revenue from Game Crazy departments accounted for 72.7% and 60.9% of
consolidated merchandise revenue with a gross margin rate of 24.1% and 24.7%
for 2004 and 2003, respectively. Hollywood Video accounted for the remainder of
merchandise revenue with a gross margin rate of 24.1% and 24.0% for 2004 and
2003, respectively.
Merchandise sales gross margin increased to 24.4% for 2003 from 24.0% for 2002.
The increase was primarily the result of an increase in the percentage of
merchandise sales from Game Crazy and Hollywood Video's concessions business,
which typically have higher margins than new movie sales in Hollywood Video.
OPERATING COSTS AND EXPENSES
Operating and Selling Expenses
Total operating and selling expenses for 2004 increased as a percentage of
revenue to 44.5% from 43.2% for 2003. Total operating and selling expense for
2004 increased $66.3 million to $793.3 million from $727.0 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 178 weighted-average
game departments. Payroll and related expenses increased by $23.2 million
(including a $15.2 million increase from Game Crazy), rent and related expenses
increased by $22.5 million, depreciation increased by $10.6 million (including
a fixed asset impairment charge of $13.8 million), advertising increased by
$3.1 million, and other operating and selling expenses increased by $6.9
million for 2004 compared to 2003.
Total operating and selling expenses for 2003 decreased as a percentage of
revenue to 43.2% from 43.5% for 2002. The percentage decrease was primarily the
result of leverage from increased revenue. Total operating and selling expense
for 2003 increased $79.5 million to $727.0 million from $647.5 million for
2002. The increase was primarily the result of increased variable costs
associated with increased store revenue, an increase of 47 weighted-average
stores and an increase in operating and selling expenses associated with the
addition of 319 Game Crazy departments. Payroll and related expenses increased
by $40.0 million, rent and related expenses increased by $15.9 million,
advertising increased by $11.7 million, and other operating and selling
expenses increased by $11.7 million for 2003 compared to 2002.
General and Administrative Expenses
General and administrative expenses for 2004 increased $17.9 million to $123.9
million, or 7.0% of total revenue, from $106.0 million, or 6.3% of total
revenue for 2003. The increase was primarily the result of an increase in
professional service expenses of $12.7 million, which included $9.4 million in
merger related expenses and $2.4 million related to reserves for legal
contingencies. All merger related costs are expensed as incurred. Payroll and
related expenses increased $2.0 million, loss on the disposal of assets
increased $4.4 million, due to the non-cash write-off of capitalized systems
development that will not be placed in service, offset by a decrease in other
general and administrative expenses of $1.2 million.
General and administrative expenses for 2003 increased $16.4 million to $106.0
million, or 6.3% of total revenue, from $89.6 million, or 6.0% of total
revenue, for 2002. Included in general and administrative expenses for 2003 was
a $1.7 million charge recognized in the first quarter to increase a class
action litigation settlement reserve related to extended rental periods.
General and administrative expenses for 2002 benefited from the net reversal of
approximately $1.6 million of non-cash stock option expense. The $1.6 million
benefit reflects stock option expense of $2.9 million recorded in the first,
second and fourth quarters and a net reversal of expense of $4.5 million
recorded in the third quarter primarily associated with the cancellation of
stock options subject to variable plan accounting. General and administrative
expenses for 2002 also benefited from the reversal of a legal accrual in the
amount of $1.6 million, as a result of the final confirmation of the settlement
of our California exempt/non-exempt class action lawsuit for an amount less
than anticipated. Excluding these items, general and administrative expenses as
a percentage of total revenue were consistent for 2003 and 2002.
NON-OPERATING INCOME (EXPENSE), NET
Interest Expense
Interest expense, net of interest income, decreased in 2004 compared to 2003 by
$5.5 million. The reduction was primarily due to decreased borrowing levels
and lower interest rates (see Note 15 to our consolidated financial statements
for a description of our outstanding debt). Interest expense, net of interest
income, decreased in 2003 compared to 2002 by $6.6 million. The reduction was
primarily due to decreased borrowing levels and lower interest rates.
Early Debt Retirement
In the first quarter of 2003, we redeemed the outstanding $250 million 10.625%
senior subordinated notes due 2004 and retired our prior credit facility due
2004. As a result, we recorded a charge of $12.5 million that included an early
redemption premium of $6.6 million and the write-off of deferred financing
costs. In the first quarter of 2002, we paid all amounts outstanding and
retired our credit facility in place at that time, resulting in a $3.5 million
charge to write-off deferred financing costs.
INCOME TAXES
Our effective tax rate was a provision of 38.8% in 2004, compared to a
provision of 40.3% in 2003 and a benefit of 80.3% in 2002, which varies from
the federal statutory rate as a result of adjustments to deferred tax asset
valuation allowances, non-deductible executive compensation and state income
taxes.
In the fourth quarter of 2000, in light of significant doubt that existed
regarding our future income and therefore our ability to use our net operating
loss carryforwards, we recorded a $229.8 million valuation allowance against
our $229.8 million net deferred tax asset. In 2002 and 2001, as a result of
our operating performance for each year, as well as anticipated future
operating performance, we determined that it was more likely than not that
future tax benefits would be realized. Consequently, we benefited by the
reversal of $165.5 million and $64.3 million of the valuation allowance in 2002
and 2001, respectively.
Federal tax laws impose restrictions on the utilization of net operating loss
carryforwards and tax credit carryforwards in the event of an "ownership
change," as defined by the Internal Revenue Code. Such ownership changes
occurred in October 2000 and December 2001 as a result of significant changes
in stock ownership. Our ability to utilize our net operating loss carryforwards
and tax credit carryforwards is subject to restrictions pursuant to these
provisions. Utilization of the federal net operating loss and tax credits will
be limited annually and any unused limitation in a given year may be carried
forward to the next year. The annual limitation on utilization of the net
operating loss carryforwards ranges between $52.4 million and $209.5 million
and varies due to the fact that there were two ownership changes. We believe
it is more likely than not that we will fully realize all net operating loss
carryforwards and tax credit carryforwards and therefore a valuation reserve is
not necessary at December 31, 2004 and 2003.
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.
Permission has been granted for the change in accounting method to accelerate
the deduction of store pre-opening supplies. The application for the
accelerated deduction of DVD and VHS movies and video games is under review by
the IRS.
RENTAL INVENTORY
Analysis of rental inventory and investment in rental product
When analyzing our rental inventory purchase activity, it is important to
consider that we acquire new releases of movies under two different pricing
structures, "revenue sharing" and "sell-through." These methods impact the
dollar amount of new releases held as rental inventory on our consolidated
balance sheet. Under revenue sharing, in exchange for acquiring agreed-upon
quantities of DVDs or tapes at reduced or no up-front costs, we share agreed-
upon portions of the revenue that we derive from the DVDs or tapes with the
studio. The studio's share of rental revenue is expensed, net of an estimated
residual value, as revenue is earned on revenue sharing titles. The resulting
revenue sharing expense is considered a direct cost of sales rather than an
investment in rental inventory. Under sell-through pricing, we purchase movies
from the studios with no obligation for future payments to the studios. Sell-
through purchases are recognized as an investment in rental inventory, which is
then amortized to cost of rental product over its estimated useful life to an
estimated residual value. Therefore, purchases of rental inventories, as shown
on our consolidated statement of cash flows, are not reflective of the total
costs of acquiring movies for rental and are impacted by the mix of movies
acquired under these pricing structures. Cost of rental product included
revenue sharing expense of $86.9 million for 2004, compared to $88.8 million
for 2003 and $130.4 million for 2002. 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 DVD revenue sharing arrangements typically result in lower
net revenue sharing expense than VHS revenue sharing arrangements.
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 increased $18.3 million to $148.2 million as
of December 31, 2004, from $129.9 million as of December 31, 2003. The increase
was primarily related to the addition of 120 game departments and game
inventory increases in existing game departments to support a 22% increase in
same store sales in 2004.
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 Game Crazy operating losses and provided the capital required
to open 100 Hollywood Video stores and add 120 game departments. Cash
generated from operations in 2004 also allowed us to make a $20 million
prepayment on our term loan facility, which is now prepaid through 2006, as
well as repurchase 295,139 shares of common stock for $3.7 million. At
December 31, 2004, we had $193.8 million of cash, cash equivalents and
marketable securities on hand.
We believe cash flow from operations, increased flexibility under our credit
facilities, cash, cash equivalents and marketable securities on hand and trade
credit will provide adequate liquidity and capital resources to execute our
business plan for the foreseeable future, including our expansion plans
discussed below in "Cash Used in Investing Activities." We continue to analyze
our capital structure and our business plan and from time to time may consider
additional capital and/or financing transactions as a source of incremental
liquidity.
Cash Provided by Operating Activities
Net cash provided by operating activities increased by $9.3 million, or 2.4%,
to $400.7 million for 2004 compared to $391.5 million for 2003. The increase
was primarily attributable to favorable changes in working capital accounts
including $14.3 million for merchandise inventory driven by a reduction in the
number of new game departments opened in 2004 compared to 2003.
Net cash provided by operating activities increased by $29.9 million, or 8.3%,
to $391.5 million for 2003 compared to $361.5 million for 2002. The increase
was primarily due to an increase in income from operations in our Hollywood
Video stores and favorable changes in working capital accounts, offset by
operating losses incurred by our Game Crazy departments.
Cash Used in Investing Activities
Net cash used in investing activities was $393.7 million and $124.3 million for
2004 and 2003, respectively. We opened 100 Hollywood Video stores and added 120
game departments during 2004 compared to opening 102 Hollywood Video stores and
adding 319 game departments during 2003. Purchases of marketable securities net
of sales of marketable securities increased $95.4 million in 2004 compared to
2003 because our share repurchase program and early debt payments were halted
due to the pending merger with Movie Gallery. Cash used in investing activities
for 2003 includes $218.5 million of proceeds delivered to subordinated note
holders on our behalf by the indenture trustee. The delivery of the proceeds to
the indenture trustee in the fourth quarter of 2002 and the subsequent use of
the proceeds to redeem the notes in the first quarter of 2003 were classified
as investing activities.
Net cash used in investing activities was $124.3 million and $548.8 million for
2003 and 2002, respectively. Net cash used in investing activities for 2003
included a $218.5 million source of cash related to a financing transaction. On
December 18, 2002, we completed the sale of $225 million 9.625% senior
subordinated notes due 2011 and delivered net proceeds of $218.5 million to the
indenture trustee to redeem $203.9 million of the $250 million 10.625% senior
subordinated notes due 2004. The delivery of the proceeds to the indenture
trustee and the subsequent use of the proceeds to redeem the notes in the first
quarter of 2003 were classified as investing activities. In 2003, we opened 102
Hollywood Video stores and 319 game departments compared to opening 41
Hollywood Video stores and 207 game departments in 2002.
We anticipate investing at least $40 million in 2005 for retail expansion
(including the investment in inventory and opening expenses) and for
maintenance capital expenditures. 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 movie
trading 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 $9.0 million use of cash for 2004
compared to a $252.3 million use of cash for 2003. The $9.0 million use of
cash for 2004 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 $252.3 million use of cash for
2003 compared to a $181.5 million source of cash for 2002. The $252.3 million
use of cash reflects the redemption of $250.0 million senior subordinated notes
and the retirement of our prior credit facility of $107.5 million with $218.5
million in proceeds from the indenture trustee and $200.0 million of initial
borrowings under our new credit facility. The use of cash also reflects the
repurchase of 1,746,173 shares of common stock for $26.3 million and $55.0
million for prepayment of term loan facility principal payments through 2005.
On March 11, 2002, we completed a public offering of 8,050,000 shares of our
common stock, resulting in proceeds of $120.8 million before fees and expenses,
of which $114.0 million was applied to the repayment of borrowings under our
prior revolving credit facility.
On March 18, 2002, we obtained senior bank credit facilities from a syndicate
of lenders led by UBS Warburg LLC and applied a portion of initial borrowings
thereunder to repay all remaining borrowings under our prior revolving credit
facility, which was then terminated. The bank credit facilities consisted of a
$150.0 million senior secured term facility maturing in 2004 and a $25.0
million senior secured revolving credit facility maturing in 2004.
On December 18, 2002, we completed the sale of $225.0 million 9.625% senior
subordinated notes due 2011. We delivered the net proceeds from the transaction
to the indenture trustee to redeem $203.9 million of the $250.0 million 10.625%
senior subordinated notes due 2004, including accrued interest and the required
call premium. At December 31, 2002, the trustee was holding $218.5 million and
we continued to carry the $250 million 10.625% senior subordinated notes on our
balance sheet, $203.9 million of which was classified as a current liability
titled "Subordinated notes to be retired with cash held by trustee." On January
17, 2003, the redemption of $203.9 million of the notes was completed.
On January 16, 2003, we obtained senior secured credit facilities from a
syndicate of lenders led by UBS Warburg LLC. These facilities consist of a
$200.0 million term loan facility and a $50.0 million revolving credit
facility, each maturing in 2008. We used the borrowings under the term loan
facility to repay amounts outstanding under our prior credit facilities which
were due in 2004, redeem the remaining $46.1 million principal amount of our
10.625% senior subordinated notes due 2004 on February 18, 2003 and for general
corporate purposes. We have prepaid $75.0 million of the term loan facility
principal payments due through 2006, including a $20.0 million payment made on
January 5, 2004.
Instruments governing our indebtedness contain various covenants, including
covenants requiring us to meet specified financial ratios and tests and
covenants that restrict our business including our ability to pay dividends and
limitations on the amount of common stock we can repurchase. As of December 31,
2004 and 2003, we were in violation of certain covenants restricting our
investments in cash equivalents and marketable securities under our credit
facility and our indenture for senior subordinated notes because we invested in
AAA-rated marketable securities with maturities beyond those allowed under our
credit facility. The lenders have waived the default through March 31, 2005; if
we correct the violation by that time, we will not need a waiver from holders
of our senior subordinated notes. We expect to correct the violation and be in
compliance with our credit facility and indenture covenants by investing in
instruments authorized by the debt covenants by March 31, 2005.
At December 31, 2004, maturities on long-term obligations for the next five
years are as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2005 $ - $ - $ 555 $ 555
2006 - - 612 612
2007 - 20,000 89 20,089
2008 - 105,000 - 105,000
2009 - - - -
Thereafter 225,000 - - 225,000
---------- ---------- --------- ---------
$ 225,000 $ 125,000 $ 1,256 $ 351,256
---------- ---------- --------- ---------
Contractual Obligations
Our contractual obligations consist of long-term debt, operating leases
(primarily store leases) and capital leases. We lease all of our stores,
corporate offices, distribution centers and zone offices under non-cancelable
operating leases. All of our stores have an initial operating lease term of
five to 15 years and most have options to renew for between five and 15
additional years. Contractual obligations as of December 31, 2004 are as
follows (in thousands):
Contractual 2-3 4-5 More than
Obligations Total 1 Year Years Years 5 Years
- --------------- ---------- -------- -------- -------- ---------
Credit Facility $ 125,000 $ - $ 20,000 $105,000 $ -
Subordinated Notes $ 225,000 $225,000
Interest Payment
On Subordinated
Notes 151,595 21,656 43,313 43,313 43,313
Capital Leases 1,256 555 701 - -
Interest Payment
On Capital
Leases 89 50 39 - -
Operating Leases 1,335,328 258,703 448,264 303,720 324,641
---------- -------- -------- -------- ---------
Total $1,838,268 $280,964 $512,317 $677,033 $ 367,954
---------- -------- -------- -------- ---------
Other Financial Measurements: Working Capital
At December 31, 2004, we had cash, cash equivalents and marketable securities
of $193.8 million and a working capital balance of $51.8 million. Prior to the
second quarter of 2004 we had operated with a working capital deficit. The
current period 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 in connection with the
proposed sale of Hollywood. Prior to the second quarter of 2004 the 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
Revenue Recognition
We recognize revenue upon the rental and sale of our products. Rental revenue
for extended rental periods (when the customer chooses to keep the product
beyond the original rental period) is recognized when the extended rental
period begins. Revenue recorded for extended rental periods includes an
estimate of future cash collections for extended rental periods that have been
incurred. Because our estimate is based upon cash collections, the amount
recorded is net of amounts that we do not anticipate collecting based upon
historical experience. We continuously monitor actual collections. Estimates
are revised when we believe it is appropriate in light of actual collections
and other relevant circumstances. Historically, actual collections have
approximated the related net revenue recorded. However, if actual collections
in the future are less than the related net revenue recorded, our results of
operations would be adversely affected.
Merchandise Inventory Valuation
Merchandise inventories, consisting primarily of new and used video game
software and hardware, new DVD and VHS movies and concessions, are stated at
the lower of cost or market. We consider several factors in our assessment of
market value including age and inventory turns. Due to the numerous variables
associated with the judgments and assumptions we make in estimating market
values, and the effects of changes in circumstances affecting these estimates
(including the effects of competing products and technologies), both the
precision and reliability of the resulting estimates are subject to substantial
uncertainties and, as additional information becomes known, we may change our
estimates significantly.
Amortization of Rental Inventory
Rental inventory, which includes DVD and VHS movies and video games, is stated
at cost and amortized over its estimated useful life to an estimated residual
value. We analyze several factors to validate our estimates such as inventory
turns, previously viewed product sales and average inventory levels per store
among many other variables. Our estimates of useful lives and residual values
affect the amounts of amortization recorded, which in turn affects the carrying
value of our rental inventory and cost of rental product (and, upon the
transfer of previously viewed items from rental inventory to merchandise
inventory, the carrying value of our merchandise inventory). For new release
movies acquired for rental under revenue sharing arrangements, the studios'
share of rental revenue is expensed as revenue is earned net of average
estimated carrying values. DVDs, tapes and video games acquired for rental at
fixed prices are amortized to estimated residual values in periods ranging from
four months to five years for DVD library. Due to the numerous variables
associated with the judgments and assumptions we make in estimating useful
lives and residual values of these items, and the effects of changes in
circumstances affecting these estimates (including the effects of competing
products and technologies and actual selling prices obtainable for previously
viewed product), both the precision and reliability of the resulting estimates
are subject to substantial uncertainties and, as additional information becomes
known, we may change our estimates significantly. See notes 6 and 7 to the
consolidated financial statements for a discussion of our current estimates and
certain changes in estimate effective in the fourth quarter of 2004.
Impairment of Long-Lived Assets and Goodwill
We review long-lived assets and goodwill for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. We periodically review and monitor our internal management
reports for indicators of impairment. We consider a trend of unsatisfactory
operating results that are not in line with management's expectations to be a
primary indicator of potential impairment. When an indicator of impairment is
noted, assets are evaluated for impairment at the lowest level for which there
are identifiable cash flows (e.g. at the store level). We deem a store to be
impaired if a forecast of undiscounted future operating cash flows directly
related to the store, including estimated disposal value, if any, is less than
the asset carrying amount. If a store is determined to be impaired, the loss is
measured as the amount by which the carrying amount on our balance sheet of the
store exceeds its fair value. Fair value is estimated using a discounted future
cash flow valuation technique similar to that used by management in making a
new investment decision. Considerable management judgment and assumptions are
necessary to estimate discounted future cash flows. Due to the numerous
variables associated with our judgments and assumptions relating to the
valuation of our assets in these circumstances, and the effects of changes in
circumstances affecting these valuations, both the precision and reliability of
the resulting estimates of the related impairment charges are subject to
substantial uncertainties and, as additional information becomes known, our
estimates may change significantly. In the fourth quarter of 2004 our video
store same store sales decreased 3%. These results were not in line with
earlier management expectations and management felt that the recent trend of
negative video store same store sales could continue. Accordingly, we evaluated
our store assets, determined that certain stores were impaired, and we recorded
a $13.8 million non-cash impairment charge.
Income Taxes
We calculate income taxes in accordance with SFAS No. 109, "Accounting for
Income Taxes," which requires recognition of deferred tax assets and
liabilities for the expected future tax consequences of events that have been
included in our financial statements and tax returns. Valuation allowances are
established when necessary to reduce deferred tax assets, including temporary
timing differences and net operating loss carryforwards, to the amount expected
to be realized in the future. Deferred assets and liabilities are measured
using enacted tax rates in effect for the year in which those temporary
differences are expected to be recovered or settled.
In the fourth quarter of 2000, in light of significant doubt that existed
regarding our future income and therefore our ability to use our net operating
loss carryforwards, we recorded a $229.8 million valuation allowance against
our $229.8 million net deferred tax asset. In 2002 and 2001, as a result of
our operating performance for each year, as well as anticipated future
operating performance, we determined that it was more likely than not that
future tax benefits would be realized. We therefore reversed $165.5 million and
$64.3 million of this valuation allowance in 2002 and 2001, respectively, which
resulted in an increase in net income and a corresponding increase/decrease in
our shareholders' equity/deficit. While changes in the valuation allowance have
no effect on the amount of income tax we pay or on our cash flows, the effects
on our reported income and shareholders' equity may be viewed by some investors
and potential lenders as significant.
Federal tax laws impose restrictions on the utilization of net operating loss
carryforwards and tax credit carryforwards in the event of an "ownership
change," as defined by the Internal Revenue Code. Such ownership changes
occurred in October 2000 and December 2001 as a result of significant changes
in stock ownership. Our ability to utilize our net operating loss carryforwards
and tax credit carryforwards is subject to restrictions pursuant to these
provisions. Utilization of the federal net operating loss and tax credits will
be limited annually and any unused limitation in a given year may be carried
forward to the next year. The annual limitation on utilization of the net
operating loss carryforwards ranges between $52.4 million and $209.5 million
and varies due to the fact that there were two ownership changes. We believe
it is more likely than not that we will fully realize all net operating loss
carryforwards and tax credit carryforwards and therefore a valuation reserve is
not necessary at December 31, 2004 or in prior periods.
Due to the numerous variables associated with our judgments, assumptions and
estimates relating to the valuation of our deferred tax assets, and the effects
of changes in circumstances affecting these valuations, both the precision and
reliability of the resulting estimates are subject to substantial uncertainties
and, as additional information becomes known, we may change our estimates
significantly.
Lease Accounting
Certain elements of lease accounting require us to make significant estimates,
judgments and assumptions. For example in order to comply with EITF 97-10, we
must estimate the fair value of store development and construction that will be
paid for by the lessor or other parties when it is determined that we are
subject to considerable construction risk. We also must make significant
judgment calls on the nature of store development assets that we purchase to
determine if the costs should be considered as fixed assets or prepaid rent.
Both the precision and reliability of our estimates and judgements are subject
to uncertainties.
Like many other publicly traded retail companies, we reviewed our accounting
practices with respect to store operating leases. This review was triggered in
part by the February 7, 2005 letter issued from the Office of the Chief
Accountant of the Securities and Exchange Commission ("SEC") to the American
Institute of Certified Public Accountants expressing the SEC's views regarding
proper accounting for certain operating lease matters under GAAP. We concluded
that we needed to correct certain errors in our accounting for leases and
restate prior periods.
Classification of Store Build-out Costs: We coordinate and directly pay for a
varying amount of the construction of new stores based upon executed lease
agreements. For some stores we are responsible for overseeing the construction
while in others the lessor may be fully responsible for building the store to
our specification. In all cases, however, we are reimbursed by the lessor for
most of the construction costs. Historically, we accounted for the unreimbursed
portion of the construction as leasehold improvement assets that depreciated
over 10 years, which approximated the term of the lease. Upon further review
of the applicable accounting guidance, we have determined that the amount of
assets recorded as leasehold improvements depends upon a number of factors,
including the nature of the assets and the amount of construction risk we have
during the construction period.
- - Nature of the assets: Store build-out costs have been segregated between
structural elements that benefit the lessor beyond the term of the lease and
assets that are considered normal tenant improvements. In accordance with EITF
96-21 "Implementation Issues in Accounting for Leasing Transactions involving
Special-Purpose Entities", payments made by us for structural elements that are
not reimbursed by the lessor should be considered a prepayment of rent that
should be amortized as rent expense over the term of the lease.
- - Construction risk: In store construction projects where we either pay
directly for a portion of the construction cost of a new store that are not
reimbursed by the lessor and/or we are responsible for cost overruns, we may be
deemed the owner of all store assets during construction under the provisions
of EITF 97-10 "The Effect of Lessee Involvement in Asset Construction." Upon
completion of construction, if we comply with the provisions of FAS 98, we are
considered to have sold and leased back the asset from the lessor. We have
analyzed all of the projects in which we were deemed the owner under the
provisions of EITF 97-10 and have concluded that we complied with the
provisions of FAS 98 for sale-leaseback treatment upon completion of the
project.
Classification of Tenant Improvement Allowances: We historically accounted for
tenant improvement allowances as a reduction to the related leasehold
improvement assets. We have concluded that certain allowances should be
considered lease incentives as discussed in Financial Accounting Standards
Board Technical Bulletin No. 88-1, "Issues Relating to Accounting for Leases,"
(FTB 88-1). For allowances determined to be incentives, FTB 88-1 requires lease
incentives to be recorded as deferred rent liabilities on the balance sheet, a
reduction in rent expense on the statement of operations and as a component of
operating activities on the consolidated statements of cash flows.
Rent Holidays: We historically recognized rent on a straight-line basis over
the lease term commencing with the store opening date. Upon re-evaluating FASB
Technical Bulletin No. 85-3, "Accounting for Operating Leases with Scheduled
Rent Increases," we have determined that the lease term should commence on the
date that the property is ready for normal tenant improvements.
Depreciation of Leasehold Improvements: Historically, we depreciated leasehold
improvements over 10 years, which approximates the contractual term of the
lease. We also depreciated leasehold improvements acquired subsequent to store
opening, such as remodels, over 10 years. We have concluded that such leasehold
improvements should be amortized over the lesser of the assets economic life of
10 years or the contractual term of the lease. Optional renewal periods are
included in the contractual term of the lease if renewal is reasonably assured
at the time the asset is placed in service.
See note 3 to the consolidated financial statements for a comparison of
previously reported financial statements to restated financial statements.
Legal Contingencies
Our estimates of our loss contingencies for legal proceedings are based on
various judgments and assumptions regarding the potential resolution or
disposition of the underlying claims and associated costs. Due to the numerous
variables associated with these judgments and assumptions, both the precision
and reliability of the resulting estimates of the related loss contingencies
are subject to substantial uncertainties. We regularly monitor our estimated
exposure to these contingencies with formal meetings between our Chief
Financial Officer and internal legal counsel and, as additional information
becomes known, we may change our estimates significantly.
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note 1 to the Consolidated Financial Statements for a discussion of
recently issued accounting standards and the impact they may have on the
financial condition or results of operations.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934 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
filed with 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 with an affiliate of Movie Gallery or
to complete a superior transaction could negatively impact the market price of
our common stock. If the Movie Gallery 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.
Completion of the merger contemplated by the merger agreement with Movie
Gallery is subject to a number of contingencies, including approval by a
majority of our shareholders, the completion of the financing and other
customary closing conditions. Notwithstanding our execution of the merger
agreement, we cannot assure you that a merger with Movie Gallery will be
completed, or if completed, that it would be completed on terms that do not
differ materially from those in the merger agreement.
Blockbuster, Inc. has commenced unsolicited tender offers for all of our
outstanding shares of common stock and for all of our outstanding 9.625% Senior
Subordinated Notes due 2011. Blockbuster has also made filings under federal
antitrust laws seeking clearance for a possible acquisition of Hollywood. Our
board of directors has recommended to shareholders that they not tender their
shares of common stock to Blockbuster, based in large part on the uncertainty
of completing a transaction with Blockbuster. The board has taken no position
with respect to the tender of outstanding senior subordinated notes. Our board
may change its views depending on whether or not Blockbuster is cleared by
federal agencies to acquire Hollywood and if so on what conditions. In
addition to antitrust clearance, Blockbuster's tender offers are subject to a
number of other contingencies, including the tender of at least a majority of
Hollywood's shares, and they may not be completed.
Since the announcement of our entering into the merger agreement with Movie
Gallery, our stock has traded above $13.25 per share, the price per share
offered by Movie Gallery. If the merger with Movie Gallery or a transaction at
a higher price is not completed, 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 or that a sales transaction at a price higher than $13.25 will
be completed; and
- - costs related to the merger, such as legal and accounting fees and a
portion of the investment banking fees and, in certain circumstances, a
termination fee of $27 million and expense reimbursement fees of up to
$3 million, must be paid even if the merger is not completed and will be
expensed in the fiscal period in which termination occurs.
Our securities are subject to delisting by Nasdaq.
We failed to hold an annual shareholders meeting in 2004 and to solicit proxies
for the meeting as required by Nasdaq listing standards. Nasdaq has agreed to
continue listing our securities provided that we hold an annual meeting no
later than March 30, 2005. We have scheduled a meeting for March 30, 2005. If
we are unable to hold a meeting on that date, our securities may be delisted
and thus no longer eligible to trade on The Nasdaq National Market System,
which may affect the liquidity of our securities and their trading price.
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 opened 100 new Hollywood Video stores and added 120
new Game Crazy departments and we anticipate adding additional Hollywood Video
stores and Game Crazy departments in 2005 and beyond. This expansion has
placed, and may continue to place, increased pressure on our operating and
management controls. To manage a larger store base and 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 profitably 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
other stores in the same 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. These key management personnel may not be able to
continue to successfully manage our existing operations and they may not remain
with us. In particular, uncertainties associated with the proposed merger with
an affiliate of Movie Gallery may cause Hollywood to lose key personnel. 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 December 31, 2004, we had total consolidated long-term debt, including
capital leases, of approximately $351.2 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. As of December 31, 2004 and 2003, we were in
violation of certain covenants restricting our investments in cash equivalents
and marketable securities under our credit facility and our indenture for
senior subordinated notes because we invested in AAA-rated marketable
securities with maturities beyond those allowed under our credit facility. The
lenders have waived the default through March 31, 2005; if we correct the
violation by that time, we will not need a waiver from holders of our senior
subordinated notes. We expect to correct the violation and be in compliance
with our credit facility and indenture covenants by investing in instruments
authorized by the debt covenants by March 31, 2005.
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:
- - the likelihood of completion of the merger with Movie Gallery and the
announcements and actions of other potential acquirors of Hollywood,
including Blockbuster;
- - 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 were named as a defendant in several purported class action lawsuits
asserting various causes of action, including claims regarding our membership
application and additional rental period charges. We have vigorously defended
these actions and maintain that the terms of our additional rental charge
policy are fair and legal. We have been successful in obtaining dismissal of
three of the actions filed against us. A statewide class action entitled George
Curtis v. Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No.
01-2-36007-8 SEA was certified on June 14, 2002 in the Superior Court of King
County, Washington. On May 20, 2003, a nationwide class action entitled George
DeFrates v. Hollywood Entertainment Corporation, No. 02 L 707 was certified in
the Circuit Court of St. Clair County, Twentieth Judicial Circuit, State of
Illinois. This settlement encompasses all of the various claims asserted in
each of the related actions. We received preliminary approval of the
settlement on August 10, 2004. Notice to class members began on October 10,
2004 and will last for six months. Final approval is scheduled for hearing on
June 10, 2005. We believe we have provided adequate reserves in connection with
these lawsuits.
We and the members of our board are defendants in several lawsuits pending in
Clackamas County, Oregon (and one in Multnomah County, Oregon). The lawsuits
assert breaches of duties associated with the merger agreement executed with a
subsidiary of Leonard Green & Partners, L.P. With the termination of the
Leonard Green transaction, we are uncertain as to whether these cases will
proceed and if so in what form. We and the members of our board have also been
named as defendants in a separate lawsuit--JDL Partners, L.P. v. Mark J.
Wattles et. al--filed in Clackamas County, Oregon Circuit Court. This lawsuit,
filed before our announcement of the merger agreement with Movie Gallery,
alleges breaches of fiduciary duties related to a recent bid by Blockbuster for
our company as well as breaches related to a loan to Mr. Wattles that the board
of directors forgave in December 2000. A motion is pending in Clackamas County
to consolidate this lawsuit with the previously filed actions. It is not clear
how the merger agreement with Movie Gallery will affect the pending litigation
and there is no assurance that a settlement will be effected or that current
reserves for this litigation will be adequate.
We were named as a defendant in three actions asserting wage and hour claims in
California. The plaintiffs sought to certify a statewide class action alleging
that certain California employees were denied meal and rest periods. There were
several additional related claims for unpaid overtime, unpaid off the clock
work, and penalties for late payment of wages and record keeping violations. A
mediation took place on September 9, 2004 and the parties reached a settlement
of all claims alleged in each of the actions. Pursuant to the settlement, two
of the actions were dismissed and all claims asserted by plaintiffs were
alleged in a single action. We received preliminary approval of the settlement
on January 10, 2005. Notice was sent directly to class members on February 4,
2005. Final approval is scheduled for hearing on April 21, 2005. 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. At
December 31, 2004, the commitments and contingencies reserve was $13.3 million.
At December 31, 2003, the legal contingencies reserve was $6.8 million.
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.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our financial position,
operating results, or cash flows due to adverse changes in financial and
commodity market prices and rates. We have entered into certain market-risk-
sensitive financial instruments for other than trading purposes, principally
short-term and long-term debt. Historically, and as of December 31, 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% in 2004 compared to the end of 2003, our interest expense would
have increased by approximately $1.3 million based on our outstanding balance
on the facility as of December 31, 2004.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Incorporated by reference to Item 15 of this report on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Hollywood Entertainment Corporation (the "Company") maintains disclosure
controls and procedures that are designed to ensure that information required
to be disclosed in the reports that the Company files or submits under the
Securities Exchange Act is recorded, processed, summarized, and reported within
the time periods specified in the SEC's rules and forms, and that such
information is accumulated and communicated to the Company's management,
including its Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required financial disclosure.
As of the end of the period covered by this report, the Company carried out an
evaluation, under the supervision and with the participation of the Company's
Disclosure Committee and management, including the Chief Executive Officer and
the Chief Financial Officer, of the effectiveness of the design and operation
of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15.
Based upon such evaluation, as well as considering the views expressed by the
Staff of the Securities and Exchange Commission ("SEC") on February 7, 2005
regarding certain lease accounting issues, as of December 31, 2004, the Chief
Executive Officer and the Chief Financial Officer concluded that our disclosure
controls and procedures were not effective, because of the material weakness
discussed below. To address the material weakness described below, the Company
performed additional analysis and other post-closing procedures to ensure our
consolidated financial statements are prepared in accordance with generally
accepted accounting principles. Accordingly, management believes that the
financial statements included in this report fairly present in all material
respects our financial condition, results of operations and cash flows for the
periods presented.
Management's Report on Internal Control Over Financial Reporting
The management of the Company is responsible for establishing and maintaining
adequate internal control over financial reporting. The Company's internal
control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally
accepted accounting principles.
The management of the Company has assessed the effectiveness of the Company's
internal control over financial reporting as of December 31, 2004. In making
its assessment of internal control over financial reporting, management used
the criteria described in "Internal Control - Integrated Framework" issued by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be
prevented or detected. As of December 31, 2004, the Company did not maintain
effective controls over the selection, application and monitoring of its
accounting policies related to leasing transactions. Specifically, the
Company's controls over its selection, application and monitoring of its
accounting policies related to the effect of lessee involvement in asset
construction, lease incentives, rent holidays and leasehold amortization
periods were ineffective to ensure that such transactions were accounted for in
conformity with generally accepted accounting principles. This control
deficiency resulted in the restatement of the Company's annual and interim
consolidated financial statements for 2003 and 2002 and for the first, second
and third quarters of 2004 as well as an audit adjustment to the fourth quarter
2004 financial statements. Additionally, this control deficiency could result
in a misstatement of prepaid rent, leasehold improvements, deferred rent, rent
expense and depreciation expense that would result in a material misstatement
to annual or interim financial statements that would not be prevented or
detected. Accordingly, management determined that this control deficiency
constitutes a material weakness. Because of this material weakness, we have
concluded that the Company did not maintain effective internal control over
financial reporting as of December 31, 2004, based on criteria in "Internal
Control-Integrated Framework" issued by the COSO.
Management's assessment of the effectiveness of the Company's internal control
over financial reporting as of December 31, 2004 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm,
as stated in their report which appears herein.
Remediation of Material Weakness
As discussed above, as of December 31, 2004, there was a material weakness in
the Company's internal control over financial reporting. In the first quarter
of 2005, the Company implemented improved monitoring controls and revisited its
accounting policies to ensure that its accounting policies relating to leases
and lease related matters, conform with generally accepted accounting
principles.
Changes in Internal Control Over Financial Reporting
Except as otherwise discussed herein, there have been no changes in the
Company's internal control over financial reporting during the most recently
completed fiscal quarter that has materially affected, or is reasonably likely
to materially affect, the Company's internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
On December 10, 2003 the board of directors determined the compensation to be
paid to independent directors for 2005. The Compensation Committee of the board
of directors has determined the compensation for the Chief Executive Officer
and for other named executive officers for 2005. A summary of the compensation
for the directors and certain executive officers is filed as Exhibit 10.15 to
this Form 10-K.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information about our directors is incorporated by reference from our
definitive proxy statement, under the caption "Nomination and Election of Board
of Directors," for our 2005 annual meeting of shareholders (the "2005 Proxy
Statement") to be filed pursuant to Regulation 14A under the Securities
Exchange Act of 1934, which proxy statement we expect to file no later than 120
days after the end of our fiscal year ended December 31, 2004. Information
with respect to our executive officers is included under Item 4A of Part I of
this report.
Information regarding our Audit Committee and "audit committee financial
expert" is incorporated by reference from the 2005 Proxy Statement.
We have adopted a Business and Ethics Code of Conduct for the guidance of our
directors, officers, and partners, including our principal executive, financial
and accounting officers and our controller. Our code of conduct, along with
other corporate governance documents, is posted on our website at
http://www.hollywoodvideo.com/investors, Corporate Governance.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this Item 11 is incorporated by reference from the 2005
Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Part of the information required by this Item 12 is incorporated by reference
from the 2005 Proxy Statement. Information with respect to options issued under
our stock option plans at December 31, 2004 is included in Item 5, Part II of
this report.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this Item 13 is incorporated by reference from the 2005
Proxy Statement.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information required by this Item 14 is incorporated by reference from the 2005
Proxy Statement.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Listed below are all financial statements, notes, schedules and exhibits filed
as part of our Annual Report on Form 10-K for the year ended December 31, 2004:
(a)(i), (ii) FINANCIAL STATEMENTS
The following financial statements of the Registrant, together with the Report
of Independent Registered Public Accounting Firm dated March 17, 2005 are filed
herewith:
(i) FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2004 and 2003
Consolidated Statements of Operations for the years ended December 31, 2004,
2003 and 2002
Consolidated Statements of Changes in Shareholders' Equity for the years ended
December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the years ended December 31, 2004,
2003 and 2002
Notes to Consolidated Financial Statements
(ii) FINANCIAL SCHEDULES
All financial schedules are omitted as the required information is inapplicable
or the information is presented in the respective Consolidated Financial
Statements or related notes.
(a) (iii) EXHIBITS
The following exhibits are filed with or incorporated by reference into this
Annual Report:
EXHIBIT
NUMBER DESCRIPTION
Items identified with an asterisk (*) are management contracts or
compensatory plans or arrangements.
2.1(a) Amended and Restated Agreement and Plan of Merger dated October 13,
2004 by and among the Registrant, Carso Holdings Corporation and
Hollywood Merger Corporation (incorporated by reference to Exhibit 2.1
to our current report on Form 8-K filed October 14, 2004). (This
agreement has been terminated and replaced by the agreement listed as
Exhibit 2.1(d).)
2.1(b) 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 our current report on
Form 8-K filed March 29, 2004). (This agreement has been terminated
and replaced by the agreement listed as Exhibit 2.1(d).)
2.1(c) 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 our current
report on Form 8-K filed June 8, 2004). (This amendment has been
terminated and replaced by the agreement listed as Exhibit 2.1(d).)
2.1(d) Agreement and Plan of Merger dated January 9, 2005 by and among
Hollywood Entertainment Corporation, Movie Gallery, Inc. and TG
Holdings, Inc. (incorporated by reference to Exhibit 2.1 to
our current report on Form 8-K dated January 11, 2005.
3.1 1993B Restated Articles of Incorporation, as amended (incorporated
by reference to our Registration Statement on Form S-1 (File No. 33-
63042)(the "Form S-1"), by reference to Exhibit 4 to our Registration
Statement on Form S-3 (File No. 33-96140), and by reference to Exhibit
3.1 to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998).
3.2 1999 Restated Bylaws (incorporated by reference to Exhibit 3.2 to our
Registration Statement on Form S-4 (File No. 333-82937)(the "1999
S-4")).
4.1 Indenture dated January 25, 2002 among the Registrant, Hollywood
Management Company, as potential guarantor, and BNY Western Trust
Company as trustee (incorporated by reference to Exhibit 4.1 to our
Registration Statement on Form S-3 (File No. 333-14802)), as
supplemented by the First Supplemental Indenture dated as of December
18, 2002 among the Registrant and Hollywood Management Company and BNY
Western Trust Company as Trustee (incorporated by reference to Exhibit
4.3 to our Annual Report on Form 10-K for the year ended December 31,
2002).
10.1 1993 Stock Incentive Plan, as amended (incorporated by reference
to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter
ended June 30, 1997). *
10.2 Form of Incentive Stock Option Agreement (incorporated by
reference to Exhibit 10.1 of the Form S-1). *
10.3 Form of Nonqualified Stock Option Agreement (incorporated by
reference to Exhibit 10.3 of the Form S-1). *
10.4 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1
to our Quarterly Report on Form 10-Q for the quarter ended March 31,
2001). *
10.5 Credit Agreement dated as of January 16, 2003 between the Registrant,
UBS Warburg LLC as Lead Arranger, UBS AG, Stamford Branch as
Administrative Agent and Bank of America, N.A., as Documentation
Agent (incorporated by reference to Exhibit 10.5 to our Annual Report
on Form 10-K for the year ended December 31, 2002), amended by the
Credit Agreement Amendment dated as of dated as of August 13, 2003
among the Registrant, an Oregon corporation, as borrower, UBS AG,
Stamford Branch, as administrative agent and the lenders from time to
time party thereto (incorporated by reference to Exhibit 10.1 to our
Quarterly Report on Form 10-Q for the quarter ended September 30,
2003).
10.6 Offer of Employment Term Sheet effective as of January 25, 2001 from
the Registrant to Mark J. Wattles (incorporated by reference
to Exhibit 10.7 to our Annual Report on Form 10-K for
the year ended December 31, 2000, filed on April 2, 2001). *
10.7 Change of Control Plan for Senior Management dated as of February 3,
2001 (incorporated by reference to Exhibit 10.8 to our
Annual Report on Form 10-K for the year ended December 31, 2000, filed
on April 2, 2001). *
10.8 Revenue Sharing Agreement dated March 2, 1998 between the Registrant
and Buena Vista Home Entertainment, Inc (incorporated by reference to
Exhibit 10.13 to our Annual Report on Form 10-K/A for the year ended
December 31, 2000, filed on January 29, 2002). +
10.9 Revenue Sharing Agreement dated July 31, 2001 between the Registrant
and MGM Home Entertainment (incorporated by reference to Exhibit 10.14
to our Annual Report on Form 10-K/A for the year ended December 31,
2000, filed on January 29, 2002). +
10.10 1997 Employee Nonqualified Stock Option Plan, as amended (incorporated
by reference to Exhibit 10.10 to our Annual Report on Form 10-K for
the year ended December 31, 2002). *
10.12 License Agreement, effective as of January 25, 2001, between the
Registrant and Boards, Inc (incorporated by reference to Exhibit 10.12
to our Annual Report on Form 10-K for the year ended December 31,
2002). *
10.13 Product and Support Agreement, effective as of January 25, 2001,
between the Registrant and Boards, Inc. (incorporated by reference to
Exhibit 10.13 to our Annual Report on Form 10-K for the year ended
December 31, 2002). *
10.14 Resolutions adopted by the Board of Directors of the Registrant on
October 13, 2004 regarding indemnification of specified officers
(incorporated by reference to Exhibit 10.1 to our Quarterly Report on
Form 10-Q for the quarter ended September 30, 2004). *
10.15 Summary of compensation arrangements with directors and executive
officers for 2005. *
21.1 List of Subsidiaries (incorporated by reference to Exhibit 21.1 to
our Annual Report on Form 10-K/A for the year ended December 31, 2000,
filed on January 29, 2002).
23.1 Consent of PricewaterhouseCoopers LLP.
31.1 Certification of Chief Executive Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer and Chief Financial Officer
of Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
+ Confidential treatment has been requested as to certain portions of these
agreements. Such omitted confidential information has been designated by an
asterisk and has been filed separately with the Securities and Exchange
Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as
amended, pursuant to an application for confidential treatment.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Hollywood Entertainment
Corporation:
We have completed an integrated audit of Hollywood Entertainment Corporation's
2004 consolidated financial statements and of its internal control over
financial reporting as of December 31, 2004 and audits of its 2003 and 2002
consolidated financial statements in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Our opinions, based
on our audits, are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(i) present fairly, in all material respects, the
financial position of Hollywood Entertainment Corporation and its subsidiaries
at December 31, 2004 and 2003, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States
of America. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit of financial statements includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
As discussed in Note 3 to the consolidated financial statements, the 2003 and
2002 financial statements have been restated to correct errors in accounting
for leases.
Internal control over financial reporting
Also, we have audited management's assessment, included in Management's Report
on Internal Control Over Financial Reporting appearing under Item 9A, that
Hollywood Entertainment Corporation did not maintain effective internal control
over financial reporting as of December 31, 2004, because the Company did not
maintain effective controls over the selection, application and monitoring of
its accounting policies related to leasing transactions, based on criteria
established in Internal Control - Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). The Company's
management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express opinions on
management's assessment and on the effectiveness of the Company's internal
control over financial reporting based on our audit.
We conducted our audit of internal control over financial reporting in
accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects. An audit of
internal control over financial reporting includes obtaining an understanding
of internal control over financial reporting, evaluating management's
assessment, testing and evaluating the design and operating effectiveness of
internal control, and performing such other procedures as we consider necessary
in the circumstances. We believe that our audit provides a reasonable basis for
our opinions.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control
over financial reporting includes those policies and procedures that (i)
pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of the assets of the
company; (ii) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures of
the company are being made only in accordance with authorizations of management
and directors of the company; and (iii) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition
of the company's assets that could have a material effect on the financial
statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be
prevented or detected. The following material weakness has been identified and
included in management's assessment. As of December 31, 2004, the Company did
not maintain effective controls over the selection, application and monitoring
of its accounting policies related to leasing transactions. Specifically, the
Company's controls over its selection, application and monitoring of its
accounting policies related to the effect of lessee involvement in asset
construction, lease incentives, rent holidays and leasehold amortization
periods were ineffective to ensure that such transactions were accounted for in
conformity with generally accepted accounting principles. This control
deficiency resulted in the restatement of the Company's annual and interim
consolidated financial statements for 2003 and 2002 and for the first, second
and third quarters of 2004 as well as an audit adjustment to the fourth quarter
2004 financial statements. Additionally, this control deficiency could result
in a misstatement of prepaid rent, leasehold improvements, deferred rent, rent
expense and depreciation expense that would result in a material misstatement
to annual or interim financial statements that would not be prevented or
detected. Accordingly, management determined that this control deficiency
constitutes a material weakness. This material weakness was considered in
determining the nature, timing, and extent of audit tests applied in our audit
of the 2004 consolidated financial statements, and our opinion regarding the
effectiveness of the Company's internal control over financial reporting does
not affect our opinion on those consolidated financial statements.
In our opinion, management's assessment that Hollywood Entertainment
Corporation did not maintain effective internal control over financial
reporting as of December 31, 2004, is fairly stated, in all material respects,
based on criteria established in Internal Control - Integrated Framework issued
by the COSO. Also, in our opinion, because of the effect of the material
weakness described above on the achievement of the objectives of the control
criteria, Hollywood Entertainment Corporation has not maintained effective
internal control over financial reporting as of December 31, 2004, based on
criteria established in Internal Control - Integrated Framework issued by the
COSO.
PricewaterhouseCoopers LLP
Portland, Oregon
March 17, 2005
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
-------------------------
December 31, December 31,
2004 2003
(Restated)
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 46,160 $ 48,057
Marketable securities 147,600 26,076
----------- -----------
Total Cash, cash equivalents,
and marketable securities 193,760 74,133
Receivables, net 37,922 33,987
Merchandise inventories 148,154 129,864
Prepaid expenses and other current
assets 22,835 13,233
----------- -----------
Total current assets 402,671 251,217
Rental inventory, net 289,144 268,748
Property and equipment, net 227,824 243,413
Goodwill 69,465 68,406
Deferred income tax asset, net 87,980 122,598
Prepaid rent 27,194 34,019
Other assets 15,249 17,654
----------- -----------
$1,119,527 $ 1,006,055
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term
obligations $ 555 $ 647
Current maturities of financing
obligations 15,581 3,245
Accounts payable 174,427 159,586
Accrued expenses 150,436 117,867
Accrued interest 6,445 6,489
Income taxes payable 3,404 284
----------- ----------
Total current liabilities 350,848 288,118
Long-term obligations, less current
portion 350,701 370,669
Deferred rent 44,346 50,056
----------- ----------
745,895 708,843
Commitments and contingencies (Note 21)
Shareholders' equity:
Preferred stock, 25,000,000 shares
authorized; no shares issued and
outstanding - -
Common stock, 100,000,000 shares
authorized; 60,970,105 and
59,666,347 shares issued and
outstanding, respectively 494,246 489,247
Unearned compensation - (133)
Accumulated deficit (120,614) (191,902)
----------- ----------
Total shareholders' equity 373,632 297,212
----------- ----------
$ 1,119,527 $ 1,006,055
=========== ===========
See notes to Consolidated Financial Statements
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Twelve Months Ended
December 31,
------------------------------------
2004 2003 2002
(Restated) (Restated)
---------- ---------- ----------
REVENUE:
Rental product revenue $1,388,298 $1,386,590 $1,324,017
Merchandise sales 394,066 295,958 166,049
---------- ---------- ----------
1,782,364 1,682,548 1,490,066
---------- ---------- ----------
COST OF REVENUE:
Cost of rental product 417,588 441,034 447,278
Cost of merchandise 299,074 223,598 126,251
---------- ---------- ----------
716,662 664,632 573,529
---------- ---------- ----------
GROSS PROFIT 1,065,702 1,017,916 916,537
Operating costs and expenses:
Operating and selling 793,317 727,024 647,483
General and administrative 123,946 106,024 89,602
Store opening expenses 2,141 4,768 3,093
Restructuring charge for closure
of internet business - - (12,430)
Restructuring charge for store
closures (190) (2,106) (828)
---------- ---------- ----------
919,214 835,710 726,920
---------- ---------- ----------
INCOME FROM OPERATIONS 146,488 182,206 189,617
Non-operating expense:
Interest expense, net (29,993) (35,507) (42,057)
Early debt retirement - (12,467) (3,534)
----------- ----------- ----------
Income before income taxes 116,495 134,232 144,026
Benefit (provision)
for income taxes (45,207) (54,162) 115,719
----------- ----------- ----------
NET INCOME $ 71,288 $ 80,070 $ 259,745
=========== =========== ==========
- ----------------------------------------------------------------------
Net income per share:
Basic $ 1.18 $ 1.32 $ 4.54
Diluted 1.14 1.25 4.16
- ----------------------------------------------------------------------
Weighted average shares outstanding:
Basic 60,496 60,439 57,202
Diluted 62,765 64,162 62,390
- ----------------------------------------------------------------------
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
(In thousands, except share amounts)
Common Stock Unearned Accumu-
------------------- Compen- lated
Shares Amount sation Deficit Total
---------- -------- -------- --------- ---------
Balance at December 31,
2001 as previously
reported $49,428,763 $375,503 $ (1,655)$(487,402)$(113,554)
---------- -------- -------- --------- ---------
Restatement of prior
periods (see note 3) - - - (44,315) (44,315)
---------- -------- -------- --------- ---------
Balance at December 31,
2001 as Restated 49,428,763 375,503 (1,655) (531,717) (157,869)
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock issuance 8,050,000 120,750 - - 120,750
Equity offering costs - (7,677) - - (7,677)
Stock options exercised 2,317,810 4,604 - - 4,604
Stock option tax benefit - 12,814 - - 12,814
Stock compensation - (2,591) 958 - (1,633)
Net income Restated - - - 259,745 259,745
---------- -------- -------- --------- ---------
Balance at
December 31, 2002 Restated 59,796,573 503,403 (697) (271,972) 230,734
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock options exercised 1,615,947 4,066 - - 4,066
Stock option tax benefit - 8,053 - - 8,053
Stock compensation - - 564 - 564
Repurchase of common stock (1,746,173) (26,275) - - (26,275)
Net income Restated - - - 80,070 80,070
---------- -------- -------- --------- ---------
Balance at
December 31, 2003 Restated 59,666,347 $489,247 $ (133)$(191,902)$ 297,212
---------- -------- -------- --------- ---------
Issuance of common stock:
Stock options exercised 1,598,897 2,419 - - 2,419
Stock option tax benefit - 6,245 - - 6,245
Stock compensation - - 133 - 133
Repurchase of common stock (295,139) (3,665) - - (3,665)
Net income - - - 71,288 71,288
---------- -------- -------- --------- ---------
Balance at
December 31, 2004 60,970,105 $494,246 $ - $(120,614) $ 373,632
========== ======== ======== ========= =========
See notes to Consolidated Financial Statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year Ended December 31,
-------------------------------
2004 2003 2002
(Restated) (Restated)
--------- --------- ---------
Operating activities:
Net income $ 71,288 $ 80,070 $ 259,745
Adjustments to reconcile net income to cash
provided by operating activities:
Write-off deferred financing costs - 5,827 2,226
Amortization of rental product 186,847 211,806 218,905
Depreciation 59,971 61,129 57,057
Amortization of prepaid rent 8,654 8,525 8,416
Impairment of long-lived assets 18,182 - -
Amortization of deferred financing costs 2,937 4,481 3,785
Tax benefit from exercise of stock options 6,245 8,053 12,814
Change in deferred rent (5,709) (6,612) (7,297)
Change in deferred taxes 34,618 42,826 (127,027)
Non-cash stock compensation 133 564 (1,633)
Net change in operating assets and liabilities:
Receivables (3,935) 1,010 (5,940)
Merchandise inventories (18,291) (32,557) (35,722)
Accounts payable 14,841 1,163 (9,056)
Accrued interest (44) 3,512 (3,249)
Other current assets and liabilities 24,988 1,658 (11,479)
--------- -------- --------
Cash provided by operating activities 400,725 391,455 361,545
--------- -------- --------
Investing activities:
Purchases of rental inventory, net (207,243) (220,364) (288,079)
Purchase of property and equipment, net (59,574) (89,081) (38,876)
Purchases of marketable securities (390,685) (211,283) -
Sales of marketable securities 269,161 185,207 -
Increase in intangibles and other assets (5,310) (7,292) (3,268)
Proceeds from indenture trustee - 218,531 (218,531)
--------- -------- --------
Cash used in investing activities (393,651) (124,282) (548,754)
--------- -------- --------
Financing activities:
Proceeds from issuance of common stock - - 120,750
Equity financing costs - - (7,677)
Issuance of subordinated debt - - 225,000
Repayment of subordinated debt - (250,000) -
Borrowings under term loan - 200,000 150,000
Repayment of revolving loan - (107,500) (240,000)
Decrease in credit facilities (20,000) (55,000) (42,500)
Debt financing costs - (7,453) (11,966)
Repayments of capital lease obligations (590) (10,291) (13,816)
Repurchase of common stock (3,665) (26,275) -
Proceeds from capital lease obligation 529 1,422 -
Increase(decrease)in financing obligations 12,336 (1,230) (2,851)
Proceeds from exercise of stock options 2,419 4,066 4,604
--------- --------- --------
Cash (used in) provided by
financing activities (8,971) (252,261) 181,544
--------- --------- --------
Increase (decrease) in cash and
cash equivalents (1,897) 14,912 (5,665)
Cash and cash equivalents at
beginning of year 48,057 33,145 38,810
--------- --------- --------
Cash and cash equivalents at end of year $ 46,160 $ 48,057 $ 33,145
========= ========= ========
Other cash flow information:
Interest expense paid 27,147 36,381 41,415
Income taxes paid, net 1,224 4,157 2,613
See notes to Consolidated Financial Statements
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003, 2002
1. SIGNIFICANT ACCOUNTING POLICIES
Corporate Organization and Consolidation
The accompanying financial statements include the accounts of Hollywood
Entertainment Corporation and its wholly owned subsidiaries (the "Company").
The Company's only subsidiary during 2004, 2003 and 2002 was Hollywood
Management Company.
Nature of the Business
The Company operates a chain of video stores ("Hollywood Video") throughout the
United States. The Company was incorporated in Oregon on June 2, 1988 and
opened its first store in October 1988. As of December 31, 2004, 2003 and
2002, the Company operated 2,006 stores in 47 states, 1,920 stores in 47 states
and 1,831 stores in 47 states, respectively. As of December 31, 2004, 695
Hollywood Video stores 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.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles (GAAP) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Significant
estimates relative to the Company include revenue recognition, merchandise
inventory valuation, amortization of rental inventory, impairment of long-lived
assets and goodwill, income taxes, lease accounting and legal contingencies.
Restatement of Prior Year Amounts
The Company recently reviewed its accounting practices with respect to store
operating leases and concluded that it needed to correct certain technical
errors in its accounting for leases and restate prior periods. See note 3 for a
discussion of the accounting changes and their impact to the financial
statements.
Reclassification of Prior Year Amounts
In addition to the restatement of prior year amounts noted above and discussed
in Note 3, certain prior year amounts have been reclassified to conform to the
presentation used for the current year. These reclassifications had no impact
on previously reported net income or shareholders' equity.
Revision of Classification
The Company recently reviewed its accounting practices with respect to balance
sheet classification of marketable securities. As a result, the Company
determined it was inappropriate to classify its marketable securities as cash
equivalents as stated in SFAS 95. See Note 1.
Recently Issued Accounting Standards
In December 2004, the FASB issued Statements of Financial Accounting Standards
No. 123R (SFAS 123R), "Share-Based Payment," which replaces SFAS 123,
"Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25,
"Accounting for Stock Issued to Employees." SFAS 123R requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the financial statements based on their fair values beginning
with the first interim or annual period after June 15, 2005. Pro forma
disclosure is no longer an alternative. See Note 19 for the impact on Net
Income. SFAS 123R is effective for the Company beginning July 1, 2005. The
Company is in the process of evaluating the effect of SFAS 123R on the
Company's overall results of operations, financial position and cash flows.
Rental Revenue and Merchandise
The Company recognizes revenue upon the rental and sale of its products.
Revenue for extended rental periods (when the customer chooses to keep the
product beyond the original rental period) is recognized when the extended
rental period begins. Revenue recorded for extended rental periods includes an
estimate of future cash collections for extended rental periods that have been
incurred but not yet collected in cash. Because our estimate is based upon cash
collections, the amount recorded is net of estimated amounts that the Company
does not anticipate collecting based upon historical experience.
Revenue generated from subscription sales or similar customer loyalty programs
where a customer receives free rentals, reduced rental prices or discounted
game prices in exchange for an up-front payment is recognized as revenue evenly
over the time period the customer receives the benefit. Upon the sale of a
loyalty program, a liability is recorded that is amortized to revenue over the
applicable time period.
Gift Card and Gift Certificate Liability
Gift card and gift certificate liabilities are recorded at the time of sale.
Costs of designing, printing and distributing the cards and certificates, and
transactional processing costs, are expensed as incurred. The liability is
relieved and revenue is recognized upon redemption of the gift cards or gift
certificate for rental or purchase at any Hollywood Video store.
Cost of Rental Product
Cost of rental product includes revenue sharing expense, amortization of DVD
and VHS movies, games, capitalized shipping and handling, the book value of
previously viewed movies and games, disk repair and the book value of rental
inventory loss.
Cost of Merchandise Sales
Cost of merchandise sales is determined using an average costing method at an
item level (by title) for movies, games and game accessories in the game
departments and by using product groupings of similar products for concessions.
Cost of merchandise sales includes product shipping and handling and valuation
adjustments or markdowns that are necessary to record inventory at the lower of
cost or market.
Cash and Cash Equivalents
The Company considers highly liquid investment instruments, with an original
maturity of three months or less, to be cash equivalents. The carrying amounts
of cash and equals fair value.
Marketable Securities
The Company accounts for marketable securities in accordance with SFAS 95,
"Accounting for Certain Investments in Debt and Equity Securities."
Substantially all of the marketable securities are auction rate preferred
securities and classified as "available for sale." Accordingly, its
investments in these AAA-rated securities are recorded at cost, which
approximates fair value due to their variable interest rate, which typically
resets every seven days. All income generated from these securities is
recorded as interest income. At December 31, 2004, the available for sale
securities had maturities of less than 30 years. Despite the long-term nature
of their stated contractual maturities, the Company has the ability to quickly
liquidate these securities upon the interest reset dates.
Inventories
Merchandise inventories, consisting primarily of video games, new movies for
sale, previously viewed movies for sale, concessions, and accessories held for
resale, are stated at the lower of cost or market (or, in the case of rental
inventory transferred to merchandise inventory at the carrying value thereof at
the time of transfer). Used video game inventory includes games accepted as
trade-ins from customers. Games are accepted from customers in exchange for
in-store credit. At the time of trade-in, the inventory is recorded as well as
the corresponding liability for the trade credit. The liability is relieved
when the trade credit is redeemed.
Rental inventory, which includes DVD and VHS movies and video games is stated
at cost and amortized over its estimated useful life to a specified residual
value. Shipping and handling charges related to rental and merchandise
inventory are included in the cost of such inventory. See Notes 6 and 7 for a
discussion of the amortization policy applied to rental inventory.
Property, Equipment, Depreciation and Amortization
Property is stated at cost and is depreciated on a straight-line basis for
financial reporting purposes over the estimated useful life of the assets,
which range from approximately five to ten years. Leasehold improvements are
amortized over the lesser of the assets economic life of 10 years or the
contractual term of the lease. Optional renewal periods are included in the
contractual term of the lease if renewal is reasonably assured at the time the
asset is placed in service.
Additions to property and equipment are capitalized and include acquisitions of
property and equipment, costs incurred in the development and construction of
new stores, including in some cases the fair value of lessor development in
accordance with EITF 97-10, major improvements to existing property and major
improvements in management information systems including certain costs incurred
for internally developed computer software. Maintenance and repair costs are
charged to expense as incurred, while improvements that extend the useful life
of the assets are capitalized. As property and equipment is sold or retired,
the applicable cost and accumulated depreciation and amortization are
eliminated from the accounts and any gain or loss thereon is recorded.
Long-lived Assets
The Company reviews for impairment of long-lived assets to be held and used in
the business whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. The Company periodically
reviews and monitors its internal management reports for indicators of
impairment. The Company considers a trend of unsatisfactory operating results
that are not in line with management's expectations to be its primary indicator
of potential impairment. When an indicator of impairment is noted, assets are
evaluated for impairment at the lowest level for which there are identifiable
cash flows (e.g., at the store level). The Company deems a store to be
impaired if a forecast of undiscounted future operating cash flows directly
related to the store, including estimated disposal value, if any, is less than
the asset carrying amount. If a store is determined to be impaired, the loss is
measured as the amount by which the carrying amount of the store exceeds its
fair value. Fair value is estimated using a discounted future cash flow
valuation technique similar to that used by management in making a new
investment decision. Considerable management judgment and assumptions are
necessary to identify indicators of impairment and to estimate discounted
future cash flows. Accordingly, actual results could vary significantly from
such estimates.
In the fourth quarter of 2004 the Company's video store same store sales
decreased 3%. These results were not in line with earlier management
expectations and management felt that the recent trend of negative video store
same store sales could continue. Accordingly, the Company evaluated its store
assets and determined that certain stores were impaired. As a result, the
Company recorded a $13.8 million charge for the period ended December 31, 2004,
consisting of $11.8 million in property and equipment and $2.0 million in
prepaid rent. There was not an impairment charge in 2003 and 2002. See Note 8
for additional discussion.
Goodwill & Intangible Assets
The Company reviews goodwill and intangible assets on an annual basis or
whenever events or circumstances occur indicating that goodwill may be
impaired. When the Company is evaluating for possible impairment of goodwill,
it compares the present value of future cash flows of its reporting unit, which
is defined as the Company's 2,006 video stores, to the goodwill recorded. If
this indicates that the goodwill is impaired, the Company would record a charge
to the extent that the goodwill balance would be adjusted to that of the
present value of future cash flows.
Store Closure Reserves
Reserves for store closures were established by calculating the present value
of the remaining lease obligation, adjusted for estimated subtenant agreements
or lease buyouts, were expensed along with any leasehold improvements. Store
furniture and equipment was either transferred at historical costs to another
location or disposed of and written-off.
Legal Contingencies Reserve
All legal contingencies, which are judged to be both probable and estimable,
are recorded as liabilities in the Consolidated Financial Statements in amounts
equal to the Company's best estimates of the costs of resolving or disposing of
the underlying claims. These estimates are based upon judgments and
assumptions. The Company regularly monitors its estimates in light of
subsequent developments and changes in circumstances and adjusts its estimates
when additional information causes the Company to believe that they are no
longer accurate. If no particular amount is determined to constitute the
Company's best estimate of a particular legal contingency, the amount
representing the low end of the range of the Company's estimate of the costs of
resolving or disposing of the underlying claim is recorded as a liability and
the range of such estimates is disclosed. Legal costs are expensed as
incurred.
Self-Insurance
The Company is self-insured for worker's compensation, general liability costs
and certain insurance plans with per occurrence and aggregate limits on losses.
The self-insurance liability recorded in the financial statements is based on
claims filed and an estimate of claims incurred but not yet reported.
Treasury Stock
In accordance with Oregon law, shares of common stock are automatically retired
and classified as available for issuance upon repurchase.
Income Taxes
The Company calculates income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes", which requires recognition of deferred tax
liabilities and assets for the expected future tax consequences of events that
have been included in the financial statements and tax returns. Valuation
allowances are established when necessary to reduce deferred tax assets to the
amount expected to be realized.
Deferred Rent
Many of the Company's operating leases contain predetermined fixed increases of
the minimum rental rate during the initial lease term and/or rent holiday
periods in which the Company does not pay rent. For these leases, the Company
recognizes the related rental expense on a straight-line basis beginning on the
date the property is delivered to the Company for construction and records the
difference between the amount charged to expense and the rent paid as deferred
rent, which is included in other liabilities.
Financing Obligations
In accordance with EITF 97-10, the Company is considered the owner of the
assets during the construction period for certain stores in which the Company
has considerable construction risk. As a result the assets and corresponding
financing obligation are recorded on the Company's balance sheet. Once the
construction is completed, the Company removes the asset and financing
obligation from its books in accordance FAS 98 "Accounting for Leases". If
upon completion of construction the project does not qualify for sale lease
back accounting per FAS 98, the financing obligation would be considered long-
term. See Note 3 for additional discussion.
Fair Value of Financial Instruments
In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments", the Company has disclosed the fair value, related carrying value
and method for determining the fair value for the following financial
instruments in the accompanying notes as referenced: cash and cash equivalents
(see above), accounts receivable (see Note 4), and long-term obligations (see
Note 15).
The Company's receivables do not represent significant concentrations of credit
risk at December 31, 2004, due to the wide variety of customers, markets and
geographic areas to which the Company's products are rented and sold.
Accounting for Stock Based Compensation
The Company accounts for its stock option plans under the recognition and
measurement principles of Accounting 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.
Year Ended December 31,
----------------------------
2004 2003 2002
-------- -------- --------
Net income as reported $ 71,288 $ 80,070 $259,745
Add: Stock-based compensation
expense included in reported
net income, net of tax 81 337 596
Deduct: Total stock- based
Employee compensation expense
under fair value based method
for all awards, net tax (4,782) (8,257) (7,941)
-------- -------- --------
Pro forma net income $66,587 $ 72,150 $252,400
======== ======== ========
Earnings per share:
Basic--as reported $ 1.18 $ 1.32 $ 4.54
Basic--pro forma 1.10 1.19 4.41
Diluted--as reported 1.14 1.25 4.16
Diluted--pro forma 1.08 1.16 4.16
Comprehensive Income
Comprehensive income is equal to net income for all periods presented.
Advertising
The Company receives cooperative reimbursements from vendors as eligible
expenditures are incurred relative to the promotion of rental and sales
product. Advertising costs, net of these reimbursements, are expensed as
incurred. Advertising expense was $19.3 million, $16.2 million and $4.5 million
for 2004, 2003 and 2002, respectively. The increase in 2004 was related to an
increase in advertising for Game Crazy.
2. MERGER AGREEMENT
On January 9, 2005 the Company signed a definitive merger agreement with Movie
Gallery, Inc. and its wholly owned subsidiary, TG Holdings, Inc., which
provides for the merger of TG Holdings into Hollywood, with Hollywood surviving
the merger as a wholly owned subsidiary of Movie Gallery. Under the terms of
the merger agreement, its shareholders will be entitled to receive $13.25 per
share in cash upon completion of the merger.
The Company had previously entered into an amended and restated merger
agreement, dated as of October 13, 2004, with Carso Holdings Corporation
("Carso") and Hollywood Merger Corp., both affiliates of Leonard Green &
Partners, L.P. Under the terms of this amended and restated merger agreement,
its shareholders were to receive $10.25 per share in cash upon completion of
the merger contemplated by the amended and restated merger agreement. By a
termination agreement dated January 9, 2005, between the Company, Carso and its
affiliates, and related documents, the Company terminated the amended and
restated merger agreement. The termination of the merger agreement with Carso
required its payment of Carso's transaction expenses of $4.0 million.
The Company terminated the agreement with Carso and entered into the merger
agreement with Movie Gallery following a unanimous recommendation in favor of
these actions by a special committee of its board of directors consisting of
the independent directors of its board of directors. The special committee and
our board of directors received a fairness opinion from Lazard Freres &
Company, LLC as to the consideration to be received by its shareholders
pursuant to the merger agreement with Movie Gallery.
The closing of the merger with TG Holdings is subject to terms and conditions
customary for transactions of its type, including shareholder approval,
antitrust clearance and the completion of financing. The parties to the merger
agreement anticipate completing the merger in the second quarter of 2005.
Blockbuster, Inc. has commenced unsolicited tender offers for all of its
outstanding shares of common stock and for all of its outstanding 9.625% Senior
Subordinated Notes due 2011. Blockbuster has also made filings under federal
antitrust laws seeking clearance for a possible acquisition of Hollywood. The
Company's board of directors has recommended to shareholders that they not
tender their shares of common stock to Blockbuster, based in large part on the
uncertainty of completing a transaction with Blockbuster; the board has taken
no position with respect to the tender of outstanding senior subordinated
notes. The Company's board may change its views depending on whether or not
Blockbuster is cleared by federal agencies to acquire Hollywood and if so on
what conditions. In addition to antitrust clearance, Blockbuster's tender
offers are subject to a number of other contingencies, including the tender of
at least a majority of Hollywood's shares, and they may not be completed.
3. RESTATEMENT
Like many other publicly traded retail companies, the Company reviewed its
accounting practices with respect to store operating leases. This review was
triggered in part by a February 7, 2005 letter issued from the Office of the
Chief Accountant of the Securities and Exchange Commission ("SEC") to the
American Institute of Certified Public Accountants expressing the SEC's views
regarding proper accounting for certain operating lease matters under GAAP. The
Company concluded that it needed to correct certain errors in its accounting
for leases and restate prior periods. The restatement resulted in a $44.3
million charge to beginning retained earnings on January 1, 2002.
Classification of Store Build-out Costs
The Company coordinates and directly pays for a varying amount of the
construction of new stores based upon executed lease agreements.
For some stores the Company is responsible for overseeing the construction
while in others the lessor may be fully responsible for building the store to
the Company's specification. In all cases, however, the Company is reimbursed
by the lessor for most of the construction costs. Historically the Company
accounted for the unreimbursed portion of the construction as leasehold
improvement assets that depreciated over 10 years, which approximated the term
of the lease. Upon further review of the applicable accounting guidance, the
Company has determined that the amount of assets recorded as leasehold
improvements depends upon a number of factors, including the nature of the
assets and the amount of construction risk the Company has during the
construction period.
Nature of the assets: Store build-out costs have been segregated between
structural elements that benefit the lessor beyond the term of the lease and
assets that are considered normal tenant improvements. In accordance with EITF
96-21 "Implementation Issues in Accounting for Leasing Transactions involving
Special-Purpose Entities" , payments made by the Company for structural
elements that are not reimbursed by the lessor should be considered a
prepayment of rent that should be amortized as rent expense over the term of
the lease. As a result, income from operations increased by $0.9 million and
$0.9 million for the years ended December 31, 2003 and 2002, respectively.
Construction risk: In store construction projects where the Company either pays
directly for a portion of the construction cost of a new store and is not
reimbursed by the lessor and/or is responsible for cost overruns, the Company
may be deemed the owner of all store assets during construction under the
provisions of EITF 97-10 "The Effect of Lessee Involvement in Asset
Construction." Upon completion of construction, if the Company complies with
the provisions of FAS 98, the Company is considered to have sold and leased
back the asset from the lessor. The Company has analyzed all of the projects
in which they were deemed the owner under the provisions of EITF 97-10 and have
concluded that they complied with the provision of FAS 98 for sale-leaseback
treatment upon completion of the project. As a result of the above, at December
31, 2003, we had an additional $3.2 million of property and equipment assets
and financing obligations of which the Company was deemed to be the owner of
during construction.
Classification of Tenant Improvement Allowances
The Company historically accounted for tenant improvement allowances as a
reduction to the related leasehold improvement assets. The Company has
concluded that certain allowances should be considered lease incentives as
discussed in Financial Accounting Standards Board Technical Bulletin No. 88-1,
"Issues Relating to Accounting for Leases," (FTB 88-1). For allowances
determined to be incentives, FTB 88-1 requires lease incentives to be recorded
as deferred rent liabilities on the balance sheet, a reduction in rent expense
on the statement of operations and as a component of operating activities on
the consolidated statements of cash flows. There is no impact to income from
operations for this reclassification.
Rent Holidays
The Company historically recognized rent on a straight-line basis over the
lease term commencing with the store opening date. Upon re-evaluating FASB
Technical Bulletin No. 85-3, "Accounting for Operating Leases with Scheduled
Rent Increases," the Company has determined that the lease term should commence
on the date the property is ready for normal tenant improvements. As a result,
income from operations increased $1.8 million and $2.3 million for the years
ended December 31, 2003 and 2002, respectively.
Depreciation of Leasehold Improvements
Historically the Company depreciated leasehold improvements over 10 years,
which approximates the contractual term of the lease. The Company also
depreciated leasehold improvements acquired subsequent to store opening, such
as remodels, over 10 years. The Company has concluded that such leasehold
improvements should be amortized over the lesser of the assets economic life of
10 years or the contractual term of the lease. Optional renewal periods are
included in the contractual term of the lease if renewal is reasonably assured
at the time the asset is placed in service. As a result, income from operations
decreased $9.0 million and $6.3 million for the years ended December 31, 2003
and 2002, respectively.
Lease Incentive
During 1996 to 2000, certain landlords reimbursed a portion of the Company's
grand opening events and advertising expenses. The Company has historically
recorded these marketing allowances received for grand opening costs as a
reduction of its advertising expense in the period that the marketing allowance
was received. The Company now believes that these allowances should be
considered lease incentives as discussed in Financial Accounting Standards
Board Technical Bulletin No. 88-1, "Issues Relating to Accounting for Leases,"
(FTB 88-1). FTB 88-1 requires lease incentives to be recorded as deferred rent
liabilities on the balance sheet, and amortized against rent expense over the
term of the lease. As a result, income from operations increased by $3.4
million and $3.4 million for the years ended December 31, 2003 and 2002,
respectively.
The effect of this restatement and the revision of the classification of
Marketable Securities was as follows:
CONSOLIDATED BALANCE SHEET AT DECEMBER 31, 2003
(In thousands, except share amounts)
As Previously
Reported As Restated
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 74,133 $ 48,057
Marketable securities - 26,076
----------- -----------
Total cash, cash equivalents,
and marketable securities 74,133 74,133
Receivables, net 33,987 33,987
Merchandise inventories 129,864 129,864
Prepaid expenses and other current
assets 13,233 13,233
----------- -----------
Total current assets 251,217 251,217
Rental inventory, net 268,748 268,748
Property and equipment, net 288,857 243,413
Goodwill 66,678 68,406
Deferred income tax asset, net 104,302 122,598
Prepaid rent - 34,019
Other assets 17,655 17,654
----------- -----------
$ 997,457 $ 1,006,055
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term
obligations $ 647 $ 647
Financing obligations - 3,245
Accounts payable 159,586 159,586
Accrued expenses 117,867 117,867
Accrued interest 6,467 6,489
Income taxes payable 284 284
----------- ----------
Total current liabilities 284,851 288,118
Long-term obligations, less current
portion 370,669 370,669
Other liabilities 16,108 50,056
----------- ----------
671,628 708,843
Common stock 489,247 489,247
Unearned compensation (133) (133)
Accumulated deficit (163,285) (191,902)
----------- ----------
Total shareholders' equity 325,829 297,212
----------- ----------
$ 997,457 $ 1,006,055
=========== ===========
CONSOLIDATED STATEMENTS OF OPERATIONS
Twelve Months Ended December 31, 2003
(In thousands, except per share amounts)
As Previously
Reported As Restated
----------- -----------
REVENUE:
Rental product revenue $1,386,590 $1,386,590
Merchandise sales 295,958 295,958
---------- ----------
1,682,548 1,682,548
---------- ----------
COST OF REVENUE:
Cost of rental product 441,034 441,034
Cost of merchandise 223,598 223,598
---------- ----------
664,632 664,632
---------- ----------
GROSS PROFIT 1,017,916 1,017,916
Operating costs and expenses:
Operating and selling 724,136 727,024
General and administrative 106,024 106,024
Store opening expenses 4,768 4,768
Restructuring charge for store
closures (2,106) (2,106)
---------- ----------
832,822 835,710
---------- ----------
INCOME FROM OPERATIONS 185,094 182,206
Non-operating expense:
Interest expense, net (35,507) (35,507)
Early debt retirement (12,467) (12,467)
----------- -----------
Income before income taxes 137,120 134,232
Provision for
income taxes (54,848) (54,162)
----------- -----------
NET INCOME $ 82,272 $ 80,070
=========== ===========
- ------------------------------------------------------------
Net income per share:
Basic $ 1.36 $ 1.32
Diluted 1.28 1.25
- ------------------------------------------------------------
CONSOLIDATED STATEMENTS OF OPERATIONS
Twelve Months Ended December 31, 2002
(In thousands, except per share amounts)
As Previously
Reported As Restated
----------- -----------
REVENUE:
Rental product revenue $1,324,017 $1,324,017
Merchandise sales 166,049 166,049
---------- ----------
1,490,066 1,490,066
---------- ----------
COST OF REVENUE:
Cost of rental product 447,278 447,278
Cost of merchandise 126,251 126,251
---------- ----------
573,529 573,529
---------- ----------
GROSS PROFIT 916,537 916,537
Operating costs and expenses:
Operating and selling 647,773 647,483
General and administrative 89,602 89,602
Store opening expenses 3,093 3,093
Restructuring charge for closure
of internet business (12,430) (12,430)
Restructuring charge for store
closures (828) (828)
---------- ----------
727,210 726,920
---------- ----------
INCOME FROM OPERATIONS 189,327 189,617
Non-operating expense:
Interest expense, net (42,057) (42,057)
Early debt retirement (3,534) (3,534)
----------- -----------
Income before income taxes 143,736 144,026
Benefit of
income taxes 98,109 115,719
----------- -----------
NET INCOME $ 241,845 $ 259,745
=========== ===========
- ------------------------------------------------------------
Net income per share:
Basic $ 4.23 $ 4.54
Diluted 3.88 4.16
- ------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
Twelve Months Ended December 31, 2003
(In thousands)
As Previously
Reported As Restated
----------- -----------
Operating activities:
Net income $ 82,272 $ 80,070
Adjustments to reconcile net income to cash
provided by operating activities:
Write-off deferred financing costs 5,827 5,827
Amortization of rental product 211,806 211,806
Depreciation 60,762 61,129
Amortization of prepaid rent 8,525
Amortization of deferred financing costs 4,481 4,481
Tax benefit from exercise of stock options 8,053 8,053
Change in deferred rent (1,364) (6,612)
Change in deferred taxes 43,512 42,826
Non-cash stock compensation 564 564
Net change in operating assets and liabilities:
Receivables 1,010 1,010
Merchandise inventories (32,557) (32,557)
Accounts payable 1,163 1,163
Accrued interest 3,544 3,512
Other current assets and liabilities 1,657 1,658
--------- --------
Cash provided by operating activities 390,730 391,455
--------- --------
Investing activities:
Purchases of rental inventory, net (220,364) (220,364)
Purchase of property and equipment, net (94,123) (89,081)
Purchase of marketable securities - (211,283)
Sales of marketable securities - 185,207
Increase in intangibles and other assets (2,755) (7,292)
Proceeds from indenture trustee 218,531 218,531
--------- --------
Cash used in investing activities (98,711) (124,282)
--------- --------
Financing activities:
Extinguishment of subordinated debt (250,000) (250,000)
Borrowings under term loan 200,000 200,000
Repayment of revolving loan (107,500) (107,500)
Decrease in credit facilities (55,000) (55,000)
Debt financing costs (7,453) (7,453)
Repayments of capital lease obligations (10,291) (10,291)
Repurchase of common stock (26,275) (26,275)
Proceeds from capital lease obligation 1,422 1,422
Increase (decrease) in financing obligations - (1,230)
Proceeds from exercise of stock options 4,066 4,066
--------- ---------
Cash used in financing activities (251,031) (252,261)
--------- ---------
Increase (decrease) in cash and
cash equivalents 40,988 14,912
Cash and cash equivalents at
beginning of year 33,145 33,145
--------- ---------
Cash and cash equivalents at end of year (1) $ 74,133 $ 48,057
========= =========
(1)Restated cash and cash equivalents excludes Marketable Securities of $26.1
million at the end of the year
CONSOLIDATED STATEMENTS OF CASH FLOWS
Twelve Months Ended December 31, 2002
(In thousands)
As Previously
Reported As Restated
----------- -----------
Operating activities:
Net income $ 241,845 $ 259,745
Adjustments to reconcile net income to cash
provided by operating activities:
Extraordinary loss on extinguishment of debt 2,226 2,226
Amortization of rental product 218,905 218,905
Depreciation 59,343 57,057
Amortization of prepaid rent 8,416
Amortization of deferred financing costs 3,785 3,785
Tax benefit from exercise of stock options 12,814 12,814
Change in deferred rent (1,368) (7,297)
Change in deferred taxes (109,417) (127,027)
Non-cash stock compensation (1,633) (1,633)
Net change in operating assets and liabilities:
Receivables (5,940) (5,940)
Merchandise inventories (35,722) (35,722)
Accounts payable (9,056) (9,056)
Accrued interest (2,649) (3,249)
Other current assets and liabilities (11,478) (11,479)
--------- --------
Cash provided by operating activities 361,655 361,545
--------- --------
Investing activities:
Purchases of rental inventory, net (288,079) (288,079)
Purchase of property and equipment, net (44,254) (38,876)
Increase in intangibles and other assets (851) (3,268)
Proceeds from indenture trustee (218,531) (218,531)
--------- --------
Cash used in investing activities (551,715) (548,754)
--------- --------
Financing activities:
Proceeds from issuance of common stock 120,750 120,750
Equity financing costs (7,677) (7,677)
Issuance of subordinated debt 225,000 225,000
Repayment of subordinated debt - -
Borrowings under term loan 150,000 150,000
Repayment of revolving loan (240,000) (240,000)
Decrease in credit facilities (42,500) (42,500)
Debt financing costs (11,966) (11,966)
Repayments of capital lease obligations (13,816) (13,816)
Repurchase of common stock - -
Proceeds from capital lease obligation - -
Increase (decrease) in financing obligations - (2,851)
Proceeds from exercise of stock options 4,604 4,604
--------- ---------
Cash provided by financing activities 184,395 181,544
--------- ---------
Increase (decrease) in cash and
cash equivalents (5,665) (5,665)
Cash and cash equivalents at
beginning of year 38,810 38,810
--------- ---------
Cash and cash equivalents at end of year $ 33,145 $ 33,145
========= =========
4. RECEIVABLES
Accounts receivable as of December 31, 2004 and 2003 consists of
(in thousands):
----------------------
2004 2003
---------- ---------
Construction receivables $ 5,455 $ 4,826
Additional rental fees, net 21,690 19,970
Marketing 5,894 8,468
Licensee receivables 1,361 1,509
Other 4,837 1,029
---------- ---------
39,237 35,802
Allowance for doubtful accounts (1,315) (1,815)
---------- ---------
$ 37,922 $ 33,987
========== =========
The carrying amount of accounts receivable approximates fair value because of
the short maturity of those receivables. The allowance for doubtful accounts is
primarily for marketing.
5. RENTAL INVENTORY
Rental inventory as of December 31, 2004 and 2003 consists of (in thousands):
-------------------------
2004 2003
---------- ----------
Rental inventory $ 813,910 $ 773,953
Less accumulated amortization (524,766) (505,205)
---------- ----------
$ 289,144 $ 268,748
========== ==========
Amortization expense related to rental inventory was $186.8 million, $211.8
million and $218.9 million in 2004, 2003 and 2002, respectively, and is
included in cost of rental product. As rental inventory is transferred to
merchandise inventory and sold as previously-viewed product, the applicable
cost and accumulated amortization are eliminated from the rental inventory
accounts, determined on a first-in-first-out ("FIFO") basis applied in the
aggregate to monthly purchases.
6. RENTAL INVENTORY AMORTIZATION POLICY
The Company manages its rental inventories of movies as two distinct
categories, new releases and catalog. New releases, which represent the
majority of all movies acquired, are those movies which are primarily purchased
on a weekly basis in large quantities to support demand upon their initial
release by the studios and are generally held for relatively short periods of
time. Catalog, or library, represents an investment in those movies the Company
intends to hold for an indefinite period of time and represents a historic
collection of movies which are maintained on a long-term basis for rental to
customers. In addition, the Company acquires catalog inventories to support new
store openings and to build-up its title selection, primarily as it relates to
changes in format preferences such as an increase in DVD from VHS.
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 as revenue is
earned on the respective revenue sharing titles, net of average estimated
carrying values that are set up in the first four months following the movies
release. The carrying value set up on VHS movies approximates the carrying
value of VHS non-revenue sharing purchases after four months. The carrying
value set up on DVD movies approximates the carrying value of DVD non-revenue
sharing purchases after four months less anticipated revenue sharing payments
on the sales of previously viewed DVD movies.
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. For games
acquired under revenue sharing arrangements, the manufacturers share of rental
revenue is charged to cost of rental as revenue is earned on the respective
revenue sharing games, net of an average estimated carrying value of
approximately $11.00 that is set up in the first four months following the
games release. Revenue sharing games that the Company expects to keep in rental
inventory for an indefinite period of time are then amortized on a straight-
line basis over the remaining 20 months to an estimated residual value of
$5.00.
7. CHANGE IN ACCOUNTING ESTIMATE FOR RENTAL INVENTORY
The Company regularly evaluates and updates rental inventory accounting
estimates. Effective October 1, 2004, the Company changed estimates relating to
the carrying value that is set up on DVD movies that are purchased under
revenue sharing arrangements. The Company reduced the set-up carrying value of
DVD movies to approximate the carrying value of non-revenue sharing purchases
less anticipated revenue sharing payments per unit on the sales of previously
viewed DVD movies. Prior to October 1, 2004, the estimated carrying value was
not reduced by an estimate of revenue sharing payments per unit on the sales of
previously viewed DVD movies. The Company believes the change results in better
matching of revenue and expense and the net impact to the fourth quarter of
2004 was immaterial.
Effective October 1, 2002, estimated average residual values on new release
movies was reduced from $3.16 to $2.00 for VHS and from $4.67 to $4.00 for DVD.
In addition, the estimated residual value of catalog DVD inventory was reduced
from $6.00 to $4.00. As a result of these changes in estimate, cost of rental
product revenue in 2002 was $4.1 million higher and net income per share (basic
and diluted) was $0.04 lower.
8. PROPERTY AND EQUIPMENT
Property and equipment as of December 31, 2004 and 2003 consists of (in
thousands):
---------------------
2004 2003
(Restated)
--------- ----------
Fixtures and equipment $ 252,165 $ 232,379
Leasehold improvements 420,712 378,098
Equipment under capital lease 2,047 4,644
Leasehold improvements under
capital lease - 6,725
--------- ----------
674,924 621,846
Less accumulated depreciation
and amortization (447,100) (378,433)
--------- ----------
$ 227,824 $ 243,413
========= ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $0.4 million and
$6.4 million at December 31, 2004 and 2003, respectively. Depreciation expense
related to property, plant and equipment was $60.0 million, $61.1 million and
$57.1 million in 2004, 2003 and 2002, respectively.
The Company reviews for impairment of long-lived assets to be held and used in
the business whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. The Company deems a store
to be impaired if a forecast of undiscounted future operating cash flows
directly related to the store, including estimated disposal value, if any, is
less than the asset carrying amount.
In the fourth quarter of 2004 the Company's video store same store sales
decreased 3%. These results were not in line with earlier management
expectations and management felt that the recent trend of negative video store
same store sales could continue. Accordingly, the Company evaluated the store
assets and determined that certain stores were impaired. As a result, the
Company recorded a $13.8 million non-cash charge in operating and selling
expense consisting of $11.8 million in property and equipment and $2.0 million
in prepaid rent. There were no impairment charges in 2003 and 2002.
In the fourth quarter of 2004 the Company concluded that certain software
development capitalized costs qualified for impairment per AICPA SOP 98-1
"Software for Internal Use" and FAS 144 "Accounting for Impairment or Disposal
of Long-Lived Assets". As a result, the Company recorded a $4.4 million
impairment charge included in general and administrative expenses.
9. STORE CLOSURE RESTRUCTURING
In December 2000, the Company approved a restructuring plan involving the
closure and disposition of 43 stores that were not operating to its
expectations (the "Restructuring Plan"). In the fourth quarter of 2000, the
company recorded charges aggregating $16.9 million, including an $8.0 million
write down of property and equipment, a $1.5 million write down of goodwill and
an accrual for store closing costs of $7.4 million. The established reserve
for cash expenditures is for lease termination fees and other store closure
costs. The Company has liquidated and plan to continue liquidating related
store inventories through store closing sales; any remaining product will be
used in other stores.
Revenue for the stores subject to the store Restructuring Plan was $6.0 million
and $6.3 million in 2003 and 2002, respectively. Operating results (defined as
income or loss before interest expense and income taxes) was $0.3 million loss
and $0.9 million loss in 2003 and 2002, respectively. The operating results
for the stores in the closure plan were included in the Consolidated Statement
of Operations.
During the twelve months ended December 31, 2001, the Company closed 12 of the
stores included in the plan and incurred $329,867 in expenses related to the
closures and received $450,000 to exit one of the leases. During the twelve
months ended December 31, 2002, the company closed one store included in the
plan and incurred $90,000 in closure expenses.
In December of 2001, 2002 and 2003, the Company amended the Restructuring Plan
and removed 16 stores, 2 stores and 9 stores from the closure list,
respectively. In accordance with the amended plans, and updated estimates on
closing costs, the company reversed $3.8 million, $0.8 million and $2.1 of the
original $16.9 million charge, leaving a $3.7 million, $2.8 million and $0.7
million accrual balance at December 31, 2001, 2002 and 2003, respectively, for
store closing costs. At December 31, 2004, 0 stores remained to be closed under
the Restructuring Plan.
During the twelve months ended December 31, 2004, the Company closed two stores
included in the plan and incurred $0.5 million in expenses related to the
closures. At December 31, 2004 there were no remaining stores to be closed
pursuant to the Company's store closure plan. As a result, the remaining
balance of $0.2 million was reversed in 2004.
10. GOODWILL AND INTANGIBLE ASSETS
Goodwill was $69.5 million and $68.4 million as of December 31, 2004 and 2003,
respectively, and represents the excess of cost over the fair value of net
assets purchased net of impairment charges and accumulated amortization
recorded prior to the adoption of FAS 142.
The increase in goodwill was the result of four stores acquired in four
separate transactions during the year ended December 31, 2004. The aggregate
purchase price was $1.3 million, of which, $1.1 million was allocated to
goodwill. The remaining purchase price represented the fair market value of the
assets acquired that were allocated to store inventory and leasehold
improvements.
In July 2001, the FASB issued SFAS Nos. 141 and 142, "Business Combinations"
and "Goodwill and Other Intangible Assets," respectively. SFAS 141 supersedes
Accounting Principles Board (APB) Opinion No. 16 and eliminates pooling-of-
interests accounting. It also provides guidance on purchase accounting related
to the recognition of intangible assets and accounting for negative goodwill.
SFAS 142 changes the accounting for goodwill from an amortization method to an
impairment only approach. Under SFAS 142, goodwill and non-amortizing
intangible assets shall be adjusted whenever events or circumstances occur
indicating that goodwill has been impaired. The Company has completed its
impairment testing of the valuation of its goodwill and has determined that
there is no impairment. SFAS 141 and 142 were effective for all business
combinations completed after June 30, 2001. Upon adoption of SFAS 142,
amortization of goodwill recorded for business combinations consummated prior
to July 1, 2001 ceased, and intangible assets acquired prior to July 1, 2001
that did not meet criteria for recognition under SFAS 141 were reclassified to
goodwill. The Company adopted SFAS 142 on January 1, 2002, the beginning of
fiscal 2002.
The components of intangible assets are as follows (in thousands):
December 31, December 31,
2003 Additions 2004
------------ --------- ------------
Goodwill $ 68,406 $ 1,059 $ 69,465
Trade-name rights 6,224 514 6,738
------------ --------- ------------
$ 74,630 $ 1,573 $ 76,203
============ ========= ============
11. REEL.COM DISCONTINUED E-COMMERCE OPERATIONS
On June 12, 2000, the Company announced that it would close down the e-commerce
business of Reel.com. Although the Company had developed a leading web-site
over the seven quarters after Reel.com was purchased in October of 1998,
Reel.com's business model of rapid customer acquisition led to large operating
losses and required significant cash funding. Due to market conditions, the
Company was unable to obtain outside financing for Reel.com, and could not
justify continued funding from its video store cash flow. As a result of the
discontinuation of Reel.com's e-commerce operations, the Company recorded a
total charge of $69.3 million in the second quarter of 2000, of which $27.3
million was accrued liabilities for contractual obligations, lease commitments,
anticipated legal claims, legal fees, financial consulting, and other
professional services incurred as a direct result of the closure of Reel.com.
The accrual was reduced by $1.6 million, $3.3 million and $12.4 million in
2000, 2001 and 2002, respectively, because the Company was able to negotiate
termination of certain obligations and lease commitments more favorably than
originally anticipated. The Company has paid for all accrued liabilities, net
of reductions, and does not anticipate further adjustments.
12. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable includes accrued revenue sharing (amounts accrued pursuant to
revenue sharing arrangements in which the Company had not yet received an
invoice).
Accrued liabilities as of December 31, 2004 and 2003 consist of
(in thousands):
----------------------
2004 2003
---------- ---------
Payroll and benefits $ 30,946 $ 27,236
Property taxes and rent
and related 16,387 12,218
Gift cards and deferred revenue 30,725 22,908
Marketing 6,758 5,709
Store closures and lease
terminations - 1,127
Property, plant and equipment 7,013 5,050
Accrued insurance 12,519 5,425
Accrued sales tax 12,543 13,320
Legal commitments and contingencies 13,296 6,803
Other operating and general
administration 20,249 18,071
---------- ---------
$ 150,436 $ 117,867
========== =========
13. EMPLOYEE BENEFIT PLANS
The Company is self-insured for employee medical benefits under the Company's
group health plan. The Company maintains stop loss coverage for individual
claims in excess of $150,000. While the ultimate amount of claims incurred is
dependent on future developments, in management's opinion, recorded reserves
are adequate to cover the future payment of claims. Adjustments, if any, to
recorded estimates of the Company's potential claims liability will be
reflected in results of operations for the period in which such adjustments are
determined to be appropriate on the basis of actual payment experience or other
changes in circumstances.
The Company has a 401(k) plan in which eligible employees may elect to
contribute up to 20% of their earnings. Eligible employees are at least 21
years of age, have completed at least one year of service and work at least
1,000 hours in a year. The Company matched 25% of the employee's first 6% of
contributions until June 30, 2003, when the Company elected to end the match.
Beginning January 1, 2005, the Company will reinstate the match program. The
2005 Company match program will match 25% of the eligible employee's first 6%
of contributions.
Beginning in April 2000 and ending January 1, 2005, the Company offered a
deferred compensation plan to certain key employees designated by the Company.
The plan allowed for the deferral and investment of current compensation on a
pre-tax basis. The Company accrued $332,689 and $247,923 related to this plan
at December 31, 2004 and 2003, respectively.
Beginning in January 2002 and ending January 1, 2005, the Company offered a
401(k) supplemental plan that allowed its highly compensated employees the
ability to receive the full 25% employer match on the first 6% of contributions
(through June 30, 2003 when the Company elected to end the match) that were not
available to them under the Company's 401(k) plan. The plan allows for the
deferral and investment of current compensation on a pre-tax basis. The
Company accrued approximately $784,723 and $738,326 related to this plan at
December 31, 2004 and 2003, respectively.
14. 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 2,006 stores operated by the Company. Mark Wattles, the
Company's founder and former 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 $1.4 million due the Company is related to current
activity. As of December 31, 2004, Boards operated 20 stores.
The following table reconciles the net receivable balance due from Boards, Inc.
(in thousands):
---------------------
Twelve Months Ended
December 31,
---------------------
2004 2003
- --------- --------
Beginning Receivable Balance $ 1,509 $ 631
-------- --------
License fee 25 275
(2%)Royalty Fees 579 376
Products & Services 11,780 10,380
-------- --------
Expenses 12,384 11,031
Payments (12,532) (10,153)
-------- --------
Ending Receivable Balance $ 1,361 $ 1,509
======== ========
15. LONG-TERM OBLIGATIONS AND LIQUIDITY
The Company had the following long-term obligations as of December 31, 2004 and
2003 (in thousands):
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 1,256 1,316
----------- ----------
351,256 371,316
Current portions:
Capital leases 555 647
----------- ----------
555 647
Total long-term obligations ----------- ----------
net of current portion $ 350,701 $ 370,669
=========== ==========
(1) Coupon payments at 9.625% are due semi-annually in March and September.
On December 18, 2002, the Company completed the sale of $225 million 9.625%
senior subordinated notes due 2011. The Company delivered the net proceeds to
an indenture trustee to redeem $203.9 million of the $250 million 10.625%
senior subordinated notes due 2004 including accrued interest and the required
call premium. At December 31, 2002, the trustee was holding $218.5 million and
the Company continued to carry the $250 million 10.625% senior subordinated
notes on its balance sheet. On January 17, 2003, the redemption of $203.9
million of the notes was completed.
The senior subordinated notes due 2011 are redeemable, at the option of the
Company, beginning in March 15, 2007, at rates starting at 104.8% of principal
amount reduced annually through March 15, 2009, at which time they become
redeemable at 100% of the principal amount. The terms of the notes may
restrict, among other things, payment of dividends and other distributions,
investments, the repurchase of capital stock or subordinated indebtedness, the
making of certain other restricted payments, the incurrence of additional
indebtedness or liens by the Company or any of the company's subsidiaries, and
certain mergers, consolidations and disposition of assets. Additionally, if a
change of control occurs, as defined, each holder of the notes will have the
right to require the Company to repurchase such holder's notes at 101% of
principal amount thereof. Blockbuster, Inc. has commenced unsolicited tender
offers for all of the company's outstanding shares of common stock and for all
of the company's outstanding 9.625% Senior Subordinated Notes due 2011.
Blockbuster has also made filings under federal antitrust laws seeking
clearance for a possible acquisition of Hollywood. The Company's board of
directors has recommended to shareholders that they not tender their shares of
common stock to Blockbuster, based in large part on the uncertainty of
completing a transaction with Blockbuster. The board has taken no position with
respect to the tender of outstanding senior subordinated notes. The Company's
board may change the company's views depending on whether or not Blockbuster is
cleared by federal agencies to acquire Hollywood and if so on what conditions.
In addition to antitrust clearance, Blockbuster's tender offers are subject to
a number of other contingencies, including the tender of at least a majority of
Hollywood's shares, and they may not be completed.
On January 16, 2003, the Company completed the closing of new senior secured
credit facilities from a syndicate of lenders led by UBS Warburg LLC. The new
facilities consist of a $200.0 million term loan facility and a $50.0 million
revolving credit facility, each maturing in 2008. The Company used the net
proceeds from the transaction to repay amounts outstanding under the Company's
existing credit facilities which were due in 2004, redeem the remaining $46.1
million outstanding principal amount of the Company's 10.625% senior
subordinated notes due 2004 and for general corporate purposes. The Company
completed the redemption of the 10.625% senior subordinated notes on February
18, 2003. The Company has prepaid $75 million of the term loan facility
principal payments due through 2006, including a $20 million payment made on
January 5, 2004.
Revolving credit loans under the new facility bear interest, at the Company's
option, at an applicable margin over the bank's base rate loan or the LIBOR
rate. The initial margin over LIBOR was 3.5% for the term loan facility and
will step down if certain performance targets are met. The credit facility
contains financial covenants (determined in each case on the basis of the
definitions and other provisions set forth in such credit agreement), some of
which may become more restrictive over time, that include a (1) maximum debt to
adjusted EBITDA test, (2) minimum interest coverage test, and (3) minimum fixed
charge coverage test. Amounts outstanding under the credit agreement are
collateralized by substantially all of the assets of the Company. Hollywood
Management Company, and any future subsidiaries of Hollywood Entertainment
Corporation, are guarantors under the credit agreement.
As of December 31, 2004 and 2003, the Company was in violation of certain
covenants restricting our investments in cash equivalents and marketable
securities under our credit facility and our indenture for senior subordinated
notes because it invested in rated marketable securities with maturities beyond
those allowed. The lenders under its credit facility have waived the default
through March 31, 2005; if the Company corrects the violation by that time, it
will not need a waiver from holders of its senior subordinated notes. The
Company expects to correct the violation and be in compliance with its credit
facility and indenture covenants by transferring its investments to instruments
authorized in the debt covenants by March 31, 2005.
Maturities on long-term obligations at December 31, 2004 for the next five
years is as follows (in thousands):
Capital
Year Ending Subordinated Credit Leases
December, 31 Notes Facility & Other Total
- ------------ ---------- ---------- --------- ---------
2005 - - 555 555
2006 - - 612 612
2007 - 20,000 89 20,089
2008 - 105,000 - 105,000
2009 - - - -
Thereafter 225,000 - - 225,000
----------- ---------- --------- ---------
$ 225,000 $ 125,000 $ 1,256 $ 351,256
----------- ---------- --------- ---------
Interest income was $1.4 million, $0.8 million, and $0.5 million for the years
ended December 31, 2004, 2003, and 2002, respectively. Total interest cost
incurred was $31.6 million, $36.5 million, and $42.6 million for the years
ended December 31, 2004, 2003, and 2002, respectively, while interest
capitalized was $0.2 million, $0.2 million, and $0.1 million, for the years
ended December 31, 2004, 2003, and 2002, respectively.
The fair value of the 9.625% senior subordinated notes due 2011 was $240.8
million and $243.6 million as of December 31, 2004 and 2003, respectively,
based on quoted market prices. The revolving credit facility is a variable rate
loan, and thus, the fair value approximates the carrying amount as of December
31, 2004 and 2003.
As of December 31, 2004 the Company had $15.7 million of outstanding letters of
credit issued upon the revolving credit facility.
16. 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.
Restated rent expense was $251.9 million, $232.9 million and $221.4 million for
the years ended December 31, 2004, 2003, and 2002, respectively. Most
operating leases require payment of additional occupancy costs, including
property taxes, utilities, common area maintenance and insurance. These
additional occupancy costs were $49.9 million, $46.2 million and $42.1 million
for the years ended December 31, 2004, 2003, and 2002, respectively.
At December 31, 2004, the future minimum annual rental commitments under non-
cancelable operating leases were as follows (in thousands):
------------------------------
Year Ending Operating
December 31, Leases
------------------------------
2005 $258,703
2006 240,881
2007 207,383
2008 168,011
2009 135,709
Thereafter 324,641
Total sublease income was $4.9 million, $5.4 million, and $6.2 million for the
years ended December 31, 2004, 2003, and 2002, respectively.
At December 31, 2004, the future minimum annual sublease income under operating
subleases were as follows (in thousands):
------------------------------
Year Ending Sublease
December 31, Income
------------------------------
2005 $ 2,402
2006 2,237
2007 1,737
2008 1,124
2009 722
Thereafter 1,036
17. INCOME TAXES
The provision for (benefit from) income taxes from continuing operations for
the years ended December 31, 2004, 2003 and 2002 consists of (in thousands):
--------------------------------
2004 2003 2002
(Restated) (Restated)
---------- ---------- ----------
Current:
Federal $ 2,855 $ 2,265 $ (3,507)
State 1,512 1,018 2,107
---------- ---------- ----------
Total current provision
(benefit) 4,367 3,283 (1,400)
Deferred:
Federal 36,537 40,952 (95,938)
State 4,303 9,927 (18,381)
---------- ---------- ----------
Total deferred provision
(benefit) 40,840 50,879 (114,272)
---------- ---------- ----------
Total provision (benefit) $ 45,207 $ 54,162 $ (115,719)
========== ========== ==========
The Company is subject to minimum state taxes in excess of statutory state
income taxes in many of the states in which it operates. These taxes are
included in the current provision for state and local income taxes. The
difference between the tax provision at the statutory federal income tax rate
and the tax provision attributable to income from continuing operations before
income taxes for the three years ended December 31 is analyzed below:
-----------------------------
2004 2003 2002
(Restated) (Restated)
-------- ---------- ---------
Statutory federal rate
provision 35.0% 35.0% 34.0%
State income taxes, net of
federal income tax benefit 3.3 5.3 4.0
Net non-deductible expense 0.5 0.4 0.4
Federal credits & adjustment (1.1) 1.4 (0.7)
Decrease in valuation allowance - - (118.0)
Change in Deferred Tax Rate - (2.9) -
Other, net 1.1 1.1 -
-------- --------- --------
38.8% 40.3% (80.3%)
======== ========= ========
Deferred income taxes reflect the impact of "temporary differences" between
amounts of assets and liabilities for financial reporting purposes and such
amounts as measured by tax laws. The tax effects of temporary differences that
give rise to significant portions of deferred tax assets and liabilities from
continuing operations at December 31 are as follows (in thousands):
----------------------
2004 2003
(Restated)
---------- ---------
Deferred tax assets:
Tax loss carryforward $107,507 $117,953
Deferred rent 39,355 38,518
Accrued liabilities and reserves 12,559 11,300
Tax credit carryforward 10,089 6,820
Restructure charges 5,335 2,604
Inventory valuation 18,444 23,957
Amortization (2,720) 1,474
---------- ---------
Total deferred tax assets 190,569 202,626
Deferred tax liabilities:
Depreciation and amortization (99,592) (76,541)
Capitalized and financing leases (2,997) (3,487)
---------- ---------
Total deferred tax liabilities (102,589) (80,028)
---------- ---------
Net deferred tax asset $ 87,980 $122,598
========== =========
As of December 31, 2004, the Company had approximately $274.4 million of
federal net operating loss carryforwards available to reduce future taxable
income. The carryforward periods expire in years 2019 through 2023. The
Company has federal Alternative Minimum Tax (AMT) credit carryforwards of $4.9
million which are available to reduce future regular taxes in excess of AMT.
These credits have no expiration date. The Company has federal and state tax
credit carryforwards of $5.2 million which are available to reduce future
taxes. The carryforward periods expire in years 2012 through 2024, or have no
expiration date.
In the fourth quarter of 2000, in light of significant doubt that existed
regarding the Company's future income and therefore the Company's ability to
use its net operating loss carryforwards, the Company recorded a $229.8 million
valuation allowance against our $229.8 million net deferred tax asset. In 2002
and 2001, as a result of our operating performance for each year, as well as
anticipated future operating performance, the Company determined that it was
more likely than not that future tax benefits would be realized. Consequently,
the Company benefited by the reversal of $165.5 million and $64.3 million of
the valuation allowance in 2002 and 2001, respectively.
Federal tax laws impose restrictions on the utilization of net operating loss
carryforwards and tax credit carryforwards in the event of an "ownership
change," as defined by the Internal Revenue Code. Such ownership changes
occurred in October 2000 and December 2001 as a result of significant changes
in stock ownership. The Company's ability to utilize its net operating loss
carryforwards and tax credit carryforwards is subject to restrictions pursuant
to these provisions. Utilization of the federal net operating loss and tax
credits will be limited annually and any unused limitation in a given year may
be carried forward to the next year. The annual limitation on utilization of
the net operating loss carryforwards ranges between $52.4 million and $209.5
million and varies due to the fact that there were two ownership changes. The
Company believes it is more likely than not that it will fully realize all net
operating loss carryforwards and tax credit carryforwards and therefore a
valuation reserve is not necessary at December 31, 2004 and December 31, 2003.
The Company realized a tax benefit in the amount of $6.2 million and $8.1
million in 2004 and 2003, respectively, as a result of the exercise of employee
stock options. For financial reporting purposes, the impact of this tax
benefit is credited directly to shareholders' equity.
18. SHAREHOLDERS' EQUITY
Preferred Stock
At December 31, 2004, the Company was authorized to issue 25,000,000 shares of
preferred stock in one or more series. With the exception of 3,119,737 shares
which have been designated as "Series A Redeemable Preferred Stock" but have
not been issued, the Board of Directors has authority to designate the
preferences, special rights, limitations or restrictions of such shares.
Common Stock
During the first quarter of 2004, the Company repurchased a total of 295,139
shares of its common stock for an aggregate purchase price of $3.7 million.
During the third and fourth quarters of 2003, the Company repurchased a total
of 1,746,173 shares of its common stock for an aggregate purchase price of
$26.3 million.
On March 11, 2002, the Company completed a public offering of 8,050,000 shares
of its common stock.
19. STOCK OPTION PLANS
In general, the Company's stock option plans provide for the granting of
options to purchase Company shares at a fixed price. It has been the Company's
Board of Directors general policy to set the price at the market price of such
shares as of the option grant date. The options generally have a nine year
term and become exercisable on a pro rata basis over the first three years or
at such other periods as determined by the Board. The Company adopted stock
option plans in 1993, 1997 and 2001 providing for the granting of non-qualified
stock options, stock appreciation rights, bonus rights and other incentive
grants to employees up to an aggregate of 21,000,000 shares of common stock.
The Company granted non-qualified stock options pursuant to the 1993, 1997 and
2001 Plans totaling 86,000, 1,485,667, and 3,311,368 in 2004, 2003 and 2002,
respectively. The Company cancelled 0.8 million, 1.3 million, and 2.2 million
of stock options in 2004, 2003 and 2002, respectively.
The Company has elected to follow APB Opinion 25; "Accounting for Stock Issued
to Employees" ("APB 25"), and related interpretations in accounting for its
employee stock options. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying
stock on the date of the grant, no compensation expense is recognized upon the
date of grant. Pro forma information regarding net income per share is
required by SFAS No. 123, "Accounting for Stock-Based Compensation", and has
been determined as if the Company had accounted for its employee stock options
under the fair value method of that statement. The fair value of these options
was estimated at the date of grant using Black-Scholes option pricing model
with the following weighted-average assumptions for 2004, 2003 and 2002:
-----------------------------
2004 2003 2002
-----------------------------
Risk free interest rate 2.44% 2.33% 2.17%
Expected dividend yield 0% 0% 0%
Expected lives 5 years 5 years 4 years
Expected volatility 93.7% 96.9% 108%
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options, which have no vesting restrictions and are
fully transferable. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in the Company's opinion, the existing available models do
not necessarily provide a reliable single measure of the fair value of the
Company's employee stock options.
Using the Black-Scholes option valuation model, the weighted average grant date
value of options granted during 2004, 2003 and 2002 was $8.17, $10.70, and
$10.03 per share subject to the option, respectively.
For the purpose of pro forma disclosures, the estimated fair value of the
options is amortized over the option's vesting period. The Company's pro forma
information is as follows (in thousands, except per share amounts):
Year Ended December 31,
----------------------------
2004 2003 2002
(Restated)(Restated)
-------- -------- --------
Net income as reported $ 71,288 $ 80,070 $259,745
Add: Stock-based compensation
expense included in reported
net income, net of tax 81 337 596
Deduct: Total stock- based
employee compensation expense
under fair value based method
for all awards, net of tax (4,782) (8,257) (7,941)
-------- -------- --------
Pro forma net income $ 66,587 $ 72,150 $252,400
======== ======== ========
Earnings per Share:
Basic--as reported $ 1.18 $ 1.32 $ 4.54
Basic--pro forma 1.10 1.19 4.41
Diluted--as reported 1.14 1.25 4.16
Diluted--pro forma 1.08 1.16 4.16
A summary of the Company's stock option activity and related information for
2004, 2003 and 2002 is as follows (in thousands, except per share amounts):
Weighted
Average
Exercise
Shares Price
-------- --------
Outstanding as December 31, 2001 12,354 3.52
Granted 3,311 13.47
Exercised (2,318) 2.39
Cancelled (2,199) 7.32
-------- --------
Outstanding as December 31, 2002 11,148 $ 5.96
Granted 1,486 14.73
Exercised (1,616) 2.96
Cancelled (1,287) 8.35
-------- --------
Outstanding as December 31, 2003 9,731 7.48
Granted 86 11.31
Exercised (1,599) 1.86
Cancelled (786) 13.67
-------- --------
Outstanding as December 31, 2004 7,432 8.08
A summary of options outstanding and exercisable at December 31, 2004 is as
follows (in thousands, except per share amounts):
------------------------------ -------------------
Options Outstanding Options Exercisable
------------------------------ -------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Range of Life Exercise Exercise
Exercise Prices Options (in years) Price Options Price
- ---------------- ------- --------- -------- ------- --------
$ 1.000 - $1.090 3,367 5.24 $ 1.09 3,367 $ 1.09
1.094 - 12.000 1,514 5.98 10.68 257 4.94
12.020 - 16.310 1,400 6.49 13.76 435 14.08
16.340 - 20.320 1,151 4.39 18.23 803 18.43
------ --------- -------- ------- --------
7,432 5.50 $ 8.08 4,862 $ 5.35
====== ========= ======== ======= ========
In the first quarter of 2000, the Company granted stock options to
approximately fifty key employees. The grants were for the same number of
shares issued to these employees prior to January 1, 2000. In the third quarter
of 2000, the Company cancelled the stock options that were issued prior to
January 1, 2000 for the fifty employees. The grant and cancellation of the same
number of options for these employees resulted in variable accounting treatment
for the related options for 850,000 shares of the Company's common stock.
Variable accounting treatment resulted in unpredictable stock-based
compensation impacted by fluctuations in quoted prices for the Company's common
stock. In 2002, the variable options were canceled and the Company reversed
expense that was recognized in 2001 on the canceled options. As a result, the
Company reversed compensation expense in 2002 of $2.6 million relating to the
variable stock options.
The Company recorded compensation expense related to certain stock options
issued below the fair market value of the related stock in the amount of $0.1
million, $0.6 million and $1.0 million for the year ended December 31, 2004,
2003 and 2002, respectively.
20. EARNINGS PER SHARE
A reconciliation of the basic and diluted per share computations for 2004,
2003 and 2002 is as follows (in thousands, except per share data):
-----------------------------------
2004
-----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ---------
Income per common share $ 71,288 60,496 $ 1.18
Effect of dilutive securities:
Stock options - 2,269 (.04)
---------- --------- ---------
Income per share assuming dilution $ 71,288 62,765 $ 1.14
========== ========= =========
-----------------------------------
2003
(Restated) (Restated)
-----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ----------
Income per common share $ 80,070 60,439 $ 1.32
Effect of dilutive securities:
Stock options - 3,723 (.07)
---------- --------- ----------
Income per share assuming dilution $ 80,070 64,162 $ 1.25
========== ========= ==========
-----------------------------------
2002
(Restated) (Restated)
-----------------------------------
Weighted Per
Average Share
Income Shares Amount
---------- --------- ----------
Income per common share $ 259,745 57,202 $ 4.54
Effect of dilutive securities:
Stock options - 5,188 (0.38)
---------- --------- ----------
Income per share assuming dilution $ 259,745 $ 62,390 4.16
========== ========= ==========
Antidilutive stock options excluded from the calculation of diluted income in
2004, 2003, and 2002 were 4.0 million, 1.3 million and 0.8 million,
respectively.
21. LEGAL CONTINGENCIES
On January 3, 2005, the Company received a letter from The Nasdaq Stock Market,
Inc. indicating that its securities were subject to delisting from The Nasdaq
National Market because it failed to comply with Marketplace Rules 4350(e) and
4350(g), which requires that the Company hold an annual shareholder meeting and
distribute a proxy statement and solicit proxies for the meeting. The Company
requested and received a hearing before a Nasdaq Listing Qualifications Panel
to review the staff determination. On February 15, 2005, the Panel informed
the Company that its securities would be delisted at the opening of business on
February 17, 2005. The Company requested that the Panel reconsider its
decision, which it did. The Panel has agreed to continue listing its
securities under specified conditions, including that the Company holds an
annual meeting on or before March 30, 2005. The Company has set a March 30,
2005 annual meeting date. If we are unable to hold a meeting on that date, our
securities may be delisted and thus no longer eligible to trade on The Nasdaq
National Market System, which may affect the liquidity of our securities and
their trading price.
The Company was named as a defendant in several purported class action lawsuits
asserting 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 reached a nationwide settlement with
the plaintiffs. This settlement encompasses all of the legal claims asserted in
each of the related actions. Preliminary approval of settlement was granted on
August 10, 2004. The Company has agreed to pay plaintiffs' legal counsel
$2.675M and to give class members a rent-one-get-one coupons on a claims made
basis with a guaranteed total redemption of $9M along with other remedial
relief. A hearing to obtain final court approval of the settlement is set for
June 24, 2005. Notice began on October 10, 2004 and will last for six months.
Coupons will likely be distributed to the class beginning in the fall of 2005
and payment will be made to plaintiffs' legal counsel following final court
approval in June 2005. The Company believes it has provided adequate reserves
in connection with these lawsuits.
The Company and the members of its board are defendants in several lawsuits
pending in Clackamas County, Oregon (and one in Multnomah County, Oregon). The
lawsuits assert breaches of duties associated with the merger agreement
executed with a subsidiary of Leonard Green & Partners, L.P. With the
termination of the Leonard Green transaction, the Company is uncertain as to
whether these cases will proceed and if so, in what form. The Company and the
members of its board have also been named as defendants in a separate lawsuit,
JDL Partners, L.P. v. Mark J. Wattles et. al, filed in Clackamas County, Oregon
Circuit Court. This lawsuit, filed before the Company's announcement of the
merger agreement with Movie Gallery, alleges breaches of fiduciary duties
related to a recent bid by Blockbuster for the Company as well as breaches
related to a loan to Mr. Wattles that the Company forgave in December 2000. A
motion is pending in Clackamas County to consolidate this lawsuit with the
previously filed actions. It is not clear how the Merger Agreement with Movie
Gallery will affect the pending litigation and there is no assurance that a
settlement will be effected or that current reserves for this litigation will
be adequate.
The Company was named as a defendant in three actions asserting wage and hour
claims in California. The plaintiffs sought to certify a statewide class
action alleging that certain California employees were denied meal and rest
periods. There were several additional related claims for unpaid overtime,
unpaid off the clock work, and penalties for late payment of wages and record
keeping violations. Mediation took place on September 9, 2004 and the parties
reached a settlement of all claims alleged in each of the actions. Pursuant to
the settlement, two of the actions were dismissed and all claims asserted by
plaintiffs were alleged in a single action. The Company received preliminary
approval of the settlement on January 10, 2005. Notice was sent directly to
class members on February 4, 2005. Final approval is scheduled for hearing on
April 21, 2005. 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. As of December 31, 2004 and 2003, the legal contingencies
reserve was $13.3 million and $6.8 million, respectively.
22. SEGMENT REPORTING
The Company's management regularly evaluates the performance of two segments,
Hollywood Video and Game Crazy, in its assessment of performance and in
deciding how to allocate resources. Hollywood Video represents the Company's
2,006 video stores excluding the operations of Game Crazy. Game Crazy
represents 715 in-store departments and free-standing stores that allows game
enthusiasts to buy, sell, and trade used and new video game hardware, software
and accessories. The Company measures segment profit as operating income
(loss), which is defined as income (loss) before interest expense and income
taxes. Information on segments and reconciliation to operating income (loss)
are as follows (in thousands):
Year Ended December 31, 2004
-----------------------------------
Hollywood Game
Video Crazy Total
---------- ----------- ----------
Revenues $1,495,830 $ 286,534 $1,782,364
Depreciation 53,259 6,712 59,971
Impairment of Assets 16,174 2,008 18,182
Income (loss) from operations 168,040 (21,552) 146,488
Goodwill 69,050 415 69,465
Total assets 1,000,495 119,032 1,119,527
Purchases of property and
equipment 50,704 8,870 59,574
Year Ended December 31, 2003
(Restated)
-----------------------------------
Hollywood Game
Video Crazy Total
---------- ----------- ----------
Revenues $1,502,416 $ 180,132 $1,682,548
Depreciation 57,077 4,052 61,129
Income (loss) from operations 206,891 (24,685) 182,206
Goodwill 67,991 415 68,406
Total assets 905,773 100,282 1,006,055
Purchases of property and
equipment 61,760 27,321 89,081
Game Crazy's loss from operations included an overhead allocation for
information support services, treasury and accounting functions, and other
general and administrative services. Game Crazy revenue for 2002 was $56.7
million. Information regarding Game Crazy's results of operations, total assets
and purchases of property and equipment as reported above for 2004 and 2003 is
not available for prior periods before 2003 due to Game Crazy's smaller scale
when costs were not segregated and captured.
23. CONSOLIDATING FINANCIAL STATEMENTS
Hollywood Entertainment Corporation (HEC) had only one wholly owned subsidiary
as of December 31, 2004, Hollywood Management Company (HMC). HMC is a guarantor
of certain indebtedness of HEC, including the obligations under the new credit
facilities and the 9.625% senior subordinated notes due 2011. Prior to June
2000, HEC had a wholly owned subsidiary, Reel.com (Reel),that was merged with
and into HEC in June 2000. The consolidating condensed financial statements
below present the results of operations and financial position of the
subsidiaries of the Company.
Consolidating Condensed Balance Sheet
December 31, 2004
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,346 $ 43,814 $ - $ 46,160
Marketable Securities - 147,600 - 147,600
Accounts receivable, net 27,119 469,279 (458,476) 37,922
Merchandise inventories 148,154 - - 148,154
Prepaid expenses and other
current assets 6,703 16,132 - 22,835
Total current assets 184,322 676,825 (458,476) 402,671
Rental inventory, net 289,144 - - 289,144
Property & equipment, net 205,286 22,538 - 227,824
Goodwill, net 69,465 - - 69,465
Deferred income tax asset 87,980 - - 87,980
Prepaid Rent 27,194 - - 27,194
Other assets, net 410,641 7,907 (403,299) 15,249
Total assets $1,274,032 $ 707,270 $ (861,775) $1,119,527
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 555 $ - $ - $ 555
Financing Obligations 15,581 - - 15,581
Accounts payable 458,476 174,427 (458,476) 174,427
Accrued expenses 30,672 119,764 - 150,436
Accrued interest 69 6,376 - 6,445
Income taxes payable - 3,404 - 3,404
Total current liabilities 505,353 303,971 (458,476) 350,848
Long-term obligations, less
current portion 350,701 - - 350,701
Other liabilities 44,346 - - 44,346
Total liabilities 900,400 303,971 (458,476) 745,895
Common stock 494,246 4,008 (4,008) 494,246
Unearned compensation - - - -
Retained earnings
(accumulated deficit) (120,614) 399,291 (399,291) (120,614)
Total shareholders' equity
equity (deficit) 373,632 403,299 (403,299) 373,632
Total liabilities and
shareholders equity
(deficit) $1,274,032 $ 707,270 $ (861,775) $1,119,527
Consolidating Condensed Balance Sheet
December 31, 2003 Restated
(in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ations idated
---------- ---------- ---------- ----------
ASSETS
Cash and cash equivalents $ 2,259 $ 45,798 $ - $ 48,057
Marketable Securities - 26,076 - 26,076
Accounts receivable, net 24,796 489,188 (479,997) 33,987
Merchandise inventories 129,864 - - 129,864
Prepaid expenses and other
current assets 10,041 3,192 - 13,233
Total current assets 166,960 564,254 (479,997) 251,217
Rental inventory, net 268,748 - - 268,748
Property & equipment, net 219,812 23,601 - 243,413
Goodwill, net 68,406 - - 68,406
Deferred income tax asset 122,598 - - 122,598
Prepaid Rent 34,019 - - 34,019
Other assets, net 344,212 7,193 (333,751) 17,654
Total assets $ 1,224,755 $ 595,048 $ (813,748) $1,006,055
LIABILITIES & SHAREHOLDERS'
EQUITY (DEFICIT)
Current maturities of
long-term obligations $ 647 $ - $ - $ 647
Financing Obligations 3,245 - - 3,245
Accounts payable 479,997 159,586 (479,997) 159,586
Accrued expenses 22,907 94,960 - 117,867
Accrued interest 22 6,467 - 6,489
Income taxes payable - 284 - 284
Total current liabilities 506,818 261,297 (479,997) 288,118
Long-term obligations, less
current portion 370,669 - - 370,669
Other liabilities 50,056 - - 50,056
Total liabilities 927,543 261,297 (479,997) 708,843
Common stock 489,247 4,008 (4,008) 489,247
Unearned compensation (133) - - (133)
Retained earnings
(accumulated deficit) (191,902) 329,743 (329,743) (191,902)
Total shareholders' equity
equity (deficit) 297,212 333,751 (333,751) 297,212
Total liabilities and
shareholders equity
(deficit) $ 1,224,755 $ 595,048 $ (813,748) $1,006,055
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2004
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,785,239 $ 169,317 $(172,192)$1,782,364
Cost of revenue 716,662 - - 716,662
Gross profit 1,068,577 169,317 (172,192) 1,065,702
Operating costs & expenses:
Operating and selling 767,882 25,435 - 793,317
General & administrative 231,281 64,857 (172,192) 123,946
Store opening expenses 2,141 - - 2,141
Restructuring charges:
Closure of Internet
business - - - -
Store closures (190) - - (190)
Income from
operations 67,463 79,025 - 146,488
Interest income - 35,552 (34,126) 1,426
Interest expense (65,545) - 34,126 (31,419)
Early debt retirement - - - -
Equity earnings in
Subsidiary 69,748 - (69,748) -
Income before
income taxes 71,666 114,577 (69,748) 116,495
(Provision for) income
taxes (378) (44,829) - (45,207)
Net income $ 71,288 $ 69,748 $ (69,748) $ 71,288
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2003 Restated
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,685,424 $ 151,186 $(154,062)$1,682,548
Cost of revenue 664,632 - - 664,632
Gross profit 1,020,792 151,186 (154,062) 1,017,916
Operating costs & expenses:
Operating and selling 703,365 23,659 - 727,024
General & administrative 211,914 48,172 (154,062) 106,024
Store opening expenses 4,768 - - 4,768
Restructuring charges:
Closure of Internet
business - - - -
Store closures (2,106) - - (2,106)
Income from
operations 102,851 79,355 - 182,206
Interest income - 38,818 (38,059) 759
Interest expense (74,325) - 38,059 (36,266)
Early debt retirement (12,467) - - (12,467)
Equity earnings
in subsidiary 70,734 - (70,734) -
Income before
income taxes 86,793 118,173 (70,734) 134,232
(Provision for) income
taxes (6,723) (47,439) - (54,162)
Net income $ 80,070 $ 70,734 $ (70,734)$ 80,070
Consolidating Condensed Statement of Operations
Twelve months ended December 31, 2002 Restated
(in thousands)
--------- --------- --------- ---------
HEC HMC Elimin- Consol-
ations idated
--------- --------- --------- ---------
Revenue $1,492,941 $ 156,057 $(158,932)$1,490,066
Cost of revenue 573,529 - - 573,529
Gross profit 919,412 156,057 (158,932) 916,537
Operating costs & expenses:
Operating and selling 637,449 10,034 - 647,483
General & administrative 199,254 49,280 (158,932) 89,602
Store opening expenses 3,093 - - 3,093
Restructuring charges:
Closure of Internet
business (12,430) - - (12,430)
Store closures (828) - - (828)
Income from
operations 92,874 96,743 - 189,617
Interest income - 31,619 (31,125) 494
Interest expense (73,676) - 31,125 (42,551)
Early debt retirement (3,534) - (3,534)
Equity earnings
in subsidiary 79,894 - (79,894) -
Income before
income taxes 95,558 128,362 (79,894) 144,026
(Provision for) income
taxes 164,187 (48,468) - 115,719
Net income $ 259,745 $ 79,894 ($ 79,894)$ 259,745
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2004
(unaudited, in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ation idated
---------- ---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 71,288 $ 69,548 $(69,548) $ 71,288
Equity Earnings in
subsidiary (69,548) - 69,548 -
Adjustments to reconcile
net income to
cash provided by
operating activities:
Write-off of deferred
financing costs - - - -
Amortization of Rental 186,847 - - 186,847
Product
Depreciation &
amortization 53,836 6,135 - 59,971
Amortization of Prepaid Rent 8,654 - - 8,654
Impairment of Long Lived
Assets 18,182 - - 18,182
Amortization of Deferred
Financing Costs 2,937 - - 2,937
Tax benefit from exercise
of stock options 6,245 - - 6,245
Change in deferred tax
asset 34,618 - - 34,618
Change in deferred rent (5,709) - - (5,709)
Non cash stock compensation 133 - - 133
Net change in operating
assets & liabilities (31,940) 49,499 - 17,559
Cash provided by (used in)
Operating activities 275,543 125,182 - 400,725
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (207,243) - - (207,243)
Purchase of property &
equipment, net (54,500) (5,074) - (59,574)
Increase in intangibles
& other assets (4,741) (569) - (5,310)
Purchases of Marketable
Securities - (390,685) - (390,685)
Sale of Marketable Securities - 269,161 - 269,161
Cash used in investing
activities (266,484) (127,167) - (393,651)
FINANCING ACTIVITIES:
Repayments of capital lease
obligations (590) - - (590)
Repurchase of Common Stock (3,665) - - (3,665)
Proceeds from exercise
of stock options 2,419 - - 2,419
Decrease in Credit Facility (20,000) - - (20,000)
Debt financing costs - - - -
Proceeds from Capital lease
Obligations 529 - - 529
Increase/(Decrease in
Financing Obligations 12,336 - - 12,336
Cash used in financing
activities (8,971) - - (8,971)
Increase in cash
and cash equivalents 88 (1,985) - (1,897)
Cash and cash equivalents
at beginning of year 2,259 45,798 - 48,057
Cash and cash equivalents at
the end of the third
quarter $ 2,347 $ 43,813 $ - $ 46,160
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2003 Restated
(unaudited, in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ation idated
---------- ---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 80,070 $ 70,733 $ (70,733) $ 80,070
Equity Earnings in
subsidiary (70,733) - 70,733 -
Adjustments to reconcile
net income to
cash provided by
operating activities:
Write-off of deferred
financing costs - - - -
Depreciation &
amortization 284,296 7,472 - 291,768
Tax benefit from exercise
of stock options 8,053 - - 8,053
Change in deferred rent (6,612) - - (6,612)
Change in deferred income
taxes 42,826 - - 42,826
Non cash stock compensation 564 - - 564
Net change in operating
assets & liabilities 218,698 (243,912) - (25,214)
Cash provided by (used in)
Operating activities 557,162 (165,707) - 391,455
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (220,364) - - (220,364)
Purchase of property &
equipment, net (77,867) (11,214) - (89,081)
Purchase of Marketable
Securities - (211,283) - (211,283)
Sale of Marketable
Securities - 185,207 - 185,207
Increase in intangibles
& other assets (6,454) (838) - (7,292)
Refinancing proceeds - 218,531 - 218,531
Cash used in investing
activities (304,685) 180,403 - (124,282)
FINANCING ACTIVITIES:
Repayment of subordinated
debt (250,000) - - (250,000)
Repayments of capital lease
obligations (8,869) - - (8,869)
Repurchase of common stock (26,275) - - (26,275)
Proceeds from exercise
of stock options 4,066 - - 4,066
Decrease in revolving loans,
net 30,047 - - 30,047
Decrease in financing
obligations (1,230) - - (1,230)
Cash provided by financing
activities (252,261) - - (252,261)
Increase in cash
and cash equivalents 216 14,696 - 14,912
Cash and cash equivalents
at beginning of year 2,045 31,100 - 33,145
Cash and cash equivalents at
end of year $ 2,259 $ 45,798 $ - $ 48,057
Consolidating Condensed Statement of Cash Flows
Twelve months ended December 31, 2002 Restated
(unaudited, in thousands)
---------- ---------- ---------- ----------
HEC HMC Elimin- Consol-
ation idated
---------- ---------- ---------- ----------
OPERATING ACTIVITIES:
Net income $ 259,745 $ 79,894 $ (79,894) $ 259,745
Equity Earnings in
subsidiary (79,894) - 79,894 -
Adjustments to reconcile
net income to
cash provided by
operating activities:
Extraordinary loss on
extinguishment of debt 2,226 - - 2,226
Depreciation &
amortization 282,635 5,528 - 288,163
Tax benefit from exercise
of stock options 12,814 - - 12,814
Change in deferred rent (7,297) - - (7,297)
Change in deferred income
taxes (127,027) - - (127,027)
Non cash stock compensation (1,633) - - (1,633)
Net change in operating
assets & liabilities (201,561) 136,115 - (65,446)
Cash provided by (used in)
operating activities 140,008 221,537 - 361,545
INVESTING ACTIVITIES:
Purchases of rental
inventory, net (288,079) - - (288,079)
Purchase of property &
equipment, net (30,948) (7,928) - (38,876)
Increase in intangibles
& other assets (2,478) (790) - (3,268)
Refinancing proceeds - (218,531) - (218,531)
Cash used in investing
activities (321,505) (227,249) - (548,754)
FINANCING ACTIVITIES:
Proceeds from sale of
common stock, net 113,073 - - 113,073
Issuance of subordinated
debt 225,000 - - 225,000
Cash used in financing
activities (13,816) - - (13,816)
Decrease in financing
obligations (2,851) - - (2,851)
Proceeds from exercise
of stock options 4,604 - - 4,604
Decrease in revolving loans,
net (144,466) - - (144,466)
Cash provided by financing
activities 181,544 - - 181,544
Increase in cash
and cash equivalents 47 (5,712) - (5,665)
Cash and cash equivalents
at beginning of year 1,999 36,811 - 38,810
Cash and cash equivalents at
end of year $ 2,046 $ 31,099 $ - $ 33,145
24. QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data is as follows (in thousands, except per share
data):
Quarter Ended
-------------------------------
March June September
2004 As Previously Reported --------- --------- ---------
- ---------------------------
Total revenue $ 442,791 $ 423,129 $ 410,554
Gross profit 270,526 258,220 256,792
Income from
Operations 45,584 41,213 34,405
Net income 22,698 20,225 15,980
Net income
per share:
Basic 0.38 0.33 0.26
Diluted 0.36 0.32 0.25
Quarter Ended
------------------------------------------
March June September December
2004 As Restated --------- --------- --------- ---------
- ---------------------------
Total revenue $ 442,791 $ 423,129 $ 410,554 $ 505,891
Gross profit 270,526 258,220 256,792 280,164
Income from
Operations 46,851 40,658 33,729 25,249
Net income 23,471 19,887 15,568 12,363
Net income
per share:
Basic 0.39 0.33 0.26 0.20
Diluted 0.38 0.32 0.25 0.20
Quarter Ended
------------------------------------------
March June September December
2003 As Previously Reported --------- --------- --------- ---------
- ---------------------------
Total revenue $ 417,592 $ 389,443 $ 401,958 $ 473,555
Gross profit 261,900 240,818 250,645 264,553
Income from
operations 55,036 39,871 41,985 48,201
Net income 19,578 19,178 20,469 23,046
Net income
per share:
Basic 0.33 0.32 0.34 0.38
Diluted 0.31 0.30 0.32 0.36
Quarter Ended
------------------------------------------
March June September December
2003 As Restated --------- --------- --------- ---------
- ---------------------------
Total revenue $ 417,592 $ 389,443 $ 401,958 $ 473,555
Gross profit 261,900 240,818 250,645 264,553
Income from
operations 54,423 39,441 41,011 47,330
Net income 19,210 18,920 19,886 22,055
Net income
per share:
Basic 0.32 0.31 0.33 0.37
Diluted 0.30 0.29 0.31 0.35
Quarter Ended
------------------------------------------
March June September December
2002 As Previously Reported --------- --------- --------- ---------
- ---------------------------
Total revenue $ 363,648 $ 345,261 $ 369,022 $ 412,135
Gross profit 223,009 216,810 228,425 248,293
Income from
operations 40,935 51,818 41,984 54,590
Net income 26,443 41,456 31,945 142,001
Net income
per share:
Basic 0.51 0.71 0.54 2.39
Diluted 0.46 0.64 0.50 2.21
Quarter Ended
------------------------------------------
March June September December
2002 As Restated --------- --------- --------- ---------
- ---------------------------
Total revenue $ 363,648 $ 345,261 $ 369,022 $ 412,135
Gross profit 223,009 216,810 228,425 248,293
Income from
operations 42,078 52,733 42,038 52,768
Net income 27,129 42,005 31,977 158,634
Net income
per share:
Basic 0.53 0.72 0.54 2.67
Diluted 0.47 0.65 0.50 2.47
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, as of March XX,
2005.
Hollywood Entertainment Corporation
By: /S/ TIMOTHY R. PRICE
---------------------------
Timothy R. Price
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities indicated as of March 16, 2005.
Signatures Title
/S/ F. BRUCE GIESBRECHT
- -----------------------
F. Bruce Giesbrecht President, Chief Executive Officer,
Chief Operating Officer and Director
/S/ TIMOTHY R. PRICE
- -----------------------
Timothy R. Price Chief Financial Officer
(Principal Financial and Accounting Officer)
/S/ WILLIAM P. ZEBE
- -----------------------
William P. Zebe Director
/S/ JAMES N. CUTLER JR.
- -----------------------
James N. Cutler Jr. Director
/S/ DOUGLAS GLENDENNING
- -----------------------
Douglas Glendenning Director
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