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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, 1998
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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
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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
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(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 Name of Each Exchange
Class on Which Registered
- ---------------------------------- ----------------------------
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. [ ]
On March 12, 1999, the registrant had 45,376,257 shares of Common Stock
outstanding, and on such date, the aggregate market value of the shares of
Common Stock held by non-affiliates of the Registrant was $568,092,134 based
upon the last sale price reported for such date on the Nasdaq National Market.
DOCUMENTS INCORPORATED BY REFERENCE
Part III - Portions of registrant's Proxy Statement which is anticipated to be
filed within 120 days after the end of the registrant's fiscal year ended
December 31, 1998.
HOLLYWOOD ENTERTAINMENT CORPORATION
ANNUAL REPORT ON FORM 10-K
YEAR ENDED DECEMBER 31, 1998
Item
PART I
1. Business
2. Properties
3. Legal Proceedings
4. Submission of Matters to a Vote of Security Holders
4(a) Executive Officers and Key Employees of the Registrant
PART II
5. Market for Registrant's Common Stock and Related Stockholder Matters
6. Selected Financial Data
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations
8. Financial Statements and Supplementary Data
9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure
PART III
10. Directors and Executive Officers of the Registrant
11. Executive Compensation
12. Security Ownership of Certain Beneficial Owners and Management
13. Certain Relationships and Related Transactions
PART IV
14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
PART I
ITEM 1. BUSINESS
GENERAL
Hollywood Entertainment owns and operates 1,260 Hollywood Video retail
superstores in 42 states as of December 31, 1998 and is the second largest video
retailer in the United States. According to video industry analyst, Paul Kagan,
Associates, Inc. ("Paul Kagan"), we operate the highest volume video stores in
the country. Hollywood Video revenue increased from $17.3 million in 1993 to
$756.6 million in 1998. We added 353 stores in 1998 and intend to add
approximately 350 stores in each of 1999 and 2000.
In addition, with the acquisition of Reel.com in October 1998, we became
the leading online video only retailer and began implementing a strategy to
electronically deliver entertainment products directly into the homes of our
customers over the internet. Reel.com had $7.3 million in revenue in the fourth
quarter of 1998.
INDUSTRY OVERVIEW
Video Retail Industry
According to the Video Software Dealers Association ("VSDA"), a video
retailing association, the videocassette rental industry grew approximately 10%
in 1998, reaching $8.1 billion in revenue, in sharp contrast to recent years in
which rental revenue was generally flat and industry growth was driven by
increases in product sales revenue. We believe this growth may continue in 1999
and possibly beyond, driven in part by greater availability of new release
videocassettes as a result of revenue sharing arrangements and increased
advertising by movie studios and video retailers. According to Paul Kagan, the
U.S. videocassette rental and sales industry has grown from $9.8 billion in
revenue in 1990 to $16.9 billion in 1998, and is expected to reach $20.8 billion
in 2002. The video rental industry is highly fragmented and in recent years has
been characterized by increased consolidation as larger "superstore" chains,
video stores with at least 7,500 videocassettes, have continued to increase
market share by opening new stores and acquiring smaller, local operators.
According to VSDA, there were between 25,000 and 30,000 video specialty stores
in operation in 1998. We believe approximately 8,500 of these stores are
"superstores." We believe this consolidation will continue as the video retail
industry evolves from independent stores to regional and national superstore
chains.
Movie Studio Dependence on Video Retail Industry
According to Paul Kagan, the video retail industry is the single largest
source of revenue to movie studios and represented approximately $6.7 billion,
or 48.5%, of the $13.8 billion of estimated domestic studio revenue in 1998. Of
the hundreds of movies produced by the major studios each year in the U.S.,
relatively few are profitable for the movie studio based on box office revenue
alone. According to the Motion Picture Association of America (the "MPAA"),
between 1990 and 1997 only 7.2% of all movies released generated in excess of
$20 million in U.S. theater revenue for studios. Over the same period, members
of the MPAA reported that the average production, advertising and distribution
cost per movie increased from $38.8 million to $75.7 million. We believe the
customer is more likely to view "non-hit" movies on rented videocassette than in
any other medium because video retail stores provide an inviting opportunity to
browse and make an impulse choice among a very broad selection of new releases.
As a result, video retail stores, including those operated by us, acquire movies
on videocassette regardless of whether the movies were successful at the box
office, thus providing movie studios a reliable source of revenue for almost all
of the hundreds of movies produced each year. Consequently, we believe movie
studios are highly motivated to protect this unique and significant source of
revenue.
Historically, movie studios have sought to generate incremental sources of
revenue through the addition of new distribution channels. To maximize revenue,
the studios have implemented a strategy of sequential release "windows," giving
each distribution channel the rights to its movies for a limited time before
making them available to the next sequential channel. The studios have
determined the sequential order in which they release movies to each
distribution channel based upon the order they believe will maximize their total
revenue from all distribution channels combined. These distribution channels
generally include, in release date order, movie theaters, video retail stores,
pay-per-view television, including direct broadcast satellite ("DBS"), premium
channels, basic cable television and, finally, network and syndicated
television.
ORDER OF SEQUENTIAL RELEASE WINDOWS TO PRIMARY CHANNELS OF DISTRIBUTION
- Movie theaters
- Video retail stores
- Pay-per-view television (including DBS)
- Premium channels (HBO, Showtime, etc.)
- Basic cable television
- Network television
- Syndicated television
TRENDS IN VIDEO RENTALS AND SALES
Studios have historically sold videocassettes to video retailers under two
pricing structures, "rental" and "sell-through." Rental titles are initially
sold at relatively high prices (typically $60 to $65 wholesale) and promoted
primarily for rental, and then later re-released for sale to consumers at a
lower price (typically $10 to $15 wholesale). Certain high-grossing box office
films, generally with box office revenue in excess of $100 million, are targeted
at the sell-through market. These titles are released on videocassette at a
relatively low initial price (approximately $15 wholesale) and are both promoted
as a rental title by video stores and sold directly to consumers through a broad
array of retailers including video stores. Studios elect to release a title
either as rental or sell-through based on which would optimize their income from
the title.
According to Paul Kagan, video rental revenue has increased from $7.4
billion in 1997 to $8.1 billion in 1998 and is expected to increase to $9.7
billion in 2002. This growth is in contrast to flat rental revenue in prior
years, when consumers attracted by lower prices increased their video purchases.
Sell-through revenue has increased from $3.2 billion in 1990 to $8.8 billion in
1998 and is expected to increase to $11.1 billion in 2002.
In 1998 a number of studios and video retailers adopted revenue sharing as
an alternative to the historical rental pricing structure. Studios began
offering retailers more videocassettes for an individual title at substantially
lower initial cost in exchange for a share of the rental revenue that those
copies generate over their initial release window. The additional copies have
contributed to improved consumer satisfaction early in a title's release because
the supply of titles better matches demand. This has led to higher rental
revenues for the video store industry as well as for studios. Revenue sharing
also gives the studios an incentive to market these titles because they share in
the revenue generated by increased transactions.
DVDs are an alternative format to VHS tapes that offer consumers digital
picture and sound and additional features such as enhanced content and
interactivity. Since their introduction in late 1997, more than 1.3 million DVD
players have reportedly been sold. The Company introduced DVDs in all its
stores in November 1998, resulting in the most successful introduction of a new
format in the Company's history. DVDs are the fastest growing new category
introduced by the Company due to increased interest in older movie titles as a
result of the substantial improvement in picture and sound quality over VHS.
BUSINESS STRATEGY
Our goal is to build a strong national brand which consumers will identify
with the entertainment industry. We have developed an effective superstore
format that distinguishes us from competitors. We attempt to quickly establish a
leadership position in each of the markets in which we open stores. We
successfully compete in both well-developed and relatively untapped markets. We
are also investing in technologies that enable us to deliver entertainment
directly into the homes of our customers. Our business strategy includes the
following key elements:
Expansion Through Company-Built Superstores. In each of the last two
years we added approximately 350 stores and we intend to open over 300
stores in each of 1999 and 2000. Of our 1,260 video superstores at
December 31, 1998, over 85% of the stores had been opened as new
stores by us.
Broad Selection and Superior Availability. We strive to provide our
customers with the broadest selection of movies and video games. Our
superstores typically carry approximately 8,000 titles and 15,000
videocassettes and video games. Our goal is to offer more copies of
popular new video releases and more titles than our competitors. In
part because of our new revenue sharing arrangements with studios, we
have increased the availability of most new releases and typically
acquire 100 to 175 copies of "hit" movies for each Hollywood Video
store.
Exciting, Enjoyable and Convenient Shopping Experience. Our
superstores are designed to capture the bright lights, energy and
excitement of the motion picture industry. We focus on creating an
inviting atmosphere that encourages browsing and generates repeat
customers. Our superstores are typically located in high traffic,
high-visibility locations. We believe excellent customer service, a
bright, clean and friendly shopping environment and convenient store
locations are important to our success.
Excellent Entertainment Value. We offer consumers the opportunity to
rent new releases, video games and any of our catalog movie titles for
five days in most of our stores. New release movies typically rent
for $3.49 and catalog movies typically rent for $1.99. We believe
movie rental in general, and our pricing structure and rental terms in
particular, provide consumers convenient entertainment and excellent
value.
Electronic Commerce. Having established our superstores as physical
"portals" linking consumers to the movie studios, we have begun
through
the acquisition of Reel.com in October 1998 to establish an electronic
"portal," linking customers in their homes to movies and movie related
entertainment. We intend to build on our relationships with movie
studios, internet businesses such as America Online and Yahoo and our
more than 25 million physical store members to enhance our electronic
commerce business.
Expanding Product Opportunities. We regularly explore opportunities
to enhance entertainment experiences of our customers. We are in the
early stages of testing a new business initiative that sells, buys and
trades video games, as an expansion of our traditional video game
rental business. This initiative is designed as a store within a
store, leveraging a portion of our existing superstore real estate.
If the test is successful, we plan to aggressively roll-out this
concept to a substantial portion of our existing store base. Although
DVD may at some point displace videocassettes, we believe it is a
format that complements our existing business and is well suited to
rental or sale. We introduced DVD for rental in the majority of our
stores in the fourth quarter of 1998, generating the highest revenues
of any new format in our history, and we plan to expand our DVD
offerings in 1999.
HOLLYWOOD VIDEO STORE DESIGN
Hollywood Video superstores average approximately 7,200 square feet and
are substantially larger than the stores of most of our competitors. The store
exteriors generally feature large Hollywood Video signs and colors, which make
our stores easily visible to and recognizable by consumers. The interior of
each store is clean and brightly lit. Our superstores are decorated with
colorful neon, murals depicting popular screen stars and walls of video monitors
with hi-fi audio accompaniment to create an exciting Hollywood environment.
Movies are organized into 28 categories, and videocassettes are arranged
alphabetically by title within each category to assist customers in locating the
movies. New releases are prominently displayed in easily recognizable locations
within the store. Videocassettes are displayed with the box cover facing the
customer for ease of selection and visual impact. We use wall-mounted and free-
standing shelves arranged in wide aisles to provide access to products and to
encourage the movement of customers throughout the store.
EXPANSION STRATEGY
Video Store Openings and Flexible Store Format
We opened our first video superstore in October 1988 and grew to 25 stores
in Oregon and Washington by the end of 1993. In 1994 we significantly
accelerated our store expansion program, adding 88 stores and expanding into
California, Texas, Nevada, New Mexico, Virginia and Utah. In 1995 we added 192
stores and entered major new markets in the midwest, southwest, east and
southeast regions of the United States. Our expansion strategy is to continue to
open stores in regions where we have existing operations and to expand into new
geographic regions where we believe we can become a dominant video retailer. We
opened 246 stores in 1996, 356 stores in 1997 and 353 in 1998. We plan to open
over 300 stores in each of 1999 and 2000.
We have been testing a smaller superstore format that reduces the target
size of new stores from 7,500 square feet to 5,000 square feet, which lowers our
per store annual rent and initial build-out costs. These smaller stores are
able to carry the same amount of video and video game inventory as larger stores
due to a new store design and shelving system, and we believe they retain a
"superstore" look to consumers. This efficient design also allows us greater
flexibility in locating new stores. Early tests suggest that these smaller,
less expensive stores are generating similar revenue volumes as larger units in
comparable locations, thus increasing our financial return on new stores. We
are rolling out these smaller stores in most of our new locations.
We believe the selection of locations for our stores is critical to the
success of our operations. We have assembled a new store development team with
broad and significant experience in retail tenant development. The majority of
our new store development personnel are located 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 Hollywood Video superstore include density of local
residential population, traffic count on roads immediately adjacent to the store
location, visibility and accessibility of the store and availability of ample
parking. We generally seek what we consider the most desirable locations,
typically locating our stores in high-visibility stand-alone structures or in
prominent locations in multi-tenant shopping developments. We typically compete
for these prime sites with other retailers, banks, restaurants and gas stations.
All of our stores are in leased premises; we do not own any real estate.
Our expansion is dependent on a number of factors, including our ability to
hire, train and assimilate management and store level employees, the adequacy of
our financial resources and our ability to identify and successfully compete in
new markets, to locate suitable store sites and negotiate acceptable lease terms
and to adapt its purchasing, management information and other systems to
accommodate expanded operations. See "Item 7-Management's Discussion and
Analysis of Financial Condition and Results of Operations-Liquidity and Capital
Resources." Our expansion is also dependent on the timely fulfillment by
landlords and others of their contractual obligations to us, the maintenance of
construction schedules and the speed at which local zoning and construction
permits can be obtained.
There is no assurance that we will be able to achieve our planned expansion
or that expansion will be profitable. Our planned expansion, including
possible growth through acquisitions, will place increasing pressure on our
management controls. A failure to manage successfully our planned expansion
would adversely affect our business. There is also no assurance that our new
stores will achieve sales and profitability comparable to our existing stores.
HOLLYWOOD'S INTERNET STRATEGY
United States internet commerce, which in 1997 accounted for approximately
$10.7 billion in sales, is expected to grow to $268.8 billion by 2002, according
to International Data Corporation. Additionally, the number of households using
e-mail, the internet or a consumer online service is predicted to grow from an
estimated 21.8 million in 1997 to 57.0 million, representing over 50% of US
households by the year 2002.
On October 1, 1999, the Company acquired Reel.com, the leading video only
store on the internet for approximately $96.9 million. Concurrent with the
acquisition of Reel.com, a group of strategic Reel.com stockholders purchased an
equity interest in the Company. The group of investors consists of CMG
Information Services, Inc. (NASDAQ: CMGI); Intel Corporation: Paul Allen's
Vulcan Ventures, Incorporated and Scott Beck. Reel.com offers over 100,000 VHS
titles and 2,300 DVD titles for sale. According to an internet study conducted
by Opinion Research Corporation in September 1998, Reel.com is the third most
recognized online merchant behind Amazon.com and CDNow and nearly 40 million
Americans recognize the Reel.com brand. The website, located at
http://www.Reel.com, offers proprietary information about movies including
descriptions, ratings, critics' reviews, recommendations and links to star
filmographies that entertain consumers and help them select and purchase movies
online. Consumers can also search through Reel.com's proprietary, hyperlinked
database and can preview selected videos.
Reel.com provides us with a new distribution channel and we believe it
complements our superstores in many ways:
While both businesses serve video retail customers, our stores
generate most video-related business through rentals, while our online
site generates virtually all of its business through product sales.
Consequently, we believe there are substantial opportunities to add to
our current on-line customer base of over 400,000 customers by
promoting the Reel.com brand to our more than 25 million superstore
customers.
Reel.com sells both new and previously viewed videocassettes. From
our physical superstores we intend to provide Reel.com with a
continuous supply of previously viewed videos, Reel.com's highest
margin product.
Reel.com's existing and developing expertise in using its intellectual
property to help consumers browse through and select movie titles that
fit their preferences can be leveraged in Hollywood Video stores to
increase rentals of videos, particularly highly profitable catalog
titles. In the future we plan to combine Reel.com's intellectual
property with our database of store customer rental history to provide
personalized video recommendations.
We believe Reel.com will also help position us for the eventual evolution
of the video business from physical delivery (through videocassettes and DVDs)
to electronic delivery directly to the home (through video-on-demand). We
believe widespread electronic delivery of movies to the home at acceptable
quality levels will not occur for a number of years due to economic and
technological limitations. If it becomes feasible in the future, we believe
Reel.com will position us to participate in that business. See "Competition."
We are evaluating strategic alternatives to maximize the value of the
acquisition to our shareholders and to provide additional financing sources for
the Reel.com business. These alternatives could include a public offering of a
minority position in Reel.com, the sale of an equity interest in Reel.com to a
strategic partner, the creation of a Reel.com tracking stock, or other
possibilities.
In February 1999, we created Internet Hollywood, Inc. to act as a holding
company for our internet businesses, which now includes only Reel.com, but which
we expect may encompass additional e-commerce or internet-related businesses in
the future. Jeffrey Jordan, who had served as our Chief Financial Officer since
September 1998, was appointed President of Internet Hollywood in February 1999.
Our ability to achieve and manage growth through electronic commerce
is subject to a number of risks and uncertainties, including those associated
with acquisitions generally and those related to the internet in particular. We
will expend financial, operational, and management resources in operating this
new business and integrating operations with our existing business. If we are
unable to do this cost-effectively, it could have a material adverse effect on
this new business and also be detrimental to the Company as a whole. Internet
retailing is highly competitive and is characterized by rapid technological
change and changes in user and customer requirements and preferences. In
addition, internet-based businesses are susceptible to technical difficulties,
including viruses, security breaches or other computer system interruptions,
which can reduce the availability of products and services, disrupt or delay
order fulfillment, and reduce customer satisfaction. Customer satisfaction may
also be adversely affected by poor performance of those parties we contract with
to handle order fulfillment. Our efforts to build recognition as an internet
retailer, enhance website content and promote ease of use, reliability and
support for customers will require us to make additional investments in this
business segment going forward, and these investments may not be profitable. The
risks described in this paragraph will be greater if the Reel.com business
continues to grow rapidly.
PRODUCTS
Video Rental. Our primary source of revenue is the rental of
videocassettes. Our superstores typically carry approximately 8,000 movie titles
and 15,000 videocassettes and video games. In 1998 we began renting DVDs in all
of our stores. Excluding new releases, movie titles are classified into 28
categories, such as "Action," "Drama," "Family" and "Children," and are
displayed alphabetically within those categories. We do not rent or sell adult
movies in our superstores. We are committed to offering more copies of popular
new releases than our competitors.
Video Sales. We offer new and previously viewed videos for sale.
Video Games. In addition to video rentals and sales, we rent and to a
lesser extent sell video games licensed by Nintendo, Sega and Sony. Each
mature Hollywood Video store offers between 1,200 and 4,000 video games. See
"Business Strategy."
Other Products. We rent audio books, and for the convenience of our
customers we rent videocassette and video game players and sell blank
videocassettes, video cleaning equipment and confectionery and other items.
REVENUE SHARING
During 1998 we formalized revenue sharing arrangements with a number of
studios which provides us with increased copies of titles in exchange for
sharing the revenues those copies generate. In the fourth quarter of 1998, we
acquired most of our rental product under these arrangements. We believe the
resulting increase in copy availability has led to greater customer satisfaction
and rental revenue growth for both the video store industry and the studios. We
believe
that by giving the studios a share of video rental revenue will cause them to
increase advertising on rental products.
ADVERTISING AND MARKETING
To further our goal of having a strong national brand that consumers will
identify with the entertainment industry, we advertise primarily using
television, radio, direct mail and the internet. We frequently use cooperative
movie advertising funds made available by studios and suppliers to promote
certain videos. We intend to increase our advertising expenditures in the
future.
PRICING
Revenue sharing arrangements significantly increased the number of new
release videocassettes purchased by the Company, thereby allowing the Company to
introduce a 5 day rental program on all product in the majority of the stores.
For the added convenience to our customers, the Company increased its prices in
the majority of the stores in the fourth quarter from $1.49 to $1.99 for catalog
titles and from $2.99 to $3.49 for new releases. The Company believes that the
pricing structure and rental terms provide consumers convenient entertainment
and excellent value.
INVENTORY AND INFORMATION MANAGEMENT
Inventory Management. We maintain detailed information on inventory
utilization. We track rental activity by individual videocassette and video game
to determine appropriate buying, distribution and disposition of videocassettes
and video games. The system provides information allowing us to determine when
to sell excess videocassettes and games, and when to redistribute to new stores.
Our inventory of videocassettes and video games for rental is prepared according
to uniform standards. Each new videocassette and video game is removed from its
original carton and placed in a rental case with a magnetic security device and
bar coding is affixed to each videocassette and video game.
Information Management. We use a scalable client-server system and
maintain two distinct system areas: a point-of-sale ("POS") system and a
corporate information system. We maintain information, updated daily, regarding
revenue, current and historical rental and sales activity, demographics of store
membership, individual customer history, and videocassette rental patterns. This
system allows us to compare current performance against historical performance
and the current year's budget, manage inventory, make purchasing decisions on
new releases and manage labor costs. We believe our system has the ability to
continue to improve customer service, operational efficiency, and management's
ability to monitor critical performance factors.
COMPETITION
The video retail industry is highly competitive. We compete with local,
regional and national video retail stores, including Blockbuster, and with
supermarkets, pharmacies, convenience stores, bookstores, mass merchants, mail
order operations and other retailers, as well as with noncommercial sources such
as libraries. According to the Video Software Dealers Association, in 1998 there
were approximately 25,000 to 30,000 video specialty stores in the U.S. We
believe approximately 8,500 of these stores were video retail superstores,
including approximately 4,200 Blockbuster stores. Some of our competitors have
significantly greater financial and marketing resources, market share and name
recognition than we have.
We believe the principal competitive factors in the video retail industry
are title selection, rental period, the number of copies of popular titles
available, store location and visibility, customer service and employee
friendliness, convenience of store access and parking and, to a lesser extent,
pricing. Substantially all of our stores compete with stores operated by
Blockbuster, most in very close proximity. As a result of direct competition
with Blockbuster, rental pricing of videocassettes and greater availability of
new releases are significant competitive factors in our business and from time
to time, in certain markets, Blockbuster has lower prices than those offered in
our stores. If price cutting occurs on a more sustained or widespread basis, it
could have an adverse impact on our results of operations. We believe we
generally offer more titles and more copies of popular titles for longer rental
periods than the majority of our competitors. In addition to competing with
other video retailers, we compete with all leisure-time activities, especially
entertainment activities such as movies, sporting events and network and cable
television programs.
We compete with cable, satellite and pay-per-view television systems, in
which subscribers pay a fee to see a movie selected by the subscriber. Existing
pay-per-view services offer a limited number of channels and movies and are only
available to households with a direct broadcast satellite receiver or a cable
converter to unscramble incoming signals. Digital compression technology and
other developing technologies are enabling cable companies, direct broadcast
satellite companies, telephone companies and other telecommunications companies
to transmit a much greater number of movies to homes at more frequently
scheduled intervals throughout the day. Certain cable and other
telecommunications companies have tested "video on demand" service in some
markets. Video on demand service would allow a viewer to pause, rewind and fast
forward movies. Based on publicly available information, we believe these tests
have been unsuccessful. We also believe movie studios have a significant
interest in maintaining a viable movie rental business because their sale of
videocassettes to stores represents the largest source of their revenue. In
addition, home video provides the only reliable source of revenue on "non-hit"
or "B-title" movies which make up the majority of movies produced by the major
studios each year. As a result, we believe movie studios will continue to make
movie titles available to cable television, satellite services or other
distribution channels only after revenues have been derived from the sale of
videos to video stores. Currently, video stores receive product approximately
two months earlier than pay per view, cable and satellite distribution
companies. The window provided to video stores by the studios has lengthened
significantly over the last two years.
In addition, we believe substantial technological developments will be
necessary to allow pay-per-view television to match the viewing convenience and
selection available through video rental, and substantial capital expenditures
will be necessary to implement these systems. In contrast, according to Adams
Media Research, 78.8 million, or 82%, of all U.S. television households own a
VCR. Although we do not believe cable television, video on demand or other
distribution channels represent a near-term competitive threat to our business,
technological advances or changes in the manner in which movies are marketed,
including in particular the earlier release of movie titles to pay-per-view,
including DBS, cable television or other distribution channels, could make these
technologies more attractive and economical, which could have a material adverse
effect on our business.
SEASONALITY
The video retail industry generally experiences relative revenue declines
in April and May, due in part to the change to Daylight Savings Time and to
improved weather, and in September and October, due in part to the start of
school and introduction of new television programs. The Company believes these
seasonality trends will continue.
EMPLOYEES
As of December 31, 1998, the Company had approximately 22,197 employees, of
which 21,510 were in the retail stores and zone offices and the remainder in the
Company's corporate administrative, and warehousing operations.
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 or Senior Vice President of Operations for each
zone office. The corporate support staff periodically has meetings with zone
personnel, regional managers, district managers and store managers to review
operations. None of the Company's employees are covered by collective
bargaining agreements and employee relations are considered to be excellent.
SERVICE MARK
The Company owns United States federal registrations for its service marks
"Hollywood Video", "Hollywood Video Superstores" and "Reel.com". The Company
considers its service mark important to its continued success.
ITEM 2. PROPERTIES
Store Locations
As of December 31, 1998, the Company's stores by location are as follows:
California 227
Texas 133
Illinois 69
Ohio 66
Florida 56
Michigan 54
Pennsylvania 48
Washington 47
New York 46
Arizona 39
Oregon 38
Georgia 34
Virginia 31
Minnesota 30
Tennessee 29
Indiana 23
Missouri 23
Colorado 22
North Carolina 22
Utah 21
Wisconsin 21
Maryland 19
Oklahoma 15
Kentucky 15
Nevada 14
New Jersey 14
Massachusetts 12
Kansas 11
Nebraska 10
Iowa 9
Idaho 9
Alabama 9
Louisiana 8
Arkansas 7
South Carolina 6
Connecticut 6
New Mexico 6
Rhode Island 4
Mississippi 2
South Dakota 2
Delaware 1
District of Columbia 1
Maine 1
Total 1,260
All of the Company's stores are located in leased premises with an initial
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
the Company to pay all taxes, insurance and common area maintenance expenses
associated with the properties. The Company anticipates that future new stores
will also be located in leased premises.
The Company's corporate headquarters is located at 9275 Southwest Peyton
Lane, Wilsonville, Oregon, and consists of approximately 123,000 square feet of
leased space. The Company's warehouse facility is located at 25600 Southwest
Parkway Center Drive, Wilsonville, Oregon and consists of approximately 175,000
square feet of leased space. These facilities are leased pursuant to agreements
that expire November 2008 and November 2005, respectively.
ITEM 3. LEGAL PROCEEDINGS
In April 1998 a complaint seeking injunctive relief and monetary damages in
the amount of approximately $200 million was filed against us, entitled Rentrak
Corporation v. Hollywood Entertainment, et al., Case No. 98-04-02811, Circuit
Court for the County of Multnomah, Portland, Oregon. The plaintiff, Rentrak,
alleges that we are contractually obligated until December 31, 2011 to deal
exclusively with Rentrak whenever we obtain videocassettes on a revenue sharing
basis, and that we have violated this alleged obligation by obtaining
videocassettes on a revenue sharing basis directly from movie studios. In
addition, Rentrak alleges that we have violated alleged audit and reporting
obligations under contractual arrangements. We believe this suit is without
merit and are vigorously defending the litigation. We do not believe the
ultimate outcome of the litigation will have a material effect on the Company.
If, however, Rentrak prevails, the results could have an adverse effect on our
relationships with revenue sharing studios and on our financial condition and
results of operations.
In July 1998 a related lawsuit seeking monetary damages in the amount of at
least $5 million was filed against the Company by Twentieth Century Fox Home
Entertainment, Inc. ("Fox"), entitled Twentieth Century Fox Home Entertainment,
Inc. v. Hollywood Entertainment Corporation and Does 1 through 100, Case No. SC
053 551, Superior Court for the County of Los Angeles, Los Angeles, California.
Fox alleges that the Company has knowingly or negligently reported inaccurate
transaction-related data concerning Fox titles to Rentrak Corporation, and that
the Company either knew or should have known that Rentrak would report to Fox
the same allegedly inaccurate transaction data for purposes of Fox's generation
of invoicing to Rentrak. In March 1999, Fox filed an amended complaint against
the Company in which it added allegations of potential misrepresentation and
fraud. We believe this suit is without merit and are vigorously defending the
litigation. We do not believe the ultimate outcome of the litigation will have
a material effect on the Company. If, however, Fox prevails, the results could
have an adverse effect on our relationships with revenue sharing studios and on
our financial condition and results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At a special meeting held on December 30, 1998, Hollywood Entertainment
Corporation common shareholders approved the conversion of 2,380,263 shares of
Series A Redeemable Preferred Stock issued and sold in connection with the
Reel.com acquisition into Common Stock on a one-for-one basis. The vote on the
matter was as follows:
In favor: 30,190,774
Against or withheld: 35,266
Abstentions: 20,864
ITEM 4(A). EXECUTIVE OFFICERS AND KEY EMPLOYEES OF THE REGISTRANT
The following table sets forth information with respect to our executive
officers and certain other key employees as of March 26, 1999.
Name Age Positions with the Company
Mark J. Wattles* 38 Chairman of the Board and Chief Executive Officer
Jeffrey B. Yapp* 40 President and Chief Operating Officer
Jeffrey D. Jordan* 40 President, Internet Hollywood, Inc.
David G. Martin* 33 Executive Vice President and Chief Financial Officer
Donald J. Ekman* 46 Senior Vice President, General Counsel, Secretary
and Director
Alex M. Bond 29 Senior Vice President of Internet Design
F. Bruce Giesbrecht 39 Senior Vice President of Strategic Planning
Glenn E. Hahn 47 Senior Vice President of Human Resources
Dale A. Naftzger 53 Senior Vice President of Operations
Roger J. Osborne 46 Senior Vice President of Operations
J. Patrick O'Malley 48 Senior Vice President of Information Systems
William E. Shull III 40 Senior Vice President of Operations
William M. Spae 47 Senior Vice President of Operations Administration
MARK J. WATTLES founded the Company in June 1988 and has served as Chairman
of the Board and Chief Executive Officer since that time. Mr. Wattles served as
President of the Company from June 1988 to September 1997. Mr. Wattles has been
an owner and operator in the video rental industry since 1985. He has been a
participant and key speaker in several entertainment industry panels and
conferences and currently serves as a member of the Video Software Dealers
Association (VSDA) Board of Directors.
JEFFREY B. YAPP was appointed President and Chief Operating Officer of the
Company in September 1997. Prior to joining the Company, Mr. Yapp served as
President Worldwide of Twentieth Century Fox Home Entertainment, Inc. from May
1997 until September 1997, and as President of Fox International from October
1994 to May 1997. Previously, Mr. Yapp was Vice President of Marketing for
Pizza Hut, Inc. from October 1994, and International Vice President of Ernest
and Julio Gallo Winery from April 1986 to October 1992.
JEFFREY D. JORDAN became President of Internet Hollywood, Inc. in February
1999. From September 1998 to February 1999, Mr. Jordan was Chief Financial
Officer of the Company. Mr. Jordan worked at the Walt Disney Company from
September 1990 until joining Hollywood, most recently as Senior Vice President
and Chief Financial Officer of the Disney Store Worldwide, a specialty retailer
that operates over 600 company-owned stores in eleven countries. Prior to that
position, he was Vice President in Disney's corporate Strategic Planning group.
Mr. Jordan worked at The Boston Consulting Group from September 1987 to
September 1990.
DAVID G. MARTIN was appointed Executive Vice President and Chief Financial
Officer, in February 1999. From 1996 until he joined the Company, Mr. Martin
worked for NationsBanc Montgomery Securities LLC, most recently as a Managing
Director of high yield finance. From 1991 to 1996, he was a Vice President of
high yield finance and merchant banking at Nomura Securities International, Inc.
Prior to 1991 Mr. Martin was an investment banker with Salomon Brothers, Inc,
specializing in mergers and acquisitions.
DONALD J. EKMAN became a director of the Company in June 1993, became Vice
President and General Counsel in March 1994 and became Senior Vice President in
1995. Mr. Ekman was a partner in Ekman & Bowersox from January 1992 until
March 1994, and from August 1990 until December 1991 he practiced law with
Foster Pepper & Shefelman.
ALEX M. BOND joined Internet Hollywood in March 1999 as Senior Vice
President of Internet Development. From January 1997 until February 1999 he was
Executive Vice President of Strategic Development for Just for Feet, Inc. From
January of 1995 until January 1997 he was with Hollywood Entertainment
Corporation as Vice President of Strategic Development. From February 1993 until
January 1995, he was an investment banker with Montgomery Securities
specializing in growth retail.
F. BRUCE GIESBRECHT was named Senior Vice President of Product Management
in January 1996 and became Senior Vice President of Strategic Planning in
January 1998. He joined the Company in May 1993 as Vice President of Corporate
Information Systems and Chief Information Officer. 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.
GLENN E. HAHN joined the Company in April 1996 as Senior Vice President of
Operations and in January 1997 became Senior Vice President of Human Resources.
From 1993 to 1996 Mr. Hahn was Senior Vice President Director of Stores for
Fayva/Parade of Shoes (a specialty retail footwear division of J. Baker),
overseeing approximately 400 stores. From 1979 to 1993 Mr. Hahn worked for
Payless Shoesource (a division of May Department Stores) in various capacities.
From 1987 to 1993 Mr. Hahn worked as Division Operations Manager for Payless
Shoesource, overseeing approximately 580 specialty retail footwear stores at the
time of his departure.
DALE A. NAFTZGER joined the Company in April 1996 as Senior Vice President
of Operations. From March 1995 to December 1995, Mr. Naftzger was Chief
Operating Officer of Caribou Coffee Company, a privately owned specialty coffee
retailer. From 1994 to 1995 Mr. Naftzger was President and Chief Executive
Officer of Chop Chop Chinese to You, a Chinese food delivery business. From
1992 to 1994 Mr. Naftzger was Senior Vice President Operations for Checkers
Drive-In Restaurants, overseeing all 248 company-owned and 200 franchised units.
ROGER J. OSBORNE is the Senior Vice President of Operations. Prior to
joining Hollywood in January 1999, he was the Executive Vice President of J.
Baker,Corporation, an apparel and footwear retailer, and President of its Work
`N Gear Division since June 1997. Before joining J. Baker Corporation, Mr.
Osborne was Senior Vice President and Zone Director for Mid-West and East coast
markets for Hollywood from November 1996 until May of 1997, and from January
1995 to November 1996, he served as the Senior Vice President of J. Baker, Inc.
and Director of its licensed shoe department business. From 1988 until January
1995, Mr. Osborne was employed as Senior Vice President and Director of Store
Operations for Pic `n Pay Stores, Inc., a chain of discount footwear stores.
J. PATRICK O'MALLEY joined the Company in October 1995 as Senior Associate
General Counsel. In May 1998, Mr. O'Malley was promoted to Senior Vice
President of Asset Management. In January 1999, Mr. O'Malley became the Senior
Vice President of Information Systems. Prior to joining the Company,
Mr. O'Malley practiced law for over 17 years and was most recently the senior
partner in O'Malley & Antell.
WILLIAM B. SHULL III joined the Company in February 1998 as Senior Vice
President of Operations. Mr. Shull previously served in various capacities at
AutoZone, most recently as the Regional Vice President overseeing the operations
and development for 250 stores.
WILLIAM M. SPAE joined the Company in July 1996 as Senior Vice President of
Operations, and in 1997 became Senior Vice President of Operations
Administration. From 1991 to June 1996 Mr. Spae worked for Wendy's
International as Divisional Vice President, overseeing the development of
approximately 130 new units during this period and the overall operations of
more than 100 company-owned and 150 franchised units at the time of his
departure. From 1987 to 1991 Mr. Spae was a Zone Vice President for Taco Bell
Corporation, overseeing more than 160 company-owned and approximately 100
franchised units.
*Executive officers
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company has not paid any cash dividends on its common stock since its
initial public offering in July 1993 and anticipates that future earnings will
be retained for the development of its business. The payment of any future
dividends will be at the discretion of the Company's Board of Directors. Loan
covenants contained in its senior subordinated notes limit the amount of
dividends the Company may pay and the amount of stock it may repurchase. As of
December 31, 1998, these covenants effectively prohibit any dividends or stock
repurchases. The Company's common stock is traded on the Nasdaq National Market
("Nasdaq") under the symbol "HLYW". The following table sets forth the
quarterly high and low last sale prices per share, as reported on Nasdaq.
1998 1997
---------------- -----------------
Quarter High Low High Low
---------- ------ ----- ------ ------
First $14.81 $8.03 $25.88 $18.25
Second 15.00 10.13 25.25 17.50
Third 20.00 9.75 23.38 11.50
Fourth 29.88 8.75 14.38 8.13
As of December 31, 1998, there were 211 holders of record of the Company's
common stock.
ITEM 6. SELECTED FINANCIAL DATA
YEAR ENDED DECEMBER 31,
---------------------------------------------
1998 1997 1996 1995 1994
---------------------------------------------
(in thousands, except per share amounts)
OPERATING RESULTS:
Revenue $763,908 $500,501 $302,342 $149,430 $ 73,288
-------- -------- -------- -------- --------
Income (loss) from
operations (37,913) 41,681 38,418 17,537 12,610
-------- -------- -------- -------- --------
Interest expense 31,893 13,806 4,339 490 795
-------- -------- -------- -------- --------
Income (loss) before
extraordinary item
and cumulative
effect of a change
in accounting
principle (50,464) 5,559 20,630 11,786 8,143
-------- -------- -------- -------- -------
Net income (loss) (50,464) 4,996 20,630 9,226 8,143
-------- -------- -------- -------- -------
- --------------------------------------------------------------------------------
NET INCOME (LOSS) PER SHARE BEFORE EXTRAORDINARY
ITEM AND CUMULATIVE EFFECT OF A CHANGE IN
ACCOUNTING PRINCIPLE:
Basic $(1.30) $ 0.15 $ 0.60 $ 0.37 $ 0.33
Diluted (1.30) 0.15 0.59 0.36 0.32
NET INCOME (LOSS)
PER SHARE:
Basic $ (1.30) $ 0.14 $ 0.60 $ 0.28 $ 0.33
Diluted (1.30) 0.13 0.59 0.28 0.32
- ------------------------------------------------------------------------------
BALANCE SHEET DATA:
Videocassette rental
inventory, net $259,255 $226,051 $144,264 $ 86,889 $36,656
Property and
equipment, net 328,182 234,497 115,812 65,958 14,606
Total assets 934,434 689,123 451,295 334,660 142,861
Long-term
obligations (1) 392,145 233,496 82,361 7,971 3,505
Mandatorily
redeemable common
stock - - - 54,250 -
Shareholders' equity 345,695 289,896 274,703 217,783 110,765
- ------------------------------------------------------------------------------
OTHER DATA
Adjusted EBITDA (2)
Hollywood
Superstores $129,397 $76,880 $57,740 $31,516 $17,875
Reel.com (7,322) - - - -
-------- -------- --------- -------- -------- -------
Consolidated 122,075 81,486 57,740 31,516 17,875
- --------------------------------------------------------------------------------
(1) Includes the current portion of long-term obligations.
(2) Adjusted EBITDA is significant to the Company's calculations of its
financial covenants and represents income from operations before
depreciation and amortization plus non-cash expenses that reduced EBITDA,
less 30% of rental revenue after deducting from such 30% of rental revenue
any cash charges associated with the acquisition of new release
videocassettes. The non-cash expenses represent the cost of goods sold on
previously viewed videocassettes and losses on inventory shrink. The
Company believes 30% of rental revenue approximates amounts spent on
purchase of new release videocassettes which are capitalized. Adjusted
EBITDA should not be viewed as a substitute for Generally Accepted
Accounting Principles (GAAP) measurements such as net income or cash
flow from operations.
FINANCIAL HIGHLIGHTS
Year Ended December 31,
-----------------------------------------------
1998 1997 1996 1995 1994
-----------------------------------------------
(in thousands, except per share amounts and other operating data)
FINANCIAL DATA:
Rental revenue $633,140 $418,527 $252,625 $123,894 $ 61,941
Product sales 130,768 81,974 49,717 25,536 11,347
-------- -------- -------- -------- --------
Total revenue 763,908 500,501 302,342 149,430 73,288
-------- -------- -------- -------- --------
Net income (loss) (1) (50,464) 4,996 20,630 9,226 8,143
- ------------------------------------------------------------------------------
PRO FORMA STATEMENT OF
OPERATIONS DATA
HOLLYWOOD VIDEO
SUPERSTORES (2):
Income from
operations $83,921 $ 53,083 $ 38,418 $ 17,537 $ 9,745
Net income 31,139 23,573 20,630 11,786 6,277
Net income per
diluted share (3) 0.78 0.63 0.59 0.36 0.25
REEL.COM (2):
Loss from operations (7,479) - - - -
- ------------------------------------------------------------------------------
OPERATING DATA:
Number of stores at
year end 1,260 907 551 305 113
Comparable store
revenue increase (4) 8% 3% 7% 1% 7%
- ------------------------------------------------------------------------------
OTHER DATA:
Weighted average
shares outstanding:
Basic 38,844 36,659 34,162 32,230 24,717
Diluted 38,844 37,718 35,159 32,962 25,578
(1) Net income(loss) for the years presented includes the following special
and/or unusual charges:
(in thousands) 1998 1997 1996 1995 1994
- ---------------------- ------- -------- -------- -------- -------
SPECIAL AND/OR UNUSUAL
PRE-TAX CHARGES:
HOLLYWOOD VIDEO
SUPERSTORES:
Settlement of securities
class action lawsuit - $18,874 - - -
Write-off obsolete video
game inventory and related
accessories - 6,798 - - -
Failed self-tender
offer - 4,604 - - -
Inventory valuation
charge $99,910 - - - -
REEL.COM:
Purchased in-process
research and development 1,900 - - - -
OTHER UNUSUAL CHARGES,
NET OF RELATED INCOME
TAX EFFECT:
HOLLYWOOD VIDEO
SUPERSTORES:
Extraordinary loss on
extinguishment of debt - 563 - - -
Cumulative effect of a
change in accounting
principle - - - $ 2,560 -
(2) Pro forma income (loss) from operations and net income eliminates special
and/or unusual charges noted above by segment and in addition Reel.com loss
from operations excludes goodwill amortization of $12.5 million (see Notes 4,
10 and 15 to the Consolidated Financial Statements). See Note 17 to the
Consolidated Financial Statements for the presentation of segment reporting.
(3) Net income per diluted share for Hollywood Video Superstores was computed by
assuming a 40.5% effective tax rate and diluted weighted average shares
outstanding of 40,133.
(4) A store is comparable after it has been open and owned by the Company for
12 full months. An acquired store converted to the Hollywood Video name and
store design is removed from the comparable store base when the conversion
process is initiated and returned 12 full months after reopening.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Summary Results of Operations
The Company's net loss for 1998 was $50.5 million, compared to net income
of $5.0 million and $20.6 million in 1997 and 1996, respectively. The 1998 and
1997 results included special and/or unusual items as previously noted.
The following table sets forth, for the periods indicated, (i) selected
statement of operations data expressed as a percentage of total revenue; and
(ii) the number of stores open at the end of each such period.
Year Ended December 31,
------------------------
1998 1997(1) 1996
------ ------ ------
REVENUE:
Rental revenue 82.9% 83.6% 83.6%
Product sales 17.1% 16.4% 16.4%
------ ------ ------
100.0% 100.0% 100.0%
------ ------ ------
OPERATING COSTS AND EXPENSES:
Cost of product sales 11.5% 10.2% 10.2%
Operating and selling 72.6% 72.4% 69.1%
General and administrative 4.9% 5.4% 6.0%
Amortization of intangibles 2.6% 1.3% 2.0%
Purchased in-process research and
development 0.3% - -
Inventory valuation charge 13.1% - -
------ ------ ------
105.0% 89.3% 87.3%
------ ------ ------
INCOME (LOSS) FROM OPERATIONS (5.0%) 10.7% 12.7%
Nonoperating expense (4.1%) (2.7%) (1.4%)
------ ------ ------
Income (loss) before income taxes (9.1%) 8.0% 11.3%
====== ====== ======
Net income (loss) (6.6%) 4.7% 6.8%
====== ====== ======
- ------------------------------------------------------------------------------
Number of superstores - end of period 1,260 907 551
(1) Adjusted to exclude the special and/or unusual costs and expenses in 1997.
See Notes 10 and 15 to the Consolidated Financial Statements.
REVENUE
Revenue increased by $263.4 million, or 53%, in 1998 compared to 1997,
primarily due to the addition of 353 new superstores in 1998. Revenue was also
favorably impacted by an increase of 8% in comparable store revenue in the
current year and the purchase of Reel.com in October 1998, which added $7.3 (on-
line revenue of $6.8 million) million in revenue. Revenue increased by $198.2
million, or 66%, in 1997 compared to 1996, due to the addition of 356 new
superstores in 1997 combined with an increase of 3% in comparable store revenue.
The Company ended 1998 with 1,260 superstores operating in 42 states, compared
to 907 stores operating in 42 states at the end of 1997 and 551 stores operating
in 29 states at the end of 1996. The Company increased its prices at most
stores in the fourth quarter of 1998 from $1.49 to $1.99 for catalog titles and
from $2.99 to $3.49 for new releases.
OPERATING COSTS AND EXPENSES
Cost of Product Sales
The cost of product sales as a percentage of product revenue increased from
62.4% in 1997, as adjusted for the game inventory write-off discussed below, to
65.2% in 1998, excluding Reel.com. The decline in product margin in 1998 is
primarily due to continuing pricing pressure on sell-through video merchandise
from mass merchant retailers, which use video sales as a loss leader to drive
customer traffic. The cost of product sales, as a percentage of product
revenue, including Reel.com was 67.1% in 1998.
The cost of product sales as a percentage of product sales increased from
61.8% in 1996 to 65.2% in 1997 due to the write-off of obsolete video game
inventory and related accessories caused by advancements in video game
technology (see Note 15 to the Consolidated Financial Statements) and pricing
pressures in the fourth quarter of 1997. The cost of product sales, as
adjusted, as a percentage of product sales remained relatively constant in 1997
compared to 1996.
Operating and Selling
Operating and selling expenses as adjusted, which consist principally of
all store expenses, including payroll, occupancy, advertising, depreciation and
rental revenue sharing, increased slightly from 72.4% in 1997 to 72.6% in 1998
primarily due to increased advertising and revenue sharing expense, mostly
offset by increased revenues without a proportionate increase in other store
operating expenses. The Company anticipates that rental product amortization
combined with revenue sharing expense will increase as a percentage of total
revenue in 1999. This increase is due to the Company's new revenue sharing
business model and new amortization method (see Note 4 to the Consolidated
Financial Statements). The Company expects that other operating and selling
expenses will decline as a percentage of revenue due to the increased sales
generated by the revenue sharing arrangements.
Operating and selling expenses, as adjusted increased as a percentage of
total revenue to 72.4% in 1997 from 69.1% in 1996. This increase was due to the
lower average revenues per store in 1997, resulting primarily from the addition
of 606 new superstores in 1996 and 1997, which had lower revenue per store than
mature Hollywood Video superstores.
General and Administrative
General and administrative expenses, as adjusted, decreased as a percentage
of total revenue to 4.9% in 1998 compared to 5.4% in 1997 and 6.0% in 1996.
These decreases as a percentage of total revenue were due to the increase in
total revenue without a proportionate increase in corporate overhead.
Amortization of Intangibles
Amortization of intangibles increased by $13.4 million in 1998 compared to
1997 due to the Reel.com acquisition as discussed in Note 7 to the Consolidated
Financial Statements combined with the full year impact of amortizing deferred
financing costs associated with the Company's notes and credit facility.
Amortization of intangibles increased by $0.7 million in 1997 compared to 1996,
primarily due to the impact of amortizing deferred financing costs associated
with the Company's senior subordinated notes and new revolving credit facility.
Other Operating Charges
The Company incurred a non-cash charge of $1.9 million in 1998 to write off
the value of purchased in-process research and development costs in connection
with the acquisition of Reel.com. The Company also changed its method of
amortizing its videocassette rental inventory in 1998 and recorded a non-cash
charge of $99.9 million to reflect the application of the new method to
inventory on hand at October 1, 1998. See Notes 4 and 7 to the Consolidated
Financial Statements.
Nonoperating Income (Expense), Net
Interest expense, net of interest income increased in 1998 compared to 1997
and 1996 due to increased levels of borrowings associated with the issuance of
senior subordinated notes in August 1997 (see Note 10 to the Consolidated
Financial Statements), combined with increased borrowings under the revolving
credit facility. The Company incurred a cash charge of $18.9 million in 1997
for the settlement of the securities litigation (see Note 15 to the Consolidated
Financial Statements).
INCOME TAXES
The Company's effective tax rate was a benefit of 27.6% in 1998 compared to
a provision of 40.5% in 1997 and a provision of 39.8% in 1996, given the
Company's net loss for financial reporting purposes versus net income for tax
reporting purposes as a result of the non-deductibility of goodwill amortization
associated with the Reel.com acquisition (see Note 11 to the Consolidated
Financial Statements). The Company believes that in 1999 the effective tax
rate will exceed 40%.
LIQUIDITY AND CAPITAL RESOURCES
The Company generates substantial operating cash flow because most of its
revenue is received in cash. The amount of cash generated from operations in
1998 significantly exceeded debt service requirements of the Company' long-term
obligations. The capital expenditures (including purchases of videocassette
rental inventory) of the Company are primarily funded by the excess operating
cash flow and through loans under a revolving line of credit. The Company has a
$300 million revolving line of credit available to address the timing of certain
working capital and capital expenditure disbursements. The Company believes
cash
flow from operations, supplemented by the availability of a revolving line of
credit, will provide the Company with adequate liquidity and the capital
necessary to achieve its planned expansion through at least 1999.
At December 31,1998, the Company had cash and cash equivalents of $4.0
million and a working capital deficit of $64.8 million. Videocassette rental
inventories are accounted for as noncurrent assets under Generally Accepted
Accounting Principles because they are not assets which are reasonably expected
to be completely realized in cash or sold in the normal business cycle.
Although the rental of this inventory generates a substantial portion of the
Company's revenue, the classification of these assets as noncurrent excludes
them from the computation of working capital. The acquisition cost of
videocassette rental inventories, however, is reported as a current liability
until paid and, accordingly, included in the computation of working capital.
Consequently, the Company believes working capital is not as significant a
measure of financial condition for companies in the video retail industry as it
is for companies in other industries. Because of the accounting treatment of
videocassette rental inventory as a noncurrent asset, the Company may, from time
to time, operate with a working capital deficit.
Cash Provided by Operating Activities
During 1998, net cash generated by operations was $69.1 million higher than
the prior year. This increase was primarily due to an increase in depreciation
and amortization expenses combined with improved results of operations,
excluding the impact of the non-cash charges related to the inventory valuation
charge and the write-off of purchased in process research and development costs
(see "Results of Operations"), partially offset by a net unfavorable change in
deferred income taxes (see Note 11 to the Consolidated Financial Statements).
Cash Used in Investing Activities
Net cash used in investing activities increased by $100.3 million from the
prior year primarily due to increased purchases of videocassette rental
inventory for new and existing stores and an increase in investment in
businesses acquired, partially offset by reduced capital expenditures with
respect to new store construction, remodeling of certain existing stores and for
the continued development of management information systems (see "Capital
Expenditures"). The Company paid approximately $32.7 million in cash for
Reel.com and approximately $14.1 million for 41 video stores, of which $8.1
million was paid in cash and $6.0 million was paid with a note payable (see Note
7 to the Consolidated Financial Statements). The Company incurred a $99.9
million non-cash, pre-tax charge in the fourth quarter of 1998 for a change in
the method of amortization of its videocassette rental inventory (see Note 4 of
the Consolidated Financial Statements).
Cash Provided by Financing Activities
Net cash provided by financing activities increased by $40.2 million from
the prior year primarily due to the issuance of 3.4 million shares of the
Company's common stock in connection with the Reel.com acquisition for an
aggregate amount of $45.4 million (see Note 7 to the Consolidated Financial
Statements), partially offset by the repurchase of 850,000 shares of the
Company's common stock for approximately $10.5 million.
Capital Expenditures
The Company's capital expenditures include product for stores, store equipment
and fixtures, remodeling a certain number of existing stores, implementing and
upgrading office and store technology and opening for new store locations. Each
new store opening requires initial capital expenditures, including leasehold
improvements, inventory, equipment and costs related to site location, lease
negotiations and construction permits of $0.6 million, excluding leasehold
improvements that are customarily paid for by the property developer. These
capital expenditures will be funded primarily by cash generated from
operations, supplemented by the availability of a senior revolving line of
credit or other forms of equipment financing and/or leasing, if necessary.
YEAR 2000 ISSUES
The year 2000 issue is the result of computer programs that were written
using two digits rather than four to define the applicable year. For example,
computer programs that have time-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. To the extent that the
Company's software applications contain source code that is unable to interpret
appropriately the upcoming calendar year 2000 and beyond, some level of
modification or replacement of such applications will be necessary to avoid
system failures and the temporary inability to process transactions or engage in
other normal business activities.
The Company's year 2000 project group has been coordinating the Company's
year 2000 compliance efforts and has identified all computer-based systems and
applications (including embedded systems) the Company uses in its operations
that might not be year 2000 compliant. The Company is determining what
modifications or replacements will be necessary to achieve compliance;
implementing any necessary modifications and replacements; conducting tests
necessary to verify that the modified systems are operational; and transitioning
the compliant systems into the regular operations of the Company. The Company
estimates that these actions with respect to systems that we believe would have
a material effect on the business are approximately three-fourths complete. The
Company estimates that all critical systems and applications will be year 2000
compliant by June 30, 1999.
The year 2000 project group is also examining the Company's relationship with
certain key outside vendors and others with whom the Company has significant
business relationships to determine, to the extent practical, the degree of such
outside parties' year 2000 compliance. The project group has begun testing
procedures with certain vendors identified as having potential year 2000
compliance issues. The Company does not believe that its relationship with any
third party is material to the Company's operations and, therefore, does not
believe that the failure of any particular third party to be year 2000 compliant
would have a material adverse effect on the Company. The Company believes that,
if it, or any third party with whom the Company has a significant business
relationship, has a year 2000 related systems failure, the most significant
impact would likely be the inability, with respect to a group of stores, to
conduct operations due to a power failure, to deliver inventory in timely
fashion, to receive certain products from vendors or to process electronically
customer sales at store level. The Company does not anticipate that any such
impact would be material to the Company's liquidity or results of operations.
The year 2000 project group is establishing and implementing a contingency
plan to provide for viable alternatives to ensure that the Company's core
business operations are able to continue in the event of a year 2000 related
systems failure. The Company expects to have a comprehensive contingency plan
established by June 30, 1999.
The Company estimates that it will incur approximately $0.7 million, to
address year 2000 compliance issues, which includes the estimated costs of all
modifications, testing and consultant fees.
GENERAL ECONOMIC TRENDS, QUARTERLY RESULTS AND SEASONALITY
The Company anticipates that its business will be affected by general
economic and other consumer trends. Future operating results may be affected by
various factors, including variations in the number and timing of new store
openings, the performance of new or acquired stores, the quality and number of
new release titles available for rental and sale, the expense associated with
the acquisition of new release titles, additional and existing competition,
marketing programs, weather, special or unusual events and other factors that
may affect retailers in general. In addition, any concentration of new store
openings and the related new store pre-opening costs and other expenses
associated with the opening of new stores near the end of a fiscal quarter could
have an adverse effect on the financial results for that quarter and could, in
certain circumstances, lead to fluctuations in quarterly financial results.
The video retail industry generally experiences relative revenue declines
in April and May, due in part to the change in Daylight Savings Time and due to
improved weather, and in September and October, due in part to the start of
school and the introduction of new television programs. The Company believes
these seasonality trends will continue.
FORWARD LOOKING STATEMENTS
The information set forth in this report in Item 1, Business, under the
caption "Expansion Strategy" with respect to planned new store openings and in
Item 7, Management's Discussion and Analysis of Financial Condition and Results
of Operations, under the caption "Liquidity and Capital Resources" with respect
to planned new store openings and the sufficiency of financial resources and
under the caption "Year 2000 Issues" with respect to Year 2000 preparedness and
financial consequences includes "forward-looking statements" within the meaning
of Section 27A of the Securities Act of 1933 and is subject to the safe harbor
created by that section. Certain factors that could cause results to differ
materially from those projected in the forward-looking statements are set forth
in Item 1, Business, under the captions "Expansion Strategy" and "Competition,"
in Item 7, Management's Discussions and Analysis of Financial Conditions and
Results of Operations, under the caption "General Economic Trends, Quarterly
Results and Seasonality" and in Item 3, Legal Proceedings.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Incorporated by reference to Item 14 of this report on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to directors of the Company is hereby incorporated
by reference from the Company's definitive proxy statement, under the caption
"Nomination and Election of Board of Directors," for its 1999 annual meeting of
shareholders (the "1999 Proxy Statement") to be filed pursuant to Regulation 14A
promulgated by the Securities and Exchange Commission under the Securities
Exchange Act of 1934, which proxy statement is anticipated to be filed no later
than 120 days after the end of the Company's fiscal year ended December 31,
1998. Information with respect to executive officers of the Company is included
under Item 4(a) of Part I of this report.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this Item 11 is hereby incorporated by reference
from the 1999 Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required by this Item 12 is hereby incorporated by reference
from the 1999 Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this Item 13 is hereby incorporated by reference
from the 1999 Proxy Statement.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
Listed below are all financial statements, notes, schedules and exhibits
filed as part of this Annual Report on Form 10-K:
(a)(1), (2) FINANCIAL STATEMENTS
The following financial statements of the Registrant, together with the
Report of Independent Accountants dated March 1, 1999, on pages F-1 to F-24
of this report on Form 10-K are filed herewith:
(i) Financial Statements
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1998 and 1997
Consolidated Statements of Operations for the years ended December 31,
1998, 1997 and 1996
Consolidated Statements of Changes in Shareholders' Equity for the years
ended December 31, 1998, 1997 and 1996
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996
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)(3) Exhibits
The following exhibits are filed with or incorporated by reference into
this Annual Report:
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
3.1 1993B Restated Articles of Incorporation, as amended (incorporated by
reference to the Registrant's Registration Statement on Form S-1 (File
No. 33-63042)(the "Form S-1") to Exhibit 4 to the Registrant's
Registration Statement on Form S-3 (File No. 33-96140), and to Exhibit
3.1 to the Registrant's Quarterly Report on Form 10-Q for the quarter
ended September 30, 1998.
3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the Form S-1).
4.1 Rights of Security Holders - See Article II of Exhibit 3.1 and
Articles I and V of Exhibit 3.2.
10.1 Indenture, dated August 13, 1997, between the Registrant and U.S.
Trust Company of California, N.A. (incorporated by reference to
Exhibit 4.1 to the Registration Statement on Form S-4 (No.333-351)(the
"1997 S-4").
10.2 1993 Stock Incentive Plan, as amended (incorporated by reference to
Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for the
quarter ended June 30, 1997).
10.3 Form of Incentive Stock Option Agreement (incorporated by reference to
Exhibit 10.1 of the Form S-1).
10.4 Form of Nonqualified Stock Option Agreement (incorporated by reference
to Exhibit 10.3 of the Form S-1).
10.5 Revolving Credit Agreement, dated as of September 5, 1997, among the
Registrant, as Borrower, and Societe Generale, DLJ Capital Funding,
Inc. Goldman Sachs Credit Partners L.P. and certain other financial
institutions, as Lenders, and Societe Generale, as Agent for the
Lenders, Donaldson, Lufkin & Jenrette Securities Corporation, as
Administrative Agent, Goldman Sachs Credit Partners, L.P., as
Documentation Agent, and Credit Lyonnais Los Angeles Branch, Barclays
Bank PLC, Deutsche Bank AG, New York Branch, U.S. Bank National
Association and KeyBank National Association, as Co-Agents
(incorporated by reference to Exhibit 10.1 of the 1997 S-4).
10.6 Employment letter between the Registrant and Jeffrey B. Yapp, dated
July 31, 1997 (incorportated by reference to Exhibit 10.7 to the
Registrant's Annual Report on Form 10-K for the year ended
December 31, 1998). *
18.1 Preferability letter from PricewaterhouseCoopers LLP.
21.1 List of Subsidiaries.
23.1 Consent of PricewaterhouseCoopers LLP.
27.1 Financial Data Schedule.
(b) REPORTS ON FORM 8-K:
A report on Form 8-K was filed by the Company on October 15, 1998 to
report under Item 2 the acquisition of Reel.com, Inc. Form 8-K/A was
filed by the Company on December 15, 1998 to report under Item 7 the
financial statements and pro forma financial information relating to
the acquisition of Reel.com, Inc.
*Management Contract.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders
of Hollywood Entertainment Corporation
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in shareholders' equity and of
cash flows present fairly, in all material respects, the financial position of
Hollywood Entertainment Corporation and its subsidiaries at December 31, 1998
and 1997, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles. 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 generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
As discussed in Note 4 of the consolidated financial statements, the Company
changed its amortization method for videocassette rental inventory in 1998.
PricewaterhouseCoopers LLP
Portland, Oregon
March 1, 1999
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
December 31
------------------
1998 1997
-------- --------
ASSETS
- --------
Current assets:
Cash and cash equivalents $ 3,975 $ 3,909
Accounts receivable 40,862 39,566
Merchandise inventories 58,083 61,482
Prepaid expenses and other current
assets 12,138 6,488
-------- --------
Total current assets 115,058 111,445
Videocassette rental inventory, net 259,255 226,051
Property and equipment, net 328,182 234,497
Goodwill, net 185,711 93,760
Deferred income tax 35,513 11,334
Other assets, net 10,715 12,036
-------- --------
$934,434 $689,123
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Current maturities of long-term
obligations $ 8,418 $ 2,341
Accounts payable 121,365 103,823
Accrued expenses 21,164 29,423
Accrued revenue sharing 13,500 -
Accrued interest 9,693 8,256
Income taxes payable 5,739 -
-------- --------
Total current liabilities 179,879 143,843
Long-term obligations, less current
portion 383,727 231,155
Other liabilities 25,133 24,229
-------- --------
588,739 399,227
-------- --------
Commitments and contingencies - -
Shareholders' equity:
Preferred stock, 19,500,000 shares
authorized no shares issued and
outstanding - -
Common stock 100,000,000 shares
authorized; 44,933,055
and 36,786,396 shares
issued and outstanding 354,067 247,950
Retained (deficit) earnings (6,476) 43,988
Intangible assets, net (1,896) (2,042)
-------- --------
Total shareholders' equity 345,695 289,896
-------- --------
$934,434 $689,123
======== ========
See notes to consolidated financial statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Year Ended December 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
REVENUE:
Rental revenue $ 633,140 $ 418,527 $ 252,625
Product sales 130,768 81,974 49,717
--------- --------- ---------
763,908 500,501 302,342
--------- --------- ---------
OPERATING COST AND EXPENSES:
Cost of product sales 87,799 53,471 30,707
Operating and selling 554,596 366,960 208,895
General and administrative 37,543 31,698 18,302
Amortization of intangibles 20,073 6,691 6,020
Purchased in-process research
and development 1,900 - -
Inventory valuation charge 99,910 - -
--------- --------- --------
801,821 458,820 263,924
--------- --------- --------
INCOME (LOSS) FROM OPERATIONS (37,913) 41,681 38,418
Nonoperating income (expense):
Interest income 141 342 203
Interest expense (31,893) (13,806) (4,339)
Litigation settlement - (18,874) -
--------- --------- --------
Income (loss) before income taxes
and extraordinary item (69,665) 9,343 34,282
Benefit from (provision for)
income taxes 19,201 (3,784) (13,652)
--------- --------- --------
Income (loss) before extraordinary
item (50,464) 5,559 20,630
Extraordinary loss on
extinguishment of debt
(net of income tax
benefit of $372) - (563) -
--------- --------- --------
NET INCOME (LOSS) $(50,464) $ 4,996 $ 20,630
========= ========= =========
- -----------------------------------------------------------------------------
NET INCOME (LOSS) PER SHARE BEFORE EXTRAORDINARY ITEM:
Basic $ (1.30) $ 0.15 $ 0.60
Diluted (1.30) 0.15 0.59
- -----------------------------------------------------------------------------
NET INCOME (LOSS) PER SHARE:
Basic $ (1.30) $ 0.14 $ 0.60
Diluted (1.30) 0.13 0.59
- -----------------------------------------------------------------------------
WEIGHTED AVERAGE SHARES OUTSTANDING:
Basic 38,844 36,659 34,162
Diluted 38,844 37,718 35,159
- -----------------------------------------------------------------------------
See notes to consolidated financial statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(In thousands, except share amounts)
Common Stock Retained
--------------------Intangible Earnings
Shares Amount Assets (Deficit) Total
---------- -------- -------- -------- --------
Balance at December 31, 1995 33,879,738 $202,005 $(2,584) $18,362 $217,783
Issuance of common stock:
Public offerings, net 2,000,000 34,705 - - 34,705
Stock options exercised 126,463 838 - - 838
Tax benefit from stock options - 473 - - 473
Amortization of intangible assets - - 274 - 274
Net income - - - 20,630 20,630
---------- -------- -------- -------- --------
Balance at December 31, 1996 36,006,201 238,021 (2,310) 38,992 274,703
Issuance of common stock:
Public offerings, net 300,000 4,695 - - 4,695
Stock options exercised 480,195 3,712 - - 3,712
Tax benefit from stock options - 1,522 - - 1,522
Amortization of intangible assets - - 268 - 268
Net income - - - 4,996 4,996
---------- -------- -------- -------- --------
Balance at December 31, 1997 36,786,396 247,950 (2,042) 43,988 289,896
Issuance of common stock:
Stock options exercised 633,859 4,376 - - 4,376
Tax benefit from stock options - 2,563 - - 2,563
Reel.com acquisition 5,000,000 53,450 - - 53,450
Sold to Reel.com affiliates 3,362,800 45,398 - - 45,398
Stock options issued for
Reel.com acquisition - 10,840 - - 10,840
Common stock repurchases (850,000) (10,510) - - (10,510)
Amortization of intangible assets - - 146 - 146
Net loss - - - (50,464) (50,464)
---------- -------- -------- -------- --------
Balance at December 31, 1998 44,933,055 $354,067 $(1,896) $(6,476) $345,695
========== ======== ======== ======== ========
See notes to consolidated financial statements
HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year Ended December 31,
------------------------------
1998 1997 1996
--------- ------- --------
OPERATING ACTIVITIES:
Net income (loss) $(50,464) $ 4,996 $ 20,630
Adjustments to reconcile net income (loss)
to cash provided by operating activities:
Extraordinary loss on extinguishment of debt - 563 -
Depreciation and amortization 196,849 140,201 87,115
Inventory valuation charge 99,910 - -
Write-off of purchased in-process
research and development 1,900 - -
Change in deferred rent 3,961 3,467 3,083
Change in deferred income taxes (27,236) (1,985) 3,350
Net change in operating assets and liabilities:
Accounts receivable (1,071) (13,781) (9,631)
Merchandise inventories 3,749 (16,227) (19,264)
Accounts payable 10,194 36,616 24,429
Accrued interest 1,437 7,843 358
Other current assets and liabilities 4,849 13,263 5,728
Cash provided by operating activities 244,078 174,956 115,798
INVESTING ACTIVITIES:
Purchases of videocassette rental
inventory, net (265,158) (194,273) (124,253)
Purchase of property and equipment,
net (132,122) (139,709) (64,038)
Investment in businesses acquired (40,804) - -
Increase in intangibles and other
assets (327) (4,138) (794)
Cash used in investing activities (438,411) (338,120) (189,085)
FINANCING ACTIVITIES:
Proceeds from the issuance of common
stock, net 45,398 4,695 34,705
Issuance of long-term obligations - 203,159 -
Repayments of long-term obligations (2,429) (1,864) (7,610)
Repurchase of common stock (10,510) - -
Proceeds from exercise of stock options 4,376 3,712 838
Tax benefit from exercise of stock
options 2,563 1,522 473
Repurchase of mandatorily redeemable
common stock - - (54,250)
Increase (decrease) in revolving loan, net 155,001 (57,000) 82,000
Cash provided by financing activities 194,399 154,224 56,156
Increase (decrease) in cash and
equivalents 66 (8,940) (17,131)
Cash and cash equivalents at
beginning of year 3,909 12,849 29,980
Cash and cash equivalents at end of year $ 3,975 $ 3,909 $ 12,849
Other Cash Flow Information:
Interest expense paid 31,562 $ 6,735 4,339
Income taxes paid (refunded), net (706) 7,282 6,130
See notes to consolidated financial statements.
HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31,1998, 1997, 1996
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 subsidiaries include Hollywood Video
Superstores, Inc., Hollywood Management Company, Reel.com, Inc. and Title
Wave Stores, Inc. All significant intercompany transactions have been
eliminated.
Nature of the Business
The Company operates a chain of video superstores ("Hollywood Video")
throughout the United States and an internet retailer of video only
products ("Reel.com"). The Company was incorporated in Oregon on June 2,
1988 and opened its first store in October 1988. As of December 31, 1998
and 1997, the Company operated 1,260 stores in 42 states and 907 stores in
42 states, respectively.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally
accepted accounting principles 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
depreciation and amortization policies.
Cash and Cash Equivalents
The Company considers highly liquid investment instruments, with an
original maturity of three months or less, to be cash equivalents.
Inventories
Merchandise inventories, consisting primarily of prerecorded
videocassettes, concessions, and other accessories held for resale, are
stated at the lower of cost or market. Cost of sales are determined on a
first-in, first-out basis ("FIFO"). Videocassette rental inventory, which
also includes video games, DVDs and audio books, is stated at cost and
amortized over its estimated useful life to a specified salvage value. See
Note 4 for a discussion of the amortization policy applied to videocassette
rental inventory and a discussion of the change in amortization method
effective October 1, 1998.
Property, Equipment, Depreciation and Amortization
Property is stated at cost and is depreciated on the straight-line basis
for financial reporting purposes over the estimated useful life of the
assets, which range from approximately five to ten years. Leasehold
improvements are amortized primarily over the lesser of ten years or the
term of the lease.
Additions to property and equipment are capitalized and include
acquisitions of property and equipment, costs incurred in the development
and construction of new stores, major improvements to existing property and
major improvements in management information systems. 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.
In 1998, the Company adopted Statement of Position 98-1 ("SOP 98-1"), which
defines the types of costs that may be capitalized for internally developed
computer software. Accordingly, the Company capitalized $1.5 million.
Long-Lived Assets
The Company follows Statement of Financial Accounting Standards (SFAS) No.
121, "Accounting for the Impairment of Long-Lived Assets." The statement
establishes accounting standards for the impairment of long-lived assets to
be held and used, and for long-lived assets to be disposed. Impairment of
long-lived assets is recognized when events or changes in circumstances
indicate that the carrying amount of the asset or related group of assets
may not be recoverable. Measurement of the amount of the impairment may be
based on the market values of similar assets or estimated discounted future
cash flows resulting from use and ultimate disposition of the asset.
Management has determined that there has been no material impairment to any
long-lived assets as of December 31, 1998 and 1997.
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.
Deferred Rent
Many of the Company's operating leases contain predetermined fixed
increases of the minimum rental rate during the initial lease term. For
these leases, the Company recognizes the related rental expense on a
straight-line basis and records the difference between the amount charged
to expense and the rent paid as deferred rent.
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 Note 1), accounts receivable (see Note 2), and long-term
obligations (see Note 10).
Earnings per Share
The Company adopted SFAS No. 128, "Earnings per Share", effective December
31, 1997. SFAS No. 128 requires a dual presentation of basic and diluted
earnings per share ("EPS"). Basic EPS is computed by dividing net income
(loss) by the weighted average shares outstanding for the period. Diluted
EPS reflects the potential dilution that could occur if contracts to issue
common stock were exercised or converted to common stock. Prior periods
have been restated to conform to SFAS No. 128.
Comprehensive Income
The Company adopted SFAS No. 130, "Reporting Comprehensive Income" as of
January 1, 1998. Comprehensive income is equal to net income (loss) for
all periods presented.
Advertising
Advertising costs, net of cooperative reimbursements from vendors, are
expensed as incurred.
Segment Reporting
The Company has adopted SFAS 131, "Disclosures about Segments of an
Enterprise and Related Information" in 1998. This statement establishes
standards for reporting information about operating segments in annual
financial statements and requires selected information about operating
segments in interim financial reports issued to shareholders. The Company
has disclosed the information required by SFAS 131 in Note 17 to its
Consolidated Financial Statements.
Store Preopening Costs
Store preopening costs, including store employee labor costs and
advertising, incurred prior to the opening of a new store have been
expensed during the first full month of a store's operation. In April
1998, SOP 98-5, "Reporting on the Costs of Start-up Activities" was
finalized, which requires that costs incurred for start-up activities, such
as store openings, be expensed as incurred. The Company will implement SOP
98-5 during the first quarter of 1999 and anticipates a charge of $1.4
million, net of tax.
2. ACCOUNTS RECEIVABLE
Accounts receivable as of December 31, 1998 and 1997 consists of:
-------------------
1998 1997
-------- -------
(In thousands)
Construction receivables $ 9,234 $ 18,906
Marketing allowances and other 31,628 20,660
-------- --------
$ 40,862 $ 39,566
======== ========
The carrying amount of accounts receivable approximates fair value because
of the short maturity of those receivables.
3. VIDEOCASSETTE RENTAL INVENTORY
Videocassette rental inventory as of December 31, 1998 and 1997 consists
of:
--------------------
1998 1997
--------- ---------
(In thousands)
Videocassette rental inventory $ 450,593 $ 324,727
Less accumulated amortization (191,338) (98,676)
--------- ---------
$ 259,255 $ 226,051
========= =========
Amortization expense related to videocassette inventory was $135.2 million,
$112.5 million and $67.1 million in 1998, 1997 and 1996, respectively, and
is included in operating and selling expenses. As videocassette rental
inventory is sold, the applicable cost and accumulated amortization are
eliminated from the accounts, determined on a FIFO basis applied in the
aggregate based on monthly purchases. Any gain or loss thereon is recorded
in the Company's consolidated statements of operations.
4. CHANGE IN AMORTIZATION METHOD FOR VIDEOCASSETTE RENTAL INVENTORY
Effective October 1, 1998, Hollywood Video adopted a new method of
amortizing videocassette rental inventory. During the fourth quarter of
1998, Hollywood Video purchased a majority of new video releases under
revenue sharing arrangements with major studios, which the Company expects
to continue in the future. Revenue sharing allows the Company to purchase
videocassettes at a lower product cost than the traditional buying
arrangements, with, a percentage of the net rental revenues shared with the
studios over a contractually determined period of time. The increased copy
depth under revenue sharing arrangements satisfies consumer demand for new
releases over a shorter period of time. As the new business model results
in significantly greater proportion of rental revenue received over a
shorter period of time, the Company has changed its method of amortizing
rental inventory in order to match expenses with the anticipated revenues
to be generated therefrom.
Under the new accounting method, the Company expenses the studio's share of
revenue (net of a salvage value of $4) as revenues are earned pursuant to
the applicable contractual arrangements.
Non-revenue sharing videocassettes acquired at a fixed price are amortized
on an accelerated basis to an average net book value of $8 over four months
and then to a salvage value of $6 over the following 56 months. Previous
to October 1, 1998, new release videocassettes were amortized on an
accelerated basis over 4 months to an average net book value of $15 and
then on a straight-line basis to their salvage value of $6 over the next 32
months. Base stock videocassettes purchased at a fixed price for new store
openings
are amortized straight-line over 60 months to an estimated $6 salvage
value. Prior to October 1, 1998 base stock was amortized on a straight-
line basis to a $6 salvage value over 36 months. The change in estimate,
effective October 1, 1998 decreased net loss by $1.0 million, net of tax in
the fourth quarter of 1998. The Company anticipates that rental product
amortization combined with revenue sharing expense will increase as a
percentage of total revenue in 1999, as compared to 1998, due to the change
in the accounting method.
The new method of amortization has been applied to rental inventory held as
of October 1, 1998. The adoption of the new method of amortization has
been accounted for as a change in accounting estimate effected by a change
in accounting principle, and accordingly the Company recorded a pre-tax
charge of $99.9 million in the fourth quarter of 1998. The calculation of
the change in operating expense attributable to videocassettes for periods
prior to October 1, 1998 would not be meaningful because the new business
model involving revenue sharing arrangements had not been implemented.
5. PROPERTY AND EQUIPMENT
Property and equipment as of December 31, 1998 and 1997 consists of:
----------------------
1998 1997
---------- ----------
(In thousands)
Fixtures and equipment $ 123,068 $ 72,306
Leasehold improvements 279,805 195,203
Equipment under capital lease 3,426 3,426
Leasehold improvements under
capital lease 7,167 7,167
---------- ----------
413,466 278,102
Less accumulated depreciation
and amortization (85,284) (43,605)
---------- ----------
$ 328,182 $ 234,497
========== ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $3.0 million and
$1.6 million at December 31, 1998 and 1997, respectively.
6. GOODWILL
Goodwill as of December 31, 1998 and 1997 consists of:
-------------------
1998 1997
-------- --------
(In thousands)
Goodwill $219,502 $109,383
Less accumulated amortization (33,791) (15,623)
-------- --------
$185,711 $93,760
======== ========
Goodwill represents the excess of cost over fair value of net assets
purchased and is being amortized on a straight-line basis over 2 or 20
years. Goodwill in connection with store acquisitions is amortized over 20
years. Goodwill from the Reel.com acquisition is being amortized over 2
years. The Company assesses the recoverability of store acquisition
intangibles by determining whether the amortization of the goodwill over
the remaining lives can be recovered through projected future operating
results on an undiscounted basis. The Company believes that there are no
impaired intangible assets with respect to store acquisitions.
7. ACQUISITIONS
Reel.com
On October 1, 1998, the Company completed the merger of Reel.com, Inc.
("Reel.com") with and into Hollywood Entertainment Corporation. At the
closing, the Company acquired all the outstanding shares of Reel.com for
$32.7 million and 4,000,000 shares of Common Stock and 1,000,000 shares of
Series A Redeemable Preferred Stock. In addition, the Company assumed
Reel.com's incentive stock option plan and converted all outstanding
Reel.com stock options into options to acquire the Company's Common Stock.
Options for a total of 958,568 shares were issued in connection with the
acquisition.
Concurrent with the acquisition of Reel.com, the Company sold 1,982,537
shares of Common Stock and 1,380,263 shares of Series A Redeemable
Preferred Stock at a price of $13.50 per share to certain shareholders and
affiliates of Reel.com.
The Series A Redeemable Preferred Stock was converted into Common Stock on
a one for one basis upon shareholder approval on December 30, 1998.
The acquisition of Reel.com for approximately $96.9 million has been
accounted for under the purchase method of accounting. The financial
statements reflect the allocation of the purchase price and assumption of
Reel.com's liabilities and include the operating results from the date of
acquisition.
The following sets forth the reconciliation of the cash paid (in thousands)
for Reel.com, Inc.:
Fair value of assets acquired $ 3,634
Goodwill 100,349
Purchased research and development 1,900
Value of stock issued (53,450)
Value of stock options issued (10,840)
Liabilities assumed (8,934)
--------
Cash paid, including transaction costs,
net of cash received $32,659
========
The value of stock options issued was determined using the Black-Scholes
stock option pricing model. Goodwill is being amortized over the estimated
useful life of 2 years.
The following unaudited pro forma information presents the results of the
Company's operations assuming the Reel.com acquisition occurred at the
beginning of each period presented (in thousands, except per share data):
Year Ended December 31,
-----------------------
1998 1997
--------- ---------
Total revenue $ 773,812 $ 502,033
Net loss (97,306) (46,247)
Net loss per share:
Basic (2.16) (1.03)
Diluted (2.16) (1.03)
The pro forma financial information is not necessarily indicative of the
operating results that would have occurred had the Reel.com acquisition
been consummated as of the beginning of each period, nor is it necessarily
indicative of future operating results.
Store Acquisitions
During 1998, the Company acquired the assets of 41 video superstores
located in New York (11) and Florida (30) for an aggregate purchase price
of $14.1 million. $6.0 million of the purchase price was paid with a note
payable bearing interest at 10.0% per annum due April 1, 1999, and the
remainder was paid in cash. The acquisitions were accounted for under the
purchase method of accounting. $9.8 million was allocated to Goodwill and
is being amortized over the estimated useful life of 20 years. The results
of operations for these acquisitions do not have a material effect on the
consolidated operating results and therefore are not included in the pro
forma data presented above.
8. OPERATING LEASES
The Company leases all of its stores, corporate offices, distribution
center and zone offices under non-cancelable operating leases. All of the
Company's 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 operating leases require payment of property taxes, utilities, common
area maintenance and insurance. Total rent expense, including related
lease-required costs, incurred during 1998, 1997, and 1996 was $154.8
million, $96.0 million and $54.1 million, respectively.
At December 31, 1998, the future minimum annual rental commitments under
non-cancelable operating leases were as follows:
Operating
(in thousands)
---------------
Year
--------------
1999 $ 160,757
2000 153,951
2001 152,036
2002 149,216
2003 147,721
Future years 698,380
9. 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 $100,000 and for annual Company claims which
exceed approximately $3.0 million in the aggregate. 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 resulting
from ultimate payments will be reflected in operations in the period in
which such adjustments are known.
Beginning January 1, 1998, the Company added a 401(k) plan in which
eligible employees may elect to contribute up to 15% of their earnings.
Eligible employees who 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 does not make any matching contributions to the 401(k) plan.
The Company does not maintain any other retirement plans nor offer any form
of post-retirement benefits.
10. LONG-TERM OBLIGATIONS
The Company had the following long-term obligations as of December 31, 1998
and 1997:
--------------------
1998 1997
--------- ---------
(In thousands)
Senior subordinated notes $ 200,000 $ 200,000
Borrowings under bank revolving
credit agreement 180,000 24,999
Obligations under capital leases 6,111 8,452
Other 6,034 45
--------- ---------
392,145 233,496
Less current obligations 8,418 2,341
--------- ---------
$ 383,727 $ 231,155
========= =========
In August 1997, the Company issued $200 million principal amount of 10.625%
senior subordinated notes (the "Notes") due August 15, 2004. The proceeds
received from the sale of the Notes, net of offering costs of $6.8 million,
were used to repay the entire outstanding indebtedness under the then
existing bank revolving loan. The Company recorded a charge for the write-
off of the remaining deferred financing costs related to the indebtedness
repaid as an extraordinary loss of $0.6 million, net of related income tax
benefit of $0.4 million, in 1997.
The Notes are redeemable, at the option of the Company, after August 14,
2001 at rates starting at 105.313% of principal amount reduced annually
through August 15, 2003, at which time they become redeemable at 100% of
the principal amount. In addition, at any time prior to August 15, 2000,
the Company may redeem in the aggregate up to 35% of the original principal
amount of the Notes with the proceeds of one or more public equity
offerings, at a redemption price of 110.625% of principal amount. The terms
of the Notes may restrict, among other things, the payment of dividends and
other distributions, investments, the repurchase of capital stock and the
making of certain other restricted payments by the Company, the incurrence
of additional indebtedness by the Company or any of its subsidiaries, and
certain mergers, consolidations and disposition of assets. Additionally,
if a change of control occurs, as defined, each holder of the Notes will
have the right to require the Company to repurchase such holder's Notes at
101% of principal amount thereof.
The Company is limited in the amount of cash dividends that it can pay and
the amount of common stock and subordinated indebtedness that it may
repurchase by applicable covenants contained in the Notes.
In September 1997, the Company entered into a senior revolving credit
agreement which provides for the availability of up to $300 million in
aggregate extension of credit. The outstanding balance is due and payable
on September 5, 2002. Revolving credit loans under the credit agreement
bear interest, at the Company's option, at an applicable margin over the
bank's base rate loan or the IBOR rate. The applicable margin is based
upon the ratio of consolidated indebtedness to consolidated adjusted
EBITDA, as defined below. The credit agreement also provides for a
commitment fee of 1/2% of any unused portion of the credit agreement.
Among other restrictions, the credit agreement contains financial covenants
relating to specified levels of: indebtedness to income from operations
before depreciation and amortization less 30% of rental revenue after
deducting from such 30% of rental revenue any non-cash charges associated
with the acquisition of new release videocassettes (adjusted EBITDA);
adjusted EBITDA less taxes paid in cash to interest expense; maintenance of
average store contribution levels; and the maintenance of minimum tangible
net worth. Amounts outstanding under the credit agreement are
collateralized by substantially all of the assets of the Company.
The Company was not in compliance with the net worth covenant as of
December 31, 1998 due to the $99.9 million pre-tax write-off of
videocassette rental inventory (see Note 4 to the Consolidated Financial
Statements). The Company has, however, obtained a waiver from the Banks
with respect to the covenant specified in the revolving credit agreement.
Effective March 1, 1999, the Company replaced the net worth covenant with a
tangible net worth covenant
As of December 31, 1998, the fair value of the Notes was $202 million. The
fair value of the Notes was based on quoted market prices as of December
31, 1998. The revolving credit facility is a variable rate loan, and thus,
the fair value approximates the carrying amount as of December 31, 1998.
---------------------------------
Year December 31,
------------- ---------------
(In thousands)
1999 $ 8,418
2000 3,727
2001 -
2002 180,000
2003 -
Thereafter 200,000
--------------
$ 392,145
==============
11. INCOME TAXES
The provision for (benefit from) income taxes for the years ended December
31, 1998, 1997 and 1996 consists of:
-----------------------------
1998 1997 1996
--------- ------- --------
(In thousands)
Current:
Federal $ - $ 1,581 $ 8,052
State 983 218 2,250
--------- ------- --------
Total current provision 983 1,799 10,302
Deferred:
Federal (17,281) 1,468 2,757
State (2,903) 517 593
--------- ------- --------
Total deferred liability
(benefit) (20,184) 1,985 3,350
--------- ------- --------
Total provision (benefit) $(19,201) $ 3,784 $13,652
========= ======= ========
The Company is subject to minimum state taxes in excess of statutory state
income taxes in many of the states which it operates. These taxes are
included in the current provision for state and local income taxes.
Certain acquisitions in 1995 and the Reel.com acquisition in 1998 yielded
nondeductible goodwill which is reflected in the tax rate reconciliation
below. The tax impact of purchase accounting adjustments is reflected in
deferred taxes. A reconciliation of the statutory federal income tax rate
with the Company's effective income tax rate is as follows:
-----------------------
1998 1997 1996
------- ------- -------
Statutory federal rate
(benefit) (34.0%) 34.0% 35.0%
State income taxes, net of
federal income tax benefit (1.8) 5.5 4.6
Tax exempt interest income - - (0.3)
Amortization of nondeductible
goodwill 6.9 - -
Other, net 1.3 1.0 0.5
-------- ------- --------
(27.6%) 40.5% 39.8%
======== ======= ========
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 at December 31 are as follows:
---------------------
1998 1997
---------- ---------
(In thousands)
DEFERRED TAX ASSETS:
Tax loss carryforward $ 26,618 $ 326
Deferred rent 5,589 3,985
Financial leases 3,883 2,039
Income deferred for financial
statement purposes 2,308 634
Tax credit carryforward 1,906 2,476
Financial statement expenses
deferred for tax purposes 784 1,114
Difference between assigned
value and tax basis of
acquired entities - 690
Other 24 70
--------- ---------
Total deferred tax assets 41,112 11,334
Valuation allowance (5,599) -
--------- ---------
Net deferred tax assets 35,513 11,334
--------- ---------
DEFERRED TAX LIABILITIES:
Depreciation and amortization (8,227) (12,468)
Capitalized leases (2,778) (1,842)
Tax expenses deferred for
financial statement purposes (248) -
--------- ---------
Total deferred tax liabilities (11,253) (14,310)
--------- ---------
Net deferred tax asset (liability) $ 24,260 $(2,976)
========= =========
At December 31, 1998, the Company had approximately $52.5 million of net
operating loss carryforwards available to reduce future income taxes,
representing operating losses of Hollywood Entertainment, Reel.com and
Title Wave, a company acquired during 1995 through a stock purchase. For
tax purposes, the preacquisition losses resulting from a change of
ownership of Reel.com and Title Wave are treated as separate return
limiting year losses. The Company expects to fully utilize Hollywood
Entertainment, post acquisition Reel.com and Title Wave losses in future
years and thus no valuation allowance has been recorded. The Company has
provided a valuation allowance for pre-acquisition losses of Reel.com. The
carryforward periods expire in years 2008 through 2018. The Company has
federal Alternative Minimum Tax ("AMT") credit carryforwards of $1.9
million which are available to reduce future regular taxes in excess of
AMT. These credits have no expiration date.
The Company may realize tax benefits as a result of the exercise of certain
employee stock options. For financial reporting purposes, any reduction in
income tax obligations as a result of these tax benefits is credited to
shareholders' equity.
12. SHAREHOLDERS' EQUITY
Preferred Stock
At December 31, 1998, the Company is authorized to issue 19,500,000 shares
of preferred stock in one or more series. The Board of Directors has
authority over the designations, preferences, special rights, limitations
or restrictions thereof as it may determine. The Company issued and sold a
total of 2,380,263 shares of Series A Redeemable Preferred Stock in
connection with the Reel.com acquisition. These shares were converted into
Common Stock on a one for one basis upon shareholder approval on December
30,1998.
Common Stock
During 1998, the Company repurchased 850,000 Common Shares on the open
market for $10.5 million.
In October 1998, the Company issued and sold a total of 8,362,800 shares of
its Common Stock in connection with the acquisition of Reel.com as
discussed in Note 7. This amount includes the Preferred Shares converted
to Common Stock discussed above.
In December 1996, the Company completed a public offering of 2,000,000
shares of its common stock. The net proceeds from the offering were
approximately $34.7 million. Additionally, in January 1997, the
underwriters purchased an additional 300,000 shares pursuant to the
overallotment option for net proceeds to the Company of approximately $4.7
million.
13. STOCK OPTION PLANS
In general, the Company's stock option plans provide for the granting of
options to purchase Company shares at the market price of such shares as of
the option grant date. The options generally have a nine year term and
become excercisable on a pro rata basis over five years.
The Company adopted stock option plans in 1993 and 1997 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
10,000,000 shares of common stock. The 1997 plan provides for the granting
of nonqualified stock options to employees up to an aggregate of 2,000,000
shares of common stock. The Company granted non-qualified stock options
pursuant to the 1993 and the 1997 Plans totaling 5,347,269, 2,165,513, and
2,858,150 in 1998, 1997 and 1996, respectively.
The Company has elected to follow APB No. 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. 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 1998, 1997 and 1996:
---------------------------
1998 1997 1996
------- -------- ------
Risk free interest rate 4.5% 5.7% 6.4%
Expected dividend yield 0% 0% 0%
Expected lives 5 years 5 years 5 years
Expected volatility 75% 65% 60%
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 1998 (excluding the options issued in
connection with the Reel.com acquisition) was $6.77 per option.
For the purpose of pro forma disclosures, the estimated fair value of the
options is amortized over the option's vesting period. Options issued in
connection with the Reel.com acquisition totaled 958,568 and had a fair
market value of $10.8 million at the closing date using the Black-Scholes
option valuation model.
The Company's pro forma information is as follows:
December 31,
----------------------
1998
----------------------
Reported Pro Forms
--------- ---------
Net loss $(50,464) $(53,583)
Earnings
per share:
Basic (1.30) (1.38)
Diluted (1.30) (1.38)
December 31,
--------------------------------------------
1997 1996
--------------------- ---------------------
Reported Pro Forma Reported Pro Forma
-------- ---------- --------- ---------
Net income $ 4,996 $ 1,459 $20,630 $18,252
Earnings
per share:
Basic 0.14 0.04 0.60 0.53
Diluted 0.13 0.04 0.59 0.52
Options to purchase 1,196,644 shares of common stock were not included in
the computation of pro forma diluted earnings per share for December 31,
1998, as such shares were anti-dilutive.
The pro forma effect on net income for 1998, 1997 and 1996 is not
representative of the pro forma effect on net income in future years
because it does not take into consideration pro forma compensation expense
related to grants made prior to 1996.
A summary of the Company's stock option activity and related information
for 1998, 1997 and 1996 is as follows (in thousands, except per share
amounts):
Weighted
Average
Exercise
Shares Price
------- ---------
Outstanding at December 31, 1995 2,174 6.57
Granted 2,858 10.24
Exercised (127) 6.62
Cancelled (865) 15.29
------- ---------
Outstanding at December 31, 1996 4,040 9.25
Granted 2,165 16.35
Exercised (480) 7.74
Cancelled (587) 11.79
------- ---------
Outstanding at December 31, 1997 5,138 12.09
Granted 5,347 8.55
Exercised (633) 7.39
Cancelled (2,392) 13.79
------- ---------
Outstanding at December 31, 1998 7,460 9.40
======= =========
A summary of options outstanding and exercisable at December 31, 1998 is as
follows (in thousands, except per share amounts):
Options Outstanding Options Exercised
----------------------------------- ---------------------
Weighted Weighted Weighted
Average Average Average
Number Remaining Exercise Number Exercise
Outstanding Life (years) Price Exercisable Price
------------------------ --------- ----------- --------
$ 0.56 - $6.50 1,803 7.52 $ 2.90 559 $ 4.23
6.84 - 9.25 1,562 7.48 8.33 272 7.65
9.50 - 10.44 1,785 8.58 10.16 56 10.27
10.50 - 15.00 1,541 7.54 12.60 440 12.58
15.13 - 24.00 769 7.31 18.68 160 19.03
7,460 7.75 $ 9.40 1,487 $ 9.14
14. Earnings per Share
A reconciliation of the basic and diluted per share computations for 1998,
1997 and 1996 is as follows (in thousands, except per share data):
------------------------------
1998
------------------------------
Weighted Per
Income Average Share
(Loss) Shares Amount
--------- -------- ---------
Income (loss) before
extraordinary item $(50,464) 38,844 $ (1.30)
Extraordinary loss, net of tax - - -
Income (loss) per common
share $(50,464) 38,844 $ (1.30)
Effect of dilutive securities:
Stock options - - -
Income (loss) per share-
assuming dilution $(50,464) 38,844 $ (1.30)
------------------------------
1997
------------------------------
Weighted Per
Income Average Share
(Loss) Shares Amount
--------- -------- ---------
Income (loss) before
extraordinary item $ 5,559 36,659 $ 0.15
Extraordinary loss, net of tax (563) - (0.01)
Income (loss) per common
share $ 4,996 36,659 0.14)
Effect of dilutive securities:
Stock options - 1,059 (0.01)
Income (loss) per share-
assuming dilution $ 4,996) 37,718 $ 0.13
------------------------------
1996
------------------------------
Weighted Per
Income Average Share
(Loss) Shares Amount
--------- -------- ---------
Income (loss) before
extraordinary item $ 20,630 34,162 $ 0.60
Extraordinary loss, net of tax - - -
Income (loss) per common share $ 20,630 34,162 0.60
Effect of dilutive securities:
Stock options - 997 (0.01)
Income (loss) per share-
assuming dilution $ 20,630 35,159 $ 0.59
Due to the Company's loss in 1998, a calculation of earnings per share assuming
dilution is not required. In 1998 dilutive securities consisted of options
convertible into approximately 1.3 million shares of common stock using the
treasury stock method to compute dilution.
15. SPECIAL AND/OR UNUSUAL ITEMS
The Company incurred the following special and/or unusual charges in 1998
and 1997.
In 1998, the Company recorded a $99.9 million charge related to the
valuation of its rental inventory (see Note 4). In addition, the Company
wrote off $1.9 million related to purchased research and development costs
associated with the Reel.com acquisition (see Note 7).
The Company recorded a $6.8 million charge in the fourth quarter of 1997 to
write-off obsolete video game inventory and related accessories caused by
advancements in video game technology. Of the $6.8 million charge, $2.3
million was included in cost of product sales and $4.5 million was included
in operating and selling expenses on the consolidated statements of
operations.
The Company recorded a $4.6 million charge in the fourth quarter of 1997
for costs related to the Company's self-tender offer to acquire shares of
its common stock at $11.00 per share, which failed because the minimum
number of shares required for the transaction was not tendered. This
charge is included in general and administrative expenses on the
consolidated statements of operations.
In March 1997, the Company recorded a $18.9 million charge for the
settlement of the securities litigation initiated in December 1995. The
charge consisted of $14.8 million in damages and $4.1 million in legal and
professional expenses. The Company agreed to the settlement to avoid
further litigation expense and inconvenience and to put an end to all
controversy and claims related to the subject of litigation.
16. COMMITMENTS AND CONTINGENCIES
In April 1998 a complaint seeking injunctive relief and monetary damages in
the amount of approximately $200 million was filed against the Company,
entitled Rentrak Corporation v. Hollywood Entertainment, et al., Case No.
98-04-02811, Circuit Court for the County of Multnomah, Portland, Oregon.
The plaintiff, Rentrak, alleges that the Company is contractually obligated
until December 31, 2011 to deal exclusively with Rentrak whenever the
Company obtains videocassettes on a revenue sharing basis, and that the
Company has violated this alleged obligation by obtaining videocassettes on
a revenue sharing basis directly from movie studios. In addition, Rentrak
alleges that the Company has violated alleged audit and reporting
obligations under contractual arrangements. The Company believes this suit
is without merit and is vigorously defending the litigation. The Company
does not believe the ultimate outcome of the litigation will have a
material effect on the Company. If, however, Rentrak prevails, the results
could have an adverse effect on the Company's relationships with revenue
sharing studios and on the Company's financial condition and results of
operations.
In July 1998 a related lawsuit seeking monetary damages in the amount of at
least $5 million was filed against the Company by Twentieth Century Fox
Home Entertainment, Inc. ("Fox"), entitled Twentieth Century Fox Home
Entertainment, Inc. v. Hollywood Entertainment Corporation and Does 1
through 100, Case No. SC 053 551, Superior Court for the County of Los
Angeles, Los Angeles, California. Fox alleges that the Company has
knowingly or negligently reported inaccurate transaction-related data
concerning Fox titles to Rentrak Corporation, and that the Company either
knew or should have known that Rentrak would report to Fox the same
allegedly inaccurate transaction data for purposes of Fox's generation of
invoicing to Rentrak. In March 1999, Fox filed an amended complaint against
the Company in which it added allegations of potential misrepresentation
and fraud. The Comnpany believes this suit is without merit and
is vigorously defending the litigation. The Company does not believe the
ultimate outcome of the litigation will have a material effect on the
Company. If, however, Fox prevails, the results could have an adverse
effect on the Company's relationships with revenue sharing studios and on
the Company's financial condition and results of operations.
17. SEGMENT REPORTING
In June 1997, the Financial Accounting Standards Board (FASB) issued
Statement No. 131, "Disclosures about Segments of an Enterprise and Related
Information" effective for fiscal years beginning after December 15, 1997.
The Company adopted Statement No. 131 in 1998.
The Company identifies its segments based on management responsibility. In
1998, the Company had 2 segments. The Hollywood Video segment consists of
the Company's 1,260 retail stores located in 42 states and the Reel.com
segment, which is the leading video-only store on the internet. The
Company measures segment profit as operating profit, which is defined as
income before interest expense and income taxes. Information on segments
and a reconciliation to income before income taxes are as follows (in
thousands):
Year Ended December 31, 1998
-------------------------------
Hollywood
Video Reel.com Total
--------- -------- ---------
Revenues $ 756,658 $ 7,250 $ 763,908
Depreciation and amortization 184,147 12,702 196,849
Unusual items (1) 99,910 1,900 101,810
Operating income:
Before unusual items 83,921 (20,024) 63,897
After unusual items (15,989) (21,924) (37,913)
Interest expense, net 31,727 166 31,893
Total assets 840,316 94,118 934,434
Purchase of property and
equipment, net 131,364 758 132,122
(1) Unusual items are as follows (in thousands):
---------------------------------
Hollywood
Video Reel.com Total
---------- --------- ---------
Inventory valuation charge $99,910 - $99,910
Purchased in-process research
and development - 1,900 1,900
--------- --------- ---------
Total $99,910 $14,445 $114,355
========= ========= =========
There was only one segment, Hollywood Video, in 1997 and 1996.
18. QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data is as follows (in thousands, except per
share data):
Quarter Ended
---------------------------------------
1998 March June September December
---------------------- -------- -------- --------- --------
Total revenue $169,952 $166,731 $184,072 $243,153
Income from operations 19,432 17,037 18,616 (92,998)
Net income (loss) 7,663 5,654 6,082 (69,863)
Net income (loss) per
share (1):
Basic 0.21 0.15 0.16 (1.56)
Diluted 0.21 0.15 0.16 (1.56)
1997
----------------------
Total revenue $110,475 $110,002 $124,621 $155,403
Income from
operations 14,329 11,177 12,143 4,032
Net income (loss) (3,607) 5,481 4,572 (1,450)
Net income (loss) per
share:
Basic (2) (0.10) 0.15 0.12 (0.04)
Diluted (0.10) 0.15 0.12 (0.04)
(1) In 1998, the sum of the four quarters earnings per share does not
equal the annual amount due to the acquisition of Reel.com and
operating loss in the fourth quarter of 1998.
(2) In 1997, the sum of the four quarters basic earnings per share does
not equal the annual amount due to rounding.
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 30, 1999.
Hollywood Entertainment Corporation
By: /S/ DAVID G. MARTIN
-----------------------------------------------------
Executive Vice President
and 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 30, 1999.
Signatures Title
- ---------- ------
MARK J. WATTLES
- --------------- Chairman of the Board of Directors,
Mark J. Wattles and Chief Executive Officer
(Principal Executive Officer)
DAVID G. MARTIN
- --------------- Executive Vice President
David G. Martin and Chief Financial Officer
(Principal Financial and Accounting Officer)
DONALD J. EKMAN
- --------------- Director
Donald J. Ekman
SCOTT A.BECK
- ------------- Director
Scott A. Beck
WILLIAM P. ZEBE
- --------------- Director
William P. Zebe