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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended January 3, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______________ to _______________.
Commission file number: 0-24548
MOVIE GALLERY, INC.
(Exact name of registrant as specified in its charter)
Delaware 63-1120122
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
739 W. Main Street, Dothan, Alabama 36301
(Address of principal executive offices) (Zip Code)
(334) 677-2108
(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:
Common Stock, $.001 par value
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES X NO ___
Indicate by check mark 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 statement or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of March 12, 1999, was approximately $34,937,024. The number
of shares of Common Stock outstanding on March 12, 1999, was 13,230,915 shares.
Documents incorporated by reference:
1. Notice of 1999 Annual Meeting and Proxy Statement (Part III of Form 10-K).
- --------------------------------------------------------------------------------
The exhibit index to this report appears at page 29.
ITEM 1. BUSINESS
General
As of March 12, 1999, Movie Gallery, Inc. (the "Company") owned and
operated 828 video specialty stores and had 94 licensees located in 22 states,
primarily in the eastern half of the United States, that rent and sell
videocassettes and video games. Since the Company's initial public offering in
August 1994, the Company has grown from 97 stores to its present size through
acquisitions and the development of new stores. The Company is among the three
largest video specialty retailers in the United States.
The Company was incorporated in Delaware in June 1994 under the name Movie
Gallery, Inc. From March 1985 until the present time, substantially all of the
Company's operations have been conducted through its wholly-owned subsidiary,
M.G.A., Inc. The Company's executive offices are located at 739 W. Main Street,
Dothan, Alabama 36301, and its telephone number is (334) 677-2108.
Video Industry Overview
Video Retail Industry. According to Paul Kagan Associates, Inc. ("Paul
Kagan"), the home video rental and sales industry has grown from $0.7 billion in
revenue in 1982 to a projected $16.8 billion in 1998 and is projected to reach
$24.3 billion by 2008. Paul Kagan estimates that in 1998 consumers rented
approximately 3.2 billion videos, a 4% increase over 1997, and purchased more
than 600 million videos. In fact, at the end of 1998 over 83% of all television
households owned a videocassette recorder ("VCR") and total VCR penetration is
expected to approach 90% within the next ten years, according to Paul Kagan. In
addition, total VCR sales in the U.S. have increased in each year during the
decade of the 1990s and are anticipated to reach their highest level ever in
1999, according to Paul Kagan.
The concept of revenue sharing and risk sharing between major retailers and
the movie studios was embraced by the industry in 1998. Revenue sharing is a
concept whereby retailers and movie studios share the risks associated with the
rental performance of individual titles. Generally, retailers pay a small
upfront fee for each copy leased under revenue sharing, typically $0 to $10. As
the movies are rented by consumers, the movie studio receives a percentage of
the revenue generated based on a predetermined formula, which is generally less
than fifty percent. After a period of time, generally six months to a year,
these movies are no longer subject to revenue sharing and are either owned
outright by the Company, purchased from the movie studio for a nominal amount or
returned to the studio. Revenue sharing allows retailers to vastly increase both
copy depth and breadth for the consumers. The increased product serves to
potentially recapture lost customers who had become disenfranchised with the
movie rental experience due to the unavailability of the most recent new
releases of movies. Paul Kagan projects that total revenues for the industry,
including both rental and sell-through, increased by 6.8% in 1998 to nearly $17
billion. In fact, Paul Kagan estimates that the combination of rental and
sell-through revenue for both VHS tapes and DVD disks will grow at a compound
annual rate of over 3% for the next ten years.
The video retail industry is highly fragmented and continues to experience
consolidation pressures. Trends toward consolidation have been fueled by the
competitive impact of superstores on smaller retailers, the need for enhanced
access to working capital and efficiencies of scale. The Company believes that
the video specialty store industry is continuing to consolidate into regional
and national chains. While many of the largest retail chains posted same-store
revenue growth, industry sources speculated that many independent operators
struggled to maintain market share. The combination of revenue sharing and other
copy depth opportunities and increased marketing efforts solidified the
positions of the largest retail chains versus independent operators.
2
The domestic video retail industry includes both rentals and sales of
videocassettes; however, the majority of revenue is generated through the rental
of prerecorded videocassettes. There are three primary pricing strategies that
the movie studios use to influence the relative levels of videocassette rentals
versus sales. First, videocassettes can be priced at relatively high levels,
typically between $60 and $75 ("rental priced movies"). These movies are
purchased by video specialty stores and are promoted primarily as rental titles.
Second, videocassettes can be priced at relatively low levels, typically between
$5 and $25 ("sell-through movies"). These movies are purchased by video
specialty stores and generally promoted for both rental and new videocassette
sales. Third, in an effort to enhance customer satisfaction with the video
rental experience, movie studios have developed revenue sharing programs. Movies
under revenue sharing programs, as previously discussed, result in quantities
purchased that are similar to sell-through movies. During late 1997 and 1998,
movie studios greatly increased their revenue sharing programs. Movie studios
attempt to maximize total revenue from videocassette releases via the combined
utilization of all three pricing structures.
The increase in sell-through priced movies and revenue sharing programs has
greatly increased the availability of previously viewed movies. These movies are
made available to the consumer for sale once initial rental demand is met.
Movie Studio Dependence on Video Rental Industry. The videocassette rental
and sales industry is the largest single source of domestic revenue to movie
studios and independent suppliers of theatrical and direct-to-video movies and,
according to Paul Kagan, represented approximately $6.7 billion, or 49%, of the
$13.8 billion of revenue generated in 1998. The Company believes that of the
many movies produced by major studios and released in the United States each
year, relatively few are profitable for the studios based on box office revenue
alone. In addition to purchasing box office hits, video specialty stores provide
the movie studios with a reliable source of revenue for a large number of their
movies by purchasing movies on videocassette that were not successful at the box
office. The Company believes the consumer is more likely to view movies which
were not box office hits on a rented videocassette than on any other medium
because video specialty stores provide an inviting opportunity to browse and
make impulse choices among a very broad selection of movie titles. In addition,
the Company believes the relatively low cost of video rentals encourages
consumers to rent films they might not pay to view at a theater.
Historically, new technologies have led to the creation of additional
distribution channels for movie studios. Movie studios seek to maximize their
revenue by releasing movies in sequential release date "windows" to various
movie distribution channels. These distribution channels include, in the
customary order of release date, movie theaters, airlines and hotels, video
specialty stores, pay-per-view satellite and cable television systems
("Pay-Per-View"), premium cable television, basic cable television and, finally,
network and syndicated television. (See "Business -- Competition and
Technological Obsolescence") The Company believes that this method of sequential
release has allowed movie studios to increase their total revenue with
relatively little adverse effect on the revenue derived from previously
established distribution channels and it is anticipated that movie studios will
continue the practice of sequential release even as near video on demand
("NVOD") and, eventually, video on demand ("VOD") become more readily available
to the consumer. According to Paul Kagan, most movie studios release hit movie
videocassettes to the home video market from 30 days to 80 days (extending up to
120 days for certain titles priced for sale rather than rental) prior to the
Pay-Per-View release date. A mid-1998 study conducted by Paul Kagan found that
movie studios and other independent suppliers of movies to the home video market
had increased their average exclusive windows for home video by 10% to 55 days
in 1998 versus 50 days in 1997. This level of commitment to the home video
industry is indicative of the importance of this channel of distribution to the
overall profitability of movie studios and other independent movie suppliers.
3
Growth Strategy
During the fiscal years 1994 through 1996, approximately 78% of the
Company's growth in total number of stores occurred through the acquisition of
stores and the balance occurred through the development of new stores. The
Company spent all of 1997 and much of 1998 absorbing the large increase in the
number of stores which began in 1994. The Company expects to accelerate its
growth rate in 1999 and is currently planning to open up to 100 new stores
during the year primarily in secondary and rural markets. It is expected that
development of new stores will account for a substantial portion of the
Company's growth although the Company may make selective, accretive and
strategically consistent acquisitions, provided these acquisitions exceed
targeted levels of return on capital. The Company's ability to execute its
stated growth strategy will be dependent upon its ability to generate cash flow
from operations. The key elements of the Company's development and acquisition
strategy include the following:
Development. From January 1, 1994 through March 12, 1999, the Company has
developed 237 stores. The Company utilizes store development to complement its
existing base of stores in rural and secondary markets where it finds attractive
locations and a sufficient population to support additional video specialty
stores. The Company attempts to develop real estate in 3,000 to 5,000 square
foot locations primarily in towns with populations from 3,000 to 60,000.
Although developed stores generally require approximately one year for revenue
to reach the level of a mature store, they typically become profitable within
the first six months of operations and produce greater returns on investment
than acquired stores.
The Company's real estate and construction departments are responsible for
new store development, including site selection, market evaluation, lease
negotiation and construction. The Company usually acts as the general contractor
with respect to the construction of its new stores and, in that regard, employs
full-time construction managers who have significant video specialty store
construction experience.
Set forth below is a historical summary showing store openings,
acquisitions and store closings by the Company since January 1, 1994.
Year Ended Fiscal Year Ended
December 31, --------------------------------- January 4,
----------- January 5, January 4, January 3, to March 12,
1994 1995 1997 1998 1999 1999
----- ---- --------- --------- ---------- ------------
New Store Openings 25 66 75 50 18 3
Stores Acquired 196 327 174(1) 2 4 0
Stores Closed 2 23 48 59 41 12
Total Stores at End
of Period 292 662 863 856 837 828
________________________
(1) Includes 98 stores acquired on July 1, 1996 and accounted for as
poolings-of-interests. Store counts, prior to the fiscal year ended January
5, 1997, have not been restated for purposes of this table. For total store
counts at the end of the fiscal years 1994 through 1996, see "Overview" in
Item 7.
Acquisitions. From January 1, 1994 through March 12, 1999, the Company
acquired 703 stores. Acquisitions permitted the Company to quickly gain market
share and experienced management in markets that the Company believed had
potential for growth. Through a combination of volume purchase discounts, larger
advertising credits, more efficient inventory management and lower average labor
costs, the Company believes it is generally able to operate these acquired
stores more profitably than their prior owners, typically single store or small
chain operators. During the latter portion of the third quarter of 1996, the
4
Company suspended its acquisition program, primarily in order to concentrate on
improving operations at the stores it had acquired and developed from August
1994 through July 1996. The Company acquired four stores in new markets during
1998. Additionally, the Company purchased the business of nine other video
stores within existing Company markets, and subsequently consolidated the
acquired and existing stores in each market into one location. During 1999, the
Company intends to carefully evaluate strategic acquisitions that are both
accretive and provide for market penetration or increased market share within
cities and towns that are consistent with its strategy.
Future store acquisitions will be selected based upon location, quality of
operations and financial criteria as determined by the Company to be consistent
with its growth strategy. In connection with future acquisitions, the Company
anticipates that some of the owners and most of the key personnel will be
employed by the Company. Historically, the owners of the stores acquired by the
Company have entered into noncompetition agreements with the Company which are
generally for a five- to ten-year term.
The Company recently entered into a definitive agreement to purchase the
assets and assume the leases of approximately 90 stores operated by Blowout
Entertainment, Inc. ("Blowout") for an aggregate purchase price of approximately
$2.4 million, subject to adjustments under certain circumstances. Blowout
operates video stores within large retailers such as Wal-Mart. The acquisition
is expected to close within the second quarter of 1999. The consummation of the
acquisition is subject to a number of closing conditions, including the receipt
of an order from a bankruptcy court approving the transaction. The Company
anticipates that other acquisition opportunities will arise in the future.
However, there can be no assurance that future acquisition opportunities will be
available or that the integration of future acquisitions will not materially and
adversely affect the Company.
Operating Strategy
Focus on Smaller Markets. Generally, the Company's stores are located in
small towns or suburban areas surrounding mid-sized cities. In these areas, the
Company's principal competition usually consists of single store or small chain
operators who have less buying power, smaller advertising budgets and generally
offer fewer copies of new release videocassettes. The Company attempts to become
the leading video retailer in its markets and believes that it can achieve a
higher return on invested capital in these smaller markets than it could in the
larger urban areas because of the reduced level of competition and lower
operating costs.
Market Concentration. By concentrating its new store development in and
around existing markets, the Company is able to achieve operating efficiencies,
primarily consisting of cost savings relating to advertising, training and store
supervision.
New Release Purchases. The Company actively manages its new videocassette
purchases in order to balance customer demand with the maximization of
profitability. Buying decisions are made centrally which allows the Company to
obtain volume discounts, market development funds and cooperative advertising
credits that are generally not available to single store or small chain
operators.
Centralized Operations. In order to increase operating efficiency, the
Company centrally manages labor costs, real estate costs, accounting and cash
management and utilizes centralized purchasing, advertising and information
systems. A Company-wide quality assurance program insures a high degree of
customer service and visually appealing stores. The Company believes this
program increases customer satisfaction and loyalty.
Store Location and Format. The Company maintains a flexible store format,
tailoring the size, inventory and look of each store to local demographics. The
Company's stores generally range from approximately 2,000 to 9,000 square feet
(averaging approximately 4,800 square feet), with inventories ranging from
approximately 4,000 to 15,000 videocassettes. Substantially all of the Company's
stores are located in strip centers, anchored by major grocery or discount drug
store chains, which provide easy access, good visibility and high traffic.
5
Movie Gallery Stores
At March 12, 1999, the Company owned and operated 828 stores, all but one
of which were located in leased premises. The following table provides
information at March 12, 1999 regarding the number of Company stores located in
each state.
Number
Of
Stores
------
Alabama............................................................. 137
Florida............................................................. 108
Texas .............................................................. 83
Georgia............................................................. 65
Virginia............................................................ 53
Ohio................................................................ 47
Maine............................................................... 43
Tennessee........................................................... 41
Indiana............................................................. 34
Mississippi ........................................................ 33
Wisconsin........................................................... 32
South Carolina ..................................................... 30
Missouri............................................................ 23
North Carolina...................................................... 21
Kentucky............................................................ 17
Kansas.............................................................. 16
Louisiana........................................................... 13
New Hampshire....................................................... 12
Illinois............................................................ 10
Massachusetts....................................................... 5
Iowa................................................................ 3
Michigan............................................................ 2
---
TOTAL............................................. 828
===
The Company's stores are generally open seven days a week, from 10:00 a.m.
to 11:00 p.m. on weekends and from 10:00 a.m. to 10:00 p.m. on weekdays. The
store fixtures, equipment and layout are designed by the Company to create a
visually-appealing, up-beat ambiance, which is augmented by a background of
television monitors displaying MGTV (Movie Gallery Television), which shows
movie previews and promotions of coming attractions, and by posters and stand-up
displays promoting specific movie titles. Movies are arranged in attractive
display boxes organized into categories by topic, except for new releases, which
are assembled alphabetically in their own section for ease of selection by
customers.
The Company has a quality assurance program to ensure compliance with the
Company's customer service and store operating policies. A team of quality
assurance auditors located in different geographic regions make periodic visits
to monitor compliance and report results to the Company's Vice President -
Support Operations. District Managers and Regional Managers are expected to
quickly address and resolve any compliance problems.
6
The Company's policy is to constantly evaluate its existing store base to
determine where improvements may benefit the Company's competitive position. In
negotiating its leases and renewals, the Company attempts to obtain short lease
terms to allow for the mobility necessary to react to changing demographics and
other market conditions. The current average remaining life of the Company's
leases is approximately two years with over 200 leases considered for renewal
each year. The Company actively pursues relocation opportunities to adapt to
market shifts. Similarly, the Company may elect to expand and/or remodel certain
of its stores in order to improve facilities, meet customer demand and maintain
the visual appeal of each store. In order to maximize profits, the Company
varies the quantity of its new release inventory, the rental and sales prices
for videocassettes and video games and the rental period for catalog titles from
location to location to meet competition and demographic demand in the area. The
Company generally has a one-day rental term for new release movies less than 90
days old (five days for new releases greater than 90 days old and catalog
titles), which tends to keep new releases more readily available and requires
the purchase of fewer copies of new releases than a two-day rental policy. Video
games generally have a five-day rental term for both the most recent new
releases and older, catalog titles.
Licensees
In connection with certain of its acquisitions, the Company assumed certain
obligations and benefits under license agreements. The Company has entered into
additional license agreements with certain former owners of acquired stores and
with existing licensees. As of March 12, 1999, the Company had 94 licensees
operating under such agreements pursuant to which the Company receives various
royalty and license payments and has certain non-monetary obligations to the
licensees. For the fiscal year ended January 3, 1999, revenues from licensees
were not material to the Company.
Products
For the fiscal year ended January 3, 1999, over 85% of the Company's rental
revenue was derived from the rental of videocassettes, with the remainder being
derived primarily from the rental of video games. Substantially all of the
Company's revenue from product sales during this period was derived from the
sale of new and previously viewed videocassettes, confectionery items and video
accessories, such as blank cassettes, cleaning equipment and movie memorabilia.
The Company's stores generally offer from 4,000 to 15,000 videocassettes
and from 200 to 1,000 video games for rental and sale, depending upon location.
New release movies are displayed alphabetically and catalog titles are displayed
alphabetically by category, such as "Action," "Comedy," "Drama" and "Children."
A typical store's inventory consists of 4,750 catalog movies plus new release
titles and older titles which continue to be in strong demand. Each store has a
few special interest titles, covering such subjects as hunting, golf and
education, selected by management to appeal to the customer base in the store's
market area. Buying decisions are made centrally and are based on box office
results, actual rental history of comparable titles within each store and
industry research.
Management believes that internal factors which most affect a typical
store's revenues are its new release title selection and the number of copies of
each new release available for rental as compared to the competition. The
Company is committed to offering as many copies of new releases as necessary to
be competitive within a market, while at the same time keeping its costs as low
as possible. New videocassettes offered for sale are primarily "hit" titles
promoted by the studios for sell-through, as well as special interest and
children's titles and seasonal titles related to particular holidays.
In an effort to provide more depth of copy on hit titles to better satisfy
initial customer demand, certain movie studios in late 1997 began offering
7
incentives and expanded revenue sharing plans which have lowered the average per
unit cost of rental inventory. These programs permit the Company to carry larger
levels of new release inventory. Thus, the Company has pursued such
opportunities and believes that during late 1997 and 1998 these programs had a
positive impact on revenues. There can be no assurance that studios will
continue to offer such programs or that such programs will continue to have
positive results.
The Company rents and sells video games, which are licensed primarily by
"Nintendo," "Sony" and "Sega." Game rentals as a percentage of the Company's
total revenues have increased since early 1997 due to the increase in the
installed base of 32-bit and 64-bit game platforms. Sony and Sega released new
platforms in late 1995, while Nintendo released its N64 platform in the fall of
1996. The Sony and Nintendo platforms continued to grow during 1998 as more
households in their markets acquired video game hardware. The Company expects
that the video game rental and sales portion of its business will continue to
grow during 1999.
Videocassette and Video Game Suppliers
In August 1997, the Company executed a contract with Major Video Concepts,
Inc. ("MVC") by which MVC became the Company's primary supplier of video
inventory requirements. The contract was effective through March 31, 1999. The
Company is in the process of negotiating a new contract for the primary sourcing
of its videocassette inventory. During Fiscal 1998, the Company purchased
approximately 70% of its video inventory from MVC. The Company also sourced
product from three other major vendors during 1998.
The Company's contract with MVC provides for the direct purchase of
videocassettes and video games at varying prices. These prices are a function of
the wholesale prices set by the movie studios, which depend upon whether a
videocassette is initially priced to encourage rental or sale. The Company
currently receives marketing funds and an advertising allowance from MVC based
in part upon a percentage of videocassette and video game purchases.
If the relationship with MVC were terminated, the Company believes that it
could readily obtain its required inventory of videocassettes and video games
from alternative suppliers at prices and on terms comparable to those available
from MVC. However, the number of alternative suppliers has diminished in recent
years and the termination of the Company's present relationship with MVC could
adversely affect the Company's results of operations until a suitable
replacement was found. There can be no assurance that the replacement would
provide service, support or payment terms as favorable as those provided by MVC.
Several companies acquired by the Company had pre-existing long-term
contracts with Rentrak Corporation ("Rentrak") whereby product would be provided
under pay-per-transaction revenue sharing arrangements. During late 1996, the
Company consolidated existing contracts with Rentrak into one national
agreement. Under this ten-year agreement, the Company has a minimum annual
purchase commitment in revenue share, handling fees, sell-through fees and
end-of-term buyout fees. The Company utilizes Rentrak on a selective title by
title basis.
Marketing and Advertising
With advertising credits and market development funds that it receives from
its video suppliers and the movie studios, the Company uses radio and television
advertising, direct mail, newspaper advertising, discount coupons and
promotional materials to promote new releases, its video specialty stores and
its trade name. Using copy prepared by the Company and the studios, advertising
is placed by in-house media buyers. Expenditures for marketing and advertising
above the amount of the Company's advertising credits from its suppliers and
movie studios have been minimal. The Company anticipates that it will continue
to make substantial marketing and advertising expenditures, but that movie
studios will continue to support most of such expenditures. The Company also
benefits from the advertising and marketing by studios and theaters in
8
connection with their efforts to promote films and increase box office revenue.
The Company prepares a monthly consumer magazine called Video Buzz and a
customized video program (MGTV), both of which feature Company programs,
promotions and new releases.
Inventory
The videocassette and video game inventory in each store consists of its
catalog titles (those in release for more than one year) and new release titles.
New releases of videocassettes and video games purchased from suppliers for
existing stores are drop-shipped to the stores.
Videocassettes and video games utilized as initial inventory in the
Company's developed stores consist of excess copies of catalog titles and new
release titles from existing stores, supplemented as necessary by purchases
directly from suppliers. This inventory for developed stores is packaged at the
Company's processing and distribution facility located in Dothan, Alabama. Each
videocassette and video game is removed from its original packaging, and an
optical bar code label, used in the Company's computerized inventory system, is
applied to the plastic rental case. The cassette is placed in the rental case,
and a display carton is created by inserting foam or cardboard into the original
packing and shrink-wrapping the carton. The repackaged videocassettes, video
games and display cartons are then shipped to the developed store ready for use.
Information Systems
In November 1995, the Company began development of its proprietary
point-of-sale ("POS") system. On January 10, 1996, the first Beta test store was
installed with the new system. Additional Beta test sites were tested through
March 31, 1996. On April 1, 1996, the Company began the rapid deployment of the
POS system in its Company stores. By July 1997, the Company had converted all of
its stores to the new POS system. The POS system provides detailed information
with respect to store operations (including the rental history of titles and
daily operations for each store) which is telecommunicated to the corporate
office on a daily basis. The POS system is installed in all developed stores
prior to opening, and the Company installs the system in all acquired stores as
soon after the closing of the acquisition as practicable.
The Company's POS system records all rental and sale information upon
customer checkout using scanned bar code information and updates the information
when the videocassettes and video games are returned. This POS system is linked
to a management information system ("MIS") at the corporate office. Each night
the POS system transmits store data into the MIS where all data is processed,
generating reports which allow management to effectively monitor store
operations and inventory, as well as to review rental history by title and
location to assist in making purchasing decisions with respect to new releases.
The POS system also enables the Company to perform its monthly physical
inventory using bar code recognition.
In addition, during the last three years the Company has installed a
financial reporting system relating to the general ledger, revenue and accounts
payable functions capable of handling the Company's anticipated growth.
Additional systems which have been developed and implemented by the Company
include a Collections system and a Processing/Distribution Center system.
Competition and Technological Obsolescence
The video retail industry is highly competitive, and the Company competes
with other video specialty stores, including stores operated by other regional
chains and national chains such as Blockbuster Video ("Blockbuster"), and with
other businesses offering videocassettes and video games such as supermarkets,
pharmacies, convenience stores, bookstores, mass merchants, mail order
operations and other retailers. Approximately 33% of the Company's stores
compete with stores operated by Blockbuster. In addition, the Company competes
9
with all forms of entertainment, such as movie theaters, network and cable
television, direct broadcast satellite television, Internet-related activities,
live theater, sporting events and family entertainment centers. Some of the
Company's competitors have significantly greater financial and marketing
resources and name recognition than the Company.
The Company believes the principal competitive factors in the video retail
industry are store location and visibility, title selection, the number of
copies of each new release available, customer service and, to a lesser extent,
pricing. The Company believes it generally offers superior service, more titles
and more copies of new releases than most of its competitors.
The Company also competes with Pay-Per-View in which subscribers pay a fee
to view a movie selected by the subscriber. Recently developed technologies,
referred to as NVOD, permit certain cable companies, direct broadcast satellite
companies (such as Direct TV), telephone companies and other telecommunications
companies to transmit a much greater number of movies to homes throughout the
United States at more frequent intervals (often as frequently as every five
minutes) throughout the day. NVOD does not offer full interactivity or VCR
functionality, such as allowing consumers to control the playing of the movie
(i.e., starting, stopping and rewinding). Ultimately, further improvements in
these technologies could lead to the availability to the consumer of a broad
selection of movies on demand, referred to as VOD, at a price which may be
competitive with the price of videocassette rentals and with the functionality
of VCRs. Certain cable and other telecommunications companies have tested and
are continuing to test limited versions of NVOD and VOD in various markets
throughout the United States and Europe.
Movies recorded on digital video discs ("DVD"), the same size as audio
discs, were introduced during the summer of 1997. Playback machines which play
both audio discs and DVD have also been introduced. Because of the ease of use
and durability of DVD, it is anticipated that eventually DVD may begin to
replace videocassettes. During the transition period, the Company's cost to
maintain its inventory may increase. Currently, the Company offers DVD for
rental and sale in limited, primarily metropolitan, markets. The Company expects
to expand its DVD software availability to other markets once the installed base
will support such an investment. Technology has been developed to offer an
alternative digital disk platform called Digital Video Express ("Divx"). Divx
disks permit 48 hours of viewing from the time playback begins. Subsequent
viewings would be available at an additional charge with access and payment
handled via modem.
The advent of DVD and Divx may result in consumers purchasing more films
than in the past, which could have a material adverse effect on the Company's
rental volume and, as a result, on its profit margins. For the near-term,
however, hardware costs for digital disk technologies are expected to remain
high, recordability is likely several years away and products on digital disks
remain available on VHS, typically at an earlier date. While both DVD and Divx
have begun to receive varying degrees of support from the movie studios, it is
yet to be determined which of these alternatives will become the dominant
alternative to VHS. The Company anticipates that it will react to changing
consumer format demands and intends to provide its customers with the rental
medium demanded. During 1998, the Company substantially increased its offerings
of the DVD technology in select markets.
The Company believes movie studios have a significant interest in
maintaining a viable movie rental business because the sale of videocassettes to
video retail stores currently represents the studios' largest source of domestic
revenue. As a result, the Company anticipates that movie studios will continue
to make movie titles available to Pay-Per-View, cable television or other
distribution channels only after revenues have been derived from the sale of
videocassettes, and perhaps digital disks, to video stores. In addition, the
Company believes that for Pay-Per-View television to match the low price,
viewing convenience and selection available through video rental, substantial
capital expenditures and further technological advances will be necessary.
Although the Company does not believe NVOD or VOD represent a near-term
competitive threat to its business, technological advances and broad consumer
10
availability of NVOD and VOD or changes in the manner in which movies are
marketed, including the earlier release of movie titles to Pay-Per-View, cable
television or other distribution channels, could have a material adverse effect
on the Company's business.
Employees
As of March 12, 1999, the Company employed approximately 6,100 persons,
referred to by the Company as "associates," including approximately 5,800 in
retail stores and the remainder in the Company's corporate offices and
distribution facility ("Support Center Staff"). Of the retail associates,
approximately 1,500 were full-time and 4,300 were part-time. None of the
Company's associates is represented by a labor union, and the Company believes
that its relations with its associates are good.
Each of the Company's stores typically employs five to fifteen persons,
including one Store Manager and, in larger stores, one Assistant Manager. Store
Managers report to District Managers who supervise the operations of 10 to 15
stores. The District Managers report to one of nine Regional Managers, who
report directly to the Company's Senior Vice President - Store Operations. As
the Company has grown, it has increased the number of District Managers and
Regional Managers, often by employing owners or key employees of acquired
stores. The Support Center Staff has regular and periodic meetings with the
Regional Managers and District Managers to review operations. Compliance with
the Company's policies, procedures and regulations is regularly monitored on a
store-to-store basis by members of the Company's Quality Assurance department.
The Company has an incentive bonus program pursuant to which retail
management personnel receive quarterly bonuses when stores meet or exceed
criteria established under the program. Management believes that its program
rewards excellence in management, gives associates an incentive to improve
operations and results in an overall reduction in the cost of operations. In
addition, District Managers, Regional Managers and certain Support Center Staff
are eligible to receive discretionary bonuses, based on individual and Company
performance, and options to purchase shares of the Company's Common Stock
(exercisable at the fair market value on the date of grant), subject to service
requirements.
Cautionary Statements
The "BUSINESS" and "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS" sections of this Report contain certain
forward-looking statements regarding the Company. The Company desires to take
advantage of the "safe harbor" provisions of the Private Securities Litigation
Reform Act of 1995 and in that regard is cautioning the readers of this Report
that the following important factors, among others, could affect the Company's
actual results of operations and may cause changes in the Company's strategy
with the result that the Company's operations and results may differ materially
from those expressed in any forward-looking statements made by, or on behalf of,
the Company.
Growth Strategy. The Company's long-term strategy is to grow primarily
through new store openings and secondarily through acquisitions of existing
stores. Successful implementation of the strategy is contingent on numerous
conditions, some of which are described below, and there can be no assurance
that the Company's business plan can be executed. The acquisition of existing
stores and the opening of new stores require significant amounts of capital. In
the past, the Company's growth strategy has been funded through proceeds
primarily from public offerings of common stock, and secondarily through bank
debt, seller financing, internally generated cash flow and use of the Company's
common stock as acquisition consideration. These and other sources of capital,
including public or private sales of debt or equity securities, may not be
available to the Company in the future.
11
New Store Openings. The Company's ability to open new stores may be
adversely affected by the following factors, among others: (i) its availability
of capital; (ii) its ability to identify new sites where the Company can
successfully compete; (iii) its ability to negotiate acceptable leases and
implement cost-effective development plans for new stores; (iv) its ability to
hire, train and assimilate new store managers and other personnel; and (v) its
ability to compete effectively against competitors for prime real estate
locations.
Acquisitions. The Company's ability to consummate acquisitions and operate
acquired stores at the desired levels of sales and profitability may be
adversely affected by: (i) the inability to consummate identified acquisitions,
which may result from a lack of available capital; (ii) the reduction in the
size of the pool of available sellers; (iii) the inability to identify
acquisition candidates that fit the Company's criteria (such as size, location
and profitability) and who are willing to sell at prices the Company considers
reasonable; (iv) more intensive competition to acquire the same video specialty
stores the Company seeks to acquire; (v) an increase in price for acquisitions;
(vi) misrepresentations and breaches of contracts by sellers; (vii) the
Company's limited knowledge and operating history of the acquired stores; (viii)
the replacement of purchasing and marketing systems of acquired stores; and (ix)
the integration of acquired stores' systems into the Company's systems and
procedures.
Same-Store Revenues Increases. The Company's ability to maintain or
increase same-store revenues during any period will be directly impacted by the
following factors, among others, which are often beyond the control of the
Company: (i) increased competition from other video stores, including large
national or regional chains, supermarkets, convenience stores, pharmacies, mass
merchants and other retailers, which might include significant reductions in
pricing to gain market share; (ii) the weather conditions in the selling area;
(iii) the timing of the release of new hit movies by the studios for the video
rental market; (iv) competition from special events such as the Olympics or an
ongoing major news event of significant public interest; (v) competition from
other forms of entertainment such as movie theaters, cable television,
Internet-related activities and Pay-Per-View television, including direct
satellite television; and (vi) a reduction in, or elimination of, the period of
time (the "release window") between the release of hit movie videocassettes to
the home video market and the release of these hit movies to the Pay-Per-View
markets (currently 30 to 80 days).
Income Estimates. The Company's ability to meet its income projections for
any period are dependent upon many factors, including the following, among
others: (i) reductions in revenues caused by factors such as those listed under
"Same-Store Revenues Increases" above; (ii) the extent to which the Company
experiences an increase in the number of new competitive openings, which tends
to divide market share and reduce profitability in a given trade area; (iii) the
extent to which the Company experiences any increase in the number of titles
released from studios priced for sell-through, which may tend to increase the
satisfaction of demand through product sales which carry lower profit margins
than rental revenues; (iv) changes in the prices for the Company's products or a
reduction in, or elimination of, the videocassette release window as compared to
Pay-Per-View, as determined by the movie studios, could result in a competitive
disadvantage for the Company relative to other forms of distribution; (v) the
Company's ability to control costs and expenses, primarily rent, store payroll
and general and administrative expenses; (vi) the Company's ability to react and
obtain other distribution sources for its products in the event that MVC or
other primary suppliers are unable to meet the terms of their contracts with the
Company; and (vii) advancements and cost reductions in various new technological
delivery systems such as (a) Pay-Per-View cable television systems and digital
satellite systems offering NVOD or VOD; (b) universal acceptance of DVD and Divx
technology which might result in lower profit margins and increased costs
associated with higher inventory requirements; and (c) other forms of new
technology, which could affect the Company's profit margins.
Year 2000. The Company believes that all operating systems will be year
2000 compliant prior to December 31, 1999, and does not believe that the costs
incurred to address the year 2000 issue have been or will be material to the
Company. However, the Company can provide no assurance that its systems or its
12
major vendors will be adequately prepared for the year 2000. Failure to resolve
year 2000 issues could have a material adverse impact on the operations of the
Company.
Directors and Executive Officers of the Company
Name Age Position(s) Held
- ---- --- ----------------
Joe Thomas Malugen(1) 47 Chairman of the Board and Chief Executive
Officer
H. Harrison Parrish(1) 51 President and Director
William B. Snow(1)(2) 67 Vice Chairman of the Board
Robert L. Sirkis 47 Executive Vice President and Chief Operating
Officer
J. Steven Roy 38 Executive Vice President and Chief Financial
Officer
S. Page Todd 37 Senior Vice President, Secretary and General
Counsel
Keith A. Cousins 30 Senior Vice President - Real Estate/
Development
William G. Guerrette, Jr. 39 Senior Vice President - Sales
Steven M. Hamil 30 Senior Vice President, Chief Accounting
Officer and Controller
Richard R. Langford 42 Senior Vice President - Management Information
Systems
Mark S. Loyd 43 Senior Vice President - Purchasing and Product
Management
Jeffrey S. Stubbs 36 Senior Vice President - Store Operations
Sanford C. Sigoloff(2)(3) 68 Director
Philip B. Smith(2)(3) 63 Director
Joseph F. Troy (1)(3) 60 Director
________________________
(1) Member of Executive Committee.
(2) Member of Compensation Committee.
(3) Member of Audit Committee.
Mr. Malugen co-founded the Company in 1985 and has been its Chairman of the
Board and Chief Executive Officer since that time. Prior to the Company's
initial public offering in August 1994, Mr. Malugen had been a practicing
attorney in the States of Alabama and Missouri since 1978, but spent a majority
of his time managing the operations of the Company beginning in early 1992. Mr.
Malugen received a B.S. degree in Business Administration from the University of
Missouri-Columbia, his J.D. from Cumberland School of Law, Samford University
and his LL.M. (in Taxation) from New York University School of Law.
Mr. Parrish co-founded the Company in 1985 and has been its President and a
Director of the Company since that time. From December 1988 until January 1992,
Mr. Parrish was Vice President of Deltacom, Inc., a regional long distance
telephone provider. Mr. Parrish received a B.A. degree from the University of
Alabama in Business Administration.
Mr. Snow was elected Vice Chairman of the Board in July 1994, and he served
as Chief Financial Officer from July 1994 until May 1996. In 1996, Mr. Snow
entered into a two-year consulting agreement with the Company and upon its
expiration, Mr. Snow and the Company entered into a one-year consulting
agreement commencing January 1, 1999. Mr. Snow was the Executive Vice President
and Chief Financial Officer and a Director of Consolidated Stores Corporation, a
publicly held specialty retailer, from 1985 until he retired in June 1994. Mr.
Snow is a director of Homeland Stores, Inc. and Lot$ Off Stores, Inc., publicly
held companies. Mr. Snow is a Certified Public Accountant, and he received his
Masters in Business Administration from the Kellogg Graduate School of
Management at Northwestern University and his Masters in Taxation from DePaul
University.
13
Mr. Sirkis was elected Executive Vice President and Chief Operating Officer
in September 1997. From 1994 until he joined the Company, Mr. Sirkis founded and
served as President and Chief Executive Officer of Finest Foodservice, L.L.C.,
which developed and operated Boston Market stores in seven states. Prior to
1994, he served as President and Chief Executive Officer of Silo, Inc., a
nationwide retailer of consumer electronics and subsidiary of London-based
Dixons Group, plc. Mr. Sirkis received a B.A. degree from Johns Hopkins
University and his Masters in Business Administration from Harvard Business
School.
Mr. Roy was elected Senior Vice President - Finance and Principal
Accounting Officer in June 1995, was elected Chief Financial Officer in May 1996
and was elected Executive Vice President in March 1998. Mr. Roy was an
accountant with the firm of Ernst & Young LLP for the 11 years prior to joining
the Company, most recently as a Senior Manager in the Audit Department. Mr. Roy
is a Certified Public Accountant and received a B.S. degree in Business
Administration from the University of Alabama.
Mr. Todd was elected Senior Vice President, Secretary and General Counsel
in December 1994. For more than the previous five years, he had been an attorney
practicing tax and corporate law in Dothan, Alabama. Mr. Todd received a B.S.
degree in Business Administration from the University of Alabama, his J.D. from
the University of Alabama School of Law and his LL.M. (in Taxation) from New
York University School of Law.
Mr. Cousins joined the Company in August 1998 and served as Senior Director
of Development, Planning and Analysis until March 1999 when he was elected
Senior Vice President - Real Estate/Development. Prior to joining the Company,
Mr. Cousins acquired four years of management consulting experience with
Computer Sciences Corporation as Program Control Manager; Management Consulting
and Research, Inc. as Cost Analyst; and Tecolote Research, Inc. as Advanced Cost
Estimator. He has seven years of real estate and property management experience
as Senior Director of Development for KinderCare Learning Centers, Inc. and
Senior Accountant with Aronov Realty Management Co., Inc. Mr. Cousins received a
B.S. degree in Business Administration from Auburn University at Montgomery.
Mr. Guerrette joined the Company in April 1997 and, after serving as Vice
President - Retail Sales, was elected Senior Vice President - Sales in December
1997. Mr. Guerrette was President of Sounds Easy Video when it was acquired by
Home Vision Entertainment, Inc. ("Home Vision") in September 1994 and served as
Executive Vice President and Chief Operating Officer of Home Vision until it was
acquired by the Company. He was elected to the Maine House of Representatives,
where he served from November 1994 to 1996. Mr. Guerrette attended Brigham Young
University and majored in Accounting.
Mr. Hamil was elected Vice President and Controller in June 1996, was
elected Chief Accounting Officer in October 1996 and was elected Senior Vice
President in March 1998. From July 1994, after receiving a Masters in Business
Administration from Duke University's Fuqua School of Business, until he joined
the Company, Mr. Hamil was an Investment Banking Associate with NationsBanc
Capital Markets, Inc. He has also served as a Staff Auditor with Ernst & Young
LLP. Mr. Hamil is a Certified Public Accountant and received a B.S. degree in
Business Administration from the University of Alabama.
Mr. Langford joined the Company in August 1995 as Vice President and was
elected Senior Vice President - Management Information Systems in October 1996.
From August 1993 until he joined the Company, Mr. Langford served as a Manager
for Payroll, Fixed Assets and Accounts Payable for Rocky Mountain Healthcare.
From February 1990 to August 1993, he was Director of Support Operations for U.
I. Video Stores, Inc. ("UIV") of Denver, Colorado. UIV was one of the largest
Blockbuster franchisees, operating 110 stores in seven states in July 1993 when
UIV was acquired by Blockbuster. Mr. Langford received a B.A. degree in
Communications from Brigham Young University.
14
Mr. Loyd joined the Company in August 1986 and has served as the retail
store coordinator as well as Vice President - Purchasing and Product Management.
In October 1996, he was elected Senior Vice President - Purchasing and Product
Management. Mr. Loyd attended Southeast Missouri State University, where he
majored in Business Administration.
Mr. Stubbs was elected Senior Vice President - Store Operations in November
1997. He joined the Company in November 1995 as a District Manager and served as
a Regional Manager prior to his current position. Mr. Stubbs attended Texas A &
M University and Southwest Texas State University, where he received his B.B.A.
degree in Business Administration and Marketing.
Mr. Sigoloff became a director of the Company in September 1994. Since
1989, Mr. Sigoloff has been Chairman of the Board, President and Chief Executive
Officer of Sigoloff & Associates, Inc., a management consulting company. In
August 1989, LJ Hooker Corporation, a client of Sigoloff & Associates, Inc.,
appointed Mr. Sigoloff to act as its Chief Executive Officer during its
reorganization under Chapter 11 of the United States Bankruptcy Code. From March
1982 until 1988, Mr. Sigoloff was Chairman of the Board, President and Chief
Executive Officer of Wickes Companies, Inc., one of the largest retailers in the
United States. Mr. Sigoloff is a director of Kaufman and Broad Home Corporation,
a publicly held company. In addition, Mr. Sigoloff is an adjunct full professor
at the John E. Anderson Graduate School of Management at the University of
California at Los Angeles.
Mr. Smith became a director of the Company in September 1994. Since 1991,
Mr. Smith has been Vice Chairman of the Board of Spencer Trask & Co., and since
June 1998, Mr. Smith has been the Vice Chairman of the Board of Laird & Co.,
LLC. He was formerly a Managing Director of Prudential Securities in its
merchant bank. Mr. Smith is a founding General Partner of Lawrence Venture
Associates, a venture capital limited partnership headquartered in New York
City. From 1981 to 1984, he served as Executive Vice President and Group
Executive of the worldwide corporations group at Irving Trust Company. Prior to
joining Irving Trust Company, he was at Citibank for 15 years, where he founded
Citicorp Venture Capital as President and Chief Executive Officer. Since 1988 he
has also been the managing general partner of Private Equity Partnership, L.P.
Mr. Smith is a director of Digital Video Systems, Inc. and KLS EnviroResources,
Inc., publicly held companies. Mr. Smith is an adjunct professor at Columbia
University Graduate School of Business.
Mr. Troy became a director of the Company in September 1994. Mr. Troy is
the founder and has been a member of the law firm of Troy & Gould Professional
Corporation since May 1970.
Directors are elected to serve until the next annual meeting of
stockholders of the Company or until their successors are elected and qualified.
Officers serve at the discretion of the Board of Directors, subject to any
contracts of employment. Non-employee directors receive an annual fee of
$16,000, a fee of $1,000 for each Board meeting attended and a fee of $500 for
each committee meeting attended. The Company has granted vested options to
purchase 105,000 shares of Common Stock to each of Messrs. Sigoloff and Smith,
vested options to purchase 130,000 shares to Mr. Troy and vested options to
purchase 140,000 shares to Mr. Snow, in each case at or above the fair market
value of the Common Stock on the date of grant.
ITEM 2. PROPERTIES
At March 12, 1999, all but one of the Company's 828 stores were located on
premises leased from unaffiliated persons pursuant to leases with remaining
terms which generally vary from one month to six years. The Company is generally
responsible for taxes, insurance and utilities under its leases. Rental rates
often increase upon exercise of any renewal option, and some leases have
percentage rental arrangements pursuant to which the Company is obligated to pay
a base rent plus a percentage of the store's revenues in excess of a stated
15
minimum. In general, the stated minimums are set at such a high level of
revenues that the Company does not pay additional rents based on reaching the
required revenue levels and does not anticipate paying such additional rents in
the future. The Company anticipates that future stores will also be located in
leased premises. The Company owns a family entertainment center, including a
video specialty store, in Meridian, Mississippi.
The Company's corporate campus is located in four buildings at 739 W. Main
Street, Dothan, Alabama, consisting of an aggregate of approximately 13,000
square feet of space, and a portion of an office building located at 2323 W.
Main Street, Dothan, Alabama, consisting of approximately 10,000 square feet of
space. Two of these buildings with an aggregate of approximately 6,500 square
feet of space are owned by the Company and are used for general corporate
offices. Two of these buildings which are used primarily for executive and
general corporate offices have an aggregate of approximately 6,500 square feet
of space and are leased from Messrs. Malugen and Parrish. In Fiscal 1998, these
payments totaled $43,800. The remaining office building space is used for
general corporate offices and is leased from an unaffiliated third party for a
one-year term with multiple one-year renewal options. The Company also leases a
41,730 square foot videocassette processing, distribution and warehouse facility
in Dothan, Alabama, from an unaffiliated third party pursuant to a three-year
lease with three, three-year renewal options.
ITEM 3. LEGAL PROCEEDINGS
The Company is occasionally involved in litigation in the ordinary course
of its business, none of which, individually or in the aggregate, is material to
the Company's business or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock began trading on the Nasdaq National Market on
August 2, 1994 under the symbol "MOVI." The following table sets forth for the
periods indicated the high and low last sale prices of the Company's Common
Stock as reported on the Nasdaq National Market.
High Low
------ ------
1999
First Quarter (through March 12, 1999) .......... $7.500 $4.156
1998
First Quarter ................................... 8.125 2.875
Second Quarter .................................. 8.063 5.500
Third Quarter ................................... 7.625 3.625
Fourth Quarter .................................. 8.000 2.813
1997
First Quarter ................................... 13.750 7.500
Second Quarter .................................. 8.000 5.000
Third Quarter ................................... 6.875 3.500
Fourth Quarter .................................. 4.125 2.500
The last sale price of the Company's Common Stock on March 12, 1999, as
reported on the Nasdaq National Market was $4.50 per share. As of March 12,
1999, there were approximately 2,700 holders of the Company's Common Stock,
including 115 stockholders of record.
The payment of dividends is within the discretion of the Company's Board of
Directors and will depend on the earnings, capital requirements, restrictions in
future credit agreements and the operating and financial condition of the
Company, among other factors. The Company presently expects to retain its
earnings to finance the expansion and further development of its business. There
can be no assurance that the Company will ever pay a dividend in the future.
17
ITEM 6. SELECTED FINANCIAL DATA
Fiscal Year Ended Year Ended
-------------------------------------- -------------------------
January 3, January 4, January 5, December 31, December 31,
1999 1998 1997(3)(4) 1995 1994 (6)
---------------------------------------------------------------------
(dollars in thousands, except per share data)
Statement of Income Data(1):
Revenues:
Rentals $ 222,784 $ 220,787 $ 219,002 $ 130,353 $ 47,782
Product sales 44,849 39,569 35,393 18,848 5,441
--------- --------- --------- --------- --------
267,633 260,356 254,395 149,201 53,223
Operating costs and expenses:
Store operating expenses 137,158 134,141 124,456 67,758 24,119
Amortization of videocassette rental inventory 106,507(2) 69,177 63,544(5) 29,102 10,263
Amortization of intangibles 7,068 7,206 7,160 3,380 606
Cost of product sales 29,744 24,597 21,143 12,600 4,018
General and administrative 17,996 17,006 20,266 13,525 5,647
Restructuring and other charges -- -- 9,595 -- --
--------- --------- --------- --------- --------
Operating income (loss) (30,840) 8,229 8,231 22,836 8,570
Interest expense, net (5,325) (6,326) (5,619) (1,528) (486)
Other, net -- -- -- -- 58
--------- --------- --------- --------- --------
Income (loss) before income taxes (36,165) 1,903 2,612 21,308 8,142
Income taxes(7) (13,089) 998 1,006 7,871 2,991
========= ========= ========= ========= ========
Net income (loss) $ (23,076) $ 905 $ 1,606 $ 13,437 $ 5,151
========= ========= ========= ========= ========
Basic earnings (loss) per share $ (1.72) $ .07 $ .12 $ 1.14 $ .64
========= ========= ========= ========= ========
Diluted earnings (loss) per share $ (1.72) $ .07 $ .12 $ 1.11 $ .63
========= ========= ========= ========= ========
Cash dividends declared per share $ -- $ -- $ -- $ -- $ .39
========= ========= ========= ========= ========
Shares used in computing earnings (loss) per share:
Basic 13,388 13,420 13,241 11,795 8,083
========= ========= ========= ========= ========
Diluted 13,388 13,421 13,368 12,153 8,152
========= ========= ========= ========= ========
Operating Data:
Number of stores at end of period(1) 837 856 863 750 352
Adjusted EBITDA(8) $ 37,378 $ 26,898 $ 26,232 $ 8,766 $ 3,902
Increase (decrease) in same-store revenues(9) 3.9% 1.1% (1.0)% 0.0% 14.3%
December 31,
January 3, January 4, January 5, -----------------------
1999 1998 1997 1995 1994
------------------------------------------------------------------
Balance Sheet Data(1):
Cash and cash equivalents $ 6,983 $ 4,459 $ 3,982 $ 6,255 $ 3,723
Videocassette rental inventory, net 44,998 92,183 89,929 72,979 27,138
Total assets 202,369 259,133 261,577 233,479 76,647
Long-term debt, less current maturities 46,212 63,479 67,883 19,622 6,681
Total liabilities 78,254 111,504 114,853 97,340 29,652
Stockholders' equity 124,115 147,629 146,724 136,139 46,995
18
_________________________
(1) Statement of income data for all periods presented has been restated to
include the results of Home Vision Entertainment, Inc. ("Home Vision") and
Hollywood Video, Inc. ("Hollywood Video"), which were acquired in two
separate pooling-of-interests transactions on July 1, 1996. Home Vision
reported on a fiscal year ending September 30 and Hollywood Video reported
on a calendar year basis. The Company's results for the fiscal year ended
January 5, 1997 are combined with results of Home Vision and Hollywood
Video for the period January 1, 1996 to the date of the acquisitions. The
results of the Company and Hollywood Video for the years ending December
31, 1995 and 1994 are combined with Home Vision's results for the years
ending September 30, 1995 and 1994, respectively. Balance sheet data has
also been restated consistent with the statement of income data except the
December 31, 1995 balance sheet data includes that of Home Vision at
December 31, 1995 instead of September 30, 1995. In order to conform with
the fiscal year end of the Company, Home Vision's net loss of $2,082,000
for the quarter ended December 31, 1995 is not reflected in the statement
of income data but is reflected in stockholders' equity at December 31,
1995. The ending number of stores for each period presented has been
restated to include the store counts of Home Vision and Hollywood Video
(2) Effective July 6, 1998, the Company changed its method of amortizing
videocassette rental inventory resulting in non-recurring, non-cash,
pre-tax charge of approximately $43.6 million.
(3) On July 1, 1996, the Company adopted a fiscal year ending on the first
Sunday following December 30, which periodically results in a fiscal year
of 53 weeks. The 1996 fiscal year, ended on January 5, 1997, reflects a
53-week year.
(4) Includes a non-recurring charge of approximately $10.4 million for store
closures, corporate restructuring and merger-related expenses.
(5) Effective April 1, 1996, the Company changed its method of amortizing
videocassette rental inventory resulting in a one-time, non-cash charge of
approximately $7.7 million.
(6) General and administrative expenses and income taxes include pro forma
adjustments for the change in compensation levels arising from employment
contracts with two stockholders who are executive officers of the Company.
(7) The provision for income tax includes pro forma adjustments to reflect
income tax expense which would have been recognized if the Company, Home
Vision and Hollywood Video had been taxed as C corporations for all periods
presented. Historical operating results of the Company, Home Vision and
Hollywood Video do not include any provision for income taxes prior to
August 2, 1994, October 1, 1994 and July 1, 1996, respectively, due to
their S corporation status prior to those dates.
(8) "Adjusted EBITDA" is earnings before interest, taxes, depreciation and
amortization, excluding non-recurring charges, less the Company's purchase
of videocassette rental inventory. For purposes of calculating Adjusted
EBITDA, the Company's videocassette rental inventory purchases for the
fiscal years ended January 3, 1999, January 4, 1998 and January 5, 1997
have been reduced by $1.2 million, $1.3 million and $5.7 million,
respectively, associated with inventory purchases specifically for new
store openings. New store inventory purchases are not separately identified
for the years ended December 31, 1995 and 1994. Adjusted EBITDA does not
take into account capital expenditures, other than purchases of
videocassette rental inventory, and does not represent cash generated from
operating activities in accordance with generally accepted accounting
principles ("GAAP"), is not to be considered as an alternative to net
income or any other GAAP measurements as a measure of operating performance
and is not indicative of cash available to fund all cash needs. The
Company's definition of Adjusted EBITDA may not be identical to similarly
titled measures of other companies. The Company believes that in addition
to cash flows and net income, Adjusted EBITDA is a useful financial
performance measurement for assessing the operating performance of the
Company because, together with net income and cash flows, Adjusted EBITDA
is widely used in the videocassette specialty retailing industry to provide
investors with an additional basis to evaluate the ability of the Company
to incur and service its debt and to fund acquisitions. To evaluate
Adjusted EBITDA and the trends it depicts, the components of Adjusted
EBITDA, such as net revenues, cost of services and sales, general and
administrative expenses, should be considered. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations."
(9) Same-store revenue is defined as the aggregate revenues from stores
operated by the Company for at least 13 months. Same-store revenues for the
Company have not been restated to include the same-store revenues of Home
Vision and Hollywood Video.
19
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Overview
From August 1994 through July 1, 1996, the Company experienced rapid growth in
revenue and operating income primarily as a result of acquiring stores and
opening new stores. Since the fall of 1996, the Company's store base has
remained relatively constant as the Company has internally developed a similar
number of stores as have been closed. The number of stores owned and operated by
the Company at the end of each of the following periods is as follows:
December 31, 1994 352
December 31, 1995 750
January 5, 1997 863
January 4, 1998 856
January 3, 1999 837
The results of operations for the fiscal year ended January 5, 1997 include the
combined results of the Company, Home Vision Entertainment, Inc. ("Home Vision")
and Hollywood Video, Inc. ("Hollywood Video"). The acquisitions of Home Vision
and Hollywood Video were consummated on July 1, 1996 and were accounted for as
poolings-of-interests. The above store count totals reflect the combined totals
of Movie Gallery, Inc., Home Vision and Hollywood Video for all periods
presented. During the fiscal year ended January 3, 1999 ("Fiscal 1998"), 18
stores were developed by the Company, 4 stores were acquired and 41 were closed.
As a result of the 507 store acquisitions during the periods January 1, 1995
through January 3, 1999, the Company recorded $84.9 million in goodwill and
other intangibles. Goodwill is amortized on a straight-line basis over twenty
years. Other intangibles, which consist primarily of non-compete agreements, are
amortized on a straight-line basis over two to ten years.
On July 1, 1996, the Company adopted a fiscal year that ends on the first Sunday
following December 30. This change results in the Company having a 52- or
53-week year. The year ended January 5, 1997 ("Fiscal 1996") was a 53-week year,
while the fiscal year ended January 4, 1998 ("Fiscal 1997") and Fiscal 1998 were
52-week years.
Effective July 6, 1998, the Company changed its amortization policy for rental
inventory, which was accounted for as a change in accounting estimate effected
by a change in accounting principle. The major impetus for the change in
amortization policy is the changing purchasing economics within the industry and
the Company, which have resulted in a significant increase in new release videos
available for rental. Revenue sharing agreements and other copy-depth
initiatives have increased customer satisfaction of the video rental experience,
especially with respect to new release videos, and, thus, the overall demand for
each new release is satisfied sooner. In order to match more accurately the
valuation of tape inventory with accelerated consumer demand, the Company has
changed its amortization policy for rental inventory. The application of the new
method of amortizing videocassette and video game rental inventory decreased
rental inventory and increased depreciation expense for the year ended January
3, 1999 by approximately $43.6 million and reduced net income and earnings per
diluted share by $27.7 million and $2.06, respectively.
Under the new amortization method, the cost of base stock videocassettes,
consisting of two copies per title for each store, is amortized on an
accelerated basis to a net book value of $8 over the first six months and to a
$4 salvage value over the next thirty months. The cost of non-base stock
20
videocassettes, consisting of the third and succeeding copies of each title per
store, is amortized on an accelerated basis over the first six months to a net
book value of $4, which is then fully amortized on a straight-line basis over
the next 30 months or until the videocassette is sold, at which time the
unamortized book value is charged to cost of sales. Video games are amortized on
a straight-line basis to a $10 salvage value over eighteen months. The Company
will continue to expense revenue sharing payments as revenues are earned
pursuant to contractual arrangements.
Prior to July 6, 1998, and pursuant to an accounting change effective April 1,
1996, videocassette and video game rental inventory was recorded at cost and
amortized over its economic useful life. Videocassettes considered to be base
stock were amortized over thirty-six months on a straight-line basis to a $5
salvage value. New release videocassettes were amortized as follows: (i) the
fourth and any succeeding copies of each title per store were amortized on a
straight-line basis over the first six months to an average net book value of $5
which was then fully amortized on a straight-line basis over the next thirty
months or until the videocassette was sold, at which time the unamortized book
value was charged to cost of sales and (ii) copies one through three of each
title per store were amortized as base stock.
During Fiscal 1996, the Company adopted a business restructuring plan to close
approximately 50 stores and reduce the corporate organizational staff by
approximately 15%. The restructuring plan resulted in a $9.6 million pretax
restructuring charge recorded in the third quarter of Fiscal 1996. The
components of the restructuring charge included approximately $5.4 million in
reserves for future cash outlays for lease terminations, miscellaneous closing
costs and legal and accounting costs, as well as approximately $4.2 million in
asset write downs. Approximately $3.2 million of costs were paid and charged
against the liability as of January 3, 1999. The store closures were
substantially completed by the end of Fiscal 1997. Additionally, during the
third quarter of Fiscal 1996 the Company incurred merger-related costs of
approximately $757,000 related to the acquisition of Home Vision and Hollywood
Video.
The provision for income taxes includes pro forma adjustments to reflect income
tax expense which would have been recognized if Hollywood Video had been taxed
as a C corporation for all periods presented. Historical operating results of
Hollywood Video do not include any provision for income taxes prior to July 1,
1996 due to their S corporation status prior to this date.
The Company currently has a net deferred tax asset of approximately $2.6
million. The Company anticipates the generation of sufficient future taxable
income, based on its current operations, to utilize these deferred tax assets.
With respect to forward-looking statements contained in this Item 7, please
review the disclosures set forth under "Cautionary Statements" in Item 1 above.
21
Results of Operations
The following table sets forth, for the periods indicated, statement of income
data, expressed as a percentage of total revenue, and the number of stores open
at the end of each period. The store count and the operating results reflect the
combined operations of Movie Gallery, Inc., Home Vision and Hollywood Video for
all periods.
Statement of Operations Data:
53 Weeks
52 Weeks Ended Ended
--------------------------------------
January 3, January 4, January 5,
1999 1998 1997
--------------------------------------
Revenues:
Rentals 83.2% 84.8% 86.1%
Product sales 16.8 15.2 13.9
----- ----- -----
100.0 100.0 100.0
Operating costs and expenses:
Store operating expenses 51.2 51.5 48.9
Amortization of videocassette rental inventory:
Recurring 23.5 26.6 22.0
Policy change 16.3 -- 3.0
Amortization of intangibles 2.7 2.8 2.8
Cost of product sales 11.1 9.4 8.3
General and administrative 6.7 6.5 8.0
Restructuring and other charges -- -- 3.8
----- ----- -----
111.5 96.8 96.8
----- ----- -----
Operating income (loss) (11.5) 3.2 3.2
Interest expense, net (2.0) (2.5) (2.2)
----- ----- -----
Income (loss) before income taxes (13.5) 0.7 1.0
Income taxes (1) (4.9) 0.4 0.4
----- ----- -----
Net income (loss) (8.6)% 0.3% 0.6%
===== ===== =====
Number of stores at end of period 837 856 863
===== ===== =====
_____________________
(1) The provision for income taxes includes pro forma adjustments to reflect
income tax expense which would have been recognized if Hollywood Video had
been taxed as a C corporation for all periods presented. Historical
operating results of Hollywood Video do not include any provision for
income taxes prior to July 1, 1996 due to its S corporation status prior to
this date.
Fiscal year ended January 3, 1999 compared to the fiscal year ended January 4,
1998
Revenue. Total revenue increased 2.8% to $267.6 million for Fiscal 1998
from $260.4 million for Fiscal 1997. The increase was due primarily to an
increase in same-store revenues of 3.9%, offset in part due to fewer average
stores open during Fiscal 1998 versus Fiscal 1997. The increase in same-store
revenues was primarily the result of (i) an increase in the number of copies of
new release videocassettes available to customers as a result of copy-depth
initiatives, including revenue sharing programs and other depth of copy programs
available from movie studios; (ii) an increase in the video game rental business
due to both increasing consumer acceptance of the Nintendo 64 and Sony
Playstation game platforms and an increase in the number of game titles
available for these platforms; and (iii) successful, chain-wide internal
marketing programs designed to generate more consumer excitement and traffic in
the Company's base of stores. Product sales increased as a percentage of total
revenues to 16.8% for Fiscal 1998 from 15.2% for Fiscal 1997, primarily as a
result of an increase in the sales of previously viewed rental inventory.
22
Operating Costs and Expenses. Store operating expenses, which include
store-level expenses such as lease payments and in-store payroll, decreased to
51.2% of total revenue for Fiscal 1998 from 51.5% for Fiscal 1997. The decrease
in store operating expenses as a percentage of revenues was primarily due to
same-store revenue increases, offset in part by an increase in revenue sharing
expense of approximately $3.0 million in Fiscal 1998 versus Fiscal 1997.
Recurring amortization of videocassette rental inventory, excluding the
non-recurring charge related to the change in amortization policy, decreased in
Fiscal 1998 as a percentage of total revenue to 23.5% from 26.6% in Fiscal 1997.
Amortization of videocassette rental inventory for all periods ending prior to
July 6, 1998, was calculated under the previous policy described in Note 1 of
the "Notes to the Consolidated Financial Statements." Significantly reduced tape
purchase dollars in Fiscal 1998 versus Fiscal 1997, an increased use of revenue
sharing, as well as the same-store revenue increases in Fiscal 1998, are the
main reasons that the amortization of inventory as a percentage of revenue in
Fiscal 1998 has declined versus Fiscal 1997.
Cost of product sales includes the costs of new videocassettes, confectionery
items and other goods, as well as the unamortized value of previously viewed
rental inventory sold in the Company's stores. Cost of product sales increased
with the increase in product sales revenue and increased as a percentage of
product sales revenue from 62.2% in Fiscal 1997 to 66.3% in Fiscal 1998. The
decrease in product sales gross margins is primarily the result of: (i) a
concentrated effort by the Company to reduce inventory levels through discounts
on selected inventory during the first half of 1998; and (ii) the impact of
Titanic, which the Company sold at a below average profit margin and for which
the Company sold more units than any sell-through priced title in its history.
General and administrative expenses increased as a percentage of revenues from
6.5% for Fiscal 1997 to 6.7% for Fiscal 1998. The increase is primarily due to
Fiscal 1998 increases in fixed asset depreciation, marketing expenses, salaries
and wages and other personnel costs, in part associated with the increase in
personnel in the Company's real estate department in anticipation of its planned
new store development during the fiscal year 1999.
As a result of the above factors, excluding the impact of the amortization
policy change, operating income increased by 55% to $12.8 million in Fiscal 1998
from $8.2 million in Fiscal 1997.
Fiscal year ended January 4, 1998 compared to the fiscal year ended January 5,
1997
Revenue. Total revenue increased 2.3% to $260.4 million for Fiscal 1997
from $254.4 million for Fiscal 1996. The increase was due primarily to an
increase in same-store revenues of 1.1%, as well as the net positive effect of
closing lower volume stores while internally developing stores that have
generated revenue results greater than the closed stores. The increase in
same-store revenues was primarily a result of (i) the Company's emphasis in the
last half of Fiscal 1997 to increase the depth of copies of "hit titles" within
its store base; (ii) an increase in the game rental business due to the advent
and consumer acceptance of the Nintendo 64 and Sony Playstation game platforms;
and (iii) a decrease in the number of competitive store openings, particularly
in the last half of Fiscal 1997. Product sales increased as a percentage of
total revenues to 15.2% for Fiscal 1997 from 13.9% for Fiscal 1996, as a result
of (i) the Company's continued and increased emphasis on the sale of previously
viewed rental inventory; and (ii) an increase in the variety of other products
sold in stores, such as video accessories and confectionery items.
Operating Costs and Expenses. Store operating expenses, which reflect
direct store expenses such as lease payments and in-store payroll, increased to
51.5% of total revenue for Fiscal 1997 from 48.9% for Fiscal 1996. The increase
in store operating expenses was primarily due to (i) strategic responses in the
Company's most competitive markets, which affected certain expenses, such as
labor hours used and advertising costs; (ii) the national minimum wage increases
23
that were implemented on September 1, 1996 and September 1, 1997; and (iii)
increases in rent in connection with the normal renewal of leases in existing
stores.
Amortization of videocassette rental inventory increased as a percentage of
revenue to 26.6% for Fiscal 1997 from 25.0% for Fiscal 1996 due primarily to (i)
a decision by the Company to increase its level of expenditures on rental
inventory during the fourth quarter of 1996 and the first half of 1997 in
response to industry-wide competitive issues; (ii) an increase in the depth of
hit new release titles purchased during the year, which results in more tapes
being substantially amortized over six months versus three years; and (iii) a
marked increase in the quantity of new game release purchases, which is due to
the buildup of inventory related to the consumer acceptance of new game
platforms (i.e., Nintendo 64 and Sony Playstation).
Cost of product sales includes the costs of new videocassettes, confectionery
items and other goods, as well as the unamortized value of previously viewed
rental inventory sold in the Company's stores. Cost of product sales increased
with the increased revenue from product sales and increased as a percentage of
revenues from product sales from 59.7% for Fiscal 1996 to 62.2% for Fiscal 1997.
The decrease in product sales gross margins resulted primarily from (i) an
increase in new tape sales which carry lower margins than other sales items; and
(ii) an effort by the Company to market more aggressively its new tape
inventory. These factors were offset, in part, by an increase in the sale of
previously viewed rental inventory, the unamortized value of which is expensed
to cost of product sales and generally generates higher margins than other
product categories.
General and administrative expenses decreased as a percentage of revenues from
8.0% for Fiscal 1996 to 6.5% for Fiscal 1997. Excluding $757,000 in
merger-related expenses associated with the acquisitions of Home Vision and
Hollywood Video, general and administrative expenses would have been 7.7% of
revenues for Fiscal 1996. The decrease is primarily due to the efficiencies
gained from the leveraging of overhead associated with acquisition activity in
1996 and a reduction in corporate overhead over the past year.
As a result of the above, operating income was essentially flat at $8.2 million
in both Fiscal 1997 and Fiscal 1996. However, excluding the effects of the
business restructuring plan, the one-time, non-recurring increase in
amortization of videocassette rental inventory due to the change in amortization
policy and the merger-related expenses from the Home Vision and Hollywood Video
acquisitions, operating income would have been $26.2 million in Fiscal 1996.
Liquidity and Capital Resources
Historically, the Company's primary capital needs have been for opening and
acquiring new stores and for the purchase of videocassette inventory. Other
capital needs include the refurbishment, remodeling and relocation of existing
stores. The Company has funded inventory purchases, remodeling and relocation
programs, new store opening costs and acquisitions primarily from cash flow from
operations, the proceeds of two public equity offerings, loans under revolving
credit facilities and seller financing.
During Fiscal 1998, the Company generated $37.4 million in Adjusted EBITDA
versus $26.9 million for Fiscal 1997. The increase in Adjusted EBITDA is
attributable primarily to both the same-store revenue increase of 3.9% and the
Company's leveraging of rental inventory purchases during Fiscal 1998 versus
Fiscal 1997. "Adjusted EBITDA" is earnings before interest, taxes, depreciation
and amortization, less the Company's purchase of videocassette rental inventory
which excludes inventory purchases specifically for new store openings. Adjusted
EBITDA does not take into account capital expenditures, other than purchases of
videocassette rental inventory, and does not represent cash generated from
operating activities in accordance with generally accepted accounting principles
("GAAP"), is not to be considered as an alternative to net income or any other
GAAP measurements as a measure of operating performance and is not indicative of
24
cash available to fund cash needs. The Company's definition of Adjusted EBITDA
may not be identical to similarly titled measures of other companies. The
Company believes that in addition to cash flows and net income, Adjusted EBITDA
is a useful financial performance measurement for assessing the operating
performance of the Company because, together with net income and cash flows,
Adjusted EBITDA is widely used in the videocassette specialty retailing industry
to provide investors with an additional basis to evaluate the ability of the
Company to incur and service its debt and to fund acquisitions.
Net cash provided by operating activities was $90.9 million for Fiscal 1998 as
compared to $83.9 million for Fiscal 1997. Net income was lower in Fiscal 1998
versus Fiscal 1997 because of the impact of the change in amortization policy.
However, cash provided by operating activities increased primarily due to a
decrease in merchandise inventory and an increase in accounts payable, as well
as higher depreciation and amortization in Fiscal 1998 versus Fiscal 1997. These
items were offset, in part, due to a decrease in deferred income taxes and an
increase in other current assets in Fiscal 1998 versus Fiscal 1997.
Net cash used in investing activities was $66.3 million for Fiscal 1998 as
compared to $83.2 million for Fiscal 1997. This decrease in funds used for
investing activities is primarily the result of a decrease in the expenditures
of capital for both videocassette rental inventory and property, furnishings and
equipment during Fiscal 1998 versus Fiscal 1997.
Net cash used by financing activities was $22.0 million for Fiscal 1998 as
compared to $0.2 million for Fiscal 1997. This change resulted directly from the
Company's increased Adjusted EBITDA generated in Fiscal 1998 versus Fiscal 1997,
which allowed the Company to decrease its debt outstanding during the year by
$21.6 million.
During Fiscal 1996, the Company entered into a $125 million reducing revolving
credit facility (the "Original Facility"). During 1997, the Company voluntarily
reduced the commitment to $90 million. The available amount under the Original
Facility began to reduce quarterly on March 31, 1998 with a final maturity date
of June 30, 2000. The interest rate of the Original Facility was based on LIBOR
plus an applicable margin percentage, which depended on the Company's cash flow
generation and borrowings outstanding. At January 3, 1999, $46 million was
outstanding and approximately $17 million was available for borrowing under the
Original Facility.
The Original Facility was replaced on January 7, 1999 with a new Credit
Agreement with First Union National Bank of North Carolina (the "New Facility").
The New Facility provides for borrowings up to $65 million, is an unsecured
revolving credit facility and matures on January 7, 2002. The Company may
increase the amount of the New Facility to $85 million after April 8, 1999 if
existing banks increase their commitments or a new bank(s) enter the Credit
Agreement. The interest rate of the New Facility is based on LIBOR plus an
applicable margin percentage, which depends on the Company's cash flow
generation and borrowings outstanding. The Company may repay the New Facility at
any time without penalty. The more restrictive covenants of the New Facility
restrict borrowings based upon cash flow levels.
The Company grows its store base through internally developed and acquired
stores and may require capital in excess of internally generated cash flow to
achieve its desired growth. The Company has announced a planned increase in its
unit growth in 1999, which will be accomplished via opening up to 100 internally
developed stores and making selective, accretive and strategically consistent
acquisitions, if available to the Company on reasonable terms. To the extent
available, future acquisitions may be completed using funds available under the
New Facility, financing provided by sellers, alternative financing arrangements
such as funds raised in public or private debt or equity offerings or shares of
the Compan's stock issued to sellers. However, there can be no assurance that
financing will be available to the Company on terms which will be acceptable, if
at all.
25
At January 3, 1999, the Company had a working capital deficit of $7.6 million,
due to the accounting treatment of its videocassette rental inventory.
Videocassette rental inventory is treated as a noncurrent asset under generally
accepted accounting principles because it is a depreciable asset and is not an
asset which is reasonably expected to be completely realized in cash or sold in
the normal business cycle. Although the rental of this inventory generates the
major portion of the Company's revenue, the classification of this asset as
noncurrent results in its exclusion from working capital. The aggregate amount
payable for this inventory, however, is reported as a current liability until
paid and, accordingly, is included in working capital. Consequently, the Company
believes that working capital is not an appropriate measure of its liquidity and
it anticipates that it will continue to operate with a working capital deficit.
The Company believes its projected cash flow from operations, borrowing capacity
with the New Facility, cash on hand and trade credit will provide the necessary
capital to fund its current plan of operations for Fiscal 1999, including its
anticipated new store openings. However, to fund a resumption of the Company's
acquisition program, or to provide funds in the event that the Company's need
for funds is greater than expected, or if certain of the financing sources
identified above are not available to the extent anticipated or if the Company
increases its growth plan, the Company will need to seek additional or
alternative sources of financing. This financing may not be available on terms
satisfactory to the Company. Failure to obtain financing to fund the Company's
expansion plans or for other purposes could have a material adverse effect on
the Company.
Other Matters
Recently Issued Accounting Standards
In April 1998, the AICPA issued Statement of Position (SOP) 98-5, "Reporting the
Costs of Start-up Activities." The SOP is effective for the Company beginning on
January 4, 1999, and requires that certain start-up costs capitalized prior to
January 4, 1999 be written off and any such future start-up costs to be expensed
as incurred. The unamortized balance of start-up costs as of January 3, 1999
(approximately $650,000 after tax) will be written off as a cumulative effect of
an accounting change as of January 4, 1999. The Company estimates the impact of
adopting this SOP will not be material to 1999 earnings.
Impact of Year 2000
The Company has performed an analysis of its operating systems to determine
systems' compatibility with the upcoming year 2000. Substantially all of the
Company's operating systems are year 2000 compliant, including its point-of-sale
system. While the Company has begun to actively replace or modify certain
software and hardware so that they will properly function on January 1, 2000 and
thereafter, the costs associated with these modifications or replacements have
not been material to the Company nor does the Company believe these costs will
be material in the future.
The Company's payroll software is not currently year 2000 compliant. However,
the Company is in the process of replacing its payroll system with a year 2000
compliant package that will provide management with better functionality and
reporting. While the current payroll software is the Company's largest year 2000
issue to resolve, the Company believes that its planned software and hardware
modifications, as well as its replacement efforts will result in no significant
operational problems. However, if such modifications and conversions are not
made, or are not completed timely, the year 2000 issue could have a material
adverse impact on the operations of the Company.
26
The Company is currently not aware of any major vendor that is not actively
managing the process of being year 2000 compliant by December 31, 1999. Thus,
the Company does not believe that there are any vendors with a year 2000 issue
that would materially impact the results of operations or the liquidity of the
Company. However, the Company has no means of ensuring that vendors will be
adequately prepared for the year 2000.
The Company is developing contingency plans in the event it experiences system
failure related to the year 2000. The Company plans to evaluate the status of
year 2000 compliance throughout 1999 to determine whether such contingency plans
are adequate, although at this time the Company knows of no reason its
modifications and replacements of operating systems will not be effective and
completed in a timely manner.
Market Risk Sensitive Instruments
The market risk inherent in the Company's financial instruments represents the
increased interest costs arising from adverse changes in interest rates
(primarily LIBOR and prime bank rates). In order to manage this risk, the
Company entered into an interest rate swap agreement that effectively fixes the
Company's interest rate exposure on $37 million of the amount outstanding under
the New Facility at 5.8% plus an applicable margin percentage. Assuming a
hypothetical 10% adverse change in the LIBOR interest rate and assuming debt
levels outstanding as of January 3, 1999, the Company would incur an immaterial
amount of additional annual interest expense on unhedged variable rate
borrowings. These amounts are determined by considering the impact of the
hypothetical change in interest rates on the Company's cost of borrowing. The
analysis does not consider the potential negative impact on overall economic
activity that could exist in such an environment. The Company believes that its
exposure to adverse interest rate changes and its impact on its total cost of
borrowing capital has been largely mitigated by the interest rate swap agreement
that is in place.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Reference is made to Part II, Item 7, "Market Risk Sensitive
Instruments" of this Form 10-K for the information required by Item 7A.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to Part IV, Item 14 of this Form 10-K for the
information required by Item 8.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
None.
27
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item (other than the information
regarding executive officers set forth at the end of Item 1 of Part I of this
Form 10-K) will be contained in the Company's definitive Proxy Statement for its
1999 Annual Meeting of Stockholders, and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item will be contained in the
Company's definitive Proxy Statement for its 1999 Annual Meeting of
Stockholders, and is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item will be contained in the
Company's definitive Proxy Statement for its 1999 Annual Meeting of
Stockholders, and is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item will be contained in the
Company's definitive Proxy Statement for its 1999 Annual Meeting of
Stockholders, and is incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Financial Statements:
Report of Ernst & Young LLP, Independent Auditors.
Consolidated Balance Sheets as of January 3, 1999 and January 4,
1998.
Consolidated Statements of Operations for the Fiscal Years Ended
January 3, 1999, January 4, 1998 and January 5, 1997.
Consolidated Statements of Stockholders' Equity for the Fiscal Years
Ended January 3, 1999, January 4, 1998 and January 5, 1997.
Consolidated Statements of Cash Flows for the Fiscal Years Ended
January 3, 1999, January 4, 1998 and January 5, 1997.
Notes to Consolidated Financial Statements.
(a)(2) Schedules:
None.
28
(a)(3) Exhibits:
The following exhibits, which are furnished with this Annual Report
or incorporated herein by reference, are filed as part of this Annual Report:
Exhibit
No. Exhibit Description
- ------- -------------------
3.1 - Certificate of Incorporation of the Company. (1)
3.2 - Bylaws of the Company. (1)
4.1 - Specimen Common Stock Certificate. (2)
10.1 - 1994 Stock Option Plan,as amended and form of Stock Option Agreement.(3)
10.2 - Form of Indemnity Agreement. (1)
10.3 - Employment Agreement between M.G.A., Inc. and Joe Thomas Malugen. (1)
10.4 - Employment Agreement between M.G.A., Inc. and H. Harrison Parrish. (1)
10.5 - Consulting Agreement between M.G.A., Inc. and William B. Snow dated
December 21, 1998. (filed herewith)
10.6 - Employment Agreement between M.G.A., Inc. and J. Steven Roy. (4)
10.7 - Employment Agreement between M.G.A., Inc. and S. Page Todd. (4)
10.8 - Employment Agreement between M.G.A., Inc. and Steven M. Hamil. (4)
10.9 - Employment Agreement between M.G.A., Inc. and Robert L. Sirkis dated
September 12, 1997. (filed herewith)
10.10 - Agreement dated March 13, 1997 between Sight & Sound Distributors, Inc.
and Movie Gallery, Inc. (3) (portions were omitted pursuant to a request
for confidential treatment)
10.11 - Agreement dated August 15, 1997 between Major Video Concepts, Inc. and
Movie Gallery, Inc.(5) (portions were omitted pursuant to a request for
confidential treatment)
10.12 - Real estate lease dated June 1, 1994 between J. T. Malugen, H. Harrison
Parrish and M.G.A., Inc.(1)
10.13 - Real estate lease dated June 1, 1994 between H. Harrison Parrish and
M.G.A., Inc.(1)
10.14 - Tax Agreement between M.G.A., Inc. and Joe T. Malugen and Harrison
Parrish.(1)
10.15 - Certificate of Title dated October 6, 1992 and United States Patent and
Trademark Office Notice of Recordation of Assignment Document dated
January 27, 1993 (relating to the Company's acquisition of the "Movie
Gallery" service mark, trade name and goodwill associated therewith) (6)
10.16 - Credit Agreement between First Union National Bank of North Carolina and
Movie Gallery, Inc. dated July 10, 1996. (7)
10.17 - Credit Agreement between First Union National Bank of North Carolina and
Movie Gallery, Inc. dated January 7, 1999. (filed herewith)
10.18 - Asset Purchase Agreement between Blowout Entertainment, Inc. and M.G.A.,
Inc. dated March 22, 1999. (filed herewith)
18 - Change in Accounting Principle.(8)
18.1 - Change in Accounting Principle.(9)
21 - List of Subsidiaries. (filed herewith)
23 - Consent of Ernst & Young LLP, Independent Auditors. (filed herewith)
27 - Financial Data Schedule. (filed herewith)
29
_______________
(1) Previously filed with the Securities and Exchange Commission on June 10,
1994, as exhibits to the Company's Registration Statement on Form S-1 (File
No. 33-80120).
(2) Previously filed with the Securities and Exchange Commission on August 1,
1994, as an exhibit to Amendment No. 2 to the Company's Registration
Statement on Form S-1.
(3) Previously filed with the Securities and Exchange Commission on April 7,
1997, as an exhibit to the Company's Form 10-K for the fiscal year ended
January 5, 1997.
(4) Previously filed with the Securities and Exchange Commission on April 6,
1998, as an exhibit to the Company's Form 10-K for the fiscal year ended
January 4, 1998.
(5) Previously filed with the Securities and Exchange Commission on November
19, 1997 as an exhibit to the Company's Form 10-Q for the quarter ended
October 5, 1997.
(6) Previously filed with the Securities and Exchange Commission on July 14,
1994, as exhibits to Amendment No. 1 to the Company's Registration
Statement on Form S-1.
(7) Previously filed with the Securities and Exchange Commission on July 15,
1996, as an exhibit to the Company's Current Report on Form 8-K.
(8) Previously filed with the Securities and Exchange Commission on August 14,
1996, as an exhibit to the Company's Form 10-Q for the quarter ended June
30, 1996.
(9) Previously filed with the Securities and Exchange Commission on November
18, 1998, as an exhibit to the Company's Form 10-Q for the quarter ended
October 4, 1998.
(b) Reports on Form 8-K:
The Company did not file any reports on Form 8-K during the quarter
ended January 3, 1999.
(c) Exhibits:
See (a)(3) above.
30
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the Registrant has duly caused this annual
report on Form 10-K to be signed on its behalf by the undersigned, thereunto
duly authorized.
MOVIE GALLERY, INC.
By /s/ JOE THOMAS MALUGEN
---------------------------
Joe Thomas Malugen,
Chairman of the Board
and Chief Executive Officer
Date: April 5, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934,
this annual report on Form 10-K has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ JOE THOMAS MALUGEN Chairman of the Board and April 5, 1999
- ----------------------- Chief Executive Officer
Joe Thomas Malugen
/s/ WILLIAM B. SNOW Vice Chairman of the Board April 5, 1999
- -----------------------
William B. Snow
/s/ H. HARRISON PARRISH Director and President April 5, 1999
- -----------------------
H. Harrison Parrish
/s/ SANFORD C. SIGOLOFF Director April 5, 1999
- -----------------------
Sanford C. Sigoloff
/s/ J. STEVEN ROY Executive Vice President and April 5, 1999
- ----------------------- Chief Financial Officer
J. Steven Roy
/s/ STEVEN M. HAMIL Senior Vice President and April 5, 1999
- ----------------------- Chief Accounting Officer
Steven M. Hamil
31
Movie Gallery, Inc.
Financial Statements
Fiscal years ended January 3, 1999, January 4, 1998 and January 5, 1997
Contents
Report of Ernst & Young LLP, Independent Auditors............................F-1
Audited Financial Statements
Consolidated Balance Sheets..................................................F-2
Consolidated Statements of Operations........................................F-3
Consolidated Statements of Stockholders' Equity..............................F-4
Consolidated Statements of Cash Flows........................................F-5
Notes to Consolidated Financial Statements...................................F-6
Report of Ernst & Young LLP, Independent Auditors
Board of Directors and Stockholders
Movie Gallery, Inc.
We have audited the accompanying consolidated balance sheets of Movie Gallery,
Inc. as of January 3, 1999 and January 4, 1998, and the related consolidated
statements of operations, stockholders' equity and cash flows for each of the
three years in period ended January 3, 1999. 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 in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Movie Gallery,
Inc. at January 3, 1999 and January 4, 1998, and the consolidated results of its
operations and its cash flows for each of the three years in period ended
January 3, 1999, in conformity with generally accepted accounting principles.
As discussed in Note 1 to the financial statements, in 1998 and 1996 the Company
changed its method of accounting for amortization of videocassette rental
inventory.
/s/ Ernst & Young, LLP
Birmingham, Alabama
February 12, 1999
F-1
Movie Gallery, Inc.
Consolidated Balance Sheets
(in thousands)
January 3, January 4,
1999 1998
---------------------------
Assets
Current assets:
Cash and cash equivalents $ 6,983 $ 4,459
Merchandise inventory 11,824 13,512
Prepaid expenses 779 1,341
Store supplies and other 3,772 2,561
Deferred income taxes 312 531
-------- --------
Total current assets 23,670 22,404
Videocassette rental inventory, net 44,998 92,183
Property, furnishings and equipment, net 43,920 50,321
Goodwill and other intangibles, net 85,743 92,321
Deposits and other assets 1,799 1,904
Deferred income taxes 2,239 --
-------- --------
Total assets $202,369 $259,133
======== ========
Liabilities and stockholders' equity
Current liabilities:
Accounts payable $ 23,396 $ 21,517
Accrued liabilities 7,426 7,014
Current portion of long-term debt 442 4,751
-------- --------
Total current liabilities 31,264 33,282
Long-term debt 46,212 63,479
Other accrued liabilities 778 1,899
Deferred income taxes -- 12,844
Stockholders' equity:
Preferred stock, $.10 par value; 2,000,000 shares
authorized, no shares issued and outstanding -- --
Common stock, $.001 par value; 60,000,000
shares authorized, 13,315,915 and 13,418,885
shares issued and outstanding 13 13
Additional paid-in capital 131,743 131,686
Retained earnings (deficit) (7,146) 15,930
Treasury stock (115,200 shares) (495) --
-------- --------
Total stockholders' equity 124,115 147,629
-------- --------
Total liabilities and stockholders' equity $202,369 $259,133
======== ========
See accompanying notes.
F-2
Movie Gallery, Inc.
Consolidated Statements of Operations
(in thousands, except per share data)
Fiscal Year Ended
---------------------------------------------
January 3, January 4, January 5,
1999 1998 1997
---------------------------------------------
Revenues:
Rentals $ 222,784 $ 220,787 $ 219,002
Product sales 44,849 39,569 35,393
--------- --------- ---------
267,633 260,356 254,395
Operating costs and expenses:
Store operating expenses 137,158 134,141 124,456
Amortization of videocassette rental inventory 106,507 69,177 63,544
Amortization of intangibles 7,068 7,206 7,160
Cost of product sales 29,744 24,597 21,143
General and administrative 17,996 17,006 20,266
Restructuring and other charges -- -- 9,595
--------- --------- ---------
Operating income (loss) (30,840) 8,229 8,231
Interest income 44 45 99
Interest expense (5,369) (6,371) (5,718)
--------- --------- ---------
Income (loss) before income taxes (36,165) 1,903 2,612
Income taxes (13,089) 998 1,131
--------- --------- ---------
Net income (loss) $ (23,076) $ 905 $ 1,481
========= ========= =========
Basic and diluted earnings (loss) per share $ (1.72) $ .07
========= =========
Pro forma earnings per share (unaudited):
Income before income taxes $ 2,612
Pro forma income taxes 1,006
---------
Pro forma net income $ 1,606
=========
Basic and diluted pro forma earnings per share $ .12
=========
Weighted average shares outstanding (in thousands):
Basic 13,388 13,420 13,241
Diluted 13,388 13,421 13,368
See accompanying notes.
F-3
Movie Gallery, Inc.
Consolidated Statements of Stockholders' Equity
(in thousands)
Additional Retained Total
Common Paid-in Earnings Treasury Stockholders'
Stock Capital (Deficit) Stock Equity
------------------------------------------------------------------
Balance at December 31, 1995 $ 13 $ 122,582 $ 13,544 $ -- $136,139
Net income -- -- 1,481 -- 1,481
Issuance of 508,455 shares of common
stock for acquisitions, net of issuance
costs of $322 -- 8,386 -- -- 8,386
Exercise of stock options for 35,100
shares -- 524 -- -- 524
Tax benefit of stock options exercised -- 218 -- -- 218
Other transactions by pooled companies -- (24) -- -- (24)
------ --------- --------- ------ --------
Balance at January 5, 1997 13 131,686 15,025 -- 146,724
Net income -- -- 905 -- 905
------ --------- --------- ------ --------
Balance at January 4, 1998 13 131,686 15,930 -- 147,629
Net loss -- -- (23,076) -- (23,076)
Exercise of stock options for
12,230 shares -- 48 -- -- 48
Tax benefit of stock options exercised -- 9 -- -- 9
Purchases of treasury stock
(115,200 shares) -- -- -- (495) (495)
------ --------- --------- ------ ---------
Balance at January 3, 1999 $ 13 $ 131,743 $ (7,146) $ (495) $ 124,115
====== ========= ========= ====== =========
See accompanying notes.
F-4
Movie Gallery, Inc.
Consolidated Statements of Cash Flows
(in thousands)
Fiscal Year Ended
---------------------------------------------------
January 3, January 4, January 5,
1999 1998 1997
---------------------------------------------------
Operating activities
Net income (loss) $ (23,076) $ 905 $ 1,481
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 126,257 88,140 79,625
Deferred income taxes (14,855) 998 822
Restructuring and other charges -- -- 9,595
Changes in operating assets and liabilities:
Merchandise inventory 1,911 (3,493) 203
Other current assets (649) 435 1,365
Deposits and other assets 105 834 (978)
Accounts payable 1,879 (2,804) (1,649)
Accrued liabilities (709) (1,134) 1,336
--------- --------- ---------
Net cash provided by operating activities 90,863 83,881 91,800
Investing activities
Business acquisitions (799) (474) (8,662)
Purchases of videocassette rental inventory, net (59,266) (70,801) (77,666)
Purchases of property, furnishings and equipment (6,251) (13,072) (18,438)
Proceeds from disposal of equipment -- 1,170 --
--------- --------- ---------
Net cash used in investing activities (66,316) (83,177) (104,766)
Financing activities
Net proceeds from issuance of common stock 48 -- 524
Purchases of treasury stock (495) -- --
Net payments on notes payable (200) -- (32,052)
Proceeds from issuance of long-term debt -- -- 72,938
Principal payments on long-term debt (21,376) (227) (30,717)
--------- --------- ---------
Net cash (used in) provided by financing activities (22,023) (227) 10,693
--------- --------- ---------
Increase (decrease) in cash and cash equivalents 2,524 477 (2,273)
Cash and cash equivalents at beginning of fiscal year 4,459 3,982 6,255
--------- --------- ---------
Cash and cash equivalents at end of fiscal year $ 6,983 $ 4,459 $ 3,982
========= ========= =========
Supplemental disclosures of cash flow
information
Cash paid during the period for interest $ 5,066 $ 5,777 $ 5,377
Cash paid during the period for income taxes 478 -- 203
Noncash investing and financing information:
Assets acquired by issuance of notes payable -- 200 --
Assets acquired by issuance of common stock -- -- 8,708
Tax benefit of stock options exercised 9 -- 218
See accompanying notes.
F-5
Movie Gallery, Inc.
Notes to Consolidated Financial Statements
January 3, 1999, January 4, 1998 and January 5, 1997
1. Accounting Policies
The accompanying financial statements present the consolidated financial
position, results of operations and cash flows of Movie Gallery, Inc. and
subsidiaries (the "Company"). All material intercompany accounts and
transactions have been eliminated.
The Company's historical financial statements for the fiscal year ended January
5, 1997 have been restated to include the financial position, results of
operations and cash flows of Home Vision Entertainment, Inc. ("Home Vision") and
Hollywood Video, Inc. ("Hollywood Video"), merger transactions in 1996 which
were accounted for as poolings-of-interests (see Note 2).
The Company owns and operates video specialty stores in 22 states, generally
located in the eastern half of the United States.
Fiscal Year
On July 1, 1996, the Company adopted a fiscal year ending on the first Sunday
following December 30, which periodically results in a fiscal year of 53 weeks.
Results for 1996 reflect a 53-week year. The Company's fiscal year includes
revenues and certain operating expenses, such as salaries, wages and other
miscellaneous expenses, on a daily basis. All other expenses, primarily
depreciation and amortization, are calculated and recorded monthly, with twelve
months included in each fiscal year.
Cash Equivalents
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.
Merchandise Inventory
Merchandise inventory consists primarily of videocassette tapes, video
accessories and concessions and is stated at the lower of cost, on a first-in
first-out basis, or market.
Long-Lived Assets
During the first quarter of 1996, the Company adopted the provisions of
Financial Accounting Standards Board (FASB) Statement No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of," which requires impairment losses to be recorded on long-lived assets used
in operations and intangible assets when indicators of impairment are present
and the undiscounted cash flows estimated to be generated by those assets are
less than the assets' carrying amounts. Statement 121 also addresses the
accounting for long-lived assets that are expected to be disposed of. The effect
of adoption of Statement 121 was not material.
F-6
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
1. Accounting Policies (continued)
Videocassette Rental Inventory
Effective July 6, 1998, the Company changed its method of amortizing
videocassette and video game rental inventory. This new method accelerates the
rate of amortization and has been adopted as a result of both an industry and a
Company trend toward significant increases in copy-depth availability from movie
studios, which have resulted in earlier satisfaction of consumer demand,
thereby, accelerating the rate of revenue recognition. Under the new method, the
cost of base stock videocassettes, consisting of two copies per title for each
store, is amortized on an accelerated basis to a net book value of $8 over the
first six months and to a $4 salvage value over the next thirty months. The cost
of non-base stock videocassettes, consisting of the third and succeeding copies
of each title per store, is amortized on an accelerated basis over the first six
months to a net book value of $4 which is then fully amortized on a
straight-line basis over the next 30 months or until the videocassette is sold,
at which time the unamortized book value is charged to cost of sales. Video
games are amortized on a straight-line basis to a $10 salvage value over
eighteen months. The Company will continue to expense revenue sharing payments
as revenues are earned pursuant to contractual arrangements.
The new method of amortization has been applied to all inventory held at July 6,
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
during the quarter ended October 4, 1998. The application of the new method of
amortizing videocassette and video game rental inventory decreased rental
inventory and increased depreciation expense for the fiscal year ended January
3, 1999 by approximately $43.6 million and reduced net income by $27.7 million,
or $2.06 per basic and diluted share.
Prior to July 6, 1998, and pursuant to an accounting change effective April 1,
1996, videocassette and video game rental inventory was recorded at cost and
amortized over its economic useful life. Videocassettes considered to be base
stock were amortized over thirty-six months on a straight-line basis to a $5
salvage value. New release videocassettes were amortized as follows: (i) the
fourth and any succeeding copies of each title per store were amortized on a
straight-line basis over the first six months to an average net book value of $5
which was then fully amortized on a straight-line basis over the next thirty
months or until the videocassette was sold, at which time the unamortized book
value was charged to cost of sales and (ii) copies one through three of each
title per store were amortized as base stock. The application of this method of
amortization increased depreciation expense and cost of sales for the quarter
ended June 30, 1996 by approximately $7.7 million. For the fiscal year ended
January 5, 1997, the adoption of this method of amortization decreased net
income by approximately $4.9 million or $0.37 per diluted share.
Videocassette rental inventory consists of the following (in thousands):
January 3, January 4,
1999 1998
----------------------
Videocassette rental inventory $ 180,858 $ 175,922
Less accumulated amortization (135,860) (83,739)
--------- ---------
$ 44,998 $ 92,183
========= =========
F-7
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
1. Accounting Policies (continued)
Property, Furnishings and Equipment
Property, furnishings and equipment are stated at cost and include costs
incurred in the development and construction of new stores. Depreciation is
provided on a straight-line basis over the estimated lives of the related
assets, generally five to seven years.
Goodwill and Other Intangibles
Goodwill is being amortized on a straight-line basis over twenty years. Other
intangibles consist primarily of non-compete agreements and are amortized on a
straight-line basis over the lives of the respective agreements which range from
two to ten years. Accumulated amortization of goodwill and other intangibles at
January 3, 1999 and January 4, 1998 was $25,245,000 and $18,261,000,
respectively.
Income Taxes
The Company accounts for income taxes under the provisions of FASB Statement No.
109, "Accounting for Income Taxes." Under Statement 109, deferred tax assets and
liabilities are determined based upon differences between financial reporting
and tax bases of assets and liabilities and are measured at the enacted tax
rates and laws that will be in effect when the differences are expected to
reverse.
Videocassette Rental Revenue
Rental revenue is recognized when the videocassette or video game is rented by
the customer.
Advertising Costs
Advertising costs, exclusive of cooperative reimbursements from vendors, are
expensed when incurred. Advertising costs were $896,000, $728,000 and $1,512,000
for the fiscal years ended January 3, 1999, January 4, 1998 and January 5, 1997,
respectively.
Store Opening Costs
Store opening costs, which consist primarily of payroll and advertising, are
expensed as incurred.
Earnings Per Share
Effective January 4, 1998, the Company adopted FASB Statement No. 128, "Earnings
per Share." This Statement is effective for fiscal periods ending after December
15, 1997 and requires restatement of prior periods' earnings per share data.
Under this Statement the calculation of primary and fully diluted earnings per
share is replaced with basic and diluted earnings per share and requires
presentation of both amounts on the income statement. Unlike primary earnings
per share, basic earnings per share excludes any dilutive effects of common
stock equivalents. Diluted earnings per share is similar to the previously
reported fully diluted earnings per share. Adoption of this Statement had no
significant impact on the earnings per share calculations for any year
presented.
F-8
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
1. Accounting Policies (continued)
Fair Value of Financial Instruments
At January 3, 1999 and January 4, 1998, the carrying value of financial
instruments such as cash and cash equivalents, accounts payable, notes payable
and long-term debt approximated their fair values, calculated using discounted
cash flow analysis at the Company's incremental borrowing rate.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the consolidated financial statements and
accompanying notes. The most significant estimates and assumptions relate to the
provision for business restructuring (see Note 3) and the amortization methods
and useful lives of videocassette rental inventory, goodwill and other
intangibles. These estimates and assumptions could change and actual results
could differ from these estimates.
Recently Issued Accounting Standards
In April 1998, the AICPA issued Statement of Position (SOP) 98-5, "Reporting the
Costs of Start-up Activities." The SOP is effective for the Company beginning on
January 4, 1999, and requires that certain start-up costs capitalized prior to
January 4, 1999 be written off and any such future start-up costs to be expensed
as incurred. The unamortized balance of start-up costs as of January 3, 1999
(approximately $650,000 after tax) will be written off as a cumulative effect of
an accounting change as of January 4, 1999. The Company estimates the impact of
adopting this SOP will not be material to 1999 earnings.
In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive
Income," which is effective for the Company's fiscal year ended January 3, 1999.
Comprehensive income is defined as the change in equity during a period from
transactions and other events and circumstances from non-owner sources.
Statement 130 establishes standards for reporting and display of comprehensive
income and its components and requires that an enterprise (a) classify items of
other comprehensive income by their nature in a financial statement and (b)
display the accumulated balance of other comprehensive income separately from
retained earnings and additional paid-in capital in the equity section of a
statement of financial position. Statement 130 has no impact on the Company as
there have been no transactions resulting in items of comprehensive income.
In June 1998, the FASB issued Statement No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which is required to be adopted in years
beginning after June 15, 1999. Management does not anticipate that the adoption
of the new Statement will have a significant effect on earnings or the financial
position of the Company.
Unaudited Pro Forma Information
Pro forma income taxes reflect income tax expense which would have been
recognized by the Company as a C corporation if the 1996 acquisition of
Hollywood Video (see Note 2) had been consummated prior to January 1, 1996.
Hollywood Video's historical operating results do not include any provision for
income taxes as Hollywood Video was taxed as an S corporation for all periods
prior to the merger.
F-9
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
1. Accounting Policies (continued)
Employee Benefits
The Company has a 401(k) savings plan available to all active employees who are
over 21 years of age and have completed one year of service. The Company makes
discretionary and matching contributions based on employee compensation. The
matching contribution for the fiscal year ended January 3, 1999 was immaterial
to the Company.
2. Acquisitions
On July 1, 1996, the Company acquired Home Vision and Hollywood Video in two
separate merger transactions accounted for as poolings-of-interests, pursuant to
which the Company issued approximately 769,000 shares of its common stock to
Home Vision and Hollywood Video shareholders and assumed approximately $24
million in liabilities. At the time of the merger, Home Vision and Hollywood
Video operated 98 video specialty stores in six northeastern and midwestern
states.
Separate results of operations of the merged entities for the periods prior to
the merger date are as follows (in thousands) (unaudited):
Six Months Ended
June 30, 1996
-----------------
Revenues:
Movie Gallery $ 106,307
Home Vision 11,191
Hollywood Video 5,307
---------
Combined $ 122,805
=========
Net income (loss):
Movie Gallery $ 3,106
Home Vision (97)
Hollywood Video (986)
---------
Combined $ 2,023
=========
Costs of approximately $757,000 incurred by the Company in connection with the
Home Vision and Hollywood Video mergers have been included in general and
administrative expenses in the consolidated statement of operations for the
fiscal year ended January 5, 1997.
During 1996, the Company acquired 76 video specialty stores in 20 transactions
with unrelated sellers for $21,447,000, including the issuance of 505,094 shares
of common stock. The goodwill recorded in connection with these purchases was
$9,726,000. These acquisitions were accounted for under the purchase method of
accounting and are included in the Company's consolidated financial statements
F-10
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
2. Acquisitions (continued)
from the dates of acquisition. The following pro forma information presents the
consolidated results of operations of the Company as though these acquisitions
had occurred as of the beginning of the 1996 fiscal year (in thousands, except
per share data) (unaudited):
Fiscal Year Ended
January 5, 1997
-----------------
Revenues $ 261,223
Net income 2,521
Earnings per share 0.19
3. Provision for Business Restructuring
During the third quarter of 1996, the Company began and completed an extensive
analysis of both its store base performance and organizational structure and
adopted a business restructuring plan to close approximately 50 stores. This
analysis resulted in the Company recording a $9.6 million pretax restructuring
charge in the third quarter of 1996. The components of the restructuring charge
included approximately $5.4 million in reserves for future cash outlays for
lease terminations, miscellaneous closing costs and legal and accounting costs,
as well as approximately $4.2 million in asset write downs. The store closures
were substantially completed by the end of the fiscal year ended January 4,
1998. Approximately $3.2 million of restructuring costs were paid and charged
against the liability as of January 3, 1999. The stores identified for closure
had revenues and operating losses of approximately $0.8 million and $0.4
million, respectively, for the fiscal year ended January 4, 1998 and
approximately $6.2 million and $1.6 million, respectively, for the fiscal year
ended January 5, 1997.
4. Property, Furnishings and Equipment
Property, furnishings and equipment consists of the following (in thousands):
January 3, January 4,
1999 1998
-------------------------
Land and buildings $ 1,889 $ 1,879
Furniture and fixtures 29,688 29,030
Equipment 24,755 23,516
Leasehold improvements and signs 24,661 22,339
-------- --------
80,993 76,764
Accumulated depreciation (37,073) (26,443)
-------- --------
$ 43,920 $ 50,321
======== ========
F-11
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
5. Long-Term Debt
On July 10, 1996, the Company entered into a Credit Agreement with First Union
National Bank of North Carolina with respect to a reducing revolving credit
facility (the "Original Facility"). The Original Facility was unsecured and
originally provided borrowings for up to $125 million. During 1997, the Company
voluntarily reduced the commitment to $90 million. The available amount under
the Original Facility began to reduce quarterly on March 31, 1998 and was to
mature on June 30, 2000. The interest rate of the Original Facility was based on
LIBOR plus an applicable margin percentage, which depended on the Company's cash
flow generation and borrowings outstanding. At January 3, 1999, $46 million was
outstanding, approximately $17 million was available for borrowing and the
effective interest rate was approximately 7.3% under the Original Facility.
The Original Facility was replaced on January 7, 1999 with a new Credit
Agreement with First Union National Bank of North Carolina (the "New Facility").
The New Facility is an unsecured revolving credit facility that will mature in
its entirety on January 7, 2002. The New Facility provides for borrowings up to
$65 million, and the Company may increase the amount of the New Facility to $85
million after April 8, 1999 if existing banks increase their commitments or a
new bank(s) enter the Credit Agreement. The interest rate of the New Facility is
based on LIBOR plus an applicable margin percentage, which depends on the
Company's cash flow generation and borrowings outstanding. The effective
interest rate of the New Facility was approximately 6.7% at January 7, 1999. The
Company may repay the New Facility at any time without penalty. The more
restrictive covenants of the New Facility restrict borrowings based upon cash
flow levels.
Concurrent with the New Facility, the Company amended its existing interest rate
swap to coincide with the maturity of the New Facility. The amended interest
rate swap agreement effectively fixes the Company's interest rate exposure on
$37 million of the amount outstanding under the New Facility at 5.8% plus an
applicable margin percentage. The interest rate swap reduces the risk of
increases in interest rates during the life of the New Facility. The Company
accounts for its interest rate swap as a hedge of its debt obligation. The
Company pays a fixed rate of interest and receives payment based on a variable
rate of interest. The difference in amounts paid and received under the contract
is accrued and recognized as an adjustment to interest expense on the debt.
There are no termination penalties associated with the interest rate swap
agreement; however, if the swap agreement was terminated at the Company's
option, the Company would either pay or receive the present value of the
remaining hedge payments at the then prevailing interest rates for the time to
maturity of the swap agreement. The interest rate swap agreement terminates at
the time the New Facility matures.
As a result of the New Facility and the amended interest rate swap agreement,
the Company will recognize an extraordinary loss on the extinguishment of debt
of approximately $1 million, or $.05 per share, during the first quarter of
1999. The extraordinary loss will be comprised primarily of unamortized debt
issue costs associated with the Original Facility and the negative value of the
original interest rate swap at the time of the amendment.
In connection with certain acquisitions, the Company issued or assumed notes
payable which had outstanding balances of $654,000 and $1,230,000 at January 3,
1999 and January 4, 1998, respectively. Generally, these notes are unsecured,
require monthly or annual payments and have fixed or variable interest rates
ranging from 7% to 9%.
F-12
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
5. Long-Term Debt (continued)
Scheduled maturities of long-term debt are as follows: $442,000 in 1999,
$212,000 in 2000 and $46,000,000 in 2002.
6. Income Taxes
The following reflects actual income tax expense (benefit) for the fiscal years
ended January 3, 1999 and January 4, 1998, and unaudited pro forma income tax
expense that the Company would have incurred had Hollywood Video (see Note 2)
been subject to federal and state income taxes for the entire fiscal year ended
January 5, 1997 (in thousands):
Fiscal Year Ended
------------------------------------------------
January 3, January 4, January 5,
1999 1998 1997
------------------------------------------------
(unaudited pro
forma information)
Current payable:
Federal $ 1,275 $ -- $ 90
State 491 -- --
-------- -------- --------
Total current 1,766 -- 90
Deferred:
Federal (13,423) 903 831
State (1,432) 95 85
-------- -------- --------
Total deferred (14,855) 998 916
-------- -------- --------
$(13,089) $ 998 $ 1,006
======== ======== ========
A reconciliation of income tax expense (benefit) at the federal income tax rate
to the Company's effective income tax provision is as follows (in thousands):
Fiscal Year Ended
----------------------------------------
January 3, January 4, January 5,
1999 1998 1997
----------------------------------------
(unaudited pro
forma information)
Income tax expense (benefit)
at statutory rate $(12,658) $ 647 $ 888
State income tax expense (benefit),
net of federal income tax benefit (612) 63 85
Other, net (primarily goodwill not
deductible for tax purposes) 181 288 33
-------- -------- --------
$(13,089) $ 998 $ 1,006
======== ======== ========
F-13
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
6. Income Taxes (continued)
At January 3, 1999, the Company had net operating loss carryforwards of
approximately $12.6 million for income taxes that expire in years 2010 through
2012. Approximately $5.5 million of these carryforwards resulted from the
Company's acquisition of Home Vision (see Note 2). Utilization of the net
operating loss carryforwards related to the Home Vision acquisition may be
subject to a substantial annual limitation due to the statutory provisions of
the Internal Revenue Code. The Company has not recorded a valuation allowance
related to its deferred tax assets as management considers it more likely than
not that available tax strategies and future taxable income will allow the
deferred tax assets to be realized.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income taxes. Components of the Company's
deferred tax assets and liabilities are as follows (in thousands):
January 3, January 4,
1999 1998
------------------------
Deferred tax liabilities:
Videocassette rental inventory $ 788 $ 17,800
Furnishings and equipment 5,740 5,340
Goodwill 2,295 1,864
Other 997 1,214
-------- --------
Total deferred tax liabilities 9,820 26,218
Deferred tax assets:
Non-compete agreements 4,839 4,522
Net operating loss carryforwards 4,806 7,870
Accrued liabilities 828 1,493
Other 438 --
Alternative minimum tax credit carryforward 1,460 20
-------- --------
Total deferred tax assets 12,371 13,905
-------- --------
Net deferred tax (assets) liabilities $ (2,551) $ 12,313
======== ========
7. Stockholders' Equity
Common Stock
In 1995, the Company registered shares of common stock with an aggregate public
offering price of $127,000,000. This common stock may be offered directly
through agents, underwriters or dealers or may be offered in connection with
business acquisitions. As of January 3, 1999, common stock of approximately
$83,000,000 was available to be issued from this registration.
As of January 3, 1999, the Company had warrants outstanding to purchase
approximately 100,000 shares of the Company's common stock, exercisable through
June 30, 2000 at an exercise price of $30.11.
F-14
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
7. Stockholders' Equity (continued)
Earnings Per Share
Basic earnings per share and basic pro forma earnings per share are computed
based on the weighted average number of shares of common stock outstanding
during the periods presented. Diluted earnings per share and diluted pro forma
earnings per share are computed based on the weighted average number of shares
of common stock outstanding during the periods presented, increased solely by
the effects of shares to be issued from the exercise of dilutive common stock
options (0, 1,000 and 127,000 for the fiscal years ended January 3, 1999,
January 4, 1998 and January 5, 1997, respectively). No adjustments were made to
net income or pro forma net income in the computation of basic or diluted
earnings per share.
Stock Option Plan
In July 1994, the Board of Directors adopted, and the stockholders of the
Company approved, the 1994 Stock Option Plan (the "Plan"). The Plan provides for
the award of incentive stock options, stock appreciation rights, bonus rights
and other incentive grants to employees, independent contractors and
consultants. During 1998, the Company increased the shares reserved for issuance
under the Plan from 2,250,000 to 2,600,000. Options granted under the Plan have
a 10-year term and generally vest over 3 to 5 years.
In October 1995, the FASB issued Statement No. 123, "Accounting for Stock-Based
Compensation." In accordance with the provisions of Statement 123, the Company
applies Accounting Principles Board Opinion No. 25 and related Interpretations
in accounting for its stock option plan and, accordingly, has not recognized
compensation cost in connection with the Plan. If the Company had elected to
recognize compensation cost based on the fair value of the options granted at
grant date as prescribed by Statement 123, net income and earnings per share
(pro forma amounts for the 1996 fiscal year) would have been reduced to the pro
forma amounts indicated in the table below. The effect on net income and
earnings per share is not expected to be indicative of the effects on net income
and earnings per share in future years.
Fiscal Year Ended
---------------------------------
January 3, January 4, January 5,
1999 1998 1997
---------------------------------
(in thousands, except per share data)
Pro forma net income (loss) $(24,324) $ (890) $ 218
Pro forma earnings (loss) per share:
Basic and diluted (1.82) (.07) .02
F-15
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
7. Stockholders' Equity (continued)
The fair value of each option grant was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions:
Fiscal Year Ended
---------------------------------
January 3, January 4, January 5,
1999 1998 1997
---------------------------------
Expected volatility 0.733 0.649 0.607
Risk-free interest rate 4.70% 6.28% 6.34%
Expected life of option in years 6.0 6.0 6.0
Expected dividend yield 0.0% 0.0% 0.0%
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. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. 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 management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
A summary of the Company's stock option activity and related information is
detailed below. During 1997, the Company modified 505,100 stock options with
exercise prices ranging from $6.00 to $42.63 by cancelling the stock options and
issuing 378,827 new stock options at an exercise price of $3.88. This
modification excluded directors and certain senior management.
Fiscal Year Ended
-----------------------------------------------------------------------------------------------
January 3, 1999 January 4, 1998 January 5, 1997
-----------------------------------------------------------------------------------------------
Weighted-Average Weighted-Average Weighted-Average
Options Exercise Price Options Exercise Price Options Exercise Price
--------- ---------------- --------- ---------------- --------- ----------------
Outstanding-beginning
of year 1,895,537 $10.62 1,318,650 $21.98 1,107,450 $24.63
Granted 363,000 5.13 1,256,087 4.04 379,500 14.15
Exercised 12,230 3.88 -- -- 35,100 14.92
Forfeited 57,408 11.32 679,200 20.50 133,200 23.58
Outstanding-end of year 2,188,899 9.73 1,895,537 10.62 1,318,650 21.98
Exercisable at end of year 1,206,397 12.68 916,908 14.43 622,125 21.28
Weighted-average fair value
of options granted during
the year $3.43 $2.62 $8.84
F-16
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
7. Stockholders' Equity (continued)
Options outstanding as of January 3, 1999 had a weighted-average remaining
contractual life of 8.2 years and exercise prices ranging from $3.00 to $40.00
as follows:
Exercise price of
-------------------------------------------------------
$3.00 to $6.00 $14.00 to $22.00 $24.00 to $40.00
-------------------------------------------------------
Options outstanding 1,530,399 390,500 268,000
Weighted-average exercise price $4.24 $15.13 $33.22
Weighted-average remaining contractual life 8.9 years 6.4 years 6.4 years
Options exercisable 633,447 347,200 225,750
Weighted-average exercise price of
exercisable options $4.13 $15.27 $32.67
8. Commitments and Contingencies
Rent expense for the fiscal years ended January 3, 1999, January 4, 1998 and
January 5, 1997 totaled $40,959,000, $40,788,000 and $37,266,000, respectively.
Future minimum payments under noncancellable operating leases which contain
renewal options and escalation clauses with remaining terms in excess of one
year consisted of the following at January 3, 1999 (in thousands):
1999 $26,065
2000 22,114
2001 13,475
2002 8,018
2003 5,255
Thereafter 7,322
-------
$82,249
=======
The Company has an agreement with Rentrak Corporation which requires the Company
to order videocassette rental inventory under lease sufficient to require an
aggregate minimum payment of $4,000,000 per year in revenue share, handling
fees, sell through fees and end-of-term buyout fees. The agreement expires in
2006.
The Company is occasionally involved in litigation in the ordinary course of its
business, none of which, individually or in the aggregate, is material to the
Company's business or results of operations.
F-17
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (continued)
9. Summary of Quarterly Results of Operations (Unaudited)
The following is a summary of unaudited quarterly results of operations (in
thousands, except per share data). Earnings per share amounts for the first
three quarters of 1997 have been restated to comply with FASB Statement No. 128,
"Earnings per Share" (see Note 1).
Thirteen Weeks Ended
--------------------------------------------
April 5, July 5, October 4, January 3,
1998 1998 1998 1999
--------------------------------------------
Revenue $70,491 $ 63,662 $ 64,397 $69,083
Operating income (loss) 4,613 495 (42,969) 7,021
Net income (loss) 1,882 (555) (28,046) 3,643
Basic and diluted earnings (loss)
per share .14 (.04) (2.09) .27
Thirteen Weeks Ended
--------------------------------------------
April 6, July 6, October 5, January 4,
1997 1997 1997 1998
--------------------------------------------
Revenue $65,678 $ 61,328 $ 62,560 $70,790
Operating income (loss) 4,716 (233) (901) 4,647
Net income (loss) 1,996 (1,203) (1,669) 1,781
Basic and diluted earnings (loss)
per share .15 (.09) (.12) .13
F-18
Index to Exhibits
Exhibit No. Description
- ----------- -----------
10.5 Consulting Agreement between M.G.A., Inc. and William B.
Snow dated December 21, 1998
10.9 Employment Agreement between M.G.A., Inc. and Robert L.
Sirkis dated September 12, 1997
10.17 Credit Agreement between First Union National Bank of North
Carolina and Movie Gallery, Inc. dated January 7, 1999
10.18 Asset Purchase Agreement between Blowout Entertainment, Inc.
and M.G.A., Inc. dated March 22, 1999
21 List of Subsidiaries
23 Consent of Ernst & Young LLP, Independent Auditors
27 Financial Data Schedule