HASTINGS ENTERTAINMENT INC - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended July 31, 2003

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 000-24381

HASTINGS ENTERTAINMENT, INC.
(Exact name of registrant as specified in its charter)

TEXAS 75-1386375
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

3601 PLAINS BOULEVARD, AMARILLO, TEXAS 79102
(Address of principal executive offices) (Zip Code)

(806) 351-2300
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such 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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]

Number of shares outstanding of the registrant's common stock, as of August 29,
2003:

Class Shares Outstanding
- -------------------------------------- ------------------------
Common Stock, $.01 par value per share 11,299,946

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JULY 31, 2003

INDEX

2

PART 1

ITEM 1 - FINANCIAL STATEMENTS

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
July 31, 2003 and 2002, and January 31, 2003
(Dollars in thousands, except par value)

See accompanying notes to unaudited consolidated financial statements.

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HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Unaudited Consolidated Statements of Operations
For the Three and Six Months Ended July 31, 2003 and 2002
(Dollars in thousands, except per share amounts)

See accompanying notes to unaudited consolidated financial statements.

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HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Unaudited Consolidated Statements of Cash Flows
For the Six Months Ended July 31, 2003 and 2002
(Dollars in thousands)

See accompanying notes to unaudited consolidated financial statements.

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Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2003 and 2002
(Tabular amounts in thousands, except per share data or unless otherwise noted)

1. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of Hastings
Entertainment, Inc. and its subsidiaries (the "Company," "We," "Our," "Us") have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with instructions in Form 10-Q and Article 10
of Regulation S-X. Certain information and footnote disclosures normally
included in annual financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
principles and regulations of the Securities and Exchange Commission. All
adjustments, consisting only of normal recurring adjustments, have been made
which, in the opinion of management, are necessary for a fair presentation of
the results of the interim periods. The results of operations for such interim
periods are not necessarily indicative of the results, which may be expected for
a full year because of, among other things, seasonality factors in the retail
business. The unaudited consolidated financial statements contained herein
should be read in conjunction with the audited consolidated financial statements
and notes thereto included in our annual report on Form 10-K for the fiscal year
2002.

Certain prior year amounts have been reclassified to conform with the fiscal
2003 presentation.

Our fiscal year ends on January 31 and is identified as the fiscal year for the
immediately preceding calendar year. For example, the fiscal year that will end
on January 31, 2004 is referred to as fiscal 2003.

2. CONSOLIDATION POLICY

The unaudited consolidated financial statements present the results of Hastings
Entertainment, Inc. and its subsidiaries. All significant intercompany
transactions and balances have been eliminated in consolidation.

3. STOCK OPTION PLANS

We account for our stock option plans in accordance with the provisions of
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees ("APB 25"), and related interpretations. Compensation expense is
recorded on the date of grant only if the market price of the underlying stock
exceeds the exercise price. Under Statement of Financial Accounting Standards
No. 123, Accounting for Stock-based Compensation ("SFAS 123"), we may elect to
recognize expense for stock-based compensation based on the fair value of the
awards, or continue to account for stock-based compensation under APB 25 and
disclose in the financial statements the effects of SFAS 123 as if the
recognition provisions were adopted. We have elected to continue to apply the
provisions of APB 25 and provide the pro forma disclosure provisions of SFAS
123.

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Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2003 and 2002
(Tabular amounts in thousands, except per share data or unless otherwise noted)

The following schedule reflects the impact on net income (loss) and net income
(loss) per share if we had applied the fair value recognition provisions of SFAS
No. 123 to stock based compensation.

4. STORE CLOSING RESERVE

From time to time and in the normal course of business, we evaluate our store
base to determine if a need to close a store(s) is present. Such evaluations
include, among other factors, current and future profitability, market trends,
age of store and lease status.

Amounts in accrued expenses and other liabilities at July 31, 2003 include
accruals for the net present value of future minimum lease payments and other
costs attributable to closed or relocated stores, net of estimated sublease
income. Expenses related to store closings are included in selling, general and
administrative expenses in our consolidated statement of operations.

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Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2003 and 2002
(Tabular amounts in thousands, except per share data or unless otherwise noted)

The following tables provide a rollforward of reserves that were established for
these charges for the six months ended July 31, 2003 and 2002.

As of July 31, 2003, the reserve balance, which is net of estimated sublease
income, is expected to be paid over the next six years. Other costs are charged
against the reserve as incurred.

6. INCOME (LOSS) PER SHARE

The computations for basic and diluted income (loss) per share are as follows:

Options to purchase 833,040 shares of common stock at exercise prices ranging
from $3.65 per share to $14.03 per share outstanding for the three months ended
July 31, 2003 and 2,087,783 shares of common stock at exercise prices ranging
from $1.27 per share to $14.03 per share outstanding for the six months ended
July 31, 2003 and options to purchase 1,834,923 shares of common stock at
exercise prices ranging from $1.27 per share to $14.03 per share outstanding at
July 31, 2002 were not included in the computation of diluted income (loss) per
share because their inclusion would have been antidilutive.

8

Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2003 and 2002
(Tabular amounts in thousands, except per share data or unless otherwise noted)

7. LITIGATION AND CONTINGENCIES

In 2000, we restated our consolidated financial statements for the first three
quarters of fiscal 1999 and the prior four fiscal years. As a result, lawsuits
were filed against us and certain of our current and former directors and
officers asserting various claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934. We agreed to settle these lawsuits, and the
settlement received final approval by the court on March 10, 2003. The
settlement required a payment of $5.75 million on behalf of the defendants in
the lawsuits ($3.15 million of which was funded from amounts remaining under our
director and officer insurance policy after the payment of litigation expenses).
The settlement resolves all claims against us and our current and former
defendant officers and directors. Based on the foregoing, we recorded loss
contingencies of $2.5 million, or $0.22 per share, and $0.1 million, or $0.00
per share, during the second and fourth fiscal quarters of fiscal 2002,
respectively. All amounts required by the settlement agreement were funded by
January 31, 2003.

We are also involved in various other claims and legal actions arising in the
ordinary course of business. In the opinion of management, the ultimate
disposition of these matters will not have a material adverse effect on our
financial position, results of operations and cash flows.

8. SEGMENT DISCLOSURES

We have two operating segments, retail stores and Internet operations. Our chief
operating decision maker, as that term is defined in the relevant accounting
standard, regularly reviews financial information about each of the above
operating segments for assessing performance and allocating resources. Revenue
for retail stores is derived from the sale of merchandise and rental of
videocassettes, video games and DVDs. Revenue for Internet operations is derived
solely from the sale of merchandise. Segment information regarding our retail
stores and Internet operations for the three and six months ended July 31, 2003
and 2002 is presented below.

For the three months ended July 31, 2003:

For the three months ended July 31, 2002:

For the six months ended July 31, 2003:

9

Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2003 and 2002
(Tabular amounts in thousands, except per share data or unless otherwise noted)

For the six months ended July 31, 2002:

9. CHANGE IN ACCOUNTING PRINCIPLE

In January 2003, the Emerging Issues Task Force reached a consensus on Issue No.
02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor" ("EITF 02-16"). The issue provides
guidelines for specific treatment and classification of certain amounts received
by a customer from a vendor in connection with product purchased from the
vendor. EITF 02-16 was effective prospectively for new arrangements entered into
after December 31, 2002. Accordingly, during the three and six months ended July
31, 2003, approximately $0.2 million, or $0.02 per diluted share, and
approximately $0.7 million, or $0.06 per diluted share, respectively, of our
vendor advertising allowances have been recorded as a reduction of merchandise
inventory and the cost of rental videos and will be recognized in cost of
revenues as inventory is sold and as rental videos are rented. As a result of
these changes, selling, general and administrative expenses were increased by
approximately $1.1 million and $2.0 million and total cost of revenues decreased
$0.9 million and $1.3 million for the three and six months ended July 31, 2003,
respectively.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Forward-looking Statements

Certain written and oral statements set forth below or made by Hastings or with
the approval of an authorized executive officer of the company constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. The words "believe," "expect," "intend,"
"anticipate," "project," "will" and similar expressions identify forward-looking
statements, which convey the uncertainty of future events and generally are not
historical in nature. All statements which address operating performance, events
or developments that we expect or anticipate will occur in the future including
statements relating to the business, expansion, merchandising and marketing
strategies of Hastings, industry projections or forecasts, the impact on our
financial statements of any adjustment to fair value of interest rate swaps,
inflation, effect of critical accounting policies including lower of cost or
market for inventory adjustments, the returns process, rental video
amortization, our store closing reserve, revenue recognition, accounting for
vendor allowances, sufficiency of cash flow from operations and borrowings under
our amended revolving credit facility and statements expressing general optimism
about future operating results are forward-looking statements. Such statements
are based upon company management's current estimates, assumptions and
expectations, which are based on information available at the time of the
disclosure, and are subject to a number of factors and uncertainties, including,
but not limited to:

- whether our assumptions turn out to be correct;

- our ability to attain such estimates and expectations;

- a downturn in market conditions in any industry, including the current
economic state of retailing, relating to the products we inventory,
sell or rent;

- the effects of, or changes in, economic and political conditions in
the U.S. and the markets in which we operate our superstores,
including the effects of inflation, deflation, recession, war,
terrorism, changes in interest and tax rates, the availability of
consumer credit and any other matters that influence customer
confidence;

- our ability to forecast and meet customer demand for products;

- our ability to access suitable merchandise for acceptable terms from
merchandise vendors;

- our ability to attract quality employees and control our labor costs;
and

- our ability to find new sites to lease for our superstores upon
acceptable terms.

Any of foregoing factors and uncertainties could cause actual results to differ
materially from those described herein. We undertake no obligation to affirm,
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise.

The following discussion should be read in conjunction with the unaudited
consolidated financial statements of the Company and the related notes thereto
appearing elsewhere in the report.

General

Hastings Entertainment is a leading multimedia entertainment retailer that
combines the sale of books, music, software, periodicals, videocassettes, video
games and DVDs with the rental of videocassettes, video games and DVDs in a
superstore and Internet Web site format. As of July 31, 2003, we operated 147
superstores averaging approximately 20,000 square feet in small to medium-sized
markets located in 21 states, primarily in the Western and Midwestern United
States. Each of our superstores is company-operated under the name of Hastings.

Our operating strategy is to enhance our position as a multimedia entertainment
retailer by expanding existing superstores, opening new superstores in selected
markets and expanding our offering of products through our Internet Web site.
References herein to fiscal years are to the twelve-month periods that end in
January of the

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following calendar year. For example, the twelve-month period ending January 31,
2004 is referred to as fiscal 2003.

Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles
generally accepted in the United States, which require management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements, the disclosure of
contingent assets and liabilities and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. We believe the following critical accounting policies affect our more
significant estimates and assumptions used in the preparation of our financial
statements. Our significant estimates and assumptions are reviewed, and any
required adjustments are recorded, on a monthly basis.

Lower of Cost or Market for Merchandise Inventory. Our merchandise inventories
are recorded at the lower of cost or market. As with any retailer, economic
conditions, cyclical customer demand and changes in purchasing or distribution
can affect the carrying value of inventory. As circumstances warrant, we record
lower of cost or market inventory adjustments. In some instances, these
adjustments can have a material effect on the financial results of an annual or
interim period. In order to determine such adjustments, we evaluate the age,
inventory turns and estimated fair value of merchandise inventory by product
category and record any adjustment if estimated market value is below cost.
Through merchandising and an automated-progressive markdown program, we quickly
take the steps necessary to increase the sell-off of slower moving merchandise
to eliminate or lessen the effect of these adjustments.

Returns Process. Merchandise inventory owned by us is generally returnable based
upon return agreements with our merchandise vendors. We continually return
merchandise to vendors based on, among other factors, current and projected
sales trends, overstock situations, authorized return timelines or changes in
product offerings. At the end of any reporting period cost accruals are required
for inventory that has been returned to vendors, or is in the process of being
returned to vendors, or has been identified to be returned to vendors. These
costs can include freight, valuation and quantity differences, and other fees
charged by a vendor. In order to appropriately match the costs associated with
the return of merchandise with the process of returning such merchandise, we
utilize an allowance for cost of inventory returns. To accrue for such costs and
estimate this allowance, we utilize historical experience adjusted for
significant estimated or contractual modifications. Certain adjustments to the
Allowance can have a material effect on the financial results of an annual or
interim period.

Rental Video Asset Cost Amortization. We have a series of direct revenue-sharing
agreements with major studios and we anticipate that our future involvement in
revenue-sharing agreements will be similar to that of fiscal year 2002. Revenue
sharing allows us to acquire rental video assets at a lower up-front capital
cost than traditional buying arrangements. We then share with studios a
percentage of the actual net rental revenues generated over a contractually
determined period of time. The increased access to additional copies of new
releases under revenue-sharing agreements allows customer demand for new
releases to be satisfied over a shorter period of time at a time when the new
releases are most popular. Under the terms of the specific contracts with
supplying studios, we expense revenue-sharing payments through rental video cost
of revenue, as revenues are recognized. The capitalized cost of all rental video
assets acquired for a fixed price is being amortized on an accelerated basis
over six months to a salvage value of $4 per unit, except for rental video
assets purchased for the initial stock of a new superstore, which are being
amortized on a straight line basis over 36 months to a salvage value of $4.
Rental video assets purchased for less than $4 are not amortized.

Certain events, including a downturn in the rental video industry as a whole or
in the markets within which we operate our superstores, further consolidation of
rental video retailers, a change in the rental home video distribution window,
which allows rental retailers an exclusive period of time to rent titles prior
to being made available for pay-per-view, video on demand, and premium, basic
cable, network and syndicated television, a substantial change in customer
demand and a change in the mix of rental video revenues, could affect the
salvage value we have assigned to our rental video assets. The effect could
result in a material reduction of the carrying value of our rental video assets
and have a material impact on the financial results of an annual or interim
period. In particular, the growth of the DVD market and the shift of consumer
purchases from VHS (videocassettes) to DVD could result in a decrease in the
salvage value of rental videos. At some point during the rental cycle, a VHS
item, as with DVD and games, is available for purchase by a customer as a
previously viewed tape. Our current experience is that the amount received for a
previously viewed tape is higher than our salvage value of that item in our
rental inventory. Based in part on this factor and sales of previously viewed
tapes, we believe our estimate of salvage value is appropriate.

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Store Closing Reserve. On a quarterly basis, and in the normal course of
business, we evaluate our store base to determine if a need to close or relocate
a store(s) is present. Management will evaluate, among other factors, current
and future profitability, market trends, age of store and lease status. The
primary expense items associated with the closure of a store relate to the net
present value of minimum lease payments (the present value of remaining lease
payments under an active lease) and the write-off of leasehold improvements and
other assets not remaining in our possession. Prior to December 31, 2002, such
expense items were recorded as of the date that management made the decision to
close or relocate a store. Subsequent to December 31, 2002, and in accordance
with the adoption of SFAS No. 146, we now recognize such expense items at the
time the location is closed or relocated. We do not anticipate that the
recognition of expense under SFAS No. 146 will have a material impact on our
financial position or results of operations. The amount recorded can fluctuate
based on the age of the closing location, term and remaining years of the lease
and the number of stores being closed or relocated. These charges can have a
material effect on the financial results of an annual or interim period. We
actively pursue sublease tenants on all closed or relocated locations and the
impact of any sublease income is estimated in the determination of the incurred
store closing reserve liability.

Revenue Recognition. We generate revenue primarily from retail sales and rental
of our products. Merchandise and rental revenues are recognized at the point of
sale or rental or at the time merchandise is shipped to the customer. Revenues
are presented net of estimated returns and exclude all taxes. Customers may
return certain merchandise for exchange or refund within our policies, and an
allowance has been established to provide for projected returns. There are no
provisions for uncollectible amounts since payment is received at the time of
sale. We, as with most retailers, also offer gift cards for sale. Deferred
revenue, a current liability, is recognized at the time a gift card is sold with
the costs of designing, printing and distributing the cards recorded as an
expense as incurred. The deferred revenue liability is relieved and revenue is
recognized upon the redemption of the gift cards. From time to time we will
offer sales incentives, in the form of customer rebates, to customers. Revenue
is reduced by the amount of estimated redemptions, based on experience of
similar types of rebate offers, and a deferred revenue liability is established.
The deferred revenue liability is relieved when the customer has completed all
criteria necessary to file a valid rebate claim. Any remaining portion of
deferred revenue is recorded as revenue following the termination of the
extended redemption period and following completion of all outstanding rebate
claims.

Comparable-Store Revenue. Stores included in the comparable-store revenues
calculation are those stores that have been open for a minimum of 60 weeks. Also
included are stores that are remodeled or relocated. Sales via the internet are
not included and closed stores are removed from each comparable period for the
purpose of calculating comparable-store revenues.

Vendor Allowances. In 2002, The Emerging Issues Task Force ("EITF") discussed
issue no. 02-16 ("EITF 02-16"), which addresses the accounting for cash
consideration received from a vendor by a reseller for various vendor-funded
allowances, including cooperative advertising support. The EITF determined that
cash consideration received from a vendor should be presumed to be a reduction
of the prices of vendor's products and, therefore, should be shown as a
reduction in the cost of goods sold when recognized in the reseller's income
statements. The only exceptions to this rule are if the reimbursement is for
specific, incremental identifiable costs. If the amount of cash consideration
received exceeds the cost being reimbursed, that excess amount should be
characterized as a reduction of cost of goods sold when recognized in the
reseller's income statements. In January 2003, the EITF issued transition
guidance concluding that this interpretation should be applied to all new or
modified arrangements entered into after December 31, 2002. We adopted EITF
02-16 beginning February 1, 2003. Accordingly, during the three and six months
ended July 31, 2003, approximately $0.2 million, or $0.02 per diluted share, and
approximately $0.7 million, or $0.06 per diluted share, respectively, of our
vendor advertising allowances have been recorded as a reduction of merchandise
inventory and the cost of rental videos and will be recognized in cost of
revenues as inventory is sold and as rental videos are rented. As a result of
these changes, selling, general and administrative expenses were increased by
approximately $1.1 million and $2.0 million and total cost of revenues decreased
$0.9 million and $1.3 million for the three and six months ended July 31, 2003,
respectively.

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Results of Operations

The following tables present our statement of operations data, expressed as a
percentage of revenue, and the number of superstores open at the end of the
periods presented herein.

Summary of Superstore Activity

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Three months ended July 31, 2003 compared to three months ended July 31, 2002

Revenues. Total revenues increased $0.4 million, or 0.3%, for the second quarter
of fiscal 2003 to $115.4 million compared to $115.0 million for the second
quarter of fiscal 2002. Total comparable-store revenues ("Comps"), which
decreased by (0.3%) for this year's second quarter as compared to the second
quarter of last year, were comprised of the following:

Merchandise Comps (1.5)%
Rental video Comps 4.0%
Total Comps (0.3)%

The increase in rental video Comps was primarily the result of an increase in
our rental video pricing initiated during the second quarter of fiscal 2003,
which also contributed to an increase in total rental video revenues for the
quarter of $1.4 million, or 5.8%, to $25.9 million, up from $24.4 million a year
earlier. DVD rentals increased 51% during the three months ended July 31, 2003
compared to the same period last year. The increase in DVD rentals was partially
offset by a 27% decline in VHS rentals. The acceptance of DVD by the consumer is
the primary reason for the decline in VHS rental revenue, but part of the
decline resulted from studios increasing the percentage of rental titles
released simultaneously for sale at a lower price-point, which entices the
consumer to purchase a title on VHS instead of renting.

Total merchandise revenue for the second quarter decreased approximately $1.1
million, or 1.2%, to $89.5 million compared to $90.6 million for the same
quarter last year, which we feel reflects the general state of retailing. Second
quarter music Comps declined (14.3%) from the second quarter of fiscal 2002
while our book Comps increased 1.4%, partially offsetting the decline in music.
Video games for sale continued to be our fastest growing category on a
percentage basis with a gross revenue increase of 70% for the three months ended
July 31, 2003 compared to the three months ended July 31, 2002. In addition, DVD
for sale continued to increase during the second quarter of fiscal 2003 with
gross revenues climbing 32% compared to the second quarter of fiscal 2002. This
increase follows a 47% increase in DVD sales for the three months ended July 31,
2002 compared to the three months ended July 31, 2001.

Gross Profit. Total gross profit of $40.5 million in the second quarter of
fiscal 2003 increased $2.4 million, or 6.3%, from $38.1 million in the second
quarter of fiscal 2002. Total gross profit as a percent of total revenue
increased for the three months ended July 31, 2003 to 35.1% compared to 33.1%
for the same period last year. Merchandise gross profit as a percent of
merchandise revenue increased slightly to 26.5% for the second quarter of fiscal
2003 compared to 26.3% for the same quarter last year. Significant changes in
the components of merchandise gross profit are as follows:

(i) a decrease of approximately $1.4 million in the expense
associated with the distribution and return of merchandise
resulting from improved management and controls;

(ii) a reduction of product costs of approximately $0.9 million as
a result of the adoption of EITF 02-16, which governs the
accounting by a customer for certain consideration received
from a vendor; and

(iii) an increase of approximately $0.4 million in certain trade and
purchase discounts.

Partially offsetting these increases in gross profit were:

(i) lower product margins of approximately $0.7 million resulting
from increased promotional pricing in our book category on new
release titles and a shift in revenue mix from music to sale
video and video games, which have a lower margin than music;
and

(ii) an increase in freight expense, which even though $0.4 million
higher than the second quarter of fiscal year 2002, was less
than our internal projections.

Rental video gross profit as a percent of rental revenue increased to 64.7% for
the second quarter of fiscal 2003 from 58.6% for the same quarter last year.
This increase was primarily due to an increase in our rental video pricing and
lower depreciation and amortization expense of approximately $1.2 million from
improved procurement procedures,

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inventory management and margins on videos acquired under revenue sharing
agreements. Partially offsetting this increase in rental video margin was an
increase in rental video shrinkage of approximately $0.4 million.

Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses for the second quarter ended July 31, 2003
decreased approximately $0.5 million to $39.8 million, or 34.5% of total
revenues, down from $40.3 million, or 35.1% of total revenues for the second
quarter ended July 31, 2002. This decrease was primarily the result of:

(i) a decline of approximately $2.7 million in accounting and
legal fees that were higher than normal during the second
quarter of fiscal 2002 due to a $2.5 million charge for the
settlement of the shareholder class action lawsuits; and

(ii) a decrease in the costs associated with our group health plan
of approximately $0.6 million the result of unplanned charges
during the second quarter of fiscal 2002.

Partially offsetting these decreases in SG&A were:

(i) an increase in net advertising costs of approximately $1.2
million during the second quarter compared to the same period
in fiscal 2002 primarily resulting from the adoption of EITF
02-16;

(ii) an increase of approximately $1.0 million in costs associated
with the operation of a greater number of superstores; and

(iii) higher costs of approximately $0.3 million associated with the
remodeling and expansion of certain of our existing
superstores.

Interest Expense. Interest expense remained unchanged at $0.5 million for the
three months ended July 31, 2003, compared to the three months ended July 31,
2002 as higher debt levels during the current quarter compared to last year were
offset by lower interest rates.

Interest Income. During the second quarter of fiscal 2002, we recorded
non-recurring interest income of approximately $1.3 million as a result of
interest earned on income tax refunds for amended returns filed for fiscal years
1995 through 1998.

Income Taxes. No income tax effect was recorded during the second quarters of
fiscal 2003 and 2002 due to adjustments in the valuation allowance related to
the net deferred tax asset.

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Six months ended July 31, 2003 compared to six months ended July 31, 2002

Revenues. Total revenues increased $4.3 million, or 1.9%, for the six months
ended July 31, 2003 to $232.2 million compared to $227.9 million for the same
period last year. Total Comps, which increased by 0.8% for the first six months
of fiscal 2003 as compared to same period last year, were comprised of the
following:

Merchandise Comps (0.8)%
Rental video Comps 6.7%
Total Comps 0.8%

Total rental revenues for the six months ended July 31, 2003 increased $3.9
million, or 8.3%, to $51.2 million from $47.3 million for the six months ended
July 31, 2002. This increase was primarily the result of titles released during
the first quarter of fiscal 2003 having significantly stronger box-office
revenues than those titles released during the first quarter of fiscal 2002,
which resulted in higher rental transactions. In addition, an increase in our
rental video pricing initiated during the second quarter of fiscal 2003
contributed to the increase. DVD rentals increased 56% during the six months
ended July 31, 2003 compared to the same period last year. The increase in DVD
rentals was partially offset by a 23% decline in VHS rentals.

Total merchandise revenue for the first six months of fiscal 2003 increased
approximately $0.4 million, or 0.2%, to $181.0 million compared to $180.6
million for the same period last year. Music Comps declined (13.0%) for the six
months ended July 31, 2003, compared to the six months ended July 31, 2002, as
the music industry reported a decline of approximately (9%) in units shipped for
the year and continues to battle on-line and physical music piracy. Book Comps
declined (1.9%) for the first six month period of fiscal 2003 as compared to the
same period in 2002. Gross revenue from video games for sale increased 84% for
the six months ended July 31, 2003 compared to the six months ended July 31,
2002. In addition, gross revenues from DVD for sale increased 40% during the
first six month period compared to the same period a year earlier.

Gross Profit. Total gross profit of $78.9 million for the six months ended July
31, 2003 increased $3.2 million, or 4.3%, from $75.7 million for the six months
ended July 31, 2002. Total gross profit as a percent of total revenue increased
for the six months ended July 31, 2003 to 34.0% compared to 33.2% for the same
period last year. Merchandise margin as a percent of merchandise revenues
decreased to 25.8% for the first six months of fiscal 2003 from 26.3% for the
same period last year due primarily to:

(i) an increase in freight expense resulting from higher shipping
costs, which even though $1.8 million higher than the first
six months of fiscal 2002, was in line with our internal
projections; and

(ii) lower product margins of approximately $1.8 million resulting
from increased promotional pricing in our book category on new
release titles and a shift in revenue mix from music to sale
video and video games, which have a lower margin than music.

Partially offsetting these decreases in gross profit were:

(i) a reduction of product costs of approximately $1.3 million as
a result of the adoption of EITF 02-16;

(ii) lower merchandise shrinkage of approximately $0.9 milllion;

(iii) a decrease of approximately $0.7 million in the expense
associated with the distribution and return of merchandise
resulting from improved management and controls; and

(iv) a decrease of approximately $0.2 million in certain trade and
purchase discounts.

Rental video gross profit increased as a percent of rental revenues to 62.8% for
the six months ended July 31, 2003 from 59.5% for the same period last year.
This increase was primarily due to improved procurement procedures, inventory
management and margins on videos acquired under revenue sharing agreements.
Partially offsetting this increase in rental video margin was an increase in
rental video shrinkage of approximately $0.8 million.

SG&A Expenses. SG&A expenses for the six months ended July 31, 2003 increased
approximately $1.9 million to $78.8 million, or 33.9% of total revenues,
compared to $76.9 million, or 33.7% of total revenues, for the same period a
year earlier. The increase was primarily the result of:

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(i) an increase in net advertising costs of approximately $2.7
million during the first six months of fiscal 2003 compared to
the same period in fiscal 2002, which is primarily comprised
of approximately $2.0 million from the adoption of EITF 02-16
and $0.6 million from increased advertising expenditures in an
attempt to offset the impact of the war in Iraq and soft
merchandise sales during the first quarter of fiscal 2003;

(ii) an increase of approximately $1.8 million in costs associated
with the operation of a greater number of superstores; and

(iii) higher costs of approximately $0.7 million associated with the
remodeling and expansion of certain of our existing
superstores.

Partially offsetting these increases in SG&A were:

(i) a decline of approximately $2.7 million in accounting and
legal fees that were higher than normal during the first six
months of fiscal 2002 due to a $2.5 million charge for the
settlement of the shareholder class action lawsuits; and

(ii) a decrease in the costs associated with our group health plan
of approximately $0.4 million the result of unplanned charges
during the first six months of fiscal 2002.

Interest Expense. Interest expense remained unchanged at $1.0 million for the
six months ended July 31, 2003, compared to the six months ended July 31, 2002
as higher debt levels during the current quarter compared to last year were
offset by lower interest rates.

Interest Income. During the second quarter, we recorded non-recurring interest
income of $1.3 million as a result of interest earned on income tax refunds for
amended returns filed for fiscal years 1995 through 1998.

Income Taxes. No income tax effect was recorded during the second quarters of
fiscal 2003 and 2002 due to adjustments in the valuation allowance related to
the net deferred tax asset.

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Liquidity and Capital Resources

We generate cash from operations exclusively from the sale of merchandise and
the rental of video products and we have substantial operating cash flow because
most of our revenue is received in cash and cash equivalents. Other than our
principal capital requirements arising from the purchase, warehousing and
merchandising of inventory and rental videos, opening new superstores and
expanding existing superstores and updating existing and implementing new
information systems technology, we have no anticipated material capital
commitments. Our primary sources of working capital are cash flow from operating
activities, trade credit from vendors and borrowings under our amended revolving
credit facility. We believe our cash flow from operations and borrowings under
our amended revolving credit facility will be sufficient to fund our ongoing
operations, new superstores and superstore expansions through fiscal 2005.

Consolidated Cash Flows

Operating Activities. Net cash flows from operating activities decreased
$1.2 million, from $22.9 million for the six months ended July 31, 2002 to
$21.7 million for the six months ended July 31, 2003. The primary reason
for the decrease was a lesser decline in inventory of approximately $2.4
million during the first six months of fiscal 2003 compared to the first
six months of fiscal 2002.

Investing Activities. Net cash used in investing activities decreased $4.5
million, or 15.5%, to $24.9 million for the six months ended July 31, 2003
from $29.4 million for the six months ended July 31, 2002. This decrease
was primarily the result of a higher amount of purchases of DVD rental
video assets under revenue sharing agreements, which generally cost less
than non-revenue sharing DVD assets, and improved rental video inventory
procurement procedures. In addition, purchases of computer hardware and
software upgrades were higher during the six months ended July 31, 2002.

Financing Activities. Cash provided by financing activities is primarily
associated with borrowings and payments made under debt agreements. For the
six months ended July 31, 2003, net borrowings under debt agreements
decreased $7.4 million compared to the six months ended July 31, 2002. Also
included in cash provided by financing activities are amounts for the
repurchase of our common stock. On September 18, 2001 we announced a stock
repurchase program of up to $5.0 million of our common stock. As of July
31, 2003, a total of 796,423 shares have been repurchased at a cost of
approximately $3.8 million, for an average cost of $4.74 per share.

Capital Structure. On August 23, 2002, we executed an amendment to our
syndicated secured Loan and Security Agreement with Fleet Retail Finance, Inc.
and The CIT Group/Business Credit, Inc, (the "Facility"). The amount outstanding
under the Facility is limited by a borrowing base predicated on eligible
inventory, as defined, and certain rental video assets, net of accumulated
depreciation less specifically defined reserves and is limited to a ceiling of
$80 million, less a $10 million availability reserve. The Facility permits
borrowings at various interest-rate options based on the prime rate or London
Interbank Offer Rate (LIBOR) plus applicable margin depending upon the level of
the Company's minimum availability. The borrowing base under the Facility is
limited to an advance rate of 65% of eligible inventory and certain rental video
assets net of accumulated amortization less specifically defined reserves, which
can be adjusted to reduce availability under the Facility. The Facility contains
no financial covenants, restricts the payment of dividends and includes certain
other debt and acquisition limitations, allows for the repurchase of up to $7.5
million of our common stock and requires a minimum availability of $10 million
at all times. The Facility is secured by substantially all of the assets of the
Company and our subsidiaries and is guaranteed by each of our three consolidated
subsidiaries. The Facility matures on August 20, 2005. At July 31, 2003, we had
$15.5 million in excess availability, after the $10 million availability
reserve, under the Facility. At July 31, 2003 and January 31, 2003,
respectively, we had borrowings outstanding of $48.3 million and $45.7 million
under the Facility. The average rate of interest being charged under the
Facility was 3.6% and 4.1% at July 31, 2003 and January 31, 2003, respectively.

From time to time, we enter into interest rate swap agreements in order to
obtain a fixed interest rate on a portion of our outstanding floating rate debt
thereby reducing our exposure to interest rate volatility. On October 4, 2002,
we cancelled, at no cost, two swap agreements entered into in November and
December of 2001 with an aggregate notional amount of $20 million and replaced
those agreements with one interest rate swap agreement with a financial
institution. The notional amount of the swap is $20 million with a fixed
interest rate of 2.45% for two years. We have designated the interest rate swap
as a hedging instrument. At July 31, 2003, the fair value of the interest rate
swap was not significant.

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At July 31, 2003, our minimum operating lease commitments remaining for fiscal
2003 were approximately $9.3 million. The present value of total existing
minimum operating lease commitments for fiscal years 2004 through 2018
discounted at 9.0% was approximately $68.4 million as of July 31, 2003.

SEASONALITY AND INFLATION

As is the case with many retailers, a significant portion of our revenues, and
an even greater portion of our operating profit, is generated in the fourth
fiscal quarter, which includes the Christmas selling season. As a result, a
substantial portion of our annual earnings has been, and will continue to be,
dependent on the results of this quarter. We experience reduced rentals of video
activity in the spring because customers spend more time outdoors. Major world
events, such as the war in Iraq, or sporting events, such as the Super Bowl, the
Olympic Games or the World Series, also have a temporary adverse effect on
revenues. Future operating results may be affected by many factors, including
variations in the number and timing of store openings, the number and popularity
of new book, music and videocassette titles, the cost of the new release or
"best renter" titles, changes in comparable-store revenues, competition,
marketing programs, increases in the minimum wage, weather, special or unusual
events, and other factors that may affect retailers in general and Hastings in
particular.

We do not believe that inflation has materially impacted operating results
during the past three years. Substantial increases in costs and expenses could
have a significant impact on our operating results to the extent such increases
are not passed along to customers.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the ordinary course of our business, we are exposed to certain market risks,
primarily changes in interest rates. Our exposure to interest rate risk consists
of variable rate debt based on the lenders base rate or LIBOR plus a specified
percentage at our option. The annual impact on our results of operations of a
100 basis point interest rate change on the July 31, 2003 outstanding balance of
the variable rate debt would be approximately $0.3 million, including the effect
of our interest rate swap. After an assessment of these risks to our operations,
we believe that the primary market risk exposures (within the meaning of
Regulation S-K Item 305) are not material and are not expected to have any
material adverse impact on our financial position, results of operations or cash
flows for the next fiscal year. In addition, we do not believe changes in the
fair value of our interest rate swap entered into in October of 2002 with a
notional amount of $20 million will be material.

ITEM 4. CONTROLS AND PROCEDURES

As required by Exchange Act Rules 13a-15 and 15d-15, an evaluation was conducted
under the supervision and with the participation of management, including our
Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures as of July 31,
2003, and based on this evaluation our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures
were effective as of such date to ensure that information required to be
disclosed by us in our reports filed or submitted under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms.

There has not been any change in our internal control over financial reporting
during the period covered by this report that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.

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PART II

ITEM 1. LEGAL PROCEEDINGS

In 2000, we restated our consolidated financial statements for the first three
quarters of fiscal 1999 and the prior four fiscal years. As a result, lawsuits
were filed against us and certain of our current and former directors and
officers asserting various claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934.

We agreed to settle these lawsuits, and the settlement received final approval
by the court on March 10, 2003. The settlement required a payment of $5.75
million on behalf of the defendants in the lawsuits ($3.15 million of which was
funded from amounts remaining under our director and officer insurance policy
after the payment of litigation expenses). The settlement resolves all claims
against us and our current and former defendant officers and directors. Based on
the foregoing, we recorded loss contingencies of $2.5 million, or $0.22 per
share, and $0.1 million, or $0.00 per share, during the second and fourth fiscal
quarters of fiscal 2002, respectively. All amounts required by the settlement
agreement were funded by January 31, 2003.

ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS

We held our Annual Meeting of Shareholders on June 11, 2003. The sole item
submitted by management to a vote of the shareholders was the election of John
H. Marmaduke, Gaines L. Godfrey and Jeffrey G. Shrader as Directors of the
Company for a term expiring in 2006. Proxies for the meeting were solicited
pursuant to Regulation 14 under the Exchange Act, there was no solicitation in
opposition to the Director nominees and all three Director nominees were
elected. The vote tabulation with respect to each nominee Directors is as
follows:

The total number of abstentions and broker non-votes was 1,045,386 out of a
total of 11,337,637 shares entitled to vote on the matter.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a. Listing of exhibits

b. On June 10, 2003, the Company filed a current report on Form 8-K reporting,
under "Item 9. Regulation FD Disclosure," the officer certification of
financial information required by 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

On May 21, 2003, the Company filed a current report on Form 8-K reporting,
under "Item 9. Regulation FD Disclosure," that the Company had announced,
among other things, its results for the quarter ended April 30, 2003.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized:

HASTINGS ENTERTAINMENT, INC.

Date: September 10, 2003 /s/ Dan Crow
--------------------------------------------
Dan Crow
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

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INDEX TO EXHIBITS