UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

Movie Gallery, Inc.

(Exact name of registrant as specified in its charter)

 

 

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 filing requirements for the past 90 days.  YES   ý      NO    o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES   ý      NO    o

 

The number of shares outstanding of the registrant’s common stock as of May 11, 2004 was 33,498,816.

 

 

Movie Gallery, Inc.

Index

 

Part I.	Financial Information
Item 1.	Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets  – January 4, 2004 and April 4, 2004
Consolidated Statements of Income – Thirteen weeks ended April 6, 2003 and April  4, 2004
Consolidated Statements of Cash Flows – Thirteen weeks ended April 6, 2003 and April 4, 2004
Notes to Consolidated Financial Statements – April 4, 2004
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
Part II.	Other Information
Item 6.	Exhibits and Reports on Form 8-K

 

 

Movie Gallery, Inc.

Consolidated Balance Sheets

(in thousands)

 

		January 4, 2004			April 4, 2004
					(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	53,720		$	48,524
Merchandise inventory		26,473			25,947
Prepaid expenses		1,377			1,650
Store supplies and other		11,019			10,184
Deferred income taxes		1,631			1,870
Total current assets		94,220			88,175
Rental inventory, net		102,479			109,773
Property, furnishings and equipment, net		114,356			121,435
Goodwill, net		136,008			136,554
Other intangibles, net		8,473			8,551
Deposits and other assets		8,753			8,297
Total assets		$	464,289		$	472,785
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	77,344		$	58,919
Accrued liabilities		26,161			28,185
Deferred revenue		10,741			8,290
Total current liabilities		114,246			95,394
Other accrued liabilities		142			205
Deferred income taxes		29,785			35,280
Stockholders’ equity:
Preferred stock, $.10 par value; 2,000,000 shares authorized, no shares issued or outstanding		—			—
Common stock, $.001 par value; 65,000,000 shares authorized, 32,840,849 and 33,415,788 shares issued and outstanding, respectively		33			34
Additional paid-in capital		225,191			230,397
Retained earnings		91,098			108,349
Accumulated other comprehensive income		3,794			3,126
Total stockholders’ equity		320,116			341,906
Total liabilities and stockholders’ equity		$	464,289		$	472,785

 

See accompanying notes.

 

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Movie Gallery, Inc.

Consolidated Statements of Income

(Unaudited)

(in thousands, except per share data)

 

		Thirteen Weeks Ended
		April 6, 2003			April 4, 2004
Revenues:
Rentals		$	153,181		$	186,757
Product sales		15,468			16,545
Total revenues		168,649			203,302
Cost of sales:
Cost of rental revenues		47,584			51,745
Cost of product sales		12,671			10,940
Gross margin		108,394			140,617
Operating costs and expenses:
Store operating expenses		74,484			96,055
General and administrative		10,776			13,796
Amortization of intangibles		426			614
Stock option compensation		469			56
Operating income		22,239			30,096
Interest expense, net		(99		)	(99		)
Income before income taxes		22,140			29,997
Income taxes		8,856			11,745
Net income		$	13,284		$	18,252
Net income per share:
Basic		$	0.41		$	0.55
Diluted		$	0.40		$	0.54
Weighted average shares outstanding:
Basic		32,097			33,071
Diluted		33,084			33,737
Cash dividends per common share		$	—		$	0.03

 

See accompanying notes.

 

2

 

Movie Gallery, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

 

		Thirteen Weeks Ended
		April 6, 2003			April 4, 2004
Operating activities:
Net income		$	13,284		$	18,252
Adjustments to reconcile net income to net cash provided by operating activities:
Rental inventory amortization and non-cash cost of rental inventory sold		35,775			34,073
Purchases of rental inventory		(35,242		)	(36,760		)
Depreciation and intangibles amortization		5,323			6,842
Stock option compensation		469			56
Tax benefit of stock options exercised		382			2,989
Deferred income taxes		2,926			5,256
Changes in operating assets and liabilities:
Merchandise inventory		59			530
Other current assets		(1,518		)	562
Deposits and other assets		(724		)	456
Accounts payable		(6,994		)	(18,425		)
Accrued liabilities and deferred revenue		1,676			(382		)
Net cash provided by operating activities		15,416			13,449
Investing activities:
Business acquisitions		(3,725		)	(2,206		)
Purchases of rental inventory-base stock		(7,145		)	(3,883		)
Purchases of property, furnishings and equipment		(10,722		)	(13,065		)
Net cash used in investing activities		(21,592		)	(19,154		)
Financing activities:
Proceeds from issuance of common stock		125			2,162
Dividends		—			(985		)
Net cash provided by financing activities		125			1,177
Effect of exchange rate changes on cash and cash equivalents		1,057			(668		)
Decrease in cash and cash equivalents		(4,994		)	(5,196		)
Cash and cash equivalents at beginning of period		39,526			53,720
Cash and cash equivalents at end of period		$	34,532		$	48,524

 

See accompanying notes.

 

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Movie Gallery, Inc.

 

Notes to Consolidated Financial Statements (Unaudited)

 

April 4, 2004

 

1.  Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, the unaudited consolidated financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the thirteen week period ended April 4, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending January 2, 2005.  For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended January 4, 2004.

 

In the first quarter of 2004, we began reporting the on-going purchases of new release rental inventory as an operating activity in the statement of cash flows versus as an investing activity as previously reported.   This reclassification is appropriate as the rental of this inventory generates the majority of our revenue. Purchases of rental inventory for new stores or other significant investments in base stock rental inventory continue to be classified as investing activities in the statements of cash flows as these purchases represent a long-term investment in our business.  Rental inventory purchases in the prior year have been reclassified to conform to the current year presentation for comparative purposes.  The reclassification had no impact on our financial position or results of operations as previously reported.

 

Stock Option Plan

 

We account for stock-based employee compensation under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  Stock option compensation is reflected in net income for variable options outstanding under the plan.  No stock option compensation is reflected in net income for fixed options outstanding under the plan where the exercise price was equal to the market value of the underlying common stock on the date of grant.

 

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The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provision of FASB Statement No. 123, Accounting for Stock-Based Compensation, as amended, to stock-based employee compensation.

 

		Thirteen Weeks Ended
		April 6, 2003			April 4, 2004
		(in thousands, except per share data)
Net income, as reported		$	13,284		$	18,252
Add:  Stock option compensation included in reported net income, net of tax		281			34
Deduct:  Stock option compensation determined under fair value based methods for all awards, net of tax		(132		)	(257		)
Pro forma net income		$	13,433		$	18,029
Net income per share, as reported:
Basic		$	0.41		$	0.55
Diluted		$	0.40		$	0.54
Pro forma net income per share:
Basic		$	0.42		$	0.55
Diluted		$	0.40		$	0.53

 

Recently Issued Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (“the Interpretation”).  The Interpretation requires the consolidation of entities in which an enterprise absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity.  Currently, entities are generally consolidated by an enterprise when it has a controlling financial interest through ownership of a majority voting interest in the entity.  The Interpretation is effective as of December 31, 2003 for all qualifying interests in special purpose entities (“SPEs”) in existence as of January 31, 2003 and as of February 1, 2003 for all qualifying SPEs obtained after January 31, 2003.  We had no qualifying interests as of January 31, 2003.  We have subsequently made equity investments in other entities during 2003 (none of which are SPEs).  These investments are immaterial, and consolidation is not currently required under the Interpretation.   The provisions of the Interpretation, as revised by the FASB in December 2003, were applied to some of our investments in the first quarter of 2004.   Our adoption of this standard did not have a material impact on our financial position or results of operations.

 

2.  Rental Inventory

 

In the fourth quarter of 2002,  we changed the estimates used to amortize rental inventory by reducing  the estimated useful lives of the rental inventory and reducing salvage value for both VHS and game inventory.    The change in estimate decreased rental inventory and increased depreciation expense for the thirteen weeks ended April 6, 2003 by approximately $2.7 million and reduced net income by $0.05 per diluted share.

 

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3.  Goodwill and Other Intangible Assets

 

The components of goodwill and amortized other intangible assets are as follows (in thousands):

 

				January 4, 2004						April 4, 2004
		Weighted-Average Amortization Period		Gross Carrying Amount			Accumulated Amortization			Gross Carrying Amount			Accumulated Amortization
Goodwill		—		$	167,419		$	(31,411	)	$	167,965		$	(31,411	)
Non-compete agreements		8 years		$	10,908		$	(7,696	)	$	11,057		$	(8,037	)
Customer lists		5 years		6,385			(1,124		)	6,926			(1,395		)
Total other intangible assets				$	17,293		$	(8,820	)	$	17,983		$	(9,432	)

 

Estimated amortization expense for other intangible assets for the remainder of 2004 and the five succeeding fiscal years is as follows (in thousands):

 

2004 (remainder)		$	1,887
2005		2,017
2006		1,690
2007		1,549
2008		1,033
2009		302

 

The changes in the carrying amounts of goodwill for the thirteen weeks ended April 4, 2004, are as follows (in thousands):

 

Balance as of January 4, 2004		$	136,008
Goodwill acquired		546
Balance as of April 4, 2004		$	136,554

 

During the thirteen weeks ended April 4, 2004, we purchased 24 stores in 8 separate transactions for approximately $2.2 million and recorded approximately $0.5 million in goodwill, $0.5 million for customer lists and $0.2 million for non-compete agreements related to these transactions

 

4.  Financing Obligations

 

On June 27, 2001, we entered into a credit agreement with a syndicate of banks, led by SouthTrust Bank, with respect to a revolving credit facility.  Our credit facility is unsecured and, as amended, provides for borrowings of up to $65 million through final maturity on July 4, 2005.  The interest rate on our credit facility is based on LIBOR plus an applicable margin percentage, which depends on cash flow generation and borrowings outstanding.  As of April 4,  2004, there were no outstanding borrowings under our credit facility.  The amount available for borrowing, which was reduced by standby letters of credit outstanding of $1.5 million, was $63.5 million as of April 4, 2004.

 

5.  Earnings Per Share

 

Basic earnings per share is computed based on the weighted average number of shares of common stock outstanding during the periods presented.  Diluted earnings per share is 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

 

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exercise of dilutive common stock options (987,000 and 666,000 for the thirteen weeks ended April 6, 2003 and April 4, 2004, respectively).  No adjustments were made to net income in the computation of basic or diluted earnings per share.

 

6.  Comprehensive Income

 

Comprehensive income was as follows (in thousands):

 

		Thirteen Weeks Ended
		April 6, 2003			April 4, 2004
Net income		$	13,284		$	18,252
Foreign currency translation adjustment		1,057			(668		)
Comprehensive income		$	14,341		$	17,584

 

7

Movie Gallery, Inc.

 

Management’s Discussion and Analysis of Financial Condition

and Results of Operations

 

Overview

 

We operate approximately 2,200 home video retail stores that rent and sell movies and video games, primarily in rural and secondary markets throughout North America.  We compete with the other two national chains (Blockbuster and Hollywood Entertainment) in only approximately one-third of our store locations.  We believe that we are the market leader in the majority of our target markets.  We estimate that there are approximately 3,000 to 4,000 markets still available for expansion in rural America, as well as opportunities throughout Canada and Mexico.  We currently plan to open approximately 300 new stores in 2004 and, subject to market and industry conditions, to continue to open new stores at a similar pace over the next several years.

 

We believe the most significant dynamic in our industry is the relationship our business maintains with the movie studios.  The studios have historically maintained an exclusive window for home video distribution (packaged goods) which provides mass merchants and video retailers approximately a 45 day period during which they can sell and rent new releases before they are made available on pay-per-view or other distribution channels.  The home video distribution channel currently provides over 60% of studio revenue.  For this reason, we believe movie studios have a significant interest in maintaining a viable home video business.  For a more detailed discussion of our business and the home video industry, see the Business discussion contained in Part I, Item 1 of our Annual Report on Form 10-K for the fiscal year ended January 4, 2004.

 

Our strategies are designed to achieve reasonable, moderate and consistent growth in same-store revenues and profitability, in a mature industry.  We foster a corporate culture of cost control, striving to minimize the operating and overhead costs associated with our business which allows us to maximize profitability and which has proven to be a successful operating model for us.  Our balance sheet reflects $48.5 million in cash and cash equivalents at April 4, 2004 and we have not had any outstanding long-term debt since May 2002.  Our store base has increased in excess of 20% in each of the last three fiscal years.

 

In addition to the relationship between our industry and the movie studios, our operating results are driven by revenue, inventory, rent and payroll.  Given those key factors, we believe that by monitoring the five operating performance indicators described below, we can continue to be successful in executing our operating plans and our growth strategy.

 

•                  Revenues.  Our business is a cash business with initial rental fees paid upfront by the customer.  Our management team constantly works with inventory levels, marketing and sales promotions, real estate strategies and personnel issues in order to maximize profitable revenues at each location.  Additionally, our team monitors revenue performance on a daily basis to quickly identify trends or issues in our store base or in the industry as a whole.

•                  Product purchasing economics.  In order to maintain the desired profit margin in our business, purchases of inventory for both rental and sale must be carefully managed.  Our purchasing models are designed to analyze the impact of the economic factors inherent in the various pricing strategies employed by the studios.  We believe that we are able to achieve purchasing levels tailored for the customer demographics of each of our markets and to maximize the return on investment for our inventory purchase dollars.

•                  Store level cost control.  The most significant store expenses are payroll and rent, followed by all other supply and service expenditures.  Our fundamental philosophy with respect to store level expenses is to exercise extreme conservatism in spending.  This is achieved primarily through budgeting systems and centralization of purchases into the corporate support center.  This enables us to measure performance carefully against expectations and to leverage our purchasing power.  Our rural focus also provides the benefit of reduced labor and real estate costs in the secondary markets we serve versus the costs associated with larger urban markets.

•                  Leverage of overhead expenses.  We apply the same principles of budgeting, accountability and conservatism in our overhead spending that we employ in managing our store operating costs.  Our general

 

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and administrative expenses include the costs to maintain our corporate support center as well as the overhead costs of our field management team.

•                  Operating cash flows.  We have generated significant levels of cash flow for several years.  We are generally able to fund the majority of our store growth and acquisitions, as well as ongoing inventory purchases, from cash flow generated from operations.  Cash flow has been sufficient to allow us to maintain a debt-free balance sheet since May 2002.

 

The following discussion of our results of operations, liquidity and capital resources will provide further insight into our performance for the first quarter of 2004 versus the first quarter of 2003.

 

New Business Initiatives

 

During the last half of 2003, we began to make some investments in various alternative delivery vehicles (both retail and digital) for movie content, and we began to explore other business initiatives within our existing base of stores, including tests of a game store-within-a-store, movie trading and in-store movie subscriptions.  We do not anticipate that any of these alternatives will replace our base video rental business.  However, we do believe it is appropriate to make selective investments in synergistic opportunities that could potentially provide ancillary sources of revenue and profitability to our base rental business.  Our operating expenses in the first quarter of 2004 include certain costs related to some of these investments, resulting in a reduction to net income of approximately $0.03 per diluted share.

 

9

 

Results of Operations

 

Selected Financial Statement and Operational Data:

		Thirteen Weeks Ended
		April 6, 2003							April 4, 2004
		($ in thousands, except per share and store data )
Revenues:
Rental		$	153,181		90.8		%		$	186,757		91.9	%
Product sales		15,468			9.2		%		16,545			8.1	%
Total revenues		168,649			100.0		%		203,302			100.0	%
Cost of sales:
Rental		47,584			28.2		%		51,745			25.5	%
Product sales		12,671			7.5		%		10,940			5.4	%
Total gross margin		$	108,394		64.3		%		$	140,617		69.2	%
Store operating expenses		$	74,484		44.2		%		$	96,055		47.2	%
G&A expenses		$	10,776		6.4		%		$	13,796		6.8	%
Stock option compensation		$	469		0.3		%		$	56		—	%
Operating income		$	22,239		13.2		%		$	30,096		14.8	%
Net income		$	13,284		7.9		%		$	18,252		9.0	%
Net income per diluted share		$	0.40						$	0.54
Cash dividends per common share		$	—						$	0.03
Same-store revenues		10.5		%					2.0		%
Gross margin percentage:
Rental		68.9		%					72.3		%
Product sales		18.1		%					33.9		%
Total gross margin		64.3		%					69.2		%
Store Count:
Beginning of period		1,784							2,158
New store builds		37							81
Stores acquired		20							24
Stores closed		18							23
End of period		1,823							2,240

 

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Revenue.   For the thirteen weeks ended April 4, 2004, total revenues increased 20.5% from the comparable period in 2003.  The increase was primarily due to a 21.9% increase from the prior year in the average number of stores operated during the first quarter of 2004, as well as same-store revenue growth of 2.0% for the first quarter of 2004.  The increase in same-store revenues primarily resulted from:

 

•                  Continued growth of DVD revenue, offset partially by corresponding declines in VHS revenue due to the consumer transition to DVD; and

•                  Increases in the sales of previously viewed inventory.

 

The same-store revenues increase was partially offset by:

 

•                  A weak release schedule during the first quarter of 2004 versus 2003;

•                  A relatively flat game business reflecting the weakness of the new game titles currently being released and industry softness that occurs in anticipation of the introduction of new game platforms; and

•                  Declines in the sales of new movies as a result of the weaker box office releases and our decision to reduce new movie inventory levels in our stores.

 

Cost of Sales.  The cost of rental revenues includes the amortization of rental inventory, revenue sharing expenses incurred and the cost of previously viewed rental inventory sold.  The gross margin on rental revenue for the thirteen weeks ended April 6, 2003 and April 4, 2004 was  68.9% and 72.3%, respectively.  The most significant factors that impacted growth in the gross margin on rental revenue were:

 

•                  A change in estimate related to our amortization policy for rental inventory during the fourth quarter of fiscal 2002 which lowered the gross rental margin in the first quarter of 2003 by approximately $2.7 million; and

•                  Slightly lower purchasing levels in the first quarter of 2004 versus 2003 due to the weaker box office.

 

Cost of product sales includes the costs of new DVDs, videocassettes, concessions and other goods sold.  The gross margin on product sales is subject to fluctuation based on the relative mix of low margin new movie inventory sales versus higher margin sales of concessions and other items.  The gross margin on product sales for the thirteen weeks ended April  6, 2003 and April 4, 2004  was  18.1% and 33.9%, respectively.  The product sales margin increase reflects an overall shift in the inventory mix from lower margin new movie inventory to other higher margin inventory items.  New release movie titles in the first quarter of 2004 were also weaker in comparison to the prior year, further reducing sales of lower margin new movie inventory.

 

Operating Costs and Expenses.  Store operating expenses include store-level expenses such as lease payments and in-store payroll, as well as start-up costs associated with new store openings.  Store operating expenses as a percentage of total revenue was 44.2% and 47.2% for the first quarter of 2003 and 2004, respectively.  The increase in store operating expenses as a percentage of total revenue in the first quarter of 2004 was primarily due to:

 

•                  Costs associated with some of our investments in various alternative delivery vehicles for movie content; and

•                  Significant increases in the level of new store openings since last year, generating store opening and start-up costs for a larger number of immature stores in the revenue base versus last year.

 

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General and administrative expenses as a percentage of revenue were 6.4% and 6.8% in the first quarter of 2003 and 2004, respectively.  The increase in general and administrative expenses as a percentage of total revenue is primarily due to:

 

•                  Overhead increases to support our growth plans, which include continued expansion in geographic areas where our market penetration is lower; and

•                  Overhead costs associated with some of our new business initiatives.

 

Stock option compensation expense represents the non-cash charge associated with certain stock options that were repriced during the first quarter of fiscal 2001 and are subsequently accounted for as variable stock options.  We expect to continue to record adjustments to income from stock option compensation in future periods.  Due to the relatively small number of these options that remain outstanding, we expect future adjustments to be immaterial.

 

Operating Income.  As a result of the impact of the above factors on revenues and expenses, operating income increased by 35.3% in the first quarter of 2004 to $30.1 million.

 

Liquidity and Capital Resources

 

Our primary capital needs are for opening and acquiring new stores and for purchasing inventory. Other capital needs include refurbishing, remodeling and relocating existing stores and refreshing, rebranding and supplying new computer hardware for acquired stores.  We fund inventory purchases, remodeling, rebranding and relocation programs, new store opening costs and acquisitions primarily from cash flow from operations and, if necessary, loans under revolving credit facilities.  At April 4, 2004, we had cash and cash equivalents of $48.5 million, no long-term debt and $63.5 million in available borrowings under our credit facility.

 

		Thirteen Weeks Ended
		April 6, 2003			April 4, 2004
		($ in thousands )
Statements of Cash Flow Data:
Net cash provided by operating activites		$	15,416		$	13,449
Net cash used in investing activities		(21,592		)	(19,154		)
Net cash provided by financing activities		125			1,177
Other Data:
Adjusted EBITDA		$	28,564		$	34,307
Adjusted EBITDA (percent of total revenue)		16.9		%	16.9		%

 

The decrease in net cash provided by operating activities was primarily attributable to higher reductions in accounts payable during the first quarter of 2004 versus the comparable period in 2003.  Net cash provided by operating activities continues to be sufficient to cover substantially all of our rental inventory replenishment and capital resource needs.

 

In the first quarter of 2004, we began reporting the on-going purchases of new release rental inventory as an operating activity in the statement of cash flows versus as an investing activity as previously reported.  This reclassification is appropriate as the rental of this inventory generates the majority of our revenue.  Purchases of rental inventory for new stores or other significant investments in base stock rental inventory continue to be classified as investing activities in the statements of cash flows as these purchases represent a long-term investment in our business.  Rental inventory purchases in the prior year have been reclassified to conform to the current year presentation for comparative purposes.  The reclassification had no impact on our financial position or results of operations as previously reported.

 

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Net cash used in investing activities includes the costs of business acquisitions, new store builds and investments in base stock rental inventory.  The decrease was primarily due to an investment in base stock DVD inventory of approximately $5.4 million in the first quarter of 2003 and lower levels of business acquisitions in the first quarter of 2004 versus 2003,  partially offset by increased expenditures relating to the higher levels of new store builds in 2004 versus the first quarter of 2003.

 

Net cash provided by financing activities includes proceeds from the exercise of stock options offset by dividends paid in the first quarter of 2004.

 

In March 2004, our board of directors declared a cash dividend of $0.03 per share under a new dividend policy instituted in December 2003.  We currently intend to continue to pay similar quarterly cash dividends on our common stock.  However, the payment of future dividends is subject to the discretion of our board of directors.  Future dividends may be increased, decreased or suspended from time to time based on a number of factors, including changes in tax laws related to dividends, our financial condition, capital requirements, future business prospects, the terms of any documents governing our indebtedness and other factors that our board of directors deems relevant.

 

Adjusted EBITDA in the first quarter of 2004 increased 20% over the comparable period in the prior year.  The increase was primarily driven by the revenue increase in the first quarter of 2004, offset partially by more significant levels of new store opening and start-up costs as well as costs associated with some of our new business initiatives.  Adjusted EBITDA is defined as earnings before interest, taxes, depreciation and amortization, non-cash stock option compensation and nonrecurring items, less our purchases of rental inventory which excludes rental inventory purchases specifically for new store openings. Adjusted EBITDA is presented not as an alternative measure of operating results or cash flow from operations (as determined in accordance with accounting principles generally accepted in the United States), but because, in the home video specialty retail industry, it is a widely accepted financial indicator of a company’s ability to finance its operations and meet its growth plans, in that it treats rental inventory as being expensed upon purchase instead of being capitalized and amortized.  This measure is also used by us internally to make new store and acquisition investment decisions and to calculate awards under incentive based compensation programs.  Our calculation of Adjusted EBITDA is not necessarily comparable to reported EBITDA and/or Adjusted EBITDA of other companies due to the lack of uniform definitions of EBITDA and Adjusted EBITDA.

 

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Our calculation of Adjusted EBITDA is reconciled to operating income and operating cash flow as follows (in thousands):

 

		Thirteen Weeks Ended
		April 6, 2003			April 4, 2004
Operating income		$	22,239		$	30,096
Rental inventory amortization		35,775			34,073
Depreciation and intangibles amortization		5,323			6,842
Stock option compensation		469			56
Purchases of rental inventory		(35,242		)	(36,760		)
Adjusted EBITDA		$	28,564		$	34,307
Net cash provided by operating activities		$	15,416		$	13,449
Changes in operating assets and liabilities		7,501			17,259
Tax benefit of stock options exercised		(382		)	(2,989		)
Deferred income taxes		(2,926		)	(5,256		)
Interest expense		99			99
Income taxes		8,856			11,745
Adjusted EBITDA		$	28,564		$	34,307

 

On June 27, 2001, we entered into a credit agreement with a syndicate of banks, led by SouthTrust Bank, with respect to a revolving credit facility.  Our credit facility is unsecured and, as amended, provides for borrowings of up to $65 million through final maturity on July 4, 2005.  The interest rate on our credit facility is based on LIBOR plus an applicable margin percentage, which depends on cash flow generation and borrowings outstanding.  As of April 4, 2004, there were no outstanding borrowings under our credit facility.  The amounts available for borrowing, reduced by standby letters of credit outstanding of $1.5 million, totaled $63.5 million as of April 4, 2004.

 

At April 2004, we had a working capital deficit of $7.2 million, due to the accounting treatment of rental inventory. Rental inventory is treated as a noncurrent asset under accounting principles generally accepted in the United States because it is a depreciable asset and a portion of this asset is not 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 our 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 reflected as a reduction in working capital. Consequently, we believe that working capital is not an appropriate measure of our liquidity and we anticipate that we will continue to operate with a working capital deficit.

 

We grow our store base through internally developed and acquired stores.  We opened 81 internally developed stores, acquired 24 stores and closed 23 stores during the first quarter of 2004.  We will continue to evaluate acquisition opportunities in 2004 as they arise.  To the extent available, new stores and future acquisitions may be completed using funds available under our credit facility, financing provided by sellers or alternative financing arrangements such as funds raised in public or private debt or equity offerings.  However, we cannot assure you that financing will be available to us on terms which will be acceptable, if at all.

 

We believe our projected cash flow from operations, cash on hand, borrowing capacity under our credit facility and trade credit will provide the necessary capital to fund our current plan of operations, including our anticipated new store openings and acquisition program, through fiscal 2004. However, to fund a major acquisition, or to provide funds in the event that our need for funds is greater than expected, or if the financing sources identified above are not available to the extent anticipated or if we increase our growth plan, we may need to seek additional or alternative sources of financing.

 

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This financing may not be available on satisfactory terms. Failure to obtain financing to fund our expansion plans or for other purposes could have a material adverse effect on our operating results.

 

Our ability to fund our current plan of operations and our growth plan will depend upon our future performance, which is subject to general economic, financial, competitive and other factors that are beyond our control.  We cannot assure you that our business will continue to generate sufficient cash flow from operations in the future to fund capital resource needs, cover the ongoing costs of operating the business and service any debt incurred in the future.  If we are unable to satisfy these requirements with cash flow from operations and cash on hand, we may be required to sell assets or to obtain additional financing.  We cannot assure you that any such sales of assets or additional financing could be obtained.

 

Critical Accounting Policies and Estimates

 

Our significant accounting policies are described in Note 1 to our consolidated financial statements as filed in our Annual Report on Form 10-K for the fiscal year ended January 4, 2004. Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of the financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate the estimates that we have made. These estimates have been based upon historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different conditions or using different assumptions. We believe our most critical accounting estimates include our policies with respect to rental inventory amortization, impairment of long-lived assets, purchase price allocation of acquired businesses and deferred income taxes.  These policies are discussed in Item 7 of our Annual Report on Form 10-K for the fiscal year ended January 4, 2004.

 

Forward Looking Statements

 

 This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which represent our expectations or beliefs about future events and financial performance.  Forward-looking statements are identifiable by the fact that they do not relate strictly to historical information and may include words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate” or other similar expressions and variations thereof.  In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements.  Our forward-looking statements are based on management’s current intent, belief, expectations, estimates and projections regarding our company and our industry.  Forward-looking statements are subject to known and unknown risks and uncertainties, including those described in our Annual Report on Form 10-K for the fiscal year ended January 4, 2004.  In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this Form 10-Q might not occur.  In addition, actual results could differ materially from those suggested by the forward-looking statements, and therefore you should not place undue reliance on the forward-looking statements.  We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.  We desire to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 and in that regard we caution the readers of this Form 10-Q that the important factors described in our Annual Report on Form 10-K for the fiscal year ended January 4, 2004, among others, could affect our actual results of operations and may cause changes in our strategy with the result that our operations and results may differ materially from those expressed in any forward-looking statements made by us, or on our behalf.

 

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Item 3.   Quantitative and Qualitative Disclosures About Market Risk

 

There have been no material changes in our inherent market risk since the disclosures made as of January 4, 2004 in our Annual Report on Form 10-K.

 

Item 4.   Controls and Procedures

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act )) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective.

 

There have not been any changes in our internal control over financial reporting (as such term is defin ed in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our first quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Part II - Other Information

 

Item 6.  Exhibits and Reports on Form 8-K

 

a)              Exhibits

31.1                          Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended. (filed herewith)

 

31.2                          Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended. (filed herewith)

 

32.1                          Certification of Chief Executive Officer Pursuant to 18 U.S.C 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

32.2                           Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

b)             Reports on Form 8-K

 

We filed a Form 8-K reporting on Items 7 and 12 dated January 7, 2004.

We filed a Form 8-K reporting on Items 5 and 7 dated February 4, 2004.

We filed a Form 8-K reporting on Items 7 and 12 dated February 19, 2004.

We filed a Form 8-K reporting on Items 5 and 7 dated April 2, 2004.

 

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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.

 

	Movie Gallery, Inc.
	(Registrant)
Date: May 14, 2004	/s/ Ivy M. Jernigan
	Ivy M. Jernigan, Senior Vice President and
	Chief Financial Officer

 

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