10-K 1 d10k.htm FORM 10-K FORM 10-K
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended January 6, 2008.

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 001-15153

 

 

BLOCKBUSTER INC.

(Exact name of registrant as specified in its charter)

 

 

 

DELAWARE   52-1655102

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

1201 Elm Street

Dallas, Texas 75270

(214) 854-3000

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Class A Common Stock, $.01 par value per share   New York Stock Exchange
Class B Common Stock, $.01 par value per share   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).    Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

As of June 29, 2007, which was the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the registrant’s common stock held by non-affiliates was $727,052,884, based on the closing price of $4.31 per share of Class A common stock and $3.91 per share of Class B common stock as reported on the New York Stock Exchange composite tape on that date.

As of February 29, 2008, 125,179,867 shares of Class A common stock, $0.01 par value per share, and 72,000,000 shares of Class B common stock, $0.01 par value per share, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitive proxy statement to be filed for our 2008 annual meeting of stockholders are incorporated by reference into Part III of this Form 10-K.

THIS ANNUAL REPORT ON FORM 10-K IS BEING DISTRIBUTED TO STOCKHOLDERS IN LIEU OF A SEPARATE ANNUAL REPORT PURSUANT TO RULE 14a-3(b) OF THE ACT AND SECTION 203.01 OF THE NEW YORK STOCK EXCHANGE LISTED COMPANY MANUAL.

 

 

 


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BLOCKBUSTER INC.

TABLE OF CONTENTS TO FORM 10-K

 

          Page

PART I

     

Item 1.

   Business    3

Item 1A.

   Risk Factors    23

Item 1B.

   Unresolved Staff Comments    37

Item 2.

   Properties    37

Item 3.

   Legal Proceedings    37

Item 4.

   Submission of Matters to a Vote of Security Holders    37

PART II

     

Item 5.

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    38

Item 6.

   Selected Financial Data    40

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operation    43

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    68

Item 8.

   Financial Statements and Supplementary Data    69

Item 9.

   Changes In and Disagreements With Accountants on Accounting and Financial Disclosure    150

Item 9A.

   Controls and Procedures    150

Item 9B.

   Other Information    152

PART III

     

Item 10.

   Directors, Executive Officers and Corporate Governance    153

Item 11.

   Executive Compensation    153

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   153

Item 13.

   Certain Relationships and Related Transactions, and Director Independence    154

Item 14.

   Principal Accountant Fees and Services    154

PART IV

     

Item 15.

   Exhibits and Financial Statement Schedules    155


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DISCLOSURE REGARDING FORWARD-LOOKING INFORMATION

This annual report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may also be included from time to time in our other public filings, press releases, our website and oral and written presentations by management. Specific forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts and include, without limitation, words such as “may,” “will,” “expects,” “believes,” “anticipates,” “plans,” “estimates,” “projects,” “predicts,” “targets,” “seeks,” “could,” “intends,” “foresees” or the negative of such terms or other variations on such terms or comparable terminology. Similarly, statements that describe our strategies, initiatives, objectives, plans or goals are forward-looking.

These forward-looking statements are based on management’s current intent, belief, expectations, estimates and projections regarding our Company and our industry. These statements are not guarantees of future performance and involve risks, uncertainties, assumptions and other factors that are difficult to predict. Therefore, actual results may vary materially from what is expressed in or indicated by the forward-looking statements. The risk factors set forth below under “Item 1A. Risk Factors,” and other matters discussed from time to time in subsequent filings with the Securities and Exchange Commission, including the “Disclosure Regarding Forward-Looking Information” and “Risk Factors” sections of our Quarterly Reports on Form 10-Q, among others, could affect future results, causing these results to differ materially from those expressed in our forward-looking statements. In that event, our business, financial condition, results of operations or liquidity could be materially adversely affected and investors in our securities could lose part or all of their investments. Accordingly, our investors are cautioned not to place undue reliance on these forward-looking statements because, while we believe the assumptions on which the forward-looking statements are based are reasonable, there can be no assurance that these forward-looking statements will prove to be accurate.

Further, the forward-looking statements included in this Form 10-K and those included from time to time in our other public filings, press releases, our website and oral and written presentations by management are only made as of the respective dates thereof. We undertake no obligation to update publicly any forward-looking statement in this Form 10-K or in other documents, our website or oral statements for any reason, even if new information becomes available or other events occur in the future.

 

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EXPLANATORY NOTE ABOUT RESTATEMENT

We have restated herein our consolidated financial statements for each of the fiscal years ended December 31, 2006 and 2005 and our condensed consolidated financial information for each of the previously reported interim periods of fiscal year 2007 and each of the interim periods of fiscal year 2006 to correct errors in such consolidated financial statements and financial information. The restatement adjustments also include previously identified errors which were not initially corrected in the respective years based on materiality, and adjustments previously included in the cumulative effect of adopting SEC Staff Accounting Bulletin No. 108 in fiscal year 2006. We present the effects of the restatement on our consolidated financial statements for the years ended December 31, 2004 and 2003 in Item 6, “Selected Financial Data.”

The impact of the restatements on periods prior to January 1, 2005 is reflected as an increase of $0.2 million to beginning accumulated deficit and a decrease of $0.2 million to beginning accumulated other comprehensive loss as of January 1, 2005. Information in “Item 6. Selected Financial Data”, however, is presented on a restated basis for all of the periods presented. The impact of the restatements on periods prior to January 1, 2003 is reflected as an increase of $4.1 million to beginning accumulated deficit and a decrease of $4.1 million to beginning accumulated other comprehensive loss as of January 1, 2003.

The following table summarizes the impact of the restatements on our reported results of operations for the fiscal years 2006 and 2005 (in millions):

 

     Fiscal Year  
     2006     2005  
     As reported     As restated     As reported     As restated  

Income (loss) from continuing operations before income taxes

   $ (8.5 )   $ (12.7 )   $ (485.0 )   $ (481.7 )

Income (loss) from continuing operations

   $ 67.9     $ 63.7     $ (548.3 )   $ (544.1 )

Net income (loss)

   $ 54.7     $ 50.5     $ (588.1 )   $ (583.9 )

More information regarding the impact of the restatements on our consolidated financial statements for fiscal years 2006 and 2005 is disclosed in Note 2 to the Consolidated Financial Statements, and the impact of the restatements on our condensed consolidated financial information for the interim periods of fiscal years 2007 and 2006 is disclosed in Note 14 to the Consolidated Financial Statements.

 

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PART I

Item 1.    Business

BLOCKBUSTER OVERVIEW

Blockbuster Inc. is a leading global provider of rental and retail movie and game entertainment, with over 7,800 stores in the United States, its territories and 21 other countries as of January 6, 2008. Our mission is to provide our customers with the most convenient access to media entertainment, including movie and game entertainment delivered through multiple distribution channels such as our stores, by-mail, and over the Internet. We believe Blockbuster offers customers a value-priced entertainment experience, combining the broad product depth of a specialty retailer with local neighborhood convenience.

Domestic Operations

Physical Delivery

 

 

 

In-store—As of January 6, 2008, we had 4,855 stores operating under the BLOCKBUSTER brand in the United States and its territories. Of these stores, 850 stores were operated through our franchisees. Our stores offer movie and game rental and new and traded movie and game product to our customers, including the addition of Blu-Ray DVDs to our product offerings in 2007. Additionally, approximately 400 of these locations include a game store-in-store concept operating under the GAME RUSH® brand.

 

   

By-mail—We offer an Internet-based subscription service that allows customers to rent DVDs by mail and offers substantially more titles than our individual stores, including a wide array of both new release and catalog DVDs. This service gives some customers the option of exchanging their DVDs through the mail or returning them to a nearby participating BLOCKBUSTER store in exchange for free in-store movie rentals through a program called BLOCKBUSTER Total Access™. In addition, some by-mail customers receive free in-store rental coupons each month, which may be used toward movie or game rentals. We believe that this by-mail rental offering allows us to attract and retain additional customers by providing them with the convenience of renting movies online or in-store, and allows us to reach customers located in geographic areas where we do not presently have convenient store locations.

 

   

Vending—We are exploring the growing vending channel as an opportunity to expand physical distribution of media entertainment. Vending machines are automated fixed capacity machines that enable the browsing and dispensing of a limited catalog of media entertainment. We recognize vending as an area of opportunity and are currently in the process of testing and evaluating solutions that would allow us to offer vending as an added form of convenience to customers.

Digital Delivery

 

   

Download to PC—During 2007, we purchased all of the outstanding membership interests of Movielink, LLC (“Movielink”), an online movie downloading business with one of the largest libraries of digital content for both rental and sale. We are currently integrating Movielink’s offering into the Blockbuster.com website. This will allow us to capitalize on the rapidly growing filmed entertainment downloading market and provide additional entertainment delivery choices to meet our customers’ needs.

 

   

Other alternatives—We are committed to providing convenient access to media entertainment and are continually seeking out alternative methods to deliver on this mission. With the convergence of media content and electronic devices, we are exploring further opportunities to digitally deliver content to our customers, including the development of digital delivery kiosks in our stores and leveraging strategic partners to digitally deliver entertainment content to our customers’ homes and electronic and portable devices.

 

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International Operations

As of January 6, 2008, we had 2,975 stores in 21 markets outside of the United States operating under the BLOCKBUSTER brand and other brand names we own. Of these stores, 907 stores were operated through our franchisees. In the Republic of Ireland and Northern Ireland, we operate under the XTRA-VISION® brand name due to its strong local brand awareness. In Canada, Italy, Mexico and Denmark, we also operate freestanding and store-in-store game locations under the GAME RUSH brand. During both 2007 and 2006, 35% of our worldwide revenues were generated outside of the United States. Our international operations have historically been more dependent on retail sales and, in particular, the retail game industry.

We disposed of two groups of international operations in 2007:

 

 

 

In the second quarter, we sold our freestanding game locations which operated under the brand name GAMESTATION®. The sale of these stores has resulted in decreased total merchandise sales and decreased merchandise sales as a percent of international revenues during 2007.

 

   

In the fourth quarter, we sold our Australian subsidiary, coupled with a master franchise license.

We plan to continue selectively licensing some of our international markets as this will allow us to retain our brand’s presence while redeploying capital. Longer term, a strong licensed presence in each country can significantly establish the BLOCKBUSTER brand, facilitate growth, and set the stage for a future digital offering.

We maintain offices for each major region and most of the countries in which we operate in order to manage, among other things, (i) store development and operations, (ii) marketing, and (iii) the purchase, supply and distribution of product. Additional information regarding our revenues and long-lived assets by geographic area and financial data by segment is included in Note 13 to the consolidated financial statements.

 

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INDUSTRY OVERVIEW

Domestic Media Entertainment Industry

We define our market as the media entertainment market. The estimated relative market sizes for various segments of the U.S. entertainment industry in which we compete are reflected in the following table (in millions):

 

     2008    2007    2006

In-store rental

   $ 5,826    $ 6,215    $ 7,030

Vending

     388      198      79

By-mail rental

     2,023      1,797      1,291
                    

Physical film rental market

     8,237      8,210      8,400
                    

Cable video-on-demand (“VOD”)

     1,164      1,038      977

Digital VOD

     84      28      12

Subscription VOD

     35      11      4
                    

Digital film rental market

     1,283      1,077      993
                    

Total film rental market

     9,520      9,287      9,393
                    

Physical retail

     15,419      15,932      16,460

Digital retail

     170      90      20
                    

Film retail market

     15,589      16,022      16,480
                    

Game software (rental and retail)

     6,047      6,016      4,864

Game hardware and accessories

     5,161      6,353      4,218
                    

Total game market

     11,208      12,369      9,082
                    

Total U.S. media entertainment market

   $ 36,317    $ 37,678    $ 34,955
                    

The foregoing estimates and projections have been compiled from reports and information published by Adams Media Research, with respect to filmed entertainment, and Jupiter Research, with respect to game entertainment.

While the overall domestic media entertainment industry grew in 2007 and the movie rental market is forecasted to continue that growth in 2008, there have been channel and product shifts, primarily driven by introduction of next-generation game consoles as well as the emergence of new channels of distribution for filmed entertainment, such as by-mail delivery, vending, and digital. We believe we are well-positioned to capitalize on the next-generation game console launches and the associated broadening of the consumer demographic. We have also taken steps to help ensure Blockbuster’s viability across the filmed entertainment category, and we expect to outperform the industry in many areas in 2008.

Movies

A competitive advantage that the U.S. retail home video industry has traditionally enjoyed over most other movie distribution channels, except theatrical release, is the early timing of its “distribution window.” Currently, studios distribute their filmed entertainment content three to six months after theatrical release to the home video market; seven to eight months after theatrical release to pay-per-view and video-on-demand (“VOD”); one year after theatrical release to satellite and cable; and two to three years after theatrical release to basic cable and syndicated networks. Recently, there has been increasing experimentation by studios and various movie content aggregators and retailers with the traditional distribution window, including simultaneous VOD and DVD releases. For example, although movie selections tend to be limited at present, customers can now download to their computers certain available movies on the same day that the movie’s DVD is released by the studios nationwide in retail stores for rental or sale. In some cases consumers can also burn the downloaded movie to a

 

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blank DVD for playback in a DVD player, allowing them to watch the movies on their TVs or portable devices. We expect that the movie studios will continue to assess the traditional release windows and it is possible that the studios may decide to alter the traditional home video retailer distribution window for an increasing number of movies, particularly in connection with simultaneous VOD distribution of movies and DVD release dates. However, we also believe that the studios have a vested interest in maintaining the home video distribution window in a manner that allows them to maximize revenues generated by the retail home video industry.

Games

According to estimates by Jupiter Research, hardware and accessory sales revenues in the United States increased by 50.6% in 2007. In addition, game software sales and rentals in the United States by 23.7% in 2007. These increases were largely due to the rapid growth of portable gaming systems, particularly the Nintendo DS Lite, and the recent introduction of new, more advanced hardware platforms, including the Xbox 360, the Sony PlayStation 3 and the Nintendo Wii.

Many next-generation hardware platforms, including Sony PlayStation 2 and 3 and Microsoft Xbox and Xbox 360, utilize a DVD software format and have the potential to serve as multi-purpose entertainment centers by doubling as players for DVD movies and compact discs. For example, the Sony PlayStation 3 consoles are equipped to play high-definition Blu-ray DVDs. In addition, Sony PlayStation 3 and PSP, Nintendo DS and Wii and Microsoft Xbox 360 all provide Internet connectivity.

Sales of video game software generally increase as next-generation platforms mature and gain wider acceptance. Historically, when a new platform is released, a limited number of compatible game titles are immediately available, but the selection grows rapidly as manufacturers and third-party publishers develop and release game titles for that new platform. With respect to game rentals, we believe that the difference between the retail price and the rental price of a popular new video game title is typically high enough to make rentals an attractive alternative for customers. We also believe rental pricing provides both a testing ground for consumers considering a game purchase and an attractive alternative for customers who do not want to buy a game on an older format as they evaluate the purchase of a next generation hardware platform.

While the typical electronic game enthusiast is male and between the ages of 14 and 35, the electronic game industry is broadening its appeal across all demographics, especially with the introduction of Nintendo Wii. In addition, the availability of used video game products for sale has enabled a lower-economic demographic, that may not have been able to afford the considerably more expensive new video game products, to participate in the video game industry.

International Home Video Industry—In-Home Movies

Some of the attributes of the home video industry outside of the United States are similar to those of the home video industry within the United States. For example, the major studios generally release movies outside of the United States according to sequential distribution windows. However, other attributes of the home video industry outside of the United States do not necessarily mirror the home video industry within the United States. For example, most countries have different systems of supply and distribution of movies, and competition in many of our international markets tends to be more fragmented. In addition, under the laws of some countries and trading blocs (e.g., the European Union), home video retailers must obtain the right to rent videos to consumers through a licensing arrangement or a “purchase-with-the-right-to-rent” arrangement. Studios may charge these home video retailers more for product purchased for rental than product purchased solely for sale to consumers. This is commonly referred to as “two-tiered pricing,” and affects our European operations. Two-tiered pricing not only results in increased competition from mass merchant retailers in those countries and trading blocs, it also creates increased competition with video rental outlets that operate in violation of the two-tiered pricing contractual limitations by renting product purchased at the lower retail price. The potential impact of studio pricing decisions is discussed under “Item 1A. Risk Factors—Changes in studio pricing policies

 

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have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability.” The international home video industry also faces high levels of piracy. Although piracy is also a concern in the United States, it is having a more significant adverse affect on the rental and retail video industry in international markets. Piracy is discussed further below under “Competition” and “Item 1A. Risk Factors—Piracy of the products we offer or the disregard of release dates by other retailers may adversely affect our operations.”

Competition

We operate in a highly competitive environment. We believe our most significant competition comes from (i) retailers that rent, sell or trade movies and games; (ii) providers of direct delivery home viewing entertainment or other alternative delivery methods of entertainment content; (iii) piracy; and (iv) other forms of leisure entertainment. In addition, many consumers maintain relationships with several different in-home entertainment providers and can shift in-home entertainment spending from one provider to another.

Competition with Retailers that Rent, Sell or Trade Movies and Games. These retailers include, among others:

 

   

mass merchant retailers, such as Wal-Mart, Best Buy and Target;

 

   

local, regional and national video and game stores, such as Movie Gallery and GameStop;

 

   

Internet sites and companies that rent or sell movies and other entertainment content, such as Netflix;

 

   

toy and entertainment retailers; and

 

   

supermarkets, pharmacies, convenience stores and fast food restaurants, including the kiosks operated by Redbox Kiosk.

We believe that the principal factors we face in competing with retailers that rent, sell or trade movies and games are:

 

   

consumer preference between purchasing and renting movies and games;

 

   

alternative product distribution channels and the perceived convenience and ease of use of such alternative channels to the customer;

 

   

pricing;

 

   

convenience and visibility of store locations;

 

   

quality, quantity and variety of titles in the desired format;

 

   

customer service; and

 

   

value-added services, such as movie search capabilities, ratings and recommendations and community features.

In particular, while the studios’ promotion of DVDs for simultaneous sale and rental has served to lower the wholesale cost of DVDs to us, it has also resulted in increased competition from mass merchant retailers, as discussed under “Item 1A. Risk Factors—Changes in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability.”

 

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Competition with Providers of Direct Delivery Home Viewing Entertainment or Other Alternative Delivery Methods of Entertainment Content. We believe that a competitive risk to our business comes from direct broadcast satellite, digital cable television, high-speed Internet access, TIVO/DVR and other alternatives for delivering videos and entertainment content to consumers. These providers offer an expanded number of conventional channels and expanded programming, including sporting events, through these services. Direct broadcast satellite, digital cable and “traditional” cable providers not only offer numerous channels of conventional television, they also offer pay-per-view movies, which permit a subscriber to pay a fee to see a selected movie, and other specialized movie services. Many digital cable providers, Internet content providers and other companies also provide “video-on-demand,” which transmits movies and other entertainment content on demand with interactive capabilities such as start, stop and rewind. In addition, some cable providers allow a subscriber to purchase a DVD movie and watch the movie over the cable system while the DVD is shipped to the subscriber.

The availability and ease of downloading movies over the Internet continues to grow. Apple’s video iPod and iTunes service, Amazon’s Unbox and announcements from other companies ranging from Netflix to Intel regarding their efforts in digital delivery of content signal future growth of video entertainment delivery. Other examples of alternative delivery methods of entertainment content include personal video recorders, download-to-burn DVDs, video vending machines, download-to-burn kiosks, video downloads to portable devices and disposable DVDs.

Any consolidation or vertical integration of media companies to include both content providers and digital distributors could pose additional competitive risk to our business. Risks associated with this competition are discussed further under “Item 1A. Risk Factors—We cannot predict the impact that the following may have on our business: (i) new or improved technologies or video formats, (ii) alternative methods of content delivery or (iii) changes in consumer behavior facilitated by these technologies or formats and alternative methods of content delivery. We also compete generally for the consumer’s entertainment dollar and leisure time.” and “Item 1A. Risk Factors—Our business would lose a competitive advantage if the movie studios were to shorten or eliminate the home video retailer distribution window or otherwise adversely change their current practices with respect to the timing of the release of movies to the various distribution channels.”

Piracy. We compete against the illegal copying and sale of movies and video games. Because piracy is an illegal activity, it is difficult to quantify its exact impact on the home video industry. The primary methods of piracy affecting the home video industry are:

 

   

the illegal copying of theatrical films at the time they are first run;

 

   

the illegal copying of DVDs that are authorized by the studios solely for retail sale and/or rental by authorized retailers; and

 

   

the illegal online downloading of movies.

These methods of piracy enable the low-cost sale of DVDs and free viewing and sharing of DVDs, both of which compete with rentals and sales by authorized retailers like us. Competition from piracy has increased in recent years, in particular in our international markets, due in part to developments in technology that allow for faster copying and downloading of DVDs. Piracy has had a lesser effect on the video game industry in the United States, but has been a significant hindrance to the development of the home video game industry in many international markets, particularly in Latin America and Asia.

Other Competition. We also compete generally for the consumer’s entertainment dollar and leisure time with, among others:

 

   

movie theaters;

 

   

Internet browsing, online gaming and other Internet-related activities;

 

   

consumers’ existing personal movie libraries;

 

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live theater;

 

   

sporting events; and

 

   

music entertainment.

These and other competitive pressures may have a material adverse effect on our business.

 

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OUR OPERATIONS

Stores and Store Operations

Store Operations. Our U.S. company-operated stores generally operate under substantially similar hours of operation. Domestic stores are generally open 365 days a year, with daily hours from approximately 10:00 a.m. to 12:00 midnight. The hours of operation for franchised stores will vary depending on the franchisee, but generally, franchisees follow the store hours of our company-operated stores. Our U.S. company-operated stores each employ an average of 10 people, including one store manager. Staffing for franchised stores will vary and is the sole responsibility of our franchisees. International store operations vary by country.

Portfolio Management. Within each targeted market, we identify potential sites for new and replacement stores by evaluating market dynamics, some of which include population demographics, customer concentration levels and possible competitive factors. We seek to place stores in locations that are convenient and visible to the public. We also seek to locate our stores in geographic areas with population and customer concentrations that enable us to better allocate available resources and manage operating efficiencies in inventory management, advertising, marketing, distribution, training and store supervision. We use our extensive membership transaction and real estate databases to monitor market conditions, select strategic store locations and attempt to maximize revenues without significantly decreasing the revenues of our nearby stores. We also periodically examine whether the sizes and formats of our existing stores are optimal for their locations and may adjust the sizes of, relocate or close existing stores as conditions require.

As a result of the declining revenues and anticipated consolidation in the in-store rental industry, during 2006 and 2007 we reviewed many of our store leases and selected a number of sites to close or downsize based on various factors, including proximity to other Blockbuster and competitor locations and profitability. During 2007, we (1) sold our freestanding game locations which operated under the GAMESTATION® brand name, (2) divested 72 stores operating as RHINO VIDEO GAMES locations in order to focus on our core Blockbuster branded stores, and (3) sold our Australian subsidiary, coupled with a master franchise license. We do not anticipate closing or divesting of a significant number of domestic store locations during 2008. We will continue to explore the divestiture of our non-core assets, including selling and/or franchising some of our remaining international operations.

The following table sets forth our store count information for both company-operated and franchised stores, domestic and international, during 2007:

 

     Company-Operated     Franchised     Total  
     U.S.     Int’l.     Total     U.S.     Int’l.     Total     U.S.     Int’l.     Total  

December 31, 2006

   4,255     2,296     6,551     939     870     1,809     5,194     3,166     8,360  

Opened

   8     42     50     9     45     54     17     87     104  

Closed

   (217 )   (90 )   (307 )   (67 )   (34 )   (101 )   (284 )   (124 )   (408 )

Purchased/(sold)

   (41 )   (180 )   (221 )   (31 )   26     (5 )   (72 )   (154 )   (226 )
                                                      

Net additions/(closures)

   (250 )   (228 )   (478 )   (89 )   37     (52 )   (339 )   (191 )   (530 )
                                                      

January 6, 2008

   4,005     2,068     6,073     850     907     1,757     4,855     2,975     7,830  
                                                      

 

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Store Locations. At January 6, 2008, in the United States and its territories, we operated 4,005 stores and our franchisees operated 850 stores. The following table sets forth, by state or territory, the number of domestic stores operated by us and our franchisees as of January 6, 2008.

 

STATE OR TERRITORY

   Company-
Operated
   Franchised    Total

Alaska

   —      17    17

Alabama

   37    24    61

Arkansas

   —      18    18

Arizona

   123    6    129

California

   529    33    562

Colorado

   104    4    108

Connecticut

   40    20    60

District of Columbia

   4    —      4

Delaware

   7    8    15

Florida

   335    58    393

Georgia

   156    —      156

Guam

   3    —      3

Hawaii

   23    —      23

Iowa

   22    2    24

Idaho

   1    10    11

Illinois

   202    3    205

Indiana

   69    39    108

Kansas

   19    35    54

Kentucky

   39    33    72

Louisiana

   67    13    80

Massachusetts

   59    53    112

Maryland

   90    22    112

Maine

   6    —      6

Michigan

   144    1    145

Minnesota

   50    8    58

Missouri

   82    13    95

Mississippi

   12    26    38

Montana

   —      5    5

North Carolina

   131    1    132

North Dakota

   —      6    6

Nebraska

   25    3    28

New Hampshire

   15    5    20

New Jersey

   123    22    145

New Mexico

   —      27    27

Nevada

   43    2    45

New York

   203    8    211

Ohio

   164    1    165

Oklahoma

   61    5    66

Oregon

   69    15    84

Pennsylvania

   161    6    167

Puerto Rico

   —      37    37

Rhode Island

   —      23    23

South Carolina

   72    2    74

South Dakota

   —      9    9

Tennessee

   42    55    97

Texas

   330    113    443

Utah

   44    2    46

Virginia

   98    30    128

Virgin Islands

   —      2    2

Vermont

   8    2    10

Washington

   116    3    119

Wisconsin

   64    4    68

West Virginia

   13    6    19

Wyoming

   —      10    10
              

Domestic Store Totals

   4,005    850    4,855
              

 

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At January 6, 2008, we operated 2,068 stores outside of the United States, including game store-in-store concepts operating under the name GAME RUSH in Canada and Denmark and 6 specialty game stand-alone stores operating under the name GAME RUSH in Italy and Mexico. In addition, our franchisees operated 907 stores outside of the United States. The following table sets forth, by country, the number of stores operated by us and by our franchisees as of January 6, 2008.

 

     Company-
Operated
   Franchised    Total

Argentina

   77    —      77

Australia

   —      370    370

Brazil

   —      175    175

Canada

   454    —      454

Chile

   72    —      72

Colombia

   —      22    22

Denmark

   70    —      70

El Salvador

   —      5    5

Great Britain

   706    —      706

Guatemala

   —      8    8

Ireland (Republic) and Northern Ireland

   188    —      188

Israel

   —      15    15

Italy

   179    61    240

Mexico

   319    4    323

New Zealand

   —      36    36

Panama

   —      16    16

Portugal

   —      19    19

Taiwan

   —      134    134

Thailand

   —      22    22

Uruguay

   3    —      3

Venezuela

   —      20    20
              

International Store Totals

   2,068    907    2,975

United States

   4,005    850    4,855
              

Domestic and International Store Totals

   6,073    1,757    7,830
              

Franchised Operations

At January 6, 2008, 195 domestic franchisee entities operated 850 stores in the United States and 279 international franchisee entities operated 907 stores outside of the United States. Our $5.5 billion in revenues during the fiscal year ended January 6, 2008 does not include the actual revenues of our franchisees, as we only record royalty and fee revenues generated from our franchised operations. Under our current U.S. franchising program, we enter into a development agreement and subsequent franchise agreement(s) with the franchisee. Pursuant to the terms of a typical development agreement, we grant the franchisee the right to develop one or a specified number of stores at a permitted location or locations within a defined geographic area and within a specified time. We generally charge the franchisee a development fee at the time of execution of the development agreement for each store to be developed during the term of the development agreement. A development agreement is not, however, typically entered into when a franchisee acquires an existing store from us or another franchisee. The typical franchise agreement is a long-term agreement that governs, among other things, the operations of the store to protect our brand. We generally require the franchisee to pay us a one-time franchise fee and continuing royalty fees, service fees and monthly payments for, among other things, maintenance of our proprietary software. In addition, from time to time we provide optional programs and product and support services to our franchisees for which we occasionally receive fees. We also require our franchisees to contribute funds for national advertising and marketing programs and require that franchisees spend an additional amount

 

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for local advertising or other marketing efforts. The amounts our franchisees are required to contribute for national advertising and marketing efforts may change from time to time in order to allow our franchisees to invest in their business. Our international franchising program is similar in many ways to our domestic franchising program. For example, our international franchisees are generally required to pay us a one-time franchise fee and continuing royalty fees and service fees.

Our franchisees have control over all operating and pricing decisions at their respective locations. For example, our franchisees have control over whether to charge extended viewing fees and the specific rental terms underlying any elimination of extended viewing fees and over whether or not to participate in the BLOCKBUSTER Total Access program. This has resulted in variations of rental terms, selling terms and restocking fees between company-operated and franchised BLOCKBUSTER stores, as well as variations in these terms among franchised BLOCKBUSTER stores. As of February 1, 2008, 123 of our franchise stores in the United States were participating in the “no late fees” program. Many of our franchisees chose not to eliminate extended viewing fees or have returned to charging extended viewing fees due to the fact that they operate under a different business model than we do, whereby they are not able, or choose not, to purchase the additional product to support the “no late fees” program. As of February 1, 2008, substantially all of our franchisees in the United States were participating in the BLOCKBUSTER Total Access program. We also do not require our franchisees to purchase inventory from us. A franchisee has sole responsibility for all financial commitments relating to the development, opening and operation of its stores, including rent, utilities, payroll and other capital and incidental expenses. We cannot offer assurances that our franchisees will be able to achieve profitability levels in their businesses sufficient to pay our franchise fees, as discussed in more detail below under “Item 1A. Risk Factors—Our results of operations could be materially adversely affected if our franchisees failed to pay our franchise fees.” Furthermore, we cannot offer assurances that we will be successful in marketing and selling new franchises, that we will continue to actively pursue new franchisees or that any new franchisees will be able to obtain desirable locations and acceptable leases. Finally, we cannot predict the impact that our franchisees’ decisions with respect to product depth and pricing may have on our overall business results.

Alternative Delivery Method Operations

In addition to our traditional stores, we also offer consumers access to home video entertainment via mail and digital downloading.

By-mail. The BLOCKBUSTER by-mail program allows subscribers to select DVDs online which are then shipped to them free of charge by U.S. mail. Once a subscriber has finished viewing the DVD, the subscriber may return the DVD via mail using the postage prepaid envelope that accompanied the DVD or at a participating Blockbuster store. BLOCKBUSTER Total Access takes the concept of convenient DVDs by mail a step further and gives online subscribers the option of exchanging their DVDs through the mail or returning them to a nearby participating BLOCKBUSTER store in exchange for free in-store movie rentals. There are no late fees or due dates for DVDs shipped via these online programs.

Digital Downloading. In 2007 we acquired all of the outstanding equity interests of Movielink, LLC, an online movie downloading business. Movielink lets customers download movies, television shows and other popular videos for rental or purchase. The customers can then watch the downloaded programs on their computer or television. Downloaded videos that are rented may be stored for up to 30 days after the customer checks out and then watched as many times as desired during a 24-hour viewing period that commences when “Play Movie” is clicked. Movielink does not charge any subscription, membership or late fees.

Marketing and Advertising

We design our marketing and advertising campaigns in order to maximize opportunities in the marketplace and thereby increase the return on our marketing and advertising expenditures. We obtain information from our

 

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membership transaction database, our real estate database and outside research agencies to formulate and adjust our marketing and advertising campaigns based on:

 

   

membership behavior and transaction trends;

 

   

consumer needs and attitudes;

 

   

our market share in the relevant market;

 

   

our financial position;

 

   

our evaluation of industry trends;

 

   

local demographics; and

 

   

other competitive issues.

This enables us to focus our resources in areas that we believe will generate the best return on our investment.

During 2007, we continued to focus on offering programs that are an alternative to the programs offered by mass merchant retailers and other online subscription service providers. For example, in the United States, heavy support of our BLOCKBUSTER Total Access program continued through August of 2007 coupled with in-store subscription acquisition throughout the year. We introduced a tent-pole title strategy in the stores over the summer with both a rent and buy message and also continued to offer our in-store movie and game subscription services—Total Access In-Store and the BLOCKBUSTER Game Pass®—and our BLOCKBUSTER Rewards® program. Each of these is discussed below.

 

 

 

BLOCKBUSTER Total Access. Online subscribers have the option of exchanging their DVDs through the mail or returning them to a nearby BLOCKBUSTER store in exchange for free in-store movie rentals. In the third quarter of fiscal 2007, the program evolved to offer various priced plans with associated in-store exchange quantity offerings including: BLOCKBUSTER Total Access Premium with free unlimited in-store exchanges; BLOCKBUSTER Total Access with free in-store exchange plans offering 2, 3 or 5 in-store exchanges/month; and lastly, BLOCKBUSTER By MailTM with movies through the mail only. In late December 2007, we reviewed our pricing structure to strike a balance between continued growth of our business and enhanced profitability. We implemented a price increase on all Total Access subscription plans effective December 27, 2007. Plan benefits did not change and customers continued to enjoy the great value and convenient access to media entertainment that our online programs offered.

 

   

Tent-Pole Title Program. This in-store program is a major focus bringing customers more copies of big box office titles to rent or to buy and is supported with a significant marketing message in the store and in our customer relations management program.

 

 

 

BLOCKBUSTER In-Store Total Access and BLOCKBUSTER Game Pass® . These in-store programs allow customers to watch or play an unlimited amount of movies or games (the number of movies or games allowed out at a time is dependent on the pass the customer selects) for one monthly price and keep them for whatever period of time that they desire during the term of the pass, subject to certain limitations.

 

   

BLOCKBUSTER Rewards. This premium in-store membership program is designed to offer benefits to our customers and enhance customer loyalty by encouraging our customers to rent movies and games only from our stores.

In 2007, we focused on customer relations management (“CRM”) business strategies to continue to build relationships with specific customer segments using database marketing tools and expertise, along with sophisticated proprietary analytical models. We delivered successful consumer-centric direct marketing communications with the goal to generate incremental net revenue and operating income. We targeted communications to retain customer segments that were identified through predictive modeling to be at risk for

 

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reducing their Blockbuster store activity. We targeted new and reactivated customer segments to engage them with targeted in-store offers. We enhanced our store-based customer acquisition marketing via direct mail to increase and protect our market share in highly competitive markets. We leveraged email marketing as a cost-effective and efficient communications channel to deepen customer relationships and drive traffic to the stores. We tested and launched triggered emails that are driven by events or behavior-based activities. We utilized the point-of-sale channel to support the store customer service representatives in relevant talking points or scripts to up-sell, cross-sell and engage the customer in the current transactions and to promote return visits.

We continued to focus on integrated CRM systems to help evaluate the holistic Blockbuster customer in terms of online consumer behavior in combination with in-store behavior to improve reporting, analysis and relevant messaging in marketing communications. We created a series of email communications to Blockbuster Total Access subscribers to encourage in-store purchases during their in-store DVD exchange visits that were customized according to in-store spend history, last store visit date and behavioral modeling. Additionally, retention strategies were used to increase online customer engagement and mitigate churn with transactional email messaging for new member education, benefit reinforcements, new features, movie recommendations to help fill queue, and value-adds like Outlet offerings.

During 2007, our advertising focus was on growing our online rental subscriber base, executed mostly during the first and second quarters. Our advertising efforts in 2008 will focus on in-store marketing of our tent-pole title strategy, growing the video games category, new product line introductions, traffic-driving promotions, improved merchandising as well as acquisition and retention support for BLOCKBUSTER Total Access. We will also continue to capitalize on our four-year exclusive alliance with The Weinstein Company, which provides us with exclusive U.S. rental rights to The Weinstein Company’s theatrical and direct-to-video movies. Meanwhile, we anticipate that the studios will continue their spending to advertise new DVD releases. In addition, some of our business alliances, including some of those with the studios, allow us to direct a portion of their home video advertising expenditures. For example, we often receive cooperative advertising funds from the studios that might be used for direct mail or point-of-purchase advertising.

Suppliers and Purchasing Arrangements

Our goal in purchasing domestic rental inventory is to design purchasing strategies with each individual studio or game publisher that will provide us with the most appropriate level of copy depth at the best available price in order to satisfy our customers’ demands and, eventually, to increase our customer traffic. In some instances, those deals involve our purchasing rental inventory on a title-by-title basis. In other instances, we may negotiate a revenue-sharing arrangement. Revenue-sharing arrangements for rental inventory generally provide for a lower initial payment in order to acquire the product. In exchange for this lower initial payment, we pay an agreed upon percentage of our rental revenues earned from that product to the studio/game vendor for a limited period of time. These revenue-sharing payments become due as the rental revenues are earned. In addition to the revenue-sharing component, most arrangements also provide for the method of disposition of the product at the conclusion of the rental cycle and/or additional payments for the early sale of unreturned product which is automatically purchased by the customer. While the terms of revenue-sharing arrangements are generally similar for rental movie and game software inventory, revenue-sharing arrangements for domestic rental movies are generally negotiated for all titles released during the term of the contract, while revenue-sharing arrangements for rental game software are generally negotiated on a title-by-title basis.

Our unit purchases of domestic movie rental inventory increased 20% in 2007 as compared with 2006 in order to maximize our product availability with the goal of improving our domestic movie rental revenues. We continued to utilize revenue-sharing arrangements during 2007 to support the increase in inventory unit purchases. However, purchases under revenue sharing arrangements made up slightly less of our total domestic movie rental unit purchases in 2007 than in 2006. Approximately 82% of our domestic movie rental units were purchased under revenue-sharing arrangements, consistent with 2006. The number of domestic game software rental inventory units purchased under revenue-sharing arrangements increased from 53% in 2006 to 58% in 2007.

 

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In our international markets, 60% of our movie and game rental inventory units are purchased on a title-by-title basis directly from the studios or through sub-wholesalers appointed by the studios to distribute the studios’ product in particular countries. The remainder of our international rental product is purchased under revenue-sharing arrangements similar to those discussed above. Our purchasing arrangements vary by country and studio depending on factors such as the availability of the rental window and revenue-sharing terms.

New retail movie and game inventory is purchased from the studios or their designated sub-wholesalers on a title-by-title basis. We also acquire retail movie and game inventory through our trading programs. We purchase general merchandise that is complementary to our rental and retail movie and video game inventory, such as confection, game and other accessories and consumer electronics, from a variety of suppliers on a product-by-product basis.

We require each franchisee to comply with basic guidelines that set forth the minimum amount and selection of movies to be kept in its store inventory. Franchisees typically obtain movies from their own suppliers and are also responsible for obtaining some of the other complementary products from their own suppliers. However, if we have purchased the distribution rights to a movie or if a franchisee participates with us under our revenue-sharing arrangements, the franchisee may obtain the applicable product from us.

Distribution and Inventory Management

In the United States, we currently receive substantially all of our movies and games for our U.S. company-operated stores at our 850,000 square foot distribution center in McKinney, Texas. The distribution center is a highly automated, centralized facility that we use to mechanically repackage newly-released movies and games to make them suitable for rental at our stores. We also use our distribution center to restock products and process returns, as well as to provide some office space. We use a network of third-party delivery agents for delivery of products to our U.S. stores. We ship our products to these delivery agents, located strategically throughout the United States, which in turn deliver them to our stores. The distribution center supports substantially all of our company-operated stores in the United States and operates 24 hours a day, six days a week. As of January 6, 2008, we employed 785 employees at our distribution center. We are currently evaluating various alternatives to optimize our distribution network, including the potential outsourcing of these distribution center operations.

In addition to our distribution center in McKinney, we also have 39 distribution centers spread strategically throughout the United States to support our by-mail subscription service. These distribution centers are spread across the country because we use the United States Postal Service to distribute our online product, and the closer the distribution center is to a customer, the faster the customer receives the product. Additionally, to expedite the delivery of product to our by-mail customers, we currently transport product from our 39 distribution centers to a total of 85 different mail entry points, which enables us to reach over 90% of our online subscriber base within one business day. Each distribution center operates 16 hours a day, 5 days a week and employs approximately 35 people, including one distribution center manager. We do not plan to add any new distribution centers in 2008 to support our by-mail subscription services.

Franchisees generally obtain their products directly from third-party suppliers, except for their point-of-sale systems’ hardware and software, some accessories and supplies, movies for which we have exclusive distribution rights and movies for franchisees that participate in our franchisee revenue-sharing programs, which domestic franchisees receive from our distribution center.

In our international markets, our stores generally receive rental product directly from the studios or sub-wholesalers. Retail product is generally distributed through a central warehouse for the market or through a third-party distributor.

 

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Management Information Systems

We believe that the accurate and efficient management of purchasing, inventory and sales records is important to our future success. We maintain information, updated daily, regarding revenues, current and historical sales and rental activity, demographics of store customers and rental patterns. This information can be organized by store, market, region, state, country or for all operations.

All of our Blockbuster branded company-operated stores use our point-of-sale system. Our national point-of-sale system in the United States is linked with a data center located in our distribution center. The point-of-sale system tracks all of our products distributed from the distribution center to each U.S. store using scanned bar code information. All domestic rental and sales transactions are recorded by the point-of-sale system when scanned at the time of customer checkout. At the end of each day, the point-of-sale system transmits store data from operations to the data center and the membership transaction database.

Our online services use internally developed software that focus on optimizing our online supply chain to ensure timely delivery of products and providing a user-friendly website experience. These systems transmit data to a data center and other systems which support, among other things, content delivery, customer web analytics and offer management.

During 2007 we completed several information technology initiatives to strengthen our relationship with customers. We introduced an Integrated Customer View application enabling our customers to transact seamlessly with any Blockbuster location. We also created an inventory transfer engine to re-allocate product between stores to meet customer demand. Multi-channel customers had their on-line queues updated with their store rental activity. Additionally, Blockbuster.com added a retail channel selling new and used DVDs and powered the MOVIECLIQUETM application on a leading social networking website. We also implemented several performance improvements to our allocation process, procurement planning, distribution center, and customer care applications to improve overall customer satisfaction for our by-mail customers.

To support our mission of providing customers with the most convenient access to media entertainment, our 2008 information technology initiatives will include the integration of Movielink’s digital retail and rental product lines with BLOCKBUSTER Online® to provide consumers more entertainment choices. We plan to deploy this enhanced functionality in 2008, with initial customer testing in the second quarter of 2008.

Regulation

Domestic Regulation

We are subject to various federal, state and local laws that govern the access to and use of our video stores by disabled customers and the disclosure, retention and security of customer records and information, including laws pertaining to the use of our membership transaction database. We also must comply with various regulations affecting our business, including federal, state or local securities, advertising, consumer protection, credit protection, franchising, licensing, zoning, land use, construction, second-hand dealer, environmental, health and safety, minimum wage, labor and employment, trading activities and other regulations.

We are also subject to the Federal Trade Commission’s Trade Regulation Rule entitled “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures” and state laws and regulations that govern the offer and sale of franchises and franchise relationships. If we want to offer and sell a franchise, we are required to furnish to each prospective franchisee a current franchise offering circular prior to the offer or sale of a franchise. In addition, a number of states require us to comply with registration or filing requirements prior to offering or selling a franchise in the state and to provide a prospective franchisee with a current franchise offering circular complying with the state’s laws, prior to the offer or sale of the franchise. We intend to maintain a franchise offering circular that complies with all applicable federal and state franchise sales and other applicable laws. However, if we are unable to comply with federal franchise sales and disclosure laws

 

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and regulations, we will be unable to offer and sell franchises anywhere in the United States. In addition, if we are unable to comply with the franchise sales and disclosure laws and regulations of any state that regulate the offer and sale of franchises, we will be unable to offer and sell franchises in that state.

We are also subject to a number of state laws and regulations that regulate some substantive aspects of the franchisor-franchisee relationship, including:

 

   

those governing the termination or non-renewal of a franchise agreement, such as requirements that:

(a) “good cause” exist as a basis for such termination; and

(b) a franchisee be given advance notice of, and a right to cure, a default prior to termination;

 

   

requirements that the franchisor deal with its franchisees in good faith;

 

   

prohibitions against interference with the right of free association among franchisees; and

 

   

those regulating discrimination among franchisees in charges, royalties or fees.

International Regulation

We are subject to various international laws that govern the disclosure, retention and security of customer records and information. For example, the laws pertaining to the use of our membership transaction database in some markets outside of the United States are more restrictive than the relevant laws in the United States and may restrict data flow across international borders.

We must also comply with various other international regulations affecting our business, including advertising, consumer protection, access to and use of our video stores by disabled customers, credit protection, film and game classification, franchising, licensing, zoning, land use, construction, second-hand dealer, environmental, health and safety, minimum wage and other labor and employment regulations. Some foreign countries have copyright and other intellectual property laws that differ from the laws of the United States. These laws may prevent or limit certain types of business activity in the affected markets.

Similar to the United States, some foreign countries have franchise registration and disclosure laws affecting the offer and sale of franchises within their borders and to their citizens. They are often not as extensive and onerous as U.S. laws and regulations. However, as in the United States, failure to comply with such laws could limit or preclude our ability to expand in those countries through franchising or could affect the enforceability of franchise agreements.

Compliance with any of the domestic or international regulations discussed above is costly and time-consuming, and we may encounter difficulties, delays or significant costs in connection with such compliance.

Historical Information

Our business and operations were previously conducted by Blockbuster Entertainment Corporation, which was incorporated in Delaware in 1982 and entered the movie rental business in 1985. Blockbuster Inc., formerly an indirect subsidiary of Viacom Inc. (“Viacom”), was incorporated under a different name on October 16, 1989 in Delaware. On September 29, 1994, Blockbuster Entertainment Corporation was merged with and into Viacom. Subsequent to the merger, our business and operations were conducted by various indirect subsidiaries of Viacom. Over the year and a half prior to our initial public offering in August 1999, our business and operations were either (1) merged into Blockbuster Inc. or (2) purchased by Blockbuster Inc. and/or one of its subsidiaries. In October 2004, Blockbuster Inc. split off from Viacom and became a fully independent company.

 

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Intellectual Property

Trademarks. We own various existing trademark registrations and have trademark applications pending registration with respect to our services and products offered worldwide. These include BLOCKBUSTER®, BLOCKBUSTER VIDEO®, TORN TICKET Logos, blockbuster.com®, BLOCKBUSTER Total Access™ word mark and logo, BLOCKBUSTER GiftCard/s®, BLOCKBUSTER Game Pass® and BLOCKBUSTER Movie Pass® word marks and logos, BLOCKBUSTER Night®, BLOCKBUSTER Online®, BLOCKBUSTER Rewards® word mark and logo, MAKE IT A BLOCKBUSTER NIGHT®, and the related BLOCKBUSTER Family of Marks, GAME RUSH® word mark and logo, MyQ Logo®, MyQ At A Glance Logo®, MOVIE STORE AT YOUR DOOR®, ONLINE RENTING WITHOUT THE WAIT™, RENTING IS BETTER THAN EVER®, THE GIFT OF ENTERTAINMENT®, QUIK DROP®, MOVIECLIQUETM, MOVIELINK® word mark and logo, and XTRA-VISION®, among others, and trade dress elements including, but not limited to, the blue and yellow awning outside our stores. In addition, we own the domain name registration for “blockbuster.com” and the related BLOCKBUSTER “Family of Domain Names” for top level and country domain names, plus a wide variety of other domain name registrations worldwide. We consider our intellectual property rights to be among our most valuable assets.

Copyrights. In addition to our own intellectual property rights, the scope of the rights of those who own copyrights in the products we rent also are of importance to us. The copyright “first sale” doctrine provides that, in the United States, the owner of a legitimate copy of a copyrighted work may, without the consent of the copyright owner, sell, rent or otherwise transfer possession of that copy. The first sale doctrine does not apply to sound recordings or computer software (other than software made for a limited purpose computer, such as a video game platform) for which the U.S. Copyright Act vests the right to control the rental of the copy in the copyright holder. The first sale doctrine does not exist in most countries outside of the United States where the copyright owner retains the rental rights to a copyrighted work. In these countries, home video retailers must obtain the right to rent videos to consumers through a licensing arrangement or a “purchase-with-the-right-to-rent” arrangement. Studios may charge these home video retailers more for product purchased for rental than product purchased solely for sale to consumers. This is commonly referred to as “two-tiered pricing” and is discussed further above under “Industry Overview—International Home Video Industry—In-Home Movies.” The potential impact of studio pricing decisions in countries where two-tiered pricing is allowed is discussed under “Item 1A. Risk Factors—Changes in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability.” The risk of changes in U.S. and international copyright laws is discussed under “Item 1A. Risk Factors—We are subject to governmental regulation particular to the retail home video industry and changes in U.S. or international laws may adversely affect us.”

Seasonality

There is a distinct seasonal pattern to the home video and video games business, with slower business in April and May, due in part to improved weather and Daylight Saving Time, and in September and October, due in part to the start of school and the introduction of new television programs. The months of November and December have historically been our highest revenue months. While we expect these months to continue to make the largest contributions to our rental revenues, we believe the strength of rental revenues in these months has been and will continue to be negatively affected, to some degree, by consumers purchasing DVDs during the holiday season. Additionally, while our online and in-store rental subscription offerings have helped us mitigate, to some extent, the impact of seasonality and weather conditions on our business by providing a more steady revenue stream across all months, seasonality and weather are expected to continue to impact our business and our period-to-period financial results in the future.

 

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Employees

As of January 6, 2008, we employed 59,643 persons, including 41,907 within the United States and 17,736 outside of the United States. Of the total number of U.S. employees, 12,694 were full-time, 27,914 were part-time and 1,299 were seasonal employees. We believe that our employee relations are good.

Directors and Executive Officers of the Registrant

The following information regarding our directors and executive officers is as of February 21, 2008.

 

Name

   Age   

Position

James W. Keyes

   52    Chairman of the Board of Directors and Chief Executive Officer

Edward Bleier

   78    Director

Robert A. Bowman

   52    Director

Jackie M. Clegg

   45    Director

James W. Crystal

   70    Director

Gary J. Fernandes

   64    Director

Jules Haimovitz

   57    Director

Carl C. Icahn

   72    Director

Strauss Zelnick

   50    Director

Thomas M. Casey

   49    Executive Vice President and Chief Financial Officer

Eric H. Peterson

   47    Executive Vice President, General Counsel and Secretary

Set forth below is a description of the background of each of our directors and executive officers.

James W. Keyes has served as our Chairman of the Board of Directors and Chief Executive Officer since July 2007. Mr. Keyes served as President and Chief Executive Officer of 7-Eleven, Inc. from 2000 to 2005. Prior to his service as President and Chief Executive Officer, he was Executive Vice President and Chief Operating Officer of 7-Eleven, Inc. from 1998 to 2000 and Chief Financial Officer of 7-Eleven, Inc. from 1996 to 1998. Since his departure from 7-Eleven, Inc., Mr. Keyes has been Chairman of Key Development, LLC, a private investment firm.

Edward Bleier was elected as a director of Blockbuster in May 2005. Mr. Bleier was with Warner Bros. Entertainment Inc., New York, New York, from October 1969 to January 2005, where he served, partly, as President of Domestic Pay-TV, Cable and Networks Features, encompassing feature films, TV programming, animation, network sales, video-on-demand and consumer marketing. Mr. Bleier is a member of the board of directors of RealNetworks, Inc. and CKX, Inc. He is also Chairman Emeritus of the Center for Communication and the Academy of the Arts Guild Hall, serves as a trustee of the Charles A. Dana Foundation and The Bleier Center for Television and Popular Culture at Syracuse University and is a member of the Council on Foreign Relations. He also authored the 2003 New York Times bestseller “The Thanksgiving Ceremony.”

Robert A. Bowman was appointed as a director of Blockbuster in December 2004. He has served as President and CEO of Major League Baseball Advanced Media LP, the interactive media and Internet company of Major League Baseball, since 2000. Mr. Bowman serves as President of the Michigan Education Trust and is a member of the board of directors of World Wrestling Entertainment Inc., The Warnaco Group Inc. and Take-Two Interactive Software, Inc.

Jackie M. Clegg was appointed as a director of Blockbuster in July 2003. She serves as Managing Partner of Clegg International Consultants, LLC, an international strategic consulting firm she founded in September 2001. In July 2001, Ms. Clegg stepped down as Vice Chairman and First Vice President of the Export-Import Bank of the United States, financier to foreign buyers of U.S. goods and services, after serving in that role since June 1997. She also served as its Chief Operating Officer from January 1999 through fiscal year 2000. Ms. Clegg also

 

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serves on the board of directors and audit committees of Brookdale Senior Living Inc., Cardiome Pharma Corp. and Javelin Pharmaceuticals Inc. (chair). In accordance with the listing standards of the NYSE, Blockbuster’s Board of Directors has determined that Ms. Clegg’s simultaneous service on Blockbuster’s Audit Committee and on the audit committees of the foregoing public companies does not impair Ms. Clegg’s ability to effectively serve on Blockbuster’s Audit Committee. Ms. Clegg also serves on the board of directors of the Chicago Mercantile Exchange.

James W. Crystal was appointed as a director of Blockbuster in February 2007. Mr. Crystal currently serves as Chairman and Chief Executive Officer of Frank Crystal & Company, a privately owned insurance brokerage firm, and has served in such capacities since 1958. Mr. Crystal also serves as Vice Chairman, trustee and member of the executive committee and Co-Chairman of the audit committee of Mt. Sinai Medical Center as well as a trustee of Congregation Emanu-El. In addition, he serves on the board of directors of Stewart & Stevenson LLC, a publicly traded company where he also serves on the audit committee, Banco de Caribe, ENNIA Caribe Holding, N.V., Uni-Alliance Insurance in Cyprus, Auto Resources, Inc. in Beverly Hills, and Atlantic International Insurance Co., Ltd., located in Bermuda.

Gary J. Fernandes was appointed as a director of Blockbuster in December 2004. He has served as Chairman of FLF Investments, a family business involved with the acquisition and management of commercial real estate properties and other assets, since 1999. Since his retirement as Vice Chairman from Electronic Data Systems Corporation in 1998, he founded Convergent Partners, a venture capital fund focusing on buyouts of technology enabled companies. In addition, from 2000 to 2001, Mr. Fernandes served as Chairman and CEO of GroceryWorks.com, an internet grocery fulfillment company. In November 1998, he founded Voyagers The Travel Store Holdings, Inc., a chain of travel agencies, and was President and sole shareholder of Voyagers. Mr. Fernandes serves on the board of directors of BancTec, Inc. and Computer Associates International, Inc. He is also a member of the board of governors of the Boys & Girls Clubs of America and serves as a trustee for the O’Hara Trust and the Hall-Voyer Foundation.

Jules Haimovitz was appointed as a director of Blockbuster in May 2006. Mr. Haimovitz currently serves as President of Haimovitz Consulting Group. From 2002 to 2007, Mr. Haimovitz served as Vice Chairman and Managing Partner of Dick Clark Productions Inc., a producer of programming for television, cable networks and syndicators. From June 1999 to July 2004, Mr. Haimovitz served in various capacities at Metro Goldwyn Mayer Inc., including President of MGM Networks Inc., a wholly-owned subsidiary, Executive Consultant to the CEO, and Chair of the Library Task Force. From July 1997 to February 1999, he served as President and Chief Operating Officer of King World Productions, Inc., a worldwide distributor of first-run programming. Mr. Haimovitz has also served in executive positions at Diva Systems Corporation, ITC Entertainment Group, Spelling Entertainment Inc. and Viacom Inc. Mr. Haimovitz is on the board of directors of Infospace, Inc., a publicly traded company, TVN Entertainment Corporation, GNet Productions and ImClone Systems, Inc., a publicly traded company. Mr. Haimovitz serves on the audit committee of Infospace, Inc. and ImClone Systems, Inc.

Carl C. Icahn was elected as a director of Blockbuster in May 2005. Mr. Icahn has served as Chairman of the Board and a director of Starfire Holding Corporation and Chairman of the Board and a director of various subsidiaries of Starfire, since 1984. Since August 2007, through his position as Chief Executive Officer of Icahn Capital LP, a wholly-owned subsidiary of Icahn Enterprises L.P., and certain related entities, Mr. Icahn’s principal occupation is managing private investment funds, including Icahn Partners LP, Icahn Partners Master Fund LP, Icahn Partners Master Fund II LP, and Icahn Partners Master Fund III LP. Between September 2004 and August 2007, Mr. Icahn conducted this occupation through his entities CCI Onshore Corp. and CCI Offshore Corp. Since November 1990, Mr. Icahn has been chairman of the Board of Icahn Enterprises G.P., Inc., the general partner of Icahn Enterprises. Icahn Enterprises is a publicly traded diversified holding company engaged in a variety of businesses, including investment management, metals, real estate, and home fashion. Mr. Icahn was also Chairman of the Board and President of Icahn & Co., Inc., a registered broker-dealer and a member of the National Association of Securities Dealers, from 1968 to 2005. Since 1994, Mr. Icahn has been the principal

 

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beneficial stockholder of American Railcar Industries, Inc., currently a publicly-traded company that is primarily engaged in the business of manufacturing covered hopper and tank railcars, and has served as Chairman of the Board and as a director of American Railcar Industries, Inc. since 1994. Since November 1990, Mr. Icahn has been Chairman of the Board of American Property Investors, Inc., the general partner of American Real Estate Partners, L.P., a public limited partnership controlled by Mr. Icahn that invests in real estate and holds various other interests, including the interests in its subsidiaries that are engaged, among other things, in the casino entertainment business and the home textile business. From October 1998 through May 2004, Mr. Icahn was the President and a director of Stratosphere Corporation, which operates the Stratosphere Hotel and Casino in Las Vegas, which is currently a subsidiary of Icahn Enterprises. Mr. Icahn has been Chairman of the Board and a director of XO Holdings, Inc. since February 2006, and was Chairman of the Board and a director of XO Communications, Inc. (XO Holdings’ predecessor) from January 2003 to February 2006. XO Holdings is a publicly-traded telecommunications services provider controlled by Mr. Icahn. In October 2005, Mr. Icahn became a director of WestPoint International, Inc. a manufacturer of bed and bath home fashion products. In September 2006, Mr. Icahn became a director of ImClone Systems Incorporated, a publicly-traded biopharmaceutical company, and since October 2006, has been the Chairman of the Board of ImClone Systems Incorporated. In August 2007, Mr. Icahn became a director of WCI Communities, Inc., a publicly-traded homebuilding company, and since September 2007 has been Chairman of the Board of WCI Communities, Inc. In December 2007, Mr. Icahn became a director of Federal-Mogul Corporation., a publicly-traded supplier of automotive products, and since January 2008 has been Chairman of the Board of Federal-Mogul Corporation. Mr. Icahn has been a director of Cadus Corporation, a publicly-traded firm that holds various biotechnology patents, since 1993.

Strauss Zelnick was elected as a director of Blockbuster in May 2005. Mr. Zelnick founded ZelnickMedia LLC, an investment and advisory firm specializing in media and entertainment, in 2001. ZelnickMedia holds interests in an array of media enterprises, providing general management and strategic advisory services in the United States, Canada, Europe, Asia and Australia. Mr. Zelnick currently serves as Executive Chairman of Take-Two Interactive Software, Inc. From 1998 to 2000, Mr. Zelnick served as President and Chief Executive Officer of BMG Entertainment, Inc., a music and entertainment unit of Bertelsmann A.G. Mr. Zelnick served as President and Chief Executive Officer of BMG’s North American business unit from 1994 through 1998. Mr. Zelnick is Chairman of the Board of CME, Inc., OTX, Inc. and ITN Networks, Inc. Mr. Zelnick is a director of Naylor, LLC.

Thomas M. Casey has served as our Executive Vice President and Chief Financial Officer since September 2007. From 1999 until the commencement of his employment at Blockbuster, Mr. Casey served as managing director for Deutsche Bank Securities, Inc. where he was responsible for the bank’s retail industry relationships in North America and served as a strategic financial advisor to some of the world’s largest companies in the retail entertainment, food and drug, convenience store, food wholesale and foodservice industries. Prior to Deutsche Bank, Mr. Casey held positions with Citigroup, Merrill Lynch and Dillon Read & Co.

Eric H. Peterson has served as our Executive Vice President, General Counsel and Secretary since October 2007. Prior to his employment at Blockbuster, Mr. Peterson served as Executive Vice President and General Counsel for the former TXU Corp. from 2002 until 2006. From 2000 to 2002, Mr. Peterson served as Senior Vice President and General Counsel for DTE Energy Company, a Michigan-based energy company. Prior to his employment at DTE Energy, Mr. Peterson was a partner in the law firm of Worsham, Forsythe & Woolridge LLP (now known as Hunton & Williams).

Available Information, Investor Relations and Certifications

We file annual, quarterly and current reports, information statements and other information with the Securities and Exchange Commission (“SEC”). The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC

 

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also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is http://www.sec.gov.

The address of our Internet website is www.blockbuster.com, and the Investor Relations section of Blockbuster’s website may be accessed directly at http://investor.blockbuster.com. Through links on the Investor Relations portion of our website, we make available free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. Such material is made available through our website as soon as reasonably practicable after we electronically file the material with, or furnish it to, the SEC. The information contained on our website does not constitute part of this annual report on Form 10-K.

Stock Transfer Agency

Computershare Trust Company, N.A.

P.O. Box 43078

Providence, RI 02940-3078

Questions and inquiries via telephone or Computershare’s website:

(877) 282-1168

http://www.computershare.com

Independent Registered Public Accounting Firm

PricewaterhouseCoopers LLP

2001 Ross Avenue

Suite 1800

Dallas, TX 75201

Stock Listing

Blockbuster Inc. Class A and Class B common stock trades on the New York Stock Exchange under the symbols BBI and BBI.B, respectively.

Certifications

We have submitted to the New York Stock Exchange the certification of our Chief Executive Officer, dated as of May 23, 2007, as required by Section 303A.12(a) of the New York Stock Exchange Listed Company Manual.

We have filed with the SEC the certifications of our Chief Executive Officer and our Chief Financial Officer required under Section 302 of the Sarbanes-Oxley Act of 2002 with respect to this Annual Report on Form 10-K. The certifications are attached hereto as Exhibits 31.1 and 31.2.

Item 1A.    Risk Factors

In addition to the information set forth elsewhere in this report, including under Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” the factors described below should be considered carefully in making any investment decisions with respect to our securities. These factors could materially affect our business, financial condition, results of operations or liquidity and cause investors in our securities to lose part or all of their investments.

 

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Changes in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability.

The studios’ current practice is generally to sequentially release their movies to different distribution channels. After the initial theatrical release of a movie, studios generally make their movies available to home video retailers (for rental and retail, including by mass merchant retailers) for a specified period of time. This distribution channel is typically exclusive against other forms of non-theatrical movie distribution, including cable and satellite distribution, and is commonly referred to as the home video retailers’ “distribution window.”

Historically, at the beginning of a particular movie title’s distribution window, the movie would be priced to home video retailers based on the applicable studio’s decision to promote the movie to the consumer either primarily for rental, or for both rental and sale, at the beginning of the distribution window. In order to promote a movie title primarily for rental at the beginning of the distribution window, a studio would initially release the title to home video retailers at a price that was too high to enable them to sell the title to consumers at an affordable price. As rental demand subsided, the studio would reduce the pricing for the movie, which would then enable retailers to sell the title to consumers at an affordable price. The time during which the studios released the title at the higher pricing was commonly referred to as the “rental window.” Currently, substantially all DVD titles are initially released to home video retailers at a price that is low enough to allow them to offer movies at affordable prices to the consumer from the beginning of the home video retailers’ distribution window. This method of pricing is commonly referred to as “sell-through” pricing, and has improved our ability to purchase rental product at lower prices. However, the studios’ sell-through pricing policy has also led to increasing competition from other retailers, in particular mass merchants such as Wal-Mart, Best Buy and Target. It has also led to increased competition from online retailers. These other retailers are able, due to the lower sell-through prices, to purchase DVDs for sale to consumers at the same time as traditional home video retailers, who, like us, purchase product for rental. In addition, some retailers lower their sales prices in order to increase overall traffic to their stores or businesses, and mass merchants may be more willing to sell at lower, or even below wholesale, prices to drive traffic and thereby increase sales of their other inventory items. All of these factors have increased consumer interest in purchasing DVDs, which has resulted in increased competition and reduced the significance of the historical rental window.

We believe that the increased consumer purchases of movies have been due in part to consumer interest in building DVD libraries of classic movies and personal favorites and that the studios will remain dependent on traditional home video retailers to generate revenues for the studios from titles that are not classics or current box office hits. We therefore believe the importance of the video rental industry to the studios will continue to be a factor in studio pricing decisions. However, we cannot control or predict studio pricing policies with certainty, and we cannot assure you that consumers will not, as a result of further decreases in studio sell-through pricing and/or sustained or further depressed pricing by competitors, increasingly desire to purchase rather than rent movies. Personal DVD libraries could also cause consumers to rent or purchase fewer movies in the future. Our profitability could, therefore, be negatively affected further if, in light of any such consumer behavior, we were unable to (i) maintain or increase our rental business; (ii) replace gross profits from generally higher-margin rentals with gross profits from increased sales of generally lower-margin sell-through product; or (iii) otherwise positively affect gross profits, such as through price increases or cost reductions. Our ability to achieve one or more of these objectives is subject to risks, including the risk that we may not be able to compete effectively with other DVD retailers, some of whom may have competitive advantages such as the pricing flexibility described above or favorable consumer perceptions regarding value.

Our profitability is also dependent on our ability to enter into arrangements with the studios that effectively balance cost considerations and the number of copies of a title stocked by us. Each type of arrangement provides different advantages and challenges for us. For example, we have benefited from sell-through pricing of DVDs because the lower cost associated with DVD product has resulted in higher rental margins than product purchased under our historical VHS revenue-sharing arrangements. Our profitability could be negatively affected

 

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if studios were to make other changes in their pricing policies, which could include changes in revenue-sharing arrangements, pricing or rental windows for DVDs or expanded exploitation by studios of international two-tiered pricing laws, which allow studios to charge different prices for movies intended for rental to consumers, as opposed to sale. In addition, we cannot predict what use the studios might make of current or future alternative supply methods, such as downloading to stores or consumers, or what impact the use of such supply chain changes by us or our competitors might have on our profitability.

Our business would lose a competitive advantage if the movie studios were to shorten or eliminate the home video retailer distribution window or otherwise adversely change their current practices with respect to the timing of the release of movies to the various distribution channels.

A competitive advantage that home video retailers currently enjoy over most other movie distribution channels, except theatrical release, is the early timing of the home video retailers’ distribution window. After the initial theatrical release of a movie, the studios’ current practice is to generally make their movies available to home video retailers (for rental and retail, including by mass merchant retailers) for specified periods of time. This distribution window has traditionally been exclusive against most other forms of non-theatrical movie distribution, such as pay-per-view, video-on-demand, premium television, basic cable, and network and syndicated television. The length of this exclusive distribution window for home video retailers varies, but since the mid-1990’s has averaged between 39 and 56 days for domestic home video retailers. Thereafter, movies are made sequentially available to television distribution channels. The studios’ traditional practices with respect to the distribution windows could change at any time.

Our business could be negatively affected if:

 

   

the home video retailer distribution windows were no longer the first following the theatrical release;

 

   

the length of the home video retailer distribution windows were shortened; or

 

   

the home video retailer distribution windows were no longer as exclusive as they are now.

This is because newly released movies would be made available earlier on these other forms of non-theatrical movie distribution, and consumers might no longer need to wait until after the home video retailer distribution window to view a newly released movie on one or more of these other distribution channels. In such event, we would need to address additional competition. According to industry statistics, more movies are now being released to pay-per-view at the shorter end of the home video retailer distribution window range than at the longer end. In addition, many of the major movie studios have entered into various ventures to provide video-on-demand or similar services of their own. Increased studio participation in or support of these types of services could impact their decisions with respect to the timing and exclusivity of the home video retailer distribution window.

Recently, there has been increasing experimentation by studios and various movie content aggregators and retailers with the traditional distribution windows, including simultaneous video-on-demand and DVD releases. For example, although movie selections tend to be limited at present, consumers can now download to their computers certain available movies on the same day that the movie’s DVD is released by the studios nationwide in retail stores for rental or sale, and, in some cases, consumers can also burn the downloaded movie to a blank DVD for playback in a DVD player, allowing them to watch the movies on their TVs or portable devices. We expect that the movie studios will continue to assess the traditional release windows and it is possible that the studios may decide to alter the traditional home video retailer distribution window for an increasing number of movies, particularly in connection with simultaneous video-on-demand distribution of movies and DVD release dates.

We believe that the studios have a significant interest in maintaining a viable home video retail industry. However, because the order, length and exclusivity of each window for each distribution channel is determined

 

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solely by the studio releasing the movie, we cannot predict the impact, if any, of any future decisions by the studios. In addition, any consolidation or vertical integration of media companies to include both content providers and digital distributors could pose a risk to the continuation of the home video retailer distribution window.

We cannot predict the impact that the following may have on our business: (i) new or improved technologies or video formats, (ii) alternative methods of content delivery or (iii) changes in consumer behavior facilitated by these technologies or formats and alternative methods of content delivery. We also compete generally for the consumer’s entertainment dollar and leisure time.

Advances in technologies such as video-on-demand, new video formats, downloading or alternative methods of content delivery or certain changes in consumer behavior driven by these or other technologies and methods of delivery could have a negative effect on our business. In particular, our business could be adversely impacted if:

 

   

newly released movies were to be made widely available by the studios to these technologies or these formats at the same time or before they are made available to home video retailers for rental; and

 

   

these technologies or new formats were to be widely accepted by consumers.

The widespread availability of additional channels on satellite and digital cable systems may significantly reduce public demand for our products. Advances in direct broadcast satellite and cable technologies may also adversely affect consumer demand for video store rentals and sales. Direct broadcast satellite providers transmit numerous channels of programs by satellite transmission into subscribers’ homes. In addition, cable providers are taking advantage of digital technology to transmit many additional channels of television programs over cable lines to subscribers’ homes. Because of their increased availability of channels, direct broadcast satellite and digital cable providers have been able to enhance their pay-per-view businesses by:

 

   

substantially increasing the number and variety of movies they can offer their subscribers on a pay-per-view basis; and

 

   

providing more frequent and convenient start times for the most popular movies.

In addition, pay-per-view allows the consumer to avoid trips to the video store for rentals and returns of movies. However, newly released movies are currently made available by the studios for rental prior to being made available on a pay-per-view basis. In addition, pay-per-view does not currently provide the same start, stop and rewind capabilities as DVD or video. If, however, direct broadcast satellite and digital cable services, including enhanced pay-per-view services, were to become more widely available and accepted, this could have a negative effect on our video store business. This is because a smaller number of movies may be rented or sold if viewers were to favor the expanded number of conventional channels and expanded content, including movies, specialty programming and sporting events, offered through these services. Additionally, increases in the size of the pay-per-view market could lead to an earlier distribution window for movies on pay-per-view if the studios were to perceive this to be a better way to maximize their revenues.

The availability of content through personal video recorders, video-on-demand and other technologies may significantly reduce the demand for our products or otherwise negatively affect our business. Any method for delivery of entertainment content that serves as an alternative to obtaining product or services from our stores or our online DVD rental service can impact our business. Examples of delivery methods that have impacted, or could impact, our business include:

 

   

personal video recorders,

 

   

video-on-demand,

 

   

download-to-burn DVDs,

 

   

video vending machines and download-to-burn kiosks,

 

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video downloads to portable devices and personal computers, and

 

   

disposable DVDs.

Moreover, technology and consumer offerings continue to develop, and we expect that new or enhanced technologies and consumer offerings will be available in the future. We cannot predict consumer acceptance of these delivery channels or their impact on our business.

We also compete generally for the consumer’s entertainment dollar and leisure time with, among others, (i) movie theaters; (ii) Internet browsing, online gaming and other Internet-related activities; (iii) consumers’ existing personal movie libraries; (iv) live theater; (v) sporting events; and (vi) music entertainment. Our results can therefore fluctuate depending on the desirability of other forms of entertainment.

Industry consolidation in the in-store home video rental industry has occurred and may continue. If we are not successful in capitalizing on this industry consolidation, our financial results may be adversely affected.

Based upon current industry projections, we believe that over-capacity exists in the video rental market and that, as a result, many video stores, including some of our own stores, will be forced to close in the future. For example, Movie Gallery, Inc., a video store retailer, announced in 2007 plans to close hundreds of underperforming and unprofitable Movie Gallery and Hollywood Video stores and filed a voluntary petition seeking reorganization relief under Chapter 11 of the U.S. Bankruptcy Code. If we are unable to capitalize on the store closings of our competitors, we may be unable to grow our market share and our financial results may be adversely affected. In addition, we have historically closed underperforming video stores and will continue to consider the closure of underperforming stores. We are currently reviewing many of our store leases and selecting sites to close or downsize based on store profitability.

Overall revenues generated from the in-store home video industry are projected to continue to decline. A faster than anticipated decline in the in-store industry has in the past and may in the future adversely affect our business and our ability to implement our strategic initiatives.

We have previously experienced challenges caused by the faster than anticipated decline in the worldwide in-store home video rental industry. We believe that the previous faster than anticipated declines were caused primarily by (i) a weak slate of titles released to home video; (ii) increased competition from retail mass merchant sales of low-priced DVDs, online rentals and other sources of in-home entertainment such as digital video recorders and other devices that are capable of downloading content for in-home viewing; (iii) competition from piracy in certain international markets; and (iv) competition from other forms of leisure entertainment. A faster than anticipated decline in the worldwide in-store home video rental industry in the future may similarly negatively impact our business and our ability to implement our strategic initiatives.

Our revenues could be adversely affected due to the variability in consumer appeal of the movie titles and game software released for rental and sale.

The quality of movie titles and game software released for rental and sale is not within our control, and our results of operations have from time to time reflected the variability in consumer appeal for such items. We cannot assure you that future releases of movie titles and game software will appeal to consumers and, as a result, our revenues and profitability may be adversely affected.

Our financial results are impacted by seasonality, including the adverse impact caused by improved weather conditions.

There is a distinct seasonal pattern to the home video and video games business, with slower business in April and May, due in part to improved weather and Daylight Saving Time, and in September and October, due

 

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in part to the start of school and the introduction of new television programs. The months of November and December have historically been our highest revenue months. While we expect these months to continue to make the largest contributions to our rental revenues, we believe the strength of rental revenues in these months has been and will continue to be negatively affected, to some degree, by consumers purchasing DVDs during the holiday season. Although our online and in-store rental subscription offerings have helped us mitigate, to some extent, the impact of seasonality and weather conditions on our business by providing a more steady revenue stream across all months, seasonality and weather are expected to continue to impact our business and our period-to-period financial results in the future.

Piracy of the products we offer or the disregard of release dates by other retailers may adversely affect our operations.

Although piracy is illegal, it is a significant threat to the home video industry. The primary methods of piracy affecting the home video industry are (i) the illegal copying of theatrical films at the time they are first run; (ii) the illegal copying of DVDs that are authorized by the studios solely for retail sale and/or rental by authorized retailers; and (iii) the illegal online downloading of movies. These methods of piracy enable the low-cost sale of DVDs as well as the free viewing and sharing of DVDs, both of which compete with rentals and sales by authorized retailers like us. Competition from piracy has increased in recent years due in part to developments in technology that allow for faster copying and downloading of DVDs.

Although piracy is a concern in the United States, it is having a more significant adverse affect on the home video industry in international markets. We cannot assure you that movie studios and others with rights in the product that we rent or sell can, or will, take steps to enforce their rights against piracy or that they will be successful in preventing the distribution of pirated content. Increases in piracy could continue to negatively affect our revenues. For example, in 2006, we closed all of our store locations in Spain, driven in part by the impact of piracy in that market.

Another risk that we face is the disregard by other home video retailers of the studios’ specified release dates for their titles. If other home video retailers rent or sell product before the specified release dates (i.e., before us), we can be adversely affected, as the first weeks after a movie title’s release typically represent a significant portion of the demand for that title. We cannot assure you that the studios can or will control such distribution and release practices, particularly in countries outside of the United States.

We have had limited experience with certain new customer proposition initiatives and cannot assure you when or if these or future initiatives will have a positive impact on our profitability.

We have implemented and expect to continue to implement initiatives that are designed to enhance efficiency, customer convenience and our product offerings. For example, in 2007, we acquired all of the outstanding equity interests of Movielink, LLC, an online movie downloading business. There is no assurance that consumers will widely adopt our online movie downloading offering or that it will be profitable. The implementation of new initiatives has involved, and will continue to involve, significant investments by us of time and money and could be adversely impacted by (i) our inability to timely implement and maintain the necessary information technology systems and infrastructure to support shifts in consumer preferences and any corresponding changes to our operating model, including continued support for our initiatives and (ii) the extent and timing of our continued investment of incremental operating expenses and capital expenditures to continue to develop and implement our initiatives and our corresponding ability to effectively control overall operating expenses and capital expenditures. Because we have limited experience with some of our new customer proposition initiatives, we cannot assure you that they will be successful or profitable, including success in retaining customers. Our ability to effectively and timely prioritize and implement our initiatives will also affect when and if they will have a positive impact on our profitability.

 

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If the average sales and rental prices for our product are not at or above expected prices, our expected gross margins may be adversely affected.

To achieve our expected revenues and gross margins, we need to sell and rent, as applicable, our product, including previously rented, retail and rental (whether in-store or online) product at or above expected prices. If the average sales or rental prices of such product are not at or above these expected prices, our revenues and gross margins may be adversely affected.

It is also important that we maximize our gross margins through our allocation of store space. We may need to turn our inventory of previously rented and retail product more quickly in the future in order to make room in our stores for additional DVDs, new customer proposition initiatives or to downsize the store. Therefore, we cannot assure you that in the future we will be able to rent or sell, on average, our product at or above the expected price.

Other factors that could affect our ability to rent or sell our product at expected prices include:

 

   

consumer desire to rent any of our movies and games;

 

   

consumer desire to own a particular movie or game;

 

   

the amount of product available for rental or sale by others to the public; and

 

   

changes in the price of product by the studios or changes by other retailers, particularly mass merchant retailers.

Our level of indebtedness may make it more difficult for us to pay our debts and more necessary for us to divert our cash flow from operations to debt service payments.

Our total indebtedness as of January 6, 2008 was $757.8 million. Our debt service obligations could have an adverse impact on our earnings and cash flows for as long as the indebtedness is outstanding.

Our indebtedness could have important consequences for our business. For example, it could:

 

   

make it more difficult for us to pay our debts as they become due during general adverse economic and market or industry conditions because any related decrease in revenues could cause us to not have sufficient cash flows from operations to make our scheduled debt payments;

 

   

limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate, including limiting our ability to invest in our strategic initiatives, and, consequently, place us at a competitive disadvantage to our competitors with less debt;

 

   

require a substantial portion of our cash flows from operations to be used for debt service payments, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, acquisitions and other general corporate purposes;

 

   

cause our trade creditors to change their terms for payment on goods and services provided to us, thereby negatively impacting our ability to receive products and services on acceptable terms; and

 

   

result in higher interest expense in the event of increases in interest rates since some of our borrowings are, and will continue to be, at variable rates of interest.

Additionally, we could incur additional indebtedness in the future and, if new debt is added to our current debt levels, the risks above could intensify. Additional debt would further increase the possibility that we may not generate sufficient cash to pay, when due, interest on and other amounts due in respect of our indebtedness, and would further reduce our funds available for operations, working capital, capital expenditures, acquisitions and other general purposes. Additional debt may also decrease our ability to refinance or restructure our indebtedness, and further limit our ability to adjust to changing market conditions. If we or our subsidiaries add new debt to our current debt levels, the related risks that we and they now face could increase.

 

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We may not have sufficient cash flows from operating activities, cash on hand and available borrowings under our credit facilities to service our indebtedness.

Our ability to make payments on and to refinance our indebtedness will depend on our ability to generate cash in the future. This, to some extent, is subject to general economic, financial, competitive, industry and other factors that are beyond our control. We cannot assure you that our future cash flow will be sufficient to meet our obligations and commitments. If we are unable to generate sufficient cash flow from operations in the future to service our indebtedness and to meet our other commitments, we will be required to adopt one or more alternatives, such as refinancing or restructuring our indebtedness, selling material assets or operations or seeking to raise additional debt or equity capital. We cannot assure you that any of these actions could be affected on a timely basis or on satisfactory terms or at all, or that these actions would enable us to continue to satisfy our capital requirements. In addition, our existing debt agreements, including the indenture governing our senior subordinated notes and our credit agreement, contain restrictive covenants which may prohibit us from adopting one or more of these alternatives, and any future debt agreements may contain similar restrictive covenants. Our failure to comply with these covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our debts, which we may be unable to repay.

Any failure by us to comply with any of the restrictions in our debt agreements could result in acceleration of our debt. Were this to occur, we might not have, or be able to obtain, sufficient cash to pay our accelerated indebtedness.

The operating and financial restrictions and covenants in our debt agreements, including our credit agreement and the indenture governing our senior subordinated notes, may adversely affect our ability to finance future operations or capital needs or to engage in new business activities. The debt agreements restrict our ability to, among other things:

 

   

declare dividends or redeem or repurchase capital stock;

 

   

prepay, redeem or repurchase other debt;

 

   

incur liens;

 

   

make loans, guarantees, acquisitions and investments;

 

   

incur additional indebtedness;

 

   

engage in sale and leaseback transactions;

 

   

amend or otherwise alter debt and other material agreements;

 

   

engage in mergers, acquisitions or asset sales; and

 

   

transact with affiliates.

In addition, our debt covenants require that we maintain certain financial measures and ratios. As a result of these covenants and ratios, we are limited in the manner in which we can conduct our business, and we may be unable to engage in favorable business activities or finance future operations or capital needs. Accordingly, these restrictions may limit our ability to successfully operate our business. A failure to comply with these restrictions or to maintain the financial measures and ratios contained in the debt agreements could lead to an event of default that could result in an acceleration of the indebtedness. During 2007, we were required to enter into an amendment to our credit agreement to modify or waive compliance with financial covenants thereunder. For an additional discussion of this amendment, please refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources—Capital Structure.”

Should the outstanding obligations under our credit agreement be accelerated and become due and payable because of our failure to comply with the applicable debt covenants in the future, we would be required to search for alternative measures to finance current and ongoing obligations of our business. If amounts outstanding under

 

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the credit agreement were called by the lenders due to a covenant violation, amounts under other agreements, such as the indenture governing our senior subordinated notes, could also become due and payable immediately. There can be no assurance that such financing will be available on acceptable terms, if at all. Our ability to obtain future financing or to sell assets could be adversely affected because a very large majority of our assets have been secured as collateral under the credit agreement. In addition, our financial results, our substantial indebtedness, our credit ratings and the declining rental industry in which we operate could adversely affect the availability and terms of our financing. Further, uncertainty surrounding our ability to finance our obligations has in the past caused some of our trade creditors to impose increasingly less favorable terms and future uncertainty could similarly result in unfavorable terms from our trade creditors. In addition, there are other situations (including a change in the composition of our Board of Directors, whereby the majority of directors who were serving on the Board at the time we entered into our credit agreement and indenture (or their successors or nominees) are no longer serving on the Board) where our debt may be accelerated and we may be unable to repay such debt. Any of these scenarios could adversely impact our liquidity and results of operations or force us to file for protection under the U.S. Bankruptcy Code.

Our financial results could be adversely affected if we are unable to manage our inventory effectively or if we are unable to obtain or maintain favorable terms from our suppliers.

Our purchasing decisions are influenced by many factors, including, among others, gross margin considerations and supplier product return policies. While much of our retail movie product in the United States, but not outside the United States, is returnable to vendors, our investments in retail movie inventory may result in excess inventories in the event anticipated sales fail to materialize. In addition, returns of our games inventory, which is prone to obsolescence risks because of the nature of the industry, are subject to negotiation with vendors.

Our purchasing decisions also involve predictions of consumer demand. While the historical growth of our in-store and online subscription programs, our elimination of extended viewing fees, our Guaranteed in Stock program for select new release titles (whereby if a Guaranteed in Stock title is unavailable, customers will be given a rain check for a free rental of that title good for 30 days at the same store) and the free in-store rentals provided by our BLOCKBUSTER Total Access program have increased consumer demand for our products, these programs have increased the complexity of our purchasing decisions. In addition, the prevalence of multiple game platforms adds to the difficulty of accurately predicting consumer demand with respect to video games. The nature of and market for our products, particularly games and DVDs, also makes them prone to risk of theft and loss.

Our operating results could therefore suffer if we are not able to:

 

   

obtain or maintain favorable terms from our suppliers with respect to such matters as copy depth, use of product, including without limitation fulfillment of online orders, and product returns;

 

   

maintain adequate copy depth to maintain customer satisfaction;

 

   

control shrinkage resulting from theft or loss; or

 

   

avoid significant inventory excesses that could force us to sell products at a discount or loss.

Further, as discussed above, uncertainty surrounding our ability to finance our obligations has in the past caused some of our trade creditors to impose increasingly less favorable terms and future uncertainty could similarly result in unfavorable terms from our trade creditors.

Our results of operations could be materially adversely affected if our franchisees failed to pay our franchise fees.

A portion of our revenues are derived from royalty fees through our franchising program. We may experience difficulties in collecting our franchise fees on a timely basis, or at all, for a variety of reasons,

 

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including the inability of our franchisees to achieve sufficient revenues and cash flows from their stores or to otherwise effectively operate their stores under challenging industry conditions. Lawsuits and other disputes with our franchisees may also reduce the amount of our royalties from franchise fees. Any failure by our franchisees to pay their franchise fees to us on time or at all could materially adversely affect our results of operations.

Any failure or inadequacy of our information technology infrastructure could harm our business.

The capacity, reliability and security of our information technology hardware and software infrastructure and our ability to expand and update this infrastructure in response to our changing needs are important to the continued implementation of our new customer proposition initiatives, as well as the operation of our business generally. To avoid technology obsolescence and enable future cost savings and customer enhancements, we are continually updating our information technology infrastructure. In addition, we intend to add new features and functionality to our products, services and systems that could result in the need to develop, license or integrate additional technologies. Our inability to add additional software and hardware or to upgrade our technology infrastructure could have adverse consequences, which could include the delayed implementation of our new customer proposition initiatives, service interruptions, impaired quality or speed of the users’ experience and the diversion of development resources. Our failure to provide new features or functionality to our systems also could result in these consequences. We may not be able to effectively upgrade and expand our systems, or add new systems, in a timely and cost effective manner and we may not be able to smoothly integrate any newly developed or purchased technologies with our existing systems. These difficulties could harm or limit our ability to improve our business. In addition, any failure of our existing information technology infrastructure could result in significant additional costs to us.

Our business model is substantially dependent on the functionality of our distribution centers.

Our domestic distribution system for our store-based operations is centralized. We ship a substantial portion of the products to our U.S. company-operated stores through our distribution center. We also have 39 regional U.S. distribution centers to support our domestic online DVD subscription service. If our distribution centers became non-operational for any reason, we could incur significantly higher costs and longer lead times associated with distributing our movies and other products. In international markets, we utilize a variety of distribution methodologies with similar risks to those in the United States.

Our financial results have been and could further be negatively impacted by impairments of goodwill or other intangible assets required by SFAS 142 and the application of future accounting policies or interpretations of existing accounting policies.

In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets referred to as “SFAS 142,” we test goodwill and other intangible assets for impairment during the fourth quarter of each year and on an interim date should factors or indicators become apparent that would require an interim test. In recent periods we have taken significant charges relating to the impairment of goodwill. See Notes 3 and 4 to the consolidated financial statements and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates” in this Form 10-K.

A downward revision in the fair value of one of our reporting units could result in additional impairments of goodwill under SFAS 142 and additional non-cash charges. Any charge resulting from the application of SFAS 142 could have a significant negative effect on our reported net income. In addition, our financial results could be negatively impacted by the application of existing and future accounting policies or interpretations of existing accounting policies, including without limitation the impact of accounting policies related to our rental library, any continuing impact of SFAS 142 or any interpretation issued in connection with Statement of Financial Accounting Standards No. 123R, Share-Based Payment.

 

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We are subject to various litigation matters that could, if judgments were to be rendered against us, have an adverse effect on our operating results.

We are a defendant in various lawsuits and may become subject to additional lawsuits in the future. If judgments were to be rendered against us in these lawsuits, our results of operations could be adversely affected. See Note 10 to the consolidated financial statements for a discussion of certain pending material litigation matters relating to our business.

Our stock price has been extremely volatile.

The price at which our common stock has traded in recent periods has fluctuated greatly, and most recently has declined significantly. The price may continue to be volatile due to a number of factors including the following, some of which are beyond our control:

 

   

variations in our operating results;

 

   

variations between our actual operating results and the expectations of securities analysts, investors and the financial community;

 

   

announcements of developments affecting our business, systems or expansion plans of others;

 

   

competition, including the introduction of new competitors, their pricing strategies and services;

 

   

market volatility in general; and

 

   

the operating results of our competitors.

As a result of these and other factors, investors in our common stock may not be able to resell their shares at or above their original purchase price.

Following certain periods of volatility in the market price of our securities, we have become the subject of securities litigation. We may experience more such litigation following future periods of volatility. This type of litigation may result in substantial costs and a diversion of management’s attention and resources.

Our business and operations have been, and could further be, negatively impacted as a result of the proxy fight during 2005 and election of three dissident nominees to our Board of Directors. Further, if a subsequent proxy fight is waged against us and is successful or if dissidents otherwise gain control of our Board, we could be in default under our credit agreement and may be unable to finance a change of control offer under the indenture governing our senior subordinated notes or repay our bank debt should it become accelerated.

On April 8, 2005, we were notified that a slate of dissident nominees would be proposed for election at our 2005 annual stockholders meeting. On May 11, 2005, the dissident nominees were elected by our stockholders to serve on our Board of Directors. As a result of the proxy contest and the subsequent elections of the dissident nominees, our business and operations have been, and may further be, negatively impacted. For example:

 

   

we incurred substantial costs associated with the proxy contest;

 

   

the proxy contest was disruptive to our operations; and

 

   

dissension on our Board of Directors may impact our ability to effectively and timely implement our initiatives and to retain and attract experienced executives and employees.

Further, under the terms of our credit agreement and the indenture governing our senior subordinated notes, a change in the composition of our Board of Directors, including as a result of one or more director resignations, whereby the majority of directors who were serving on the Board at the time we entered into our credit agreement and indenture (or their successors or nominees) are no longer serving on the Board, could constitute a change of control. If a subsequent proxy contest is waged against us and is successful or if dissidents otherwise gain control of our Board, an event of default could result under our credit agreement, and under the indenture,

 

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we may be required to make an offer for cash to purchase the notes at 101% of their principal amount, plus accrued and unpaid interest and additional interest, if any. We cannot assure you that we will have the financial resources necessary to purchase the notes upon a change of control or that we will have the ability to obtain the necessary funds on satisfactory terms, if at all. Further, our credit agreement prohibits the purchase of all of the outstanding notes prior to repayment of the borrowings under our credit agreement and any exercise by the holders of the notes of their right to require us to repurchase the notes will also cause an event of default under our credit agreement. We may be unable to repay any acceleration of our debts that may arise under this scenario.

We have experienced senior management departures, and our senior management team is largely new. If we lose key senior management or are unable to attract and retain the talent required for our business, our operating results could suffer.

During 2007, a number of members of our senior management concluded their employment with us, including our former Chairman and Chief Executive Officer and our former Chief Financial Officer. We have hired new members of our senior management team from outside of Blockbuster. As a result, a number of members of our senior management team have been employed by Blockbuster for only a short period of time. Our performance depends in part on the ability of this largely new senior management team to coalesce, motivate our employees and address the changes presented by our dynamic industry. The unexpected future loss of services of one or more members of our senior management team could have an adverse effect on our business. We will need to attract and retain additional qualified personnel and develop, train and manage management-level employees. We cannot assure you that we will be able to attract and retain personnel as needed in the future.

We are subject to governmental regulation particular to the retail home video industry and changes in U.S. or international laws may adversely affect us.

Any finding that we have been, or are, in noncompliance with respect to, or otherwise liable under, the laws affecting our business could result in costs, including, among other things, governmental penalties or private litigant damages, which could have a material adverse effect on us. We are subject to various international and U.S. federal and state laws that govern the offer and sale of our franchises because we act as a franchisor. In addition, because we operate video stores and develop new video stores, we are subject to various international and U.S. federal and state laws that govern, among other things, the disclosure and retention of our video rental records and access to and use of our video stores by disabled persons, and are subject to various international, U.S. federal, state and local advertising, consumer protection, credit protection, franchising, licensing, zoning, land use, construction, trading activities, second-hand dealer, minimum wage and labor and other employment regulations, as well as laws and regulations relating to the protection and cleanup of the environment and health and safety matters. The international home video and video game industry varies from country to country due to, among other things, legal standards and regulations, such as those relating to foreign ownership rights; unauthorized copying; intellectual property rights; movie ratings, which in many countries are legal standards unlike the voluntary standards of the United States; labor and employment matters; trade regulation and business practices; franchising and taxation; environmental matters; and format and technical standards. Our obligation to comply with, and the effects of, the above governmental regulations are increased by the magnitude of our operations.

Changes in existing laws, including environmental and employment laws, adoption of new laws or increases in the minimum wage, may increase our costs or otherwise adversely affect us. For example, the repeal or limitation in the United States of certain favorable copyright laws would have an adverse impact in the United States on our rental business. Similarly, the adoption or expansion of laws in any other country to allow copyright owners to charge retailers more for rental product than for sell-through product could have an adverse impact on our rental business in that country.

 

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Any acquisitions we make involve a degree of risk.

We have in the past, and may in the future, engage in acquisitions to expand our domestic and international rental and retail presence or to expand our consumer offerings. For example, in 2007 we acquired all of the outstanding equity interests of Movielink, LLC, an online movie downloading business. If these or any future acquisitions are not successfully integrated with our business, our ongoing operations could be adversely affected. Additionally, acquisitions may not achieve desired profitability objectives or result in any anticipated successful expansion of the acquired businesses or concepts. Although we review and analyze assets or companies we acquire, such reviews are subject to uncertainties and may not reveal all potential risks. Additionally, although we attempt to obtain protective contractual provisions, such as representations, warranties and indemnities, in connection with acquisitions, we cannot assure you that we can obtain such provisions in our acquisitions or that they will fully protect us from unforeseen costs of the acquisition. We may also incur significant costs in connection with pursuing possible acquisitions, even if the acquisition is not ultimately consummated.

We have assumed obligations pursuant to agreements with Viacom relating to certain real estate leases guaranteed by Viacom, which obligations may adversely affect our ability to negotiate renewals or modifications to a subset of such leases.

In October 2004, we completed our divestiture from Viacom. We entered into an amended and restated initial public offering and split-off agreement with Viacom in connection with this divestiture. This agreement, which is referred to as the “IPO agreement,” imposes various restrictions and limitations on our ability to renew or modify, in a manner that increases Viacom’s potential liability, a subset of the leases guaranteed by Viacom, which could make it more difficult and expensive, and in some cases impossible, to renew or modify certain of these leases.

We have also assumed obligations pursuant to the IPO agreement to maintain letters of credit in favor of Viacom, which obligations reduce our borrowing capacity.

Pursuant to the IPO agreement, we have provided letters of credit, at Viacom’s expense, for the benefit of Viacom to support Viacom’s potential liability for certain real estate lease obligations of ours. The letters of credit reduce our borrowing capacity under the terms of our credit facilities by $150 million. Until the letters of credit or any renewals thereof are terminated, we anticipate any future or additional lenders may treat our letter of credit obligation as if it were outstanding indebtedness when assessing our borrowing capacity. Furthermore, if we are unable to renew or otherwise replace the letters of credit prior to their expiration as required by the IPO agreement, Viacom has the right to draw down the full amount of the outstanding letters of credit, which may cause us to borrow funds under our credit facility to reimburse the issuing bank. In either case, our obligation to maintain the letters of credit may restrict or prevent us from being able to borrow amounts necessary to engage in favorable business activities, consummate strategic acquisitions or otherwise fund capital needs.

We, along with Viacom and certain of Viacom’s related entities, are a party to two judgment sharing agreements arising out of two revenue-sharing antitrust cases. Should we, Viacom or Viacom’s related entities incur liability with respect to such cases, we would be responsible for satisfying a portion of that liability.

On November 9, 2001, we entered into a judgment sharing agreement with Viacom, Paramount Home Entertainment, Inc. (“Paramount”), Sumner Redstone and certain studio defendants in Cleveland, et al. v. Viacom Inc., et al, No. SA-99-CA-0783 in the United States District Court for the Western District of Texas and in Merchant, et al. v. Redstone, et al., No. BC 244 270 in the Superior Court for the State of California, County of Los Angeles, whereby we, Viacom, Paramount and Mr. Redstone agreed to be responsible for an allocated portion of any liability that arises out of either of the two revenue-sharing antitrust cases. No liability will arise from the Cleveland case as judgment was entered in favor of us and the other defendants and all appeals by plaintiffs failed. The Merchant case was appealed following judgment in our favor and remanded back to the trial court for further proceedings. On June 18, 2004, in connection with our split-off from Viacom, we entered into

 

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an agreement with Viacom, Paramount and Mr. Redstone, which we refer to as the Viacom entities, whereby we agreed to pay a percentage allocation of any liability arising from a judgment or from the November 9, 2001 judgment sharing agreement of 33.33% and the Viacom entities agreed to pay 66.67% of any such liability. On May 2, 2007, the trial court in the Merchant case granted summary judgment in favor of Blockbuster, Viacom and Mr. Redstone. The Merchant plaintiffs have appealed the ruling, and the appeal is currently pending. We cannot assure you that we will not be held liable in the Merchant case. Therefore, we may become responsible for contributing one-third of any liability arising from such case.

We have material weaknesses in our internal control over financial reporting which could adversely affect our ability to report our financial condition and results of operations accurately and on a timely basis.

In connection with our restatement and our assessment of internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002, we identified material weaknesses in our internal control. For a discussion of our internal control over financial reporting and a description of the identified material weaknesses, see “Item 9A. Controls and Procedures.”

Material weaknesses in our internal control over financial reporting could adversely impact our ability to provide timely and accurate financial information. We are developing remediation plans to strengthen our internal controls in response to the previously identified material weaknesses. If we are unsuccessful in developing, implementing or following our remediation plan, or fail to update our internal control as our business evolves, we may not be able to timely or accurately report our financial condition, results of operations or cash flows or maintain effective disclosure controls and procedures. If we are unable to report financial information timely and accurately or to maintain effective disclosure controls and procedures, we could be subject to, among other things, regulatory or enforcement actions by the SEC and the NYSE, including a delisting from the NYSE, securities litigation, events of default under our new credit facilities, debt rating agency downgrades or rating withdrawals, and a general loss of investor confidence, any one of which could adversely affect our business prospects and the valuation of our common stock.

Furthermore, there are inherent limitations to the effectiveness of any system of controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. We could face additional litigation exposure and a greater likelihood of an SEC enforcement or NYSE regulatory action if further restatements were to occur or other accounting-related problems emerge. In addition, any future restatements or other accounting-related problems may adversely affect our financial condition, results of operations and cash flows.

Provisions in our charter documents and Delaware law could make it more difficult to acquire our Company.

Our second amended and restated certificate of incorporation (“certificate of incorporation”) and amended and restated bylaws (“bylaws”) contain provisions that may discourage, delay or prevent a third party from acquiring us, even if doing so would be beneficial to our stockholders. Our bylaws limit who may call special meetings of stockholders to any officer at the request of a majority of our Board of Directors, the Chairman of the Board or the Chief Executive Officer of the Company. Our certificate of incorporation and bylaws provide that the bylaws may be altered, amended or repealed by the Board of Directors.

Pursuant to our certificate of incorporation, the Board of Directors may by resolution establish one or more series of preferred stock, having such number of shares, designation, relative voting rights, dividend rates, liquidation or other rights, preferences and limitations as may be fixed by the Board of Directors without any further stockholder approval. Such rights, preferences, privileges and limitations as may be established could have the effect of impeding or discouraging the acquisition of control of us, which could adversely affect the price of our equity securities.

 

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In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting us from engaging in a business combination with an interested stockholder for a period of three years after the person becomes an interested stockholder.

 

Item 1B.    Unresolved Staff Comments

None.

 

Item 2.    Properties

Our corporate headquarters are located at 1201 Elm Street, Dallas, Texas 75270 and consist of 242,615 square feet of space leased pursuant to an agreement that expires on June 30, 2017. Our primary distribution center is located at 3000 Redbud Blvd., McKinney, Texas 75069 and consists of about 850,000 square feet of space leased pursuant to an agreement that expires on December 31, 2012. We have set up our payroll and benefits center in Spartanburg, South Carolina. We also lease and operate 39 online distribution centers spread strategically throughout the United States to support our domestic online rental service.

We have country head offices in Buenos Aires, Argentina; Toronto, Canada; Santiago, Chile; Uxbridge, England; Dublin, Ireland; Milan, Italy; Herlev, Denmark; and Mexico City, Mexico. For most countries in which we have company-operated stores, we maintain offices to manage our operations within that country.

We lease substantially all of our existing store sites. Within the United States and Canada, these leases generally have a term of five to ten years and provide options to renew for between five and ten additional years. We expect that most future stores will also occupy leased properties.

 

Item 3.    Legal Proceedings

Information regarding our material legal proceedings is set forth in Note 10 to the consolidated financial statements, in Item 8 of Part II of this Form 10-K, which information is incorporated herein by reference.

 

Item 4.    Submission of Matters to a Vote of Security Holders

None.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The shares of Blockbuster Class A and Class B common stock are listed and traded on the New York Stock Exchange, or “NYSE,” under the symbols “BBI” and “BBI.B,” respectively. Our Class A common stock began trading on August 11, 1999, following our initial public offering and our Class B common stock began trading on October 14, 2004, in conjunction with our divestiture from Viacom Inc. (“Viacom”). The following table contains, for the periods indicated, the high and low sales prices per share of our Class A and Class B common stock as reported on the NYSE composite tape and the cash dividends per share of our Class A and Class B common stock:

 

     Blockbuster Class A
Common Stock
Sales Price
   Blockbuster Class B
Common Stock
Sales Price
   Cash Dividends
per share of
Common Stock(1)
     High    Low    High    Low   

Year Ended December 31, 2006:

              

Quarter Ended March 31, 2006

   $ 4.28    $ 3.30    $ 3.90    $ 2.95    $ —  

Quarter Ended June 30, 2006

   $ 5.12    $ 3.69    $ 4.68    $ 3.36    $ —  

Quarter Ended September 30, 2006

   $ 5.11    $ 3.57    $ 4.60    $ 3.15    $ —  

Quarter Ended December 31, 2006

   $ 5.59    $ 3.66    $ 5.14    $ 3.29    $ —  

Year Ended January 6, 2008:

              

Quarter Ended April 1, 2007

   $ 7.30    $ 5.41    $ 6.90    $ 4.98    $ —  

Quarter Ended July 1, 2007

   $ 6.67    $ 3.94    $ 6.18    $ 3.54    $ —  

Quarter Ended September 30, 2007

   $ 5.71    $ 3.96    $ 5.00    $ 3.57    $ —  

Quarter Ended January 6, 2008

   $ 5.80    $ 2.99    $ 5.12    $ 2.57    $ —  

 

(1) We historically paid a quarterly recurring cash dividend of $0.02 per share on both our Class A and Class B common stock, however, we have not paid a dividend since the second quarter of 2005. Our Board of Directors may evaluate declaring quarterly cash dividends in the future.

The terms of our debt agreements, as discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources,” limit our ability to repurchase common stock and pay dividends. Subject to these limitations, our Board of Directors may change our dividend practices from time to time and decrease or increase the dividend paid, or not pay a dividend, on our common stock based on factors such as results of operations, financial condition, cash requirements and future prospects and other factors deemed relevant by our Board of Directors.

The number of holders on record of shares of our Class A and Class B common stock as of February 29, 2008 was 1,148 and 815, respectively.

For information regarding our equity compensation plans, refer to the proxy statement to be filed for our 2008 annual meeting of stockholders incorporated by reference into Item 12 of Part III of this Form 10-K.

 

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Stock Performance Graphs

The following Stock Performance Graphs and related information shall not be deemed “soliciting material” or “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, except to the extent that the Company specifically incorporates it by reference into such filing.

The following graph compares the cumulative total stockholder return on our Class A common stock over the five-year period ended December 31, 2007, with the cumulative total return during such period of the Standard and Poor’s 500 Stock Index (“S&P 500 Index”) and the Hemscott Industry Group Index 743-Music & Video Stores (“Hemscott Group Index”). The comparison assumes $100 was invested on December 31, 2002, in the Company’s Class A common stock and in each of the foregoing indices and assumes reinvestment of dividends. The stock performance shown on the graph below represents historical stock performance and is not necessarily indicative of future stock price performance.

LOGO

 

     12/31/02    12/31/03    12/31/04    12/31/05    12/31/06    12/31/07

Blockbuster Inc. Class A common stock

   100.00    147.23    124.75    49.25    69.47    51.22

Hemscott Group Index*

   100.00    166.45    135.68    99.10    106.93    98.35

S&P 500 Index

   100.00    128.68    142.69    149.70    173.34    182.87

 

* The Hemscott Group Index consists of the following issuers: Blockbuster Inc. (Class A and Class B common stock); Hastings Entertainment, Inc.; Netflix, Inc.; and Trans World Entertainment Corporation.

 

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The following graph compares the cumulative total stockholder return on our Class B common stock over the period from October 14, 2004 to December 31, 2007, with the cumulative total return during such period of the S&P 500 Index and the Hemscott Group Index. The comparison assumes $100 was invested on December 31, 2002, in the Company’s Class B common stock and in each of the foregoing indices and assumes reinvestment of dividends. The stock performance shown on the graph below represents historical stock performance and is not necessarily indicative of future stock price performance.

LOGO

 

     10/14/04    12/31/04    06/30/05    12/31/05    06/30/06    12/31/06    06/30/07    12/31/07

Blockbuster Inc. Class B common stock

   100.00    115.51    113.00    43.86    57.82    64.53    51.50    45.31

Hemscott Group Index*

   100.00    109.70    122.47    86.22    96.13    91.95    70.25    81.58

S&P 500 Index

   100.00    109.23    108.35    114.60    117.70    132.70    141.93    139.99

 

* The Hemscott Group Index consists of the following issuers: Blockbuster Inc. (Class A and Class B common stock); Hastings Entertainment, Inc.; Netflix, Inc.; and Trans World Entertainment Corporation.

 

Item 6.    Selected Financial Data

The following table sets forth our selected consolidated historical financial data as of the dates and for the periods indicated. The selected consolidated statement of operations and balance sheet data for fiscal years 2003 through 2007 are derived from our consolidated financial statements. The financial information herein may not necessarily reflect our results of operations, financial position and cash flows in the future or what our results of operations, financial position and cash flows would have been had Viacom not owned a large majority of our equity and voting interest during some of the periods presented.

Our financial results for the years ended December 31, 2006, 2005, 2004 and 2003 have been restated. The impact of the restatements on our Statement of Operations Data for the years ended December 31, 2006 and 2005 and on our Balance Sheet Data as of December 31, 2006 is discussed in Note 2 to our Consolidated Financial Statements. The impact of the restatements on our Statements of Operations Data for the years ended December 31, 2004 and 2003 and on our Balance Sheet Data as of December 31, 2005, 2004 and 2003 is discussed in footnote 8 to the schedule of selected financial data.

 

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BLOCKBUSTER SELECTED CONSOLIDATED HISTORICAL

FINANCIAL DATA

The following data should be read in conjunction with, and is qualified by reference to, the consolidated financial statements and related notes, and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this document.

 

    Fiscal Year Ended or at Year End,  
    2007(1)(2)     2006(3)(4)(5)     2005(3)(6)(7)(8)     2004(8)(9)(10)(11)     2003(8)(12)  
          (As restated)     (As restated)     (As restated)     (As restated)  
    (In millions, except per share amounts)  

Statement of Operations Data:

         

Revenues

  $ 5,542.4     $ 5,522.2     $ 5,721.8     $ 5,932.8     $ 5,826.4  

Gross profit

  $ 2,864.6     $ 3,042.5     $ 3,160.8     $ 3,545.0     $ 3,475.9  

Impairment of goodwill and other long-lived assets(13)

  $ 2.2     $ 5.1     $ 341.9     $ 1,499.7     $ 1,280.0  

Operating income (loss)

  $ 39.1     $ 73.6     $ (382.9 )   $ (1,242.0 )   $ (805.0 )

Income (loss) before discontinued operations and cumulative effect of change in accounting principle

  $ (74.2 )   $ 63.7     $ (544.1 )   $ (1,251.2 )   $ (949.1 )

Income (loss) per common share before discontinued operations and cumulative effect of change in accounting principle—basic

  $ (0.45 )   $ 0.28     $ (2.96 )   $ (6.91 )   $ (5.27 )

Income (loss) per common share before discontinued operations and cumulative effect of change in accounting principle—diluted

  $ (0.45 )   $ 0.28     $ (2.96 )   $ (6.91 )   $ (5.27 )

Income (loss) from discontinued operations, net of tax(14)

  $ 0.4     $ (13.2 )   $ (39.8 )   $ 4.9     $ (23.8 )

Cumulative effect of change in accounting principle

  $ —       $ —       $ —       $ —       $ (4.4 )

Net income (loss)

  $ (73.8 )   $ 50.5     $ (583.9 )   $ (1,246.3 )   $ (977.3 )

Preferred stock dividends(15)

  $ (11.3 )   $ (11.3 )   $ —       $ —       $ —    

Net income (loss) applicable to common stockholders

  $ (85.1 )   $ 39.2     $ (583.9 )   $ (1,246.3 )   $ (977.3 )

Net income (loss) per common share—basic

  $ (0.45 )   $ 0.21     $ (3.18 )   $ (6.88 )   $ (5.43 )

Net income (loss) per common share—diluted

  $ (0.45 )   $ 0.21     $ (3.18 )   $ (6.88 )   $ (5.43 )

Cash dividends per common share

  $ —       $ —       $ 0.04     $ 0.08     $ 0.08  

Special distribution per share

  $ —       $ —       $ —       $ 5.00     $ —    

Weighted average shares outstanding—basic

    190.3       187.1       183.9       181.2       180.1  

Weighted average shares outstanding—diluted

    190.3       189.0       183.9       181.2       180.1  

Balance Sheet Data:

         

Cash and cash equivalents

  $ 184.6     $ 394.9     $ 276.2     $ 330.3     $ 233.4  

Total assets

  $ 2,733.6     $ 3,134.6     $ 3,184.0     $ 3,991.5     $ 4,914.4  

Long-term debt, including capital leases

  $ 703.0     $ 899.5     $ 1,121.6     $ 1,119.7     $ 75.1  

Stockholders’ equity

  $ 655.7     $ 723.3     $ 637.6     $ 1,062.9     $ 3,188.4  

 

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(1) During 2007, we recorded an $81.5 million gain on sale of Gamestation and a $6.3 million gain on sale of our Australian subsidiary, both of which are included in Operating income (loss).
(2) During 2007, we recognized $14.6 million of compensation expense related to share-based compensation as required by Statement of Financial Accounting Standards No. 123 (revised), Share-Based Payments (“SFAS 123R”).
(3) See Note 2 to our consolidated financial statements for discussion of the restatements for fiscal years 2006 and 2005.
(4) During 2006, we recorded $111.9 million in tax benefits resulting from the resolution of multi-year income tax audits.
(5) During 2006, we recognized $25.5 million of compensation expense related to share-based compensation as required by SFAS 123R.
(6) During 2005, we recorded a valuation allowance on our deferred tax assets in various jurisdictions. See Note 9 to our consolidated financial statements.
(7) During 2005, we recognized $39.1 million of compensation expense related to share-based compensation as required by SFAS 123R.
(8) The Statement of Operations Data for the years ended December 31, 2004 and 2003 and the Balance Sheet Data as of December 31, 2005, 2004 and 2003 have been restated as follows, primarily related to the issues discussed in Note 2 to our consolidated financial statements:

 

     Fiscal year ended December 31,  
     2004     2003  
     As
reported
    Adjustments     As
restated
    As
reported
    Adjustments     As
restated
 

Statement of Operations Data:

            

Revenues

   $ 5,932.5     $ 0.3     $ 5,932.8     $ 5,826.1     $ 0.3     $ 5,826.4  

Gross profit

   $ 3,553.8     $ (8.8 )   $ 3,545.0     $ 3,474.1     $ 1.8     $ 3,475.9  

Impairment of goodwill and other long-lived assets

   $ 1,502.7     $ (3.0 )   $ 1,499.7     $ 1,280.8     $ (0.8 )   $ 1,280.0  

Operating income (loss)

   $ (1,241.6 )   $ (0.4 )   $ (1,242.0 )   $ (805.4 )   $ 0.4     $ (805.0 )

Income (loss) before discontinued operations and cumulative effect of change in accounting principle

   $ (1,253.7 )   $ 2.5     $ (1,251.2 )   $ (950.5 )   $ 1.4     $ (949.1 )

Income (loss) per common share before discontinued operations and cumulative effect of change in accounting principle—basic

   $ (6.92 )   $ 0.01     $ (6.91 )   $ (5.28 )   $ 0.01     $ (5.27 )

Income (loss) per common share before discontinued operations and cumulative effect of change in accounting principle—diluted

   $ (6.92 )   $ 0.01     $ (6.91 )   $ (5.28 )   $ 0.01     $ (5.27 )

Net income (loss)

   $ (1,248.8 )   $ 2.5     $ (1,246.3 )   $ (978.7 )   $ 1.4     $ (977.3 )

Net income (loss) applicable to common stockholders

   $ (1,248.8 )   $ 2.5     $ (1,246.3 )   $ (978.7 )   $ 1.4     $ (977.3 )

Net income (loss) per common share-basic

   $ (6.89 )   $ 0.01     $ (6.88 )   $ (5.43 )   $ —       $ (5.43 )

Net income (loss) per common share-diluted

   $ (6.89 )   $ 0.01     $ (6.88 )   $ (5.43 )   $ —       $ (5.43 )

 

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    At December 31,
    2005   2004   2003
    As reported   Adjustments   As restated   As reported   Adjustments     As restated   As reported   Adjustments     As restated

Balance Sheet Data:

                 

Total assets

  $ 3,179.6   $ 4.4   $ 3,184.0   $ 3,994.6   $ (0.9 )   $ 3,993.7   $ 4,918.1   $ (1.5 )   $ 4,916.6

Stockholders’ equity

  $ 631.6   $ 6.0   $ 637.6   $ 1,062.9   $ —       $ 1,062.9   $ 3,188.4   $ —       $ 3,188.4

The impact of the restatements on periods prior to January 1, 2003 is reflected as an increase of $4.1 million to beginning accumulated deficit and a decrease of $4.1 million to beginning accumulated other comprehensive loss as of January 1, 2003.

 

(9) During 2004, we recognized a $37.1 million tax benefit as a result of specific federal income tax audit issues resolved during 2004.
(10) In conjunction with our adoption of SFAS 123R, we recognized $18.3 million of compensation expense related to share-based compensation in 2004. We also adopted the expense recognition provisions of FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (“FIN 28”) as of January 1, 2004. Because we applied the disclosure-only provisions of SFAS 123 through September 30, 2004, the cumulative effect of change in accounting principle of $23.1 million, net of tax, recognized upon adoption of the expense recognition provisions of FIN 28 has not been reflected in our Consolidated Statements of Operations for the year ended December 31, 2004.
(11) During the third quarter of 2004, we paid a $5.00 special distribution per share prior to our divestiture from Viacom.
(12) During the first quarter of 2003, we adopted SFAS No. 143, Accounting for Asset Retirement Obligations (“SFAS 143”), which requires the capitalization of any retirement costs as part of the total cost of the related long-lived asset and the subsequent allocation of the total expense to future periods. The application of this accounting standard required us to record a $4.4 million cumulative effect of change in accounting principle, net of tax.
(13) We have recognized non-cash charges to impair goodwill and other long-lived assets in accordance with SFAS 142 and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). See Note 3 to the consolidated financial statements for a discussion of impairment charges.

(14)

During 2006, we completed the divestiture of Movie Brands Inc. and MOVIE TRADING CO. ® in addition to closing all of our store locations in Spain. In January 2007, we also completed the sale of RHINO VIDEO GAMES®. In accordance with SFAS 144, these operations have been classified as discontinued operations.

(15) During the third quarter of 2005, we completed a private placement of Series A cumulative convertible perpetual preferred stock. The first dividend payment was declared and paid in the first quarter of 2006.

 

Item 7. Managements’ Discussion and Analysis of Financial Condition and Results of Operations

(Tabular Dollars in Millions)

Management’s Discussion and Analysis of Financial Condition and Results of Operations set forth in this Item 7 reflects the restatement of our consolidated financial statements for fiscal years 2006 and 2005 as discussed below, and all amounts for these prior periods and prior period comparisons reflect the balances and amounts on a restated basis. Unless otherwise noted, the following discussion and analysis relates only to results from continuing operations. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this document.

Restatement of Financial Statements

We have restated herein our consolidated financial statements for each of the fiscal years ended December 31, 2006 and 2005 to correct errors in such consolidated financial statements. See Note 2 to the Consolidated Financial Statements for more information regarding the impact of the restatement on our consolidated financial statements.

 

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Change in Fiscal Year End

On October 12, 2006, our Board of Directors approved a change in our fiscal year from a calendar year ending on December 31st to a 52/53 week fiscal year ending on the first Sunday following December 30th. The change in our fiscal year took effect on January 1, 2007 and, therefore, there was no transition period in connection with this change of fiscal year-end. Fiscal year 2007 includes the 53 weeks ended January 6, 2008, while fiscal years 2006 and 2005 include the calendar years ended on December 31 of each year.

Overview

Blockbuster Inc. is a leading global provider of in-home rental and retail movie and game entertainment, with over 7,800 stores in the United States, its territories and 21 other countries as of January 6, 2008. We also offer rental and retail movie entertainment through the Internet and by mail in the United States.

While the overall media entertainment industry has remained stable over the past few years, it has experienced a channel shift primarily driven by the emergence of new channels of distribution, such as by-mail delivery, vending and digital. The increasing availability of in-home entertainment through delivery methods other than traditional in-store models and other leisure activities have resulted in the decline in the in-store home video rental channel. Recognizing that shift, we invested significantly in the by-mail delivery channel over the past three years.

During the first half of 2007, we continued with our strategy to aggressively expand our by-mail subscriber base through offerings such as BLOCKBUSTER Total Access. Through heavy in-store promotion of our by-mail subscription offerings, we successfully shifted a large number of in-store customers to that channel. The significant growth in our by-mail subscriber base proved the competitive strength of BLOCKBUSTER Total Access; but it also revealed the significant costs associated with the offering. We estimate that the cost of providing free in-store exchanges under the BLOCKBUSTER Total Access program was approximately $140 million in 2007, which contributed to a significant decrease in our profitability for the year.

On July 2, 2007, we announced the appointment of James W. Keyes, our new Chairman of the Board and Chief Executive Officer. Mr. Keyes has begun to create a culture and a business process at Blockbuster that is responsive to change and able to keep pace with the changing needs of customers.

Our vision for the “new” Blockbuster is to be in the forefront of that change and become the most convenient source for media entertainment for our customers. Going forward, the three principal strategies behind our mission are to:

 

   

restore and grow our rental DVD business, both in-store and by-mail;

 

   

facilitate in-store transition from rental to retail; and

 

   

position our company for an eventual transformation from DVD to digital.

To this end, we took a series of actions during the second half of 2007 designed to improve short-term profitability and position Blockbuster to achieve our strategic objectives going forward:

 

   

Appointing a new leadership team—During the second half of 2007, we have built a new leadership team, including the appointment of a new Chief Financial Officer and General Counsel.

 

 

 

Striking an appropriate balance between the growth of our by-mail subscription service and enhanced profitability—These changes included modifications to the BLOCKBUSTER Total Access program which targeted our highest cost by-mail subscribers. As a result of the pricing modifications, a significant number of our highest cost by-mail subscribers left the service or migrated to a higher priced subscription plan. We also reduced our advertising spend for BLOCKBUSTER Total Access and minimized promotion of the program in our stores. Through these actions we were able to significantly reduce the number of unprofitable BLOCKBUSTER Total Access subscribers, many of whom returned to shopping in our stores, thereby improving profitability across the remaining subscriber base.

 

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Implementing cost controls— We completed a preliminary review of our cost structure and have implemented a plan to reduce annualized overhead costs by approximately $100 million through the elimination of staffing and operational redundancies in our in-store and online corporate support structure and through operational improvements. Further, management continues to evaluate a number of other methods to reduce costs, including outsourcing various corporate functions.

 

   

Leveraging and growing our leadership position in the movie and game rental business—These changes include maximizing product availability of new releases, simplifying pricing terms, improving customer service, obtaining exclusive content and innovatively merchandising our product offerings. Additionally, we are currently testing a number of new store prototypes ranging from a refreshed and modernized look and feel of a typical Blockbuster store to stores that emphasize gaming, an interactive children’s area and video-enabled electronic devices.

 

   

Developing new retail opportunities— We are leveraging our leadership position in the rental market to increase sales of movies, games and other complementary entertainment-related products.

Key Financial Points for 2007

 

 

 

Estimated impact of the 53rd week in fiscal 2007:

 

   

Revenues increased by $102 million.

 

   

Gross profit increased by $52 million.

 

   

Operating income increased by $7 million.

 

   

Sales and closures of stores. Targeting our poorest performing company-operated locations, we had net closures of 257 stores. Additionally, we had net sales of 221 stores.

 

   

Domestic shift from in-store to by-mail rentals:

 

   

Subscription rental revenues—increased $278 million, due mainly to our continued aggressive marketing of the by-mail services in the first half of 2007.

 

   

Cost of rental revenues—incurred an estimated $140 million for the cost of in-store exchanges under the BLOCKBUSTER Total Access program.

 

   

Gain on sale of Gamestation. During the second quarter of 2007, we completed the divestiture of Gamestation for $147.7 million and recorded an $81.5 million gain on the sale.

Outlook

We have made significant progress in 2007, both strategically and financially, and believe we are on our way to transforming Blockbuster into a company that is able to generate total revenue growth, effectively redeploy resources and balance investment in a manner that delivers favorable returns. For 2008, we are committed to executing our strategy and improving profitability primarily through improving the profitability of our by-mail channel, ensuring the realization of our cost savings measures and developing new retail and rental opportunities. We will also continue to explore the divestiture of our non-core assets, including selling and/or franchising some of our international operations. Additionally, we believe that closures of Movie Gallery stores, the expansion and growth of Blu-Ray players and content, and a weakened economy in the U.S. could have a favorable impact on our 2008 results.

 

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Results of Operations

Consolidated Results

The following table sets forth a summary of consolidated results of certain operating and other financial data.

 

     Fiscal Year Ended,  
     January 6,
2008
    December 31,
2006
    December 31,
2005
 
           (As restated)     (As restated)  

Statement of Operations Data:

      

Revenues

   $ 5,542.4     $ 5,522.2     $ 5,721.8  

Cost of sales

     2,677.8       2,479.7       2,561.0  
                        

Gross profit

     2,864.6       3,042.5       3,160.8  

Operating expenses(1)

     2,825.5       2,968.9       3,543.7  
                        

Operating income (loss)

     39.1       73.6       (382.9 )

Interest expense

     (88.7 )     (101.6 )     (98.7 )

Interest income

     6.5       9.9       4.1  

Other items, net

     (1.5 )     5.4       (4.2 )
                        

Income (loss) before income taxes

     (44.6 )     (12.7 )     (481.7 )

Benefit (provision) for income taxes(2)

     (29.6 )     76.4       (62.4 )
                        

Income (loss) before discontinued operations

     (74.2 )     63.7       (544.1 )

Income (loss) from discontinued operations, net of tax(3)

     0.4       (13.2 )     (39.8 )
                        

Net Income (loss)

   $ (73.8 )   $ 50.5     $ (583.9 )
                        

Cash Flow Data:

      

Cash flows provided by (used for) operating activities

   $ (56.2 )   $ 329.4     $ (70.5 )

Cash flows provided by (used for) investing activities

   $ 76.7     $ (41.0 )   $ (114.2 )

Cash flows provided by (used for) financing activities

   $ (241.0 )   $ (183.2 )   $ 138.3  

Other Data:

      

Depreciation and intangible amortization

   $ 185.7     $ 210.9     $ 224.3  

Impairment of goodwill and other long-lived assets

   $ 2.2     $ 5.1     $ 341.9  

Margins:

      

Rental margin(4)

     60.7 %     65.2 %     66.4 %

Merchandise margin(5)

     23.3 %     24.9 %     21.8 %

Gross margin(6)

     51.7 %     55.1 %     55.2 %

Worldwide Store Data:

      

Same-store revenues increase (decrease)(7)

     3.4 %     (2.1 )%     (4.8 )%

Company-operated stores at end of year

     6,073       6,551       7,158  

Franchised and joint venture stores at end of year

     1,757       1,809       1,884  

Total stores at end of year

     7,830       8,360       9,042  

 

     Total
Number
   Avg Selling
Sq. Footage
   Total Sq.
Footage
          (in thousands)    (in thousands)

Real Estate Data at January 6, 2008:

        

Domestic

        

Stores

   4,005    5.6    22,158

Distribution centers

   40    N/A    1,133

Corporate / regional offices

   12    N/A    420

International

        

Stores

   2,068    3.0    6,158

Distribution centers

   8    N/A    249

Corporate / regional offices

   8    N/A    127

 

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(1) Operating expenses include (a) non-cash charges to impair goodwill and other long-lived assets in accordance with SFAS 142 and SFAS 144 totaling approximately $2.2 million, $5.1 million and $341.9 million for fiscal years 2007, 2006 and 2005, respectively, and (b) a gain on sale of Gamestation of $81.5 million for fiscal 2007.
(2) The benefit for income taxes in 2006 mainly relates to a benefit recorded in the first and second quarters of 2006 from the resolution of multi-year income tax audits. The provision for income taxes in 2005 includes a valuation allowance recorded on our deferred tax assets in various jurisdictions. See Note 9 to our consolidated financial statements.

(3)

During 2006, Blockbuster completed the divestiture of Movie Brands Inc. and MOVIE TRADING CO. in addition to closing all of its store locations in Spain. During January 2007, Blockbuster also completed the sale of RHINO VIDEO GAMES. In accordance with SFAS No. 144, these operations have been classified as discontinued operations.

(4) Rental gross profit (rental revenues less cost of rental revenues) as a percentage of rental revenues.
(5) Merchandise gross profit (merchandise sales less cost of merchandise sold) as a percentage of merchandise sales.
(6) Gross profit as a percentage of total revenues.
(7) A store is included in the same-store revenues calculation after it has been opened and operated by us for more than 52 weeks. An acquired store becomes part of the same-store base in the 53rd week after its acquisition and conversion. The percentage change is computed by comparing total net revenues for same-stores at the end of the applicable reporting period with total net revenues from these same-stores for the comparable period in the prior year. The same-store revenues calculation does not include the impact of foreign exchange. Due to the integrated nature of the online pass, revenues generated from our online rental service have been and will continue to be included in total same-store rental revenues.

Segments

Beginning in the fourth quarter of fiscal 2007, we operate our business in two reportable segments: Domestic and International. We identify segments based on how management makes operating decisions, assesses performance and allocates resources.

 

   

The Domestic segment is comprised of all U.S. store operations and by-mail subscription service operations in addition to the digital delivery of movies through Movielink. As of January 6, 2008, we had 4,855 stores operating under the BLOCKBUSTER brand in the United States and its territories. Of these stores, 850 stores were operated through our franchisees.

 

 

 

The International segment is comprised of all non-U.S. store operations including operations in Europe, Latin America, Australia, Canada, Mexico and Asia. As of January 6, 2008, we had 2,975 stores operating under the BLOCKBUSTER brand and other brand names owned by us located in 21 markets outside of the United States. Of these stores, 907 stores were operated through our franchisees. In the Republic of Ireland and Northern Ireland, we operate under the XTRA-VISION® brand name due to its strong local brand awareness. In Canada, Italy, Mexico and Denmark, we also operate freestanding and store-in-store game locations under the GAME RUSH brand. During 2007, we sold our freestanding game locations which operated under the brand name GAMESTATION® and we retained 34 Gamestation locations that operate as a “store-in-store” within BLOCKBUSTER stores. Additionally, during 2006 and 2007, we sold our Taiwanese and Australian subsidiaries, respectively, each coupled with a master franchise license. The results of Gamestation, Taiwan and Australia have been included in continuing operations through the period in which they were sold.

 

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The following table is a summary of operating income (loss) by business segment.

 

     Domestic
Segment
   International
Segment
    Unallocated /
Corporate
    Total  

Statement of Operations Data:

         

Fiscal Year Ended January 6, 2008

         

Revenues

   $ 3,607.9    $ 1,934.5     $ —       $ 5,542.4  

Cost of sales

     1,638.9      1,038.9       —         2,677.8  
                               

Gross profit

     1,969.0      895.6       —         2,864.6  

Operating expenses

     1,907.9      734.7       182.9       2,825.5  
                               

Operating income (loss)

   $ 61.1    $ 160.9     $ (182.9 )   $ 39.1  
                               

Fiscal Year Ended December 31, 2006 (as restated)

         

Revenues

   $ 3,617.2    $ 1,905.0     $ —       $ 5,522.2  

Cost of sales

     1,452.5      1,027.2       —         2,479.7  
                               

Gross profit

     2,164.7      877.8       —         3,042.5  

Operating expenses

     1,930.9      833.9       204.1       2,968.9  
                               

Operating income (loss)

   $ 233.8    $ 43.9     $ (204.1 )   $ 73.6  
                               

Fiscal Year Ended December 31, 2005 (as restated)

         

Revenues

   $ 3,860.6    $ 1,861.2     $ —       $ 5,721.8  

Cost of sales

     1,596.5      964.5       —         2,561.0  
                               

Gross profit

     2,264.1      896.7       —         3,160.8  

Operating expenses

     2,129.4      1,175.5       238.8       3,543.7  
                               

Operating income (loss)

   $ 134.7    $ (278.8 )   $ (238.8 )   $ (382.9 )
                               

 

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Comparison of Fiscal 2007 to 2006

Domestic Segment. The following table is a summary of domestic results of operations.

 

     Fiscal Year Ended
January 6, 2008
    Fiscal Year Ended
December 31, 2006
    Increase/
(Decrease)
 
     Amount    Percent of
Revenue
    Amount    Percent of
Revenue
    Dollar     Percent  
     (As restated)  

Revenues:

              

Rental revenues

              

Base movie rental

   $ 1,862.9    51.7 %   $ 2,111.5    58.3 %   $ (248.6 )   (11.8 )%

Base game rental

     220.6    6.1 %     246.4    6.8 %     (25.8 )   (10.5 )%

Subscription rental

     526.4    14.6 %     248.3    6.9 %     278.1     112.0 %

Previously rented product (“PRP”)

     527.3    14.6 %     494.8    13.7 %     32.5     6.6 %
                                    

Total rental revenues

     3,137.2    87.0 %     3,101.0    85.7 %     36.2     1.2 %
                                    

Merchandise sales

              

Movie sales

     221.2    6.1 %     234.7    6.5 %     (13.5 )   (5.8 )%

Game sales

     47.4    1.3 %     77.5    2.1 %     (30.1 )   (38.8 )%

General merchandise sales

     177.9    4.9 %     161.6    4.5 %     16.3     10.1 %
                                    

Total merchandise sales

     446.5    12.3 %     473.8    13.1 %     (27.3 )   (5.8 )%
                                    

Royalties and other

     24.2    0.7 %     42.4    1.2 %     (18.2 )   (42.9 )%
                                    

Total revenues

     3,607.9    100.0 %     3,617.2    100.0 %     (9.3 )   (0.3 )%
                                    

Cost of sales:

              

Cost of rental revenues

     1,314.3    36.4 %     1,111.5    30.7 %     202.8     18.2 %

Cost of merchandise sold

     324.6    9.0 %     341.0    9.5 %     (16.4 )   (4.8 )%
                                    
     1,638.9    45.4 %     1,452.5    40.2 %     186.4     12.8 %
                                    

Gross profit

     1,969.0    54.6 %     2,164.7    59.8 %     (195.7 )   (9.0 )%
                                    

Operating expenses:

              

General and administrative
Stores

     1,547.8    42.9 %     1,557.7    43.0 %     (9.9 )   (0.6 )%

Corporate and field

     85.0    2.4 %     117.7    3.3 %     (32.7 )   (27.8 )%
                                    

Total general and administrative

     1,632.8    45.3 %     1,675.4    46.3 %     (42.6 )   (2.5 )%
                                    

Advertising

     150.5    4.2 %     118.7    3.3 %     31.8     26.8 %

Depreciation and intangible amortization

     122.4    3.3 %     136.8    3.8 %     (14.4 )   (10.5 )%

Impairment of goodwill and other long-lived assets

     2.2    0.1 %     —      —         2.2     —    
                                    
     1,907.9    52.9 %     1,930.9    53.4 %     (23.0 )   (1.2 )%
                                    

Operating income (loss)

   $ 61.1    1.7 %   $ 233.8    6.4 %   $ (172.7 )   (73.9 )%
                                    

 

     Fiscal Year Ended
January 6, 2008
 

Same-store revenues increase/(decrease)

  

Total

  

Rental revenues

   2.6 %

Merchandise revenues

   (3.7 )%

Total revenues

   1.7 %

Store only

  

Rental revenues

   (7.2 )%

Merchandise revenues

   (3.7 )%

Total revenues

   (6.9 )%

 

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Rental revenues

 

   

We focused on driving BLOCKBUSTER Total Access subscriber growth early in fiscal 2007, which significantly increased subscription revenues.

 

   

Base movie rental revenues decreased due to the transition of in-store only customers to BLOCKBUSTER Total Access customers who transact both online and in-store. Additionally, the in-store movie rental industry remained under pressure during 2007. Although we expect the in-store movie rental industry to remain under pressure in 2008, we believe that our initiatives to maximize product availability of new releases, simplify pricing terms, improve customer service, obtain exclusive content and innovatively merchandise our product offerings will help at least partially offset these negative trends.

 

   

Base game rentals decreased as the rentals of older game platforms declined more than the growth of rentals in the next-generation game platforms. We expect this trend to improve in 2008 as we focus on increasing the quantity of next-generation game rental inventory in our stores.

 

   

PRP revenues increased due primarily to an increase of 8.5% in same-store sales for movie PRP.

Merchandise sales

 

   

Game sales, including sales of new and traded game software, hardware consoles and accessories, decreased due primarily to a reduction in our retail game inventory which led to a 37.2% decrease in same-store game sales for 2007.

 

   

The increase in general merchandise sales was driven by an increase in both confection and licensed merchandise sales.

Royalties and other revenues

 

   

Royalties and fees received from our franchisees decreased $10.4 million due to:

 

   

a reduction in royalty rates charged to franchisees during 2007 and

 

   

a decrease in total revenues generated by our franchisees.

 

   

In-store advertising sales decreased $8.7 million.

Cost of sales and Gross profit

 

   

Rental gross margin decreased from 64.2% in 2006 to 58.1% in 2007 primarily due to an increase in cost of sales associated with the purchase of additional movie rental product to support BLOCKBUSTER Total Access.

 

   

Merchandise gross margin of 27.3% for 2007 remained relatively flat from 2006.

Operating expenses

 

   

Stores general and administrative expense, which includes expenses incurred both in-store and online:

 

   

decreased due to the closure of company-owned stores;

 

   

increased due to the impact of the 53rd week;

 

   

increased due to $9.6 million lower gains recognized during 2007 from sales of store operations and property and equipment; and

 

   

increased due to the increase in costs associated with the growth of BLOCKBUSTER Total Access.

 

   

Corporate and field general and administrative expense, which includes expenses incurred at the field and regional levels for store operations, decreased due primarily to:

 

   

lower bonus expense in 2007 and

 

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our continued cost reduction efforts in 2007.

 

   

Advertising expense, which includes online subscriber acquisition costs, increased primarily due to the increase in our advertising spend during the first quarter of 2007 to support BLOCKBUSTER Total Access.

 

   

Depreciation and intangible amortization decreased primarily due to certain store assets becoming fully depreciated in 2007 as well as decreased store count.

International Segment. The following table is a summary of international results of operations.

 

     Fiscal Year Ended
January 6, 2008
    Fiscal Year Ended
December 31, 2006
    Increase/
(Decrease)
 
     Amount     Percent of
Revenue
    Amount    Percent of
Revenue
    Dollar     Percent  
     (As restated)  

Revenues:

             

Rental revenues

             

Base movie rental

   $ 756.9     39.1 %   $ 745.1    39.1 %   $ 11.8     1.6 %

Base game rental

     59.4     3.1 %     61.8    3.2 %     (2.4 )   (3.9 )%

Previously rented product (“PRP”)

     129.0     6.7 %     121.2    6.4 %     7.8     6.4 %
                                     

Total rental revenues

     945.3     48.9 %     928.1    48.7 %     17.2     1.9 %
                                     

Merchandise sales

             

Movie sales

     222.9     11.5 %     205.9    10.8 %     17.0     8.3 %

Game sales

     549.1     28.4 %     587.9    30.9 %     (38.8 )   (6.6 )%

General merchandise sales

     181.6     9.4 %     164.3    8.6 %     17.3     10.5 %
                                     

Total merchandise sales

     953.6     49.3 %     958.1    50.3 %     (4.5 )   (0.5 )%
                                     

Royalties and other

     35.6     1.8 %     18.8    1.0 %     16.8     89.4 %
                                     

Total revenues

     1,934.5     100.0 %     1,905.0    100.0 %     29.5     1.5 %
                                     

Cost of sales:

             

Cost of rental revenues

     289.7     15.0 %     292.4    15.3 %     (2.7 )   (0.9 )%

Cost of merchandise sold

     749.2     38.7 %     734.8    38.6 %     14.4     2.0 %
                                     
     1,038.9     53.7 %     1,027.2    53.9 %     11.7     1.1 %
                                     

Gross profit

     895.6     46.3 %     877.8    46.1 %     17.8     2.0 %
                                     

Operating expenses:

             

General and administrative
Stores

     616.1     31.9 %     610.8    32.1 %     5.3     0.9 %

Corporate and field

     108.7     5.6 %     122.0    6.4 %     (13.3 )   (10.9 )%
                                     

Total general and administrative

     724.8     37.5 %     732.8    38.5 %     (8.0 )   (1.1 )%
                                     

Advertising

     43.5     2.2 %     35.6    1.9 %     7.9     22.2 %

Depreciation and intangible amortization

     47.9     2.5 %     60.4    3.1 %     (12.5 )   (20.7 )%

Gain on sale of Gamestation

     (81.5 )   (4.2 )%     —      —         (81.5 )   —    

Impairment of goodwill and other long-lived assets

     —       —         5.1    0.3 %     (5.1 )   (100.0 )%
                                     
     734.7     38.0 %     833.9    43.8 %     (99.2 )   (11.9 )%
                                     

Operating income (loss)

   $ 160.9     8.3 %   $ 43.9    2.3 %   $ 117.0     266.5 %
                                     

 

     Fiscal Year Ended
January 6, 2008
 

Same-store revenues increase/(decrease)(1)

  

Rental revenues

   (2.8 )%

Merchandise revenues

   23.3 %

Total revenues

   7.5 %

 

(1) Changes in international same-store revenues do not include the impact of foreign exchange.

 

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Rental revenues

 

   

Favorable foreign currency exchange impact of $60.4 million.

 

   

Same-store base game rental revenues decreased 11.0% driven primarily by our U.K. operations as they shifted their focus to selling new games.

Merchandise sales

 

   

Favorable foreign currency exchange impact of $73.9 million.

 

   

Game sales, including sales of new and traded game software, hardware consoles and accessories:

 

   

decreased due to the sale of Gamestation in second quarter of 2007;

 

   

increased due to an increase of 65.9% in same-store game sales driven by continued demand for new and traded games in various markets, resulting mainly from the introduction of next-generation game platforms during the first quarter of 2007; and

 

   

increased due to favorable foreign currency exchange.

 

   

General merchandise sales, which include sales of confections, other movie and game-related products and product sales to franchisees increased primarily due to favorable foreign currency exchange.

Royalties and other revenues

 

   

We received $20 million of termination fees in the first quarter of 2007 in connection with the termination of our franchise agreement with our franchisee in Brazil and $5 million in connection with a subsequent license agreement in Brazil during the second quarter of 2007.

Cost of sales and Gross Profit

 

   

Unfavorable foreign currency exchange impact of $76.5 million.

 

   

Merchandise gross margin decreased from 23.3% in 2006 to 21.4% in 2007. The decrease in merchandise gross margin and increase in cost of merchandise sold is due primarily to the mix of our DVD and games sales shifting from higher margin used products to the lower margin new products.

 

   

Rental gross margin of 69.3% for 2007 remained relatively flat from 2006.

Operating expenses

 

   

Unfavorable foreign currency exchange impact of $52.1 million.

 

   

General and administrative expenses remained relatively flat because the costs savings associated with the sale of Gamestation and the closure of company-stores was offset by unfavorable foreign currency exchange and the impact of the 53rd week.

 

   

Advertising expense increased due to:

 

   

several markets increasing their advertising spend to promote sales of merchandise inventory, and

 

   

unfavorable foreign currency exchange.

 

   

Depreciation and intangible amortization expense decreased due to the sale of Gamestation and the closure of company-owned stores.

 

   

In 2007, we recorded $81.5 million gain on the sale of Gamestation and $6.3 million gain on the sale of operations in Australia, which is recorded as a reduction to “General and administrative” expenses.

 

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Unallocated Corporate. The following table is a summary of corporate operating expenses that are not allocated to either business segment.

 

     Fiscal Year Ended    Increase/ (Decrease)  
     January 6,
2008
   December 31,
2006
   Dollar     Percent  
          (As restated)             

General and administrative

   $ 167.5    $ 190.4    $ (22.9 )   (12.0 )%

Depreciation and intangible amortization

     15.4      13.7      1.7     12.4 %
                        

Operating expenses

   $ 182.9    $ 204.1    $ (21.2 )   (10.4 )%
                        

 

   

General and administrative expenses decreased primarily due to:

 

   

lower bonus expense in 2007;

 

   

lower stock-based compensation expense in 2007; and

 

   

continued cost-savings efforts.

Additional Consolidated Results.

 

   

Interest expense decreased primarily due to lower average outstanding debt balances during 2007 than 2006.

 

   

Interest income decreased due to lower average cash balances.

 

   

Benefit (provision) for income taxes for 2006 included a tax benefit of $111.9 million resulting from the resolution of multi-year income tax audits. The $111.9 million benefit is reflected as a $97.9 million tax benefit in “Benefit (provision) for income taxes” and a $14.0 million tax benefit within “Income (loss) from discontinued operations.”

 

   

Income (loss) from discontinued operations for 2007 primarily contains the results of operations for RHINO. The 2006 amounts contain the results of operations for Spain, MTC, MBI, and RHINO.

 

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Table of Contents

Comparison of 2006 to 2005

Domestic Segment. The following table is a summary of domestic results of operations.

 

     Fiscal Year Ended
December 31, 2006
    Fiscal Year Ended
December 31, 2005
    Increase/
(Decrease)
 
     Amount    Percent of
Revenue
    Amount    Percent of
Revenue
    Dollar     Percent  
     (As restated)     (As restated)              

Revenues:

              

Rental revenues

              

Base movie rental

   $ 2,111.5    58.3 %   $ 2,256.8    58.5 %   $ (145.3 )   (6.4 )%

Base game rental

     246.4    6.8 %     305.0    7.9 %     (58.6 )   (19.2 )%

Subscription rental

     248.3    6.9 %     143.0    3.7 %     105.3     73.6 %

Previously rented product (“PRP”)

     494.8    13.7 %     461.1    11.9 %     33.7     7.3 %
                                    

Total rental revenues

     3,101.0    85.7 %     3,165.9    82.0 %     (64.9 )   (2.0 )%
                                    

Merchandise sales

              

Movie sales

     234.7    6.5 %     329.0    8.5 %     (94.3 )   (28.7 )%

Game sales

     77.5    2.1 %     144.7    3.8 %     (67.2 )   (46.4 )%

General merchandise sales

     161.6    4.5 %     166.4    4.3 %     (4.8 )   (2.9 )%
                                    

Total merchandise sales

     473.8    13.1 %     640.1    16.6 %     (166.3 )   (26.0 )%
                                    

Royalties and other

     42.4    1.2 %     54.6    1.4 %     (12.2 )   (22.3 )%
                                    

Total revenues

     3,617.2    100.0 %     3,860.6    100.0 %     (243.4 )   (6.3 )%
                                    

Cost of sales:

              

Cost of rental revenues

     1,111.5    30.7 %     1,083.9    28.1 %     27.6     2.5 %

Cost of merchandise sold

     341.0    9.5 %     512.6    13.3 %     (171.6 )   (33.5 )%
                                    
     1,452.5    40.2 %     1,596.5    41.4 %     (144.0 )   (9.0 )%
                                    

Gross profit

     2,164.7    59.8 %     2,264.1    58.6 %     (99.4 )   (4.4 )%
                                    

Operating expenses:

              

General and administrative
Stores

     1,557.7    43.0 %     1,629.8    42.2 %     (72.1 )   (4.4 )%

Corporate and field

     117.7    3.3 %     143.3    3.7 %     (25.6 )   (17.9 )%
                                    

Total general and administrative

     1,675.4    46.3 %     1,773.1    45.9 %     (97.7 )   (5.5 )%
                                    

Advertising

     118.7    3.3 %     204.6    5.3 %     (85.9 )   (42.0 )%

Depreciation and intangible amortization

     136.8    3.8 %     150.8    3.9 %     (14.0 )   (9.3 )%

Impairment of goodwill and other long-lived assets

     —      —         0.9    0.0 %     (0.9 )   (100.0 )%
                                    
     1,930.9    53.4 %     2,129.4    55.1 %     (198.5 )   (9.3 )%
                                    

Operating income (loss)

   $ 233.8    6.4 %   $ 134.7    3.5 %   $ 99.1     73.6 %
                                    

 

     Fiscal Year Ended
December 31, 2006
 

Same-store revenues increase/(decrease)

  

Store and online

  

Rental revenues

   1.1 %

Merchandise revenues

   (24.2 )%

Total revenues

     (3.3 )%

Store only

  

Rental revenues

     (2.7 )%

Merchandise revenues

   (24.2 )%

Total revenues

     (6.6 )%

 

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Rental revenues

 

   

We focused on driving BLOCKBUSTER Total Access subscriber growth in 2006, which significantly increased subscription revenues.

 

   

Base movie rental revenues decreased due to the transition of in-store only customers to BLOCKBUSTER Total Access customers who transact both online and in-store. Additionally, the in-store movie rental industry remained under pressure during 2006.

 

   

Base game rental revenues decreased primarily due to the closure of company-owned stores and the decline in same-store base game rental revenues. The decline in same-store base game rental revenues resulted from:

 

   

release of fewer quality game titles during 2006;

 

   

decrease in our marketing of game concepts;

 

   

tendency of early adopters to buy versus rent; and

 

   

low penetration of next-generation game platforms which were released during late 2005 and 2006.

 

   

PRP revenues increased due primarily to increased promotional activity around our PRP offerings.

Merchandise sales

 

   

Reduction in movie sales resulted from:

 

   

closure of company-owned stores;

 

   

reduction of lower margin merchandise inventory in an effort to shift our resources towards higher margin products; and

 

   

continued competition from retail mass merchant sales of low-priced DVDs.

 

   

The decline in game sales resulted from:

 

   

closure of company-owned stores;

 

   

reduction of lower margin merchandise inventory in an effort to shift our resources towards higher margin products;

 

   

decrease in marketing activities surrounding our game concepts; and

 

   

release of fewer quality game titles during 2006.

Royalties and other revenues

 

   

Decreased due mainly to lower advertising sales since 2005.

Cost of sales and Gross profit

 

   

Rental gross margin of 64.2% for 2006 decreased from 65.8% for 2005 due to increased purchases of movie rental product to support BLOCKBUSTER Total Access.

 

   

Merchandise gross margin increased from 19.9% to 28.0% primarily due to:

 

   

a reduction in our promotional pricing activity around our new movies and games, and

 

   

a shift in revenues from lower margin new movie and game sales towards higher margin retail offerings, including traded games and general merchandise sales.

 

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Table of Contents

Operating expenses

 

   

Stores general and administrative expenses, which includes expenses incurred both in-store and online:

 

   

decreased due to closure of company-owned stores;

 

   

decreased due to our cost reduction efforts which focused on the optimization of store labor hours;

 

   

decreased due to increased gains recorded during 2006 from sales of store operations and property and equipment; and

 

   

increased due to an increase in lease termination costs incurred in connection with our store closures in 2006.

 

   

Corporate and field general and administrative expenses, which includes expenses incurred at the field and regional level for store operations:

 

   

decreased due to our cost-savings measures and a reduction in the number of employees; and

 

   

increased due to higher bonus expense in 2006 due to improved profitability year-over-year.

 

   

Advertising expense, which includes online subscriber acquisition costs, decreased due to:

 

 

 

advertising costs incurred for the national launch of our “no late fees” and LIFE AFTER LATE FEES® campaigns during 2005; and

 

   

decreased advertising of in-store promotions.

 

   

Depreciation and intangible amortization:

 

   

decreased primarily due to reduced capital expenditures and the closure of company-owned stores during 2006, and

 

   

slightly increased due to depreciation acceleration for future store closures.

 

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International Segment. The following table is a summary of international results of operations detailing revenue by product category.

 

     Fiscal Year Ended
December 31, 2006
    Fiscal Year Ended
December 31, 2005
    Increase/(Decrease)  
     Amount    Percent of
Revenue
    Amount     Percent of
Revenue
    Dollar     Percent  
     (As restated)     (As restated)              

Revenues:

             

Rental revenues

             

Base movie rental

   $ 745.1    39.1 %   $ 794.2     42.7 %   $ (49.1 )   (6.2 )%

Base game rental

     61.8    3.2 %     71.2     3.8 %     (9.4 )   (13.2 )%

Previously rented product (“PRP”)

     121.2    6.4 %     129.4     7.0 %     (8.2 )   (6.3 )%
                                     

Total rental revenues

     928.1    48.7 %     994.8     53.5 %     (66.7 )   (6.7 )%
                                     

Merchandise sales

             

Movie sales

     205.9    10.8 %     209.3     11.2 %     (3.4 )   (1.6 )%

Game sales

     587.9    30.9 %     475.1     25.6 %     112.8     23.7 %

General merchandise sales

     164.3    8.6 %     164.4     8.8 %     (0.1 )   (0.1 )%
                                     

Total merchandise sales

     958.1    50.3 %     848.8     45.6 %     109.3     12.9 %
                                     

Royalties and other

     18.8    1.0 %     17.6     0.9 %     1.2     6.8 %
                                     

Total revenues

     1,905.0    100.0 %     1,861.2     100.0 %     43.8     2.4 %
                                     

Cost of sales:

             

Cost of rental revenues

     292.4    15.3 %     312.7     16.8 %     (20.3 )   (6.5 )%

Cost of merchandise sold

     734.8    38.6 %     651.8     35.0 %     83.0     12.7 %
                                     
     1,027.2    53.9 %     964.5     51.8 %     62.7     6.5 %
                                     

Gross profit

     877.8    46.1 %     896.7     48.2 %     (18.9 )   (2.1 )%
                                     

Operating expenses:

             

General and administrative
Stores

     610.8    32.1 %     611.8     32.9 %     (1.0 )   (0.2 )%

Corporate and field

     122.0    6.4 %     114.9     6.2 %     7.1     6.2 %
                                     

Total general and administrative

     732.8    38.5 %     726.7     39.1 %     6.1     0.8 %
                                     

Advertising

     35.6    1.9 %     46.2     2.5 %     (10.6 )   (22.9 )%

Depreciation and intangible amortization

     60.4    3.1 %     61.6     3.3 %     (1.2 )   (1.9 )%

Impairment of goodwill and other long-lived assets

     5.1    0.3 %     341.0     18.3 %     (335.9 )   (98.5 )%
                                     
     833.9    43.8 %     1,175.5     63.2 %     (341.6 )   (29.1 )%
                                     

Operating income (loss)

   $ 43.9    2.3 %   $ (278.8 )   (15.0 )%   $ 322.7     (115.7 )%
                                     

 

     Fiscal Year Ended
December 31, 2006
 

Same-store revenues increase/(decrease)(1)

  

Rental revenues

   (7.4 )%

Merchandise revenues

   9.7 %

Total revenues

   0.4 %

 

(1) Changes in international same-store revenues do not include the impact of foreign exchange.

 

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Rental revenues

 

   

Favorable foreign currency exchange impact of $21.8 million.

 

   

Base movie rental revenues decreased due to continued significant negative industry trends in selected markets and a growing rate of piracy.

 

   

Base game rental revenues declined due to:

 

   

release of fewer quality game titles during 2006;

 

   

the tendency of early adopters to buy versus rent; and

 

   

the low penetration of next-generation game platforms which were released during late 2005 and 2006.

Merchandise sales

 

   

Favorable foreign currency impact of $21.6 million.

 

   

Same-store game sales, including sales of new and traded game software, hardware consoles and accessories, increased 19.3% due to continued strong results from our freestanding Gamestation stores and from the demand for new and traded games internationally.

Cost of sales and Gross profit

 

   

Gross margins remained relatively flat between 2007 and 2006 for rental revenues and merchandise sales.

Operating expenses

 

   

Advertising expense decreased primarily due to decreased advertising in the United Kingdom.

 

   

We recognized $332.0 million of goodwill impairment charges on our international segment in 2005.

Unallocated Corporate. The following table is a summary of corporate operating expenses that are not allocated to either business segment.

 

     Fiscal Year Ended    Increase/(Decrease)  
     December 31,
2006
   December 31,
2005
   Dollar     Percent  
     (As restated)    (As restated)             

General and administrative

   $ 190.4    $ 225.0    $ (34.6 )   (15.4 )%

Advertising

     —        1.9      (1.9 )   (100.0 )%

Depreciation and intangible amortization

     13.7      11.9      1.8     15.1 %
                        

Operating expenses

   $ 204.1    $ 238.8    $ (34.7 )   (14.5 )%
                            

 

   

General and administrative expenses decreased due primarily to:

 

   

lower stock-based compensation expense in 2006, and

 

   

professional fees recognized for the Hollywood Entertainment Corporation acquisition costs during 2005.

Additional Consolidated Results

 

   

Interest expense increased due to higher rates on our variable rate debt.

 

   

Interest income increased due to:

 

   

higher cash balances during 2006, and

 

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$2.7 million additional income resulting from the favorable resolution of multi-year income tax audits.

 

   

Benefit (provision) for income taxes:

 

   

In 2006, we recognized a tax benefit of $111.9 million resulting from the resolution of multi-year income tax audits. The $111.9 million benefit is reflected as a $97.9 million tax benefit in “Benefit (provision) for income taxes” and a $14.0 million tax benefit within “Income (loss) from discontinued operations”.

 

   

In 2005, we recognized a provision of $62.4 million primarily as a result of a valuation allowance recorded on our deferred tax assets.

 

   

Income (loss) from discontinued operations:

 

   

In 2006, we recognized a $14.0 million tax benefit in connection with the resolution of multi-year income tax audits.

 

   

In 2005, we recognized impairment charges to write down the value of certain goodwill and long-lived assets.

 

   

In 2005, we also recognized a tax provision as a result of a valuation allowance recorded on our deferred tax assets.

Liquidity and Capital Resources

General

We generate cash from operations predominately from the rental and retail sale of movies and games and most of our revenue is received in cash and cash equivalents. Working capital requirements, including rental library purchases, and normal capital expenditures are generally funded with cash from operations. We expect cash on hand, cash from operations and available borrowings under our revolving credit facility to be sufficient to fund the anticipated cash requirements for working capital purposes, including rental library purchases, and capital expenditures under our normal operations as well as commitments and payments of principal and interest on our borrowings and dividends on our 7 1/2% Series A cumulative convertible perpetual preferred stock (the “Series A convertible preferred stock”) for at least the next twelve months.

As discussed in Note 8 to the consolidated financial statements, our outstanding debt and our ability to borrow additional funds under our credit facilities are subject to compliance with various covenants. We expect to be in compliance with these covenants over the next twelve months. However, our substantial indebtedness and the declining in-store rental industry in which we operate could adversely affect our ability to comply with these covenants. Further, uncertainty surrounding our industry may impact our ability to finance our obligations and may cause some of our creditors to impose unfavorable terms. See further discussion of these risks under “Item 1A. Risk Factors.” Adverse future developments affecting our pending legal proceedings and other contingencies may also have a material adverse impact on our liquidity. See Note 10 to the consolidated financial statements for further discussion of these items.

In 2007 we reduced our debt associated with our credit facilities by $214.1 million. The debt payments were comprised of $20.4 million of scheduled payments under the terms of our credit agreement, an excess cash flow payment of $45.4 million as required by our credit agreement and $148.3 million of prepayments primarily related to the sale of assets. We believe the changes we have implemented in our business will continue to provide us with improved financial flexibility.

 

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Contractual Obligations

As described more fully in Notes 8 and 10 to the consolidated financial statements, at January 6, 2008, our contractual obligations, were as follows:

 

Contractual Obligations(1)

   < 1 Year    1-3 Years    3-5 Years    After 5 Years    Total

Operating leases

   $ 542.6    $ 754.1    $ 357.7    $ 408.5    $ 2,062.9

Capital lease obligations(2)

     13.4      20.6      12.3      14.5      60.8

Purchase obligations(3)

     225.4      46.3      28.5      15.8      316.0

Revenue-sharing obligations(4)

     114.6      —        —        —        114.6

Long-term debt

     44.7      220.4      445.2      —        710.3

Interest expense on long-term debt(5)

     64.3      111.1      53.2      —        228.6

Preferred stock dividends(6)

     11.3      22.5      22.5      —        56.3
                                  
   $ 1,016.3    $ 1,175.0    $ 919.4    $ 438.8    $ 3,549.5
                                  

 

(1) Due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at January 6, 2008, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authority. Therefore, $1.9 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 9 to the Consolidated Financial Statements for a discussion on income taxes.

 

(2) Includes both principal and interest.

 

(3) Purchase obligations include agreements to purchase goods or services as of January 6, 2008 that are legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. Purchase obligations that can be cancelled without penalty have been excluded. In addition, these amounts exclude revenue-sharing obligations, which are included on the “Revenue-sharing obligations” line above, and outstanding accounts payable or accrued liabilities. For information about outstanding accounts payable and accrued liabilities, see the Consolidated Balance Sheets and Note 6 to the consolidated financial statements.

 

(4) As of January 6, 2008, we were a party to revenue-sharing arrangements with various studios that expire between January 2007 and January 2011. These contracts include minimum purchase requirements, based upon the box office results of the title, at a lower initial product cost as compared to traditional purchases. In addition, these contracts require net rental revenues to be shared with the studios over an agreed upon period of time. We have included an estimate of our contractual obligation under these agreements for minimum purchase requirements and performance guarantees for the period in which they can reasonably be estimated, which is usually two to four months in the future. Although these contracts may extend beyond the estimated two to four month period, we cannot reasonably estimate these amounts due to the uncertainty of purchases that will be made under these agreements. The amounts presented above do not include revenue-sharing accruals for rental revenues recorded during fiscal 2007. For information on revenue-sharing accruals for fiscal 2007 and 2006, see Note 6 to the consolidated financial statements.

 

(5) As of January 6, 2008, $410.3 million of our long-term debt outstanding under our senior secured credit facility was subject to variable rates of interest. Interest expense on these variable rate borrowings for future years was calculated using a weighted-average interest rate of 9.1% based on the LIBOR rate in effect at January 6, 2008.

 

(6) Our shares of preferred stock do not mature; therefore, amounts are provided for the next five years only.

Capital Structure

On August 20, 2004, we entered into $1,150.0 million in senior secured credit facilities with a syndicate of lenders (the “Credit Facilities”), consisting of (i) a five-year $500.0 million revolving credit facility, of which $150.0 million is reserved for issuance of the Viacom Letters of Credit, described in Note 8 to the consolidated financial statements; (ii) a five-year $100.0 million term loan A facility; and (iii) a seven-year $550.0 million term loan B facility, and we issued $300.0 million aggregate principal amount of 9% senior subordinated notes

 

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due 2012 (the “Senior Subordinated Notes”). These borrowings are described in Note 8 to the consolidated financial statements. Proceeds from the Credit Facilities and the Senior Subordinated Notes were used (i) to fund the payment of the special distribution in August 2004; (ii) to finance transaction costs and expenses in connection with our divestiture from Viacom and the special distribution; (iii) to repay amounts outstanding under our prior credit agreement; and (iv) for working capital and other general corporate purposes.

During 2005, we and the syndicate of lenders for the Credit Facilities amended the credit agreement in certain respects. As part of the amendments, our obligations with respect to maintaining a maximum leverage ratio and maintaining a minimum fixed charge coverage ratio were amended. The amendment entered into on August 8, 2005 provided for a waiver of the then current second and third quarter 2005 leverage ratio covenant and the then current third quarter 2005 fixed charge coverage covenant. Without the benefit of the lender’s waiver of the leverage ratio covenant during the second and third quarters of 2005 that was contained in such amendment, we would have been in default of such covenant. In connection with such amendment, the applicable interest rate margin for borrowings under the Credit Facilities increased 50 basis points through the end of the waiver period. We paid a standard amendment fee in connection with the 2005 amendments.

In conjunction with our $150.0 million Series A convertible preferred stock offering, on November 4, 2005, we entered into another amendment to the credit agreement (the “third amendment”) with our lenders to modify the financial covenants and make other modifications. Upon the effectiveness of the third amendment, the interim waiver period provisions contained in the prior amendment ceased to be in effect and certain changes to the credit agreement became effective and, to the extent previously contained in the waiver period provisions of the prior amendment, permanent.

On April 18, 2007, we entered into an amendment to our amended and restated credit agreement which provided for additional sales, transfers or other dispositions of assets with a cumulative aggregate fair market value of up to $150 million, and required us to make prepayments on the Credit Facilities in an amount equal to 100% of the net proceeds received from such additional sales, transfers or other dispositions of assets.

On July 2, 2007, we entered into an additional amendment (the “Second Amendment”) to our amended and restated credit agreement which became effective on July 13, 2007 and which:

 

   

accelerated reductions in the revolving commitments that were previously scheduled to occur on October 1, 2007 and January 1, 2008, which effectively reduced the total amount of the revolving commitments from $500 million to $450 million;

 

   

modified the applicable interest rate margins;

 

   

amended the definition of Consolidated EBITDA;

 

   

amended the asset sale baskets and the related mandatory prepayment requirements;

 

   

provided for a premium of 1.0% in the event of certain refinancings through April 6, 2008;

 

   

deferred the applicability of the Fixed Charge Coverage Ratio and Leverage Ratio requirements from fiscal 2008 to fiscal 2009;

 

   

provided for a one-time fee payable by the Company to the administrative agent, for the accounts of the lenders, in an amount equal to (a) 0.25% of the aggregate amount of revolving commitments and outstanding term loans on April 6, 2008, if the Leverage Ratio on such date exceeds 3.00 to 1.00 but does not exceed 3.50 to 1.00 or (b) 0.50% of the aggregate amount of revolving commitments and outstanding term loans on April 6, 2008, if the Leverage Ratio on such date exceeds 3.50 to 1.00;

 

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amended the Consolidated EBITDA requirements such that we may not permit Consolidated EBITDA for any period of four consecutive fiscal quarters to be less than (a) $140 million for the periods ending July 1, 2007 and September 30, 2007, (b) $165 million for the period ending January 6, 2008, (c) $180 million for the period ending April 6, 2008, (d) $200 million for the period ending July 6, 2008, (e) $225 million for the period ending October 5, 2008, and (f) $250 million for the period ending January 4, 2009; and

 

   

waived any default resulting from our failure to comply with the Consolidated EBITDA requirement with respect to the period of four consecutive fiscal quarters ending July 1, 2007.

The Credit Facilities currently require compliance with a minimum EBITDA covenant through January 4, 2009, a maximum capital expenditure covenant for the remaining term of the credit agreement and maximum leverage ratio and minimum fixed charge coverage ratio covenants from 2009 through 2011. Additionally, the Credit Facilities and Senior Subordinated Notes contain certain restrictive covenants, which, among other things, limit, during the terms of the Credit Facilities and the Senior Subordinated Notes, (i) the amount of dividends that we may pay, (ii) the amount of our common stock that we may repurchase and (iii) the amount of other distributions that we may make in respect of our common stock.

On November 15, 2005, we completed a private placement of $150 million in Series A convertible preferred stock. The aggregate discounts and commissions to the initial purchasers and fees paid to third parties in conjunction with the preferred stock issuance were $6.0 million. We used the net proceeds from the offering to repay a portion of our borrowings under our revolving credit facility and for general corporate purposes. See Note 5 to the consolidated financial statements for a description of the Series A convertible preferred stock.

During 2006, as a result of our improvement in profitability, we paid down $155 million in debt, including the pay down of the entire outstanding balance under our revolving credit facility which totaled $135 million at December 31, 2005. As of January 6, 2008, our available borrowing capacity under our Credit Facilities, excluding the $150 million reserved for issuance of the Viacom Letters of Credit and $52.7 million reserved to support other letters of credit, totaled $247.3 million.

Beginning with fiscal 2005, we have been required to make prepayments on the Credit Facilities in an aggregate amount equal to 50% of annual excess cash flow, as defined by the credit agreement. Such payments are due at the end of the first quarter of the following year. We did not generate excess cash flow in fiscal 2007 and 2005. In fiscal 2006, we generated excess cash flow, as defined, and made a prepayment of $46 million to the term portions of the Credit Facilities during the first quarter of fiscal 2007. Additionally, we are required to make prepayments on the Credit Facilities related to sales of store operations and property and equipment, as defined by the amended and restated credit agreement. In 2007 we reduced our debt associated with the Credit Facilities by $214.1 million. The debt payments were comprised of $20.4 million of scheduled payments under the terms of our credit agreement, an excess cash flow payment of $45.4 million as required by our credit agreement and $148.3 million of prepayments primarily related to the sale of assets.

 

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The following table sets forth the current portion of our long-term debt and capital lease obligations:

 

     January 6, 2008    December 31, 2006

Credit Facilities:

     

Term A Loan Facility, interest rate ranging from 8.9% to 9.3% at January 6, 2008

   $ 24.0    $ 20.8

Term B Loan Facility, interest rate ranging from 9.0% to 9.6% at January 6, 2008

     20.7      52.6
             

Total current portion of long-term debt

     44.7      73.4

Current portion of capital lease obligations

     10.1      11.3
             
   $ 54.8    $ 84.7
             

The following table sets forth our long-term debt and capital lease obligations, less current portion:

 

     January 6, 2008    December 31, 2006

Credit Facilities:

     

Term A Loan Facility, interest rate ranging from 8.9% to 9.3% at January 6, 2008

   $ 18.8    $ 60.5

Term B Loan Facility, interest rate ranging from 9.0% to 9.6% at January 6, 2008

     346.8      490.5

Senior Subordinated Notes, interest rate of 9% at January 6, 2008

     300.0      300.0
             

Total long-term debt, less current portion

     665.6      851.0

Capital lease obligations, less current portion

     37.4      48.5
             
   $ 703.0    $ 899.5
             

Consolidated Cash Flows

Operating Activities. Net cash flows from operating activities decreased $385.6 million to $56.2 million of cash used for operating activities in fiscal year 2007 from $329.4 million of cash provided by operating activities in 2006, primarily because:

 

   

Our net income as adjusted for non-cash items has decreased;

 

   

we increased our rental inventory purchases by $52.9 million in order to improve the selection and availability of product in our stores; and

 

   

we built up our outstanding accounts payable balances by $133.4 million in 2006, but in 2007 we paid down $32.6 million of accounts payable mainly due to the timing of our year end.

Investing Activities. Net cash flows from investing activities increased $117.7 million to $76.7 million of cash provided by investing activities in fiscal year 2007 from $41.0 million used for investing activities in 2006, due mainly to:

 

   

$147.7 million of net proceeds on the sale of Gamestation in 2007; offset by

 

   

$12.2 million lower proceeds from sales of property and equipment than in 2006; and

 

   

payments of $7.4 million to acquire patent rights in 2007.

Financing Activities. Net cash used for financing activities increased $57.8 million to $241.0 million of cash used for financing activities in 2007 from $183.2 million of cash used for financing activities in 2006. This change was primarily due to net repayments of long-term debt under our credit facilities of $214.1 million in 2007 as compared to $155.5 million in 2006.

 

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General Economic Trends, Quarterly Results of Operations and Seasonality

We anticipate that our business will be affected by general economic and other consumer trends. Our business is subject to fluctuations in future operating results due to a variety of factors, many of which are outside of our control. These fluctuations may be caused by, among other things, a distinct seasonal pattern to the home video and video games business, particularly weaker business in April and May, due in part to improved weather and Daylight Saving Time, and in September and October, due in part to the start of school and the introduction of new television programs, and those factors set forth above under “Item 1A. Risk Factors.” The months of November and December have historically been our highest revenue months. While we expect these months to continue to make the largest contributions to our rental revenues, we believe the strength of rental revenues in these months has been and will continue to be negatively affected, to some degree, by consumers purchasing DVDs during the holiday season. Additionally, while our online and in-store rental subscription offerings have helped us mitigate, to some extent, the impact of seasonality and weather conditions on our business by providing a more steady revenue stream across all months, seasonality and weather are expected to continue to impact our business and our period-to-period financial results in the future.

Critical Accounting Estimates

The preparation of our consolidated financial statements, in conformity with accounting principles generally accepted in the United States, requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to the useful lives and residual values surrounding our rental library, estimated accruals related to revenue-sharing titles subject to performance guarantees, merchandise inventory reserves, revenues generated by customer programs and incentives, useful lives of property and equipment, income taxes, impairment of our long-lived assets, including goodwill, share-based compensation and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may materially differ from these estimates under different assumptions or conditions.

We believe the following accounting policies require more significant judgments and estimates and that changes in these estimates or the use of different estimates could have a material impact on our results of operations or financial position.

Rental Library Amortization

We have established amortization policies with respect to our rental library that most closely allow for the matching of product costs with the related revenues generated by the utilization of our rental library product. These policies require that we make significant estimates based upon our experience as to the ultimate revenue and the timing of the revenue to be generated by our rental library product. We utilize the accelerated method of amortization because it approximates the pattern of demand for the product, which is generally high when the product is initially released for rental by the studios and declines over time. In establishing residual values for our rental library product, we consider the sales prices and volume of our previously rented product and other used product.

Based upon these estimates and our current customer propositions and offerings, we currently amortize the cost of our in-store and online rental library, which includes movies and games, over periods ranging from six months to twenty-four months to estimated residual values ranging from $0 to $5 per unit, according to the product category.

 

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We also review the carrying value of our rental library to ensure that estimated future cash flows exceed the carrying value. We record adjustments to the value of previously rented product primarily for estimated obsolete or excess product based upon changes in our original assumptions about future demand and market conditions. If future demand or actual market conditions are less favorable than those estimated by management, additional adjustments, including adjustments to rental amortization periods or residual values, may be required. We continually evaluate the estimates surrounding the useful lives and residual values used in amortizing our rental library. Changes to these estimates resulting from changes in consumer demand, changes in our customer propositions or the price or availability of retail video product may materially impact the carrying value of our rental library and our rental margins.

For example, as discussed in Note 1 to the consolidated financial statements, during the first quarter of 2005, we re-evaluated our estimates surrounding the useful life and residual value of our rental library due to recent changes in our rental business, including the launch of the BLOCKBUSTER Movie Pass and our online subscription service in 2004 as well as the elimination of extended viewing fees under our “no late fees” program in 2005. Each of these initiatives has changed the delivery method, pricing and cost structure of the rental programs that we offer to our customers as well as the customers’ rental habits. These programs allow customers to keep rental product for longer periods of time and generate increased rental transactions and overall rentals per piece of library product. Beginning in the first quarter of 2005, we changed the estimated useful life of our online new release DVDs from six months to twelve months and the estimated useful life of our online catalog inventory from 12 months to 24 months. In addition, we reduced the residual value of our online catalog inventory from $4 to $0 in the first quarter of 2005. We also changed the estimated useful life of our in-store DVD catalog inventory in the United States from 12 months to 24 months. As our business continues to change as a result of our initiatives and market dynamics, we will continue to evaluate the reasonableness of the estimates surrounding our rental library.

Merchandise Inventory

Our merchandise inventory, which includes new and traded movies and games and other general merchandise, including confections, is stated at the lower of cost or market. We record adjustments to the value of inventory primarily for estimated obsolete or excess inventory equal to the difference between the carrying value of inventory and the estimated market value based upon assumptions about future demand and market conditions. If future demand or actual market conditions are less favorable than those projected by management, additional inventory adjustments may be required. Our accrual for inventory shrinkage is based on the actual historical shrink results of our most recent physical inventories adjusted, if necessary, for current economic conditions. These estimates are compared with actual results as physical inventory counts are taken and reconciled to the general ledger. DVD and video game products are susceptible to shrinkage due to their portability and popularity.

Income Taxes

In determining net income for financial statement purposes, we make certain estimates and judgments in the calculation of tax expense and the resulting tax liabilities and in the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense.

We record deferred tax assets and liabilities for future income tax consequences that are attributable to differences between financial statement carrying amounts of assets and liabilities and their income tax bases. We base the measurement of deferred tax assets and liabilities on enacted tax rates that we expect will apply to taxable income in the year when we expect to settle or recover those temporary differences. We recognize the effect on deferred tax assets and liabilities of any change in income tax rates in the period that includes the enactment date.

 

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As of January 1, 2007, we adopted Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities. The determination is based on the technical merits of the position and presumes that each uncertain tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information. We recognize interest and penalties relating to income taxes as components of income tax expense. See Note 9 to our consolidated financial statements.

We record valuation allowances to reduce our deferred tax assets to amounts that are more likely than not to be realized. In 2005, we determined that it was unclear as to the timing of when we will generate sufficient taxable income to realize our deferred tax assets. This was primarily due to the negative industry trends, which caused our actual and anticipated financial performance to be significantly worse than we originally projected. Accordingly, we recorded a valuation allowance against our deferred tax assets in the United States and certain foreign jurisdictions and, as such, we are not a taxpayer in the United States and certain foreign jurisdictions. Until we determine that it is more likely than not that we will generate sufficient taxable income to realize our deferred income tax assets in certain markets, income tax benefits associated with current period losses will not be recognized.

Impairment of Goodwill and Other Long-Lived Assets

In accordance with SFAS 142, we test goodwill and other intangible assets for impairment during the fourth quarter of each year and on an interim date should factors or indicators become apparent that would require an impairment test.

Goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is to identify a potential impairment by comparing the book value of our reporting units, domestic and international, to their estimated fair values. The estimates of fair value of our reporting units are computed using the present value of estimated future cash flows. This analysis utilizes a multi-year forecast of estimated cash flows and a terminal value at the end of the cash flow period. The forecast period assumptions consist of internal projections that are based on our budget and long-range strategic plan. The discount rate used at the testing date is our weighted-average cost of capital. The assumptions included in the discounted cash flow analysis require judgment, and changes to these inputs could materially impact the results of the calculation.

If the fair value of a reporting unit exceeds its book value, goodwill of the reporting unit is not deemed impaired and the second step of the impairment test is not performed. If the book value of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the estimated fair value of the reporting unit to the estimated fair value of our existing tangible assets and liabilities as well as existing identified intangible assets and previously unrecognized intangible assets. The unallocated portion of the estimated fair value of the reporting unit is the implied fair value of goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.

See the discussion of impairment charges for goodwill and other long-lived assets in Note 3 to the consolidated financial statements.

 

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Share-Based Compensation

In 2004, we adopted SFAS 123R, which requires us to recognize compensation expense for all share-based payments made to employees based on the fair value of the share-based payment on the date of grant. We elected to use the modified prospective method for adoption, which requires compensation expense to be recorded for all unvested stock options and restricted shares beginning in the first quarter of adoption. For all unvested options outstanding as of October 1, 2004, the previously measured but unrecognized compensation expense, based on the fair value at the original grant date, is recognized on an accelerated basis in the Consolidated Statements of Operations over the remaining vesting period. For share-based payments granted subsequent to October 1, 2004, compensation expense, based on the fair value on the date of grant, is recognized in the Consolidated Statements of Operations on an accelerated basis over the vesting period. In determining the fair value of stock options, we use the Black-Scholes option pricing model that employs the following assumptions:

 

   

Expected volatility—based on the weekly historical volatility of our stock price, over the expected life of the option.

 

   

Expected term of the option—based on the vesting terms and the contractual life of the respective option.

 

   

Risk-free rate—based upon the rate on a zero coupon U.S. Treasury bill, for periods within the contractual life of the option, in effect at the time of grant.

 

   

Dividend yield—calculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant.

Our stock price volatility and option lives involve management’s best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option.

The fair value of most of our restricted shares is based on the price of a share of our Class A common stock on the date of grant. Our performance-based awards of restricted shares and restricted share units are based on the price of a share of our Class A common stock on the date the award is approved and marked to market at each reporting period if we believe it is probable that the performance criteria will be met. Once the performance criteria are met, these awards will be granted and the fair value will be based on the share price at that date. The fair value of our grants of restricted shares and restricted share units that are subject to hold provisions is discounted for the lack of marketability due to such post-vesting restrictions.

SFAS 123R also requires that we recognize compensation expense for only the portion of options or restricted shares that are expected to vest. Therefore, we apply estimated forfeiture rates that are derived from historical employee termination behavior using a stratified model based on the employee’s position within the Company and the vesting period of the respective stock options or restricted shares. If the actual number of forfeitures differs from those estimated by management, additional adjustments to compensation expense may be required in future periods.

Market Risk

We are exposed to various market risks including interest rates on our debt and foreign exchange rates, and we monitor these risks throughout the normal course of business. Significant fluctuations in our interest rates or foreign exchange rates could cause us to adjust our financing and operating strategies to mitigate these risks. At January 6, 2008 and December 31, 2006, we did not have any interest rate or foreign exchange hedging instruments in place.

Interest Rate Risk

Our primary exposure to interest rate risk results from outstanding borrowings under our credit agreement. Interest rates for the credit agreement are based on LIBOR plus an applicable margin or the prime rate or the

 

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federal funds rate plus applicable margins, at our option at the time of borrowing. The applicable margins vary based on the borrowing and specified leverage ratios. Our borrowings under the credit agreement totaled $410.3 million as of January 6, 2008, and the weighted-average interest rate for these borrowings was 9.1%. Our vulnerability to changes in LIBOR or other applicable rates could result in material changes to our interest expense, as a one percentage point increase or decrease in LIBOR or the other applicable rates would have a $4.1 million impact on our interest expense annually. In addition, a change in our gross leverage ratio, which could be driven by a change in our debt balance or our income, could result in an increase or decrease in the applicable margins on our Term A loan, Term B loan and revolving credit facility, thereby impacting our annual interest expense.

Foreign Exchange Risk

Operating in international markets involves exposure to movements in currency exchange rates. Currency exchange rate movements typically also reflect economic growth, inflation, interest rates, government actions and other factors. As currency exchange rates fluctuate, translation of the statements of operations of our international businesses into U.S. dollars may affect year-over-year comparability and could cause us to adjust our financing and operating strategies. Revenues and operating income would have decreased by $135.4 million and $3.6 million, respectively, for 2007 if foreign exchange rates in 2007 were consistent with 2006.

Our operations outside the United States, mainly in Europe and Canada, constituted 35%, 35%, and 33% of our total revenues in fiscal years 2007, 2006, and 2005, respectively. Consequently, we have foreign exchange rate exposure to movements in exchange rates primarily for the British Pound, the Euro and the Canadian Dollar.

Recent Accounting Pronouncements

See Note 1 to the consolidated financial statements for a discussion of recently issued accounting pronouncements.

Off-Balance Sheet Arrangements

None.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

The response to this item is included in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market Risk.”

 

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Item 8.    Financial Statements and Supplementary Data

BLOCKBUSTER INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   70

Audited Consolidated Financial Statements:

  

Consolidated Statements of Operations—Fiscal Years 2007, 2006 and 2005

   72

Consolidated Balance Sheets—January 6, 2008 and December 31, 2006

   73

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Loss—Fiscal Years 2007, 2006 and 2005

   74

Consolidated Statements of Cash Flows—Fiscal Years 2007, 2006 and 2005

   75

Notes to Consolidated Financial Statements

   76

All supplementary financial statement schedules have been omitted

because the information required to be set forth therein is either not applicable

or is shown in the consolidated financial statements or notes thereto.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and

Stockholders of Blockbuster Inc.:

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Blockbuster Inc. and its subsidiaries at January 6, 2008 and December 31, 2006, and the results of their operations and their cash flows for each of the three years in the period ended January 6, 2008 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of January 6, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because material weaknesses in internal control over financial reporting related to (i) the completeness and accuracy of general and administrative expense accruals and the related expense accounts; and (ii) the completeness and accuracy of foreign currency cumulative translation adjustments existed as of that date. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. The material weaknesses referred to above are described in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. We considered these material weaknesses in determining the nature, timing, and extent of audit tests applied in our audit of the fiscal 2007 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in management’s report referred to above. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As discussed in Note 2 to the consolidated financial statements, the Company has restated its 2006 and 2005 financial statements.

As discussed in Note 9 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertain tax positions as of January 1, 2007.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PricewaterhouseCoopers LLP

Dallas, Texas

March 6, 2008

 

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BLOCKBUSTER INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In millions, except per share amounts)

 

     Fiscal Year Ended,  
     January 6, 2008     December 31, 2006     December 31, 2005  
           (As restated)     (As restated)  

Revenues:

      

Base rental revenues

   $ 3,426.2     $ 3,413.1     $ 3,570.2  

Previously rented product (“PRP”) revenues

     656.3       616.0       590.5  
                        

Total rental revenues

     4,082.5       4,029.1       4,160.7  

Merchandise sales

     1,400.1       1,431.9       1,488.9  

Other revenues

     59.8       61.2       72.2  
                        
     5,542.4       5,522.2       5,721.8  
                        

Cost of sales:

      

Cost of rental revenues

     1,604.0       1,403.9       1,396.6  

Cost of merchandise sold

     1,073.8       1,075.8       1,164.4  
                        
     2,677.8       2,479.7       2,561.0  
                        

Gross profit

     2,864.6       3,042.5       3,160.8  
                        

Operating expenses:

      

General and administrative

     2,525.1       2,598.6       2,724.8  

Advertising

     194.0       154.3       252.7  

Depreciation and intangible amortization

     185.7       210.9       224.3  

Impairment of goodwill and other long-lived assets

     2.2       5.1       341.9  

Gain on sale of Gamestation

     (81.5 )     —         —    
                        
     2,825.5       2,968.9       3,543.7