10-Q 1 r10q-q2.txt 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended July 1, 2007 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission File Number 0-24548 Movie Gallery, Inc. (Exact name of registrant as specified in charter) DELAWARE 63-1120122 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 900 West Main Street, Dothan, Alabama 36301 (Address of principal executive offices) (zip code) (334) 677-2108 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] The number of shares outstanding of the registrant's common stock, par value $0.001 per share as of August 1, 2007 was 33,096,866. Part I - Financial Information Forward Looking Statements This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which represent our expectations or beliefs about future events and financial performance. Forward-looking statements are identifiable by the fact that they do not relate strictly to historical information and may include words such as "believe," "anticipate," "expect," "intend," "plan," "will," "may," "estimate" or other similar expressions and variations thereof. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Our forward-looking statements are based on management's current intent, belief, expectations, estimates and projections regarding our company and our industry. Forward- looking statements are subject to known and unknown risks and uncertainties, including those described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. Forward-looking statements include statements regarding our ability to restructure our indebtedness, our ability to continue to fund our operations, our ability to make projected capital expenditures, the impact of litigation on our business, the importance of the home video industry to movie studios, our ability to expand into the online video rental market, the receipt of our federal tax refund for the 2002 tax year, as well as general market conditions, competition and pricing. Our forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially, including, but not limited to, risks and uncertainties that: - revenues are less than projected; - we could incur additional impairment charges on our long-lived assets should our future estimates of operating cash flows differ from our current estimates; - we are unable to extend our Forbearance Agreement (as amended) or otherwise amend the financial covenants contained in our senior credit facility; - we default on our second lien facility and/or our 11% Senior Notes; - our real estate subleasing program and other initiatives fail to generate anticipated cost reductions; - the availability of new movie releases priced for sale negatively impacts consumers' desire to rent movies; - unforeseen issues arise with the continued integration of the Hollywood Entertainment business; - our actual expenses or liquidity requirements differ from estimates and expectations; - consumer demand for movies and games is less than expected; - the availability of movies and games is less than expected; - competitive pressures are greater than anticipated; - we are unable to obtain additional working capital for our business; or - are related to a restructuring of our indebtedness either pursuant to an out-of-court transaction or through a chapter 11 proceeding. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this quarterly report on Form 10-Q might not occur. In addition, actual results could differ materially from those suggested by the forward-looking statements, and therefore you should not place undue reliance on the forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. We desire to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, and, in that regard, we caution the readers of this quarterly report on Form 10-Q that the important factors described under Part II, Item 1A. Risk Factors in this quarterly report on Form 10-Q and under Item 1A. Risk Factors in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, among others, could affect our actual results of operations and may cause changes in our strategy with the result that our operations and results may differ materially from those expressed in any forward-looking statements made by us, or on our behalf. Item 1. Financial Statements Movie Gallery, Inc. Consolidated Balance Sheets (In thousands, except per share amounts) -------------------------- December 31, July 1, 2006 2007 ------------ ------------ (Unaudited) Assets Current assets: Cash and cash equivalents $ 32,953 $ 45,513 Merchandise inventory, net 140,614 175,470 Prepaid expenses 45,324 45,787 Store supplies and other 20,211 16,722 Assets held for sale - 7,613 Deferred income taxes 209 - ------------ ------------ Total current assets 239,311 291,105 Rental inventory, net 339,981 325,259 Property, furnishings and equipment, net 242,935 153,925 Goodwill 115,569 - Other intangibles, net 181,912 82,673 Deferred income taxes, net - 3,031 Deposits and other assets 33,569 36,000 ------------ ------------ Total assets $ 1,153,277 $ 891,993 ============ ============ Liabilities and stockholders' deficit Current liabilities: Current maturities of long-term obligations $ 4,580 $ 1,197,683 Accounts payable 86,380 64,322 Accrued liabilities 80,432 72,825 Accrued payroll 47,896 34,276 Accrued interest 6,774 11,239 Deferred revenue 42,055 38,870 ------------ ------------ Total current liabilities 268,117 1,419,215 Long-term obligations, less current portion 1,087,875 - Other accrued liabilities 33,716 33,072 ------------ ------------ 1,389,708 1,452,287 Stockholders' deficit: Preferred stock, $.10 par value; 2,000 shares authorized, no shares issued or outstanding - - Common stock, $.001 par value; 65,000 shares authorized, 31,840 and 32,275 shares issued and outstanding, respectively 32 32 Additional paid-in capital 197,961 199,130 Accumulated deficit (443,602) (768,407) Accumulated other comprehensive income 9,178 8,951 ------------ ------------ Total stockholders' deficit (236,431) (560,294) ------------ ------------ Total liabilities and stockholders' deficit $ 1,153,277 $ 891,993 ============ ============ The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Consolidated Statements of Operations (Unaudited, in thousands, except per share amounts) Thirteen Weeks Ended Twenty-Six Weeks Ended ----------------------- ----------------------- July 2, July 1, July 2, July 1, 2006 2007 2006 2007 ---------- ---------- ----------- ----------- Revenue: Rentals $ 493,546 $ 433,405 $ 1,063,975 $ 944,449 Product sales 107,739 127,819 231,677 264,469 --------- ---------- ----------- ----------- Total revenue 601,285 561,224 1,295,652 1,208,918 Cost of sales: Cost of rental revenue 154,904 140,993 328,481 296,016 Cost of product sales 77,413 96,114 171,293 199,502 -------- ---------- ----------- ----------- Gross profit 368,968 324,117 795,878 713,400 Operating costs and expenses: Store operating expenses 305,494 303,621 617,221 611,603 General and administrative 48,523 45,930 95,464 92,895 Amortization of intangibles 708 686 1,441 1,381 Impairment of goodwill - 115,570 - 115,570 Impairment of other intangibles - 97,879 - 97,879 Impairment of property, furnishings, and equipment - 43,001 - 43,001 Other expenses - (325) - (303) -------- --------- ----------- ----------- Operating income (loss) 14,243 (282,245) 81,752 (248,626) Interest expense, net (includes $17,538 write off of debt issuance costs for the twenty- six weeks ended July 1, 2007) 30,694 28,679 58,147 76,479 -------- --------- ----------- ----------- Income (loss) before income taxes (16,451) (310,924) 23,605 (325,105) Income taxes (benefit) (1,553) (985) (1,847) (300) -------- --------- ----------- ----------- Net income (loss) $(14,898) $(309,939) $ 25,452 $ (324,805) ======== ========= =========== =========== Net income (loss) per share: Basic $ (0.47) $ (9.69) $ 0.80 $ (10.18) Diluted $ (0.47) $ (9.69) $ 0.80 $ (10.18) Weighted average shares outstanding: Basic 31,828 31,986 31,759 31,917 Diluted 31,828 31,986 31,828 31,917 The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Consolidated Statements of Cash Flows (Unaudited, in thousands) Twenty-Six Weeks Ended ---------------------- July 2, July 1, 2006 2007 --------- --------- Operating activities: Net income (loss) $ 25,452 $(324,805) Adjustments to reconcile net income (loss) to net cash used in operating activities: Rental inventory amortization 119,750 93,779 Purchases of rental inventory, net (82,236) (77,264) Purchases of rental inventory-base stock (9,434) (524) Depreciation and intangibles amortization 52,080 47,126 Gain on disposal of property, furnishings, equipment, net (697) (268) Stock-based compensation 1,057 635 Amortization of debt issuance cost 3,243 3,388 Write off of debt issuance cost - 17,538 Impairment of goodwill - 115,570 Impairment of other intangibles - 97,879 Impairment of property, furnishings, and equipment - 43,001 Other non-cash (income) expense - (1,806) Deferred income taxes 687 (2,851) Changes in operating assets and liabilities, net of business acquisitions: Merchandise inventory 14,709 (34,486) Other current assets (7,326) 5,223 Deposits and other assets (75) (1,460) Accounts payable (144,096) (22,397) Accrued interest 54 4,466 Accrued liabilities and deferred revenue (8,404) (24,932) --------- --------- Net cash used in operating activities (35,236) (62,188) Investing activities: Business acquisitions, net of cash acquired (319) (3,129) Purchase of property, furnishings and equipment (15,091) (1,384) Proceeds from disposal of property, furnishings and equipment 1,320 537 --------- --------- Net cash used in investing activities (14,090) (3,976) Financing activities: Repayment of capital lease obligations (328) (1,034) Net borrowings (repayments) on credit facilities (1,395) 83,477 Debt financing fees (5,528) (23,239) Proceeds from issuance of long-term debt - 775,000 Principal payments on long-term debt (58,840) (754,858) --------- --------- Net cash provided by (used in) financing activities (66,091) 79,346 Effect of exchange rate changes on cash and cash equivalents 1,330 (622) --------- --------- Increase (decrease) in cash and cash equivalents (114,087) 12,560 Cash and cash equivalents at beginning of period 135,238 32,953 --------- --------- Cash and cash equivalents at end of period $ 21,151 $ 45,513 ========= ========= Supplemental non-cash investing and financing activities: Change in construction phase assets $ 373 $ - Borrowings of capital lease obligations - 2,365 The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Notes to Consolidated Financial Statements (Unaudited) July 1, 2007 1. Liquidity The accompanying financial statements have been prepared on a going concern basis, which assumes that we will realize our assets and satisfy our liabilities in the normal course of business. However, we have experienced recurring losses from operations, which have generated an accumulated deficit of $768.4 million through July 1, 2007. In addition, we are not in compliance with the financial covenants contained in our first lien facilities described in Note 8 as of July 1, 2007 and accordingly, the obligations due under our first lien facilities have been classified as current liabilities as of July 1, 2007. Due to this default under the first lien credit agreement, the obligations due under our second lien term loan and the 11% senior notes, each as described in Note 8, have also been classified as current liabilities as of July 1, 2007. As of July 1, 2007, we have a working capital deficiency of $1.1 billion. At July 1, 2007, we had $45.5 million of cash and cash equivalents and did not have any available borrowings under our March 2007 Credit Facility. These events raise substantial doubt as to our ability to continue as a going concern. The accompanying financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets, or amounts and classification of liabilities that may result from the outcome of this uncertainty. As a result of our non-compliance with the financial covenants contained in the first lien facilities and our resulting default under the first lien credit agreement, the first lien credit agreement lenders have the right to terminate their commitments, accelerate all of our obligations and exercise their remedies under the first lien credit agreement. We have executed a Forbearance Agreement (as amended), effective as of July 2, 2007, with certain lenders under the first lien credit agreement. Under the Forbearance Agreement (as amended), the lenders will forbear until August 14, 2007 from exercising default-related rights and remedies arising from existing defaults, absent any new defaults under the first lien credit agreement or the Forbearance Agreement (as amended). We have also begun discussions with the advisors representing our first lien lenders on extending the Forbearance Agreement (as amended). We are currently in discussions with the advisors representing our first lien lenders and other major creditors to address our current financial situation. In the near future, we expect to present a longer-term solution to the first lien lender group and other major creditors that will address the operational and financial issues currently impacting our business. This longer-term solution includes accelerating the closure of unprofitable stores, consolidating stores in certain markets, obtaining additional working capital, realigning our cost structure to better reflect our reduced size and seeking a more competitive capital structure. In connection with a solution, it is likely that we will need the first lien lenders to waive our existing defaults under the first lien credit agreement and to substantially modify the financial covenants contained therein. We cannot assure you that: - we will reach such an agreement with our first lien lenders prior to the expiration of the forbearance period discussed above; - we will be able to obtain an extension of our forbearance period if we are not able to reach such an agreement with our first lien lenders prior to the August 14, 2007 expiration of the forbearance period; or - if we do reach an agreement, what the terms of such agreement will be or what actions we will be required to undertake in connection with such an agreement, such as selling assets, closing stores, securing additional financing, reducing or delaying capital expenditures or restructuring our existing indebtedness. If we fail to reach such an agreement, the first lien lenders could institute foreclosure proceedings against our assets securing borrowings under the first lien facilities. Our liquidity is dependent upon our cash flows from store operations, access to our existing credit facility and vendor financing. Historically, we maintained favorable payment terms with our vendors, which has been a significant source of liquidity for us. During the latter part of fiscal 2006, and continuing into fiscal 2007, we have experienced significant vendor terms contraction, which eroded our working capital capacity. Due to our non-compliance with the covenants contained in the first lien facilities, many of our significant vendors have discontinued extending us trade credit, requiring us to pay for product before it is shipped, and we have experienced additional tightening of terms with other vendors. If we continue to experience substantial restrictions or tightening of terms with our vendors and continue to generate operating losses similar to those experienced for the twenty-six weeks ended July, 1, 2007, we do not believe we will have sufficient liquidity to operate our business through the third quarter of 2007 without gaining access to additional capital. See Note 8 and Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" in this Quarterly Report on Form 10-Q for additional information regarding our long term obligations, liquidity, and ongoing discussions with our major creditors. 2. Accounting Policies References herein to "Movie Gallery", the "Company", "we", "our", or "us" refer to Movie Gallery, Inc. and its subsidiaries unless the context specifically indicates otherwise. References herein to "Hollywood" refer to Hollywood Entertainment Corporation. Principles of Consolidation The accompanying financial statements present the consolidated financial position, results of operations and cash flows of Movie Gallery, Inc. and its subsidiaries. All intercompany accounts and transactions have been eliminated. Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements. The balance sheet at December 31, 2006 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal, recurring adjustments and accruals) considered necessary for a fair presentation have been included. Operating results for the thirteen and twenty-six weeks ended July 1, 2007 are not necessarily indicative of the results that may be expected for the fiscal year ending January 6, 2008. For further information, refer to the consolidated financial statements and related footnotes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. Reclassifications and Revisions Certain reclassifications have been made to the prior year financial statements to conform to the current year presentation. These reclassifications had no impact on stockholders' deficit or net income (loss). For the thirteen and twenty-six weeks ended July 2, 2006, $2.3 million and $4.6 million, respectively, in depreciation expense was reclassified from Store operating expenses to General and administrative expenses related to depreciation on corporate fixed assets. Goodwill and Other Indefinite-Lived Intangible Assets Goodwill and other indefinite-lived intangible assets are not amortized, but are subject to impairment testing annually or whenever indicators of impairment are present. Finite-lived intangible assets are amortized on a straight-line basis over their estimated useful lives. In accordance with Statement of Financial Accounting Standards, or SFAS, No. 142, "Goodwill and Other Intangible Assets," or SFAS No. 142, we assess goodwill and intangible assets with indefinite lives for impairment at the reporting unit level on an annual basis and between annual tests if events occur or circumstances change that could more likely than not reduce the fair value of these assets below their carrying amount. SFAS No. 142 requires that the impairment test be performed through the application of a two-step fair value test. The first step of the test compares the book value of our reporting units to their estimated fair values at the respective test dates. The estimated fair values of the reporting units are computed using the present value of estimated future cash flows. If fair value does not exceed carrying value then the second step must be performed to quantify the amount of the impairment. The second step of the goodwill impairment test compares the implied fair value of goodwill to the book value of goodwill. The implied fair value of goodwill is calculated as the excess of the estimated fair value of the reporting unit being tested over the fair value of its tangible assets and liabilities as well as existing recorded and unrecorded identifiable intangible assets. The estimated implied fair value of goodwill and the estimated fair value of identified intangibles are compared to their respective carrying values and any excess carrying value is recorded as a charge to operating income. See Note 5 and Note 6 below for a discussion of goodwill, other intangible assets and impairment charges. Impairment of Long-Lived Assets Long-lived assets, including rental inventory, property, furnishings and equipment and intangible assets with finite lives, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable, in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," or SFAS No. 144. We consider a continuing trend of significantly unsatisfactory operating results that are not in line with our expectations to be our primary indicator of potential impairment. When an indicator of impairment is noted, assets are evaluated for impairment at the lowest level for which there are identifiable cash flows (e.g., at the store level). We deem a store to be impaired if a forecast of undiscounted future operating cash flows directly related to the store, including estimated disposal value, if any, is less than the asset carrying amount. If a store is determined to be impaired, the loss is measured as the amount by which the carrying amount of the store's assets exceeds its fair value and is recorded as a charge to operating income. We primarily use discounted cash flow methods to estimate the fair value of long-lived assets. See Note 5 below for a discussion on impairment of long-lived assets. Stock-Based Compensation Effective January 2, 2006, we adopted SFAS No. 123(R), "Share-Based Payment," or SFAS No. 123(R), which no longer permits the use of the intrinsic value method under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," or APB No. 25. We used the modified prospective method to adopt SFAS No. 123(R), which requires that compensation expense be recorded for all stock-based compensation granted on or after January 2, 2006, as well as the unvested portion of previously granted options. Earnings/Loss Per Share Basic earnings/loss per share is computed based on the weighted average number of shares of common stock outstanding during the periods presented. Diluted earnings per share is computed using the weighted average number of shares of common stock outstanding and common stock issuable upon the assumed exercise of dilutive common stock options and non-vested shares for the periods presented. For the twenty-six weeks ended July 2, 2006, dilutive common stock options exercisable into 895,751 shares of common stock and 1,351,519 shares of non- vested stock were included in the calculation of diluted earnings per share. Due to our loss for the thirteen weeks ended July 2, 2006, common stock options exercisable into 895,751 shares of common stock and 1,351,519 shares of non- vested stock were excluded from the calculation of diluted loss per share, as their inclusion would have been anti-dilutive. Due to our loss for the thirteen weeks and twenty-six weeks ended July 1, 2007, common stock options exercisable into 763,703 shares of common stock and 890,370 shares of non- vested stock were excluded from the calculation of diluted loss per share, as their inclusion would have been anti-dilutive. Recently Issued Accounting Pronouncements On July 13, 2006, the Financial Accounting Standards Board, or the FASB, issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109," or FIN 48, which clarifies the way companies account for uncertainty in income taxes. FIN 48 is effective for the first fiscal year beginning after December 15, 2006, which for us was our fiscal year beginning January 1, 2007. The adoption of FIN 48 did not have a material impact on our consolidated financial statements. See Note 4 "Income Taxes" for further discussion. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," or SFAS No. 157, which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS No. 157 also responds to investors' requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS No. 157 is effective for our fiscal year beginning January 7, 2008. We are in the process of evaluating the effect of SFAS No. 157 on our financial statements. In February 2007, the FASB issued SFAS No.159, "The Fair Value Option for Financial Assets and Financial Liabilities," or SFAS No. 159, which provides guidance on applying fair value measurements on financial assets and liabilities. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 attempts to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings, caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is effective for us for our fiscal year beginning January 7, 2008. We are in the process of evaluating the effect of SFAS No. 159 on our financial statements. 3. Property, Furnishings and Equipment Property, furnishings and equipment consists of the following (in thousands): ----------- ---------- December 31, July 1, 2006 2007 ----------- ---------- Land and buildings $ 19,716 $ 18,739 Furnishings and equipment 240,075 231,873 Leasehold improvements 279,009 276,150 Asset removal obligation 5,860 5,767 Equipment under capital lease 1,659 2,365 ----------- ---------- 546,319 534,894 Less accumulated depreciation, amortization, and impairment charges (303,384) (380,969) ----------- ---------- $ 242,935 $ 153,925 =========== ========== Accumulated depreciation and amortization, as presented above, includes accumulated amortization of assets under capital leases of $0.8 million and $0.2 million at December 31, 2006 and July 1, 2007, respectively. Depreciation expense related to property, furnishings and equipment was $24.5 million and $45.6 million for the thirteen weeks and twenty-six weeks ended July 1, 2007, respectively, compared to $23.8 million and $48.8 million for the corresponding periods in 2006. During the second quarter of fiscal 2007, we recorded an impairment charge of $43.0 million on our property, furnishings, and equipment. See Note 5 for further discussion of this impairment charge. During the second quarter of fiscal 2007, we began to pursue the sale of one of our aircraft in conjunction with our review of non-core assets for disposal. As of July 1, 2007, we have determined that the plan of sale criteria as set forth in SFAS No. 144 related to this aircraft has been met. We have estimated that the fair value less costs to sell is $7.8 million, based on quoted market prices from a third party. As of July 1, 2007, the carrying amount of the aircraft was $7.6 million. As such, no impairment charge was recorded to bring the asset to its estimated fair value. The carrying value of the aircraft is presented in the "Assets Held for Sale" caption in our consolidated balance sheet. 4. Income Taxes The effective tax rate was a benefit of 0.3% and 0.1% for the thirteen weeks and twenty-six weeks ended July 1, 2007, respectively, as compared to a benefit of 9.4% and 7.8% for corresponding prior year periods. The projected annual effective tax rate is a provision of 0.4%, which differs from the benefit of 0.3% for the quarter ended July 1, 2007, due to changes in the proportion of income earned from foreign operations and various state income tax changes. In July 2006, the FASB issued FIN 48, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. We adopted the provisions of FIN 48 on January 1, 2007. The adoption of FIN 48 did not have a material effect on our consolidated balance sheet or statement of operations. The amount of unrecognized benefits as of January 1, 2007 is $11.2 million, of which $4.8 million would impact our effective rate, if realized. There were no material changes to unrecognized benefits during the twenty-six weeks ended July 1, 2007. We have filed amended federal and state returns that claimed refunds of approximately $3.0 million for the 2002 tax year. This refund claim is included in our unrecognized benefits as of January 1, 2007. Subsequent to the twenty-six weeks ended July 1, 2007, we received notification from the IRS that our refund claim has been processed, and we expect to receive and record this refund during the third quarter of fiscal 2007. Besides this 2002 tax year refund claim, we cannot estimate a range of potential changes in the amount of unrecognized tax benefits during the next twelve months. We recognize accrued interest and penalties related to unrecognized tax benefits in income tax expense in our consolidated statements of operations, which is consistent with the recognition of these items in prior reporting periods. As of January 1, 2007, we had recorded a liability of approximately $0.3 million for the payment of interest and penalties. All statutes of limitations related to federal income tax returns of Movie Gallery, Inc. are closed through 2001. The statutes related to federal tax returns of Hollywood Entertainment Corporation are closed through 1997. Due to net operating losses generated by Hollywood in 1998 and later years, the statute of limitations remains open for those years to the extent of the net operating losses. State income tax returns are generally subject to examination for a period of three to five years after the filing of the respective return. The state impact of any federal changes remains subject to examination by various states for a period of up to one year after formal notification to the states. Also, we have generated net operating losses for state purposes in certain states, which have had the effect of extending the statute of limitations in those states. 5. Impairment of Other Long-Lived Assets, Other Indefinite-Lived Intangibles, and Goodwill Impairment Indicators SFAS No. 142 and SFAS No. 144 require interim testing for impairment of other long-lived assets, other indefinite-lived intangible assets and goodwill when impairment indicators are present. SFAS No. 144 provides examples of events or changes in circumstances that might indicate that impairment exists for a particular long-lived asset or asset group. During the month of March 2007 and most notably during the second quarter of fiscal 2007, our industry in general, and our business in particular, have experienced events and circumstances that required us to assess the recoverability of the carrying value of certain of our long-lived assets. Among those events and circumstances that we believe to be impairment indicators are: - substantially larger than anticipated drop in year-over-year same store sales and gross margins; - a continuing trend of operating losses; - projected cash flow losses for a substantial number of our stores; - a significant drop in our stock price and resulting market capitalization; - a significant drop in trading prices for our first and second lien debt and 11% senior notes; and - recent significant adverse changes in our industry as discussed in Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations". Other Long-Lived Assets Long-lived assets are reviewed for impairment in accordance with SFAS No. 144. When an indicator of impairment is noted, assets are evaluated for impairment at the lowest level for which there are identifiable cash flows (e.g., at the store level). Due to the impairment indicators noted above, we performed impairment testing on our long-lived assets as of July 1, 2007. As a result, we determined that the long-lived assets associated with certain stores were impaired. We recorded a charge of $26.2 million and $16.8 million related to the impairment of property, furnishings, and equipment under the Hollywood and Movie Gallery operating segments, respectively. We also determined that our definite-lived intangible asset for the customer list in the Hollywood segment was impaired as a result of attrition in active customers. We therefore recorded an impairment charge of $2.5 million, which was recognized in Impairment of other intangibles. Other Indefinite-Lived Intangibles We normally conduct our annual test of the valuation of our indefinite-lived intangible asset, the Hollywood trademark, during the fourth quarter of each fiscal year in accordance with our policy and the requirements as set forth in SFAS No. 142. However due to the impairment indicators noted above, we performed impairment testing on the Hollywood trademark as of July 1, 2007. The impairment testing of the Hollywood trademark compared the fair value of the trademark with its carrying value. The fair value was determined by the Relief from Royalty method, a specific discounted cash flow approach, to analyze cash flows attributable to the Hollywood trademark. The carrying value of the Hollywood trademark was greater than its fair value and therefore was deemed to be impaired. The implied fair value of the Hollywood trademark was determined to be $75.5 million, and therefore an impairment charge was recorded for $95.4 million in Impairment of other intangibles. Goodwill We normally conduct our annual test of the valuation of goodwill during the fourth quarter of each fiscal year in accordance with our policy and the requirements as set forth in SFAS No. 142. However, due to the impairment indicators noted above, we performed impairment testing on our valuation of goodwill as of July 1, 2007. Goodwill is tested at a reporting unit level, which for this purpose consists solely of Hollywood Video, as our Movie Gallery reporting unit had an immaterial amount of goodwill and our Game Crazy reporting unit has no goodwill. Goodwill is impaired if the fair value of a reporting unit is less than the carrying value of its assets. The estimated fair value of the Hollywood Video reporting unit was computed using the present value of estimated future cash flows, which included the impact of trends in the business and industry noted in Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations." In addition to these business and industry trends, the computation of estimated fair value considered market prices of our debt and equity securities. When we performed our testing, the first step of the impairment test indicated that the fair value of the Hollywood Video reporting unit was lower than its carrying value, and therefore the goodwill of the Hollywood reporting unit was determined to be impaired. The second step of the impairment test indicated that the implied fair value of goodwill for the Hollywood reporting unit was zero, and therefore a goodwill impairment charge was recorded for $115.6 million. Impairment Estimates and Assumptions The impairment charges related to our long-lived assets associated with our stores, our definite-lived intangible assets, our indefinite-lived intangible asset, and our goodwill were calculated using our best estimate of future forecasted cash flows from the respective assets and a discount rate inherent within our cost of capital. The nature of this analysis requires significant management judgment about our future operating results, including revenues, margins, operating expenses and applicable discount rate. If we had used different assumptions and estimates regarding our future operating results or discount rate, the impairment charge might have been materially different. However, we believe that our assumptions and estimates are reasonable and represent our most likely future operating results based upon the current information available. To date, we have not recorded any impairment charges related to our rental inventory. In addition to our property, furnishings, and equipment impairment charges and our customer list impairment charge, we could incur impairment charges to our rental inventory. If we were to close a significant number of our stores, we may need to liquidate the on-hand rental inventory for amounts that are less than the carrying value of the rental inventory product. These future asset impairments could have a materially adverse effect on our consolidated results of operations. We will continue to review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In circumstances where impairment is determined to exist, we will write down the assets to their fair market value. 6. Goodwill and Other Intangible Assets The components of goodwill and other intangible assets are as follows (in thousands): December 31, 2006 July 1, 2007 Weighted- ------------------------ --------------------- Average Gross Gross Amortization Carrying Accumulated Carrying Accumulated Period Amount Amortization Amount Amortization ------------ -------- ------------ -------- ------------ Goodwill Segments: Movie Gallery - $ 147 $ - $ - $ - Hollywood Video - 115,422 - - - -------- ------------ -------- ------------ Total goodwill $115,569 $ - $ - $ - ======== ============ ======== ============ Other intangible assets: Non-compete agreements 8 years $ 12,263 $ (10,880) $ 12,329 $ (11,273) Trademarks: Hollywood Video Indefinite 170,977 - 75,543 - Game Crazy 15 years 4,000 (444) 4,000 (578) Customer lists 5 years 8,994 (2,998) 8,994 (6,342) -------- ------------ -------- ------------ $196,234 $ (14,322) $100,866 $ (18,193) ======== ============ ======== ============ Estimated amortization expense for other intangible assets for the remainder of fiscal 2007 and the five succeeding fiscal years is as follows (in thousands): 2007 886 2008 1,614 2009 1,427 2010 671 2011 292 2012 269 The changes in the carrying amounts of goodwill, indefinite-lived intangibles, and definite-lived intangibles for the fiscal year ended December 31, 2006 and the twenty-six weeks ended July 1, 2007, are as follows (in thousands): Indefinite- Definite- Lived Lived Goodwill Intangibles Intangibles --------- ----------- ----------- Net balance as of January 1, 2006 $ 118,404 $ 170,959 $ 13,712 Additions and adjustments (2,835) 18 61 Amortization expense - - (2,838) --------- ----------- ----------- Net balance as of December 31, 2006 $ 115,569 $ 170,977 $ 10,935 --------- ----------- ----------- Additions and adjustments 1 - 21 Impairment charges (115,570) (95,434) (2,445) Amortization expense - - (1,381) --------- ----------- ----------- Net balance as of July 1, 2007 $ - $ 75,543 $ 7,130 ========= =========== =========== 7. Store Closure, Merger and Restructuring Reserves Store Closure We continue to evaluate underperforming stores and stores that have overlap trade areas in our Movie Gallery, Hollywood Video and Game Crazy segments. During the twenty-six weeks ended July 1, 2007, we closed 92 underperforming stores. We recognized $1.1 million in store closure expenses for the twenty- six weeks ended July 1, 2007. Movie Hollywood Gallery Video Total ---------- --------- --------- Store closure reserve: Balance as of January 1, 2006 $ 10,112 $ 3,613 $ 13,725 Additions and adjustments 3,344 (145) 3,199 Payments (5,474) (773) (6,247) ---------- --------- --------- Balance as of December 31, 2006 $ 7,982 $ 2,695 $ 10,677 Additions and adjustments (846) 624 (222) Payments (2,075) (422) (2,497) ---------- --------- --------- Balance as of July 1, 2007 $ 5,061 $ 2,897 $ 7,958 ========== ========= ========= Restructuring During fiscal 2005 and fiscal 2006, in accordance with EITF 95-3, "Recognition of Liabilities in Connection with a Purchase Business Combination," we established and maintained restructuring reserves in the Hollywood segment for Hollywood executives and other employees that were terminated shortly after the merger with Hollywood in fiscal 2005, including some employees that were terminated as part of our integration efforts. During this same time, we also established and maintained restructuring reserves in the Movie Gallery segment for termination benefits associated with the relocation or elimination of positions according to our plan of integration. During the second quarter of fiscal 2007, we established additional restructuring reserves in both the Hollywood and Movie Gallery segments for termination benefits associated with the elimination of positions as part of a planned headcount reduction of corporate and field associates. This headcount reduction was instituted as part of our cost-cutting initiatives. Severance, retention incentives and outplacement services costs are recognized in Store operating expenses and General and administrative expenses. A summary of our restructuring reserve activity is as follows: Movie Hollywood Gallery Video Total Termination benefits: ---------- --------- -------- Balance as of January 1, 2006 $ 1,190 $ 4,116 $ 5,306 Additions and adjustments 1,135 - 1,135 Payments (1,985) (3,034) (5,019) ---------- --------- -------- Balance as of December 31, 2006 $ 340 $ 1,082 $ 1,422 Additions and adjustments 297 471 768 Payments (357) (1,118) (1,475) ---------- --------- -------- Balance as of July 1, 2007 $ 280 $ 435 $ 715 ========== ========= ======== Estimated future additions and adjustments $ 113 $ 377 $ 490 Total termination benefits cost $ 2,736 $ 7,503 $ 10,239 8. Long Term Obligations Long term debt consists of the following (in thousands): December 31, July 1, Instrument 2006 2007 ----------------------------------- ----------- ------------ Movie Gallery Senior Notes $ 322,044 $ 322,321 April 2005 Credit Facility Term A Loan 66,787 - Term B Loan 688,070 - Revolving credit facility 15,024 - March 2007 Credit Facility First lien term loan - 598,500 Second lien term loan - 175,000 Revolving credit facility - 100,000 Hollywood senior subordinated notes 450 450 Capital leases 80 1,412 ------------ ------------ Total 1,092,455 1,197,683 Less current portion (4,580) (1,197,683) ------------ ------------ $ 1,087,875 $ - ============ ============ March 2007 Credit Facility On March 8, 2007, we entered into a new $900 million senior secured credit facility, or the March 2007 Credit Facility. The March 2007 Credit Facility refinanced a previous $829.9 million senior secured credit facility, or the April 2005 Credit Facility, which we entered into in April 2005 in connection with the acquisition of Hollywood. The $325 million of 11% senior unsecured notes due 2012, or the 11% senior notes, which we also issued in connection with the Hollywood acquisition, remain outstanding. We accounted for the refinancing of the April 2005 Credit Facility as an extinguishment of debt, and in the first quarter of fiscal 2007 we recognized a debt extinguishment charge of $17.5 million to write off the unamortized deferred financing fees related to the April 2005 Credit Facility. In addition, we have deferred $23.2 million in debt financing fees related to the March 2007 Credit Facility, which will be recognized ratably over the term of the March 2007 Credit Facility. The March 2007 Credit Facility consists of: - a $100 million revolving credit facility, which we refer to as the revolver; - a $25 million first lien synthetic letter of credit facility; - a $600 million first lien term loan; and - a $175 million second lien term loan. We sometimes collectively refer to the revolver, the first lien term loan and the letter of credit facility as the first lien facilities. The first lien facilities require us to meet certain financial covenants, including a secured leverage test, a total leverage test and an interest coverage test. Each of these covenants is calculated based on trailing four quarter results using specific definitions that are contained in the first lien credit agreement. Due to current industry conditions and increasing competition in the home video market, as discussed in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations, we were not in compliance with the financial covenants contained in the first lien facilities as of the end of the second quarter of fiscal 2007. The second lien credit facility contains no financial covenants, but a default under the first lien credit agreement could create a cross default under the second lien term loan and the 11% senior notes. As a result of our non-compliance with the financial covenants contained in the first lien facilities and our resulting default under the first lien credit agreement, the first lien credit agreement lenders have the right to terminate their commitments, accelerate all of our obligations and exercise their remedies under the first lien credit agreement. We have executed a Forbearance Agreement (as amended), effective as of July 2, 2007, with certain lenders under the first lien credit agreement. Under the Forbearance Agreement (as amended), the lenders will forbear until August 14, 2007 from exercising default-related rights and remedies arising from existing defaults, absent any new defaults under the first lien credit agreement or the Forbearance Agreement (as amended). Due to our default under the first lien credit agreement, we have classified all obligations due under the first lien facilities as current liabilities as of July 1, 2007. Due to the uncertainty that our default under the first lien credit agreement could trigger the cross default provisions on our second lien term loan and 11% senior notes, we have classified our $175 million second lien term loan and our $325 million 11% senior notes as current liabilities as of July 1, 2007. For further information regarding our March 2007 Credit Facility and our default under our first lien credit agreement, see Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" in this Quarterly Report on Form 10-Q. Interest Rate Hedges Our March 2007 Credit Facility requires that no later than 90 days subsequent to entering into the March 2007 Credit Facility, 50% of our total outstanding debt was to be converted to fixed rate debt for a period of three years subsequent to March 8, 2007. On April 3, 2007, we executed a floating-to-fixed interest rate swap for an amount of $225.0 million, with an effective date of April 5, 2007 and a termination date of June 29, 2007. Under the terms of this swap agreement, we paid fixed-rate interest on the $225.0 million at a rate of 5.348% and received floating-rate interest based on a linear interpolation of two-month and three- month LIBOR for the 85 days covering the term of this swap. We received $0 in consideration upon settlement of this interest rate swap. On April 3, 2007, we executed a forward-starting floating-to-fixed interest rate swap for an amount of $225.0 million, with an effective date of June 29, 2007 and a termination date of June 30, 2010. Under the terms of this forward- starting swap agreement, we paid fixed-rate interest on the $225.0 million at a rate of 5.128% and received floating-rate interest based on three-month LIBOR. On July 5, 2007, we settled this interest rate swap (prior to the scheduled termination date) and received $1.3 million in consideration. On July 31, 2007, we entered into a new 6.5% interest rate cap agreement with a notional amount of $275.0 million, for which we paid a fixed fee of $0.3 million. Under the terms of the new cap agreement, we will pay floating-rate interest up to a maximum of 6.50% and receive floating-rate interest based on three-month LIBOR through the scheduled termination date of March 8, 2010. 9. Stock Based Compensation We recognize stock-based compensation expense in accordance with SFAS No. 123(R). Stock options granted under our stock plans have a ten-year term and generally vest over four years. There was no expense recognized related to stock options in the twenty-six weeks ended July 2, 2006 or July 1, 2007, as all of our outstanding options were fully vested as of the end of fiscal 2005. Following is a summary of our stock option activity for the twenty-six weeks ended July 1, 2007: Weighted- Options Average Exercise Outstanding Price Per Share ------------- ---------------- Outstanding at December 31, 2006 779,828 14.47 Granted - - Exercised - - Cancelled (16,125) 17.52 ------------- ---------------- Outstanding at July 1, 2007 763,703 14.40 Exercisable at December 31, 2006 779,828 14.47 Exercisable at July 1, 2007 763,703 14.40 Service-based non-vested share awards vest over periods ranging from one to four years. Compensation expense, representing the excess of the fair market value of the shares at the date of issuance over the nominal purchase price, if any, of the shares, net of assumptions regarding estimated future forfeitures, is charged to earnings over the vesting period. Compensation expense charged to operations related to these stock grants was $0.7 million and $0.6 million for the twenty-six weeks ended July 2, 2006 and July 1, 2007, respectively. The total grant date fair value of service-based share awards vested during the twenty-six weeks ended July 2, 2006 and July 1, 2007 was $1.5 million and $3.5 million, respectively. Following is a summary of our service-based non-vested share activity for the twenty-six weeks ending July 1, 2007: Weighted-Average Grant-Date Fair Shares Value ---------- ------------------ Outstanding at December 31, 2006 1,331,067 $ 8.00 Granted 135,000 3.58 Vested (436,015) 8.14 Cancelled (139,682) 6.65 ---------- Outstanding at July 1, 2007 890,370 7.48 ========== Performance-based non-vested share awards entitle participants to acquire shares of stock upon attainment of specified performance goals. Compensation expense, representing the excess of the fair market value of the shares at the date of issuance over the nominal purchase price, if any, net of assumptions regarding future forfeitures and the likelihood that the performance requirements will be attained, is charged to earnings over the vesting period. Compensation cost of $0.3 million and $0 for performance-based stock grants was recognized for the twenty-six weeks ended July 2, 2006 and July 1, 2007, respectively, using the accelerated expense attribution method under SFAS Interpretation No. 28, or EITF 00-23. The total grant date fair value of performance-based share awards vested during the twenty-six weeks ended July 2, 2006 and July 1, 2007 was $1.5 million and $0.8 million, respectively. Following is a summary of our performance-based non-vested share activity for the twenty-six weeks ended July 1, 2007: Weighted-Average Grant-Date Fair Shares Value ---------- ------------------ Outstanding at December 31, 2006 25,000 $ 30.03 Granted - - Vested (25,000) 30.03 Cancelled - - ---------- Outstanding at July 1, 2007 - - ========== Total compensation cost related to all non-vested awards that is not yet recognized was $4.3 million at July 1, 2007 and is expected to be recognized over a weighted-average period of approximately two years. 10. Comprehensive Income (Loss) Comprehensive income is as follows (in thousands): Thirteen Weeks Ended Twenty-Six Weeks Ended ---------------------- ---------------------- July 2, July 1, July 2, July 1, 2006 2007 2006 2007 --------- --------- --------- --------- Net income (loss) $ (14,898) $(309,939) $ 25,452 $(324,805) Change in foreign currency cumulative translation adjustment, net of taxes 1,418 1,327 1,330 1,579 Change in value of interest rate swap, net of taxes (1,148) (893) (146) (1,806) --------- --------- --------- --------- Comprehensive income (loss) $ (14,628) $(309,505) $ 26,636 $(325,032) ========= ========= ========= ========= 11. Commitments and Contingencies Hollywood and the members of its former board of directors (including Hollywood's former chairman Mark Wattles) were named as defendants in several lawsuits in the Circuit Court in Clackamas County, Oregon. The lawsuits, filed between March 31, 2004 and April 14, 2004, asserted breaches of duties associated with the merger agreement executed with a subsidiary of Leonard Green & Partners, L.P., or LGP. The Clackamas County actions were later consolidated, and the plaintiffs filed an Amended Consolidated Complaint alleging four claims for relief against Hollywood's former board members arising out of the merger of Hollywood with Movie Gallery. The purported four claims for relief are breach of fiduciary duty, misappropriation of confidential information, failure to disclose material information in the proxy statement in support of the Movie Gallery merger, and a claim for attorneys' fees and costs. The Amended Consolidated Complaint also names UBS Warburg and LGP as defendants. Following the merger with Movie Gallery, the plaintiffs filed a Second Amended Consolidated Complaint. The plaintiffs restated their causes of action and generally allege that the defendants adversely impacted the value of Hollywood through the negotiations and dealings with LGP. Hollywood and the former members of its board have also been named as defendants in a separate lawsuit entitled JDL Partners, L.P. v. Mark J. Wattles et al. filed in Clackamas County, Oregon, Circuit Court on December 22, 2004. This lawsuit, filed before Hollywood's announcement of the merger agreement with Movie Gallery, alleges breaches of fiduciary duties related to a bid by Blockbuster Inc. to acquire Hollywood, as well as breaches related to a loan to Mr. Wattles that Hollywood forgave in December 2000. On April 25, 2005, the JDL Partners action was consolidated with the other Clackamas County lawsuits. The plaintiffs seek damages and attorneys' fees and costs. The parties agreed to settle the case and entered into a Stipulation of Settlement and Release dated March 29, 2007. An order and final judgment, approving the settlement and dismissing the case with prejudice, was entered by the court on June 4, 2007. Due to our current liquidity situation, we have not yet performed our obligations pursuant to the Stipulation of Settlement and Release. By letter dated August 29, 2005, Boards, Inc., or Boards, an entity controlled by Mark Wattles, the founder and former Chief Executive Officer of Hollywood, exercised a contractual right to require Hollywood to purchase all of the 20 Hollywood Video stores, including 17 Game Crazy stores, owned and operated by Boards, pursuant to a put option. The put option, and a related call option, were contained in the license agreement between Hollywood and Boards that was effective January 25, 2001. On a change of control (as defined in the license agreement), Hollywood had an option to purchase the stores within six months. Likewise, on a change of control, Boards had the option to require Hollywood to purchase the stores within six months. In both cases, the process by which the price would be determined was detailed in the license agreement and was at fair value as determined by an appraisal process. In accordance with the terms of the license agreement, Hollywood and Boards have agreed to the retention of a valuation expert and are proceeding with the valuation of the stores. As of July 1, 2007, the purchase price had not yet been determined. It is possible that the transaction will close in fiscal 2007. On March 7, 2007, Boards sent to us a demand for arbitration, which we refer to as the Demand, seeking to determine the purchase price of these stores, along with accrued interest. Additionally, Boards claims an additional $10.0 million in punitive damages, alleging that we have taken action to deliberately diminish the value of the Boards stores in order to lower the purchase price. We believe the allegations contained in the Demand are without merit and intend to vigorously defend this matter. In addition, we have been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. A negative outcome in certain of the ongoing litigation could harm our business, financial condition, liquidity or results of operations. In addition, prolonged litigation, regardless of which party prevails, could be costly, divert management's attention or result in increased costs of doing business. We believe we have provided adequate reserves for contingencies and that the outcome of these matters will not have a material adverse effect on our consolidated results of operation, financial condition or liquidity. At July 1, 2007, the legal contingencies reserve was $2.0 million, of which $1.0 million relates to pre-Hollywood acquisition contingencies. 12. Segment Reporting Our reportable segments are based on our three store brands, Movie Gallery, Hollywood Video, and Game Crazy. Movie Gallery represents 2,522 video stores serving mainly rural markets in the United States and Canada; Hollywood Video represents 2,017 video stores serving predominantly urban markets; and Game Crazy represents 623 in-store departments and 14 free-standing stores serving the game market in urban locations. We measure segment profit as operating income (loss), which is defined as income (loss) before interest and other financing costs, equity in losses of unconsolidated entities and income taxes. Information on our reportable operating segments is as follows (in thousands): Thirteen Weeks Ended July 2, 2006 ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Rental revenue $ 191,351 $ 302,195 $ - $ 493,546 Product sales 17,880 25,001 64,858 107,739 Depreciation and amortization 9,664 13,239 2,459 25,362 Rental amortization 23,883 30,495 - 54,378 Operating income (loss) (1,824) 17,400 (1,333) 14,243 Goodwill 147 117,771 - 117,918 Total assets 369,534 730,436 97,666 1,197,636 Purchases of property, furnishings and equipment 3,890 2,199 19 6,108 Thirteen Weeks Ended July 1, 2007 ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Rental revenue $ 174,802 $ 258,603 $ - $ 433,405 Product sales 18,943 26,732 82,144 127,819 Depreciation and amortization 11,069 12,201 2,014 25,284 Rental amortization 20,119 24,337 - 44,456 Impairment of goodwill 148 115,422 - 115,570 Impairment of other intangibles - 97,879 - 97,879 Impairment of property, furnishings, and equipment 16,769 23,256 2,976 43,001 Operating loss (15,787) (265,912) (546) (282,245) Goodwill - - - - Total assets 338,773 433,868 119,352 891,993 Purchases of property, furnishings and equipment 531 (246) - 285 Twenty-six Weeks Ended July 2, 2006 ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Rental revenue $ 414,032 $ 649,943 $ - $1,063,975 Product sales 39,595 54,668 137,414 231,677 Depreciation and amortization 19,059 27,785 5,236 52,080 Rental amortization 52,670 67,080 - 119,750 Operating income (loss) 13,542 71,106 (2,896) 81,752 Goodwill 147 117,771 - 117,918 Total assets 369,534 730,436 97,666 1,197,636 Purchases of property, furnishings and equipment 10,709 4,289 93 15,091 Twenty-six Weeks Ended July 1, 2007 ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Rental revenue $ 385,012 $ 559,437 $ - $ 944,449 Product sales 37,660 54,556 172,253 264,469 Depreciation and amortization 19,063 24,017 4,046 47,126 Rental amortization 42,687 51,092 - 93,779 Impairment of goodwill 148 115,422 - 115,570 Impairment of other intangibles - 97,879 - 97,879 Impairment of property, furnishings, and equipment 16,769 23,256 2,976 43,001 Operating income (loss) 4,970 (254,783) 1,187 (248,626) Goodwill - - - - Total assets 338,773 433,868 119,352 891,993 Purchases of property, furnishings and equipment 453 931 - 1,384 13. Consolidating Financial Statements The following tables present condensed consolidating financial information for: (a) Movie Gallery, Inc., or the Parent, on a stand-alone basis; (b) on a combined basis, the guarantors of our 11% Senior Notes due 2012, or the Subsidiary Guarantors, which include Movie Gallery US, LLC; Hollywood Entertainment Corporation; M.G.A. Realty I, LLC; M.G. Digital, LLC; and (c) on a combined basis, the non-guarantor subsidiaries, which include Movie Gallery Canada, Inc., Movie Gallery Mexico, Inc., S. de R.L. de C.V., and MG Automation, Inc. Each of the Subsidiary Guarantors is wholly owned by Movie Gallery, Inc. The guarantees issued by each of the Subsidiary Guarantors are full, unconditional, joint and several. Accordingly, separate financial statements of the wholly owned Subsidiary Guarantors are not presented because the Subsidiary Guarantors are jointly, severally and unconditionally liable under the guarantees, and we believe separate financial statements and other disclosures regarding the Subsidiary Guarantors are not material to investors. Furthermore, there are no significant legal restrictions on the Parent's ability to obtain funds from its subsidiaries by dividend or loan. The Parent is a Delaware holding company and has no independent operations other than investments in subsidiaries and affiliates. Consolidating Statement of Operations Thirteen weeks ended July 2, 2006 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- --------- --------- --------- Revenue: Rentals $ - $ 473,467 $ 20,079 $ - $ 493,546 Product sales - 105,449 2,290 - 107,739 --------- --------- --------- --------- --------- Total revenue - 578,916 22,369 - 601,285 Cost of sales: Cost of rental revenue - 145,875 9,029 - 154,904 Cost of product sales - 75,516 1,897 - 77,413 --------- --------- --------- --------- --------- Gross profit - 357,525 11,443 - 368,968 Operating costs and expenses: Store operating expenses - 291,566 13,928 - 305,494 General and administrative 106 47,314 1,103 - 48,523 Amortization of intangibles - 672 36 - 708 -------- -------- -------- -------- --------- Operating income (loss) (106) 17,973 (3,624) - 14,243 Interest expense, net 20,321 10,337 36 - 30,694 Equity in earnings (losses) of subsidiaries 5,193 (2,526) - (2,667) - -------- -------- -------- -------- --------- Income (loss) before income taxes (15,234) 5,110 (3,660) (2,667) (16,451) Income benefit (336) (83) (1,134) - (1,553) -------- -------- -------- -------- --------- Net income (loss) $(14,898) $ 5,193 $ (2,526) $ (2,667) $(14,898) ======== ======== ======== ======== ========= Consolidating Statement of Operations Thirteen weeks ended July 1, 2007 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- ---------- --------- ------- --------- Revenue: Rentals $ - $ 414,571 $ 18,834 $ - $ 433,405 Product sales - 125,349 2,470 - 127,819 --------- ---------- --------- ------- --------- Total revenue - 539,920 21,304 - 561,224 Cost of sales: Cost of rental revenue - 135,423 5,570 - 140,993 Cost of product sales - 94,037 2,077 - 96,114 --------- ---------- --------- ------- --------- Gross profit - 310,460 13,657 - 324,117 Operating costs and expenses: Store operating expenses - 290,353 13,268 - 303,621 General and administrative 2,690 41,677 1,563 - 45,930 Amortization of intangibles - 650 36 - 686 Impairment of goodwill - 115,556 14 - 115,570 Impairment of other intangibles - 97,879 - - 97,879 Impairment of property, Furnishings, and equipment - 38,953 4,048 - 43,001 Other expenses - - (325) - (325) --------- --------- --------- ------- --------- Operating loss (2,690) (274,608) (4,947) - (282,245) Interest expense, net 19,070 9,609 - - 28,679 Equity in earnings (losses) of subsidiaries (288,592) (4,074) - 292,666 - --------- --------- --------- ------- --------- Income (loss) before income taxes (310,352) (288,291) (4,947) 292,666 (310,924) Income taxes (benefit) (413) 301 (873) - (985) --------- --------- --------- -------- --------- Net income (loss) $(309,939) $(288,592)$ (4,074) $292,666 $(309,939) ========= ========= ========= ======== ========= Consolidating Statement of Operations Twenty-six weeks ended July 2, 2006 (unaudited, in thousands) --------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- ---------- --------- --------- ---------- Revenue: Rentals $ - $1,021,067 $ 42,908 $ - $1,063,975 Product sales - 226,564 5,113 - 231,677 --------- ---------- --------- --------- ---------- Total revenue - 1,247,631 48,021 - 1,295,652 Cost of sales: Cost of rental revenue - 310,738 17,743 - 328,481 Cost of product sales - 166,750 4,543 - 171,293 --------- ---------- --------- --------- ---------- Gross profit - 770,143 25,735 - 795,878 Operating costs and expenses: Store operating expenses - 590,224 26,997 - 617,221 General and administrative 2,897 90,262 2,305 - 95,464 Amortization of intangibles - 1,369 72 - 1,441 -------- --------- -------- -------- ---------- Operating income (loss) (2,897) 88,288 (3,639) - 81,752 Interest expense, net 40,147 17,884 116 - 58,147 Equity in earnings (losses) of subsidiaries 68,131 (2,594) - (65,537) - -------- --------- -------- -------- ---------- Income (loss) before income taxes 25,087 67,810 (3,755) (65,537) 23,605 Income benefit (365) (321) (1,161) - (1,847) -------- --------- -------- -------- ---------- Net income (loss) $ 25,452 $ 68,131 $ (2,594) $(65,537)$ 25,452 ======== ========= ======== ======== ========== Consolidating Statement of Operations Twenty-six weeks ended July 1, 2007 (unaudited, in thousands) --------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- ---------- --------- --------- ---------- Revenue: Rentals $ - $ 904,843 $ 39,606 $ - $ 944,449 Product sales - 259,720 4,749 - 264,469 --------- ---------- --------- --------- ---------- Total revenue - 1,164,563 44,355 - 1,208,918 Cost of sales: Cost of rental revenue - 284,402 11,614 - 296,016 Cost of product sales - 195,645 3,857 - 199,502 --------- ---------- --------- --------- ---------- Gross profit - 684,516 28,884 - 713,400 Operating costs and expenses: Store operating expenses - 585,526 26,077 - 611,603 General and administrative 5,543 84,429 2,923 - 92,895 Amortization of intangibles - 1,311 70 - 1,381 Impairment of goodwill - 115,556 14 - 115,570 Impairment of other intangibles - 97,879 - - 97,879 Impairment of property, Furnishings, and equipment - 38,953 4,048 - 43,001 Other expenses - - (303) - (303) -------- --------- -------- -------- ---------- Operating income (loss) (5,543) (239,138) (3,945) - (248,626) Interest expense, net (Parent includes $17,538 write off of debt issuance costs) 56,697 19,762 20 - 76,479 Equity in earnings (losses) of subsidiaries (262,509) (3,616) - 266,125 - --------- --------- -------- -------- ---------- Income (loss) before income taxes (324,749) (262,516) (3,965) 266,125 (325,105) Income taxes (benefit) 56 (7) (349) - (300) --------- --------- -------- -------- ---------- Net income (loss) $(324,805) $(262,509) $ (3,616) $266,125 $ (324,805) -======== ========= ======== ======== ========== Condensed Consolidating Balance Sheet December 31, 2006 (in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- -------- --------- ---------- Assets Current assets: Cash and cash equivalents $ - $ 29,274 $ 3,679 $ - $ 32,953 Merchandise inventory, net - 136,887 3,727 - 140,614 Prepaid expenses - 43,683 1,641 - 45,324 Store supplies and other - 18,764 1,447 - 20,211 Deferred income taxes - - 209 - 209 --------- --------- ------ ----------- -------- Total current assets - 228,608 10,703 - 239,311 Rental inventory, net - 326,183 13,798 - 339,981 Property, furnishings and equipment, net - 230,146 12,789 - 242,935 Goodwill - 115,556 13 - 115,569 Other intangibles, net - 181,646 266 - 181,912 Deposits and other assets 28,906 4,175 488 - 33,569 Investments in subsidiaries 878,144 16,833 - (894,977) - --------- ---------- ------- ----------- ---------- Total assets $ 907,050 $1,103,147 $38,057 $ (894,977)$1,153,277 ========= ========== ======= =========== ========== Liabilities and stockholders' equity (deficit): Current liabilities: Current maturities of long-term obligations $ 4,500 $ 80 $ - $ - $ 4,580 Accounts payable - 81,007 5,373 - 86,380 Accrued liabilities 858 79,262 312 - 80,432 Accrued payroll 534 45,568 1,794 - 47,896 Accrued interest 6,567 13 194 - 6,774 Deferred revenue - 41,362 693 - 42,055 --------- --------- ------- ---------- ---------- Total current liabilities 12,459 247,292 8,366 - 268,117 Long-term obligations, less current portion 1,087,425 450 - - 1,087,875 Other accrued liabilities - 31,346 2,370 - 33,716 Intercompany promissory note (receivable) (384,200) 384,200 - - - Payable to (receivable from) affiliate 427,797 (438,285) 10,488 - - Stockholders' equity (deficit) (236,431) 878,144 16,833 (894,977) (236,431) ---------- ---------- ------- ----------- ---------- Total liabilities and stockholders' equity (deficit) $ 907,050 $1,103,147 $38,057 $ (894,977)$1,153,277 ========== ========== ======= =========== ========== Condensed Consolidating Balance Sheet July 1, 2007 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- ------- ---------- ---------- Assets Current assets: Cash and cash equivalents $ - $ 40,961 $ 4,552 $ - $ 45,513 Merchandise inventory, net - 171,120 4,350 - 175,470 Prepaid expenses - 43,942 1,845 - 45,787 Store supplies and other - 15,821 901 - 16,722 Assets held for sale - 7,613 - - 7,613 --------- --------- ------ ----------- -------- Total current assets - 279,457 11,648 - 291,105 Rental inventory, net - 310,305 14,954 - 325,259 Property, furnishings and equipment, net - 146,282 7,643 - 153,925 Other intangibles, net - 82,456 217 - 82,673 Deferred income taxes, net 1,774 - 1,257 - 3,031 Deposits and other assets 34,109 1,583 308 - 36,000 Investments in subsidiaries 617,216 14,985 - (632,201) - --------- ---------- ------- ----------- ---------- Total assets $ 653,099 $ 835,068 $36,027 $ (632,201)$ 891,993 ========= ========== ======= =========== ========== Liabilities and stockholders' equity (deficit): Current liabilities: Current maturities of long-term obligations $1,195,821 $ 1,862 $ - $ - $1,197,683 Accounts payable - 61,504 2,818 - 64,322 Accrued liabilities 3,641 67,800 1,384 - 72,825 Accrued payroll - 32,724 1,552 - 34,276 Accrued interest 11,226 13 - - 11,239 Deferred revenue - 38,355 515 - 38,870 --------- --------- ------- ---------- --------- Total current liabilities 1,210,688 202,258 6,269 - 1,419,215 Long-term obligations, less current portion - - - - - Other accrued liabilities - 31,025 2,047 - 33,072 Intercompany promissory note (receivable) (384,200) 384,200 - - - Payable to (receivable from) affiliate 386,905 (399,631) 12,726 - - Stockholders' equity (deficit) (560,294) 617,216 14,985 (632,201) (560,294) ---------- ---------- ------- ---------- ---------- Total liabilities and stockholders' equity (deficit) $ 653,099 $ 835,068 $36,027 $ (632,201)$ 891,993 ========== ========== ======= ========== ========== Condensed Consolidating Statement of Cash Flow Twenty-six weeks ended July 2, 2006 (unaudited, in thousands) ------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated -------- --------- -------- -------- --------- Operating Activities: Net income (loss) $ 25,452 $ 68,131 $ (2,594) $(65,537) $ 25,452 Equity in earnings (losses) of subsidiaries (68,131) 2,594 - 65,537 - Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities: Rental inventory amortization - 110,903 8,847 - 119,750 Purchases of rental inventory - (75,986) (6,250) - (82,236) Purchase of rental inventory-base stock - (9,160) (274) - (9,434) Depreciation and intangibles amortization - 49,774 2,306 - 52,080 Gain on disposal of property, furnishings, and equipment - (697) - - (697) Stock based compensation 1,253 (196) - - 1,057 Amortization of debt issuance cost 3,243 - - - 3,243 Deferred income taxes 669 - 18 - 687 Changes in operating assets and liabilities, net of business acquisitions: Merchandise inventory - 13,974 735 - 14,709 Other current assets 19 (7,384) 39 - (7,326) Deposits and other assets (1,434) 1,405 (46) - (75) Accounts payable - (142,056) (2,040) - (144,096) Accrued interest 42 3 9 - 54 Accrued liabilities and deferred revenue 302 (8,458) (248) - (8,404) -------- --------- -------- -------- --------- Net cash provided by (used in) operating activities (38,585) 2,847 502 - (35,236) Investing Activities: Business acquisitions, net of cash acquired - (300) (19) - (319) Purchase of property, furnishings and equipment - (13,577) (1,514) - (15,091) Proceeds from disposal of property, furnishings and equipment - 1,320 - - 1,320 Investment in subsidiaries 88,576 (1,748) - (86,828) - -------- --------- -------- -------- --------- Net cash provided by (used in) investing activities 88,576 (14,305) (1,533) (86,828) (14,090) Financing Activities: Repayment of capital lease obligations - (328) - - (328) Intercompany payable/ receivable 8,855 (14,360) 5,505 - - Net borrowings on credit facilities 5,464 - (6,859) - (1,395) Debt financing fees (5,528) - - - (5,528) Principal payments on debt (58,782) - (58) - (58,840) Capital contribution from parent - (88,576) 1,748 86,828 - -------- --------- -------- -------- --------- Net cash provided by (used in) financing activities (49,991) (103,264) 336 86,828 (66,091) Effect of exchange rate changes on cash and cash equivalents - 1,330 - - 1,330 -------- --------- -------- -------- --------- Decrease in cash and cash equivalents - (113,392) (695) - (114,087) Cash and cash equivalents at beginning of period - 133,901 1,337 - 135,238 -------- --------- -------- -------- --------- Cash and cash equivalents at end of period $ - $ 20,509 $ 642 $ - $ 21,151 ======== ========= ======== ======== ========= Condensed Consolidating Statement of Cash Flow Twenty-six weeks ended July 1, 2007 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated -------- --------- --------- -------- --------- Operating Activities: Net income (loss) $(324,805)$(262,509) $ (3,616) $266,125 $(324,805) Equity in earnings (losses) of subsidiaries 262,509 3,616 - (266,125) - Adjustments to reconcile net income (loss) to cash used in operating activities: Rental inventory amortization - 88,602 5,177 - 93,779 Purchases of rental inventory, net - (72,200) (5,064) - (77,264) Purchases of rental inventory base stock - (524) - - (524) Depreciation and intangibles amortization - 44,842 2,284 - 47,126 Gain on disposal of property, furnishings, and equipment (228) (40) - (268) Stock based compensation 538 97 - - 635 Amortization of debt issuance cost 3,388 - - - 3,388 Write off of debt issuance costs 17,538 - - - 17,538 Impairment of goodwill - 115,556 14 - 115,570 Impairment of other intangibles - 97,879 - - 97,879 Impairment of property, furnishings, and equipment - 38,953 4,048 - 43,001 Other non-cash (income) expense (1,806) - - - (1,806) Deferred income taxes (1,774) - (1,077) - (2,851) Changes in operating assets and liabilities, net of business acquisitions: Merchandise inventory - (34,233) (253) - (34,486) Other current assets - 4,660 563 - 5,223 Deposits and other assets (2,613) 943 210 - (1,460) Accounts payable - (19,503) (2,894) - (22,397) Accrued interest 4,659 - (193) - 4,466 Accrued liabilities and deferred revenue 2,783 (27,632) (83) - (24,932) --------- --------- -------- -------- --------- Net cash used in operating activities (39,583) (21,681) (924) - (62,188) Investing Activities: Business acquisitions, net of cash acquired - (3,129) - - (3,129) Purchases of property, furnishings and equipment - (1,291) (93) - (1,384) Proceeds from disposal of property, furnishings, and - 450 87 537 equipment Investment in subsidiaries - (179) 179 - - --------- --------- -------- -------- --------- Net cash provided by (used in) investing activities - (4,149) 173 - (3,976) Financing Activities: Repayments of capital lease obligations - (1,034) - - (1,034) Intercompany payable/ receivable (40,797) 38,551 2,246 - - Net borrowings (repayments) on credit facilities 83,477 - - - 83,477 Debt financing fees (23,239) - - - (23,239) Proceeds from the issuance of debt 775,000 - - - 775,000 Principal payments on long-term debt (754,858) - - - (754,858) -------- -------- -------- -------- --------- Net cash provided by financing activities 39,583 37,517 2,246 - 79,346 Effect of exchange rate changes on cash and cash equivalents - - (622) - (622) -------- -------- -------- -------- --------- Increase in cash and cash equivalents - 11,687 873 - 12,560 Cash and cash equivalents at beginning of period - 29,274 3,679 - 32,953 -------- --------- -------- -------- --------- Cash and cash equivalents at end of period $ - $ 40,961 $ 4,552 $ - $ 45,513 ======== ========= ======== ======== ========= Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Overview Summary of Financial Condition During the thirteen weeks ended July 1, 2007, we incurred significant losses from operations as a result of current industry conditions and increased competition in the home video market. Our operating results caused us to fail the financial covenants contained in our first lien credit facilities as of the end of the second quarter of fiscal 2007, which in turn creates uncertainty that the associated default under the first lien credit agreement could trigger cross default provisions on our second lien term loan and 11% senior notes. As a result of these recent losses, we updated our future projections of operating cash flows, which caused us to recognize substantial impairment charges on certain of our long-lived assets. Subsequent to the end of the second quarter of fiscal 2007, many of our significant vendors have discontinued extending us trade credit, and we have experienced additional tightening of terms with other vendors. Consequently, our liquidity has been adversely affected and there is now substantial doubt as to our ability to continue as a going concern. For additional information regarding our long term obligations, liquidity and ongoing discussions with our major creditors, see "Liquidity and Capital Resources" further below in this Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations." Current Industry Conditions Our Movie Gallery and Hollywood Video retail store locations compete in the home video retail industry. The home video retail industry includes the sale and rental of movies by traditional video store retailers, online retailers, subscription rental retailers, mass merchants and other retailers. A number of industry-wide factors have combined to negatively impact the rental market, which include but are not limited to: - weak movie title lineup; - cannibalization of rentals by low-priced movies available for sale; - growth of the online rental segment; - the standard DVD format nearing the end of its life cycle; - movie studios structuring their DVD movie releases towards the later part of the year; - competing high definition DVD formats delaying content release and consumer acceptance; and - the proliferation of alternative consumer entertainment options, including movies available through video-on-demand, TIVO/DVR, digital cable, satellite TV, broadband, and Internet and broadcast television. While these trends have been apparent for some time, they have been more prevalent over the past four months. In addition, while the movie rental market was expected to be soft during the first half of 2007, we experienced significantly sharper than anticipated declines in revenue also over the past four months. These declines were primarily the result of competitive pricing between Blockbuster and Netflix over their subscription services and greater than expected customer acceptance of Blockbuster's Total Access program, which mixes elements of instore and online movie rentals. These factors along with the trends discussed above have had a negative impact on our business over the twenty-six weeks ended July 1, 2007. We expect that these factors and trends will continue to have a negative impact on the rental market for at least the next six months, if not longer. Our Business As of July 1, 2007, we operated approximately 4,550 home video retail stores that rent and sell movies and video games in urban, rural and suburban markets. We currently plan to open fewer than 10 new stores for the full fiscal year 2007, subject to market and industry conditions. We operate three distinct brands: Movie Gallery, Hollywood Video and Game Crazy. Movie Gallery's eastern-focused rural and secondary market presence and Hollywood's western- focused prime urban and suburban superstore locations combine to form a nationwide geographical store footprint. We believe the most significant dynamic in our industry is the relationship our industry maintains with the movie studios. The studios have historically maintained an exclusive window for home video distribution (available for rental and sale), which provides the home video industry with an approximately 45- to 60- day period during which we can rent and sell new releases before they are made available on pay-per-view or through other distribution channels. According to Adams Media Research, the domestic home video industry accounted for approximately 60% of domestic studio movie revenue in 2006. For this reason, we believe movie studios have a significant interest in maintaining a viable home video business. Our strategies are focused on developing and maintaining a sustainable business model. We strive to minimize the operating and overhead costs associated with our business. It is our belief that the brick-and-mortar stores will continue to retain their relevance, and that relevance can be augmented with certain enhancements, such as: - store size optimization; - geographical placement and branding of stores within our fleet; - expansion of the movie kiosk program; - integration of complementary in-store technology; - integration of online video rental and video on demand; and - balanced marketing and promotions that provide a meaningful return on investment. To that end, we have continued to explore the economic viability of various alternative delivery channels, and we are taking steps to develop our own online video rental and video-on-demand delivery systems. We anticipate offering online video rental to the broader marketplace in early fiscal 2008, and we recently acquired MovieBeam, Inc., or MovieBeam, an on-demand movie service. We do not see a cost-benefit advantage in the adoption of a first-mover strategy that ignores underlying economic fundamentals. Rather, it is our intent to deliver complementary offerings to our customers when these offerings can provide not only compelling value propositions, but also tangible contributions to our operating performance. In addition to the relationship between our industry and the movie studios, our operating results are driven by revenue, inventory, rent and payroll. Given those key factors, we believe that monitoring our five operating performance indicators described below will contribute to the execution of our operating plans and strategy. - Revenues. Our business is a cash business with initial rental fees paid upfront by the customer. Our management team continuously reviews inventory levels, marketing and sales promotions, real estate strategies, and staffing requirements in order to maximize revenues at each location. Additionally, our team monitors revenue performance on a daily basis to quickly identify trends or issues in our store base or in the industry as a whole. Our management closely monitors same-store revenues, which we define as revenues at stores that we have operated for at least 12 full months, excluding stores that have been downsized or remodeled, to assess the performance of our business. - Product purchasing economics. In order to maintain the desired profit margin in our business, we carefully manage purchases of inventory for both rental and sale. Our purchasing models are designed to analyze the impact of the economic factors inherent in the various pricing strategies employed by the studios. We believe that our models enable us to achieve purchasing levels tailored for the customer demographics of each of our markets and to maximize the return on investment of our inventory purchase dollars. - Store level cost control. The most significant store expenses are payroll and rent, followed by other supply and service expenditures. We attempt to control these expenses primarily through budgeting systems and centralization of purchases in our corporate support centers. This enables us to measure performance against expectations and to leverage our purchasing power. We also benefit from the reduced labor and real estate costs the Movie Gallery brand stores enjoy by being located in rural markets versus the higher costs associated with the larger urban markets. We are also able to adjust store hours and staffing levels to specific market conditions, as well as leverage best practices from both Movie Gallery and Hollywood to reduce expense and increase operating efficiency. - Leverage of overhead expenses. We apply the same principles of budgeting, accountability and conservatism in our overhead spending that we employ in managing our store operating costs. Our general and administrative expenses include the costs to maintain our corporate support centers as well as the overhead costs of our field management teams. Our integration strategy is focused on eliminating duplication, leveraging best practices and reaping the financial benefits of economies of scale to reduce costs. - Operating cash flows. In prior years, our stores generated significant levels of cash flow. These cash flows were able to fund the majority of our store growth and acquisitions, as well as ongoing inventory purchases. An exception to this was the acquisition of Hollywood, which we funded through a combination of cash on hand and significant long-term debt. Currently our inventory purchases are being funded through a combination of store cash flows and cash on hand, as a result of our having fully drawn the remaining availability under the revolving portion of our March 2007 Credit Facility. During the second quarter of fiscal 2007, Bill Kosturos, a Managing Director at restructuring and corporate advisory firm Alvarez & Marsal, resumed his role as our Chief Restructuring Officer. Alvarez & Marsal was retained by us in 2006 to bolster our accounting and finance functions and assist in improving our overall operating performance. Alvarez & Marsal's responsibilities have now expanded to include helping us evaluate available strategic and restructuring alternatives. In addition to Alvarez & Marsal, we have hired Lazard Freres & Co. LLC to serve as an independent financial advisor. Seasonality There is a distinct seasonal pattern to the home video and game retail business. Compared to other months during the year, we typically experience peak revenues during the months of November, December, January, and February due to the holidays in these months, inclement weather conditions and frequently the home video release of the preceding summer's hit titles. September is typically the lowest revenue period with schools back in session and the premiere of new fall broadcast television programs. Seasonal patterns for our Game Crazy operating segment are similar to traditional retail revenue peaks, which are significantly weighted towards holiday periods and when schools are out of session. Pending Acquisition By letter dated August 29, 2005, Boards, Inc., or Boards, an entity controlled by Mark Wattles, the founder and former Chief Executive Officer of Hollywood, exercised a contractual right to require Hollywood to purchase all of the 20 Hollywood Video stores, including 17 Game Crazy stores, owned and operated by Boards, pursuant to a put option. The put option, and a related call option, were contained in the license agreement between Hollywood and Boards that was effective January 25, 2001. On a change of control (as defined in the license agreement), Hollywood had an option to purchase the stores within six months. Likewise, on a change of control, Boards had the option to require Hollywood to purchase the stores within six months. In both cases, the process by which the price would be determined was detailed in the license agreement and was at fair value as determined by an appraisal process. In accordance with the terms of the license agreement, Hollywood and Boards have agreed to the retention of a valuation expert and are proceeding with the valuation of the stores. As of July 1, 2007, the purchase price had not yet been determined. It is possible that the transaction will close in fiscal 2007. On March 7, 2007, Boards sent to us a demand for arbitration, which we refer to as the Demand, seeking to determine the purchase price of these stores, along with accrued interest. Additionally, Boards claims an additional $10.0 million in punitive damages, alleging that we have taken action to deliberately diminish the value of the Boards stores in order to lower the purchase price. We believe the allegations contained in the Demand are without merit and intend to vigorously defend this matter. Results of Operations The following discussion of our results of operations, liquidity and capital resources is intended to provide further insight into our performance for the thirteen weeks and twenty-six weeks ended July 2, 2006 and July 1, 2007. Selected Financial Statement and Operational Data: Thirteen Weeks Ended Twenty-Six Weeks Ended -------------------- ---------------------- July 2, July 1, July 2, July 1, 2006 2007 2006 2007 --------- --------- ---------- --------- ($ in thousands, except per share and store data) Rental revenue $ 493,546 $ 433,405 $1,063,975 $ 944,449 Product sales 107,739 127,819 231,677 264,469 --------- --------- ---------- ---------- Total revenue 601,285 561,224 1,295,652 1,208,918 Cost of rental revenue 154,904 140,993 328,481 296,016 Cost of product sales 77,413 96,114 171,293 199,502 --------- --------- ---------- ---------- Total gross profit $ 368,968 $ 324,117 $ 795,878 $ 713,400 Store operating expenses $ 305,494 $ 303,621 $ 617,221 $ 611,603 General and administrative expenses $ 48,523 $ 45,930 $ 95,464 $ 92,895 Impairment of goodwill $ - $ 115,570 $ - $ 115,570 Impairment of other intangibles $ - $ 97,879 $ - $ 97,879 Impairment of property, furnishings, and equipment $ - $ 43,001 $ - $ 43,001 Operating income (loss) $ 14,243 $(282,245) $ 81,752 $ (248,626) Interest expense, net (includes $17,538 write off of debt issuance costs for the twenty-six weeks ended July 1, 2007) $ 30,694 $ 28,679 $ 58,147 $ 76,479 Net income (loss) $ (14,898) $(309,939) $ 25,452 $ (324,805) Net income (loss) per diluted share $ (0.47) $ (9.69) $ 0.80 $ (10.18) Rental margin 68.6% 67.5% 69.1% 68.7% Product sales margin 28.1% 24.8% 26.1% 24.6% Total gross margin 61.4% 57.8% 61.4% 59.0% Percent of total revenue: Rental revenue 82.1% 77.2% 82.1% 78.1% Product sales 17.9% 22.8% 17.9% 21.9% Store operating expenses 50.8% 54.1% 47.6% 50.6% General and administrative expenses 8.1% 8.2% 7.4% 7.7% Impairment of goodwill - 20.6% - 9.6% Impairment of other intangibles - 17.4% - 8.1% Impairment of property, furnishings, and equipment - 7.7% - 3.6% Operating income (loss) 2.4% (50.3%) 6.3% (20.6%) Interest expense, net 5.1% 5.1% 4.5% 6.3% Net income (loss) (2.5%) (55.2%) 2.0% (26.9%) Total same-store revenues (4.6%) (4.7%) (5.6%) (5.3%) Movie Gallery same-store revenues 1.6% (3.5%) (1.3%) (3.7%) Hollywood same-store revenues (7.3%) (5.3%) (7.5%) (6.2%) Total same-store rental revenues (5.3%) (10.4%) (6.6%) (10.1%) Movie Gallery same-store revenues 1.1% (4.8%) (2.5%) (4.0%) Hollywood same-store revenues (8.5%) (13.9%) (8.7%) (13.8%) Total same-store product sales (1.5%) 21.0% (1.2%) 15.9% Movie Gallery same-store sales 6.1% 10.4% 12.3% (1.4%) Hollywood same-store sales (2.9%) 23.0% (3.4%) 19.2% Store count: Beginning of period 4,773 4,589 4,749 4,642 New store builds 32 2 102 3 Stores acquired - - - - Stores closed (42) (38) (88) (92) --------- --------- ---------- --------- End of period 4,763 4,553 4,763 4,553 ========= ========= ========== ========= Revenue For the thirteen weeks and twenty-six weeks ended July 1, 2007, consolidated total revenues decreased 6.7% from the comparable periods in 2006, primarily due to a decline in consolidated same-store sales and a decrease in the number of weighted average stores operated. For the thirteen weeks and twenty-six weeks ended July 1, 2007, consolidated same-store sales declined 4.7% and 5.3%, respectively, and the number of weighted average stores operated declined 4.1% and 4.4%, respectively, compared to the prior year periods. Consolidated same- store sales for the thirteen-week period consisted of a 10.4% decline in same- store rental revenue, partially offset by a 21.0% increase in same-store product revenue. For the thirteen weeks and twenty-six weeks ended July 1, 2007, the Movie Gallery operating segment's total revenues decreased 7.4% and 6.8% from the comparable periods in 2006, primarily due to a decline in same-store sales and a decrease in the number of weighted average stores operated. For the thirteen weeks and twenty-six weeks ended July 1, 2007, the Movie Gallery operating segment's same-store sales declined 3.5% and 3.7%, respectively, and the number of weighted average stores operated declined 6.1% and 6.7%, respectively, compared to the prior year periods. Same-store sales for the thirteen-week period consisted of a 4.8% decline in same-store rental revenue, partially offset by a 10.4% increase in same-store product revenue. Total revenue for the Hollywood and Game Crazy operating segments for the thirteen weeks and twenty-six weeks ended July 1, 2007 decreased 6.3% and 6.6%, respectively, from the comparable periods in 2006, primarily due to a decline in same-store sales of 5.3% and 6.2%, respectively. Same-store sales for the thirteen-week period consisted of a 13.9% decline in same-store rental revenue, partially offset by a 23.0% increase in same-store product revenue. The increase in same-store product revenue was driven by a 32.0% and 29.1% increase in Game Crazy same-store/department sales for the thirteen weeks and twenty-six weeks ended July 1, 2007, respectively. We believe the following factors contributed to the decline in our same-store rental revenues: - aggressive pricing and promotion tactics recently implemented by our competition; - the overabundance of DVD titles available for sale in the marketplace; - the growth of online rental; - the maturation of the DVD life cycle; and - the widespread availability of content through other audio/video media such as recorded television, pay-per-view movies and the Internet. Cost of Sales The cost of rental revenues includes the amortization of rental inventory, revenue-sharing expenses incurred and the cost of previously viewed rental inventory sold. The gross margins on rental revenue for the thirteen weeks and twenty-six weeks ended July 1, 2007 were 67.5% and 68.7%, respectively, compared to 68.6% and 69.1% for the comparable periods in 2006. Gross margins for 2006 were negatively impacted by $4.5 million for the thirteen-week period and $11.3 million for the twenty-six week period for charges that were recorded to reflect changes in rental amortization estimates. The decrease in rental gross margins is primarily due to a decline in the average sales price of previously viewed movies and an increase in the cost of product acquired under revenue sharing arrangements. Cost of product sales includes the costs of new video game merchandise and used video game merchandise taken in on trade within the Game Crazy operating segment, new movies, concessions and other goods sold. New movies and new game merchandise typically have a much lower margin than used game merchandise and concessions. The gross margin on product sales is subject to fluctuations in the relative mix of the products that are sold. The gross margins on product sales for the thirteen weeks and twenty-six weeks ended July 1, 2007 were 24.8% and 24.6%, respectively, compared to 28.1% and 26.1% for the comparable periods in 2006. The decrease in product gross margins was primarily due to a shift in the sales mix towards lower-margin products such as DVD movies, game hardware and game software and away from higher-margin products such as concessions. Operating Costs and Expenses Store operating costs and expenses include store-level operational expense, store labor, depreciation, advertising, and other store expenses. Operational expense includes store lease payments, utilities, banking fees, repairs and maintenance, and store supplies expense. Store labor expense includes salaries and wages, employment taxes, benefits, and bonuses for our store employees. Store operating expenses as a percentage of total revenue was 54.1% and 50.6% for the thirteen weeks and twenty-six weeks ended July 1, 2007, respectively, compared to 50.8% and 47.6% for the comparable periods of fiscal 2006. The following table sets forth the changes in store operating costs and expenses as a percent of total revenue for the thirteen weeks and twenty-six weeks ended July 1, 2007, compared to the comparable periods in fiscal 2006: Thirteen Weeks Ended ---------------------------------- July 2, July 1, Net 2006 2007 Change --------- --------- --------- Operational expenses 26.0% 27.4% 1.4% Store labor expense 19.3% 20.3% 1.0% Depreciation expense 3.4% 3.8% 0.4% Advertising expense 0.8% 1.4% 0.6% Other store expense 1.3% 1.2% (0.1%) --------- --------- --------- 50.8% 54.1% 3.3% Twenty-Six Weeks Ended --------------------------------- July 2, July 1, Net 2006 2007 Change --------- --------- --------- Operational expenses 24.2% 25.5% 1.3% Store labor expense 18.3% 19.4% 1.1% Depreciation expense 3.3% 3.2% (0.1%) Advertising expense 0.6% 1.2% 0.6% Other store expense 1.2% 1.3% 0.1% --------- ---------- -------- 47.6% 50.6% 3.0% The increases in store operating costs and expenses as a percentage of total revenue for the thirteen weeks and twenty-six weeks ended July 1, 2007 was due to the proportion of fixed costs affected by the decrease in sales of 6.7% for both the thirteen weeks and twenty-six weeks ended July 1, 2007. General and Administrative Expenses General and administrative expenses as a percentage of revenue for the thirteen weeks and twenty-six weeks ended July 1, 2007 were 8.2% and 7.7%, respectively, compared to 8.1% and 7.4% for the corresponding periods of 2006. The increase in General and administrative expenses as a percentage of revenue for the thirteen-weeks ended July 1, 2007 was primarily due to a decrease in year over year sales of 6.7%. For the thirteen-weeks ended July 1, 2007, payroll and related expenses decreased by $7.5 million, or 1.0% of revenue, from the corresponding period of 2006, which was partially offset by expenses of MovieBeam of $3.0 million and professional fees of $2.0 million. In absolute dollar terms, including MovieBeam expenses, General and administrative expenses decreased $2.6 million compared to the comparable period of fiscal 2006. For the thirteen weeks ended July 2, 2006, $2.3 million in depreciation expense was reclassified from Store operating expenses to General and administrative expenses related to depreciation on corporate fixed assets. General and administrative expenses as a percentage of revenue for the twenty- six weeks ended July 1, 2007 was relatively flat, increasing 0.3% when compared to the corresponding period of the prior year. For the twenty-six weeks ended July 1, 2007, payroll and related expenses were reduced by $8.7 million, or 0.7% of revenue. This decrease was partially offset by MovieBeam expenses of $5.3 million, or 0.4% of revenue. In absolute dollar terms, including MovieBeam expenses, General and administrative expenses decreased $2.6 million compared to the comparable period of fiscal 2006. For the twenty-six weeks ended July 2, 2006, $4.6 million in depreciation expense was reclassified from Store operating expenses to General and administrative expenses related to depreciation on corporate fixed assets. Stock compensation expense primarily represents non-cash charges associated with non-vested stock grants. Beginning in fiscal 2006, we adopted Statement of Financial Accounting Standards, or SFAS, No. 123(R), "Accounting for Stock- Based Compensation," or SFAS No. 123(R). We used the modified prospective method to adopt SFAS No. 123(R), which requires that compensation expense be recorded for all stock-based compensation granted on or after January 2, 2006, as well as the unvested portion of previously granted options. For the twenty-six weeks ended July 2, 2006 and July 1, 2007, we recognized $0.7 million and $0.6 million, respectively, in compensation expenses related to service-based stock grants, and $0.3 million and $0, respectively, in expenses related to performance-based stock grants. Total compensation cost related to all non-vested awards that is not yet recognized was $4.3 million at July 1, 2007 and is expected to be recognized over a weighted-average period of approximately two years. We may, from time to time, decide to issue stock-based compensation in the form of stock grants and stock options, which under SFAS No. 123(R) requires a fair value recognition approach and will be expensed in income from continuing operations. As a result, the amount of compensation expense we recognize over the vesting period will generally not be affected by subsequent changes in the trading value of our common stock. Furthermore, projections as to the number of stock awards that will ultimately vest requires making estimates, and to the extent that actual results or updated estimates differ from current estimates, such amounts will be recorded as a cumulative adjustment in the period that estimates are revised. Actual results and future changes in estimates may differ substantially from the current estimates. Impairment of Other Long-Lived Assets, Other Indefinite-Lived Intangibles, and Goodwill Other Long-Lived Assets Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long Lived Assets," or SFAS No. 144. When an indicator of impairment is noted, assets are evaluated for impairment at the lowest level for which there are identifiable cash flows (e.g., at the store level). Due to the impairment indicators noted in Note 5 to our Notes to Consolidated Financial Statements, we performed impairment testing on our long-lived assets as of July 1, 2007. As a result, we determined that the long-lived assets associated with certain stores were impaired. We recorded a charge of $26.2 million and $16.8 million related to the impairment of property, furnishings, and equipment under the Hollywood and Movie Gallery operating segments, respectively. We also determined that our definite-lived intangible asset for the customer list in the Hollywood segment was impaired as a result of attrition in active customers. We therefore recorded an impairment charge of $2.5 million, which was recognized in Impairment of other intangibles. Other Indefinite-Lived Intangibles We normally conduct our annual test of the valuation of our indefinite-lived intangible asset, the Hollywood trademark, during the fourth quarter of each fiscal year in accordance with our policy and the requirements as set forth in SFAS No. 142, "Goodwill and Other Intangible Assets," or SFAS No. 142. However due to the impairment indicators noted in Note 5 to our Notes to Consolidated Financial Statements, we performed impairment testing on the Hollywood trademark as of July 1, 2007. The impairment testing of the Hollywood trademark compared the fair value of the trademark with its carrying value. The fair value was determined by the Relief from Royalty method, a specific discounted cash flow approach, to analyze cash flows attributable to the Hollywood trademark. The carrying value of the Hollywood trademark was greater than its fair value and therefore was deemed to be impaired. The implied fair value of the Hollywood trademark was determined to be $75.5 million, and therefore an impairment charge was recorded for $95.4 million in Impairment of other intangibles. Goodwill We normally conduct our annual test of the valuation of goodwill during the fourth quarter of each fiscal year in accordance with our policy and the requirements as set forth in SFAS No. 142. However, due to the impairment indicators noted in Note 5 to our Notes to Consolidated Financial Statements, we performed impairment testing on our valuation of goodwill as of July 1, 2007. Goodwill is tested at a reporting unit level, which for this purpose consists solely of Hollywood Video, as our Movie Gallery reporting unit had an immaterial amount of goodwill and our Game Crazy reporting unit has no goodwill. Goodwill is impaired if the fair value of a reporting unit is less than the carrying value of its assets. The estimated fair value of the Hollywood Video reporting unit was computed using the present value of estimated future cash flows, which included the impact of trends in the business and industry noted in the Overview section above. In addition to these business and industry trends, the computation of estimated fair value also considered market prices of our debt and equity securities. When we performed our testing, the first step of the impairment test indicated that the fair value of the Hollywood Video reporting unit was lower than its carrying value, and therefore the goodwill of the Hollywood reporting unit was determined to be impaired. The second step of the impairment test indicated that the implied fair value of goodwill for the Hollywood reporting unit was zero, and therefore a goodwill impairment charge was recorded for $115.6 million. Interest Expense, net Interest expense, net decreased $2.0 million from $30.7 million for the thirteen weeks ended July 2, 2006 to $28.7 million for the thirteen weeks ended July 1, 2007. The decrease is primarily attributed to lower interest rates on our March 2007 Credit Facility. Interest expense, net increased $18.3 million from $58.1 million for the twenty-six weeks ended July 2, 2006 to $76.4 million for the twenty-six weeks ended July 1, 2007. The increase is primarily attributed to a debt extinguishment charge of $17.5 million to write off the unamortized deferred financing fees related to our previous senior credit facility when it was refinanced in the first quarter of fiscal 2007. Income Taxes In the ordinary course of business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws. No assurance can be given that the final outcome of these matters will not be different than the estimated outcomes reflected in the current and historical income tax provisions and accruals. In July 2006, the Financial Accounting Standards Board, or FASB, issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, Accounting for Income Taxes," or 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 a 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, based on the merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods and requirements for increased disclosures. We adopted the provisions of FIN 48 on January 1, 2007. The adoption of FIN 48 did not have a material effect on our consolidated balance sheet or statement of operations. The amount of unrecognized benefits as of January 1, 2007 is $11.2 million, of which $4.8 million would impact our effective rate, if recognized. There were no material changes to unrecognized benefits during the twenty-six weeks ended July 1, 2007. The effective tax rate was a benefit of 0.3% and 0.1% for the thirteen weeks and twenty-six weeks ended July 1, 2007, respectively, as compared to a benefit of 9.4% and 7.8% for the corresponding prior year periods. The projected annual effective tax rate is a provision of 0.4%, which differs from the benefit of 0.3% for the quarter ended July 1, 2007, due to changes in the proportion of income earned from foreign operations and various state income tax changes. Liquidity and Capital Resources Summary Our primary capital needs are for seasonal working capital, debt service, remodeling and relocating existing stores, new technology initiatives, such as online video rental, MovieBeam, kiosks, and e-commerce, and to a much lesser extent, new store investment. As discussed above, we currently plan to open fewer than 10 new stores for the full fiscal year 2007. We have historically funded our capital needs primarily by cash flow from operations and borrowings under the revolving portion of our senior secured credit facility, or our March 2007 Credit Facility. For the twenty-six weeks ended July 1, 2007, net cash used in operating activities was $62.2 million, resulting in an increased use of borrowings under our March 2007 Credit Facility to fund our operating and capital needs. At July 1, 2007, we had cash and cash equivalents of $45.5 million and $0 in available borrowings under the revolving portion of our March 2007 Credit Facility. The $325 million of 11% senior unsecured notes due 2012, or 11% senior notes, which we issued in connection with the Hollywood acquisition, remain outstanding. March 2007 Credit Facility Our March 2007 Credit Facility consists of: - a $100 million revolving credit facility, which we refer to as the revolver; - a $25 million first lien synthetic letter of credit facility; - a $600 million first lien term loan; and - a $175 million second lien term loan. We sometimes collectively refer to the revolver, the first lien term loan and the letter of credit facility as the first lien facilities. The first lien facilities require us to meet certain financial covenants, including a secured leverage test, a total leverage test and an interest coverage test. Each of these covenants is calculated based on trailing four quarter results using specific definitions that are contained in the first lien credit agreement. Due to current industry conditions and increasing competition in the home video market, as discussed in the Overview section above, we were not in compliance with the financial covenants contained in the first lien facilities as of end of the second quarter of fiscal 2007. The second lien credit facility contains no financial covenants, but a default under the first lien credit agreement could create a cross default under the second lien term loan and 11% senior notes. As a result of our non-compliance with the financial covenants contained in the first lien facilities and our resulting default under the first lien credit agreement, the first lien credit agreement lenders have the right to terminate their commitments, accelerate all of our obligations and exercise their remedies under the first lien credit agreement. We have executed a Forbearance Agreement (as amended), effective as of July 2, 2007, with certain lenders under the first lien credit agreement. Under the Forbearance Agreement (as amended), the lenders will forbear until August 14, 2007 from exercising default-related rights and remedies arising from existing defaults, absent any new defaults under the first lien credit agreement or the Forbearance Agreement (as amended). We have also begun discussions with the advisors representing our first lien lenders on extending the Forbearance Agreement (as amended). The Forbearance Agreement (as amended) further provides for the amendment of the first lien credit agreement to increase the interest rate margin applicable to revolving borrowings by 1.0% per year and the interest rate margin applicable to term loan borrowings and synthetic letter of credit obligations by 2.0% per year. The Forbearance Agreement (as amended) also provides for additional information delivery requirements by us, increases the Applicable Loan to Value Ratio to 3.5 to 1.0 from 3.0 to 1.0, and modifies to make more restrictive the use and application of proceeds of certain assets sales. We are currently in discussions with the advisors representing our first lien lenders and other major creditors to address our current financial situation. In the near future, we expect to present a longer-term solution to the first lien lender group and other major creditors that will address the operational and financial issues currently impacting our business. This longer-term solution includes accelerating the closure of unprofitable stores, consolidating stores in certain markets, obtaining additional working capital, realigning our cost structure to better reflect our reduced size and seeking a more competitive capital structure. In connection with a solution, it is likely that we will need the first lien lenders to waive our existing defaults under the first lien credit agreement and to substantially modify the financial covenants contained therein. We cannot assure you that: - we will reach such an agreement with our first lien lenders prior to the expiration of the forbearance period discussed above; - we will be able to obtain an extension of our forbearance period if we are not able to reach such an agreement with our first lien lenders prior to the August 14, 2007 expiration of the forbearance period; or - if we do reach an agreement, what the terms of such agreement will be or what actions we will be required to undertake in connection with such an agreement, such as selling assets, closing stores, securing additional financing, reducing or delaying capital expenditures or restructuring our existing indebtedness. If we fail to reach such an agreement, the first lien lenders could institute foreclosure proceedings against our assets securing borrowings under the first lien facilities. Due to our default under the first lien credit agreement, we have classified all obligations due under the first lien facilities as current liabilities as of July 1, 2007. Due to the uncertainty that our default under the first lien credit agreement could trigger cross default provisions on our second lien term loan and 11% senior notes, we have classified our $175 million second lien term loan and our $325 million 11% senior notes as current liabilities as of July 1, 2007. Our liquidity is dependent upon our cash flows from store operations, access to our existing credit facility and vendor financing. Historically, we maintained favorable payment terms with our vendors, which has been a significant source of liquidity for us. During the latter part of fiscal 2006, and continuing into fiscal 2007, we have experienced significant vendor terms contraction, which eroded our working capital capacity. Due to our non-compliance with the covenants contained in the first lien facilities, many of our significant vendors have discontinued extending us trade credit, requiring us to pay for product before it is shipped, and we have experienced additional tightening of terms with other vendors. If we continue to experience substantial restrictions or tightening of terms with our vendors and continue to generate operating losses similar to those experienced for the twenty-six weeks ended July, 1, 2007, we do not believe we will have sufficient liquidity to operate our business through the third quarter of 2007 without gaining access to additional capital. Due to our significant operating losses for the twenty six weeks ended July 1, 2007 and our present liquidity position, we have reduced planned capital and maintenance expenditures for, among other things, projects related to our management information systems infrastructure, which include, but are not limited to: - replacing old and outdated hardware technology in our stores and in our two store support centers; - either replacing, or updating and integrating our multiple point-of- sale, or POS, systems; - additional integration of systems between our two store support centers; and - upgrading our present versions of certain operating and applications systems platforms, including our Oracle database environment, without which we may incur additional cost for ongoing maintenance and support. We cannot make assurances that our business will not be adversely affected should this reduction in capital and maintenance expenditures contribute to a failure of our management information systems to perform as expected. In response to the challenging market conditions facing our business, we will continue to take actions to conserve cash and improve profitability. These actions include accelerating the closure of unprofitable stores, consolidating stores in certain markets, realigning our cost structure to better reflect our reduced size, and seeking a more competitive capital structure. We also intend to consider a number of alternatives, including asset divestitures, recapitalizations, restructurings, alliances with strategic partners, and a sale to or merger with a third party, as well as whether a restructuring needs to be completed under chapter 11 of the Bankruptcy Code. We cannot make assurances that such actions or alternatives will be successful or that, even if such actions or alternatives are successful, that we will be able to continue to service our existing indebtedness. Our March 2007 Credit Facility is fully and unconditionally guaranteed on a joint and several basis by all of our domestic subsidiaries. It is also secured by (i) in the case of the first lien credit facility, first priority security interests in, and liens on, substantially all of our direct and indirect domestic subsidiaries' tangible and intangible assets (other than leasehold mortgages on stores), first priority pledges of all the equity interests owned by us in our existing and future direct and indirect wholly owned domestic subsidiaries, and 65% of the equity interests owned by us in our existing and future wholly owned non-domestic subsidiaries, and (ii) in the case of the second lien credit facility, second priority security interests in, and liens on, substantially all of our direct and indirect domestic subsidiaries' tangible and intangible assets (other than leasehold mortgages on stores), second priority pledges of all the equity interests owned by us in our existing and future direct and indirect wholly owned domestic subsidiaries, and 65% of the equity interests owned by us in our existing and future wholly owned non-domestic subsidiaries. For additional information regarding our March 2007 Credit Facility, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources" in our Annual Report on Form 10-K for the year ended December 31, 2006. Interest Rate Hedges Our March 2007 Credit Facility requires that no later than 90 days subsequent to entering into the March 2007 Credit Facility, 50% of our total outstanding debt was to be converted to fixed rate debt for a period of three years subsequent to March 8, 2007. On April 3, 2007, we executed a floating-to-fixed interest rate swap for an amount of $225.0 million, with an effective date of April 5, 2007 and a termination date of June 29, 2007. Under the terms of this swap agreement, we paid fixed-rate interest on the $225.0 million at a rate of 5.348% and received floating-rate interest based on a linear interpolation of two-month and three- month LIBOR for the 85 days covering the term of this swap. We received $0 in consideration upon settlement of this interest rate swap. On April 3, 2007, we executed a forward-starting floating-to-fixed interest rate swap for an amount of $225.0 million, with an effective date of June 29, 2007 and a termination date of June 30, 2010. Under the terms of this forward- starting swap agreement, we paid fixed-rate interest on the $225.0 million at a rate of 5.128% and received floating-rate interest based on three-month LIBOR. On July 5, 2007, we settled this interest rate swap (prior to the scheduled termination date) and received $1.3 million in consideration. On July 31, 2007, we entered into a new 6.5% interest rate cap agreement with a notional amount of $275.0 million, for which we paid a fixed fee of $0.3 million. Under the terms of the new cap agreement, we will pay floating-rate interest up to a maximum of 6.50% and receive floating-rate interest based on three-month LIBOR through the scheduled termination date of March 8, 2010. Contractual Obligations. The following table discloses our contractual obligations and commercial commitments as of July 1, 2007. The operating lease information presented is as of December 31, 2006; however, these amounts approximate the obligations as of July 1, 2007. Contractual 2-3 4-5 More than Obligations Total 1 Year Years Years 5 Years --------------- ---------- ---------- -------- --------- ---------- Principal Payments March 2007 Credit Facility (1) First lien term loan $ 598,500 $ 598,500 $ - $ - $ - Second lien term loan 175,000 175,000 - - - 2007 Revolver 100,000 100,000 - - - Senior Notes (1) 325,450 325,450 - - - Capital leases 1,412 1,412 - - - Interest First lien term loan (2) 64,753 64,753 - - - Second lien term loan (2) 20,781 20,781 - - - Senior Notes 35,793 35,793 - - - Capital leases 37 37 - - - Operating leases 1,478,182 376,012 557,087 329,453 215,630 Estimatable unrecognized tax benefits (3) (3,000) (3,000) - - - ---------- ---------- -------- --------- ---------- Total (3) $2,796,908 $1,694,738 $557,087 $ 329,453 $ 215,630 ---------- ---------- -------- --------- ---------- (1) Due to our default under the first lien credit agreement, we have classified all obligations due under our March 2007 Credit Facility as well as our 11% senior notes as current liabilities as of July 1, 2007. (2) Interest rates based on current LIBOR rates plus margin. As of July 1, 2007, the first lien term loan and second lien term loan rates are 10.86% and 11.88%, respectively. The first lien term loan rate of 10.86% is quoted inclusive of the 2% interest rate margin increase effective July 2, 2007 in accordance with the Forbearance Agreement (as amended). We have assumed these interest rates will stay the same for the remaining terms of the loans for purposes of presenting future interest payments. (3) Unrecognized tax benefits of $8.4 million as of July 1, 2007 are not included as we are unable to reasonably estimate the amounts that will be settled within each year in the table as presented above. Statement of Cash Flow Data Twenty-Six Weeks Ended ------------------------ July 2, July 1, 2006 2007 ---------- ---------- ($ in thousands) Statements of Cash Flow Data: Net cash used in operating activities $ (35,236) $ (62,188) Net cash used in investing activities (14,090) (3,976) Net cash provided by (used in) financing activities (66,091) 79,346 Operating Activities The decrease in net cash provided by operating activities for the twenty-six weeks ended July 1, 2007 compared to the same period of fiscal 2006 was primarily due to a decrease in operating income, an increase in interest expense and an increase in Game Crazy inventory purchases, partially offset by a decrease in the use of cash for accounts payable. Investing Activities Net cash used in investing activities includes the cost of business acquisitions, new store builds and other capital expenditures. For the twenty- six weeks ended July 1, 2007, net cash used for investing activities was $4.0 million, which included $3.1 million in acquisitions and $1.4 million for improvements to our existing store base, offset by proceeds from asset disposals. For the twenty-six weeks ended July 2, 2006, net cash used for investing activities was $14.1 million, which included the addition of 102 stores. Capital expenditure requirements for fiscal 2007 are estimated at $25 million to fund a limited number of store openings, maintenance on our existing store base and strategic investments. This estimate also does not include capital required to fund our acquisition of the Boards stores pursuant to a contractual put provision. The Boards stores acquisition may occur in fiscal 2007; however, a purchase price has yet to be negotiated. Financing Activities Net cash flow related to financing activities for the twenty-six weeks ended July 1, 2007 was a source of cash of $79.3 million, which included $83.5 million of net borrowings on our March 2007 Credit Facility. Net cash flow related to financing activities for the twenty-six weeks ended July 2, 2006 was a use of cash of $66.1 million, primarily due to an excess cash flow payment of $56.9 million under the terms of our previous senior credit facility and lender fees of $5.5 million to the amendment of that facility. At July 1, 2007, we had a working capital deficit of $1.1 billion. This is primarily due to the reclassification of our long-term debt as a current liability and, to a much lesser extent, the accounting treatment of rental inventory. Rental inventory is treated as a non-current asset under accounting principles generally accepted in the United States because it is a depreciable asset. Although the rental of this inventory generates a majority of our revenue, the classification of this asset as non-current results in its exclusion from working capital. However, accounts payable incurred in connection with purchases of this inventory are reported as a current liability until paid and accordingly, is reflected as a reduction in working capital. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Critical Accounting Policies and Estimates Our critical accounting policies are described in our Annual Report on Form 10- K for the fiscal year ended December 31, 2006. No changes have occurred to our critical accounting policies during the twenty-six weeks ended July 1, 2007. Recently Issued Accounting Pronouncements On July 13, 2006, the FASB issued FIN 48, which clarifies the way companies account for uncertainty in income taxes. FIN 48 is effective for the first fiscal year beginning after December 15, 2006, which for us was our fiscal year beginning January 1, 2007. The adoption of FIN 48 did not have a material impact on our consolidated financial statements. See Note 4 for further discussion of income taxes. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," or SFAS No. 157, which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS No. 157 also responds to investors' requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS No. 157 is effective for our fiscal year beginning January 7, 2008. We are in the process of evaluating the effect of SFAS No. 157 on our financial statements. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," or SFAS No. 159, which provides guidance on applying fair value measurements on financial assets and liabilities. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 attempts to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is effective for us for our fiscal year beginning January 7, 2008. We are in the process of evaluating the effect of SFAS No. 159 on our financial statements. Item 3. Quantitative and Qualitative Disclosures About Market Risk Market risk represents the risk of loss that may impact our financial position, operating results, or cash flows due to adverse changes in financial and commodity market prices and rates. We have entered into certain market-risk- sensitive financial instruments for other than trading purposes, principally to hedge against fluctuations in variable interest rates on our debt. Interest payable on our March 2007 Credit Facility is based on variable interest rates equal to a specified Eurodollar rate or base rate and is therefore affected by changes in market interest rates. If variable base rates were to increase 1% from the three-month LIBOR at July 1, 2007, our interest expense on an annual basis would increase by approximately $7.7 million on the principal, based on both the outstanding balance on our March 2007 Credit Facility as of July 1, 2007 and its mandatory principal payment schedule. Item 4. Controls and Procedures We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As of the end of the period covered by this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Securities and Exchange Act Rule 13a-15. Based upon this evaluation as of July 1, 2007, management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were not effective for the reasons more fully described below, related to the unremediated material weakness in our internal control over financial reporting identified during our evaluation pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 as of the fiscal year ended December 31, 2006. To address this control weakness, we performed additional analysis and other procedures in order to prepare this Quarterly Report on Form 10-Q, including the unaudited quarterly consolidated financial statements prepared in accordance with generally accepted accounting principles in the United States contained herein. Accordingly, management believes that the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented. Management's assessment identified one material weakness in our internal control over financial reporting as of December 31, 2006 that is in the process of being remediated as of July 1, 2007, as described further below. This section of Item 4. "Controls and Procedures," should be read in conjunction with Item 9A. "Controls and Procedures," included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 for additional information on Management's Report on Internal Controls Over Financial Reporting. As of July 1, 2007, the unremediated material weakness was: Ineffective controls over lease accounting. Our process related to identifying, understanding, and properly accounting for lease terms that have an accounting impact did not function to reduce to remote the likelihood that material misstatements would not be prevented or detected in a timely manner. The material weakness stems from the aggregation of control deficiencies related to the identification of non-standard lease terms, insufficient knowledge of accounting for leases under generally accepted accounting principles in the United States, and an inadequate process in place to review and identify all terms included in leases that impact the accounting for leases. The material weakness resulted in adjustments to property, furnishings, and equipment, asset retirement obligations, deferred rent, depreciation and amortization expense, rent expense, and store closure reserve accounts in both the annual and interim financial statements for the fiscal year ended December 31, 2006. Remediation Remediation efforts surrounding ineffective controls over lease accounting will occur in future quarters of fiscal 2007. Other Changes in Internal Control over Financial Reporting In April 2007, Richard Langford, our Chief Information Officer, resigned. John Rossman from Alvarez & Marsal Business Consulting, LLC was appointed Interim Chief Information Officer and Tracy Sennett, also from Alvarez & Marsal Business Consulting, LLC, was appointed Interim Assistant Chief Information Officer until we appoint a new Chief Information Officer. In May 2007, Jeff Stubbs, Chief Operating Officer of the Movie Gallery division, was appointed President of Retail Operations for the company. In his new position, Mr. Stubbs is responsible for all aspects of retail operations of our three brands: Movie Gallery, Hollywood Video, and Game Crazy. In June 2007, Timothy A. Winner, Executive Vice President and Chief Operating Officer of the Hollywood division, resigned. During the second quarter of fiscal 2007, Jon Goulding from the firm of Alvarez & Marsal assumed the position of interim Treasurer, replacing Ryan McCarthy, also from Alvarez & Marsal, who we have reassigned to assist us with the management of certain of our technology initiatives. In June 2007, Michelle Lewis, our Senior Vice President - Finance, resigned. We currently have no plans to fill this position. There have been no other changes in our internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Part II - Other Information Item 1. Legal Proceedings Hollywood and the members of its former board of directors (including Hollywood's former chairman Mark Wattles) were named as defendants in several lawsuits in the Circuit Court in Clackamas County, Oregon. The lawsuits, filed between March 31, 2004 and April 14, 2004, asserted breaches of duties associated with the merger agreement executed with a subsidiary of Leonard Green & Partners, L.P., or LGP. The Clackamas County actions were later consolidated, and the plaintiffs filed an Amended Consolidated Complaint alleging four claims for relief against Hollywood's former board members arising out of the merger of Hollywood with Movie Gallery. The purported four claims for relief are breach of fiduciary duty, misappropriation of confidential information, failure to disclose material information in the proxy statement in support of the Movie Gallery merger, and a claim for attorneys' fees and costs. The Amended Consolidated Complaint also names UBS Warburg and LGP as defendants. Following the merger with Movie Gallery, the plaintiffs filed a Second Amended Consolidated Complaint. The plaintiffs restated their causes of action and generally allege that the defendants adversely impacted the value of Hollywood through the negotiations and dealings with LGP. Hollywood and the former members of its board have also been named as defendants in a separate lawsuit entitled JDL Partners, L.P. v. Mark J. Wattles et al. filed in Clackamas County, Oregon, Circuit Court on December 22, 2004. This lawsuit, filed before Hollywood's announcement of the merger agreement with Movie Gallery, alleges breaches of fiduciary duties related to a bid by Blockbuster Inc. to acquire Hollywood, as well as breaches related to a loan to Mr. Wattles that Hollywood forgave in December 2000. On April 25, 2005, the JDL Partners action was consolidated with the other Clackamas County lawsuits. The plaintiffs seek damages and attorneys' fees and costs. The parties agreed to settle the case and entered into a Stipulation of Settlement and Release dated March 29, 2007. An order and final judgment, approving the settlement and dismissing the case with prejudice, was entered by the court on June 4, 2007. Due to our current liquidity situation, we have not yet performed our obligations pursuant to the Stipulation of Settlement and Release. In addition, we have been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. A negative outcome in certain of the ongoing litigation could harm our business, financial condition, liquidity or results of operations. In addition, prolonged litigation, regardless of which party prevails, could be costly, divert management's attention or result in increased costs of doing business. We believe we have provided adequate reserves for contingencies and that the outcome of these matters will not have a material adverse effect on our consolidated results of operation, financial condition or liquidity. At July 1, 2007, the legal contingencies reserve was $2.0 million, of which $1.0 million relates to pre-Hollywood acquisition contingencies. Item 1A. Risk Factors Our Annual Report on Form 10-K for the year ended December 31, 2006 includes a detailed discussion of our risk factors, which could materially affect our business, financial condition or future results. The information presented below amends, updates and should be read in conjunction with the risk factors and information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006. The risks described in our Annual Report on Form 10-K for the year ended December 31, 2006 and the information presented below are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results. Our business could continue to be adversely affected by increased competition, including new business initiatives by our competitors. We compete with: - local, regional and national video retail stores, including stores operated by Blockbuster, Inc., the largest video retailer in the United States; - Internet-based, mail-delivery home video rental subscription services, such as Netflix, Blockbuster Online, and Blockbuster Total Access, a subscription service incorporating both mail-delivery and video retail stores; - mass merchants; - specialty retailers, including GameStop and Suncoast; - supermarkets, pharmacies, convenience stores, bookstores and other retailers that rent or sell similar products as a component, rather than the focus, of their overall business; - mail order operations and online stores, including Amazon.com; and - noncommercial sources, such as libraries. Pricing strategies for movies and video games, including Blockbuster's "No Late Fees" and "Total Access" programs, are major competitive factors in the video retail industry, and we have fewer financial and marketing resources, lower market share and less name recognition than Blockbuster. In recent months, we experienced significant declines in revenue as a result of competitive pricing between Blockbuster and Netflix over their subscription services and greater customer acceptance of Blockbuster's Total Access program. Other types of entertainment, such as theaters, television, personal video recorders, Internet-related activities, sporting events, and family entertainment centers, also compete with our movie and video game businesses. Some of our competitors, such as online stores, mass merchants and warehouse clubs, may operate at margins lower than we do and may be able to distribute and sell movies at lower price points than we can. These competitors may even be willing to sell movies below cost due to their broad inventory mix. If any of our competitors were to substantially increase their presence in the markets we serve, our revenues and profitability could decline, our financial condition, liquidity, and results of operations could be harmed and the continued success of our business could be challenged. Our failure to comply with the financial covenants in our first lien facilities could result in an acceleration of all of our outstanding indebtedness. The first lien facilities require us to meet certain financial covenants, including a secured leverage test, a total leverage test and an interest coverage test. Each of these covenants is calculated based on trailing four quarter results using specific definitions that are contained in the first lien credit agreement. Due to current industry conditions and increasing competition in the home video market, as discussed in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations, we were not in compliance with the financial covenants contained in the first lien facilities as of end of the second quarter of fiscal 2007. As a result of our non-compliance with the financial covenants contained in the first lien facilities and our resulting default under the first lien credit agreement, the lenders have the right to terminate their commitments, accelerate all of our obligations and, subject to the terms of the Forbearance Agreement (as amended) described below, exercise their remedies under the first lien credit agreement. We have executed a Forbearance Agreement (as amended), effective as of July 2, 2007, with certain lenders under the first lien credit agreement. Under the Forbearance Agreement (as amended), the lenders will forbear until August 14, 2007 from exercising default-related rights and remedies arising from existing defaults, absent any new defaults under the first lien credit agreement or the Forbearance Agreement (as amended). We have also begun discussions with the advisors representing our first lien lenders on extending the Forbearance Agreement (as amended). If the obligations under the first lien credit agreement are accelerated or 60 days have passed since the date of the default under the first lien credit agreement, a cross default will exist under our second lien credit facility. If a cross default were to occur, and subject to the terms of the intercreditor agreement between the parties to the first lien credit agreement and second lien credit agreement, the lenders under the second lien credit agreement may accelerate our obligations and exercise their remedies. If the obligations under the first lien credit agreement or the second lien credit agreement are accelerated, a cross default under the 11% senior note indenture will result. Our assets and cash flow will not be sufficient to fully repay our outstanding indebtedness if such indebtedness were accelerated. We are currently in discussions with the advisors representing our first lien lenders and other major creditors to address our current financial situation. In the near future, we expect to present a longer-term solution to the first lien lender group and other major creditors that will address the operational and financial issues currently impacting our business. This longer-term solution includes accelerating the closure of unprofitable stores, consolidating stores in certain markets, obtaining additional working capital, realigning our cost structure to better reflect our reduced size and seeking a more competitive capital structure. In connection with a solution, it is likely that we will need the first lien lenders to waive our existing defaults under the first lien credit agreement and to substantially modify the financial covenants contained therein. We cannot assure you that: - we will reach such an agreement with our first lien lenders prior to the expiration of the forbearance period discussed above; - we will be able to obtain an extension of our forbearance period if we are not able to reach such an agreement with our first lien lenders prior to the August 14, 2007 expiration of the forbearance period; or - if we do reach an agreement, what the terms of such agreement will be or what actions we will be required to undertake in connection with such an agreement, such as selling assets, closing stores, securing additional financing, reducing or delaying capital expenditures or restructuring our existing indebtedness. If we fail to reach such an agreement, the first lien lenders could institute foreclosure proceedings against our assets securing borrowings under the first lien facilities. We may not be able to generate sufficient cash flows to meet our liquidity needs. Our business may not generate sufficient cash flow from operations, or future borrowings under our March 2007 Credit Facility, or from other sources; and cash flows may not be available to us in an amount sufficient to enable us to meet our capital needs, which include funding for seasonal working capital, debt service, remodeling and relocating existing stores and, to a lesser extent, new store investment. Our ability to generate cash from operations is, to a significant extent, subject to general conditions within the video rental market. In recent months, a number of industry-wide factors have combined to negatively impact the rental market. These factors include: weak movie title lineup; cannibalization of rentals by low-priced movies available for sale; growth of the online rental segment; the standard DVD format nearing the end of its life cycle; movie studios structuring their DVD movie releases towards the later part of the year; competing high definition DVD formats delaying content release and consumer acceptance; and the proliferation of alternative consumer entertainment options including movies available through video-on-demand, TIVO/DVR, digital cable, satellite TV, broadband, Internet and broadcast television. We expect that these factors will continue to have a negative impact on the rental market for at least the next six months, if not longer. Our ability to generate cash from operations has been negatively impacted by current market conditions. For the twenty-six weeks ended July 1, 2007, our operating activities used $62.2 million of cash, which was funded through additional borrowings under our March 2007 Credit Facility. At July 1, 2007, we had $45.5 million of cash and cash equivalents and did not have any available borrowings under our March 2007 Credit Facility. Due to our substantial indebtedness, we have significant debt service obligations. For the remainder of fiscal 2007 we have scheduled interest payments aggregating approximately $60.7 million. If we cannot meet our capital needs, including servicing our indebtedness, we may have to take actions such as selling assets, seeking additional equity, reducing or delaying capital expenditures and restructuring our indebtedness. Historically, we maintained favorable payment terms with our vendors, which has been a significant source of liquidity for us. During the latter part of fiscal 2006, and continuing into fiscal 2007, we have experienced significant vendor term contraction, which eroded our working capital capacity. Due to our non- compliance with the covenants contained in the first lien facilities, many of our significant vendors have discontinued extending us trade credit, requiring us to pay for product before it is shipped, and we have experienced additional tightening of terms with other vendors. If we continue to experience substantial restrictions or tightening of terms with our vendors and continue to generate operating losses similar to those experienced for the twenty-six weeks ended July 1, 2007, we do not believe we will have sufficient liquidity to operate our business through the third quarter of 2007 without gaining access to additional capital. Our stock may be delisted from the Nasdaq Stock Market. Since July 2, 2007, our common stock has failed to maintain a minimum per share bid price of one dollar. If our common stock does not maintain a minimum per share bid price of one dollar over a period of 30 consecutive trading days, we will be in non-compliance with the requirements for continued listing on the Nasdaq Stock Market and will be subject to possible delisting proceedings by the Nasdaq Stock Market. A common course of action for companies attempting to maintain their listing by ensuring a bid price in excess of one dollar per share is the institution of a reverse stock split. At present, we have made no decision with respect to this course of action but will continue to evaluate this alternative in light of all other options, including accepting a delisting determination. A reverse stock split could negatively impact the value of our stock by allowing additional downward pressure on the stock price as its relative value becomes greater following the reverse split. That is to say, the stock at its new higher price has farther to fall and therefore more room for investors to short or otherwise trade the value of the stock downward. Similarly, a delisting may negatively impact the value of the stock, as stocks trading on the over-the-counter market are typically less liquid and trade with larger variations between the bid and ask price, and we could lose support from institutional investors, brokerage firms and market makers, if any, that currently buy and sell our stock and provide information to investors about us. We may be required to recognize additional asset impairment charges. We have incurred in the past, and continue to incur, impairment charges with respect to our indefinite-lived intangible assets such as goodwill and the Hollywood trademark, our definite-lived intangible assets such as customer lists, and our definite-lived tangible assets such as property, furnishings, and equipment. In accordance with the applicable accounting literature, we test for impairment when impairment indicators arise, which include, but are not limited to: - significant adverse changes in the business climate; - current period operating or cash flow losses combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with long-lived assets; - a current expectation that more-likely-than-not (e.g., a likelihood that is more than 50%) long-lived assets will be sold or otherwise disposed of significantly before the end of their previously estimated useful life; and - a significant drop in our stock price. Due to the impairment indicators noted in Note 5 to our Notes to Consolidated Financial Statements, we performed impairment testing on our indefinite-lived and definite-lived intangible assets and our definite-lived tangible assets as of July 1, 2007. As a result, we determined that each were impaired and recorded charges of $115.6 million, $97.9 million, and $43.0 million related to the impairment of goodwill, impairment of other intangibles, and the impairment of property, furnishings, and equipment, respectively, for the thirteen weeks ended July 1, 2007. Our impairment calculations are based upon our best estimates at the time of preparation of the recoverability of the assets' values using primarily discounted cash flow methods. Future industry trends and our future performance relative to our competition may require us to revise our cash flow estimates and thus compel us to recognize additional long-lived asset impairment charges. To date, we have not recorded any impairment charges related to our rental inventory. In addition to our property, furnishings, and equipment impairment charges and our customer list impairment charge, we could incur impairment charges to our rental inventory. If we were to close a significant number of our stores we may need to liquidate the on-hand rental inventory for amounts that are less than carrying values of the rental inventory product. These future asset impairments could have a materially adverse effect on our consolidated statement of operations. Our business could be adversely affected by the failure of our management information systems to perform as expected, or by additional loss of key management information systems personnel. Due to our significant operating losses for the twenty six weeks ended July 1, 2007 and our present liquidity position, we have reduced planned capital and maintenance expenditures for, among other things, projects related to our management information systems infrastructure, which include, but are not limited to: - replacing old and outdated hardware technology in our stores and in our two store support centers; - either replacing, or updating and integrating our multiple point-of- sale, or POS, systems; - additional integration of systems between our two store support centers; and - upgrading our present versions of certain operating and applications systems platforms, including our Oracle database environment, without which we may incur additional cost for ongoing maintenance and support. We depend on our management information systems for the efficient operation of our business. Our merchandise operations use our inventory utilization system to track rental activity by format for each individual movie and video game title so that we may determine appropriate buying, distribution and disposition of our inventory. We also rely on a scalable client-server system to maintain and update information relating to revenue, rental and sales activity, movie and video game rental patterns, store membership demographics, and individual customer history. These systems, together with our POS and in-store systems, allow us to control our cash flow, keep our in-store inventories at optimum levels, move our inventory more efficiently and track and record our performance. We rely on our management information systems personnel to operate and maintain these systems, however we have experienced attrition in key positions within this area. If our management information systems failed to perform as expected, or if we were to continue to lose personnel in this area, our ability to manage our inventory and monitor our performance could be adversely affected, which, in turn, could harm our business and financial condition. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders Our Annual Meeting of Stockholders was held on June 7, 2007. The following action was taken at the Annual Meeting, for which proxies were solicited pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended: 1. The five individuals nominated by the Board of Directors for election as directors were elected by the following votes: Name For Withheld -------------------- ---------- -------- Joe T. Malugen 23,643,923 973,122 H. Harrison Parrish 23,642,117 974,928 John J. Jump 23,702,602 914,443 James C. Lockwood 23,702,902 914,143 William B. Snow 23,658,668 958,377 2. A proposal to approve an amendment to the Company's Certificate of Incorporation to increase the number of authorized shares of common stock from 65,000,000 to 250,000,000 and the number of authorized shares of preferred stock from 2,000,000 to 10,000,000 required the affirmative vote of a majority of the Company's outstanding shares and was not approved by a vote of 12,510,336 for versus 3,764,546 against. There were 28,788 abstentions and 8,313,375 broker non-votes. 3. A proposal to ratify the appointment of Ernst & Young LLP as the Company's independent registered public accounting firm for the 2007 fiscal year was approved by a vote of 24,418,228 for versus 173,915 against. There were 24,902 abstentions. Item 5. Other Information None. Item 6. Exhibits a) Exhibits 3.2 Amended and Restated Bylaws dated April 12, 2007, previously filed as exhibit of the same number to the Company's Current Report on Form 8-K filed on April 18, 2007, and incorporated herein by reference. 31.1 Certification of Chief Executive Officer pursuant to Rule 13a- 14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a- 14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934. 32.1 Certification of Chief Executive Officer pursuant to Rule 13a- 14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C Section 1350. 32.2 Certification of Chief Financial Officer pursuant to Rule 13a- 14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C Section 1350. Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Movie Gallery, Inc. ------------------- (Registrant) Date: August 10, 2007 /s/ Thomas D. Johnson, Jr. ------------------------------ Thomas D. Johnson, Jr. Executive Vice President and Chief Financial Officer