10-Q/A 1 r10qa-9.txt QUARTERLY REPORT ON FORM 10-Q/A UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 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 0-21824 HOLLYWOOD ENTERTAINMENT CORPORATION (Exact name of registrant as specified in charter) OREGON 93-0981138 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 9275 S.W. Peyton Lane, Wilsonville, Oregon 97070 (Address of principal executive offices) (zip code) (503) 570-1600 (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 short 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 [ ] As of October 29, 2001 there were 49,361,936 shares of the registrant's Common Stock outstanding. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (In thousands, except per share amounts) Three Months Ended Nine Months Ended September 30, September 30, ------------------ ------------------ 2001 2000 2001 2000 -------- -------- --------- -------- REVENUE: Rental revenue $288,398 $262,077 $ 852,169 $796,429 Product sales 56,516 44,455 160,062 168,061 -------- -------- --------- -------- 344,914 306,532 1,012,231 964,490 COST OF REVENUE: Cost of rental 93,602 82,695 294,588 253,556 Cost of product 39,707 31,754 110,995 148,074 -------- -------- --------- -------- 133,309 114,449 405,583 401,630 -------- -------- --------- -------- GROSS MARGIN 211,605 192,083 606,648 562,860 OPERATING COSTS AND EXPENSES: Operating and selling 156,706 155,998 462,903 480,685 General and administrative 23,313 15,832 70,781 54,430 Restructuring charge for closure of internet business - - - 48,548 Amortization of intangibles 1,276 1,814 3,781 28,097 -------- -------- --------- -------- 181,295 173,644 537,465 611,760 -------- -------- --------- -------- INCOME (LOSS) FROM OPERATIONS 30,310 18,439 69,183 (48,900) Non-operating income (expense): Interest income 131 40 318 142 Interest expense (14,733) (17,275) (43,261) (46,892) -------- -------- --------- -------- Income (loss) before income taxes 15,708 1,204 26,240 (95,650) Benefit from (provision for) income taxes (334) (488) (555) 21,159 -------- -------- --------- --------- NET INCOME (LOSS) $ 15,374 $ 716 $ 25,685 $(74,491) ======== ======== ========= ========= Net income (loss) per share: Basic $0.31 $ 0.02 $ 0.52 $(1.62) Diluted $0.28 $ 0.02 $ 0.50 $(1.62) Weighted average shares outstanding: Basic 49,311 46,207 49,006 46,119 Diluted 54,984 46,483 51,836 46,119 The accompanying notes are an integral part of this financial statement HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts) September 30, December 31, ------------ ----------- 2001 2000 ------------ ----------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 18,886 $ 3,268 Receivables 25,701 23,830 Merchandise inventories 56,394 54,201 Prepaid expenses and other current assets 11,524 10,099 ----------- ----------- Total current assets 112,505 91,398 Rental inventory, net 159,683 168,462 Property and equipment, net 283,220 323,666 Goodwill, net 66,114 69,616 Other assets, net 13,680 11,972 ----------- ----------- $ 635,202 $ 665,114 =========== =========== LIABILITIES AND SHAREHOLDERS' DEFICIT Current liabilities: Current maturities of long-term obligations $ 73,422 $ 261,164 Accounts payable 128,789 169,503 Accrued expenses 112,092 114,633 Accrued revenue sharing 33,819 30,855 Accrued interest 7,737 11,817 Income taxes payable 4,605 4,844 ----------- ----------- Total current liabilities 360,464 592,816 Long-term obligations, less current portion 445,823 275,237 Other liabilities 19,082 19,438 ----------- ----------- 825,369 887,491 ----------- ----------- Shareholders' deficit: Preferred stock, 25,000,000 shares authorized; no shares issued and outstanding - - Common stock, 100,000,000 shares authorized; 49,336,765 and 46,247,599 shares issued and outstanding, respectively 374,080 365,441 Unearned compensation (2,114) - Accumulated deficit (562,133) (587,818) ----------- ----------- Total shareholders' deficit (190,167) (222,377) ----------- ----------- $ 635,202 $ 665,114 =========== =========== The accompanying notes are an integral part of this financial statement. HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands) Nine Months Ended September 30, ------------------------ 2001 2000 ----------- ---------- OPERATING ACTIVITIES: Net income (loss) $ 25,685 $ (74,491) Adjustments to reconcile net income (loss) to cash provided by operating activities: Depreciation and amortization 185,919 168,727 Amortization of deferred financing costs 2,553 1,934 Tax benefit from exercise of stock options - 63 Change in deferred rent (356) 1,791 Change in deferred income taxes - (22,227) Net asset write down for closure of internet business - 40,087 Non-cash stock compensation 6,147 - Net change in operating assets and liabilities: Receivables (1,871) 1,181 Merchandise inventories (2,193) (3,279) Accounts payable (40,714) 36,522 Accrued interest (4,080) (6,215) Accrued revenue sharing 2,964 11,334 Other current assets and liabilities (4,250) 516 --------- -------- Cash provided by operating activities 169,804 155,943 --------- -------- INVESTING ACTIVITIES: Purchases of rental inventory, net (126,691) (130,331) Purchases of property and equipment, net (6,222) (71,464) Increase in intangibles and other assets (4,495) (13,187) --------- -------- Cash used in investing activities (137,408) (214,982) --------- -------- FINANCING ACTIVITIES: Issuance of long-term obligations - 12,511 Repayments of long-term obligations (12,156) (11,106) Proceeds from exercise of stock options 378 782 Increase (decrease) in revolving loan, net (5,000) 60,000 --------- -------- Cash provided by (used in) financing activities (16,778) 62,187 --------- -------- INCREASE IN CASH AND CASH EQUIVALENTS 15,618 3,148 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 3,268 6,941 --------- --------- CASH AND CASH EQUIVALENTS AT END OF THE THIRD QUARTER $ 18,886 $ 10,089 ========= ========= NON-CASH FINANCING ACTIVITIES Issuance of common stock as part of a legal settlement agreement $ - $ 2,288 The accompanying notes are an integral part of this financial statement. HOLLYWOOD ENTERTAINMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although, the Company believes that the disclosures made are adequate to make the information presented not misleading. The information furnished reflects all adjustments which are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented, and which are of a normal, recurring nature. These financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company's Annual Report on Form 10-K/A for the year ended December 31, 2000, filed with the Securities and Exchange Commission. Results of operations for interim periods may not necessarily be indicative of the results that may be expected for the full year or any other period. (1) Accounting Policies The consolidated financial statements included herein have been prepared in accordance with the accounting policies described in Note 1 to the December 31, 2000 audited consolidated financial statements included in the Company's Annual Report on Form 10-K/A. Certain prior year amounts have been reclassified to conform to the presentation used for the current year. These reclassifications had no impact on previously reported net loss or shareholders' deficit. In the first quarter of 2001 the Company adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" issued by the Financial Accounting Standards Board(FASB) on June 15, 1998. The adoption of SFAS No. 133 did not have an effect on the Company's results of operations or its financial position. In July 2001, the Financial Accounting Standards Board (FASB) issued FASB Statements Nos. 141 and 142 (SFAS 141 and SFAS 142), "Business Combinations" and "Goodwill and Other Intangible Assets." SFAS 141 replaces APB 16 and eliminates pooling-of-interests accounting prospectively. It also provides guidance on purchase accounting related to the recognition of intangible assets and accounting for negative goodwill. SFAS 142 changes the accounting for goodwill from an amortization method to an impairment only approach. Under SFAS 142, goodwill will be tested annually and whenever events or circumstances occur indicating that goodwill might be impaired. SFAS 141 and 142 are effective for all business combinations completed after June 30, 2001. Upon adoption of SFAS 142, amortization of goodwill recorded for business combinations consummated prior to July 1, 2001 will cease, and intangible assets acquired prior to July 1, 2001 that do not meet criteria for recognition under SFAS 141 will be reclassified to goodwill. Companies are required to adopt SFAS 142 for fiscal years beginning after December 15, 2001. The Company will adopt SFAS 142 on January 1, 2002, the beginning of fiscal 2002. In connection with the adoption of SFAS 142, the Company will be required to perform a transitional goodwill impairment assessment. The Company has not yet determined the impact these standards will have on its results of operations and financial position. On October 3, 2001, the FASB issued Statement of Accounting Standards No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144"). FAS 144 supercedes FAS 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." FAS 144 applies to all long-lived assets (including discontinued operations) and consequently amends Accounting Principles Board Opinion No. 30 (APB 30), Reporting Results of Operations--Reporting the Effects of Disposal of a Segment of a Business. FAS 144 develops one accounting model for long-lived assets that are to be disposed of by sale. FAS 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, FAS 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. FAS 144 is effective for the Company for all financial statements issued beginning January 1, 2002. (2) Statements of Changes in Shareholders' Deficit An analysis of the shareholders' deficit amounts for the nine months ended September 30, 2001 is as follows (in thousands, except share amounts): Common Stock Unearned ------------------- Compen- Accumulated Shares Amount sation Deficit Total ---------- -------- -------- --------- --------- Balance at 12/31/2000 46,247,599 $365,441 - $(587,818) $(222,377) ---------- -------- -------- --------- --------- Issuance of common stock: Compensation grant 3,000,000 $ 3,281 $ 3,281 Stock options exercised 89,166 378 378 Stock compensation 4,980 (2,114) 2,866 Net income 25,685 25,685 ---------- -------- -------- --------- --------- Balance at 9/30/2001 49,336,765 $374,080 (2,114) $(562,133) $(190,167) ========== ======== ======== ========= ========= (3) Operating Leases The Company leases all of its stores, corporate offices, distribution centers and zone offices under non-cancelable operating leases. All of the Company's stores have an initial operating lease term of five to fifteen years and most have options to renew for between five and fifteen additional years. Rent expense was $52.9 million and $159.0 million for the three months ended September 30, 2001 and nine months ended September 30 2001, respectively, compared with $52.5 million, and $152.9 for the corresponding periods of the prior year. Most operating leases require payment of additional occupancy costs including property taxes, utilities, common area maintenance and insurance. These additional occupancy costs were $10.3 million and $30.7 million for the three months ended September 30, 2001 and nine months ended September 30 2001, respectively, compared with $9.5 million, and $28.0 for the corresponding periods of the prior year. (4) Long-term Obligations On June 5, 2001, the Company amended its revolving credit facility. The amendment extends the maturity of the facility from September 5, 2002 to December 23, 2003, and creates a new amortization payment schedule. The new amortization payment schedule on the $240 million outstanding on September 30, 2001 is as follows (in thousands): After Prior to Amendment Amendment --------- --------- Fiscal 2001 - 127,500 First Quarter 2002 18,500 37,500 Second Quarter 2002 20,000 37,500 Third Quarter 2002 20,000 37,500 Fourth Quarter 2002 40,000 First Quarter 2003 25,000 - Second Quarter 2003 25,000 - Third Quarter 2003 25,000 - Fourth Quarter 2003 66,500 - --------- --------- 240,000 240,000 --------- --------- Consideration paid to the lenders to complete the amendment was an up-front fee of 1.5% of the outstanding principal balance on June 5, 2001. The interest rate is set at LIBOR plus 5.0% and will step down if certain performance targets are met. The Company had the following long-term obligations as of September 30, 2001 and as of December 31, 2000 (in thousands): September 30, December 31, ------------- ------------ 2001 2000 ----------- ---------- Senior subordinated notes * $250,000 $ 250,000 Borrowings under revolving credit facility 240,000 245,000 Obligations under capital leases 29,245 41,396 Other - 5 ----------- ---------- 519,245 536,401 Current portions: Credit facility 58,500 245,000 Capital leases 14,922 16,164 ----------- ---------- 73,422 261,164 Total long-term obligations ----------- ---------- net of current portion $ 445,823 $ 275,237 =========== ========== * Coupon payments at 10.625% are due semi-annually in February and August of each year. The principal amount is due in August 2004. (5) Earnings per Share Basic earnings per share are calculated based on income available to common shareholders and the weighted-average number of common shares outstanding during the reported period. Diluted earnings per share includes additional dilution from the effect of potential issuances of common stock, such as stock issuable pursuant to the exercise of stock options, warrants outstanding and the conversion of debt. The following tables are a reconciliation of the basic and diluted earnings per share computations: (In thousands, except per share amounts) Three Months Ended September 30, ------------------------------------------------------- 2001 2000 ------------------------- -------------------------- Net Per Share Net Per Share Income Shares Amounts Income Shares Amounts ------- ------- ------- -------- ------- ------- Basic income per share: $15,374 49,311 $ 0.31 $ 716 46,207 $ .02 Effect of dilutive securities: Stock options - 5,673 - 276 ------- ------- -------- ------- Diluted income per share: $15,374 54,984 $ 0.28 $ 716 46,483 $ .02 ======= ======= ======= ======== ======= ======= Antidilutive stock options excluded from the calculation of diluted income (loss) per share were 1.7 million shares and 5.5 million shares in the three months ended September 30, 2001 and 2000, respectively. Nine Months Ended September 30, ------------------------------------------------------- 2001 2000 ------------------------- -------------------------- Net Per Share Per Share Income Shares Amounts Loss Shares Amounts ------- ------- ------- -------- ------- ------- Basic income (loss) per share: $25,685 49,006 $ 0.52 $(74,491) 46,119 $ (1.62) Effect of dilutive securities: Stock options - 2,830 - - ------- ------- -------- ------- Diluted income (loss) per share: $25,685 51,836 $ 0.50 $(74,491) 46,119 $ (1.62) ======= ======= ======= ======== ======= ======= Antidilutive stock options excluded from the calculation of diluted income (loss) per share were 4.8 million shares and 8.2 million shares in the first nine months of 2001 and 2000, respectively. (6) Segment Reporting The Company identifies its segments based on management responsibility. The Hollywood Video segment, which consists of the Company's 1,809 retail stores located in 47 states, was the only segment operated by the Company in the three months ended September 30, 2001 and nine months ended September 30, 2001. The Company operated only the Hollywood Video segment in the three months ended September 30, 2000 and the Hollywood Video segment and one other segment, the Reel.com segment, in the nine months September 30, 2000. The Reel.com segment was primarily an e-commerce company specializing in movies. During the second quarter of 2000, the Company announced the discontinuation of e-commerce operations at Reel.com (see Note 7). All assets of Reel.com were transferred to the Hollywood Video segment on June 12, 2000. The Company measures segment profit as operating profit, which is defined as income (loss) before interest expense and income taxes. Information on segments and a reconciliation to operating income (loss) are as follows (in thousands): Nine Months Ended September 30, 2000 ------------------------------------ Hollywood Video Reel.com Total ----------- -------- ---------- Revenue $ 938,210 $ 26,280 $ 964,490 Tape depreciation 88,621 110 88,731 Other depreciation and amortization 56,504 23,492 79,996 Gross margin 581,834 (18,974) 562,860 Operating income (loss) * 73,869 (122,769) (48,900) Interest expense, net 42,484 4,266 46,750 Total assets 1,119,836 - 1,119,836 Purchases of property and equipment, net 69,946 1,518 71,464 * Reel.com's operating loss includes a restructuring charge of $69.3 million for discontinued e-commerce operations. The loss also includes $22.7 million in goodwill amortization. Excluding the restructuring charge and goodwill amortization, Reel.com's operating loss would have been $30.8 million for the nine months ended September 30, 2000. (7) Reel.com Discontinued E-commerce Operations On June 12, 2000, the Company announced that it would close down the e-commerce business at Reel.com. The Company developed a leading web-site over the seven quarters after Reel.com was purchased in October of 1998, but its business model of rapid customer acquisition led to large operating losses and required significant cash funding. Due to market conditions, the Company was unable to obtain outside financing for Reel.com, and could not justify continued funding from its video store cash flow. On June 13, 2000, the Company terminated employment of approximately 200 of Reel.com's 240 employees, and paid $1.9 million in involuntary termination benefits. The remaining employees have since been terminated or integrated into Hollywood Entertainment. As a result of the discontinuation of e-commerce operations, the Company recorded a total charge of $69.3 million in the second quarter of 2000, of which $48.5 million was classified as a restructuring charge on the consolidated statement of operations and $20.8 million was included in cost of product sales. In the fourth quarter of 2000, the charge was reduced by $1.6 million to $46.9 million because the Company was able to negotiate termination of certain obligations and lease commitments more favorably than originally anticipated. The restructuring charge line item included $1.9 million of severance and benefits paid on June 13, 2000, $19.3 million of asset write downs, and $25.7 million of accrued liabilities. The assets written down include the remaining $14.9 million of goodwill associated with the acquisition of Reel.com, and $4.4 million to write down equipment, leasehold improvements, prepaid expenses and accounts receivable to their net realizable values. Amounts accrued include $19.9 million for contractual obligations, lease commitments and anticipated legal claims against the Company and $5.8 million for legal, financial, and other professional services incurred as a direct result of the closure of Reel.com. As of September 30, 2001, the Company had paid $7 million of the accrued amounts. The Company used some of the equipment from Reel.com at the distribution center in Nashville, Tennessee, and at the corporate offices in Wilsonville, Oregon. Equipment not utilized by the Company was sold. Proceeds of $250,000 were received in the third quarter of 2000. The $20.8 million write down of Reel.com inventory, primarily DVD's, to net realizable value was charged to cost of goods sold. This represented excess product for the Hollywood Video segment. The Company liquidated over 85% of this inventory in 2000. The remaining amount was liquidated or integrated into Hollywood Video inventory in 2001. (8) Restructuring Charge for Store Closures In December 2000, the Company approved a restructuring plan involving the closure and disposition of 43 stores that were not operating to management's expectations (the "Restructuring Plan"). The Company has recognized a charge of $16.9 million, including an $8.0 million write down of property and equipment, a $1.5 million write down of goodwill and an accrual for store closing costs of $7.4 million. The established reserve for cash expenditures is for lease termination fees and other store closure costs. The Company has liquidated and plans to continue liquidating all inventories through store closing sales; any remaining product will be used in other stores. Revenue during the years ended December 31, 2000, 1999 and 1998 for the stores included in the Restructuring Plan was approximately $15.5 million, $13.4 million and $9.1 million, respectively. Operating results (defined as income or loss before interest expense and income taxes) during the years ended December 31, 2000, 1999 and 1998 for the stores included in the Restructuring Plan were approximately $1.8 million loss, $0.5 million loss and $15,684 income, respectively. For the nine months ended September 30, 2001 these stores recorded a combined net loss of $2.2 million that is included in the Consolidated Statement of Operations. As of September 30, 2001, the Company had closed 10 of the 43 scheduled stores that are included in the Restructuring Plan and anticipates closing the remaining stores by June 2002. The Company incurred $281,919 in expenses during the nine months ended September 30, 2001 related to the closures. (9) Related Party Transactions In July 2001 Boards, Inc. (Boards) opened two Hollywood Video stores as licensee of the Company pursuant to rights granted by the Company and approved by the Board of Directors in January 2001. These stores will be operated by Boards and are not included in the 1,809 stores operated by the Company. Mark Wattles, the Company's Founder, Chief Executive Officer and President, is the majority owner of Boards. Under the license arrangement, Boards will pay the Company $25,000 per store, a royalty of 2% of revenue and may purchase product and services from the Company. At September 30, 2001 Boards owed the Company approximately $506,000 for fees, services, and product including rental inventory to open the stores. (10) Legal Proceedings During 1999, Hollywood was named as a defendant in three complaints which have been coordinated into a single action entitled California Exemption Cases, Case No. CV779511, in the Superior Court of the State of California in and for the County of Santa Clara. The plaintiffs are seeking to certify a class made up of certain exempt employees, which they claim are owed overtime payments in certain stores in California. The case is in the early stages of discovery. A class has not been certified. The Company believes it has provided adequate reserves in connection with this claim and intends to vigorously defend the action. On November 15, 2000, 3PF, a subsidiary of Rentrak Corporation filed a demand for arbitration with the American Arbitration Association, Case No. 75 181 00413 00 GLO against Hollywood and Reel.com, Inc. ("Reel"). 3PF and Reel entered into a Warehousing and Distribution Agreement on February 7, 2000. 3PF has alleged that Reel is in default under the Agreement, has failed to perform material obligations under the Agreement, and has failed to pay amounts due 3PF. 3PF seeks to recover approximately $4.8 million and consequential damages. The parties have substantially completed discovery. The Company believes it has provided adequate reserves in connection with this claim and continues to vigorously defend the action. The Company is a party to various claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. In the opinion of management, the outcome of these matters should not have a material adverse effect on the Company's consolidated financial condition. (11) Consolidating Financial Statements Hollywood Entertainment Corporation (HEC) had one wholly owned subsidiary during the nine months ended September 30, 2001, Hollywood Management Company (HMC). HMC may become a guarantor of certain indebtedness of HEC. The consolidating condensed financial statements below present the results of operations and financial position of HEC and HMC. Consolidating Condensed Statement of Operations Nine months ended September 30, 2001 (in thousands) ---------- -------- --------- ---------- HEC HMC Elimin- Consol- ations idated ---------- -------- --------- ---------- Revenue $1,014,388 $111,029 $(113,186) $1,012,231 Cost of revenue 405,583 -- -- 405,583 Gross profit 608,805 111,029 (113,186) 606,648 Operating costs & expenses: Operating and selling 453,351 9,552 -- 462,903 General & administrative 148,970 34,997 (113,186) 70,781 Amortization of intangibles 3,502 279 -- 3,781 Income from operations 2,982 66,201 -- 69,183 Interest income -- 26,757 (26,439) 318 Interest expense (69,700) -- 26,439 (43,261) Income (loss) before income Taxes (66,718) 92,958 -- 26,240 (Provision for) benefit from income taxes 33,839 (34,394) -- (555) Net income (loss) $ (32,879) 58,564 -- 25,685 Consolidating Condensed Balance Sheet September 30, 2001 (in thousands) ---------- -------- --------- --------- HEC HMC Elimin- Consol- ations idated ---------- -------- --------- --------- ASSETS Cash and cash equivalents $ 1,915 $ 16,971 $ -- $ 18,886 Accounts receivable 17,953 378,966 (371,218) 25,701 Merchandise inventories 56,394 -- -- 56,394 Prepaid expenses and other current assets 8,044 3,480 -- 11,524 Total current assets 84,306 399,417 (371,218) 112,505 Rental inventory, net 159,683 -- -- 159,683 Property & equipment, net 274,526 8,694 -- 283,220 Goodwill, net 66,114 -- -- 66,114 Other assets, net 13,022 4,666 (4,008) 13,680 Total Assets $ 597,651 $412,777 $(375,226) $ 635,202 LIABILITIES & SHAREHOLDERS' EQUITY (DEFICIT) Current maturities of long-term obligations $ 73,422 $ -- $ -- $ 73,422 Accounts payable 371,218 128,789 (371,218) 128,789 Accrued expenses 6,555 105,537 -- 112,092 Accrued revenue sharing -- 33,819 -- 33,819 Accrued interest -- 7,737 -- 7,737 Income taxes payable -- 4,605 -- 4,605 Total current liabilities 451,195 280,487 (371,218) 360,464 Long-term obligations, less current portion 445,823 -- -- 445,823 Other liabilities 19,082 -- -- 19,082 Total liabilities 916,100 280,487 (371,218) 825,369 Preferred stock Common stock 374,080 4,008 (4,008) 374,080 Unearned compensation (2,114) (2,114) Accumulated deficit (690,415) 128,282 -- (562,133) Total shareholders' equity equity (deficit) (318,449) 132,290 (4,008) (190,167) Total liabilities and shareholders equity (deficit) $ 597,651 $412,777 $(375,226) $ 635,202 Consolidating Condensed Statement of Cash Flows Nine months ended September 30, 2001 (in thousands) ---------- -------- ---------- HEC HMC Consol- idated ---------- -------- ---------- Operating activities: Net income (loss) $ (32,879)$ 58,564 $ 25,685 Adjustments to reconcile net income (loss) to cash provided by operating activities: Depreciation & amortization 183,714 4,758 188,472 Tax benefit from exercise of stock options -- -- -- Change in deferred rent (356) -- (356) Non cash stock compensation 6,147 -- 6,147 Net change in operating assets & liabilities (4,177) (45,967) (50,144) Cash provided by operating activities 152,449 17,355 169,804 Investing activities: Purchases of rental inventory, net (126,691) -- (126,691) Purchase of property & equipment, net (4,905) (1,317) (6,222) Increase in intangibles & other assets (4,075) (420) (4,495) Cash used in investing activities (135,671) (1,737) (137,408) Financing activities: Proceeds from the sale of common stock, net -- -- -- Issuance of long-term obligations -- -- -- Repayments of long-term obligations (12,156) -- (12,156) Proceeds from exercise of stock options 378 -- 378 Increase in revolving loan, net (5,000) -- (5,000) Cash provided by financing activities (16,778) -- (16,778) Increase (decrease) in cash and cash equivalents -- 15,618 15,618 Cash and cash equivalents at beginning of year 1,915 1,353 3,268 Cash and cash equivalents at end of year $ 1,915 $ 16,971 $ 18,886 ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Summary Results of Operations The Company's net income for the three months ended September 30, 2001 and nine months ended September 30, 2001 was $15.4 million and $25.7 million, respectively, compared with net income of $0.7 million and a net loss of $74.5 million for the corresponding periods of 2000. The improvement in net income was the result of closing down e-commerce operations at Reel.com and improved operating performance in the Company's existing store base. The following table sets forth (i) selected results of operations data, expressed as a percentage of total revenue; (ii) other financial data; and (iii) selected operating data. Three Months Ended Nine Months Ended September 30, September 30, ---------------------- ---------------------- 2001 2000 2001 2000 ---------- ---------- ---------- ---------- (Unaudited) REVENUE: Rental revenue 83.6% 85.5% 84.2% 82.6% Product sales 16.4 14.5 15.8 17.4 ---------- ---------- ---------- ---------- 100.0 100.0 100.0 100.0 ---------- ---------- ---------- ---------- GROSS MARGIN 61.4 62.7 59.9 58.4 OPERATING COSTS AND EXPENSES: Operating and selling 45.4 50.9 45.7 49.8 General and administrative 6.7 5.2 7.0 5.7 Restructuring charge for closure of internet business - - - 5.0 Amortization of intangibles 0.4 0.6 0.4 2.9 ---------- ---------- ---------- ---------- 52.5 56.7 53.1 63.4 ---------- ---------- ---------- ---------- INCOME (LOSS) FROM OPERATIONS 8.9 6.0 6.8 (5.0) Non-operating expense, net (4.3) (5.6) (4.2) (4.9) ---------- ---------- ---------- ---------- Income (loss) before income taxes 4.6 0.4 2.6 (9.9) Benefit from (provision for ) income taxes (0.1) (0.2) (0.1) 2.2 ---------- ---------- ---------- --------- NET INCOME (LOSS) 4.5% 0.2% 2.5% (7.7%) ---------- ---------- ---------- --------- Three Months Ended Nine Months Ended September 30, September 30, ---------------------- ---------------------- 2001 2000 2001 2000 ---------- ---------- ---------- ---------- OTHER FINANCIAL DATA: Rental gross margin (1) 67.5% 68.4% 65.4% 68.2% Product gross margin (2) 29.7% 28.6% 30.7% 11.9% EBITDA (3) (In thousands) Hollywood Video segment EBITDA $ 88,862 $ 68,681 $255,102 $218,991 Reconciliation to Adjusted EBITDA (4) Add non-cash expenses(5) 22,709 15,924 61,889 51,020 Less existing store investment in new release inventory (6) (54,844) (44,591) (166,001) (127,527) ---------- ---------- ---------- ---------- ADJUSTED EBITDA HOLLYWOOD VIDEO 56,727 40,014 150,990 142,484 Reel.com segment EBITDA - - - (29,834) ---------- ---------- ---------- ---------- CONSOLIDATED ADJUSTED EBITDA $ 56,727 $ 40,014 $150,990 $112,650 CASH FLOW FROM:(In thousands) Operating activities $ 68,474 $ 54,899 $169,804 $155,943 Investing activities (55,600) (56,093) (137,408) (214,982) Financing activities (13,755) 6,912 (16,778) 62,187 OPERATING DATA: Number of stores at quarter end 1,809 1,796 1,809 1,796 Weighted average stores open during the period 1,812 1,786 1,815 1,729 Comparable store revenue increase (7) 11% 1% 4% 4% --------------------------------- (1) Rental gross margin as a percentage of rental revenue. (2) Product gross margin as a percentage of product revenue. (3) EBITDA represents income (loss) from operations before interest, tax, depreciation and amortization. EBITDA should not be viewed as a measure of financial performance under Generally Accepted Accounting Principles (GAAP) or as a substitute for GAAP measurements such as net income or cash flow from operations. This calculation of EBITDA is not necessarily comparable to reported EBITDA of other companies due to the lack of a uniform definition of EBITDA. (4) Adjusted EBTIDA represents income (loss) from operations, before interest, tax, depreciation and amortization ("EBITDA"), plus certain special charges, plus non-cash expenses minus the cost of replenishing new release rental inventory for existing stores which is capitalized. Adjusted EBITDA should not be viewed as measures of financial performance under GAAP or as substitute for GAAP measurements such as net income or cash flow from operations. Our calculation of Adjusted EBITDA is not necessarily comparable to reported Adjusted EBITDA of other companies due to the lack of uniform definition of EBITDA and Adjusted EBITDA. (5) Expenses which were non-cash in nature for the current year and prior year include tape loss and the book cost of previously viewed movies sold. Additionally, in the three months ended September 30, 2001 and nine months ended September 30, 2001, non-cash items included $1.6 million and $6.1 million of stock compensation, respectively. (6) This represents existing store purchases that are considered replenishment of new release tapes, games and DVDs which are included in the amounts presented as investing activities on the statement of cash flows. This is in addition to the cost of product represented by revenue sharing expense already included in the statement of operations. (7) A store is comparable after it has been open and owned by the Company for 12 full months. REVENUE Revenue increased by $38.4 million or 12.5% in the three months ended September 30, 2001 and $47.7 million or 4.9% in the nine months ended September 30, 2001 when compared with the corresponding periods of the prior year. Excluding Reel.com, for the nine months ended September 30, 2001 revenue increased by $74 million or 7.9% when compared to the corresponding period of the prior year. In the three months ended September 30, 2001, and in the nine months ended September 30, 2001, revenue was favorably impacted by comparable store sales of 11% and 4%, respectively. Also favorably impacting revenue was an addition of 16 new superstores for the 12 months ended September 30, 2001. Rental revenue from initial rental periods was $252 million in the current year third quarter and $742 million in the nine months ended September 30, 2001 compared to $230 million and $700 million in the corresponding periods of the prior year. Rental revenue from extended rental periods was $37 million in the current year third quarter and $111 million in the nine months ended September 30, 2001 compared to $31 million and $96 million in the corresponding periods of the prior year. GROSS MARGIN Rental margin as a percentage of rental revenue decreased to 67.5% in the three months ended September 30, 2001 from 68.4% in the corresponding period of the prior year. Rental margins for the nine months ended September 30, 2001 decreased to 65.4% from 68.2% in the corresponding period of the prior year. The decrease in margin primarily relates to an increase in rental product depreciation expense caused by changes in depreciation estimates. During the fourth quarter of 2000, the Company made several key observations that led management to change estimates regarding rental inventory lives and residual values. As a result of the growing demand for DVD the estimated residual value of catalog VHS cassettes was reduced from $6.00 to $2.00 and the estimated useful life was reduced from five years to one year. The Company adopted the changes in estimate prospectively on October 1, 2000. By applying these changes prospectively, the Company recorded incremental depreciation of approximately $2 million and $18 million in the three months ended September 30, 2001 and in the nine months ended September 30, 2001, respectively. Product margin as a percentage of product sales increased to 29.7% in the three months ended September 30, 2001 from 28.6% in the corresponding period of the prior year. The improvement in margin is primarily due to improved margins on previously viewed movie sales. Compared to the prior year, margins on previously viewed product have increased due to the depreciation change in estimate, which results in lower residual values that are charged to cost of product sales. Product margins for the nine month period ended September 30, 2001 increased to 30.7% from 11.9% in the corresponding period of the prior year. The increase in margin is primarily due to the discontinuation of e-commerce sales at Reel.com in June 2000. Excluding Reel.com, product margins improved to 30.7% from 27.6% primarily due to improved margins on previously viewed movie sales caused by the deprecation change in estimate. OPERATING COSTS AND EXPENSES Operating and Selling Total operating and selling expense in the three months ended September 30, 2001 decreased as a percentage of revenue to 45.4% compared to 50.9% in the corresponding period of the prior year. The percentage decrease is primarily the result of leverage on increased revenue and lower advertising expense. The net $0.7 million increase in operating and selling expense in the three months ended September 30, 2001 compared to the corresponding prior year period was primarily the result of new store additions. Payroll and related expenses increased by $3.5 million, rent and related expense by $0.9 million and other operating and selling expenses by $1.1 million. These increases were offset by a decrease in advertising expense of $4.8 million. Total operating and selling expense for the nine month period ended September 30, 2001 decreased as a percentage of revenue to 45.7% compared to 49.8% in the prior year. The percentage decrease is due to leverage on increased revenue, lower advertising expense and the discontinuation of Reel.com. The decrease of total operating and selling expense for the nine month period ended September 30, 2001 of $17.8 million was primarily caused by the discontinuation of Reel.com, which had operating and selling expense of $27.4 million in the prior year. Excluding Reel.com, there was a net increase of $9.6 million for the nine month period ended September 30 2001, primarily due to new store additions. Payroll and related expense increased by $8.5 million and rent and related expenses by $7.7 million, which was partially offset by a decrease in advertising expense of $6.3 million and other operating and selling expense of $0.3 million. General and Administrative General and administrative expenses in the three months ended September 30, 2001 and nine months ended September 30, 2001 increased $7.5 million and $16.4 million, respectively, compared to the corresponding prior year periods to $23.3 million and $70.8 million. The increase for the three months ended September 30, 2001 was primarily due to an increase in payroll and related expenses of $6.4 million when compared to the prior year period, of which $1.6 million was non-cash stock compensation. The increase for the nine months ended September 30, 2001 was primarily due to an increase in payroll and related expenses of $18.0 million. Of the payroll and related expense increase, $5.6 million was compensation expense related to a stock grant to the Company's Chief Executive Officer as part of a three year employment agreement and $2.9 million was non-cash stock compensation associated with the Company's stock option plans. The Company made the decision to invest in certain elements of the business such as the store field supervision structure, the loss prevention function and human resources. The Company believes these investments will have a direct impact on the business by improving the level of execution. The increase was partially offset by the discontinuation of Reel.com, which had general and administrative expenses of $5.1 million in the nine months ended September 30, 2000. Restructuring Charge for Closure of Internet Business On June 12, 2000, the Company announced that it would close down the e-commerce business at Reel.com. The Company developed a leading web-site over the seven quarters after Reel.com was purchased in October of 1998, but its business model of rapid customer acquisition led to large operating losses and required significant cash funding. Due to market conditions, the Company was unable to obtain outside financing for Reel.com, and could not justify continued funding from its video store cash flow. On June 13, 2000, the Company terminated employment of approximately 200 of Reel.com's 240 employees, and paid $1.9 million in involuntary termination benefits. The remaining employees have since been terminated or integrated into Hollywood Entertainment. As a result of the discontinuation of e-commerce operations, the Company recorded a total charge of $69.3 million in the second quarter of 2000, of which $48.5 million was classified as a restructuring charge on the consolidated statement of operations and $20.8 million was included in cost of product sales. In the fourth quarter of 2000, the charge was reduced by $1.6 million to $46.9 million because the Company was able to negotiate termination of certain obligations and lease commitments more favorably than originally anticipated. The restructuring charge line item included $1.9 million of severance and benefits paid on June 13, 2000, $19.3 million of asset write downs, and $25.7 million of accrued liabilities. The assets written down include the remaining $14.9 million of goodwill associated with the acquisition of Reel.com, and $4.4 million to write down equipment, leasehold improvements, prepaid expenses and accounts receivable to their net realizable values. Amounts accrued include $19.9 million for contractual obligations, lease commitments and anticipated legal claims against the Company and $5.8 million for legal, financial, and other professional services incurred as a direct result of the closure of Reel.com. As of September 30, 2001, the Company had paid $7 million of the accrued amounts. Charged to cost of goods sold was the write down of Reel.com inventory, primarily DVD's, to net realizable value. This represented excess product for the Hollywood Video segment. The Company maintains the web-site as a content-only site to minimize any negative effect the Reel.com shutdown may have on existing Hollywood Video store customers. To offset the costs of maintaining the web-site the Company entered into a short-term agreement with Buy.com to direct Reel.com visitors to Buy.com to make purchases. This agreement expired in the current year first quarter. In the current year third quarter the Company entered into a strategic partnership with 800.com that should enable Reel.com to continue as a content- only site. Revenues associated with the Buy.com and 800.com agreements and the expenses of maintaining the web-site have been recognized as earned and incurred, respectively. Amortization of Intangibles Amortization of intangibles decreased to $1.3 million and $3.8 million in the three months ended September 30, 2001 and nine months ended September 30, 2001, respectively. The decrease was caused by a write down of Reel.com's goodwill as e-commerce operations were discontinued in the prior year second quarter, and by goodwill write downs in the fourth quarter of 2000 for planned store closures and SFAS No. 121 impairment charges. NONOPERATING INCOME (EXPENSE), NET Interest expense, net of interest income, decreased by $2.6 million and $3.8 million in the three months ended September 30, 2001 and nine months ended September 30, 2001, respectively, compared to the corresponding periods of the prior year. The decrease is due to decreased borrowings under the Company's revolving credit facility and lower interest rates. INCOME TAXES The Company's income tax rate is 2.1% for both the three months ended September 30, 2001 and the nine months ended September 30, 2001, compared with a provision of 40.5% and a benefit of 22.1% for the corresponding periods in the prior year. The difference between the tax provision for the nine months ended September 30, 2001 and the tax benefit recorded in the prior year period resulted primarily from minimum state taxes in excess of statutory state income taxes, nondeductible executive compensation and a valuation allowance placed against the net deferred tax assets. The decrease in the effective rate for the three months ended September 30, 2001 compared to the prior year is due to a decrease in taxable income. The estimated fiscal 2001 effective rate impact attributable to the change in valuation allowance is 40%. LIQUIDITY AND CAPITAL RESOURCES Overview The Company generates substantial operating cash flow because most of its revenue is received in cash from the rental and sales of videocassettes, DVDs and games. The amount of cash generated from operations in the nine months ended September 30, 2001 funded the Company's debt service requirements and all capital expenditures with enough cash left over to reduce accounts payable and accrued liabilities by $46 million and long-term obligations by over $17 million. At September 30, 2001 the Company had $18.9 million of cash and cash equivalents on hand. The Company believes that cash flow from operations, increased flexibility under the amended credit facility, cash on hand and trade credit will provide adequate liquidity and capital resources to execute its business plan for the next twelve months. With respect to the Company's longer term cash requirements and desire for increased financial and operating flexibility, taking into account the scheduled expiration of the amended credit facility in 2003 and the maturity of the Company's outstanding subordinated notes in 2004, the Company will likely need to effect additional capital and/or financing transactions, such as the procurement of a new credit facility and/or the issuance of debt and/or equity securities. Accordingly, the Company continues to analyze its capital structure and related flexibility, and from time to time, may consider additional capital and/or financing transactions as a source of incremental liquidity. Although the Company believes that it will be able to timely effect additional capital and/or financing transactions on acceptable terms, any failure to do so could impair the Company's ability to execute its business plan over the longer term and/or satisfy its other cash requirements over the longer term. Cash Provided by Operating Activities Net cash flow provided by operating activities increased by $14 million in the nine months ended September 30, 2001 when compared to the corresponding period of the prior year. The Company's net income/loss plus adjustments to reconcile net income/loss to cash provided by operating activities increased by $104 million or 90% in the nine months ended September 30, 2001 compared to the corresponding period of the prior year. The increase was due to the discontinuation of e-commerce operations at Reel.com and improved operating performance in the existing store base. The increase was offset by pay-downs of accounts payable and accrued liabilities of $46 million compared to a net increase in accounts payable and accrued liabilities of $42 million in the prior year period. Cash Used in Investing Activities Net cash used in investing activities decreased by $77.6 million, or 36%, to $137.4 million in the nine months ended September 30, 2001 from $215 million in the corresponding period of the prior year. The decrease was primarily due to fewer new store openings. The Company opened only 6 new stores in the first nine months of 2001 compared to 184 in the first nine months of 2000. The Company anticipates that the number of new store openings in 2001 will be fewer than 10. Capital expenditures other than rental inventory include equipment, fixtures, and leasehold improvements for new and existing stores, remodeling projects, and implementing and upgrading office and store technology. We anticipate that capital expenditures, other than purchases of rental inventory, will be less than $10 million in 2001, of which approximately 70% is anticipated to relate to new, relocated and remodeled stores and related store maintenance. The remaining balance relates to corporate capital expenditures. Cash Provided by Financing Activities In the nine months ended September 30, 2001 the Company's cash flow from financing activities was a net use of $16.8 million compared to $62.2 million of cash provided by financing activities in the nine months ended September 30, 2000. The slowing of store growth coupled with an increase of cash provided by operations is allowing the Company to operate with internally generated cash flow instead of outside financing. On June 5, 2001, the Company amended its revolving credit facility. The amendment extends the maturity of the facility from September 5, 2002 to December 23, 2003, and creates a new amortization payment schedule. (See Note 4 to the Consolidated Financial Statements for a table of amortization payments.) Consideration paid to the lenders to complete the amendment was an up-front fee of 1.5% of the outstanding principal balance on June 5, 2001. The interest rate is set at LIBOR plus 5.0% and will step down if certain performance targets are met. As of September 30, 2001 the balance on the revolving credit facility was $240 million. Other Financial Measurements: Working Capital At September 30, 2001, the Company had cash and cash equivalents of $18.9 million and a working capital deficit of $248 million. The working capital deficit is primarily the result of the accounting treatment of rental inventory as discussed below. Other factors contributing to the deficit are the current amounts due under the revolving credit facility and significant accrued expenditures. Rental inventories are accounted for as non-current assets under generally accepted accounting principles because they are not assets which are reasonably expected to be completely realized in cash or sold in the normal business cycle. Although the rental of this inventory generates a substantial portion of the Company's revenue, the classification of these assets as non- current excludes them from the computation of working capital. The acquisition cost of rental inventories, however, is reported as a current liability until paid and, accordingly, included in the computation of working capital. Consequently, the Company believes working capital is not as significant a measure of financial condition for companies in the video retail industry as it is for companies in other industries. Because of the accounting treatment of rental inventory as a non-current asset, the Company will, more likely than not, operate with a working capital deficit. The Company believes the current existence of a working capital deficit does not effect its ability to operate its business and meet obligations as they come due. Disclosure Regarding 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 are intended to be covered by the safe harbors created thereby. These statements can be identified by the fact that they do not relate strictly to historical information and include the words expects, believes, anticipates, plans or other similar expressions. These forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those currently anticipated. These risks and uncertainties include, but are not limited to, items discussed in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000 under the heading "Cautionary Statements". PART II OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 4.1 Third Supplemental Indenture, dated as of February 12, 2002, between Hollywood Entertainment Corporation, as Issuer, Hollywood Management Company, as Subsidiary Guarantor, and BNY Western Trust Company, as Trustee. (b) Reports on Form 8-K None reported during the period. HOLLYWOOD ENTERTAINMENT CORPORATION 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. HOLLYWOOD ENTERTAINMENT CORPORATION (Registrant) February 12, 2002 /S/James Marcum ------------------ ------------------------------------------------- (Date) James Marcum Executive Vice President and Chief Financial Officer (Authorized Officer and Principal Financial and Accounting Officer of the Registrant)