10-K 1 r10k-03.txt ANNUAL REPORT ON FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington DC 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2003 ----------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to --------------- ---------------- Commission file number 0-21824 ---------- HOLLYWOOD ENTERTAINMENT CORPORATION (Exact name of registrant as specified in its charter) Oregon 93-0981138 ----------------------------------------------------------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) identification No.) 9275 SW Peyton Lane, Wilsonville, OR 97070 ----------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (503) 570-1600 (Registrant's telephone number, including area code) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Title of Each Class Name of Each Exchange on ----------------------- Which Registered -------------------------- Common Stock Nasdaq National Market Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period than the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10- K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [ ] On June 30, 2003 (the last business day of the registrant's most recently completed second fiscal quarter), the aggregate market value of the shares of Common Stock held by non-affiliates of the Registrant was $986,093,237 based upon the last sale price reported for such date on the Nasdaq National Market. Shares of Common Stock held by executive officers and directors of the registrant are not included in the computation. However, the registrant has made no determination that such individuals are "affiliates" within the meaning of Rule 405 under the Securities Act of 1933. On March 9, 2004, the registrant had 59,801,579 shares of Common Stock outstanding PART I ITEM 1. BUSINESS OUR BUSINESS We are the second largest rental retailer of DVDs, videocassettes and video games in the United States. We opened our first video store in October 1988 and, as of December 31, 2003, we operated 1,920 Hollywood Video stores in 47 states and the District of Columbia. As of December 31, 2003, we also operated 595 Game Crazy stores, which are game specialty stores where game enthusiasts can buy, sell and trade new and used video game hardware, software and accessories. A typical Game Crazy store carries over 2,500 video game titles and occupies an area of approximately 700 to 900 square feet adjacent to a Hollywood Video store. Our total revenue and cash provided by operating activities were $1.683 billion and $390.8 million, respectively, for the year ended December 31, 2003 and $1.490 billion and $361.6 million, respectively, for the year ended December 31, 2002. Revenue from our Hollywood Video stores represented approximately 89% of our revenue for the year ended December 31, 2003 consisting of approximately 92% from rental products and 8% from the sale of new DVD and VHS movies and concessions. Revenue from our Game Crazy stores for the year ended December 31, 2003 represented approximately 11% of our total revenue. Our strategy is to successfully build and operate two separately managed national chains, each with a retail model designed to compete favorably against the primary competitors in its segment of the entertainment industry. The Hollywood Video retail model, including the types of real estate sites we pursue, the store design, employee hiring and training practices, and inventory and merchandising standards, is designed to maximize the number of customers per store, as well as the frequency of customer visits and the amount that consumers spend per visit. Hollywood Video stores are typically located in high-traffic, high-visibility locations with convenient access and parking. Inside the store, we focus on providing a superior selection of movies and video games for rent, in a friendly and inviting atmosphere that encourages browsing. We believe that consumers view movie rentals in general, and our pricing structure and rental terms in particular, as a convenient form of entertainment and an excellent value. Our Game Crazy retail model, including the core concept of allowing consumers to buy, sell and trade new and used merchandise, combined with store design, employee selection and training, and our inventory selection and merchandising presentation, is designed to appeal to both "hard-core" and casual game consumers. Remerchandising a Hollywood Video in order to accommodate a Game Crazy, including reducing its size, does not cannibalize Hollywood Video revenue. Further, we believe that there is significant customer overlap, enabling the Hollywood Video and Game Crazy retail models to complement each other, allowing each of the concepts to have a competitive advantage versus its primary competitor. HOME VIDEO MOVIES - INDUSTRY OVERVIEW Consumer Spending According to Adams Media Research ("AMR"), the total domestic video retail industry (consisting of both rentals and sales) grew from $16.4 billion in revenue in 1998 to an estimated $24.4 billion in 2003, and is expected to grow to approximately $30.7 billion by 2007. AMR estimates that the total domestic video retail industry grew approximately 10% in 2003. Total video rental spending, according to AMR, has remained fairly flat from 1998 to 2003 increasing from $9.7 billion in 1998 to $9.9 billion in 2003 and AMR estimates that rental spending declined by 1% in 2003 from 2002. The following factors, among others, continue to make video rental an attractive medium of entertainment for millions of customers: - the continued improvement in home entertainment technology (e.g. DVD, surround sound, HDTV) which encourages consumers to spend more time watching movies at home; - the opportunity to entertain one or more people at home for a reasonable price; - the opportunity to browse among a very broad selection of movies at a retail location; and - the ability to control the viewing experience, such as the ability to start, stop, pause, fast-forward and rewind. According to AMR, at the end of 2003 VCR penetration stood at approximately 87.6% of the 108.9 million domestic television households, while DVD player penetration was 49.3%. Movie Studio Dependence on Video Retail Industry We believe the home video industry is the single largest source of revenue to movie studios. According to AMR, the home video industry represented approximately $12.3 billion, or 59%, of the $20.8 billion of estimated domestic studio revenue in 2002. As a result, the movie studios are highly motivated to protect this significant source of revenue. A majority of all movies that are produced by movie studios are either released directly to video and generate no box office revenues or are unprofitable based on box office revenues alone. Accordingly, the video retail industry provides movie studios with an important distribution channel and revenue source for their direct-to-video and non-hit movies as well as their hit movies. In addition, the browsing characteristics of the retail environment frequently results in consumers selecting more than one movie, which based on our experience typically includes both hit and non- hit movie titles, for rental or purchase. As a result, we believe that the movie studios are highly motivated to protect this significant source of revenue. Exclusive Rental Window As a result of the importance of the video retail industry to the movie studios' revenue base, the home video rental and sell-through markets enjoy a period of time during which they have the exclusive rights to distribute a movie. This period of exclusivity has been in place since the mid 1980s. The period typically begins after a film finishes its domestic theatrical run (usually five months after its debut) or upon its release to video in the case of direct-to-video releases, and lasts for 30 to 60 days thereafter. This period of exclusivity is intended to maximize revenue to the movie studio prior to a movie being released to other distribution channels, including pay-per- view, video-on-demand, premium or pay cable and other television distribution, and provides what we believe is a significant competitive advantage for the rental retail channel. Exclusive windows have been used historically to protect each distribution channel from downstream channels, principally protecting theaters from home video, home video from pay-per-view or video-on-demand and pay-per-view or video-on-demand from premium cable and other television channels. The exclusive home video window protects both mass merchants who sell videos and video retailers who rent videos. New Release Movie Pricing to Home Video Retailers Studios are currently offering substantially all new release DVD titles to rental retailers and mass merchant retailers at low, "sell-through", prices (typically under $18 wholesale). This is a departure from the historical VHS pricing model in which a majority of the new release titles were purchased by rental retailers at high "rental" prices (typically $60 to $65 wholesale) and promoted primarily for rental. Then later (approximately six months) these titles would be re-released for sale to consumers at a lower price (typically $10 to $15 wholesale). However, even under this historical VHS pricing model, prominent children's titles and certain high-grossing box office films were simultaneously targeted at the rental and consumer sell-through markets, in which case those titles were priced at the lower "sell-through" level upon initial release. In 1998, the major studios and several large video retailers, including us, began entering into VHS revenue sharing arrangements as an alternative to purchasing at the historically high "rental" prices (typically $60 to $65). Under revenue sharing arrangements, rental retailers were able to acquire significantly more copies of movies in order to satisfy consumer demand faster and improve overall consumer satisfaction. In exchange for receiving more copies of movies at significantly reduced or no up-front cost, rental retailers, including us, agreed to share a pre-determined portion of the revenues derived from the those movies during the revenue sharing period (generally 26 weeks). We believe that VHS revenue sharing produced significant benefits for us, including: (i) substantially increasing the availability of newly released videos in our stores; (ii) improving customer satisfaction as more consumers have been able to get the movie they want; (iii) increasing revenue and same store sales; and (iv) aligning the studios' economic interests more closely with our economic interests. Nearly all DVDs are being initially released at "sell-through" pricing. Because of the lower wholesale pricing, the benefits of entering into revenue sharing arrangements for DVDs are not as significant as they were for VHS, we believe there are advantages to revenue sharing on DVDs, especially the ability to improve availability and thus customer satisfaction. We have DVD revenue sharing arrangements with a number of studios, with approximately half of our new release DVD rental product revenue in 2003 occurring under revenue sharing arrangements. We are in discussions regarding additional revenue sharing arrangements and believe that additional revenue sharing would have a positive impact on our business. VIDEO GAMES - INDUSTRY OVERVIEW Consumer Spending According to NPD Group, Inc. ("NPD"), the video game industry was an approximately $10.0 billion market in the United States in 2003, with software accounting for $5.8 billion and hardware and accessories accounting for $4.2 billion. In 2000 and 2001, Nintendo's GameCube, Sony's PlayStation 2 and Microsoft's Xbox, three new-generation hardware technology products, were introduced. These platforms have substantially increased the installed base of video game hardware units and have driven significant growth in the video game software segment. As with the introduction of previous new platforms, consumers have increased both their purchase and rental of games. Hardware Platform Technology Hardware platform technology continues to evolve. The early products launched in the 1980's had only 8-bit processing speeds compared to the hardware available today, Sony Playstation 2, Microsoft Xbox and Nintendo Game Cube, which have 128-bit processing speeds. Advancements in processing speed and data storage provide for significant improvements in graphics and audio quality that software developers utilize to create more exciting games. In addition, new hardware technology is available with capabilities beyond gaming, such as playing DVD movies and providing internet connectivity. These advancements encourage existing game players to upgrade their systems and can attract new game players. Increased Video Game Software Selection Production of video game software generally increases with the introduction of next-generation hardware as video game publishers attempt to capitalize on the excitement generated by new technology. According to NPD, the video game software industry grew 5% to approximately $5.8 billion in 2003 compared to 2002, and is projected to grow 8% to $6.2 billion in 2004. Growth in the overall number of titles available for game platforms has been rapid, with an estimated 830 new titles were released in 2003. Widening Demographic Trends Because of advancing technologies, enhanced functionality and the aging of the gamer population, the video game market has steadily broadened its demographic appeal over the past two decades. According to a poll released in August 2003 by the Entertainment Software Association and conducted by Peter D. Hart Research Associates, Inc., game players over the age of 50 now account for 17% of game players, up from 13% in 2000. The data also shows women who are 18 and over now make up a larger percentage of game players (26%) than boys ages 6 to 17 (21%). We believe these broadening demographic trends will benefit our Game Crazy stores. Viable and Growing Used Games Market The buying, selling and trading of used games by consumers is relatively new and has caused the used game category to grow rapidly for certain specialty retailers. The total installed base of video game hardware has increased with the introduction of new platforms, which has increased the used game market by extending the life of older platforms and enabling game consumers access to additional software titles in the used market. Used titles compatible with legacy hardware provide video game retailers with a highly profitable category, as margins on used games are significantly higher than on new games. The introduction of the three new platforms and the significant increase in new titles has created a greater supply and demand of used product. At the same time, the high price of new games for the latest platforms has increased the perceived value of used game software. As a result, we believe the used video game market will increase as consumers increasingly look to realize the "in- store currency" value of products they already own when making new purchases. BUSINESS STRATEGY - HOLLYWOOD VIDEO We are committed to enhancing our position as the nation's second largest rental retailer of DVDs, videocassettes and video games by focusing on the following strategies: Provide Broad Selection and Superior Service We are committed to providing superior service and satisfying customers' movie and video game demands by carrying a broad array of titles for rent. Our stores typically carry more than 10,000 movie and game titles on more than 25,000 DVDs, videocassettes and video games. Through our revenue sharing arrangements with studios and lower wholesale prices on DVDs, we have increased the availability of most new movie releases and typically acquire 100 to 250 copies of "hit" movies for each store. This breadth and depth of movie titles, together with our emphasis on superior customer service, results in a higher average level of rentals per store visit, creates greater customer satisfaction and encourages repeat visits. Provide Entertainment Convenience and Value We offer an inexpensive and convenient form of entertainment by allowing consumers to rent new movie releases, older "catalog" movie titles and video games for five days in most of our stores. Both new release and catalog DVDs typically rent for $3.79 and new movie release titles in the VHS format typically rent for $3.79 while older VHS catalog movies rent for $1.99. We often offer a $1.00 rebate for early return on select new release titles in their first few weeks of release. In addition, we focus our movie sales efforts on the sale of previously viewed movies, which we believe offer a better value than new movies for those consumers who choose to purchase as opposed to rent movies. Video games typically rent for $4.99 or $5.99, with games for the newer system platforms renting for the higher amount. We also offer used games for sale in Hollywood Video stores that do not have an adjacent Game Crazy. Capitalize on Continued Industry Consolidation Hollywood Video grew its revenue from $17 million in 1993 to $1.5 billion in 2003, which management believes is primarily attributable to taking market share in a fragmented industry. The home video rental industry has experienced consolidation in recent years, as the larger video store chains have taken market share from independent store operators, but the industry still remains fragmented. In 2003, we estimated the share of the three largest video rental store chains, including us, to represent approximately half of the domestic consumer video rental market. The remainder of the market share is divided amongst a relatively large number of smaller independent and regional operators. We believe our size is a competitive advantage with respect to smaller operators because it allows us to benefit from strong studio relationships, access to more copies of individual movie titles through direct revenue sharing arrangements, sophisticated information systems, greater access to prime real estate locations, greater access to managerial resources, greater marketing efficiencies, greater access to capital, greater flexibility setting competitive prices and other operating efficiencies made possible by size. Pursue Organic Store Growth To maintain and enhance our market share and number two position in the video rental industry, we will pursue organic store growth. Unlike many video retailers who have grown through acquisitions, we have focused primarily on organic growth through internal site selection. Approximately 95% of the 1,678 video stores that we have opened since 1996 have been the result of internal site selection and development rather than the acquisition of existing stores. We believe that control over site selection and discipline in the real estate process have been among our key competitive advantages. Our organic store growth strategy is to selectively add Hollywood stores in existing markets where we believe the market will successfully absorb additional Hollywood stores. We are targeting long-term growth of our store base of between 5% and 10% per year. BUSINESS STRATEGY - GAME CRAZY Game Crazy has performed below our expectations to date, generating significant operating losses for the Company. While we anticipate continued losses through at least 2004, we believe Game Crazy represents a compelling long-term opportunity. We believe in the game industry and are committed to increasing our share of the growing market for new and used video game hardware, software and accessories. As part of our strategy, we will continue to maintain a separate organizational structure that oversees all aspects of Game Crazy's existing operations as well as new store growth. Provide Broad Selection and Superior Service Our Game Crazy stores typically offer our customers over 2,500 video game titles on all major hardware systems. This extensive selection is continuously updated as software publishers release new titles. We believe our breadth of product selection and deep availability of newly released titles appeals to the hard-core game enthusiast as well as the casual game player and seasonal gift buyer. In addition, we seek to hire knowledgeable and passionate sales associates who are generally "gamers" themselves, and then train them to create exceptional shopping experiences for our customers. Destination Location for Game Consumers We believe our combination of product selection, knowledgeable sales staff, exceptional customer service, exciting merchandising presentation, convenient location, and availability of games for rental in our video stores will compel game consumers of all types to recognize Game Crazy as the destination location for video games. Our merchandising presentation includes interactive game terminals where customers can try games before they purchase and where our sales staff can demonstrate tricks and strategies to win games. Our Game Crazy stores benefit from the quality of the real estate in which our video stores are located, typically in high-visibility, stand-alone structures or prominent locations within multi-tenant shopping developments, with convenient accessibility to the store and availability of ample parking. We believe the significant expansion and adoption of new game platforms is driving consumers to become more economical by purchasing and trading-in used games, as well as by renting more games. The proliferation of game titles is also causing growth in the "trade-in" market, where consumers exchange their games for new games or other used games. Based on our experience, the greater the number of available titles in the market, the more consumers are inclined to trade and/or rent games. We believe our broad selection of used video games in combination with our rental selection in our video stores will differentiate us from our competitors and be a significant factor in a customer's decision on where to shop for video games. Continue Opening New Game Crazy Stores We opened 67 Game Crazy stores in 1999 and had 69 stores in operation at the end of 2000. In 2002, we began opening additional Game Crazy stores, adding 207 new stores in 2002 and 319 new stores in 2003. Stores opened prior to 2002 ("mature stores") generated average annual revenue of approximately $540,000 in 2003. Although stores opened since 2002 have experienced lower volumes than mature stores, we are optimistic about our ability to increase revenue per store. In addition, we believe the game industry will experience significant growth with the anticipated release of new hardware platforms in 2006, and we seek to be a major player in the game industry when this occurs. As such, we plan to continue our expansion of Game Crazy and anticipate adding approximately 150 new stores in 2004. The opening of a Game Crazy and the remerchandising of the adjacent Hollywood Video store is typically accomplished with minimal disruption and results in higher Hollywood Video revenue once the remerchandising is complete. The cost of a Game Crazy and simultaneous remerchandising of the Hollywood Video store is approximately $200,000 including construction, fixtures, inventory and opening expenses. We expect to continue the expansion of Game Crazy on a market-by-market basis in order to obtain marketing, management and other operational efficiencies. STORES AND STORE OPERATIONS Video Store Openings We opened our first video store in October 1988 and grew to 25 stores in Oregon and Washington by the end of 1993. In 1994, we significantly accelerated our store expansion program, adding 88 stores and expanding into California, Texas, Nevada, New Mexico, Virginia and Utah. In 1995, we added 192 stores and entered major new markets in the Midwest, Southwest, East and Southeast regions of the United States. The following table shows store growth from 1994. Year Ended December 31, ---------------------------------------------------------------- 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 ---------------------------------------------------------------- Beginning 25 113 305 551 907 1,260 1,615 1,818 1,801 1,831 ---------------------------------------------------------------- Opened 33 122 250 356 312 319 208 6 41 96 Acquired 55 70 - - 41 43 - - - 6 Closed - - (4) - - (7) (5) (23) (11) (13) ---------------------------------------------------------------- Ending 113 305 551 907 1,260 1,615 1,818 1,801 1,831 1,920 ================================================================ Site Selection We believe that the selection of locations for our stores is critical to the success of our operations. We have assembled a store development team with broad and significant experience in retail tenant development. Most of our new store development personnel have expertise in and reside in the geographic area for which they are responsible, but all final site approval takes place at the corporate office where new sites are approved by a committee of senior management personnel. Final approval of all new sites is the responsibility of the Chairman of the Real Estate Committee of the Board of Directors. Important criteria for the location of a store include density of local residential population, traffic count on roads immediately adjacent to the store location, visibility and accessibility of the store, availability of ample parking and proximity of competition. Management generally seeks what it considers the most desirable locations, typically locating stores in high-visibility, stand-alone structures or in prominent locations in multi-tenant shopping developments. All of our stores are located in leased premises; we do not own any real estate. Our real estate and store development team is scaled to meet our planned store growth. PRODUCTS Hollywood Video Our video stores typically carry more than 10,000 movie and game titles on 25,000 units of DVDs, VHS and games, consisting of a combination of new releases and an extensive selection of older "catalog" movies. Excluding new releases, movie titles are classified into categories, such as "Action," "Comedy," "Drama" and "Children," and are displayed alphabetically within those categories. We do not rent or sell adult movies. In addition to video rentals, we rent video games primarily for Sony Playstation 1 & 2, Microsoft Xbox and Nintendo Game Cube. Hollywood video stores contributed 89% of our consolidated revenue in 2003. Revenue from rental products, including rental and sale of previously viewed DVD, VHS and video games, represented approximately 92% of video store revenue for 2003. In addition to the growth of DVD rentals, we have experienced significant growth in the sale of previously viewed DVDs. Our ability to sell previously viewed movies at lower prices than new movies provides a competitive advantage over mass-market retailers. We expect the market for previously viewed DVDs to experience strong growth as DVD player penetration increases and consumers begin to build their own DVD libraries. Furthermore, previously viewed DVDs do not suffer from the quality degradation that VHS tapes do, making them an attractive option for consumers looking to build their personal movie libraries. The remaining approximately 8% of video store revenue was from the sale of new DVDs and videocassettes and concessions (e.g., popcorn, sodas, candy and magazines). Game Crazy Game Crazy offers new and used video game software, hardware and accessories. Each Game Crazy typically carries over 2,500 video game titles that can be played on all major new and legacy game systems. We offer new and used Sony Playstation 2, Microsoft Xbox, Nintendo Game Cube, Game Boy Advance and Game Boy hardware systems as well a broad selection of used legacy hardware systems. In addition, we offer new and used game accessories such as controllers, memory cards and game media such as strategy guides. Revenue from new and used software represented 68% of Game Crazy revenue for 2003, while 32% was from new and used hardware and accessories. SUPPLIERS AND PURCHASING ARRANGEMENTS We purchase the majority of our movies directly from the studios through revenue sharing arrangements or other direct purchasing methods, and we purchase a majority of our video games directly from video game publishers, except for used games which are purchased from our customers with in-store credit. ADVERTISING AND MARKETING Our primary goal in advertising is to increase transactions in our stores from both new and existing members. Our primary focus is on cost-effective direct mail strategies and in-store marketing efforts. In addition, we continue to use cooperative movie advertising funds made available by studios and suppliers to promote certain titles. We occasionally test the effectiveness of mass media campaigns in select markets, but anticipate that our primary marketing vehicle will continue to be direct mailings. We believe that our current marketing strategy is the most productive and cost effective manner to increase customer visits. We currently have a customer transaction database containing information on approximately 36.0 million household member accounts, which enables targeted marketing based on historical usage patterns. Beginning in the fourth quarter of 2003, we increased our advertising budget for Game Crazy stores in an attempt to capture market share and to support the new stores. A majority of our Game Crazy advertising is in mass mail distributions and newspaper free-standing inserts. INVENTORY AND INFORMATION MANAGEMENT Inventory Management We maintain detailed information on inventory utilization. Our information systems enable us to track rental activity by individual videocassette, DVD and video game to determine appropriate buying, distribution, pricing and disposition of inventory, including the sale of previously viewed product. Our inventory of videocassettes, DVDs and video games for rental is prepared according to uniform standards. Each new DVD, videocassette and video game is removed from its original carton, bar coded, and placed in a rental case with a magnetic security device. Our Game Crazy stores utilize their own independent inventory system with enhanced functionality that allows us to manage used product trade-in credit values and retail pricing based upon multiple factors such as age and current inventory levels. Game Crazy's point-of-sale system provides us with sufficient detail to manage our breadth of titles and maintain in-stock positions with frequent replenishment cycles. The inventory system also permits us to match supply with demand title by title, adjust ordering, transfer inventories from one store location to another and actively manages new and used title pricing. Information Management We use a scalable client-server system and maintain three distinct system areas: point-of-sale systems for Hollywood Video and Game Crazy and a corporate information system. We maintain information, updated daily, regarding revenue, current and historical rental and sales activity, demographics of store membership, individual customer history, as well as DVD, videocassette and video game rental patterns. This system allows us to measure our current performance, manage inventory, make purchasing decisions and manage labor costs. This system has the ability to continue to improve customer service, operational efficiency, and management's ability to monitor critical performance factors. COMPETITION The video retail industry is highly competitive. We compete with local, regional and national video retail stores, including Blockbuster and Movie Gallery, and with mass merchants, mail-delivery video rental subscription services, such as Netflix, supermarkets, pharmacies, convenience stores, bookstores and other retailers, as well as with non-commercial sources such as libraries. We believe that the principal competitive factors in the video rental industry are price, title selection, rental period, the number of copies of popular titles available, store location and visibility, customer service and employee friendliness, and convenience of store access and parking. Substantially all of our stores compete with stores operated by Blockbuster, most in very close proximity. We also compete with cable, satellite, and pay-per-view television systems, in which subscribers pay a fee to see a movie selected by the subscriber. As digital cable and digital satellite services have continued to increase penetration, consumers have been given more choices in their viewing of pay- per-view movies and in some cases video-on-demand. We estimate that cable or satellite is available in over 90 million households. These systems can offer multiple channels dedicated to pay-per-view and in some cases video-on-demand, allowing for companies to transmit a significantly greater number of movies to homes at more frequently scheduled intervals throughout the day. The video game industry is highly fragmented. With the possible exception of Wal-Mart, we believe no major player holds more than a 20% share of the market, leaving a significant opportunity for our Game Crazy stores to rapidly gain market share. Video game software and hardware is typically sold through retail channels, including specialty retailers, mass merchants, toy retail chains, consumer electronic retailers, computer stores, regional chains, wholesale clubs, via the Internet and through mail order. In addition, the used market is offered in specialty retail chains that feature an educated game staff such as GameStop and Electronics Boutique. EMPLOYEES As of December 31, 2003, we had approximately 27,900 employees, of whom 26,800 were in the retail stores and zone offices and the remainder in our corporate, administrative and distribution centers. None of our employees are covered by collective bargaining agreements. We consider our employee relations to be excellent. Video store managers report to district managers, who supervise the operations of the stores. The district managers report to regional managers, who report directly to the Vice President of Operations for each zone. The corporate support staff periodically has meetings with zone personnel, regional managers, district managers and store managers to review operations. We have created a separate management infrastructure for Game Crazy including store level operators who report to district managers, who in turn report to regional managers. We have made a concerted effort to hire sales associates who are game enthusiasts through our established recruiting and training process. This is particularly important in the video game industry, which requires product knowledge on a large and growing number of titles. We have attracted a staff of dedicated gamers for our Game Crazy stores who provide attentive customer service and possess knowledge of the industry. SERVICE MARKS We own United States federal registrations for the service marks "Hollywood Video", "Hollywood Entertainment", "Hollywood Video Stores" and "Game Crazy". We consider our service marks important to our continued success. HISTORICAL INFORMATION We file annual reports, quarterly reports, proxy statements and other information with the Securities and Exchange Commission (SEC). You may read and copy any materials we file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains our reports, proxy statements, and other information. The SEC's Internet address is http://www.sec.gov. We also make available free of charge through our Internet website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and, if applicable, amendments to those reports as soon as reasonably practical after we file such materials with the SEC (http://hollywoodvideo.com/investors/SECfilings). ITEM 2. PROPERTIES As of December 31, 2003, Hollywood's stores by state are as follows: HOLLYWOOD ENTERTAINMENT NUMBER OF HOLLYWOOD VIDEO (HV) AND GAME CRAZY (GC) STORES BY STATE HV GC HV GC --- --- --- --- Alabama 13 - Nebraska 14 - Arizona 57 32 Nevada 28 13 Arkansas 9 - New Hampshire 2 - California 326 140 New Jersey 35 12 Colorado 36 14 New Mexico 11 - Connecticut 16 3 New York 75 20 Delaware 2 - North Carolina 32 - Florida 84 - North Dakota 3 1 Georgia 36 - Ohio 82 33 Idaho 14 4 Oklahoma 23 - Illinois 90 51 Oregon 67 19 Indiana 41 16 Pennsylvania 76 18 Iowa 13 - Rhode Island 9 3 Kansas 14 - South Carolina 16 - Kentucky 17 2 South Dakota 3 - Louisiana 18 - Tennessee 37 15 Maine 2 - Texas 190 69 Maryland 31 12 Utah 37 13 Massachusetts 44 5 Virginia 42 19 Michigan 64 16 Washington 91 34 Minnesota 37 19 Washington, D.C. 2 - Mississippi 9 - West Virginia 1 - Missouri 35 5 Wisconsin 34 7 Montana 1 - Wyoming 1 - Total Stores 1,920 595 Total States (excluding Washington, D.C.) 47 27 We lease all of our stores, corporate offices, distribution centers and zone offices under non-cancelable operating leases. All of our stores have an initial operating lease term of five to 15 years and most have options to renew for between five and 15 additional years. Most of the store leases are "triple net," requiring us to pay all taxes, insurance and common area maintenance expenses associated with the properties. Our corporate headquarters are located at 9275 Southwest Peyton Lane, Wilsonville, Oregon, and consist of approximately 123,000 square feet of leased space. The lease expires in November 2008. We currently lease space in three distribution centers, two to primarily support Hollywood Video and a separate facility to support Game Crazy. The Hollywood Video distribution centers are located at 25600 Southwest Parkway Center Drive, Wilsonville, Oregon (approximately 175,000 square feet) and at 501 Mason Road, LaVergne, Tennessee (approximately 98,000 square feet). The Game Crazy facility is located at 9445 SW Ridder Road, Wilsonville, Oregon (approximately 84,000 square feet). All of these facilities are leased pursuant to agreements that expire in November 2005, June 2010 and February 2008, respectively. ITEM 3. LEGAL PROCEEDINGS In 1999, the Company was named as a defendant in three complaints that have been consolidated 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 sought to certify a class of former and current California salaried Store Managers and Assistant Managers alleging that the Company engaged in unlawful conduct by improperly designating its salaried Store Managers and Assistant Store Managers as "exempt" from California's overtime compensation requirements in violation of the California Labor Code. The Company maintains that its California Store Managers and Assistant Store Managers were properly designated as exempt from overtime. The parties entered into a settlement agreement, which was given final approval by the court on January 28, 2003. A third party claims administrator was hired to process claims and distribute funds to the class. All claims submitted have been processed, and verified claims have been paid. The Company has satisfied its obligations under the settlement agreement and a final Case Management Conference took place on August 12, 2003. Reserves established prior to the beginning of fiscal 2003 were adequate to cover amounts in the settlement agreement. The Company has been named in several purported class action lawsuits alleging various causes of action, including claims regarding its membership application and additional rental period charges. The Company has vigorously defended these actions and maintains that the terms of its additional rental charge policy are fair and legal. The Company has been successful in obtaining dismissal of three of the actions filed against it. A statewide class action entitled George Curtis v. Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was certified on June 14, 2002 in the Superior Court of King County, Washington. On May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of St. Clair County, Twentieth Judicial Circuit, State of Illinois. The Company believes it has provided adequate reserves in connection with these lawsuits. The Company has been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. The Company believes it has provided adequate reserves for these various contingencies and that the outcome of these matters should not have a material adverse effect on its consolidated results of operation, financial condition or liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no submissions of matters to a vote of security holders in the fourth quarter of 2003. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information concerning our executive officers as of December 31, 2003: Name Age Position ---------------------- --- ---------------------------------------- Mark J. Wattles 43 Chairman of the Board, Chief Executive Officer, President and Director F. Bruce Giesbrecht 44 General Manager of Corporate Operations Roger J. Osborne 51 General Manager of Store Operations Timothy R. Price 45 Chief Financial Officer ---------------------- Mark J. Wattles founded Hollywood in June 1988 and has served as a director, Chairman of the Board, and Chief Executive Officer since that time. From June 1988 through September 1998, Mr. Wattles also served as President of Hollywood. From August 1998 through June 2000, Mr. Wattles left his full time position at Hollywood and served as CEO of Reel.com. In August 2000, Mr. Wattles returned full time to Hollywood and in January 2001 was re-appointed President of Hollywood by the Board. Mr. Wattles has been an owner and operator in the video rental industry since 1985. In 2001, Mr. Wattles was appointed to the National Advisory Council of the Marriot Business School at Brigham Young University. F. Bruce Giesbrecht was announced as the Company's President and Chief Operating Officer on January 29, 2004. Mr. Giesbrecht was named Executive Vice President of Business Development in March 2000 and became General Manager of Corporate Operations in July 2003. Mr. Giesbrecht joined Hollywood in May 1993 as Vice President of Corporate Information Systems and Chief Information Officer, was named Senior Vice President of Product Management in January 1996 and became Senior Vice President of Strategic Planning in January 1998. Prior to joining Hollywood Mr. Giesbrecht was a founder of RamSoft, Inc., a software development company specializing in management systems for the video industry, and served as its President. Roger J. Osborne was named Executive Vice President of Operations in October 2000 and became General Manager of Store Operations in July 2003. Prior to being named Senior Vice President of Operations at Hollywood in January 1999, he was the Executive Vice President of J. Baker, Corporation, a major apparel and footwear retailer, and President of its Work `N Gear Division since June 1997. Before rejoining J. Baker Corporation, Mr. Osborne was Senior Vice President and Zone Director for Mid-West and East coast markets for Hollywood from November 1996 until May of 1997. From 1993 until 1996, Mr. Osborne worked for J. Baker, Corporation, serving as Senior Vice President and Director of its licensed shoe department business from January 1995 to November 1996. Mr. Osborne served in executive capacities with Bata Shoe Company from 1988 until 1993 and with the Payless Shoe Store division of May Company from 1975 until 1988. Timothy R. Price joined Hollywood in January 2003 as Senior Vice President of Finance and was named Chief Financial Officer in July 2003. Prior to joining Hollywood, Mr. Price was with May Company for four years holding the positions of Chief Financial Officer for Robinson's-May from 2000 to 2002 and Vice President and Controller of Hecht's from 1998 to 2000. Prior to the May Company, Mr. Price served as Vice President and Controller of Kohl's from 1996 to 1998 and held a variety of financial executive positions at the Limited from 1988 to 1996. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS We have not paid any cash dividends on our common stock since our initial public offering in July 1993 and anticipate that future earnings will be retained for the development of our business. Loan covenants contained in our bank credit facilities and senior subordinated notes limit the amount of dividends we may pay and the amount of stock we may repurchase (see Management's Discussion and Analysis of Results of Operations and Financial Condition under the caption "Liquidity and Capital Resources"). Our common stock is traded on the Nasdaq National Market ("Nasdaq") under the symbol "HLYW". The following table sets forth the quarterly high and low sales prices per share, as reported on Nasdaq. 2003 2002 ---------------------------------------- Quarter High Low High Low ------- ------- ------ -------- ------- Fourth $17.97 $12.35 $20.19 $14.30 Third 18.65 15.60 20.15 12.83 Second 18.18 15.75 20.72 17.08 First 16.26 12.59 17.70 11.35 As of March 9, 2004, there were 177 holders of record of our common stock, and no shares of preferred stock were issued and outstanding. ITEM 6. SELECTED FINANCIAL DATA The information presented below for, and as of the end of, each of the fiscal years in the five-year period ended December 31, 2003 is derived from our audited financial statements. The following information should be read in conjunction with "Management's Discussion and Analysis of Results of Operation and Financial Condition," including a discussion of critical accounting policies that require significant management estimates, judgments and assumptions. Except as otherwise noted, the information in the table below reflects, among other things, operating losses incurred by Reel.com in 1999 through June 12, 2000, when we discontinued its e-commerce operations. Year Ended December 31, --------------------------------------------------------- 2003 2002 2001 2000 1999 --------- ---------- ---------- ---------- ---------- OPERATING RESULTS: Revenue $1,682,548 $1,490,066 $1,379,503 $1,296,237 $1,096,841 --------- ---------- ---------- ---------- ---------- Income (loss) from operations 185,094 189,327 119,277 (436,321) (2,513) --------- ---------- ---------- ---------- --------- Interest expense, net 35,507 42,057 56,129 62,127 45,477 --------- ---------- ---------- ---------- --------- Income (loss) before cumulative effect of a change in accounting principle 82,272 241,845 100,416 (530,040) (49,858) --------- ---------- ---------- ---------- --------- Net income (loss)(1) 82,272 241,845 100,416 (530,040) (51,302) --------- ---------- ---------- ---------- --------- Net income (loss) per share before cumulative effect of a change in accounting principle: Basic $ 1.36 $ 4.23 $ 2.05 $(11.48) $(1.09) Diluted 1.28 3.88 1.90 (11.48) (1.09) ---------- ---------- ---------- --------- --------- Net income (loss) per share: Basic $ 1.36 $ 4.23 $ 2.05 $(11.48) $(1.13) Diluted 1.28 3.88 1.90 (11.48) (1.13) ---------- ---------- ---------- --------- --------- ------------------------------------------------------------------------------ BALANCE SHEET DATA: Rental inventory, net $268,748 $260,190 $191,016 $168,462 $339,912 Property and equipment, net 288,857 255,497 270,586 323,666 382,345 Total assets 997,457 1,146,376 718,544 665,114 1,053,291 Long-term obligations(2) 371,316 388,746 514,002 536,401 533,906 Shareholders' equity (deficit) 325,829 257,149 (113,554) (222,377) 304,529 ------------------------------------------------------------------------------ Year Ended December 31, ------------------------------------------------------- 2003 2002 2001 2000 1999 ---------- ---------- ---------- --------- -------- OPERATING DATA: Number of stores at year end 1,920 1,831 1,801 1,818 1,615 Weighted average stores open during the year 1,852 1,805 1,813 1,751 1,405 Number of Game Crazy stores at year end 595 276 69 69 67 Weighted average Game Crazy stores open during the year 469 97 69 68 20 Same store revenue increase (3) 11% 8% 6% 2% 12% ---------------------------------------------------------------------------- (1) We adopted Statement of Financial Accounting Standards No. 142 on January 1, 2002, and concurrently ceased to amortize goodwill recorded in connection with prior business combinations and our trade name rights. See Note 8 to the Consolidated Financial Statements. Excluding amortization of these intangible assets would have reduced our net loss or increased our net income by $3.1 million, $29.9 million and $54.7 million, respectively, for the years ended December 31, 2001, 2000 and 1999. (2) Includes the current portion of long-term obligations. For the year ended December 31, 2002, excludes $203.9 million of our 10.625% senior subordinated notes that were called on December 18, 2002 and redeemed on January 17, 2003. (3) A store is comparable after it has been open and owned by the Company for 12 full months. An acquired store converted to the Hollywood Video name store design is removed from the comparable store base when the conversion process is initiated and returned 12 full months after reopening. In the fourth quarter of 2003, the Company began to report comparable revenue increases for each of its two segments, Hollywood Video and Game Crazy. For 2003, same store sales for Hollywood Video was 3% while same store sales for Game Crazy was 16%. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION ABOUT HOLLYWOOD ENTERTAINMENT We are the second largest rental retailer of DVDs, videocassettes and video games in the United States. We opened our first video store in October 1988 and, as of December 31, 2003, we operated 1,920 Hollywood Video stores in 47 states and the District of Columbia. As of December 31, 2003, we also operated 595 Game Crazy stores, which are game specialty stores where game enthusiasts can buy, sell and trade new and used video game hardware, software and accessories. A typical Game Crazy store carries over 2,500 video game titles and occupies an area of approximately 700 to 900 square feet adjacent to a Hollywood Video store. Hollywood Video stores accounted for 89% of consolidated revenue in 2003 while Game Crazy contributed 11%. Hollywood Video derives 92% of its revenue from rentals of DVD and VHS movies and video games and from the sale of previously viewed movies and games. The remaining 8% of Hollywood Video's revenue is from the sale of new DVD and VHS movies and concessions. Although domestic consumer rental spending has remained fairly flat over the past five years, Hollywood Video stores have been able to generate positive same store sales by taking market share. We believe we can continue to take market share as the rental industry is still highly fragmented. We estimate approximately half of the market share remains divided amongst a relatively large number of smaller independent and regional operators. The studio's current movie distribution practice provides an exclusive window for DVD and VHS retail channels before the movies are available to pay-per view, video-on-demand and other distribution channels. Changes in the studio distribution practice or changes in pricing of movies could negatively impact our business. For a discussion of risks inherent to rental retailers in general and Hollywood video in particular, please see "Cautionary Statements". Game Crazy generates revenue from the sale of new and used game software, hardware and accessories. The video game industry, an approximately $10 billion market in the United States in 2003 according to NPD Group, Inc., has historically experienced peaks and valleys in consumer spending dependent upon the availability of new technology. In 2000 and 2001, Sony's PlayStation 2, Nintendo's GameCube and Microsoft's Xbox, three new-generation hardware technology products, were introduced. These platforms have substantially increased the installed base of video game hardware units and have driven significant growth in the video game software segment. As with the introduction of previous new platforms, consumers have increased both their purchase and rental of games. Buying, selling and trading used games is relatively new and has caused the used game category to grow rapidly for certain specialty retailers. Each new platform introduction has increased trade-ins of used titles compatible with legacy hardware, which in turn extends the life of older platforms by enabling the game consumer access to additional software titles through the used market. Our strategy is to successfully build and operate two separately managed national chains, each with a retail model designed to compete favorably against the primary competitors in its segment of the entertainment industry. The Hollywood Video retail model, including the types of real estate sites we pursue, the store design, employee hiring and training practices, and inventory and merchandising standards, is designed to maximize the number of customers per store, as well as the frequency of customer visits and the amount that consumers spend per visit. Hollywood Video stores are typically located in high-traffic, high-visibility locations with convenient access and parking. Inside the store, we focus on providing a superior selection of movies and video games for rent, in a friendly and inviting atmosphere that encourages browsing. We believe that consumers view movie rentals in general, and our pricing structure and rental terms in particular, as a convenient form of entertainment and an excellent value. Our Game Crazy retail model, including the core concept of allowing consumers to buy, sell and trade new and used merchandise, combined with store design, employee selection and training, and our inventory selection and merchandising presentation, is designed to appeal to both "hard-core" and casual game consumers. Remerchandising a Hollywood Video in order to accommodate a Game Crazy, including reducing its size, does not cannibalize Hollywood Video revenue. Further, we believe that there is significant customer overlap, enabling the Hollywood Video and Game Crazy retail models to complement each other, allowing each of the concepts to have a competitive advantage versus its primary competitor. We analyze operating results by segment, Hollywood Video and Game Crazy. Key indicators used in running our business include total revenue growth, same store sales, gross margin rates, inventory levels, and operating expenses in dollars and as percentage of revenue. We also assess rental revenue performance by product type, DVD, VHS and games. Our operating results are subject to the application of critical accounting policies as discussed in "Critical Accounting Policies and Estimates." These policies require management to make significant estimates, judgements and assumptions that are subject to uncertainties that may change as additional information becomes known. RESULTS OF OPERATIONS Summary Results of Operations Our income from operations for 2003 was $185.1 million compared to $189.3 million for 2002. The decrease was primarily due to operating losses incurred by Game Crazy for 2003 and a $12.4 million reversal of an accrual related to the closure of our former internet business, Reel.com, that benefited income from operations for 2002. For 2003, Hollywood Video generated $205.1 million in income from operations while Game Crazy generated a net loss from operations of $20.0 million. Our net income for 2003 was $82.3 million compared with net income of $241.8 million and $100.4 million for 2002 and 2001, respectively. The decrease in net income was primarily the result of a change in our provision for income taxes. Net income for 2002 and 2001 benefited from a reduction in our valuation allowance on our deferred income tax assets, resulting in an income tax benefit of $98.1 million and $37.3 million, respectively. We believe that an effective tax rate of 40.5% would have represented a normalized provision for income taxes excluding the valuation allowance reductions. The effective tax rate for 2003 was 40.0%. Also contributing to the decrease in net income for 2003 was a $12.5 million charge recorded in the first quarter of 2003 for early debt retirement compared to an early debt retirement charge in the first quarter of 2002 of $3.5 million. Results of Operation Expressed as a Percentage of Revenue The following table sets forth (i) results of operations data expressed as a percentage of total revenue and (ii) gross margin data. Year Ended December 31, ------------------------------ 2003 2002 2001 -------- -------- -------- Revenue: Rental product revenue 82.4% 88.9% 92.2% Merchandise sales 17.6% 11.1% 7.8% -------- -------- -------- 100.0% 100.0% 100.0% -------- -------- -------- Gross margin 60.5% 61.5% 60.5% Operating costs and expenses: Operating and selling 43.0% 43.5% 45.0% General and administrative 6.3% 6.0% 7.0% Store opening expense 0.3% 0.2% - Restructuring charge for closure of internet business 0.0% (0.8%) (0.2%) Restructuring charge for store closures (0.1%) (0.1%) (0.3%) Amortization of intangibles - - 0.4% -------- -------- -------- 49.5% 48.8% 51.9% -------- -------- -------- Income from operations 11.0% 12.7% 8.6% Interest expense, net (2.1%) (2.8%) (4.0%) Early debt retirement (0.7%) (0.2%) - -------- -------- -------- Income before income taxes 8.2% 9.7% 4.6% (Provision for) benefit from income taxes (3.3%) 6.5% 2.7% -------- -------- -------- Net income 4.9% 16.2% 7.3% ======== ======== ======== Year Ended December 31, --------------------------- 2003 2002 2001 -------- ------- ------- Other data: Rental product gross margin (1) 68.2% 66.2% 63.9% Merchandise sales gross margin (2) 24.4% 24.0% 21.0% ------------------------------------------------------------- (1) Rental product gross margin as a percentage of rental product revenue. (2) Merchandise sales gross margin as a percentage of merchandise sales. REVENUE Revenue increased by $192.5 million, or 12.9%, for 2003 compared to 2002. The increase was primarily due to a 3% increase in Hollywood Video same store sales, the addition of 102 Hollywood Video stores and 319 Game Crazy stores and a 16% increase in Game Crazy same store sales. Revenue increased by $110.6 million, or 8.0%, for 2002 compared to 2001. The increase was primarily due to a 6% increase in Hollywood Video same store sales and the addition of 41 Hollywood Video stores and 207 Game Crazy stores. The following is a summary of revenue by product category and operating segment (in thousands): ---------- ---------- ---------- 2003 2002 2001 ---------- ---------- ---------- DVD rental product revenue $ 763,352 $ 480,177 $ 228,245 VHS rental product revenue 504,181 727,347 942,056 Game rental product revenue 119,057 116,493 101,093 ---------- ---------- ---------- Total rental product revenue 1,386,590 1,324,017 1,271,394 ---------- ---------- ---------- Video store merchandise revenue 115,826 109,382 81,143 Game Crazy revenue 180,132 56,667 26,966 ---------- ---------- ---------- Total merchandise revenue 295,958 166,049 108,109 ---------- ---------- ---------- ---------- ---------- ---------- Total revenue $1,682,548 $1,490,066 $1,379,503 ========== ========== ========== Rental revenue is generated from the rental of DVD and VHS movies and video games and from the eventual sale of previously viewed movies and games. We currently offer a 5-day rental program on all products in the majority of our stores. All DVDs and new release VHS movies typically rent for $3.79. Catalog VHS movies typically rent for $1.99. Since the fourth quarter of 1999, we have not increased prices on DVDs, new release VHS or catalog VHS. Video games rent for $4.99 and $5.99, with games designed for the newer platforms renting for the higher amount. Customers who choose not to return movies within the applicable rental period are deemed to have commenced a new rental period of equal length at the same price. Revenue recorded for extended rental periods is net of estimated amounts that we do not anticipate collecting based upon historical collection experience. The percentage of rental revenues generated from extended rental periods has not changed significantly in several years. Game Crazy revenue represented 60.9% of consolidated merchandise revenue for 2003. Game Crazy revenue is generated from the sale of new and used video game hardware, software and accessories. The remaining 39.1% of merchandise revenue was generated in Hollywood Video stores through the sale of new DVD and VHS movies and concessions. GROSS MARGIN Rental Product Margins Rental gross margin as a percentage of rental revenue increased to 68.2% for 2003 from 66.2% for 2002 and 63.9% for 2001. The increase for 2003 compared to 2002 was primarily due to a shift in revenue from VHS product to DVD product, which typically has higher gross margins. The increase for 2002 compared to 2001 also benefited from increased DVD revenue as well as the absence of incremental amortization that was recorded in 2001 associated with an amortization change in estimate. The Company regularly evaluates and updates rental inventory accounting estimates. Effective October 1, 2002, estimated average residual values on new release movies was reduced from $4.67 to $4.00 for DVD and from $3.16 to $2.00 for VHS. In addition, the estimated residual value of catalog DVD inventory was reduced from $6.00 to $4.00. These changes resulted in a $4.1 million increase in cost of rental product in 2002. We also made several key observations that led us to change estimates regarding rental inventory lives and residual values during the fourth quarter of 2000. As a result of the growing demand for DVDs, 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. We adopted the changes in estimate prospectively on October 1, 2000, and recorded a charge of $164.3 million. By applying these changes prospectively, we also recorded incremental depreciation expense of approximately $52 million and $18 million in the fourth quarter of 2000 and in the first three quarters of 2001, respectively. Merchandise Sales Margins Merchandise sales gross margin as a percentage of merchandise sales increased to 24.4% for 2003 from 24.0% for 2002 and 21.0% for 2001. The increase is primarily the result of an increase in the percentage of merchandise sales from Game Crazy and Hollywood Video's concessions business, which typically have higher margins than new movie sales in Hollywood Video. In 2003, Game Crazy revenue accounted for 60.9% of consolidated merchandise revenue with a gross margin rate of 24.7%, while Hollywood Video accounted for the remainder with a gross margin rate of 24.0%. OPERATING COSTS AND EXPENSES Operating and Selling Expenses Total operating and selling expenses for 2003 decreased as a percentage of revenue to 43.0% from 43.5% for 2002. The percentage decrease was primarily the result of leverage from increased revenue. Total operating and selling expense for 2003 increased $76.4 million to $724.1 million from $647.8 million for 2002. The increase was primarily the result of increased variable costs associated with increased store revenue, an increase of 47 weighted-average stores and an increase in operating and selling expenses associated with the expansion of our Game Crazy stores. Payroll and related expenses increased by $40.0 million, rent and related expenses increased by $15.4 million, advertising increased by $11.7 million, and other operating and selling expenses increased by $9.3 million for 2003 compared to 2002. Total operating and selling expenses for 2002 decreased as a percentage of revenue to 43.5% from 45.0% for 2001. The percentage decrease was primarily the result of leverage from increased revenue. Total operating and selling expense for 2002 increased $26.5 million to $647.8 million from $621.3 million for 2001. The increase was primarily the result of increased variable costs associated with increased store revenue and an increase in operating and selling expenses associated with the expansion of Game Crazy stores. Payroll and related expenses increased by $23.1 million and other operating and selling expenses increased by $3.4 million for 2002 compared to 2001. General and Administrative Expenses General and administrative expenses for 2003 increased $16.4 million to $106.0 million, or 6.3% of total revenue, from $89.6 million, or 6.0% of total revenue for 2002. Included in general and administrative expenses for 2003 was a $1.7 million charge recognized in the first quarter to increase a class action litigation settlement reserve related to extended rental periods. General and administrative expenses for 2002 benefited from the net reversal of approximately $1.6 million of non-cash stock option expense. The $1.6 million benefit reflects stock option expense of $2.9 million recorded in the first, second and fourth quarters and a net reversal of expense of $4.5 million recorded in the third quarter primarily associated with the cancellation of stock options subject to variable plan accounting. General and administrative expenses for 2002 also benefited from the reversal of a legal accrual in the amount of $1.6 million, as a result of the final confirmation of the settlement of our California exempt/non-exempt class action lawsuit for an amount less than anticipated. Excluding these items, general and administrative expenses as a percentage of total revenue were consistent for 2003 and 2002. General and administrative expenses for 2002 decreased $6.8 million to $89.6 million, or 6.0% of total revenue, from $96.4 million, or 7.0% of total revenue for 2001. General and administrative expenses for 2002 benefited from the net reversal of approximately $1.6 million of non-cash stock option expense and also benefited from a $1.6 million reversal of a legal accrual. Included in general and administrative expenses in 2001 were $4.8 million of non-cash compensation expense related to a stock grant to our Chief Executive Officer as part of a three-year employment agreement. Also included was $4.1 million of non-cash stock compensation associated with other grants under our stock option plans. Excluding these items, general and administrative expenses as a percentage of total revenue declined slightly in 2002 as compared 2001. NON-OPERATING INCOME (EXPENSE), NET Interest Expense Interest expense, net of interest income, decreased in 2003 as compared to 2002 by $6.6 million. The reduction was primarily due to decreased borrowing levels and lower interest rates (see Note 13 to our consolidated financial statements for a description of our outstanding debt). Interest expense, net of interest income, decreased in 2002 as compared to 2001 by $14.1 million. The reduction was primarily due to decreased levels of revolving credit borrowings and lower interest rates offset by incremental interest for bonds issued on December 18, 2002. Early Debt Retirement In the first quarter of 2003, we redeemed the outstanding $250 million 10.625% senior subordinated notes due 2004 and retired our prior credit facility due 2004. As a result, we recorded a charge of $12.5 million that included an early redemption premium of $6.6 million and the write-off of deferred financing costs. In the first quarter of 2002, we paid all amounts outstanding and retired our credit facility in place at that time, resulting in a $3.5 million charge to write-off deferred financing costs. INCOME TAXES Our effective tax rate was a provision of 40.0% in 2003, compared to a benefit of 68.3% in 2002 and a benefit of 59.0% in 2001, which varies from the federal statutory rate as a result of adjustments to deferred tax asset valuation allowances, non-deductible executive compensation, non-deductible goodwill amortization associated with the Reel.com acquisition and state income taxes. We anticipate an effective tax rate of 40.0% for 2004. In the fourth quarter of 2000, in light of significant doubt that existed regarding our future income and therefore our ability to use our net operating loss carryforwards, we recorded a $211.2 million valuation allowance on our $211.2 million net deferred tax asset. In 2002 and 2001, as a result of our operating performance for each year, as well as anticipated future operating performance, we determined that it was more likely than not that certain future tax benefits would be realized. Consequently, we benefited by the reversal of $147.8 million and $63.4 million of the valuation allowance in 2002 and 2001, respectively. In the fourth quarter of 2003 we applied for a change in accounting method with the Internal Revenue Service (IRS) to accelerate the deduction of store pre- opening supplies and the amortization of DVD and VHS movies and video games. The application is under review by the IRS. Based on internal forecasts and utilization of our net operating loss carryforwards, we do not anticipate significant cash tax payments until 2005. RENTAL INVENTORY Analysis of rental inventory and investment in rental product When analyzing our rental inventory purchase activity, it is important to consider that we acquire new releases of movies under two different pricing structures, "revenue sharing" and "sell-through." These methods impact the dollar amount of new releases held as rental inventory on our consolidated balance sheet. Under revenue sharing, in exchange for acquiring agreed-upon quantities of DVDs or tapes at reduced or no up-front costs, we share agreed- upon portions of the revenue that we derive from the DVDs or tapes with the studio. The studio's share of rental revenue is expensed, net of an estimated residual value, as revenue is earned on revenue sharing titles. The resulting revenue sharing expense is considered a direct cost of sales rather than an investment in rental inventory. Under sell-through pricing, we purchase movies from the studios with no obligation for future payments to the studios. Sell- through purchases are recognized as an investment in rental inventory, which is then amortized to cost of rental product over its estimated useful life to an estimated residual value. Therefore, purchases of rental inventories, as shown on our consolidated statement of cash flows, are not reflective of the total costs of acquiring movies for rental and are impacted by the mix of movies acquired under these pricing structures. Cost of rental product included revenue sharing expense of $88.8 million for 2003, compared to $130.4 million for 2002 and $191.3 million for 2001. The decline in revenue sharing expense is primarily the result of an increase in the percentage of movies acquired in the DVD format compared to VHS, as we currently have fewer DVD revenue sharing arrangements than VHS revenue sharing arrangements. MERCHANDISE INVENTORY Merchandise inventory in Hollywood Video stores consists of new DVD and VHS movies for sale, concessions and accessory items for sale, and the residual book value of movies and games that are transferred from rental inventory to merchandise inventory to be sold as previously viewed product. Merchandise inventory in our Game Crazy stores consist of new and used game software, hardware and accessories. Consolidated merchandise inventory increased $32.6 million to $129.9 million as of December 31, 2003, from $97.3 million as of December 31, 2002. The increase was primarily due to the addition of 319 Game Crazy stores in 2003 and an increase in the breadth and depth of games at existing Game Crazy stores. LIQUIDITY AND CAPITAL RESOURCES Overview Our primary source of operating cash flow is generated from the rental and sales of DVDs, videocassettes and games. The amount of cash generated from our video store operations in 2003 funded our debt service requirements, maintenance capital expenditures, and Game Crazy operating losses and provided the capital required to add 319 Game Crazy stores and 102 Hollywood Video stores. At December 31, 2003, we had $74.1 million of cash and cash equivalents on hand. During 2002 and early 2003, we completed several refinancing transactions that lengthened maturities on our long-term debt, lowered our effective interest rate and increased working capital availability (see "Cash Used in Financing Activities" below). We believe that cash flow from operations, increased flexibility under our new credit facilities, cash on hand and trade credit will provide adequate liquidity and capital resources to execute our business plan for the foreseeable future, including our expansion plans discussed below in "Cash Used in Investing Activities." We continue to analyze our capital structure and our business plan and from time to time may consider additional capital and/or financing transactions as a source of incremental liquidity. Cash Provided by Operating Activities Net cash provided by operating activities was $390.8 million and $361.6 million for 2003 and 2002, respectively. The increase of $29.2 million or 8.1% was primarily due to an increase in income from operations in our Hollywood Video stores and favorable changes in working capital accounts, offset by operating losses incurred by our Game Crazy stores. Cash Used in Investing Activities Net cash used in investing activities was $98.8 million and $551.6 million for 2003 and 2002, respectively. Net cash used in investing activities for 2003 included a $218.5 million source of cash related to a financing transaction. On December 18, 2002, we completed the sale of $225 million 9.625% senior subordinated notes due 2011 and delivered net proceeds of $218.5 million to the indenture trustee to redeem $203.9 million of the $250 million 10.625% senior subordinated notes due 2004. The delivery of the proceeds to the indenture trustee and the subsequent use of the proceeds to redeem the notes in the first quarter of 2003 were classified as investing activities. In 2003, we opened 102 Hollywood Video stores, of which 20 included a Game Crazy, and remerchandised 299 stores to include a Game Crazy compared to opening 41 Hollywood Video stores and remerchandising 203 stores to include Game Crazy in 2002. We currently anticipate investing approximately $105 million in 2004 to open 150 Hollywood Video stores, of which approximately 40 may include a Game Crazy, to remerchandise 110 existing Hollywood Video stores to include a Game Crazy, and for maintenance capital expenditures in property and equipment. We regularly consider new business initiatives that would enhance, expand, or complement our position in the entertainment industry. Some of those under consideration, such as in-store subscription services and mail delivery rental services, are closely related to our existing business. Any initiative undertaken could require significant capital investment, could be unsuccessful, or, even if successful, could have a short-term adverse impact on our financial condition and operating results. Cash Used in Financing Activities Net cash flow from financing activities was a $251.0 million use of cash for 2003 compared to a $184.4 million source of cash in the corresponding period of the prior year. The $251.0 million use of cash reflects the redemption of $250.0 million senior subordinated notes and the retirement of our prior credit facility of $107.5 million with $218.5 million in proceeds from the indenture trustee and $200.0 million of initial borrowings under our new credit facility. The use of cash also reflects the repurchase of 1,746,173 shares of common stock for $26.3 million and $55.0 million for prepayment of term loan facility principal payments through 2005. In January 2004, we paid an additional $20 million on the term loan facility, and are now prepaid through 2006 and we also repurchased 295,139 shares of common stock for $3.7 million. On March 11, 2002, we completed a public offering of 8,050,000 shares of our common stock, resulting in proceeds of $120.8 million before fees and expenses, of which $114.0 million was applied to the repayment of borrowings under our prior revolving credit facility. On March 18, 2002, we obtained senior bank credit facilities from a syndicate of lenders led by UBS Warburg LLC and applied a portion of initial borrowings thereunder to repay all remaining borrowings under our prior revolving credit facility, which was then terminated. The bank credit facilities consisted of a $150.0 million senior secured term facility maturing in 2004 and a $25.0 million senior secured revolving credit facility maturing in 2004. On December 18, 2002, we completed the sale of $225.0 million 9.625% senior subordinated notes due 2011. We delivered the net proceeds from the transaction to the indenture trustee to redeem $203.9 million of the $250.0 million 10.625% senior subordinated notes due 2004, including accrued interest and the required call premium. At December 31, 2002, the trustee was holding $218.5 million and we continued to carry the $250 million 10.625% senior subordinated notes on our balance sheet, $203.9 million of which was classified as a current liability titled "Subordinated notes to be retired with cash held by trustee." On January 17, 2003, the redemption of $203.9 million of the notes was completed. On January 16, 2003, we obtained new senior secured credit facilities from a syndicate of lenders led by UBS Warburg LLC. The new facilities consist of a $200.0 million term loan facility and a $50.0 million revolving credit facility, each maturing in 2008. We used the borrowings under the term loan facility to repay amounts outstanding under our existing credit facilities which were due in 2004, redeem the remaining $46.1 million principal amount of our 10.625% senior subordinated notes due 2004 on February 18, 2003 and for general corporate purposes. We have prepaid $75.0 million of the term loan facility principal payments due through 2006, including a $20.0 million payment made on January 5, 2004. Instruments governing our indebtedness contain various covenants, including covenants requiring us to meet specified financial ratios and tests and covenants that restrict our business including our ability to pay dividends and limitations on the amount of common stock we can repurchase. At December 31, 2003, we were in compliance with all covenants contained within our debt agreements. At December 31, 2003, maturities on long-term obligations for the next five years are as follows (in thousands): Capital Year Ending Subordinated Credit Leases December, 31 Notes Facility & Other Total ------------ ---------- ---------- --------- --------- 2004 $ - $ - $ 647 $ 647 2005 - - 454 454 2006 - 20,000(1) 215 20,215 2007 - 20,000 - 20,000 2008 - 105,000 - 105,000 Thereafter 225,000 - - 225,000 ---------- ---------- --------- --------- $ 225,000 $ 145,000 $ 1,316 $ 371,316 ---------- ---------- --------- --------- (1)Paid on January 5, 2004. Contractual Obligations Our contractual obligations consist of long-term debt, operating leases (primarily store leases) and capital leases. We lease all of our stores, corporate offices, distribution centers and zone offices under non-cancelable operating leases. All of our stores have an initial operating lease term of five to 15 years and most have options to renew for between five and 15 additional years. Contractual obligations as of December 31, 2003 are as follows (in thousands): Contractual 2-3 4-5 More than Obligations Total 1 Year Years Years 5 Years --------------- ---------- -------- -------- -------- --------- Long-term Debt $ 370,000 $ - $ 20,000 $125,000 $ 225,000 Capital Leases 1,316 647 669 - - Operating Leases 1,355,531 237,821 438,057 318,519 361,134 ---------- -------- -------- -------- --------- Total $1,726,847 $238,468 $458,726 $443,519 $ 586,134 ---------- -------- -------- -------- --------- Other Financial Measurements: Working Capital At December 31, 2003, we had cash and cash equivalents of $74.1 million and a working capital deficit of $33.6 million. The working capital deficit is primarily the result of the accounting treatment of rental inventory. Rental inventories are accounted for as non-current assets under GAAP because they are not assets that 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 our revenue and the majority of this inventory has a relatively short useful life (as evidenced by our amortization policies), 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, we believe working capital is not as significant a measure of financial condition for companies in the video rental industry as it is for companies in other industries. Because of the accounting treatment of rental inventory as a non- current asset, we will, more likely than not, operate with a working capital deficit. We believe the current existence of a working capital deficit does not affect our ability to operate our business and meet our obligations as they come due. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Revenue Recognition We recognize revenue upon the rental and sale of our products. Rental revenue for extended rental periods (when the customer chooses to keep the product beyond the original rental period) is recognized when the extended rental period begins. Revenue recorded for extended rental periods is net of estimated amounts that we do not anticipate collecting based upon historical collection experience. We continuously monitor actual collections. Estimates are revised when we believe it is appropriate in light of actual collection rates and other relevant circumstances. Historically, actual collections have approximated the related net revenue recorded. However, if actual collections in the future are less than the related net revenue recorded, our results of operations would be adversely affected. Merchandise Inventory Valuation Merchandise inventories, consisting primarily of new and used video game software and hardware, new DVD and VHS movies and concessions, are stated at the lower of cost or market. We consider several factors in our assessment of market value including age and inventory turns. Due to the numerous variables associated with the judgments and assumptions we make in estimating market values, and the effects of changes in circumstances affecting these estimates (including the effects of competing products and technologies), both the precision and reliability of the resulting estimates are subject to substantial uncertainties and, as additional information becomes known, we may change our estimates significantly. Amortization of Rental Inventory Rental inventory, which includes DVD and VHS movies and video games, is stated at cost and amortized over its estimated useful life to an estimated residual value. We analyze several metrics to validate our estimates such as inventory turns, previously viewed product sales and average inventory levels per store among many other variables. Our estimates of useful lives and residual values affect the amounts of amortization recorded, which in turn affects the carrying value of our rental inventory and cost of rental product (and, upon the transfer of previously viewed items from rental inventory to merchandise inventory, the carrying value of our merchandise inventory). For new release movies acquired for rental under revenue sharing arrangements, the studios' share of rental revenue is expensed as revenue is earned net of average estimated residual values. DVDs, tapes and video games acquired for rental at fixed prices are amortized to estimated residual values in periods ranging from four months to five years for DVD library. Due to the numerous variables associated with the judgments and assumptions we make in estimating useful lives and residual values of these items, and the effects of changes in circumstances affecting these estimates (including the effects of competing products and technologies and actual selling prices obtainable for previously viewed product), both the precision and reliability of the resulting estimates are subject to substantial uncertainties and, as additional information becomes known, we may change our estimates significantly. For example, in the fourth quarter of 2000, a number of observations led us to change our estimates of rental inventory lives and residual values, which resulted in a $164.3 million increase to amortization expense in that quarter. More recently, in the fourth quarter of 2002, our updated estimates resulted in a $4.1 million increase in cost of rental. Impairment of Long-Lived Assets and Goodwill We review long-lived assets and goodwill for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We periodically review and monitor our internal management reports for indicators of impairment. We consider a trend of unsatisfactory operating results that are not in line with management's expectations to be a 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 on our balance sheet of the store exceeds its fair value. Fair value is estimated using a discounted future cash flow valuation technique similar to that used by management in making a new investment decision. Considerable management judgment and assumptions are necessary to estimate discounted future cash flows. Due to the numerous variables associated with our judgments and assumptions relating to the valuation of our assets in these circumstances, and the effects of changes in circumstances affecting these valuations, both the precision and reliability of the resulting estimates of the related impairment charges are subject to substantial uncertainties and, as additional information becomes known, our estimates may change significantly. Income Taxes We calculate income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our financial statements and tax returns. Valuation allowances are established when necessary to reduce deferred tax assets, including temporary timing differences and net operating loss carryforwards, to the amount expected to be realized in the future. Deferred assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. In the fourth quarter of 2000, in light of significant doubt that existed regarding our future income and therefore our ability to use our net operating loss carryforwards, we recorded a $211.2 million valuation allowance on our $211.2 million net deferred tax asset. In 2001 and 2002, as a result of our operating performance for each year, as well as anticipated future operating performance, we determined that it was more likely than not that certain future tax benefits would be realized. We therefore reversed $63.4 million and $147.8 million of this valuation allowance in 2001 and 2002, respectively, which resulted in a corresponding increase in net income and corresponding increases/decreases in our shareholders' equity/deficit. While changes in the valuation allowance have no effect on the amount of income tax we pay or on our cash flows, the effects on our reported income and shareholders' equity may be viewed by some investors and potential lenders as significant. Due to the numerous variables associated with our judgments, assumptions and estimates relating to the valuation of our deferred tax assets, and the effects of changes in circumstances affecting these valuations, both the precision and reliability of the resulting estimates are subject to substantial uncertainties and, as additional information becomes known, we may change our estimates significantly. Legal Contingencies Our estimates of our loss contingencies for legal proceedings are based on various judgments and assumptions regarding the potential resolution or disposition of the underlying claims and associated costs. Due to the numerous variables associated with these judgments and assumptions, both the precision and reliability of the resulting estimates of the related loss contingencies are subject to substantial uncertainties. We regularly monitor our estimated exposure to these contingencies with formal meetings between our Chief Financial Officer and internal legal counsel and, as additional information becomes known, we may change our estimates significantly. RECENTLY ISSUED ACCOUNTING STANDARDS See Note 1 to the Consolidated Financial Statements for a discussion of recently issued accounting standards and the impact they may have on the financial condition or results of operations. FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K 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, that involve substantial risks and uncertainties and 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", "may", "will", "intend", "estimate", "continue" 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 below under the heading "Cautionary Statements." Forward-looking statements speak only as of the date made. We undertake no obligation to publicly release or update forward-looking statements, whether as a result of new information, future events or otherwise. You are, however, advised to consult any further disclosures we make on related subjects in our quarterly reports on Form 10-Q and any reports made on Form 8-K to the Securities and Exchange Commission. CAUTIONARY STATEMENTS We are subject to a number of risks that are particular to our business and that may or may not affect our competitors. We describe some of these risks below. If any of these risks materialize, our business, financial condition, liquidity and results of operations could be harmed, and the value of our securities could fall. We face intense competition and risks associated with technological obsolescence, and we may be unable to compete effectively. The home video and home video game industries are highly competitive. We compete with local, regional and national video retail stores, including those operated by Blockbuster, Inc., the largest video retailer in the United States, and with mass merchants, specialty retailers, supermarkets, pharmacies, convenience stores, bookstores, mail order operations, online stores and other retailers, as well as with noncommercial sources, such as libraries. We also compete with Internet-based mail-delivery video rental subscription services, such as Netflix. Substantially all of our stores compete with stores operated by Blockbuster, most in very close proximity. Some of our competitors have significantly greater financial and marketing resources, market share and name recognition than Hollywood. As a result of direct competition with Blockbuster and others, pricing strategies for videos and video games is a significant competitive factor in our business. Our home video and home video game businesses also compete with other forms of entertainment, including cinema, television, sporting events and family entertainment centers. If we do not compete effectively with competitors in the home video industry or the home video game industry or with providers of other forms of entertainment, our revenues and/or our profit margin could decline and our business, financial condition, liquidity and results of operations could be harmed. We also compete with cable and direct broadcast satellite television systems. These systems offer both movie channels, for which subscribers pay a subscription fee for access to movies selected by the provider at times selected by the provider, and pay-per-view services, for which subscribers pay a discrete fee to view a particular movie selected by the subscriber. Historically, pay-per-view services have offered a limited number of channels and movies, and have offered movies only at scheduled intervals. Over the past five years, however, advances in digital compression and other developing technologies have enabled cable and satellite companies, and may enable internet service providers and others, to transmit a significantly greater number of movies to homes at more frequently scheduled intervals throughout the day. In addition, certain cable companies, internet service providers and others are testing or offering video-on-demand services. As a concept, video- on-demand provides a subscriber with the ability to view any movie included in a catalog of titles maintained by the provider at any time of the day. If video-on-demand or other alternative movie delivery systems whether alone or in conjunction with sophisticated digital recording systems that allow viewers to record, pause, rewind and fast forward live broadcasts, achieve the ability to enable consumers to conveniently view and control the movies they want to see when they want to see them and they receive the movies from the studios at the same time video stores do, such alternative movie delivery systems could achieve a competitive advantage over the traditional video rental industry. While we believe that there presently exist substantial technological, economic and other impediments to alternative movie delivery systems achieving such a competitive advantage, if they did, our business and financial condition could suffer materially. Changes in the way that movie studios price DVDs and/or videocassettes could adversely affect our revenues and profit margins. Movie studios use various pricing models to maximize the revenues they receive from the home video industry. Historically, these pricing models have enabled a profitable video rental market to exist and compete effectively with mass merchant retailers and other sellers of home videos. If the studios were to significantly change their pricing policies in a manner that increases our cost of obtaining movies under revenue sharing or other arrangements, or decreases wholesale prices leading consumers to purchase movies instead of renting movies, our revenues and/or profit margin could decrease, and our business, financial condition, liquidity and results of operations could be harmed. We can neither control nor predict with certainty whether the studios' pricing policies will continue to enable us to operate our business as profitably as we can under current pricing arrangements. We could lose a significant competitive advantage if the movie studios were to adversely change their current distribution practices. Currently, video stores receive movie titles approximately 30 to 60 days earlier than pay-per-view, cable and satellite distribution companies. If movie studios were to change the current distribution schedule for movie titles such that video stores were no longer the first major distribution channel to receive a movie title after its theatrical or direct-to-video release or to provide for the earlier release of movie titles to competing distribution channels, we could be deprived of a significant competitive advantage, which could negatively impact the demand for our products and reduce our revenues and could harm our business, financial condition, liquidity and results of operations. The video store industry could be adversely impacted by conditions affecting the motion picture industry. The video store industry is dependent on the continued production and availability of motion pictures produced by movie studios. Any conditions that adversely affect the motion picture industry, including constraints on capital, financial difficulties, regulatory requirements and strikes, work stoppages or other disruptions involving writers, actors or other essential personnel, could reduce the number and quality of the new release titles in our stores. This in turn could reduce consumer demand and negatively impact our revenues, which would harm our business, financial condition, liquidity and results of operations. The failure of video game software and hardware manufacturers to timely introduce new products could hurt our ability to attract and retain video game customers. We are dependent on the introduction of new and enhanced video games and game systems to attract and retain video game customers. We currently anticipate that hardware manufactures will release new products with enhanced features some time in 2006. If manufacturers fail to introduce or delay the introduction of new games and systems, the demand for games available to us could decline, negatively impacting our revenues, and our business, financial condition, liquidity and results of operations could be harmed. Expansion of our store base and new business initiatives have placed and may continue to place pressure on our operations and management controls. We have expanded the size of our store base and the geographic scope of operations significantly since our inception. Between 1996 and 2000 we opened an average of 306 stores per year. In the second half of 2002 we began an accelerated rollout of our Game Crazy stores, stores within our Hollywood Video stores that specialize in selling and trading video games, opening 207 new stores. In 2003 we added 319 Game Crazy stores and opened 102 Hollywood Video stores and we anticipate adding additional Game Crazy stores and opening additional Hollywood Video stores in 2004 and beyond. This expansion has placed, and may continue to place, increased pressure on our operating and management controls. To manage a larger store base and additional Game Crazy stores, we will need to continue to evaluate and improve our financial controls, management information systems and distribution facilities. We may not adequately anticipate or respond to all of the changing demands of expansion on our infrastructure. In addition, our ability to open and operate new stores in a profitable manner depends upon numerous contingencies, many of which are beyond our control. These contingencies include but are not limited to: - our ability under the terms of the instruments governing our existing and future indebtedness to make capital expenditures associated with new store openings; - our ability to locate suitable store sites, negotiate acceptable lease terms, and build out or refurbish sites on a timely and cost-effective basis; - our ability to hire, train and retain skilled associates; and - our ability to integrate new stores into our existing operations. We may also open stores in markets where we already have significant operations in order to maximize our market share within these markets. If we do so, we cannot assure you that these newly opened stores will not adversely affect the revenues and profitability of those pre-existing stores in any given market. We also regularly consider new business initiatives that would enhance, expand, or complement our position in the entertainment industry. Some of those under consideration, such as in-store subscription services and mail delivery rental services, are closely related to our existing business. Any initiative undertaken could require significant capital investment, could be unsuccessful, or, even if successful, could have a short-term adverse impact on our financial condition and operating results. We depend on key personnel whom we may not be able to retain. Our future performance depends on the continued contributions of certain key management personnel. From late 2000 through mid-2001, we made significant changes to our management personnel, including reinstatement of Mark J. Wattles, Hollywood's founder and Chief Executive Officer, full-time as President, and hiring or restructuring other executive and senior management positions. New members of management may not be able to successfully manage our existing operations and they may not remain with us. A loss of one or more of these key management personnel, our inability to attract and retain additional key management personnel, including qualified store managers, or the inability of management to successfully manage our operations could prevent us from implementing our business strategy and harm our business, financial condition, liquidity or results of operations. The failure of our management information systems to perform as we anticipate could harm our business. The efficient operation of our business is dependent on our management information systems. In particular, we rely on an inventory utilization system used by our merchandise organization and in our distribution centers to track rental activity by individual DVD, videocassette and video game to determine appropriate buying, distribution and disposition of DVDs, videocassettes and video games. In addition, our Game Crazy point-of-sale system is used to determine appropriate used game trade-in values and used game prices. We use a scalable client-server system to maintain information, updated daily, regarding revenue, current and historical rental and sales activity, demographics of store membership, individual customer history, and DVD, videocassette and video game rental patterns. We rely on these systems as well as our proprietary point-of-sale and in-store systems to keep our in-store inventories at optimum levels, to move inventory efficiently and to track and record our performance. The failure of our management information systems to perform as we anticipate could impair our ability to manage our inventory and monitor our performance and harm our business, financial condition, liquidity and results of operations. We have a substantial amount of indebtedness and debt service obligations, which could adversely affect our financial and operational flexibility and increase our vulnerability to adverse conditions. As of December 31, 2003, we had total consolidated long-term debt, including capital leases, of approximately $371.3 million. We and our subsidiary could incur substantial additional indebtedness in the future, including indebtedness that would be secured by our assets or those of our subsidiary. If we increase our indebtedness, the related risks that we now face could intensify. For example, it could: - require us to dedicate a substantial portion of our cash flow to payments on our indebtedness; - limit our ability to borrow additional funds; - increase our vulnerability to general adverse economic and industry conditions; - limit our ability to fund future working capital, capital expenditures and other general corporate requirements; - limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate or taking advantage of potential business opportunities; - limit our ability to execute our business strategy successfully; and - place us at a potential competitive disadvantage in our industry. Our ability to satisfy our indebtedness obligations will depend on our financial and operating performance, which may fluctuate significantly from quarter to quarter and is subject to economic, industry and market conditions and to risks related to our business and other factors beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us in amounts sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. Instruments governing our existing and future indebtedness contain or may contain various covenants, including covenants requiring us to meet specified financial ratios and tests and covenants that restrict our business. Our failure to comply with all applicable covenants could result in our indebtedness being immediately due and payable. The instruments governing our existing indebtedness contain various covenants which, among other things, limit our ability to make capital expenditures and require us to meet specified financial ratios, which generally become more stringent over time, including a maximum leverage ratio and a minimum interest and rent coverage ratio. The instruments governing our future indebtedness may impose similar or other restrictions and may require us to meet similar or other financial ratios and tests. Our ability to comply with covenants contained in the instruments governing our existing and future indebtedness may be affected by events and circumstances beyond our control. If we breach any of these covenants, one or more events of default, including cross-defaults between multiple components of our indebtedness, could result. These events of default could permit our creditors to declare all amounts owing to be immediately due and payable, and terminate any commitments to make further extensions of credit. If we were unable to repay indebtedness owed to our secured creditors, they could proceed against the collateral securing the indebtedness owed to them. At December 31, 2003, we were in compliance with all covenants contained within our debt agreements. Instruments governing our bank credit facilities and our senior subordinated notes contain, and our future indebtedness may contain, covenants that, among other things, significantly restrict our ability to: - open new stores; - incur additional indebtedness; - repurchase shares of our common stock; - guarantee third-party obligations; - enter into capital leases; - create liens on assets; - dispose of assets; - repay indebtedness or amend debt instruments; - make capital expenditures; - make investments, loans or advances; - pay dividends; - make acquisitions or engage in mergers or consolidations; and - engage in certain transactions with our subsidiaries and affiliates. We are subject to governmental regulations that impose obligations and restrictions and may increase our costs. We are subject to various U.S. federal and state laws that govern, among other things, the disclosure and retention of our video rental records and access and use of our Hollywood Video stores by disabled persons, and are subject to various state and local licensing, zoning, land use, construction and environment regulations. Furthermore, changes in existing laws, including environmental and employment laws, new laws or increases in the minimum wage may increase our costs. Terrorist attacks, such as the attacks that occurred in New York and Washington, D.C. on September 11, 2001, and other acts of violence or war may affect the markets on which our common stock trades, the markets in which we operate, our operations and our profitability. Any of these events could cause consumer confidence and spending to decrease further or result in increased volatility in the United States and worldwide financial markets and economy. They could also impact consumer television viewing habits and may reduce the amount of time available for watching rented movies, which could adversely impact our revenue. They also could result in an economic recession in the United States or abroad. Any of these occurrences could harm our business, financial condition or results of operations, and may result in the volatility of the market price for our securities and on the future price of our securities. Terrorist attacks and other acts of violence or war may negatively affect our operations and your investment. There can be no assurance that there will not be further terrorist attacks or other acts of violence or war against the United States or United States businesses. Also, as a result of terrorism, the United States has entered into armed conflict. These attacks or armed conflicts may directly impact our physical facilities or those of our suppliers. Furthermore, these attacks or armed conflicts may make travel and the transportation of our supplies and products more difficult and more expensive and ultimately affect our revenues. Our quarterly operating results will vary, which may affect the value of our securities in a manner unrelated to our long-term performance. Our quarterly operating results have varied in the past and we expect that they will continue to vary in the future depending on a number of factors, many of which are outside of our control. Factors that may cause our quarterly operating results to vary include: - the level of demand for movie and game rentals and purchases; - existing and future competition from providers of similar products and alternative forms of entertainment; - the prices for which we are able to rent or sell our products; - the availability and cost to us of new release movies, games and game hardware; - changes in other significant operating costs and expenses; - weather; - seasonality; - variations in the number and timing of store openings; - the performance of newer stores; - acquisitions by us of existing video stores; - initial investments in and success of new business initiatives and related acquisitions; - other factors that may affect retailers in general; - changes in movie rental habits resulting from domestic and world events; - actual events, circumstances, outcomes and amounts differing from judgments, assumptions and estimates used in determining the amount of certain assets (including the amounts of related valuation allowances), liabilities and other items reflected in our consolidated financial statements; and - acts of God or public authorities, war, civil unrest, fire, floods, earthquakes, acts of terrorism and other matters beyond our control. Our securities may experience extreme price and volume fluctuations. The market price of our securities has been and can be expected to be significantly affected by a variety of factors, including: - public announcements concerning us, our competitors or the home video rental industry and video game industry; - fluctuations in our operating results; - introductions of new products or services by us or our competitors; - the operating and stock price performance of other comparable companies; and - changes in analysts' revenue or earnings estimates. In addition to these factors, the market price of our debt securities may be significantly affected by change in market rates of interest, yields obtainable from investments in comparable securities, credit ratings assigned to our debt securities by third parties and perceptions regarding our ability to pay our obligations on our debt securities. In the past, companies that have experienced volatility in the market price of their securities have been the target of securities class action litigation. If we were sued in a securities class action, we could incur substantial costs and suffer from a diversion of our management's attention and resources. Future sales of shares of our common stock may negatively affect our stock price. If we or our shareholders sell substantial amounts of our common stock in the public market, the market price of our common stock could fall. In addition, sales of substantial amounts of our common stock might make it more difficult for us to sell equity or equity-related securities in the future. We do not expect to pay dividends in the foreseeable future. We have never declared or paid any cash dividends on our common stock and we do not expect to declare dividends on our common stock in the foreseeable future. The instruments governing our existing and future indebtedness contain or may contain provisions prohibiting or limiting the payment of dividends on our common stock. Provisions of Oregon law and our articles of incorporation may make it more difficult to acquire us, even though an acquisition may be beneficial to our shareholders. Provisions of Oregon law condition the voting rights that would otherwise be associated with any shares of our common stock that may be acquired in specified transactions deemed to constitute a "control share acquisitions" upon approval by our shareholders (excluding, among other things, the acquirer in any such transaction). Provisions or Oregon law also restrict, subject to specified exceptions, the ability of a person owning 15% or more of our common stock to enter into any "business combination transaction" with us. In addition, under our articles of incorporation, our Board of Directors has the authority to issue up to 25.0 million shares of preferred stock and to fix the rights, preferences, privileges and restrictions of those shares without any further vote or action by the shareholders. These provisions of Oregon law and our articles of incorporation have the effect of delaying, deferring or preventing a change in control of Hollywood, may discourage bids for our common stock at a premium over the market price of our common stock and may adversely affect the market price of, and the voting and other rights of the holders of, our common stock and the occurrence of a control share acquisition may constitute an event of default under, or otherwise require us to repurchase or repay, our indebtedness. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE 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 short-term and long-term debt. Historically, and as of December 31, 2003, we have not held derivative instruments or engaged in hedging activities. However, we may in the future enter into such instruments for the purpose of addressing market risks, including market risks associated with variable-rate indebtedness. The interest payable on our bank 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 had increased 1% in 2003 compared to the end of 2002, our interest expense would have increased by approximately $1.5 million based on our outstanding balance on the facility as of December 31, 2003. The fair market value of long-term fixed interest rate debt is also subject to interest rate risk. Generally, the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. The estimated fair value of our long-term fixed interest rate debt at December 31, 2003 was $243.6. We believe the effect of an estimated 1% change in interest rates would not have a material impact on our future operating results or cash flows with respect to our fixed interest rate debt. Fair values were determined from quoted market prices. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated by reference to Item 15 of this report on Form 10-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Disclosure Controls and Procedures We evaluated, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934. Based on the evaluation, our Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures are effective in ensuring that information required to be disclosed is recorded, processed, summarized and reported in a timely manner. Internal Control Over Financial Reporting There has been no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information about our directors is incorporated by reference from our definitive proxy statement, under the caption "Nomination and Election of Board of Directors," for our 2004 annual meeting of shareholders (the "2004 Proxy Statement") to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, which proxy statement we expect to file no later than 120 days after the end of our fiscal year ended December 31, 2003. Information with respect to our executive officers is included under Item 4A of Part I of this report. We have adopted a Business and Ethics Code of Conduct for the guidance of our directors, officers, and partners, including our principal executive, financial and accounting officers and our controller. Our code of conduct, along with other corporate governance documents, is posted on our website at http://www.hollywoodvideo.com/investors under the link Corporate Governance. ITEM 11. EXECUTIVE COMPENSATION Information required by this Item 11 is incorporated by reference from the 2004 Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Part of the information required by this Item 12 is incorporated by reference from the 2004 Proxy Statement. The following table summarizes information with respect to options under the Company's stock option plans at December 31, 2003: Options Outstanding Options --------------------- remaining Weighted available average for future exercise issuance under Options price the plans ---------- -------- -------------- Stock option plans approved by security holders 7,640,005 $6.44 2,797,766 Stock option plans not approved by security holders 2,090,846 $11.29 1,475,201 ---------- -------- -------------- 9,730,851 $ 7.48 4,272,967 ========== ======== ============== The stock option plans not approved by security holders have generally the same features as those approved by security holders. For further information regarding the Company's stock option plans, see Note 17 to the Consolidated Financial Statements. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this Item 13 is incorporated by reference from the 2004 Proxy Statement. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information required by this Item 14 is incorporated by reference from the 2004 Proxy Statement. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Listed below are all financial statements, notes, schedules and exhibits filed as part of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2003: (a)(i), (ii) FINANCIAL STATEMENTS The following financial statements of the Registrant, together with the Report of Independent Accountants dated February 16, 2004, are filed herewith: (i) FINANCIAL STATEMENTS Report of Independent Auditors Consolidated Balance Sheets as of December 31, 2003 and 2002 Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2003, 2002 and 2001 Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001 Notes to Consolidated Financial Statements (ii) FINANCIAL SCHEDULES All financial schedules are omitted as the required information is inapplicable or the information is presented in the respective Consolidated Financial Statements or related notes. (a) (iii) EXHIBITS The following exhibits are filed with or incorporated by reference into this Annual Report: EXHIBIT NUMBER DESCRIPTION Items identified with an asterisk (*) are management contracts or compensatory plans or arrangements. 3.1 1993B Restated Articles of Incorporation, as amended (incorporated by reference to our Registration Statement on Form S-1 (File No. 33- 63042)(the "Form S-1"), by reference to Exhibit 4 to our Registration Statement on Form S-3 (File No. 33-96140), and by reference to Exhibit 3.1 to our Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). 3.2 1999 Restated Bylaws (incorporated by reference to Exhibit 3.2 to our Registration Statement on Form S-4 (File No. 333-82937)(the "1999 S-4")). 4.1 Indenture dated January 25, 2002 among the Registrant, Hollywood Management Company, as potential guarantor, and BNY Western Trust Company as trustee (incorporated by reference to Exhibit 4.1 to our Registration Statement on Form S-3 (File No. 333-14802)), as supplemented by the First Supplemental Indenture dated as of December 18, 2002 among the Registrant and Hollywood Management Company and BNY Western Trust Company as Trustee (incorporated by reference to Exhibit 4.3 to our Annual Report on Form 10-K for the year ended December 31, 2002). 10.1 1993 Stock Incentive Plan, as amended (incorporated by reference to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter ended June 30, 1997). * 10.2 Form of Incentive Stock Option Agreement (incorporated by reference to Exhibit 10.1 of the Form S-1). * 10.3 Form of Nonqualified Stock Option Agreement (incorporated by reference to Exhibit 10.3 of the Form S-1). * 10.4 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2001). * 10.5 Credit Agreement dated as of January 16, 2003 between the Registrant, UBS Warburg LLC as Lead Arranger, UBS AG, Stamford Branch as Administrative Agent and Bank of America, N.A., as Documentation Agent (incorporated by reference to Exhibit 10.5 to our Annual Report on Form 10-K for the year ended December 31, 2002), amended by the Credit Agreement Amendment dated as of dated as of August 13, 2003 among the Registrant, an Oregon corporation, as borrower, UBS AG, Stamford Branch, as administrative agent and the lenders from time to time party thereto (incorporated by reference to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2003). 10.6 Offer of Employment Term Sheet effective as of January 25, 2001 from the Registrant to Mark J. Wattles (incorporated by reference to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2000, filed on April 2, 2001). * 10.7 Change of Control Plan for Senior Management dated as of February 3, 2001 (incorporated by reference to Exhibit 10.8 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2000, filed on April 2, 2001). * 10.8 Revenue Sharing Agreement dated March 2, 1998 between the Registrant and Buena Vista Home Entertainment, Inc (incorporated by reference to Exhibit 10.13 to our Annual Report on Form 10-K/A for the year ended December 31, 2000, filed on January 29, 2002). + 10.9 Revenue Sharing Agreement dated July 31, 2001 between the Registrant and MGM Home Entertainment (incorporated by reference to Exhibit 10.14 to our Annual Report on Form 10-K/A for the year ended December 31, 2000, filed on January 29, 2002). + 10.10 1997 Employee Nonqualified Stock Option Plan, as amended (incorporated by reference to Exhibit 10.10 to our Annual Report on Form 10-K for the year ended December 31, 2002). * 10.12 License Agreement, effective as of January 25, 2001, between the Registrant and Boards, Inc (incorporated by reference to Exhibit 10.12 to our Annual Report on Form 10-K for the year ended December 31, 2002). * 10.13 Product and Support Agreement, effective as of January 25, 2001, between the Registrant and Boards, Inc. (incorporated by reference to Exhibit 10.13 to our Annual Report on Form 10-K for the year ended December 31, 2002). * 21.1 List of Subsidiaries (incorporated by reference to Exhibit 21.1 to our Annual Report on Form 10-K/A for the year ended December 31, 2000, filed on January 29, 2002). 23.1 Consent of PricewaterhouseCoopers LLP. 31.1 Certification of Chief Executive Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer and Chief Financial Officer of Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 + Confidential treatment has been requested as to certain portions of these agreements. Such omitted confidential information has been designated by an asterisk and has been filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended, pursuant to an application for confidential treatment. (b) REPORTS ON FORM 8-K: On October 20, 2003 we filed a current report on Form 8-K under "Item 12. Results of Operation and Financial Condition" reporting that on October 13, 2003, we issued a press release announcing our financial results for the quarter ended September 30, 2003. Our press release was attached to the report as Exhibit 99.1. Report of Independent Auditors To the Board of Directors and Shareholders of Hollywood Entertainment Corporation: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Hollywood Entertainment Corporation and its subsidiaries at December 31, 2003 and December 31, 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 8 to the consolidated financial statements, the Company changed its method of accounting for goodwill in 2002. /S/PricewaterhouseCoopers LLP Portland, Oregon February 16, 2004 HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts) ------------------------- December 31, December 31, 2003 2002 ----------- ----------- ASSETS Current assets: Cash and cash equivalents $ 74,133 $ 33,145 Cash held by trustee for refinancing - 218,531 Receivables, net 33,987 34,996 Merchandise inventories 129,864 97,307 Prepaid expenses and other current assets 13,233 14,772 ----------- ----------- Total current assets 251,217 398,751 Rental inventory, net 268,748 260,190 Property and equipment, net 288,857 255,497 Goodwill 66,678 64,934 Deferred income tax asset, net 104,302 147,813 Other assets 17,655 19,191 ----------- ----------- $ 997,457 $ 1,146,376 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current maturities of long-term obligations $ 647 $ 27,678 Subordinated notes to be retired with cash held by trustee (including accrued interest of $8.1 million) - 212,080 Accounts payable 159,586 158,423 Accrued expenses 117,867 108,432 Accrued interest 6,467 2,923 Income taxes payable 284 1,151 ----------- ---------- Total current liabilities 284,851 510,687 Long-term obligations, less current portion 370,669 361,068 Other liabilities 16,108 17,472 ----------- ---------- 671,628 889,227 Commitments and contingencies - - Shareholders' equity: Preferred stock, 25,000,000 shares authorized; no shares issued and outstanding - - Common stock, 100,000,000 shares authorized; 59,666,347 and 59,796,573 shares issued and outstanding, respectively 489,247 503,403 Unearned compensation (133) (697) Accumulated deficit (163,285) (245,557) ----------- ---------- Total shareholders' equity 325,829 257,149 ----------- ---------- $ 997,457 $ 1,146,376 =========== =========== See notes to Consolidated Financial Statements HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) Twelve Months Ended December 31, ------------------------------------ 2003 2002 2001 ---------- ---------- ---------- REVENUE: Rental product revenue $1,386,590 $1,324,017 $1,271,394 Merchandise sales 295,958 166,049 108,109 ---------- ---------- ---------- 1,682,548 1,490,066 1,379,503 ---------- ---------- ---------- COST OF REVENUE: Cost of rental product 441,034 447,278 459,071 Cost of merchandise 223,598 126,251 85,406 ---------- ---------- ---------- 664,632 573,529 544,477 ---------- ---------- ---------- GROSS PROFIT 1,017,916 916,537 835,026 Operating costs and expenses: Operating and selling 724,136 647,773 621,343 General and administrative 106,024 89,602 96,382 Store opening expenses 4,768 3,093 - Restructuring charge for closure of internet business - (12,430) (3,256) Restructuring charge for store closures (2,106) (828) (3,778) Amortization of intangibles - - 5,058 ---------- ---------- ---------- 832,822 727,210 715,749 ---------- ---------- ---------- INCOME FROM OPERATIONS 185,094 189,327 119,277 Non-operating expense: Interest expense, net (35,507) (42,057) (56,129) Early debt retirement (12,467) (3,534) - ----------- ----------- ---------- Income before income taxes 137,120 143,736 63,148 Benefit (provision) for income taxes (54,848) 98,109 37,268 ----------- ----------- ---------- NET INCOME $ 82,272 $ 241,845 $ 100,416 =========== =========== ========== ---------------------------------------------------------------------- Net income per share: Basic $ 1.36 $ 4.23 $ 2.05 Diluted 1.28 3.88 1.90 ---------------------------------------------------------------------- Weighted average shares outstanding: Basic 60,439 57,202 49,101 Diluted 64,180 62,390 52,880 ---------------------------------------------------------------------- See notes to Consolidated Financial Statements. HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT) (In thousands, except share amounts) Common Stock Unearned Accumu- ------------------- Compen- lated Shares Amount sation Deficit Total ---------- -------- -------- --------- --------- Balance at December 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 181,164 1,097 - - 1,097 Tax impact from stock options - (61) - - (61) Stock compensation - 5,745 (1,655) - 4,090 Net income - - - 100,416 100,416 ---------- -------- -------- --------- --------- Balance at December 31, 2001 49,428,763 375,503 (1,655) (487,402) (113,554) ---------- -------- -------- --------- --------- Issuance of common stock: Stock issuance 8,050,000 120,750 - - 120,750 Equity offering costs - (7,677) - - (7,677) Stock options exercised 2,317,810 4,604 - - 4,604 Stock option tax benefit - 12,814 - - 12,814 Stock compensation - (2,591) 958 - (1,633) Net income - - - 241,845 241,845 ---------- -------- -------- --------- --------- Balance at December 31, 2002 59,796,573 503,403 (697) (245,557) 257,149 ---------- -------- -------- --------- --------- Issuance of common stock: Stock options exercised 1,615,947 4,066 - - 4,066 Stock option tax benefit - 8,053 - - 8,053 Stock compensation - - 564 - 564 Repurchase of common stock (1,746,173) (26,275) - - (26,275) Net income - - - 82,272 82,272 ---------- -------- -------- --------- --------- Balance at December 31, 2003 59,666,347 $489,247 $ (133)$(163,285)$ 325,829 ========== ======== ======== ========= ========= See notes to Consolidated Financial Statements. HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Year Ended December 31, ------------------------------- 2003 2002 2001 --------- --------- --------- Operating activities: Net income $ 82,272 $ 241,845 $ 100,416 Adjustments to reconcile net income to cash provided by operating activities: Write-off deferred financing costs 5,827 2,226 - Amortization of rental product 211,806 218,905 180,237 Depreciation 60,762 59,343 66,939 Amortization of deferred financing costs 4,481 3,785 3,715 Tax benefit from exercise of stock options 8,053 12,814 (61) Change in deferred rent (1,364) (1,368) (598) Change in deferred taxes 43,512 (109,417) (38,396) Non-cash stock compensation 564 (1,633) 7,371 Net change in operating assets and liabilities: Receivables 1,010 (5,940) (5,226) Merchandise inventories (32,557) (35,722) (7,384) Accounts payable 1,163 (9,056) (32,879) Accrued interest 3,544 (2,649) 1,895 Other current assets and liabilities 1,718 (11,544) (2,146) --------- -------- -------- Cash provided by operating activities 390,791 361,589 273,883 --------- -------- -------- Investing activities: Purchases of rental inventory, net (220,364) (288,079) (202,790) Purchase of property and equipment, net (94,123) (44,254) (8,802) Increase in intangibles and other assets (2,816) (785) (791) Proceeds from indenture trustee 218,531 (218,531) - --------- -------- -------- Cash used in investing activities (98,772) (551,649) (212,383) --------- -------- -------- Financing activities: Proceeds from issuance of common stock - 120,750 - Equity financing costs - (7,677) - Issuance of subordinated debt - 225,000 - Repayment of subordinated debt (250,000) - - Borrowings under new term loan 200,000 150,000 - Repayment of prior revolving loan (107,500) (240,000) - Decrease in credit facilities (55,000) (42,500) (5,000) Debt financing costs (7,453) (11,966) (4,656) Repayments of capital lease obligations (10,291) (13,816) (17,399) Repurchase of common stock (26,275) - - Proceeds from capital lease obligation 1,422 - - Proceeds from exercise of stock options 4,066 4,604 1,097 --------- --------- -------- Cash (used in) provided by financing activities (251,031) 184,395 (25,958) --------- --------- -------- Increase (decrease) in cash and cash equivalents 40,988 (5,665) 35,542 Cash and cash equivalents at beginning of year 33,145 38,810 3,268 --------- --------- -------- Cash and cash equivalents at end of year $ 74,133 $ 33,145 $ 38,810 ========= ========= ======== Other Cash Flow Information: Interest expense paid $ 36,381 $ 41,415 $ 54,651 Income taxes paid, net 4,157 2,613 768 See notes to Consolidated Financial Statements HOLLYWOOD ENTERTAINMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003, 2002, 2001 1. SIGNIFICANT ACCOUNTING POLICIES Corporate Organization and Consolidation The accompanying financial statements include the accounts of Hollywood Entertainment Corporation and its wholly owned subsidiaries (the "Company"). The Company's only subsidiary during 2003, 2002 and 2001 was Hollywood Management Company. Nature of the Business The Company operates a chain of video stores ("Hollywood Video") throughout the United States. The Company was incorporated in Oregon on June 2, 1988 and opened its first store in October 1988. As of December 31, 2003, 2002 and 2001, the Company operated 1,920 stores in 47 states, 1,831 stores in 47 states and 1,801 stores in 47 states, respectively. In 2003, the Company began reporting operating results for two segments, Hollywood Video, as described above, and Game Crazy, game specialty stores where game enthusiasts can buy, sell and trade new and used video game hardware, software and accessories. A Game Crazy typically occupies an area of approximately 700 to 900 square feet within a Hollywood Video store. As of December 31, 2003, the Company operated 595 Game Crazy stores in 27 states Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates relative to the Company include revenue recognition, depreciation and amortization policies, impairment of long-lived assets and goodwill, income taxes and legal contingencies. Reclassification of Prior Year Amounts 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 income or shareholders' equity. Recently Issued Accounting Standards In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 143 (SFAS 143), "Accounting for Asset Retirement Obligations." SFAS 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, the entity is required to capitalize the cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. SFAS 143 is effective for fiscal years beginning after June 15, 2002 and was adopted by the Company on January 1, 2003. Adoption of the standard did not impact the Company's results of operations, financial position or liquidity in 2003. In May 2002, the FASB issued Statement of Financial Accounting Standards No. 145 (SFAS 145), "Rescission of SFAS Nos. 4, 44 and 64, Amendment of SFAS 13, and Technical Corrections." Among other things, SFAS 145 rescinds various pronouncements regarding the treatment of early extinguishment of debt as an extraordinary item unless the provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effect of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" are met. SFAS 145 provisions regarding early extinguishment of debt were generally effective for fiscal years beginning after May 15, 2002. In the first quarter of 2003, the Company redeemed its $250 million 10.625% senior subordinated notes due 2004 and retired its prior credit facility due 2004, resulting in a pre-tax charge of $12.5 million that was not considered an extraordinary item. Additionally, in the first quarter of 2002, the Company retired its credit facility in place at that time, resulting in a $3.5 million pre-tax charge that was considered an extraordinary item in the Company's Consolidated Statement of Operations in its Quarterly Report on Form 10-Q for the period ended March 31, 2002. In accordance with SFAS 145, this charge has been reclassified to conform to the presentation of the current period. In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (SFAS 146), "Accounting for Costs Associated with Exit or Disposal." SFAS 146 supersedes EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)." SFAS 146 applies to costs that are associated with exit activities that are not covered by SFAS 144, "Accounting for the Impairment of Disposal of Long-Lived Assets," or entities that are newly acquired in a business combination. The costs that are covered are one- time termination benefits paid to employees who were involuntarily terminated, costs to terminate contracts that are not capital leases and costs to consolidate facilities and relocate employees. The Company adopted SFAS 146 on January 1, 2003. Adoption of the standard did not have a material impact on the Company's results of operations, financial position or liquidity. In November 2002, the FASB's Emerging Issues Task Force reached a consensus on Issue 02-16 (EITF 02-16) addressing the accounting of cash consideration received by a customer from a vendor, including vendor rebates and refunds. The Company implemented the provisions of EITF 02-16 on January 1, 2003 to account for payments and credits it receives from its vendors primarily related to co-operative advertising arrangements. Pursuant to the provisions of EITF 02-16, vendor consideration which represents a reimbursement of specific, incremental, identifiable costs is included in operating and selling costs and expenses on the consolidated statements of operations, along with the related costs, in the period the promotion takes place. Any consideration that exceeds such costs is now classified as a reduction of the cost of product purchased, resulting in an increase in net advertising expense and a reduction in inventory cost, thereby reducing cost of revenue when the product is rented or sold. As a result, the change could impact the timing of recognition of these specific considerations. Implementation of EITF 02-16 did not have a material impact on the Company's results of operation, financial position or liquidity in 2003. In November 2002, the FASB issued Interpretation No. 45 (FIN 45), "Guarantor's Accounting and Disclosure Requirements for Guarantees." FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation it has undertaken in issuing the guarantee. The Company will apply FIN 45 to guarantees, if any, issued after December 31, 2002. In addition, FIN 45 also requires guarantors to disclose certain information for guarantees, including product warranties, outstanding at December 31, 2002. The Company does not have significant guarantees that require liability recognition or disclosure. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46). FIN 46 requires the consolidation of variable interest entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Application of this interpretation is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The adoption of this interpretation did not have, and is not expected to have, a material impact on the Company's financial position or results of operations. Rental Revenue and Merchandise The Company recognizes revenue upon the rental and sale of its products. Revenue for extended rental periods (when the customer chooses to keep the product beyond the original rental period) is recognized when the extended rental period begins. Revenue recorded for extended rental periods is net of estimated amounts that the Company does not anticipate collecting based upon its historical collection experience. Revenue generated from subscription sales or similar programs where a customer receives free rentals, reduced rental prices or discounted game prices (MVP cards in Game Crazy) in exchange for an up-front payment is recognized as revenue evenly over the time period the customer receives the benefit. Upon the sale of a subscription or MVP card, a liability is recorded that is amortized to revenue over the applicable time period. Gift Card and Gift Certificate Liability Gift card and gift certificate liabilities are recorded at the time of sale. Costs of designing, printing and distributing the cards and certificates, and transactional processing costs, are expensed as incurred. The liability is relieved and revenue is recognized upon redemption of the gift cards or gift certificate for rental or purchase at any Hollywood Video store. Cost of Rental Product Cost of rental product includes revenue sharing expense, amortization of DVD and VHS movies, games, capitalized shipping and handling, the book value of previously viewed movies and games, disk repair and the book value of rental inventory loss. Cost of Merchandise Sales Cost of merchandise sales is determined using an average costing method for groups with similar product characteristics for Hollywood Video and at an item level for Game Crazy. Cost of merchandise sales includes product shipping and handling and valuation adjustments or markdowns that are necessary to record inventory at the lower of cost or market. Cash and Cash Equivalents The Company considers highly liquid investment instruments, with an original maturity of three months or less, to be cash equivalents. The carrying amounts of cash and cash equivalents equals fair value. Inventories Merchandise inventories, consisting primarily of video games, new movies for sale, previously viewed movies for sale, concessions, and accessories held for resale, are stated at the lower of cost or market (or, in the case of rental inventory transferred to merchandise inventory at the carrying value thereof at the time of transfer). Used video game inventory includes games accepted as trade-ins from customers. Games are accepted from customers in exchange for in-store credit. At the time of trade-in, the inventory is recorded as well as the corresponding liability for the trade credit. The liability is relieved when the trade credit is redeemed. Rental inventory, which includes VHS videocassettes, DVDs and video games is stated at cost and amortized over its estimated useful life to a specified residual value. Shipping and handling charges related to rental and merchandise inventory are included in the cost of such inventory. See Notes 4 and 5 for a discussion of the amortization policy applied to rental inventory. Property, Equipment, Depreciation and Amortization Property is stated at cost and is depreciated on a straight-line basis for financial reporting purposes over the estimated useful life of the assets, which range from approximately five to ten years. Leasehold improvements are amortized primarily over ten years, which generally approximates the term of the lease. Additions to property and equipment are capitalized and include acquisitions of property and equipment, costs incurred in the development and construction of new stores, major improvements to existing property and major improvements in management information systems including certain costs incurred for internally developed computer software. Maintenance and repair costs are charged to expense as incurred, while improvements that extend the useful life of the assets are capitalized. As property and equipment is sold or retired, the applicable cost and accumulated depreciation and amortization are eliminated from the accounts and any gain or loss thereon is recorded. Long-lived Assets The Company reviews for impairment of long-lived assets to be held and used in the business whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company periodically reviews and monitors its internal management reports for indicators of impairment. The Company considers a trend of unsatisfactory operating results that are not in line with management's expectations to be its 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). The Company deems 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 exceeds its fair value. Fair value is estimated using a discounted future cash flow valuation technique similar to that used by management in making a new investment decision. Considerable management judgment and assumptions are necessary to identify indicators of impairment and to estimate discounted future cash flows. Accordingly, actual results could vary significantly from such estimates. There were no impairment charges in 2003 or 2002. Goodwill & Intangible Assets The Company reviews goodwill and intangible assets on an annual basis or whenever events or circumstances occur indicating that goodwill may be impaired. When the Company is evaluating for possible impairment of goodwill, it compares the present value of future cash flows of its reporting unit, which is defined as the Company's 1,920 video stores, to the goodwill recorded. If this indicates that the goodwill is impaired, the Company would record a charge to the extent that the goodwill balance would be adjusted to that of the present value of future cash flows. Store Closure Reserves Reserves for store closures were established by calculating the present value of the remaining lease obligation, adjusted for estimated subtenant agreements or lease buyouts, were expensed along with any leasehold improvements. Store furniture and equipment was either transferred at historical costs to another location or disposed of and written-off. Litigation Liabilities All material litigation loss contingencies, which are judged to be both probable and estimable, are recorded as liabilities in the Consolidated Financial Statements in amounts equal to the Company's best estimates of the costs of resolving or disposing of the underlying claims. These estimates are based upon judgments and assumptions. The Company regularly monitors its estimates in light of subsequent developments and changes in circumstances and adjusts its estimates when additional information causes the Company to believe that they are no longer accurate. If no particular amount is determined to constitute the Company's best estimate of a particular litigation loss contingency, the amount representing the low end of the range of the Company's estimate of the costs of resolving or disposing of the underlying claim is recorded as a liability and the range of such estimates is disclosed. Treasury Stock In accordance with Oregon law, shares of common stock are automatically retired and classified as available for issuance upon repurchase. Income Taxes We calculate income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our financial statements and tax returns. Valuation allowances are established when necessary to reduce deferred tax assets, including temporary timing differences and net operating loss carryforwards, to the amount expected to be realized in the future. Deferred assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. In the fourth quarter of 2000, in light of significant doubt that existed regarding our future income and therefore our ability to use our net operating loss carryforwards, we recorded a $211.2 million valuation allowance on our $211.2 million net deferred tax asset. In 2001 and 2002, as a result of our operating performance for each year, as well as anticipated future operating performance, we determined that it was more likely than not that certain future tax benefits would be realized. We therefore reversed $63.4 million and $147.8 million of this valuation allowance in 2001 and 2002, respectively, which resulted in an increase in net income and a corresponding increase/decrease in our shareholders' equity/deficit. While changes in the valuation allowance have no effect on the amount of income tax we pay or on our cash flows, the effects on our reported income and shareholders' equity may be viewed by some investors and potential lenders as significant. Due to the numerous variables associated with our judgments, assumptions and estimates relating to the valuation of our deferred tax assets, and the effects of changes in circumstances affecting these valuations, both the precision and reliability of the resulting estimates are subject to substantial uncertainties and, as additional information becomes known, we may change our estimates significantly Deferred Rent Many of the Company's operating leases contain predetermined fixed increases of the minimum rental rate during the initial lease term. For these leases, the Company recognizes the related rental expense on a straight-line basis and records the difference between the amount charged to expense and the rent paid as deferred rent and is included in other liabilities. Fair Value of Financial Instruments In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial Instruments", the Company has disclosed the fair value, related carrying value and method for determining the fair value for the following financial instruments in the accompanying notes as referenced: cash and cash equivalents (see above), accounts receivable (see Note 2), and long-term obligations (see Note 13). The Company's receivables do not represent significant concentrations of credit risk at December 31, 2003, due to the wide variety of customers, markets and geographic areas to which the Company's products are rented and sold. Accounting for Stock Based Compensation The Company accounts for its stock option plans under the recognition and measurement principles of Accounting Principal Board opinion No. 25, "Accounting for Stock Issued to Employees, and related Interpretations." Pursuant to the disclosure requirements of Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation" and Statement of Financial Accounting Standards No. 148, "Accounting for Stock- Based Compensation - Transition and Disclosure - an Amendment of SFAS 123." The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123. Year Ended December 31, ---------------------------- 2003 2002 2001 -------- -------- -------- Net income as reported $ 82,272 $241,845 $100,416 Add: Stock-based compensation expense included in reported net income, net of tax 339 596 2,378 Deduct: Total stock- based Employee compensation expense under fair value based method for all awards, net tax (8,295) (7,941) (4,180) -------- -------- -------- Pro forma net income $74,316 $234,500 $ 98,614 ======== ======== ======== Earnings per share: Basic--as reported $ 1.36 $ 4.23 $ 2.05 Basic--pro forma 1.23 4.10 2.01 Diluted--as reported 1.28 3.88 1.90 Diluted--pro forma 1.19 3.87 1.93 Comprehensive Income Comprehensive income is equal to net income for all periods presented. Advertising The Company receives cooperative reimbursements from vendors as eligible expenditures are incurred relative to the promotion of rental and sales product. Advertising costs, net of these reimbursements, are expensed as incurred. Advertising expense was $16.2 million, $4.5 million and $5.1 million for 2003, 2002 and 2001, respectively. The increase in 2003 was related to an increase in advertising for Game Crazy and the adoption of EITF 02-16 that reclassified certain credits from concession vendors to cost of merchandise revenue. 2. RECEIVABLES Accounts receivable as of December 31, 2003 and 2002 consists of (in thousands): ---------------------- 2003 2002 ---------- --------- Construction receivables $ 4,826 $ 2,079 Additional rental fees, net 19,970 18,450 Marketing 8,468 14,399 Due from employees 244 533 Licensee receivables 1,509 631 Other 785 1,360 ---------- --------- 35,802 37,452 Allowance for doubtful accounts (1,815) (2,456) ---------- --------- $ 33,987 $ 34,996 ========== ========= The carrying amount of accounts receivable approximates fair value because of the short maturity of those receivables. The allowance for doubtful accounts is primarily for marketing. 3. RENTAL INVENTORY Rental inventory as of December 31, 2003 and 2002 consists of (in thousands): ------------------------- 2003 2002 ---------- ---------- Rental inventory $ 773,953 $ 722,582 Less accumulated amortization (505,205) (462,392) ---------- ---------- $ 268,748 $ 260,190 ========== ========== Number of stores 1,920 1,831 Inventory/store 140 142 Amortization expense related to rental inventory was $211.8 million, $218.9 million and $180.2 million in 2003, 2002 and 2001, respectively, and is included in cost of rental product. As rental inventory is transferred to merchandise inventory and sold as previously-viewed product, the applicable cost and accumulated amortization are eliminated from the accounts, determined on a first-in-first-out ("FIFO") basis applied in the aggregate to monthly purchases. 4. RENTAL INVENTORY AMORTIZATION POLICY The Company manages its rental inventories of movies as two distinct categories, new releases and catalog. New releases, which represent the majority of all movies acquired, are those movies which are primarily purchased on a weekly basis in large quantities to support demand upon their initial release by the studios and are generally held for relatively short periods of time. Catalog, or library, represents an investment in those movies the Company intends to hold for an indefinite period of time and represents a historic collection of movies which are maintained on a long-term basis for rental to customers. In addition, the Company acquires catalog inventories to support new store openings and to build-up its title selection, primarily as it relates to new formats such as DVD. Purchases of new release movies are amortized over four months to current estimated average residual values of approximately $2.00 for VHS and $4.00 for DVD (net of estimated allowances for losses). Purchases of VHS and DVD catalog are currently amortized on a straight-line basis over twelve months and sixty months, respectively, to estimated residual values of $2.00 for VHS and $4.00 for DVD. For new release movies acquired under revenue sharing arrangements, the studios' share of rental revenue is charged to cost of rental, net of average estimated residual values which are approximately equal to the residual values of purchased inventory, as outlined above. The expense is recorded as revenue is earned on the respective revenue sharing titles. The majority of games purchased are amortized over four months to an average residual value below $5.00. Games that the Company expects to keep in rental inventory for an indefinite period of time are amortized on a straight-line basis over two years to a current estimated residual value of $5.00. 5. CHANGE IN ACCOUNTING ESTIMATE FOR RENTAL INVENTORY - 2002 The Company regularly evaluates and updates rental inventory accounting estimates. Effective October 1, 2002, estimated average residual values on new release movies was reduced from $3.16 to $2.00 for VHS and from $4.67 to $4.00 for DVD. In addition, the estimated residual value of catalog DVD inventory was reduced from $6.00 to $4.00. As a result of these changes in estimate, cost of rental product revenue in 2002 was $4.1 million higher and net income per share (basic and diluted) was $0.04 lower. 6. PROPERTY AND EQUIPMENT Property and equipment as of December 31, 2003 and 2002 consists of (in thousands): --------------------- 2003 2002 --------- ---------- Fixtures and equipment $ 232,379 $ 187,300 Leasehold improvements 465,874 380,047 Equipment under capital lease 4,644 15,784 Leasehold improvements under capital lease 6,725 37,112 --------- ---------- 709,622 620,243 Less accumulated depreciation and amortization (420,765) (364,746) --------- ---------- $ 288,857 $ 255,497 ========= ========== Accumulated depreciation and amortization, as presented above, includes accumulated amortization of assets under capital leases of $6.4 million and $24.4 million at December 31, 2003 and 2002, respectively. Depreciation expense related to property, plant and equipment was $56.7 million, $59.3 million and $61.9 million in 2003, 2002 and 2001, respectively. 7. STORE CLOSURE RESTRUCTURING In December 2000, we approved a restructuring plan involving the closure and disposition of 43 stores that were not operating to our expectations (the "Restructuring Plan"). In the fourth quarter of 2000, we recorded charges aggregating $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. We have liquidated and plan to continue liquidating related store inventories through store closing sales; any remaining product will be used in other stores. Revenue for the stores subject to the store Restructuring Plan was $6.0 million, $6.3 million, $13.8 million and $15.5 million in 2003, 2002, 2001 and 2000, respectively. Operating results (defined as income or loss before interest expense and income taxes) was $0.3 million loss, $0.9 million loss, $2.5 million loss and $1.8 million loss in 2003, 2002, 2001 and 2000, respectively. The operating results for the stores in the closure plan were included in the Consolidated Statement of Operations. During the twelve months ended December 31, 2001, we closed 12 of the stores included in the plan and incurred $329,867 in expenses related to the closures and received $450,000 to exit one of the leases. During the twelve months ended December 31, 2002, we closed one store included in the plan and incurred $90,000 in closure expenses. In December of 2001, 2002 and 2003, we amended the Restructuring Plan and removed 16 stores, 2 stores and 9 stores from the closure list, respectively. In accordance with the amended plans, and updated estimates on closing costs, we reversed $3.8 million, $0.8 million and $2.1 of the original $16.9 million charge, leaving a $3.7 million, $2.8 million and $0.7 million accrual balance at December 31, 2001, 2002 and 2003, respectively, for store closing costs. At December 31, 2003, 3 stores remained to be closed under the Restructuring Plan, one of which closed in January 2004. 8. GOODWILL AND INTANGIBLE ASSETS Goodwill was $66.7 as of December 31, 2003 and $64.9 million as of December 31, 2002 and 2001 and represents the excess of cost over the fair value of net assets purchased net of impairment charges and accumulated amortization recorded prior to the adoption of FAS 142. The increase in Goodwill was the result of six stores acquired in four separate transactions during the year ended December 31, 2003. The aggregate purchase price was $2.0 million, of which, $1.7 million was allocated to Goodwill. The remaining purchase price represented the fair market value of the assets acquired that were allocated to store inventory and leasehold improvements. In July 2001, the FASB issued SFAS Nos. 141 and 142, "Business Combinations" and "Goodwill and Other Intangible Assets," respectively. SFAS 141 supersedes Accounting Principles Board (APB) Opinion No. 16 and eliminates pooling-of- interests accounting. 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 and non-amortizing intangible assets shall be adjusted whenever events or circumstances occur indicating that goodwill has been impaired. The Company has completed its impairment testing of the valuation of its goodwill and has determined that there is no impairment. SFAS 141 and 142 were 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 ceased, and intangible assets acquired prior to July 1, 2001 that did not meet criteria for recognition under SFAS 141 were reclassified to goodwill. The Company adopted SFAS 142 on January 1, 2002, the beginning of fiscal 2002. The components of intangible assets are as follows (in thousands): December 31, December 31, 2002 Additions 2003 ------------ --------- ------------ Goodwill $ 64,934 $ 1,744 $ 66,678 Trade-name rights 5,345 879 6,224 ------------ --------- ------------ $ 70,279 $ 2,623 $ 72,902 ============ ========= ============ The following table summarizes the pro forma impact of excluding amortization of intangible assets for the years ended December 31, 2003, 2002 and 2001 (in thousands, except per share amounts): Year Ended December 31, -------- -------- --------- 2003 2002 2001 -------- -------- --------- Net income, as reported $ 82,272 $241,845 $ 100,416 Add back: Amortization of intangible assets, net of tax - - 3,116 -------- -------- --------- Pro forma net income $ 82,272 $241,845 $ 103,532 ======== ======== ========= Basic net income per share: As reported $ 1.36 $ 4.23 $ 2.05 Pro forma net income per share $ 1.36 $ 4.23 $ 2.11 Diluted net income per share: As reported $ 1.28 $ 3.88 $ 1.90 Pro forma net income per share $ 1.28 $ 3.88 $ 1.96 9. REEL.COM DISCONTINUED E-COMMERCE OPERATIONS On June 12, 2000, the Company announced that it would close down the e-commerce business of Reel.com. Although the Company had developed a leading web-site over the seven quarters after Reel.com was purchased in October of 1998, Reel.com's 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. As a result of the discontinuation of Reel.com's e-commerce operations, the Company recorded a total charge of $69.3 million in the second quarter of 2000, of which $27.3 million was accrued liabilities for contractual obligations, lease commitments, anticipated legal claims, legal fees, financial consulting, and other professional services incurred as a direct result of the closure of Reel.com. The accrual was reduced by $1.6 million, $3.3 million and $12.4 million in 2000, 2001 and 2002, respectively, because the Company was able to negotiate termination of certain obligations and lease commitments more favorably than originally anticipated. The Company has paid for all accrued liabilities, net of reductions, and does not anticipate further adjustments. 10. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable includes accrued revenue sharing (amounts accrued pursuant to revenue sharing arrangements in which the Company had not yet received an invoice). Accrued revenue sharing was $23.6 million and $15.9 million at December 31, 2003, and 2002, respectively. Accrued liabilities as of December 31, 2003 and 2002 consist of (in thousands): ---------------------- 2003 2002 ---------- --------- Payroll and benefits $ 26,456 $ 24,136 Property taxes and common area maintenance 11,045 9,313 Gift cards and discount cards 22,908 15,672 Marketing 5,709 5,815 Store closures and lease terminations 1,127 4,453 Property, plant and equipment 5,050 10,531 Accrued insurance 5,425 3,332 Accrued sales tax 13,320 11,433 Other operating and general administration 26,827 23,747 ---------- --------- $ 117,867 $ 108,432 ========== ========= 11. EMPLOYEE BENEFIT PLANS The Company is self-insured for employee medical benefits under the Company's group health plan. The Company maintains stop loss coverage for individual claims in excess of $125,000. While the ultimate amount of claims incurred is dependent on future developments, in management's opinion, recorded reserves are adequate to cover the future payment of claims. Adjustments, if any, to recorded estimates of the Company's potential claims liability will be reflected in results of operations for the period in which such adjustments are determined to be appropriate on the basis of actual payment experience or other changes in circumstances. The Company has a 401(k) plan in which eligible employees may elect to contribute up to 20% of their earnings. Eligible employees are at least 21 years of age, have completed at least one year of service and work at least 1,000 hours in a year. The Company matched 25% of the employee's first 6% of contributions until June 30, 2003, when the company elected to end the match. Beginning in April 2000, the Company offered a deferred compensation plan to certain key employees designated by the Company. The plan allows for the deferral and investment of current compensation on a pre-tax basis. The Company has accrued $247,923 and $140,660 related to this plan at December 31, 2003 and 2002, respectively. Beginning in January 2002, the Company offered a 401(k) supplemental plan that allowed our highly compensated employees the ability to receive the full 25% employer match on the first 6% of contributions (through June 30, 2003 when the company elected to end the match) that were not available to them under the Company's 401(k) plan. The plan allows for the deferral and investment of current compensation on a pre-tax basis. The Company has accrued approximately $738,326 and $373,829 related to this plan at December 31, 2003 and 2002, respectively. 12. RELATED PARTY TRANSACTIONS On January 25, 2001, the Compensation Committee of the Board of Directors of the Company unanimously approved an employment agreement between the Company and Mark J. Wattles as President and Chief Executive Officer. Pursuant to the terms of the agreement, on January 25, 2001, Mr. Wattles received a grant of $3.28 million in common stock (3 million shares). In July 2001, Boards, Inc. (Boards) began to open Hollywood Video stores as licensee of the Company pursuant to rights granted by the Company and approved by the Board of Directors in connection with Mark J. Wattles' employment agreement in January 2001. These stores are operated by Boards and are not included in the 1,920 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 pays the Company an initial license fee of $25,000 per store, a royalty of 2.0% of revenue and also purchases products and services from the Company at the Company's cost. From July 2001 through December 31, 2003, Boards has incurred license fees and royalties, and purchased products and services from the Company totaling $16.0 million, of which, $14.5 million has been paid as of December 31, 2003. Boards is in compliance with the 30 day payment terms under the arrangement. The outstanding balance of $1.5 million due the Company is related to current activity. In the twelve months ended December 31, 2003, Boards incurred charges of $11.0 million and made $10.2 million in payments. As of December 31, 2003, Boards operated 20 stores. 13. LONG-TERM OBLIGATIONS AND LIQUIDITY The Company had the following long-term obligations as of December 31, 2003 and 2002 (in thousands): December 31, ----------- ---------- 2003 2002 ----------- ---------- Borrowings under credit facilities $ 145,000 $ 107,500 Senior subordinated notes due 2011 (1) 225,000 225,000 Senior subordinated notes due 2004 (2) - 250,000 Obligations under capital leases 1,316 10,178 ----------- ---------- 371,316 592,678 Current portions: Credit facilities - 17,500 Capital leases 647 10,178 ----------- ---------- 647 27,678 Subordinated notes to be retired with cash held by trustee - 203,932 Total long-term obligations net of current portion and notes to ----------- ---------- be retired with cash held by trustee $ 370,669 $ 361,068 =========== ========== (1) Coupon payments at 9.625% are due semi-annually in March and September. (2) On December 18, 2002, the Company called $203.9 million of the notes, which were redeemed on January 17, 2003. The remaining $46.1 million was called on January 17, 2003 and redeemed on February 18, 2003. On December 18, 2002, the Company completed the sale of $225 million 9.625% senior subordinated notes due 2011. The Company delivered the net proceeds to an indenture trustee to redeem $203.9 million of the $250 million 10.625% senior subordinated notes due 2004 including accrued interest and the required call premium. At December 31, 2002, the trustee was holding $218.5 million and the Company continued to carry the $250 million 10.625% senior subordinated notes on its balance sheet. On January 17, 2003, the redemption of $203.9 million of the notes was completed. The senior subordinated notes due 2011 are redeemable, at the option of the Company, beginning in March 15, 2007, at rates starting at 104.8% of principal amount reduced annually through March 15, 2009, at which time they become redeemable at 100% of the principal amount. The terms of the notes may restrict, among other things, payment of dividends and other distributions, investments, the repurchase of capital stock or subordinated indebtedness, the making of certain other restricted payments, the incurrence of additional indebtedness or liens by the Company or any of its subsidiaries, and certain mergers, consolidations and disposition of assets. Additionally, if a change of control occurs, as defined, each holder of the notes will have the right to require the Company to repurchase such holder's notes at 101% of principal amount thereof. At December 31, 2003, the company was in compliance with the restrictions, and other terms of the notes. On January 16, 2003, the Company completed the closing of new senior secured credit facilities from a syndicate of lenders led by UBS Warburg LLC. The new facilities consist of a $200.0 million term loan facility and a $50.0 million revolving credit facility, each maturing in 2008. The Company used the net proceeds from the transaction to repay amounts outstanding under the Company's existing credit facilities which were due in 2004, redeem the remaining $46.1 million outstanding principal amount of the Company's 10.625% senior subordinated notes due 2004 and for general corporate purposes. The Company completed the redemption of the 10.625% senior subordinated notes on February 18, 2003. The Company has prepaid $75 million of the term loan facility principal payments due through 2006, including a $20 million payment made on January 5, 2004. Revolving credit loans under the new facility bear interest, at the Company's option, at an applicable margin over the bank's base rate loan or the LIBOR rate. The initial margin over LIBOR was 3.5% for the term loan facility and will step down if certain performance targets are met. The credit facility contains financial covenants (determined in each case on the basis of the definitions and other provisions set forth in such credit agreement), some of which may become more restrictive over time, that include a (1) maximum debt to adjusted EBITDA test, (2) minimum interest coverage test, and (3) minimum fixed charge coverage test. Amounts outstanding under the credit agreement are collateralized by substantially all of the assets of the Company. Hollywood Management Company, and any future subsidiaries of Hollywood Entertainment Corporation, are guarantors under the credit agreement. At December 31, 2003, the Company was in compliance with all covenants contained within the agreement. Maturities on long-term obligations at December 31, 2003 for the next five years is as follows (in thousands): Capital Year Ending Subordinated Credit Leases December, 31 Notes Facility & Other Total ------------ ---------- ---------- --------- --------- 2004 - - 647 647 2005 - - 454 454 2006 - 20,000(1) 215 20,215 2007 - 20,000 - 20,000 2008 - 105,000 - 105,000 Thereafter 225,000 - - 225,000 ----------- ---------- --------- --------- $ 225,000 $ 145,000 $ 1,316 $ 371,316 ----------- ---------- --------- --------- (1) Paid on January 5, 2004. The fair value of the 9.625% senior subordinated notes due 2011 was $243.6 million and $229.5 million as of December 31, 2003 and 2002, respectively, based on quoted market prices. The revolving credit facility is a variable rate loan, and thus, the fair value approximates the carrying amount as of December 31, 2003 and 2002. As of December 31, 2003, the Company had $5.1 million of outstanding letters of credit issued upon the revolving credit facility. 14. OFF BALANCE SHEET ARRANGEMENTS The Company leases all of its stores, corporate offices, distribution centers and zone offices under non-cancelable operating leases. The Company's stores generally 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 $225.0 million, $213.2 million and $212.7 million for the years ended December 31, 2003, 2002 and 2001, respectively. Most operating leases require payment of additional occupancy costs, including property taxes, utilities, common area maintenance and insurance. These additional occupancy costs were $46.2 million, $42.1 million and $40.4 million for the years ended December 31, 2003, 2002 and 2001, respectively. At December 31, 2003, the future minimum annual rental commitments under non- cancelable operating leases were as follows (in thousands): ------------------------------ Year Ending Operating December 31, Leases ------------------------------ 2004 $237,821 2005 228,986 2006 209,071 2007 178,674 2008 139,845 Thereafter 361,134 15. INCOME TAXES The provision for (benefit from) income taxes from continuing operations for the years ended December 31, 2003, 2002 and 2001 consists of (in thousands): ------------------------------ 2003 2002 2001 ---------- -------- -------- Current: Federal $ 2,265 $ (3,507) $ 312 State 1,018 2,107 816 --------- -------- -------- Total current provision (benefit) 3,283 (1,400) 1,128 Deferred: Federal 42,785 (82,243) (30,852) State 8,780 (14,466) (7,544) --------- -------- -------- Total deferred liability (benefit) 51,565 (96,709) (38,396) --------- -------- -------- Total provision (benefit) $ 54,848 $(98,109) $(37,268) ========= ======== ======== The Company is subject to minimum state taxes in excess of statutory state income taxes in many of the states in which it operates. These taxes are included in the current provision for state and local income taxes. Certain acquisitions in 1995 and the Reel.com acquisition in 1998 yielded non- deductible goodwill which is reflected in the tax rate reconciliation below. The tax impact of purchase accounting adjustments is reflected in deferred taxes. The difference between the tax provision at the statutory federal income tax rate and the tax provision attributable to income from continuing operations before income taxes for the three years ended December 31 is analyzed below: -------------------------- 2003 2002 2001 -------- ------- ------- Statutory federal rate provision 35.0% 34.0% 34.0% State income taxes, net of federal income tax benefit 4.6 3.9 4.4 Amortization of non-deductible Goodwill - - 0.1 Net non-deductible expenses 0.5 0.4 3.8 Federal credits & adjustments 1.4 (0.6) (1.2) Decrease in valuation allowance - (103.4) (100.5) Change in Deferred Tax Rate (2.6) - - Other, net 1.1 - 0.4 -------- ------- ------- 40.0% (65.7%) (59.0%) ======== ======= ======= Deferred income taxes reflect the impact of "temporary differences" between amounts of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws. The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities from continuing operations at December 31 are as follows (in thousands): ---------------------- 2003 2002 ---------- --------- Deferred tax assets: Tax loss carryforward $117,953 $102,131 Deferred rent 6,319 7,027 Accrued liabilities and reserves 11,300 14,081 Tax credit carryforward 6,820 6,623 Restructure charges 2,604 3,526 Inventory valuation 23,957 35,038 Amortization 1,474 5,944 ---------- --------- Total deferred tax assets 170,427 174,370 Deferred tax liabilities: Depreciation and amortization (62,638) (22,648) Capitalized and financing leases (3,487) (3,909) ---------- --------- Total deferred tax liabilities (66,125) (26,557) ---------- --------- Net deferred tax asset $104,302 $147,813 ========== ========= The Company believes that it is more likely than not that certain future tax benefits will be realized as a result of current and anticipated future income. Accordingly, the valuation allowance was reduced by $147.8 million in 2002 to reflect anticipated net deferred tax asset utilization. As of December 31, 2003, the Company had approximately $304.3 million of net operating loss carryforwards available to reduce future income taxes. The carryforward periods expire in years 2019 through 2021. The Company has federal Alternative Minimum Tax ("AMT") credit carryforwards of $3.0 million which are available to reduce future regular taxes in excess of AMT. These credits have no expiration date. The Company has federal and state tax credit carryforwards of $3.8 million which are available to reduce future taxes. The carryforward periods expire in years 2018 through 2023, or have no expiration date. The Company realized a tax benefit in the amount of $8.1 million and $12.8 in 2003 and 2002, respectively, as a result of the exercise of employee stock options. For financial reporting purposes, the impact of this tax benefit is credited directly to shareholders' equity. 16. SHAREHOLDERS' EQUITY Preferred Stock At December 31, 2003, the Company was authorized to issue 25,000,000 shares of preferred stock in one or more series. With the exception of 3,119,737 shares which have been designated as "Series A Redeemable Preferred Stock" but have not been issued, the Board of Directors has authority to designate the preferences, special rights, limitations or restrictions of such shares. Common Stock During the third and fourth quarters of 2003, the Company repurchased a total of 1,746,173 shares of its common stock for an aggregate purchase price of $26.3 million. On March 11, 2002, the Company completed a public offering of 8,050,000 shares of its common stock. 17. STOCK OPTION PLANS In general, the Company's stock option plans provide for the granting of options to purchase Company shares at a fixed price. It has been the Company's Board of Directors general policy to set the price at the market price of such shares as of the option grant date. The options generally have a nine year term and become exercisable on a pro rata basis over the first three years or at such other periods as determined by the Board. The Company adopted stock option plans in 1993, 1997 and 2001 providing for the granting of non-qualified stock options, stock appreciation rights, bonus rights and other incentive grants to employees up to an aggregate of 21,000,000 shares of common stock. The Company granted non-qualified stock options pursuant to the 1993, 1997 and 2001 Plans totaling 1,485,667, 3,311,368, and 11,063,683 in 2003, 2002 and 2001, respectively. The Company cancelled 1.3 million, 2.2 million, and 4.0 million of stock options in 2003, 2002 and 2001, respectively. The Company has elected to follow APB Opinion 25; "Accounting for Stock Issued to Employees" ("APB 25"), and related interpretations in accounting for its employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized upon the date of grant. Pro forma information regarding net income per share is required by SFAS No. 123, "Accounting for Stock-Based Compensation", and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The fair value of these options was estimated at the date of grant using Black-Scholes option pricing model with the following weighted-average assumptions for 2003, 2002 and 2001: ----------------------------- 2003 2002 2001 ----------------------------- Risk free interest rate 2.33% 2.17% 3.87% Expected dividend yield 0% 0% 0% Expected lives 5 years 4 years 3 years Expected volatility 96.9% 108% 100% The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the Company's opinion, the existing available models do not necessarily provide a reliable single measure of the fair value of the Company's employee stock options. Using the Black-Scholes option valuation model, the weighted average grant date value of options granted during 2003, 2002 and 2001 was $10.70, $10.03, and $1.55 per share subject to the option, respectively. For the purpose of pro forma disclosures, the estimated fair value of the options is amortized over the option's vesting period. The Company's pro forma information is as follows (in thousands, except per share amounts): Year Ended December 31, ---------------------------- 2003 2002 2001 -------- -------- -------- Net income as reported $ 82,272 $241,845 $100,416 Add: Stock-based compensation expense included in reported net income, net of tax 339 596 2,378 Deduct: Total stock- based employee compensation expense under fair value based method for all awards, net of tax (8,295) (7,941) (4,180) -------- -------- -------- Pro forma net income $74,316 $234,500 $ 98,614 ======== ======== ======== Earnings per Share: Basic--as reported $ 1.36 $ 4.23 $ 2.05 Basic--pro forma 1.23 4.10 2.01 Diluted--as reported 1.28 3.88 1.90 Diluted--pro forma 1.19 3.87 1.93 A summary of the Company's stock option activity and related information for 2003, 2002 and 2001 is as follows (in thousands, except per share amounts): Weighted Average Exercise Shares Price -------- -------- Outstanding as December 31, 2000 5,422 9.45 Granted 11,064 2.05 Exercised (181) 6.24 Cancelled (3,951) 7.39 -------- -------- Outstanding as December 31, 2001 12,354 3.52 Granted 3,311 13.47 Exercised (2,318) 2.39 Cancelled (2,199) 7.32 -------- -------- Outstanding as December 31, 2002 11,148 $ 5.96 Granted 1,486 14.73 Exercised (1,616) 2.96 Cancelled (1,287) 8.35 -------- -------- Outstanding as December 31, 2003 9,731 7.48 ======== ======== The 1.5 million options granted in 2003 were granted with an exercise price equal to market value. A summary of options outstanding and exercisable at December 31, 2003 is as follows (in thousands, except per share amounts): ------------------------------ ------------------- Options Outstanding Options Exercisable ------------------------------ ------------------- Weighted Average Weighted Weighted Remaining Average Average Range of Life Exercise Exercise Exercise Prices Options (in years) Price Options Price ---------------- ------- --------- -------- ------- -------- $ 1.000 - $1.090 4,371 6.24 $ 1.09 2,440 $ 1.09 1.094 - 1.563 549 6.21 1.47 187 1.31 2.040 - 12.000 1,878 6.95 11.17 147 8.79 12.010 - 20.390 2,933 6.66 15.78 853 17.55 ------ --------- -------- ------- -------- 9,731 6.50 $ 7.48 3,627 $ 5.32 ====== ========= ======== ======= ======== In the first quarter of 2000, the Company granted stock options to approximately fifty key employees. The grants were for the same number of shares issued to these employees prior to January 1, 2000. In the third quarter of 2000, the Company cancelled the stock options that were issued prior to January 1, 2000 for the fifty employees. The grant and cancellation of the same number of options for these employees resulted in variable accounting treatment for the related options for 850,000 shares of the Company's common stock. Variable accounting treatment resulted in unpredictable stock-based compensation dependent on fluctuations in quoted prices for the Company's common stock. In 2002, the variable options were canceled and the Company reversed expense that was recognized in 2001 on the canceled options. Options subject to variable accounting outstanding at December 31, 2003, 2002 and 2001 were 0, 0 and 482,750, respectively. The Company reversed compensation expense in 2002 of $2.6 million relating to the variable stock options compared to compensation expense of $2.7 million in 2001. The Company recorded compensation expense related to certain stock options issued below the fair market value of the related stock in the amount of $0.6 million, $1.0 million and $1.4 million for the year ended December 31, 2003, 2002 and 2001, respectively. 18. EARNINGS PER SHARE A reconciliation of the basic and diluted per share computations for 2003, 2002 and 2001 is as follows (in thousands, except per share data): ---------------------------------- 2003 ---------------------------------- Weighted Per Average Share Income Shares Amount ---------- --------- --------- Income per common share $ 82,272 60,439 $ 1.36 Effect of dilutive securities: Stock options - 3,741 (.08) ---------- --------- --------- Income per share assuming dilution $ 82,272 64,180 $ 1.28 ========== ========= ========= ---------------------------------- 2002 ---------------------------------- Weighted Per Average Share Income Shares Amount ---------- --------- --------- Income per common share $ 241,845 57,202 $ 4.23 Effect of dilutive securities: Stock options - 5,188 (0.35) ---------- --------- --------- Income per share assuming dilution $ 241,845 $ 62,390 3.88 ========== ========= ========= ---------------------------------- 2001 ---------------------------------- Weighted Per Average Share Income Shares Amount ---------- --------- --------- Income per common share $ 100,416 49,101 $ 2.05 Effect of dilutive securities: Stock options - 3,779 (0.15) ---------- --------- --------- Income per share assuming dilution $ 100,416 52,880 $ 1.90 ========== ========= ========= Shares subject to antidilutive stock options excluded from the calculation of diluted income in 2003, 2002, and 2001 were 1.3 million, 0.8 million and 3.0 million, respectively. 19. COMMITMENTS AND CONTINGENCIES In 1999, the Company was named as a defendant in three complaints that have been consolidated 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 sought to certify a class of former and current California salaried Store Managers and Assistant Managers alleging that the Company engaged in unlawful conduct by improperly designating its salaried Store Managers and Assistant Store Managers as "exempt" from California's overtime compensation requirements in violation of the California Labor Code. The Company maintains that its California Store Managers and Assistant Store Managers were properly designated as exempt from overtime. The parties entered into a settlement agreement, which was given final approval by the court on January 28, 2003. A third party claims administrator was hired to process claims and distribute funds to the class. All claims submitted have been processed, and verified claims have been paid. The Company has satisfied its obligations under the settlement agreement and a final Case Management Conference took place on August 12, 2003. Reserves established prior to the beginning of fiscal 2003 were adequate to cover amounts in the settlement agreement. The Company has been named in several purported class action lawsuits alleging various causes of action, including claims regarding the Company's membership application and additional rental period charges. The Company has vigorously defended these actions and maintains that the terms of our additional rental charge policy are fair and legal. The Company has been successful in obtaining dismissal of three of the actions filed against it. A statewide class action entitled George Curtis v. Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was certified on June 14, 2002 in the Superior Court of King County, Washington. On May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of St. Clair County, Twentieth Judicial Circuit, State of Illinois. The Company believes it has provided adequate reserves in connection with these lawsuits. The Company has been under examination by the Internal Revenue Service (IRS) for the tax years 1994 through 1997. In connection with those examinations, the IRS proposed adjustments for tax years 1994 through 1997, which the Company did not agree with at the exam or appeals level. In April 2001, the IRS issued a Notice of Deficiency (the Notice) for tax years 1994 through 1997 with respect to various issues. In July 2001, the Company filed a petition in United States Tax Court requesting a re-determination of the proposed deficiency. In April 2003, the parties reached a settlement agreement related to the various issues and the Company established a deferred tax asset in the amount of $3.1 million. The settlement did not impact the Company's provision for income taxes in 2003. The Company has been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. The Company believes it has provided adequate reserves for these various contingencies and that the outcome of these matters should not have a material adverse effect on the Company's consolidated results of operations, financial condition or liquidity. 20. SEGMENT REPORTING The Company's management regularly evaluates the performance of two segments, Hollywood Video and Game Crazy, in its assessment of performance and in deciding how to allocate resources. Hollywood Video represents the Company's 1,920 video stores excluding the operations of Game Crazy. Game Crazy represents 595 in-store departments that allows game enthusiasts to buy, sell, and trade used and new video game hardware, software and accessories. The Company measures segment profit as operating income (loss), which is defined as income (loss) before interest expense and income taxes. Information on segments and reconciliation to operating income (loss) are as follows (in thousands): Year Ended December 31, 2003 ----------------------------------- Hollywood Game Video Crazy Total ---------- ----------- ---------- Revenues $1,502,416 $ 180,132 $1,682,548 Depreciation 56,699 4,063 60,762 Income (loss) from operations 205,080 (19,986) 185,094 Total assets 888,030 109,427 997,457 Purchases of property and equipment 65,769 28,354 94,123 Game Crazy's loss from operations includes an overhead allocation of 1% of Game Crazy revenue for information support services, treasury and accounting functions, and other general and administrative services. Game Crazy revenue for 2002 was $56.7 million. Information regarding Game Crazy's results of operations, total assets and purchases of property and equipment as reported above for 2003 is not available for prior periods due to Game Crazy's smaller scale prior to 2003 when costs were not segregated and captured. 21. QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data is as follows (in thousands, except per share data): Quarter Ended ------------------------------------------ March June September December 2003 --------- --------- --------- --------- ------------------------- Total revenue $ 417,592 $ 389,443 $ 401,958 $ 473,555 Gross profit 261,900 240,818 250,645 264,553 Income from operations 55,036 39,871 41,985 48,201 Net income 19,578 19,178 20,469 23,046 Net income per share: Basic 0.33 0.32 0.34 0.38 Diluted 0.31 0.30 0.32 0.36 Quarter Ended ------------------------------------------ March June September December 2002 --------- --------- --------- --------- ------------------------- Total revenue $ 363,648 $ 345,261 $ 369,022 $ 412,135 Gross profit 223,009 216,810 228,425 248,293 Income from operations 40,935 51,818 41,984 54,590 Net income 26,443 41,456 31,945 142,001 Net income per share: Basic 0.51 0.71 0.54 2.39 Diluted 0.46 0.64 0.50 2.21 Quarter Ended ------------------------------------------ March June September December 2001 --------- --------- --------- --------- ------------------------- Total revenue $ 342,245 $ 325,072 $ 344,914 $ 367,272 Gross profit 197,804 197,239 211,605 228,378 Income from Operations 18,432 20,441 30,310 50,094 Net income 3,526 6,785 15,374 74,731 Net income per share: Basic 0.07 0.14 0.31 1.51 Diluted 0.07 0.13 0.28 1.35 22. CONSOLIDATING FINANCIAL STATEMENTS Hollywood Entertainment Corporation (HEC) had only one wholly owned subsidiary as of December 31, 2003, Hollywood Management Company (HMC). HMC is a guarantor of certain indebtedness of HEC, including the obligations under the new credit facilities and the 9.625% senior subordinated notes due 2011. Prior to June 2000, HEC had a wholly owned subsidiary, Reel.com (Reel), that was merged with and into HEC in June 2000. The consolidating condensed financial statements below present the results of operations and financial position of the subsidiaries of the Company. Consolidating Condensed Balance Sheet December 31, 2003 (in thousands) ---------- ---------- ---------- ---------- HEC HMC Elimin- Consol- ations idated ---------- ---------- ---------- ---------- ASSETS Cash and cash equivalents $ 2,259 $ 71,874 $ - $ 74,133 Cash held by trustee for Refinancing - - Accounts receivable, net 24,796 461,250 (452,059) 33,987 Merchandise inventories 129,864 - - 129,864 Prepaid expenses and other current assets 10,041 3,192 - 13,233 Total current assets 166,960 536,316 (452,059) 251,217 Rental inventory, net 268,748 - - 268,748 Property & equipment, net 265,257 23,600 - 288,857 Goodwill, net 66,678 - - 66,678 Deferred income tax asset 104,302 - - 104,302 Other assets, net 14,469 7,194 (4,008) 17,655 Total assets $ 886,414 $ 567,110 $ (456,067) $ 997,457 LIABILITIES & SHAREHOLDERS' EQUITY (DEFICIT) Current maturities of long-term obligations $ 647 $ - $ - $ 647 Subordinated notes to be Retired with cash held by Trustee (including accrued Interest of $8.1 million) - - - - Accounts payable 452,059 159,586 (452,059) 159,586 Accrued expenses 22,907 94,960 - 117,867 Accrued interest - 6,467 - 6,467 Income taxes payable - 284 - 284 Total current liabilities 475,613 261,297 (452,059) 284,851 Long-term obligations, less current portion 370,669 - - 370,669 Other liabilities 16,108 - - 16,108 Total liabilities 862,390 261,297 (452,059) 671,628 Common stock 489,247 4,008 (4,008) 489,247 Unearned compensation (133) - - (133) Retained earnings (accumulated deficit) (465,090) 301,805 - (163,285) Total shareholders' equity equity (deficit) 24,024 305,813 (4,008) 325,829 Total liabilities and shareholders equity (deficit) $ 886,414 $ 567,110 $ (456,067) $ 997,457 Consolidating Condensed Balance Sheet December 31, 2002 (in thousands) ---------- ---------- ---------- ---------- HEC HMC Elimin- Consol- ations idated ---------- ---------- ---------- ---------- ASSETS Cash and cash equivalents $ 2,045 $ 31,100 $ - $ 33,145 Cash held by trustee for Refinancing - 218,531 - 218,531 Accounts receivable, net 20,529 218,517 (204,050) 34,996 Merchandise inventories 97,307 - - 97,307 Prepaid expenses and other current assets 11,995 2,777 - 14,772 Total current assets 131,876 470,925 (204,050) 398,751 Rental inventory, net 260,190 - - 260,190 Property & equipment, net 234,964 20,533 - 255,497 Goodwill, net 64,934 - - 64,934 Deferred income tax asset 147,813 - - 147,813 Other assets, net 17,361 5,838 (4,008) 19,191 Total assets $ 857,138 $ 497,296 $ (208,058) $1,146,376 LIABILITIES & SHAREHOLDERS' EQUITY (DEFICIT) Current maturities of long-term obligations $ 27,678 $ - $ - $ 27,678 Subordinated notes to be Retired with cash held by Trustee (including accrued Interest of $8.1 million) 203,940 8,140 - 212,080 Accounts payable 204,050 158,423 (204,050) 158,423 Accrued expenses 16,852 91,580 - 108,432 Accrued interest - 2,923 - 2,923 Income taxes payable - 1,151 - 1,151 Total current liabilities 452,520 262,217 (204,050) 510,687 Long-term obligations, less current portion 361,068 - - 361,068 Other liabilities 17,472 - - 17,472 Total liabilities 831,060 262,217 (204,050) 889,227 Common stock 503,403 4,008 (4,008) 503,403 Unearned compensation (697) - - (697) Retained earnings (accumulated deficit) (476,628) 231,071 - (245,557) Total shareholders' equity equity (deficit) 26,078 235,079 (4,008) 257,149 Total liabilities and shareholders equity (deficit) $ 857,138 $ 497,296 $ (208,058) $1,146,376 Consolidating Condensed Statement of Operations Twelve months ended December 31, 2003 (in thousands) --------- --------- --------- --------- HEC HMC Elimin- Consol- ations idated --------- --------- --------- --------- Revenue $1,685,424 $ 151,186 $(154,062)$1,682,548 Cost of revenue 664,632 - - 664,632 Gross profit 1,020,792 151,186 (154,062) 1,017,916 Operating costs & expenses: Operating and selling 700,477 23,659 - 724,136 General & administrative 211,914 48,172 (154,062) 106,024 Store opening expenses 4,768 - - 4,768 Restructuring charges: Closure of Internet business - - - - Store closures (2,106) - - (2,106) Income from operations 105,739 79,355 - 185,094 Interest income - 38,818 (38,059) 759 Interest expense (74,325) - 38,059 (36,266) Early debt retirement (12,467) - - (12,467) Income before income taxes 18,947 118,173 - 137,120 (Provision for) income taxes (7,409) (47,439) - (54,848) Net income $ 11,538 $ 70,734 - $ 82,272 Consolidating Condensed Statement of Operations Twelve months ended December 31, 2002 (in thousands) --------- --------- --------- --------- HEC HMC Elimin- Consol- ations idated --------- --------- --------- --------- Revenue $1,492,941 $ 156,057 $(158,932)$1,490,066 Cost of revenue 573,529 - - 573,529 Gross profit 919,412 156,057 (158,932) 916,537 Operating costs & expenses: Operating and selling 637,739 10,034 - 647,773 General & administrative 199,254 49,280 (158,932) 89,602 Store opening expenses 3,093 - - 3,093 Restructuring charges: Closure of Internet business (12,430) - - (12,430) Store closures (828) - - (828) Income from operations 92,584 96,743 - 189,327 Interest income - 31,619 (31,125) 494 Interest expense (73,676) - 31,125 (42,551) Early debt retirement (3,534) - (3,534) Income before income taxes 15,374 128,362 - 143,736 (Provision for) income taxes 146,577 (48,468) - 98,109 Net income $ 161,951 $ 79,894 - $ 241,845 Consolidating Condensed Statement of Operations Twelve months ended December 31, 2001 (in thousands) --------- --------- --------- --------- HEC HMC Elimin- Consol- ations idated --------- --------- --------- --------- Revenue $1,382,378 $ 154,075 $(156,950)$1,379,503 Cost of revenue 544,477 - - 544,477 Gross profit 837,901 154,075 (156,950) 835,026 Operating costs & expenses: Operating and selling 610,274 11,069 - 621,343 General & administrative 204,563 48,769 (156,950) 96,382 Restructuring charges: Closure of Internet business (3,256) - - (3,256) Store closures (3,778) - - (3,778) Amortization of intangibles 4,683 375 - 5,058 Income from operations 25,415 93,862 - 119,277 Interest income - 35,438 (35,021) 417 Interest expense (91,567) - 35,021 (56,546) Income(loss) before income taxes (66,152) 129,300 - 63,148 (Provision for) income taxes 85,109 (47,841) - 37,268 Net income $ 18,957 $ 81,459 $ - $ 100,416 Consolidating Condensed Statement of Cash Flows Twelve months ended December 31, 2003 (in thousands) ---------- ---------- ---------- HEC HMC Consol- idated ---------- ---------- ---------- Operating activities: Net income $ 11,539 $ 70,733 $ 82,272 Adjustments to reconcile net income to cash provided by operating activities: Depreciation & amortization 275,404 7,472 282,876 Tax benefit from exercise of stock options 8,053 - 8,053 Change in deferred rent (1,364) - (1,364) Change in deferred income taxes 43,512 - 43,512 Non-cash stock compensation 564 - 564 Net change in operating assets & liabilities 218,729 (243,851) (25,122) Cash provided by operating activities 556,437 (165,646) 390,791 Investing activities: Purchases of rental inventory, net (220,364) - (220,364) Purchase of property & equipment, net (82,909) (11,214) (94,123) Increase in intangibles & other assets (1,917) (899) (2,816) Refinancing proceeds - 218,531 218,531 Cash used in investing activities (305,190) 206,418 (98,772) Financing activities: Proceeds from the sale of common stock, net - - - Issuance of subordinated debt - - - Extinguishment of Subordinated debt (250,000) - (250,000) Repayments of capital lease obligations (8,869) - (8,869) Repurchase of common stock (26,275) - (26,275) Proceeds from exercise of stock options 4,066 - 4,066 Decrease in revolving loans, net 30,047 - 30,047 Cash provided by financing activities (251,031) - (251,031) Increase in cash and cash equivalents 216 40,772 40,988 Cash and cash equivalents at beginning of year 2,045 31,100 33,145 Cash and cash equivalents at end of year $ 2,261 $ 71,872 $ 74,133 Consolidating Condensed Statement of Cash Flows Twelve months ended December 31, 2002 (in thousands) ---------- ---------- ---------- HEC HMC Consol- idated ---------- ---------- ---------- Operating activities: Net income $ 161,951 $ 79,894 $ 241,845 Adjustments to reconcile net income to cash provided by operating activities: Extraordinary loss on Extinguishment of debt 2,226 - 2,226 Depreciation & amortization 276,505 5,528 282,033 Tax benefit from exercise of stock options 12,814 - 12,814 Change in deferred rent (1,368) - (1,368) Change in deferred income taxes (109,417) - (109,417) Non-cash stock compensation (1,633) - (1,633) Net change in operating assets & liabilities (200,961) 136,050 (64,911) Cash provided by operating activities 140,117 221,472 361,589 Investing activities: Purchases of rental inventory, net (288,079) - (288,079) Purchase of property & equipment, net (36,326) (7,928) (44,254) Increase in intangibles & other assets (61) (724) (785) Refinancing proceeds - (218,531) (218,531) Cash used in investing activities (324,466) (227,183) (551,649) Financing activities: Proceeds from the sale of common stock, net 113,073 - 113,073 Issuance of subordinated debt 225,000 - 225,000 Repayments of capital lease obligations (13,816) - (13,816) Proceeds from exercise of stock options 4,604 - 4,604 Decrease in revolving loans, net (144,466) - (144,466) Cash provided by financing activities 184,395 - 184,395 Increase in cash and cash equivalents 46 (5,711) (5,665) Cash and cash equivalents at beginning of year 1,999 36,811 38,810 Cash and cash equivalents at end of year $ 2,045 $ 31,100 $ 33,145 Consolidating Condensed Statement of Cash Flows Twelve months ended December 31, 2001 (in thousands) ---------- ---------- ---------- HEC HMC Consol- idated ---------- ---------- ---------- Operating activities: Net income $ 18,957 $ 81,459 $ 100,416 Adjustments to reconcile net income to cash provided by operating activities: Depreciation & amortization 244,521 6,370 250,891 Non-cash asset write downs Tax benefit from exercise of stock options (61) - (61) Change in deferred rent (598) - (598) Change in deferred income taxes (38,396) - (38,396) Non-cash stock compensation 7,371 - 7,371 Net change in operating assets & liabilities 4,238 (49,978) (45,740) Cash provided by operating activities 236,032 37,851 273,883 Investing activities: Purchases of rental inventory, net (202,790) - (202,790) Purchase of property & equipment, net (7,063) (1,739) (8,802) Increase in intangibles & other assets (137) (654) (791) Cash used in investing activities (209,990) (2,393) (212,383) Financing activities: Debt financing costs (4,656) - (4,656) Repayments of long-term obligations (17,399) - (17,399) Proceeds from exercise of stock options 1,097 - 1,097 Increase in revolving loan, net (5,000) - (5,000) Cash provided by financing activities (25,958) - (25,958) Increase in cash and cash equivalents 84 35,458 35,542 Cash and cash equivalents at beginning of year 1,915 1,353 3,268 Cash and cash equivalents at end of year $ 1,999 $ 36,811 $ 38,810 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, as of March 12, 2004. Hollywood Entertainment Corporation By: /S/ TIMOTHY R. PRICE --------------------------- Timothy R. Price Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated as of March 12, 2004 Signatures Title /S/ MARK J. WATTLES ----------------------- Mark J. Wattles Chairman of the Board of Directors, and Chief Executive Officer (Principal Executive Officer) /S/ F. BRUCE GIESBRECHT ----------------------- F. Bruce Giesbrecht President and Chief Operating Officer and Director /S/ TIMOTHY R. PRICE ----------------------- Timothy R. Price Chief Financial Officer (Principal Financial and Accounting Officer) /S/ WILLIAM P. ZEBE ----------------------- William P. Zebe Director /S/ JAMES N. CUTLER JR. ----------------------- James N. Cutler Jr. Director /S/ DOUGLAS GLENDENNING ----------------------- Douglas Glendenning Director