-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, AIq+oNC2ddxYdY8QJSYQXlCLNT40z9T7jZfhEwDns86Cge8I//BAXFUGnRuUh4t9 FACfIc7XBfTV9P5nOD57hQ== 0000905895-04-000013.txt : 20041021 0000905895-04-000013.hdr.sgml : 20041021 20041021171423 ACCESSION NUMBER: 0000905895-04-000013 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20040930 FILED AS OF DATE: 20041021 DATE AS OF CHANGE: 20041021 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HOLLYWOOD ENTERTAINMENT CORP CENTRAL INDEX KEY: 0000905895 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-VIDEO TAPE RENTAL [7841] IRS NUMBER: 930981138 STATE OF INCORPORATION: OR FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-21824 FILM NUMBER: 041090201 BUSINESS ADDRESS: STREET 1: 9275 SW PEYTON LANE CITY: WILSONVILLE STATE: OR ZIP: 97070 BUSINESS PHONE: 5035701600 MAIL ADDRESS: STREET 1: 9275 SW PEYTON LANE CITY: WILSONVILLE STATE: OR ZIP: 97070 10-Q 1 r10q-930.txt CURRENT REPORT ON FORM 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 0-21824 HOLLYWOOD ENTERTAINMENT CORPORATION (Exact name of registrant as specified in charter) OREGON 93-0981138 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 9275 S.W. Peyton Lane, Wilsonville, Oregon 97070 (Address of principal executive offices) (zip code) (503) 570-1600 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such short period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] As of October 19, 2004 there were 60,906,808 shares of the registrant's Common Stock outstanding. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited, in thousands, except per share amounts) Three Months Ended Nine Months Ended September 30, September 30, ------------------ --------------------- 2004 2003 2004 2003 -------- -------- ---------- ---------- REVENUE: Rental product revenue $325,379 $337,306 $1,028,905 $1,031,784 Merchandise sales 85,175 64,652 247,568 177,208 -------- -------- ---------- ---------- 410,554 401,958 1,276,473 1,208,992 COST OF REVENUE: Cost of rental product 93,253 104,641 307,952 327,408 Cost of merchandise 60,509 46,672 182,984 128,222 -------- -------- ---------- ---------- 153,762 151,313 490,936 455,630 -------- -------- ---------- ---------- GROSS MARGIN 256,792 250,645 785,537 753,362 Operating costs and expenses: Operating and selling 194,580 181,791 576,321 531,328 General and administrative 27,347 25,650 86,706 81,200 Store opening expenses 460 1,219 1,497 3,942 Restructuring charges for store closures - - (190) - ------- -------- ---------- ---------- 222,387 208,660 664,334 616,470 ------- -------- ---------- ---------- INCOME FROM OPERATIONS 34,405 41,985 121,203 136,892 Non-operating expense: Interest expense, net (7,772) (7,879) (23,031) (25,715) Early debt retirement - - - (12,467) -------- -------- ---------- ---------- Income before income taxes 26,633 34,106 98,172 98,710 Provision for income taxes (10,653) (13,636) (39,269) (39,484) -------- -------- ---------- ---------- NET INCOME $ 15,980 $ 20,470 $ 58,903 $ 59,226 ======== ======== ========== ========== - ----------------------------------------------------------------------------- Net income per share: Basic $ 0.26 $ 0.34 $ 0.98 $ 0.98 Diluted $ 0.25 $ 0.32 $ 0.94 $ 0.92 - ----------------------------------------------------------------------------- Weighted average shares outstanding: Basic 60,788 60,942 60,349 60,482 Diluted 62,846 64,624 62,657 64,414 - ----------------------------------------------------------------------------- The accompanying notes are an integral part of this financial statement HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts) -------------------------- September 30, December 31, 2004 2003 ------------ ----------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 145,929 $ 74,133 Receivables, net 29,287 33,987 Merchandise inventories 136,422 129,864 Prepaid expenses and other current assets 13,351 13,233 ------------ ----------- Total current assets 324,989 251,217 Rental inventory, net 267,029 268,748 Property and equipment, net 275,918 288,857 Goodwill 67,737 66,678 Deferred income tax asset, net 73,508 104,302 Other assets 15,519 17,655 ------------ ----------- $ 1,024,700 $ 997,457 ============ =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current maturities of long-term obligations $ 547 $ 647 Accounts payable 142,821 159,586 Accrued expenses 122,061 117,867 Accrued interest 992 6,467 Income taxes payable 2,926 284 ----------- ----------- Total current liabilities 269,347 284,851 Long-term obligations, less current portion 350,862 370,669 Other liabilities 15,349 16,108 ----------- ----------- 635,558 671,628 Shareholders' equity: Preferred stock, 25,000,000 shares authorized; no shares issued and outstanding - - Common stock, 100,000,000 shares authorized; 60,853,693 and 59,666,347 shares issued and outstanding, respectively 493,524 489,247 Unearned compensation - (133) Accumulated deficit (104,382) (163,285) ----------- ----------- Total shareholders' equity 389,142 325,829 ----------- ----------- $ 1,024,700 $ 997,457 =========== =========== The accompanying notes are an integral part of this financial statement. HOLLYWOOD ENTERTAINMENT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited, in thousands) Nine Months Ended September 30, -------------------- 2004 2003 --------- --------- Operating activities: Net income $ 58,903 $ 59,226 Adjustments to reconcile net income to cash provided by operating activities: Write-off deferred financing costs - 5,827 Amortization of rental product 143,120 158,552 Depreciation 47,232 45,675 Amortization of deferred financing costs 2,507 1,910 Tax benefit from exercise of stock options 5,754 7,485 Change in deferred rent (759) (1,146) Change in deferred taxes 30,793 27,694 Non-cash stock compensation 133 432 Net change in operating assets and liabilities: Receivables 4,700 10,457 Merchandise inventories (6,559) (31,014) Accounts payable (16,765) (21,361) Accrued interest (5,475) (10,113) Other current assets and liabilities 6,562 (7,353) --------- --------- Cash provided by operating activities 270,146 246,271 --------- --------- Investing activities: Purchases of rental inventory, net (141,401) (152,388) Purchase of property and equipment, net (34,293) (70,798) Increase in intangibles and other assets (1,271) (1,088) Proceeds from indenture trustee - 218,531 --------- --------- Cash used in investing activities (176,965) (5,743) --------- --------- Financing activities: Extinguishment of subordinated debt - (250,000) Borrowings under new term loan - 200,000 Repayment of prior revolving loan - (107,500) Decrease in credit facilities (20,000) (55,000) Debt financing costs - (7,454) Repayments of capital lease obligations (437) (7,818) Repurchase of common stock (3,665) (9,412) Proceeds from capital lease obligation 529 - Proceeds from exercise of stock options 2,188 3,452 --------- --------- Cash used in financing activities (21,385) (233,732) --------- --------- Increase in cash and cash equivalents 71,796 6,796 Cash and cash equivalents at beginning of year 74,133 33,145 --------- --------- Cash and cash equivalents at end of third quarter $ 145,929 $ 39,941 ========= ========= The accompanying notes are an integral part of this financial statement. HOLLYWOOD ENTERTAINMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to those rules and regulations, although Hollywood Entertainment Corporation (the "Company") believes that the disclosures made are adequate to make the information presented not misleading. The information furnished reflects all adjustments (consisting of normal recurring adjustments) that are, in the opinion of management, necessary to provide a fair statement of the results for the interim periods presented. These financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission. Results of operations for interim periods may not necessarily be indicative of the results that may be expected for the full year or any other period. (1) Accounting Policies The Consolidated Financial Statements included herein have been prepared in accordance with the accounting policies described in Note 1 to audited Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003. 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 gross profit, net income or shareholders' equity. The Company accounts for its stock option plans under the recognition and measurement principles of Accounting Principles 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. (in thousands, except per share amounts) Three Months Nine Months Ended September 30, Ended September 30, -------- -------- -------- -------- 2004 2003 2004 2003 -------- -------- -------- -------- Net income, as reported $ 15,980 $ 20,470 $ 58,903 $ 59,226 Add: Stock-based compensation expense included in reported net income, net of tax 0 80 80 259 Deduct: Total stock-based employee compensation expense under fair value based method for all awards, net of tax (1,038) (1,723) (3,731) (6,206) -------- -------- -------- -------- Pro forma net income $ 14,942 $ 18,827 $ 55,252 $ 53,279 ======== ======== ======== ======== Earnings per Share: Basic--as reported $ 0.26 $ 0.34 $ 0.98 $ 0.98 Basic--pro forma 0.25 0.31 0.92 0.88 Diluted--as reported 0.25 0.32 0.94 0.92 Diluted--pro forma $ 0.24 $ 0.30 $ 0.90 $ 0.85 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 a material impact on the Company's financial position or results of operations. (2) Merger Agreement On March 28, 2004 the Company signed a definitive merger agreement with Carso Holdings Corporation ("Carso") and its wholly owned subsidiary, Hollywood Merger Corporation ("Merger Corp"), both affiliates of Leonard Green & Partners, L.P. ("LGP"), which provided for the merger of Merger Corp into the Company with the Company surviving as a wholly owned subsidiary of Carso. On October 14, 2004, the Company filed a current report on Form 8-K announcing that the Company had executed an amended and restated merger agreement with Carso and Merger Corp, dated as of October 13, 2004. The amended and restated merger agreement reduces the merger consideration from $14.00 to $10.25 per share and includes other modifications, including the elimination of the termination fee previously payable to LGP and restrictions on the Company's ability to solicit offers from other interested acquirors. If the merger is completed as contemplated by the amended and restated merger agreement, Hollywood Entertainment shareholders, except for Mark Wattles, the Company's founder, Chairman and Chief Executive Officer, and other members of senior management who will acquire Carso common stock, will receive $10.25 per share in cash. Mr. Wattles will continue in his current capacities following the merger and will own 50% of the common stock and 50% of the junior preferred stock of Carso on a fully diluted basis. Green Equity Investors IV, LP will own 50% of the common stock of Carso, 50% of the junior preferred stock of Carso, and all of the senior preferred stock of Carso on a fully dilutive basis. The Company entered into the amended and restated merger agreement following the unanimous recommendation of a special committee comprised of the independent directors of the Company's Board of Directors (the "Special Committee"). The Special Committee and the Board of Directors received a fairness opinion from Lazard Freres & Company, LLC as to the consideration to be received by the Company's shareholders pursuant to the amended and restated merger agreement. The closing of the merger is subject to terms and conditions customary for transactions of its type, including shareholder approval and the completion of financing. The parties to the amended and restated merger agreement anticipate completing the merger in January 2005. (3) 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 that 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 newer 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. (4) PROPERTY AND EQUIPMENT Property and equipment as of September 30, 2004 and December 31, 2003 consists of (in thousands): --------------------- 2004 2003 --------- ---------- Fixtures and equipment $ 242,115 $ 229,183 Leasehold improvements 497,685 469,070 Equipment under capital lease 1,950 4,644 Leasehold improvements under capital lease - 6,725 --------- ---------- 741,750 709,622 Less accumulated depreciation and amortization (465,832) (420,765) --------- ---------- $ 275,918 $ 288,857 ========= ========== Depreciation expense related to property, plant and equipment was $15.4 million and $15.7 million for the three months ended September 30, 2004 and 2003, respectively, and $47.2 million and $45.7 million for the nine months ended September 30, 2004 and 2003, respectively. (5) Statements of Changes in Shareholders' Equity A summary of changes to shareholders' equity amounts for the nine months ended September 30, 2004 is as follows (in thousands, except share numbers): Common Stock Unearned ------------------- Compen- Accumulated Shares Amount sation Deficit Total ---------- -------- -------- --------- -------- Balance at 12/31/2003 59,666,347 $489,247 $ (133) $(163,285) $325,829 ---------- -------- -------- --------- -------- Issuance of common stock: Stock options exercised 1,482,485 2,188 2,188 Stock options tax benefit 5,754 5,754 Stock compensation - 133 133 Repurchase of common stock (295,139) (3,665) (3,665) Net income 58,903 58,903 ---------- -------- -------- --------- -------- Balance at 09/30/2004 60,853,693 $493,524 $ - $(104,382) $389,142 ========== ======== ======== ========= ======== (6) 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 $60.6 million and $179.5 million for the three months and the nine months ended September 30, 2004, respectively, compared to $56.7 million and $167.5 million for the corresponding periods of the prior year. Most operating leases require payment of additional occupancy costs, including property taxes, utilities, common area maintenance and insurance. These additional occupancy costs were $12.4 million and $37.0 million for the three months and the nine months ended September 30, 2004, respectively, compared to $11.3 million and $34.4 million for the corresponding periods of the prior year. At December 31, 2003, the last fiscal year-end date, 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 (7) LONG-TERM OBLIGATIONS AND LIQUIDITY The Company had the following long-term obligations as of September 30, 2004 and December 31, 2003 (in thousands): September 30, December 31, ------------ ----------- 2004 2003 ------------ ----------- Borrowings under credit facilities $ 125,000 $ 145,000 Senior subordinated notes due 2011 (1) 225,000 225,000 Obligations under capital leases 1,409 1,316 ------------ ----------- 351,409 371,316 Current portion: Capital leases 547 647 Total long-term obligations ------------ ----------- net of current portion $ 350,862 $ 370,669 ============ =========== (1) Coupon payments at 9.625% are due semi-annually in March and September. If the merger described in Note 2 is completed, the Company's capital structure is expected to change significantly. In connection with the proposed merger, the Company anticipates the senior subordinated notes due 2011 and the current term loan credit facility will be retired and replaced with new financing arrangements. The new arrangements would substantially increase the long-term obligations of the Company. The senior subordinated notes due 2011 are redeemable, at the option of the Company, beginning 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 indenture governing 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 the holder's notes at 101% of principal amount thereof. At September 30, 2004, the Company was in compliance with the restrictions, covenants, and other terms of the indenture. Hollywood Management Company, and any future subsidiaries of Hollywood Entertainment Corporation, are guarantors under the credit agreement. On January 16, 2003, the Company completed the closing of the senior secured credit facilities from a syndicate of lenders led by UBS Warburg LLC. The 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 prior credit facilities that 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 specified 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 September 30 2004, the Company was in compliance with all covenants contained in the agreement. Maturities on long-term obligations at September 30, 2004 for the next five years are as follows (in thousands): Capital Year Ending Subordinated Credit Leases December, 31 Notes Facility & Other Total - ------------ ---------- ---------- --------- --------- 2004 $ - $ - $ 153 $ 153 2005 - - 594 594 2006 - - 578 578 2007 - 20,000 84 20,084 2008 - 105,000 - 105,000 Thereafter 225,000 - - 225,000 ---------- ---------- --------- --------- $ 225,000 $ 125,000 $ 1,409 $ 351,409 ---------- ---------- --------- --------- (8) Earnings per Share Earnings per basic share are calculated based on income available to common shareholders and the weighted-average number of common shares outstanding during the reported period. Earnings per diluted share include additional dilution from the effect of potential issuances of common stock, such as stock issuable pursuant to the exercise of stock options. The following tables are reconciliations of the earnings per basic and diluted share computations (in thousands, except per share amounts): Three Months Ended September 30, ---------------------------------------------------------- 2004 2003 --------------------------- ----------------------------- Net Per Share Net Per Share Income Shares(1) Amounts Income Shares(1) Amounts ------- --------- ------- -------- --------- -------- Income per basic share: $ 15,980 60,788 $ 0.26 $ 20,470 60,942 $ 0.34 Effect of dilutive ======= ======= securities: Stock options - 2,058 - 3,682 ------- --------- -------- --------- Income per diluted share: $ 15,980 62,846 $ 0.25 $ 20,470 64,624 $ 0.32 ======= ========= ======= ======== ========= ======== (1) Represents weighted average shares outstanding. Antidilutive stock options excluded from the calculation of income per diluted share were 4.0 million shares and 1.1 million shares for the three months ended September 30, 2004 and 2003, respectively. Nine Months Ended September 30, ----------------------------------------------------------- 2004 2003 ---------------------------- ----------------------------- Net Per Share Net Per Share Income Shares(1) Amounts Income Shares(1) Amounts ------- --------- -------- -------- ------- ---------- Income per basic share: $58,903 60,349 $ 0.98 $ 59,226 60,482 $ 0.98 Effect of dilutive ======= ========= securities: Stock options - 2,308 - 3,932 ------- --------- -------- ------- Income per diluted share: $58,903 62,657 $ 0.94 $ 59,226 64,414 $ 0.92 ======= ========= ======== ======== ======= ========= (1) Represents weighted average shares outstanding. Antidilutive stock options excluded from the calculation of income per diluted share were 4.1 million shares and 1.2 million shares in the nine months ended September 30, 2004 and 2003, respectively. (9) Store Closure Restructuring At September 30, 2004, there were no remaining stores to be closed pursuant to the Company's store closure plan adopted in December of 2000 and amended in December of 2001, 2002 and 2003. As a result, the remaining balance of $0.2 million was reversed in the second quarter of 2004. (10) Commitments and Contingencies 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 received preliminary approval on August 10, 2004 of an agreement to settle these claims and expects final approval in June 2005. Notice to class members began on October 10, 2004 and will last for six months. The Company believes it has provided adequate reserves in connection with these lawsuits. The Company is aware of eight lawsuits filed in the circuit courts of Oregon for the counties of Clackamas and Multnomah related to the proposed merger of the Company with an affiliate of Leonard Green & Partners, L.P. (LGP) pursuant to the initial Agreement and Plan of Merger, dated as of March 28, 2004, among the Company and affiliates of LGP (the "March 28 Merger Agreement"). These purported class action and derivative suits each seek a court order enjoining completion of the Merger, and costs and attorneys' fees to the plaintiffs' lawyers. Some of the suits additionally request damages in an unstated amount allegedly suffered by the Company's shareholders by reason of the March 28 Merger Agreement. The Clackamas County suits were consolidated and, on July 28, 2004, the parties to the Clackamas and Multnomah County suits entered into a memorandum of understanding regarding a potential settlement of claims. The Company described, in a current report on Form 8-K filed July 8, 2004, the terms of the proposed settlement, which included additional disclosure in the Company's proxy statement regarding the merger, modifications to the termination fee and shareholder approval requirements in the March 28 Merger Agreement, covenants from an affiliate of LGP regarding the future sale of the Company, and payment of $995,000 of the plaintiff's attorney fees. The Company provided a reserve for this litigation that it believed was adequate. An amended and restated merger agreement was entered into on October 13, 2004. Plaintiffs in the consolidated cases have informed the Company of their intent to file a consolidated complaint that includes allegations regarding the amended and restated merger agreement. It is not clear how the reduction in the per share consideration and other changes in the amended and restated merger agreement will affect the settlement negotiations and there is no assurance that a settlement will be effected or that current reserves for this litigation will be adequate. In 2003, the Company was named as a defendant in two complaints regarding wage and hour claims in California. In 2004, an additional lawsuit was filed with substantially similar claims. The plaintiffs are seeking to certify a class action alleging that certain California employees were denied meal and rest periods. There are several additional related wage and hours claims for unpaid overtime, late payment of wages and off the clock work. A mediation took place on September 9, 2004 and the parties reached a settlement of all claims alleged in each of the actions. The parties will jointly move for preliminary approval of the settlement in November 2004. Following preliminary approval, notice of the settlement will be provided to class members. The Company believes it has provided adequate reserves in connection with these lawsuits. In addition, 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 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. At September 30, 2004, the commitments and contingencies reserve was $9.3 million. At December 31, 2003, the commitments and contingencies reserve was $6.8 million. (11) Related Party Transactions In July 2001, Boards, Inc. (Boards) began to open Hollywood Video stores as a 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 1,973 stores operated by the Company. Mark Wattles, the Company's founder and Chief Executive Officer, 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. Boards is in compliance with the 30 day payment terms under the arrangement. The outstanding balance of $0.5 million due the Company is related to current activity. As of September 30, 2004, Boards operated 20 stores. The following table reconciles the net receivable balance due from Boards, Inc. (in thousands): --------------------- --------------------- Three Months Ended Nine Months Ended September 30, September 30, --------------------- --------------------- 2004 2003 2004 2003 -------- -------- -------- -------- Beginning Receivable Balance $ 985 $ 468 $ 1,509 $ 631 -------- -------- -------- -------- License fee - 50 25 225 (2%)Royalty Fees 135 101 398 233 Products & Services 2,249 2,173 7,303 6,549 -------- -------- -------- -------- Expenses 2,384 2,324 7,726 7,007 Payments (2,826) (2,135) (8,692) (6,981) -------- -------- -------- -------- Ending Balance September 30 $ 543 $ 657 $ 543 $ 657 ======== ======== ======== ======== (12) Segment Reporting In 2003, in an effort to ensure the creation of a "gamer" culture within its game departments, the Company began managing its business as two separate segments, Hollywood Video and Game Crazy. The Hollywood Video segment represents the Hollywood Video stores and the Game Crazy segment represents the in-store game departments. Beginning with the 2003 annual report on Form 10-K, the Company chose to present its financial results pursuant to the guidelines for segment reporting under FAS 131, including the presentation of operating income by segment. When calculating operating income by segment, in addition to any direct costs incurred as a result of operating the game departments, the Company also allocated a portion of the Company's total corporate overhead based on needed resources to support game departments. Assigned costs included costs associated with information technology support, treasury and accounting functions and other general and administrative services. Three Months Ended Three Months Ended September 30, 2004 September 30, 2003 ------------------------------ ------------------------------ Hollywood Game Hollywood Game Video Crazy Total Video Crazy Total ---------- -------- ---------- ---------- -------- ---------- Revenues $ 349,197 $ 61,357 $ 410,554 $ 363,030 $ 38,928 $ 401,958 Depreciation 13,605 1,745 15,350 14,360 1,308 15,668 Overhead Allocation (572) 572 - (389) 389 - Income (loss) from operations 38,775 (4,370) 34,405 46,360 (4,375) 41,985 Total assets 913,285 111,415 1,024,700 856,779 88,332 945,111 Purchases of property and equipment, net 7,312 3,194 10,506 18,328 7,085 25,413 Nine Months Ended Nine Months Ended September 30, 2004 September 30, 2003 ------------------------------ ------------------------------ Hollywood Game Hollywood Game Video Crazy Total Video Crazy Total ---------- -------- ---------- ---------- -------- ---------- Revenues $1,104,788 $171,685 $1,276,473 $1,114,771 $ 94,221 $1,208,992 Depreciation 42,486 4,746 47,232 42,718 2,957 45,675 Overhead Allocation (1,665) 1,665 - (942) 942 - Income (loss) from operations 136,093 (14,890) 121,203 149,493 (12,601) 136,892 Total assets 913,285 111,415 1,024,700 856,779 88,332 945,111 Purchases of property and equipment, net 28,428 5,865 34,293 45,675 25,123 70,798 (13) Consolidating Financial Statements Hollywood Entertainment Corporation (HEC) had one subsidiary, Hollywood Management Company (HMC), during the three months ended September 30, 2004. HMC is wholly owned and a guarantor of the senior subordinated notes of HEC. The consolidating condensed financial statements below present the results of operations, financial position and liquidity of HEC and HMC. Consolidating Condensed Statement of Operations Three months ended September 30, 2004 (unaudited, in thousands) ---------- ---------- --------- ---------- HEC HMC Elimin- Consol- ations idated ---------- ---------- --------- ---------- REVENUE $ 411,272 $ 38,326 $ (39,044)$ 410,554 COST OF REVENUE 153,762 - - 153,762 GROSS MARGIN 257,510 38,326 (39,044) 256,792 OPERATING COSTS & EXPENSES: Operating and selling 188,802 5,778 - 194,580 General & administrative 50,526 15,865 (39,044) 27,347 Store Opening Expenses 460 - - 460 Restructuring charge for Store closure - - - - INCOME FROM OPERATIONS 17,722 16,683 - 34,405 Interest income - 8,287 (7,854) 433 Interest expense (16,059) - 7,854 (8,205) Early debt retirement - - - - Equity Earnings in Subsidiary 14,982 - (14,982) - Income before income taxes 16,645 24,970 (14,982) 26,633 Benefit from (provision for) income taxes (665) (9,988) - (10,653) NET INCOME $ 15,980 $ 14,982 $(14,982) $ 15,980 Consolidating Condensed Statement of Operations Three months ended September 30, 2003 (unaudited, in thousands) ---------- ---------- --------- ---------- HEC HMC Elimin- Consol- ations idated ---------- ---------- --------- ---------- REVENUE $ 402,675 $ 31,857 $ (32,574)$ 401,958 COST OF REVENUE 151,313 - - 151,313 GROSS MARGIN 251,362 31,857 (32,574) 250,645 OPERATING COSTS & EXPENSES: Operating and selling 176,323 5,468 - 181,791 General & administrative 51,148 7,076 (32,574) 25,650 Store Opening Expenses 1,219 - - 1,219 Restructuring charge for Store closure - - - - INCOME FROM OPERATIONS 22,672 19,313 - 41,985 Interest income - 9,863 (9,680) 183 Interest expense (17,742) - 9,680 (8,062) Early debt retirement - - - - Equity Earnings in Subsidiary 17,512 - (17,512) - Income before income taxes 22,442 29,176 (17,512) 34,106 Benefit from (provision for) income taxes (1,972) (11,664) - (13,636) NET INCOME $ 20,470 $ 17,512 $(17,512) $ 20,470 Consolidating Condensed Statement of Operations Nine months ended September 30, 2004 (unaudited, in thousands) ---------- ---------- --------- ---------- HEC HMC Elimin- Consol- ations idated ---------- ---------- --------- ---------- REVENUE $1,278,629 $ 113,208 $(115,364)$1,276,473 COST OF REVENUE 490,936 - - 490,936 GROSS MARGIN 787,693 113,208 (115,364) 785,537 OPERATING COSTS & EXPENSES: Operating and selling 558,737 17,584 - 576,321 General & administrative 158,896 43,174 (115,364) 86,706 Store Opening Expenses 1,497 - - 1,497 Restructuring charge for Store closure (190) - - (190) INCOME FROM OPERATIONS 68,753 52,450 - 121,203 Interest income - 26,244 (25,511) 733 Interest expense (49,275) - 25,511 (23,764) Early debt retirement - - - - Equity Earnings in Subsidiary 47,409 - (47,409) - Income before income taxes 66,887 78,694 (47,409) 98,172 Benefit from (provision for) income taxes (7,984) (31,285) - (39,269) NET INCOME $ 58,903 $ 47,409 $ (47,409)$ 58,903 Consolidating Condensed Statement of Operations Nine months ended September 30, 2003 (unaudited, in thousands) ---------- ---------- --------- ---------- HEC HMC Elimin- Consol- ations idated ---------- ---------- --------- ---------- REVENUE $ 1,211,149 $ 109,590 $(111,747)$1,208,992 COST OF REVENUE 455,630 - - 455,630 GROSS MARGIN 755,519 109,590 (111,747) 753,362 OPERATING COSTS & EXPENSES: Operating and selling 517,794 13,534 - 531,328 General & administrative 161,079 31,868 (111,747) 81,200 Store Opening Expenses 3,942 - - 3,942 Restructuring charge for Store closure - - - - INCOME FROM OPERATIONS 72,704 64,188 - 136,892 Interest income - 26,915 (26,185) 730 Interest expense (52,630) - 26,185 (26,445) Equity in Earnings Of Subsidiary 54,323 - (54,323) - Early debt retirement (12,467) - - (12,467) Income before income taxes 61,930 91,103 (54,323) 98,710 Benefit from (provision for) income taxes (2,704) (36,780) - (39,484) NET INCOME $ 59,226 $ 54,323 $ (54,323)$ 59,226 Consolidating Condensed Balance Sheet September 30, 2004 (unaudited, in thousands) ---------- ---------- ---------- ---------- HEC HMC Elimin- Consol- ations idated ---------- ---------- ---------- ---------- ASSETS Cash and cash equivalents $ 2,372 $ 143,557 $ - $ 145,929 Receivables 21,982 417,312 (410,007) 29,287 Merchandise inventories 136,422 - - 136,422 Prepaid expenses and other 9,414 3,937 - 13,351 current assets Total current assets 170,190 564,806 (410,007) 324,989 Rental inventory, net 267,029 - - 267,029 Property & equipment, net 250,242 25,676 - 275,918 Goodwill, net 67,737 - - 67,737 Deferred tax assets, net 73,508 - - 73,508 Other assets, net 360,967 7,772 (353,220) 15,519 Total Assets $1,189,673 $ 598,254 $ (763,227)$1,024,700 LIABILITIES & SHAREHOLDERS' EQUITY (DEFICIT) Current maturities of long-term obligations $ 547 $ - $ - $ 547 Accounts payable 410,007 142,821 (410,007) 142,821 Accrued expenses 23,766 98,295 - 122,061 Accrued interest - 992 - 992 Income taxes payable - 2,926 - 2,926 Total current liabilities 434,320 245,034 (410,007) 269,347 Long-term obligations, less current portion 350,862 - - 350,862 Other liabilities 15,349 - - 15,349 Total liabilities 800,531 245,034 (410,007) 635,558 Common stock 493,524 4,008 (4,008) 493,524 Unearned compensation - - - - Retained earnings (accumulated deficit) (104,382) 349,212 (349,212) (104,382) Total shareholders' equity (deficit) 389,142 353,220 (353,220) 389,142 Total liabilities and shareholders' equity (deficit) $1,189,673 $ 598,254 $(763,227) $1,024,700 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 10,461 7,194 - 17,655 Investment in Subsidiary 305,813 - (305,813) - Total assets $1,188,219 $ 567,110 $ (757,872) $ 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) (163,285) 301,805 (301,805) (163,285) Total shareholders' equity (deficit) 325,829 305,813 (305,813) 325,829 Total liabilities and shareholders equity (deficit) $1,188,219 $ 567,110 $ (757,872) $ 997,457 Consolidating Condensed Statement of Cash Flows Nine months ended September 30, 2004 (unaudited, in thousands) ---------- ---------- ---------- ---------- HEC HMC Elimin- Consol- ation idated ---------- ---------- ---------- ---------- OPERATING ACTIVITIES: Net income $ 58,903 $ 47,409 $ (47,409)$ 58,903 Equity Earnings in subsidiary (47,409) - 47,409 - Adjustments to reconcile net income to cash provided by operating activities: Write-off of deferred financing costs - - - - Depreciation & amortization 188,699 4,160 - 192,859 Tax benefit from exercise of stock options 5,754 - - 5,754 Change in deferred tax asset 30,793 - - 30,793 Change in deferred rent (759) - - (759) Non cash stock compensation 133 - - 133 Net change in operating assets & liabilities (44,308) 26,771 - (17,537) Cash provided by (used in) Operating activities 191,806 78,340 - 270,146 INVESTING ACTIVITIES: Purchases of rental inventory, net (141,401) - - (141,401) Purchase of property & equipment, net (28,056) (6,237) - (34,293) Increase in intangibles & other assets (851) (420) - (1,271) Refinancing Proceeds - - - - Cash used in investing activities (170,308) (6,657) - (176,965) FINANCING ACTIVITIES: Proceeds from the sale of common stock, net - - - - Repayments of capital lease obligations (437) - - (437) Repurchase of Common Stock (3,665) - - (3,665) Proceeds from exercise of stock options 2,188 - - 2,188 Decrease in Credit Facility (20,000) - - (20,000) Debt financing costs - - - - Proceeds from Capital lease Obligations 529 - - 529 Cash used in financing activities (21,385) - - (21,385) Increase in cash and cash equivalents 113 71,683 - 71,796 Cash and cash equivalents at beginning of year 2,259 71,874 - 74,133 Cash and cash equivalents at the end of the third quarter $ 2,372 $ 143,557 $ - $ 145,929 Consolidating Condensed Statement of Cash Flows Nine months ended September 30, 2003 (unaudited, in thousands) ---------- ---------- ---------- ---------- HEC HMC Elimin- Consol- ation idated ---------- ---------- ---------- ---------- OPERATING ACTIVITIES: Net income $ 59,226 $ 54,323 $ (54,323)$ 59,226 Equity Earnings in subsidiary (54,323) - 54,323 - Adjustments to reconcile net income to cash provided by operating activities: Write-off of deferred financing costs 5,827 - - 5,827 Depreciation & amortization 199,948 6,189 - 206,137 Tax benefit from exercise of stock options 7,485 - - 7,485 Change in deferred tax asset 27,694 - - 27,694 Change in deferred rent (1,146) - - (1,146) Non cash stock compensation 432 - - 432 Net change in operating assets & liabilities 204,721 (264,105) - (59,384) Cash provided by (used in) Operating activities 449,864 (203,593) - 246,271 INVESTING ACTIVITIES: Purchases of rental inventory, net (152,388) - - (152,388) Purchase of property & equipment, net (63,186) (7,612) - (70,798) Increase in intangibles & other assets (380) (708) - (1,088) Net Proceeds from indenture trustee - 218,531 - 218,531 Cash used in investing activities (215,954) 210,211 - (5,743) FINANCING ACTIVITIES: Repayment of subordinated debt (250,000) - - (250,000) Borrowings under new term loan 200,000 - - 200,000 Repayment of prior revolving loan (107,500) - - (107,500) Decrease in credit facilities (55,000) - - (55,000) Debt financing costs (7,454) - - (7,454) Repayments of capital lease obligations (7,818) - - (7,818) Repurchase of common stock (9,412) - - (9,412) Proceeds from exercise of stock options 3,452 - - 3,452 Cash used in financing activities (233,732) - - (233,732) Increase in cash and cash equivalents 178 6,618 - 6,796 Cash and cash equivalents at beginning of year 2,045 31,100 - 33,145 Cash and cash equivalents at the end of the third quarter $ 2,223 $ 37,718 $ - $ 39,941 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION ABOUT HOLLYWOOD ENTERTAINMENT We are the second largest rental retailer of movies and video games in the United States. We opened our first Hollywood Video store in October 1988 and, as of September 30, 2004, we operated 1973 Hollywood Video stores in 47 states and the District of Columbia, of which 678 included an in-store game department("Game Crazy"), where game enthusiasts can buy, sell and trade new and used video game hardware, software and accessories. A typical Game Crazy department carries over 2,500 video game titles and occupies an area of approximately 700 to 900 square feet within the store. For the nine months ended September 30, 2004, we derived 80.6% of our revenue from movie and game rental products, 13.4% from the sale of new and used game hardware, software and accessories in our game departments, and 6.0% from the sale of new movies, concessions and video accessories. Although domestic rental spending has remained fairly flat over the past five years and appears to be declining in 2004, we have increased our total revenue through opening new stores, taking market share and selling more used movies. We estimate approximately half of the rental industry's market share remains divided among a relatively large number of smaller independent and regional operators. The studios' 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 our industry in general and Hollywood video in particular, please see "Cautionary Statements". 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 attributable to the release of new technology platforms for game play. 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 video game software. As with the introduction of previous new platforms, consumers have increased both their purchase and rental of games. In addition, the emergence and acceptance of buying, selling and trading used games has caused used game sales to grow rapidly for certain retailers who sell used games, including us. Our strategy is to make Hollywood Video stores a total home entertainment destination. 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. Our 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 games for rent as well as new and used movies and games for sale, in a friendly and inviting atmosphere that encourages browsing. We believe that consumers view movie and game rentals in general, and our pricing structure and rental terms in particular, as a convenient form of entertainment and an excellent value. As it relates to movie sales, our focus is primarily on used movies which we believe offer a better value to those consumers who choose to purchase instead of rent. As it relates to game sales, our approach is to build dedicated departments within the store. This approach, combined with the core concept of buy, sell and trade, along with our employee hiring and training, and inventory selection and merchandising presentation, is designed to appeal to both "hard-core" and casual game consumers. Remerchandising a Hollywood Video to include a game department allows us to leverage our real estate investment and customer traffic, and even though we reduce the area dedicated to movie merchandising in order to make room for a game department, increases rental membership, customer traffic and movie- related revenue and total transactions. Moreover, we believe that there is significant customer overlap, and that our integrated approach provides a competitive advantage by enabling us to offer consumers a total home entertainment destination. 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 use key indicators that are non- GAAP including EBITDA, Adjusted EBITDA, free cash flow and return on investment. 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, judgments and assumptions that are subject to uncertainties that may change as additional information becomes known. Merger Agreement On March 28, 2004 we signed a definitive merger agreement with Carso Holdings Corporation ("Carso") and its wholly owned subsidiary Hollywood Merger Corporation ("Merger Corp"), both affiliates of Leonard Green & Partners, L.P., which provided for the merger of Merger Corp into Hollywood Entertainment with Hollywood Entertainment surviving as a wholly owned subsidiary of Carso. On October 14, 2004, we filed a current report on Form 8-K announcing that we had executed an amended and restated merger agreement with Carso and Merger Corp, dated as of October 13, 2004. The amended and restated merger agreement reduces the merger consideration from $14.00 to $10.25 per share and includes other modifications, including the elimination of the termination fee previously payable to LGP and restrictions on our ability to solicit offers from other interested acquirors. If the merger is completed as contemplated by the amended and restated merger agreement, our shareholders, except for Mark Wattles, our founder, Chairman and Chief Executive Officer, and other members of senior management who will acquire Carso common stock, will receive $10.25 per share in cash. Mr. Wattles will continue in his current capacities following the merger and will own 50% of the common stock and 50% of the junior preferred stock of Carso on a fully diluted basis. Green Equity Investors IV, LP will own 50% of the common stock of Carso, 50% of the junior preferred stock of Carso on a fully diluted basis, and all of the senior preferred stock of Carso. We entered into the amended and restated merger agreement following the unanimous recommendation of a special committee comprised of the independent directors of the Company's Board of Directors (the "Special Committee"). The Special Committee and the Board of Directors received a fairness opinion from Lazard Freres & Company, LLC as to the consideration to be received by our shareholders pursuant to the amended and restated merger agreement. The closing of the merger is subject to terms and conditions customary for transactions of its type, including shareholder approval and the completion of financing. The parties to the amended and restated merger agreement anticipate completing the merger in January 2005. RESULTS OF OPERATIONS Summary Results of Operations Total revenue for the three months and nine months ended September 30, 2004 was $410.6 million and $1,276.5 million, respectively, compared to $402.0 million and $1,209.0 million for the corresponding periods of the prior year. The increase was primarily attributable to the increased number of Hollywood Video stores open, as well as the impact of more game departments and positive same store sales per game department, which more than offset the negative same store revenue from rental products. Our income from operations for the three months ended September 30, 2004 was $34.4 million compared to $42.0 million for the three months ended September 30, 2003. The decrease was attributable to increased operating and selling expenses of $12.8 million, and increased general and administrative expenses of $1.6 million, partially offset by increased gross profit of $6.1 million and a reduction in store opening expenses of $0.8 million. The increase in operating and selling expenses was driven by increased store occupancy costs and repair and maintenance costs of $6.7 million, increased Game Crazy operating expenses of $4.1 million, and increased labor and advertising associated with new video merchandising initiatives of $1.4 million. The increase in general and administrative expenses was attributable to $1.7 million in merger-related expenses. Income from operations for the nine months ended September 30, 2004 was $121.2 million compared to $136.9 million for the nine months ended September 30, 2003. The decrease was attributable to increased operating and selling expenses of $45.0 million and increased general and administrative expenses of $5.5 million, partially offset by increased gross margin of $32.2 million and a reduction in store opening expenses of $2.4 million. The increase in operating and selling expenses was driven by increased store occupancy costs of $16.6 million, increased Game Crazy operating expenses of $17.1 million, increased labor of $4.9 million due to a higher video store count, and increased video advertising of $3.9 million. The increase in general and administrative expenses was attributable to $5.3 million in merger-related expenses. Net income for the three months ended September 30, 2004 was $16.0 million compared to net income of $20.5 million for the three months ended September 30, 2003. The decrease was attributable to the $12.8 million increase in operating and selling expenses and $1.7 million in merger-related expenses, partially offset by increased gross profit of $6.1 million. Net income for the nine months ended September 30, 2004 was $58.9 million compared to net income of $59.2 million for the nine months ended September 30, 2003. The decrease was attributable to increased gross profit of $32.2 million, as well as a $12.5 million expense for early debt retirement in the first quarter of 2003, which causes net income to increase year-over-year by the same amount, offset by the $45.0 million increase in operating and selling expenses and $5.3 million of merger-related expenses for the nine months ended September 30, 2004. 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. Three Months Ended Nine Months Ended September 30, September 30, ------------------- ------------------- 2004 2003 2004 2003 -------- -------- -------- -------- Revenue: Rental product revenue 79.3% 83.9% 80.6% 85.3% Merchandise sales 20.7% 16.1% 19.4% 14.7% -------- -------- -------- -------- 100.0% 100.0% 100.0% 100.0% -------- -------- -------- -------- Gross margin 62.5% 62.4% 61.5% 62.3% Operating costs and expenses: Operating and selling 47.4% 45.2% 45.1% 43.9% General and administrative 6.7% 6.4% 6.8% 6.7% Store opening expense 0.1% 0.3% 0.1% 0.3% Restructuring Charges for Store Closure 0.0% 0.0% 0.0% 0.0% -------- -------- -------- -------- 54.2% 51.9% 52.0% 50.9% -------- -------- -------- -------- Income from operations 8.3% 10.5% 9.5% 11.4% Interest expense, net (1.8%) (2.0%) (1.8%) (2.1%) Early debt retirement 0.0% 0.0% 0.0% (1.1%) -------- -------- -------- -------- Income before income taxes 6.5% 8.5% 7.7% 8.2% Provision for income taxes (2.6%) (3.4%) (3.1%) (3.3%) -------- -------- -------- -------- Net income 3.9% 5.1% 4.6% 4.9% ======== ======== ======== ======== Other data: Rental product gross margin (1) 71.3% 69.0% 70.1% 68.3% Merchandise sales gross margin (2) 29.0% 27.8% 26.1% 27.6% - -------------------------- (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 $8.6 million, or 2.1%, and $67.5 million, or 5.6%, for the three months and nine months ended September 30, 2004, respectively, compared to the three months and nine months ended September 30, 2003. The increases were primarily due to opening new Hollywood Video stores and additional game departments. We operated an additional 109 and 100 weighted-average Hollywood Video stores and 131 and 201 additional weighted-average game departments for the three months and nine months ended September 30, 2004, respectively. Same store sales decreased 2% in the three months ended September 30, 2004 and increased 1% in the nine months ended September 30, 2004. Decreases in same store sales from rental product of 8% and 5% for the three months and nine months ended September 30, 2004 were offset by same store increases for our game departments of 32% and 29%. The following is a summary of revenue by product category (in thousands): Three Months Ended Nine months Ended September 30, September 30, -------------------- ---------------------- 2004 2003 2004 2003 --------- --------- ---------- ---------- DVD rental product revenue $ 229,966 $ 193,208 $ 704,039 $ 550,759 VHS rental product revenue 68,223 117,357 239,648 394,612 Game rental product revenue 27,190 26,741 85,218 86,413 --------- --------- ---------- ---------- Total rental product revenue 325,379 337,306 1,028,905 1,031,784 --------- --------- ---------- ---------- Game Crazy departments 61,357 38,928 171,685 94,221 New movies, concessions and accessories 23,818 25,724 75,883 82,987 --------- --------- ---------- ---------- Total merchandise sales 85,175 64,652 247,568 177,208 --------- --------- ---------- ---------- --------- --------- ---------- ---------- Total revenue $ 410,554 $ 401,958 $1,276,473 $1,208,992 ========= ========= ========== ========== Rental product revenue is generated from the rental of movies and games and from the sale of used movies and games no longer needed as rental inventory. We currently offer a 5-day rental term 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 typically 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 amounts that we do not anticipate collecting. The percentage of rental product revenues generated from extended rental periods has not changed significantly in several years. In the third quarter of 2004 we began to offer nationally the Movie Value Pass (MVP), an in-store movie rental subscription service that allows customers to rent an unlimited number of most new release movies and all catalog movies during the term of the pass, subject to a limit on the number of movies that can be out at one time. Subscription fees are paid up-front and recognized as revenue on a straight-line basis over the applicable term of the pass. Merchandise sales are generated from the sale of new and used game hardware, software and accessories, new movies, concessions and miscellaneous video accessory items. Revenue from our game departments increased 57.6% and 82.2% in the three months and nine months ended September 30, 2004, respectively, compared to the three months and nine months ended September 30, 2003. The increase was primarily due to the addition of 98 new departments and favorable year-over-year increases for existing departments. GROSS MARGIN Rental Product Margin Rental product gross profit as a percentage of rental product revenue ("gross margin") increased to 71.3% and 70.1% for the three months and the nine months ended September 30, 2004, respectively, from 69.0% and 68.3% for the three months and the nine months ended September 30, 2003. The increase was primarily due to a shift in revenue from VHS product to DVD product resulting in an increase in the percentage of new release movies acquired under DVD revenue sharing arrangements, which typically have a higher gross margin than VHS revenue sharing arrangements. Improved inventory management on titles not purchased under revenue sharing arrangements also contributed to the increase in gross margin. Merchandise Sales Margins Merchandise sales gross margin increased to 29.0% for the three months ended September 30, 2004 from 27.8% for the three months ended September 30, 2003. The increase was partially attributable to a decrease in discounts on concession sales related to promotional programs. Merchandise sales gross margin decreased to 26.1% for the nine months ended September 30, 2004 from 27.6% for the nine months ended September 30, 2003. The decrease was primarily the result of an increase in the percentage of revenue from new game sales, which typically have lower gross margins than other product categories, such as used games, accessories and concessions. OPERATING COSTS AND EXPENSES Operating and Selling Expenses Total operating and selling expenses for the three months ended September 30, 2004 increased as a percentage of revenue to 47.4% from 45.2% for the three months ended September,30 2003. Total operating and selling expenses for the three months ended September 30, 2004 increased $12.8 million to $194.6 million from $181.8 million for 2003. The increase was primarily the result of increased variable costs associated with increased total revenue, an increase of 109 weighted-average stores and an increase in operating and selling expenses associated with the expansion of our Game Crazy initiative, including operating an additional 131 weighted-average game departments. Payroll and related expenses increased by $3.6 million, rent and related expenses increased by $5.0 million, utilities increased by $1.4 million, and other operating and selling expenses increased by $2.8 million for the three months ended September 30, 2004 compared to the corresponding period of the prior year. Total operating and selling expenses for the nine months ended September 30, 2004 increased as a percentage of revenue to 45.1% from 43.9% for the nine months ended September 30, 2003. Total operating and selling expense for the nine months ended September 30, 2004 increased $45.0 million to $576.3 million from $531.3 million for 2003. The increase was primarily the result of increased variable costs associated with increased total revenue, an increase of 100 weighted-average stores and an increase in operating and selling expenses associated with the expansion of our Game Crazy initiative, including operating an additional 201 weighted-average game departments. Payroll and related expenses increased by $17.4 million, rent and related expenses increased by $14.5 million, advertising increased by $6.0 million, and other operating and selling expenses increased by $7.1 million for the nine months ended September 30, 2004 compared to the corresponding period of the prior year. General and Administrative Expenses General and administrative expenses for the three months ended September 30, 2004 increased $1.6 million to $27.3 million, or 6.7% of total revenue, from $25.7 million, or 6.4% of total revenue for the three months ended September 30, 2003. Included in the general and administrative expenses for three months ended September 30, 2004 was $1.7 million in merger-related expenses. General and administrative expenses for the nine months ended September 30, 2004 increased $5.5 million to $86.7 million, or 6.8% of total revenue, from $81.2 million, or 6.7% of total revenue for the nine months ended September 30, 2003. Included in the general and administrative expenses for nine months ended September 30, 2004 was $5.3 million in merger-related expenses. NON-OPERATING INCOME (EXPENSE), NET Interest Expense Interest expense, net of interest income, was $7.8 million and $23.0 million for the three months and nine months ended September 30, 2004, respectively compared to $7.9 million and $25.7 million for the corresponding periods of the prior year. The reduction was primarily due to decreased borrowing levels and lower interest rates (see Note 7 to see a detailed table of long-term obligations). 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 non-cash write-off of deferred financing costs. INCOME TAXES Our effective tax rate was 40% for the three months and nine months ended September 30, 2004 compared to 40% for the three months and nine months ended September 30, 2003. Our effective tax rate varies from the federal statutory rate as a result of nondeductible officer's compensation, other permanent items and minimum state income taxes. 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, but excluding any impact of the proposed merger, 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 videocassettes at reduced or no up-front costs, we share with the studio agreed-upon portions of the revenue that we derive from those DVDs or videocassettes. The studio's share of the 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 revenue rather than an investment in rental inventory. Under sell-through pricing, we purchase movies from the studios with no further obligation to make payments to the studios for those movies. 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 $12.0 million and $45.9 million for the three months and nine months ended September 30, 2004 compared to $18.8 million and $70.4 million for the three months and nine months ended September 30, 2003. The decline in revenue sharing expense is primarily the result of an increase in the percentage of movies acquired on DVD compared to VHS, as DVD revenue sharing arrangements typically result in lower net revenue sharing expense than VHS revenue sharing arrangements. MERCHANDISE INVENTORY Merchandise inventory consists of new and used game software, hardware and accessories, new 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 used. Consolidated merchandise inventory increased $6.5 million to $136.4 million as of September 30, 2004, from $129.9 million as of December 31, 2003. The increase was primarily related to the addition of 83 game departments and game inventory increases in existing game departments to support a 29% increase in same store sales in the nine months ended September 30, 2004. LIQUIDITY AND CAPITAL RESOURCES Overview Our primary source of operating cash flow is generated from the rental and sales of movies on DVD and VHS, video game hardware and software, video game and movie accessories, and concessions. The amount of cash generated from operations in nine months ended September 30, 2004 funded our debt service requirements, maintenance capital expenditures, and provided the capital required to open 64 Hollywood Video stores and add 83 game departments. At September 30, 2004, we had $145.9 million of cash and cash equivalents on hand. We believe cash flow from operations, flexibility under our 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." If the merger disclosed above under the heading "Merger Agreement" is completed, our capital structure will change significantly. The financing required to complete the merger transaction will substantially increase our long-term obligations, which will increase our debt service requirements. Information regarding the merger agreement and related financing can be found in the Company's preliminary proxy statement filed on July 8, 2004, as updated by the Company's current report on Form 8-K filed October 14, 2004. The Company will amend its preliminary proxy statement to reflect the amended and restated terms of the merger agreement with affiliates of LGP. Cash Provided by Operating Activities Net cash provided by operating activities increased by $23.9 million, or 9.7%, to $270.1 million for the nine months ended September 30, 2004 compared to $246.3 million for the corresponding period of the prior year. The increase was primarily attributable to favorable changes in working capital accounts including $24.5 million for merchandise inventory driven by a reduction in the number of new game departments opened in the current year period. Cash Used in Investing Activities Net cash used in investing activities was $177.0 million for the nine months ended September 30, 2004 compared to $5.7 million for the corresponding period of the prior year. We opened 64 Hollywood Video stores and added 83 game departments in the nine months ended September 30, 2004 compared to opening 42 Hollywood Video stores and adding 304 game departments in the nine months ended September 30, 2003. Cash used in investing activities for the nine months ended September 30, 2003 includes $218.5 million of proceeds delivered to subordinated note holders on our behalf by the indenture trustee. The delivery of the proceeds to the indenture trustee in the fourth quarter of 2002 and the subsequent use of the proceeds to redeem the notes in the first quarter of 2003 were classified as investing activities. We anticipate investing approximately $85 million in 2004 to open approximately 100 Hollywood Video stores and to add approximately 120 game departments (including the investment in inventory and opening expenses) and for maintenance capital expenditures. In addition, 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 movie trading 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, liquidity and operating results. Cash Used in Financing Activities Net cash flow from financing activities was a $21.4 million use of cash for the nine months ended September 30, 2004 that included a $20 million prepayment on our term loan facility, which is now prepaid through 2006, as well as the repurchase of 295,139 shares of common stock for $3.7 million. Net cash flow from financing activities was a $233.7 million use of cash for the nine months ended September 30, 2003. The use of cash reflected the redemption of $250.0 million of 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. 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 repurchase common stock. At September 30, 2004, we were in compliance with all covenants contained within our debt agreements. At September 30, 2004, 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 $ - $ - $ 153 $ 153 2005 - - 594 594 2006 - - 578 578 2007 - 20,000 84 20,084 2008 - 105,000 - 105,000 Thereafter 225,000 - - 225,000 ---------- ---------- --------- --------- $ 225,000 $ 125,000 $ 1,409 $ 351,409 ---------- ---------- --------- --------- 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. Our stores generally 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, the last fiscal year-end date, 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 September 30, 2004, we had cash and cash equivalents of $145.9 million and a positive working capital balance of $55.6 million. Prior to the second quarter of 2004 we had operated with a working capital deficit. The current period positive working capital balance was primarily due to the discontinuation of prepayments on our term facility and the cessation of all activity related to our share repurchase program in connection with the proposed merger with an affiliate of LGP. Prior to the second quarter of 2004 the working capital deficits were 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 may be 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 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 The preparation of financial statements and related disclosures in conformity with generally accepted accounting principles (GAAP) requires us to make judgments, assumptions and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 1 to the audited Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2003 and Note 1 to the Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q describe the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. Our judgments, assumptions and estimates affect, among other things: the amounts of receivables; rental and merchandise inventories; property and equipment, net; goodwill; deferred income tax assets, net; other liabilities; revenue; cost of revenue; and operating costs and expenses. We base our judgments, assumptions and estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances. Actual results could differ significantly from amounts based on our judgments, assumptions and estimates. Certain critical accounting policies that involve significant judgments, assumptions and estimates which affect amounts recorded in the Consolidated Financial Statements are discussed in our Annual Report on Form 10-K for the year ended December 31, 2003 in Management's Discussion and Analysis of Results of Operations and Financial Condition under the heading "Critical Accounting Policies." For a discussion of new accounting pronouncements, refer to Note 1, "Accounting Policies," to the Consolidated Financial Statements. ITEM 3. 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 September 30, 2004, 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% during the twelve months ended September 30, 2004 our interest expense would have increased by approximately $1.3 million based on our outstanding balance on the facility as of September 30, 2004. ITEM 4. 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. DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934, 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 filed with 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. Failure to complete our proposed merger could negatively impact the market price of our common stock. If the merger is terminated and our board of directors seeks another merger or business combination, shareholders cannot be certain that we will be able to find a partner willing to pay an equivalent or better price than the price to be paid in the merger. Completion of the merger contemplated by the amended and restated merger agreement is subject to a number of contingencies, including approval by a majority of our shareholders (with shares held by Mark J. Wattles counted toward determining the number of shares outstanding, but not counted toward reaching majority approval), the completion of the financing, and other customary closing conditions. Prior to execution of the amended and restated merger agreement, Leonard Green & Partners, L.P. had informed us that, due to industry and market conditions, Leonard Green & Partners, L.P. believed the financing condition to the completion of the merger (on the terms set forth in the original merger agreement dated March 28, 2004) would not be satisfied. Notwithstanding our execution of the amended and restated merger agreement, we do not assure you that a merger with Carso will be completed, or if completed, that it would be completed on terms that do not differ materially from those in the amended and restated merger agreement. In addition, eight class action lawsuits have been filed naming us, the members of our board of directors, one of our executive officers and Leonard Green & Partners. The lawsuits seek to enjoin the completion of the merger. Uncertainties associated with the proposed merger may cause Hollywood to lose key personnel. If the merger is not completed for any reason, Hollywood will be subject to a number of risks, including: - - the market price of Hollywood common stock may decline to the extent the current market price reflects an assumption that the merger will be completed; and - - costs related to the merger, such as legal and accounting fees and a portion of the investment banking fees and, in certain circumstances, termination and expense reimbursement fees, must be paid even if the merger is not completed and will be expensed in the fiscal period in which termination occurs. We face intense competition in the rental and sale of our products. The home video and video game industries are fragmented and highly competitive. We compete for the rental and sale of our products with: - - local, regional and national video retail stores, including those operated by Blockbuster, Inc., the largest video retailer in the United States, and Movie Gallery; - - mass merchants, including Wal-Mart; - - specialty retailers, including GameStop, Electronics Boutique and Suncoast; - - supermarkets, pharmacies, convenience stores, bookstores and other retailers that rent or sell our products as a component, rather than the focus, of their overall business; - - Internet-based mail-delivery home video rental subscription services, such as Netflix; - - mail order operations and online stores, including Amazon.com; and - - noncommercial sources, such as libraries. In particular, substantially all of our stores compete with stores operated by Blockbuster, most in very close proximity. Some of our competitors, including Blockbuster, have significantly greater financial and marketing resources, market share and name recognition than Hollywood. In addition, some retailers sell DVDs and videocassettes at lower prices in order to increase overall traffic to their stores or businesses, and mass merchants may be more willing to sell at lower, or even below wholesale, prices because of the variety of their inventory. As a result of direct competition with Blockbuster and others, pricing strategies for movies and video games is a significant competitive factor in our business. If we do not compete effectively with competitors in the home video industry or the video game industry, our revenues and/or our profit margins could decline and our business, financial condition, liquidity and results of operations could be harmed. New technologies could create competitive advantages for our competitors. Advances in technologies that benefit our competitors may materially adversely effect our business. For example, advances in cable and direct broadcast satellite technologies, including high definition digital television transmissions offered through those systems, may adversely affect public demand for video store rentals. Expanded content available through these media, including movies, specialty programming and sporting events could result in fewer movies being rented. In addition, higher quality resolution and sound offered through these services and technologies could require us to increase capital expenditures: for example, to upgrade our DVD inventory to provide movies in high definition. Cable and direct broadcast satellite technologies 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. Certain cable companies, Internet service providers and others are also 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 pay-per-view, video-on-demand or other alternative movie delivery systems achieve the ability to enable consumers to conveniently view and control the movies they want to see when they want to see them, such alternative movie delivery systems could achieve a competitive advantage over the traditional home video rental industry. This risk would be exacerbated if these competitors receive the movies from the studios at the same time video stores do and by the increased popularity and availability of personal digital recording systems (such as TiVo) that allow viewers to record, pause, rewind and fast forward live broadcasts and create their own personal library of movies. In addition, we may compete in the future with other distribution or entertainment technologies that are either in their developmental or testing phases now or that may be developed in the future. For example, some retailers have begun to rent or sell DVDs through kiosks or vending machines. Additionally, the technology exists to offer disposable DVDs which would allow a consumer to view a DVD an unlimited number of times during a specified period of time, at the end of which the DVD becomes unplayable. We cannot predict the impact that future technologies will have on our business. If any of the technologies described above create a competitive advantage for our competitors, our business, financial condition, liquidity and results of operations could be harmed. 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 home video rental market to exist and compete effectively with mass merchant retailers and other sellers of home movies. 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 margins 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. If the studios were to significantly change their pricing policies in a manner that increases our cost of obtaining movies under revenue sharing arrangements or other arrangements, our revenues and/or profit margins could decrease, and our business, financial condition, liquidity and results of operations could be harmed. We could lose a significant competitive advantage if the movie studios were to adversely change their current distribution practices. Currently, Hollywood Video stores and other retail outlets 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 and other retail outlets 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 home video 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 Hollywood Video 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 video game systems to attract and retain video game customers. We currently anticipate that hardware manufactures will release new products with enhanced features some time within the next few years. If manufacturers fail to introduce or delay the introduction of new video games and systems, the demand for video games available to us could decline, negatively impacting our revenues, and our business, financial condition, liquidity and results of operations could be harmed. In addition, although past introductions of new hardware platforms have expanded sales and rentals, we cannot be certain that the next generation will provide similar benefits to our business. 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 resumed opening Hollywood Video stores and began a significant remerchandising initiative to add Game Crazy departments to existing Hollywood Video stores, opening 41 new Hollywood Video stores and adding 207 Game Crazy departments. In 2003, we opened 102 Hollywood Video stores and added 319 Game Crazy departments. In 2004, we anticipate opening approximately 100 new Hollywood Video stores and adding approximately 120 new Game Crazy departments. This expansion has placed, and may continue to place, increased pressure on our operating and management controls. To manage a larger store base and a growing video game buy, sell and trade business, 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 profitably 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, these newly opened stores could adversely affect the revenues and profitability of other stores in the same 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 and senior management involvement, 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, including Mark J. Wattles, our founder, chairman and chief executive officer. These key management personnel may not be able to continue 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 movies 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. If we experience delays in implementing and testing our internal control over financial reporting, our independent auditors may be unable to attest to our report on its effectiveness, and our stock price could suffer. On October 6, 2004 we received from PricewaterhouseCoopers, our independent auditors, a letter noting that, if our implementation of systems necessary for the auditors' attestation of management's report on internal control over financial reporting is delayed due to remediative or other requirements, our auditors may not have the resources available to timely complete their assessment and report on internal control over financial reporting. Some slippage in our implementation schedule has already occurred due to remediative action on some of our information systems, which has reduced the margin for implementing any additional remediative action. Although we believe our internal control over financial reporting is effective, if management or our independent auditors are unable to report on its effectiveness when we file our annual report for the fiscal year ending December 31, 2004, our stock price may suffer. 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 September 30, 2004, we had total consolidated long-term debt, including capital leases, of approximately $351.4 million. We and our subsidiary could incur substantial additional indebtedness in the future, including the financing required to complete the merger, which will substantially increase our indebtedness. An increase in our indebtedness could intensify the related risks that we now face. 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 September 30, 2004, 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 home video rental records and access and use of 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. We are aware of eight putative class action lawsuits related to the merger agreement. We may incur substantial costs related to our defense and we may 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. We are party to various legal proceedings with respect to which a negative outcome could have a material adverse effect on our operations. In addition to the merger-related litigation described above, we have been named in several purported class action lawsuits alleging various causes of action, including claims regarding our membership application and additional rental period charges. We have been successful in obtaining dismissal of three of the actions filed against us. 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. In 2003, we were named as a defendant in two complaints regarding wage and hour claims in California. In 2004, an additional suit was filed with substantially similar claims. The plaintiffs are seeking to certify a class action alleging that certain California employees were denied meal and rest periods. There are several additional related wage and hours claims for unpaid overtime, late payment of wages and off the clock work. In addition, we have been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. A negative outcome in any of the foregoing actions could harm our business, financial condition, liquidity or results of operations and could cause us to vary aspects of our operations. In addition, prolonged litigation, regardless of which party prevails, could be costly, divert management attention or result in increased costs of doing business. PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We have been named in several purported class action lawsuits alleging various causes of action, including claims regarding its membership application and additional rental period charges. We have vigorously defended these actions and maintain that the terms of our additional rental charge policy are fair and legal. We have been successful in obtaining dismissal of three of the actions filed against us. 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. We received preliminary approval on August 10, 2004 of an agreement to settle these claims and expect final approval in June 2005. Notice to class members began on October 10, 2004 and will last for six months. We believe we have provided adequate reserves in connection with these lawsuits. We are aware of eight lawsuits filed in the circuit courts of Oregon for the counties of Clackamas and Multnomah related to the proposed merger of the Company with an affiliate of Leonard Green & Partners, L.P. (LGP) pursuant to the initial Agreement and Plan of Merger, dated as of March 28, 2004, among Hollywood Entertainment and affiliates of LGP (the "March 28 Merger Agreement"). These purported class action and derivative suits each seek a court order enjoining completion of the Merger, and costs and attorneys' fees to the plaintiffs' lawyers. Some of the suits additionally request damages in an unstated amount allegedly suffered by our shareholders by reason of the March 28 Merger Agreement. The Clackamas County suits were consolidated and, on July 28, 2004, the parties to the Clackamas and Multnomah County suits entered into a memorandum of understanding regarding a potential settlement of claims. We described, in a current report on Form 8-K filed July 8, 2004, the terms of the proposed settlement, which included additional disclosure in our proxy statement regarding the merger, modifications to the termination fee and shareholder approval requirements in the March 28 Merger Agreement, covenants from an affiliate of LGP regarding the future sale of Hollywood Entertainment, and payment of $995,000 of the plaintiff's attorney fees. We provided a reserve for this litigation that we believe was adequate. An amended and restated merger agreement was entered into on October 13, 2004. Plaintiffs in the consolidated cases have informed us of their intent to file a consolidated complaint that includes allegations regarding the amended and restated merger agreement. It is not clear how the reduction in the per share consideration and other changes in the amended and restated merger agreement will affect the settlement negotiations and there is no assurance that a settlement will be effected or that current reserves for this litigation will be adequate. In 2003, we were named as a defendant in two complaints regarding wage and hour claims in California. In 2004, an additional lawsuit was filed with substantially similar claims. The plaintiffs are seeking to certify a class action alleging that certain California employees were denied meal and rest periods. There are several additional related wage and hours claims for unpaid overtime, late payment of wages and off the clock work. A mediation took place on September 9, 2004 and the parties reached a settlement of all claims alleged in each of the actions. The parties will jointly move for preliminary approval of the settlement in November 2004. Following preliminary approval, notice of the settlement will be provided to class members. We believe we have provided adequate reserves in connection with these lawsuits. In addition, we have been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. We believe we have provided adequate reserves for contingencies and that the outcome of these matters should not have a material adverse effect on our consolidated results of operation, financial condition or liquidity. At September 30, 2004, the commitments and contingencies reserve was $9.3 million. At December 31, 2003, the commitments and contingencies reserve was $6.8 million. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS A summary of our purchases of shares of our common stock for the three months ended September 30, 2004 is as follows (in thousands , except share amounts): ISSUER PURCHASES OF EQUITY SECURITIES ------------------------------------------------------------ Period Total Average Total Maximum Number of Price Paid Number of Number(or Shares per Share Shares Approximate Purchased Purchased as Dollar Part of Value) Publicly of Share Announced that May Plans or Yet Be Programs Purchased Under the Plans or Programs(1) --------- --------- --------- --------- July 1-31 - $ - - $ 20,690 August 1-5 - - - $ 20,690 August 6-31 - - - $ 40,951 Sept. 1-30 - - - $ 40,951 --------- --------- --------- Total - $ - - ========= ========= ========= (1) Hollywood's ability to purchase shares under its publicly announced plan is limited by its bank credit facility. The calculation is outlined in our amended credit facility as exhibit 10.1 in our quarterly report on Form 10-Q for the period ended September 30, 2003. We do not intend to make further purchases under the plan while our proposed merger transaction is pending. ITEM 6. EXHIBITS 2.1 Amended and Restated Agreement and Plan of Merger dated October 13, 2004 by and among the Registrant, Carso Holdings Corporation and Hollywood Merger Corporation (incorporated by reference to Exhibit 2.1 to the Registrant's current report on Form 8-K filed October 14, 2004). 2.1(a) Agreement and Plan of Merger dated March 28, 2004 by and among the Registrant, Carso Holdings Corporation and Cosar Corporation (incorporated by reference to Exhibit 2.1 to the Registrant's current report on Form 8-K filed March 29, 2004). (This agreement has been superseded by the agreement listed as Exhibit 2.1). 2.1(b) First Amendment to Agreement and Plan of Merger by and among the Registrant, Carso Holdings Corporation and Cosar Corporation dated June 4, 2004 (incorporated by reference to Exhibit 2.1 to the Registrant's current report on Form 8-K filed June 8, 2004). (This amendment has been superseded by the agreement listed as Exhibit 2.1.) 3.1 1993B Restated Articles of Incorporation, as amended (incorporated by reference to the Registrant's Registration Statement on Form S-1 (File No. 33- 63042), by reference to Exhibit 4 to the Registrant's Registration Statement on Form S-3 (File No. 33-96140), and by reference to Exhibit 3.1 to the Registrant's 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 the Registrant's Registration Statement on Form S-4 (File No. 333-82937). 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 Resolutions adopted by the Board of Directors of the Registrant October 13, 2004 regarding Indemnification of Specified Officers. 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. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HOLLYWOOD ENTERTAINMENT CORPORATION (Registrant) October 21, 2004 /S/Timothy R. Price - ------------------ ------------------------------------------------- (Date) Timothy R. Price Chief Financial Officer (Authorized Officer and Principal Financial and Accounting Officer of the Registrant) EX-10 2 ex101.txt EXHIBIT 10.1 EXHIBIT 10.1 Resolved, that the Company undertakes the following indemnification obligation with respect to each of the management personnel of the Company identified on the attached Annex A with respect to actions taken or to be taken by such person on or before March 31, 2005: The Company shall indemnify to the fullest extent not prohibited by law each person identified on the attached Annex A who is made, or threatened to be made, a party to an action, suit or proceeding, whether civil, criminal, administrative, investigative or other (including an action, suit or proceeding by or in the right of the Company), by reason of the fact that such person is or was a director, an officer, employee or agent of the Company or a fiduciary within the meaning of the Employee Retirement Income Security Act of 1974 with respect to any employee benefit plan of the Company, or serves or served at the request of the Company as a director, officer, employee or agent, or as a fiduciary of an employee benefit plan, of another company, partnership, joint venture, trust or other enterprise. The Company shall pay for or reimburse the reasonable expenses incurred by any such person in any such proceeding in advance of the final disposition of the proceeding if the person sets forth in writing (i) the person's good faith belief that the person is entitled to indemnification hereunder and (ii) the person's agreement to repay all advances if it is ultimately determined that the person is not entitled to indemnification. No modification that limits the Company's obligation hereunder to indemnify any person shall be made without the prior written consent of such person. This obligation shall not be deemed exclusive of any other provisions for indemnification or advancement of expenses of directors, officers, employees, agents and fiduciaries that may be included in any statute, bylaw, agreement, general or specific action of the Board of Directors, vote of shareholders or other document or arrangement. Resolved, that the officers of the Company are authorized and directed to promptly communicate the indemnification obligation above to each of the persons listed on Annex A. Annex A: List of Indemnified Persons All Senior Vice Presidents Don Ekman Mark Moreland Bart Walker Steve Short Bill Besselman EX-31 3 ex311.txt EXHIBIT 31.1 Exhibit 31.1 CERTIFICATION I, Mark J. Wattles, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Hollywood Entertainment Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 20, 2004 /s/ Mark J. Wattles ----------------------- Mark J. Wattles Chief Executive Officer EX-31 4 ex312.txt EXHIBIT 31.2 Exhibit 31.2 CERTIFICATION I, Timothy R. Price, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Hollywood Entertainment Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 20, 2004 /s/ Timothy R. Price ----------------------- Timothy R. Price Chief Financial Officer EX-32 5 ex321.txt EXHIBIT 32.1 Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Hollywood Entertainment Corporation (the "Company") on Form 10-Q for the quarterly period ended September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), each of the undersigned, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of their knowledge: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Mark J. Wattles /s/ Timothy R. Price - ----------------------------- --------------------------- Mark J. Wattles Timothy R. Price Chairman, President and Chief Chief Financial Officer Executive Officer Dated: October 20, 2004 -----END PRIVACY-ENHANCED MESSAGE-----