** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-K**

 

**(MarkOne)**
| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                            |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                                                           |
|       | **For the  fiscal year ended January 2, 2005**                                                                                                                                                                                                                       |
|       |                                                                                                                                                                                                                                                                 |
|       | **OR**                                                                                                                                                                                                                                                               |
|       |                                                                                                                                                                                                                                                                 |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                        |
| ** ** | ** **                                                                                                                                                                                                                                                           |
|       | **For the  transition period from                      to                    .** |

 

**Commission file number:  0-24548**

 

**MOVIE GALLERY, INC.**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                         | ** ** | **63-1120122**                        |
|----------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)      |       | (I.R.S. Employer  Identification No.) |
|                                                                 |       |                                  |
| **900 West Main Street, Dothan, Alabama**                            | ** ** | **36301**                             |
| (Address of principal executive offices)                             |       | (Zip Code)                            |
|                                                                 |       |                                  |
| **(334) 677-2108**                                                   |
| (Registrant’s Telephone Number, including Area Code)            |
|                                                                 |       |                                  |
| Securities registered pursuant to Section 12(b) of  the Act:**None** |
|                                                                 |       |                                  |
| Securities registered pursuant to Section 12(g) of  the Act:         |
| **Common Stock, $.001 par value**                                    |
| (Title of class)                                                     |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  YES  ý  NO  o

 

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

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Act).  YES  ý  NO  o

 

The aggregate marketvalue of the common stock held by non-affiliates of the registrant as of July 4,2004, was approximately $491,028,799, assuming solely for purposes of thiscalculation that all directors and executive officers of the registrant and allstockholders beneficially owning more than 10% of the registrant’s common stockare “affiliates.”  This determination ofaffiliate status is not necessarily a conclusive determination for otherpurposes.

 

The number of shares ofcommon stock outstanding on February 28, 2005 was 31,223,337 shares.

 

Documents incorporated by reference:

1.  Portion ofthe Proxy Statement for the  2005 AnnualMeeting of Stockholders filed with the Secrities and Exchange Commission (PartIII of Form 10-K).

 

The exhibit indexto this report appears at page        .

 

 

----

 

**PART I**

 

**ITEM 1.**  **BUSINESS**

 

**Our Company**

 

Weare the leading home video specialty retailer primarily focused on rural andsecondary markets.  We currently own andoperate approximately 2,500 retail stores, located throughout North America,that rent and sell DVDs, videocassettes and video games.  Our target markets are small towns andsuburban areas of cities with populations generally between 3,000 and 20,000where our primary competitors are typically independently owned stores andsmall regional chains.  We compete withthe other two national chains (Blockbuster and Hollywood) in approximatelyone-third of our store locations.  Sinceour initial public offering in August 1994, we have grown from 97 stores to ourpresent size through acquisitions and new store openings.

 

Webelieve we are the lowest cost operator among the leading national home videospecialty retail chains.  We havedeveloped and implemented a flexible and disciplined business strategy thatcenters on driving revenue growth, maximizing store level productivity andprofitability and minimizing operating costs. By focusing on rural and secondary markets we are able to reduce ouroperating costs through lower rents, flexible leases, reduced labor costs, andeconomies of scale while simultaneously offering a large product assortment.

 

Asa result of our competitive strengths, our operating and growth strategies andour management team, we have achieved substantial growth over the past ninefiscal years.  From fiscal 1995, thefirst full year of operations following our initial public offering, through fiscal2004, total revenues have grown from $149.2 million to $791.2 million, acompound annual growth rate of 20.4%.  Inaddition, over the same period, operating income has grown from $22.8 millionto $87.6 million, a compound annual growth rate of 16.1% and net cash providedby operating activities has grown from $10.2 million to $105.5 million, acompound annual growth rate of 29.6%. (Net cash provided by operatingactivities for fiscal 1995, has been restated to conform with current year presentation.  See Note 1 to our consolidated financialstatements).

 

MovieGallery, Inc. was incorporated in Delaware in June 1994.  Substantially all of our operations areconducted through our wholly-owned subsidiaries, Movie Gallery US, Inc. andMovie Gallery Canada, Inc.  Our executiveoffices are located at 900 West Main Street, Dothan, Alabama 36301, and ourtelephone number is (334) 677-2108.

 

**Pending Acquisitions**

 

OnJanuary 9, 2005, we entered into an Agreement and Plan of Merger (“MergerAgreement”) with Hollywood Entertainment, Inc. (Nasdaq: HLYW) (“Hollywood”) providingfor our acquisition of Hollywood for approximately $850 million in cash plusour assumption of approximately $350 million in debt of Hollywood.  Hollywood is the second largest home videospecialty retailer in the United States, operating approximately 2,000 storesin 47 states and the District of Columbia, some of which contain theapproximately 700 Game Crazy video game specialty retail stores, where gameenthusiasts can buy, sell and trade new and used video game hardware, softwareand accessories.  Pursuant to the MergerAgreement, we will merge a subsidiary of ours with and into Hollywood, withHollywood surviving the merger as our wholly-owned subsidiary.  See Part II Item 7.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations for more information regardingthe pending merger.

 

Consummationof the Hollywood merger is subject to the satisfaction of a variety of closingconditions, including the approval of the proposed merger by the shareholdersof Hollywood and our consummation of the financing necessary to fund theacquisition.  In addition, both we andHollywood have customary termination rights, in some circumstances, including aright by Hollywood to terminate the Merger Agreement to accept an unsolicitedsuperior acquisition proposal.  We canmake no assurances that we will successfully acquire Hollywood or, if we doacquire Hollywood, that we will successfully integrate its business with ourbusiness.

 

2

----

 

OnMarch 2, 2005, we entered into a definitive agreement with VHQ Entertainment,Inc. ("VHQ") to commence a tender offer for all of its outstandingcommon stock at a price of C$1.15 per share. Total consideration for the transaction is approximately C$20.4 million(US $16.5 million), including C$17.5 million in equity and C$2.9 million inassumed debt.  The common stock of VHQtrades on the Toronto Stock Exchange under the symbol “VHQ.”  VHQ owns and operates 61 video rental storesin secondary and suburban markets in Alberta, Saskatchewan and the NorthwestTerritories.

 

The VHQ transaction isconditioned upon, among other matters, the tender of two-thirds of VHQ’soutstanding shares into the offer and the receipt of certain third partyconsents.  Shareholders of VHQEntertainment representing approximately 50% of the outstanding shares havecommitted to tender their shares into our offer.  The transaction is also subject to customaryregulatory approvals, including receipt of notice from the Minister of Culturethat the acquisition provides a net benefit to Canada, consistent with the conditionsof the Investments Canada Act.  

 

**IndustryOverview**

 

***Home Video Industry***

 

*Size and Growth.*  According to Adams Media Research, thedomestic home video industry grew from an estimated $15.3 billion in revenue in1996 to $26 billion in revenue in 2004, representing a 6.85% compound annualgrowth rate, exceeding the 2.3% growth rate of the Consumer Price Index duringthe same period.  Adams Media expectsthis industry to reach $33.7 billion in revenue by 2009, fueled primarily byDVD growth.  At the end of 2004, AdamsMedia estimates that the majority of all domestic television households owned aVCR and approximately 64% owned a DVD player. According to Adams Media, the number of households owning DVD players isexpected to exceed 90% by 2009.  Based onour experience, we believe that for a period of time after a householdpurchases a DVD player,  the household generallyincreases both its rentals and purchases of movies.

 

*Trends.*  The home video specialty retail industrycontinues to experience consolidation, particularly in the rural and secondarymarkets in which we operate.  Adams MediaResearch has estimated that as of the end of 2004 there are approximately24,000 domestic stores in our industry.  Further, the three largest video store chainsaccount for approximately 10,200 stores, or 42% of total domestic stores.  The remaining 58% of total stores arecomprised of independent operators, small chains, franchises and other rentaloutlets.  We believe that the home videospecialty retail industry will continue to consolidate.  Over the past several years, the combinationof increased product offerings, economies of scale, access to capital, andimproved marketing efforts have solidified the positions of the largest retailchains versus independent operators and undercapitalized, second-tier regionalchains.

 

*Interdependence of Movie Studios and Home Video.* Historically, new technologies, including the development of the VCRand, more recently, DVD, have led to the creation of additional distributionchannels for movie studios beyond the traditional movie theater arena. Moviestudios seek to maximize their revenue from distribution channels by releasingmovies in sequential release date “windows” to the various movie distributionchannels.  The order of distribution ofmovies is currently: (1) movie theaters; (2) home video, which includes homevideo specialty retailers such as Movie Gallery and other distribution channelsfor packaged media, such as mass merchant retailers; (3) pay-per-view, whichincludes newer video-on-demand (“VOD”) technologies; and (4) all other sources,including cable and syndicated television. Most movie studios release hit movie titles (defined as movies with boxoffice revenues of more than $80 million) to the home video marketapproximately 45 days prior to the pay-per-view release date.  We believe that this window of release fromthe movie studios is indicative of the importance of the home video retailchannel to the overall profitability of movie studios and other independentmovie suppliers.   We also believe that 

 

3

----

 

because the sequential release method has allowedmovie studios to increase their overall revenues, movie studios will continuethe practice of sequential release even as VOD becomes more readily availableto consumers.  However, we can provide noassurance that the sequential release windows will not be narrowed oreliminated in the future.

 

Accordingto industry sources, home video is currently the largest single source ofdomestic revenue for the movie studios, accounting for approximately 57% ofdomestic studio revenue in 2004.  Only asmall percentage of the movies produced are profitable from the studios’portion of the theatrical box office receipts. As a result, the movie studios depend on the revenues earned from thehome video industry to produce substantial revenues not only from the hitmovies, but from the lower grossing non-hit and direct-to-video movies.  Non-hit movies (defined as movies with boxoffice revenues of less than $80 million) and direct-to-video films accountedfor approximately 75% of our combined purchase dollars and 96% of titlepurchases in 2004.  We do not believethat any other existing movie distribution channel, including VOD, can providea better market for these non-hit and direct-to-video titles than the homevideo retail store.

 

*Product Pricing.*  The home video retail channel is comprised ofboth rentals and sales of DVDs and videocassettes.  We purchase products under revenue sharingarrangements direct from the studios or under fixed cost arrangements withstudios or distributors.

 

Revenuesharing between retailers and movie studios was embraced by the industry in1998.  Under revenue sharing, retailersand movie studios share the risks associated with the rental performance ofindividual titles.  The movie studiosreceive a fee based on a predetermined percentage, typically less than 50% ofthe revenue generated from the rental of these titles.  After a specified period of time, generallysix months, these titles are no longer subject to revenue sharing and areeither purchased by the retailer from the movie studio for a nominal amount orreturned to the studio.  Revenue sharingis now being used by the studios on a broad base of titles in both DVD and VHSformats.  We believe that revenue sharingagreements provide significant advantages to retailers, including:

 

•    allows for substantial increases in both the quantity and selection ofnewly-released video titles at significantly lower up-front costs;

 

•    provides opportunity for increases in revenues as a result of highertransaction volume; and

 

•    further interdependence of movie studios and video retailers.

 

Allmovie releases are available at fixed cost pricing.  Fixed cost pricing is negotiated with thestudio or distributor and is typically less than $20 per copy.

 

***Video Game Industry***

 

Accordingto industry reports, domestic annual retail sales of video game hardware,software and accessories were $9.9 billion in 2004, compared to $10 billion in2003. Total hardware sales declined 27% to $2.4 billion during 2004, primarily dueto an inadequate supply of PlayStation 2  and Xbox units available to retailers in thefall of 2004. Even with a decrease in hardware sales, video game software saleswere up to $6.2 billion in 2004, compared to $5.8 billion in 2003.

 

Accordingto a new report from research firm DFC Intelligence, the worldwide market forvideo games, computer games and interactive hardware and software is forecastedto grow from $23.2 billion in 2003 to as much as $31.6 billion by 2009. Leadingthe market is the Sony PlayStation 2 brand, capturing approximately 51% of thehardware and software sales (not including handheld portables) in 2004.  Other industry leaders are Microsoft Xbox,Nintendo Gameboy, and Nintendo GameCube. Each of the three leading hardware andsoftware companies are expected (according to industry reports) to release newhardware platforms in late 2005 or 2006, helping to drive market expansion.

 

The video game industry ischaracterized by the lifecycles of hardware and software due to the rapidchanges that tend to occur in technology. Growth in this industry is driven by increases in the installed base ofvideo game hardware 

 

4

----

 

systems and is dependent upon theintroduction of new hardware platforms and continued improvement in systemstechnology leading to the development of new game titles.  We believe the video game industry willcontinue to grow as a result of significant technological advancements made inthe last few years.  These advancementsallow for more flexibility and creativity in software development, as well asthe introduction of hardware offering capabilities beyond gaming, such as theability to play DVDs and compact discs and the backward compatibility of gamesoftware.

 

**CompetitiveStrengths**

 

*Primary Focus on Rural and Secondary Markets.*  We aim tolocate newly built stores in small towns or suburban areas of cities withpopulations typically between 3,000 and 20,000 where we can be the marketleader.  We believe our focus on smallermarkets allows us to achieve a higher return on invested capital with substantiallyless risk than we would face in larger urban markets because of the reducedlevel of competition, lower operating costs and our expertise in operating inrural and secondary markets.  Ourprincipal competitors are single store and small chain operators that webelieve generally have smaller advertising budgets than ours, higher cost ofinventory and more limited access to revenue sharing, thus resulting in limitedinventory breadth and depth and less access to capital than we have.

 

Webelieve our market focus also delays competition arising from new technologiessuch as VOD.  We expect that the ruraland secondary markets in which we operate are likely to be among the lastmarkets to build the infrastructure necessary to support VOD.  The typical plant upgrades required todeliver VOD are costly, and as a result, cable and digital subscriber lineoperators have pursued development in higher density areas where they canachieve better returns on invested capital.

 

*Low Cost Operator.*  We believe that we are the lowest costoperator of the leading national chains. In 2004, our average initial investment to build new stores wasapproximately $125,000 per store.  Thisinvestment included leasehold improvements, fixtures,signage, and inventory(net of payables).  We have developed astrategy to minimize operating expenses that includes:

 

•  negotiating favorable lease terms;

 

•  centralized purchasing;

 

•  reduced labor costs; and

 

•  stringent expense controls.

 

*Flexible and Disciplined Business Model.*  We have aflexible and disciplined business model designed to maximize our revenues andreduce our costs.  The key components ofour business model include:

 

•    flexible store formats, which allow us to tailor the size, inventory andlook of each store to fit its locale; our stores average approximately 4,200square feet, and have inventories ranging from approximately 2,500 to 15,000movies and 200 to 1,500 video games for rental;

 

•    short lease terms that allow us to respond quickly to changingdemographics, competition and other market conditions and to closenon-performing stores promptly; our remaining lease terms currently average threeyears with over 400 leases considered for renewal each year;

 

•    inventory management that targets customer demographics and customer preferencesin each of our markets; and

 

•    pricing management, including store specific pricing of promotionalprograms that are managed and modified based upon competitive, demographic andvarious other operating considerations.

 

5

----

 

*Proven Acquisition Strategy.*  From 1994 to 1996, we grew from97 stores to over 860 stores, primarily as a result of an aggressiveacquisition strategy.  In 1999, wereinitiated our opportunistic acquisition strategy.  From the beginning of fiscal 1999 throughFebruary 28, 2005, we acquired 1,016 stores in 113 separate transactions.  Historically, acquired stores have beenrapidly integrated into our operations with minimal disruption.  Typically, we are able to increase revenue andcash flow in our acquired stores due to our product purchasing practices andeconomies of scale.  The average cost ofconverting an acquired store to the Movie Gallery format is minimal andconsists primarily of expenditures related to new signage, implementing ourpoint of sale system and minor remodeling.

 

*Proprietary Information Systems to Drive Revenue and EnhanceProfitability.*  We compete with other home video specialtyretailers to provide our customers with a broad selection of movies and videogames for rental at a competitive price. To help us manage our inventory in the most profitable manner, we havedeveloped proprietary management information systems and a point of sale systemfor our stores designed to enable us to optimize inventory levels, monitorcustomer purchase patterns and selection preferences, as well as providecomparative revenue data on a daily basis. We believe these capabilities enable us to efficiently manage our rentalinventory as well as reallocate rental inventory and adjust our merchandisingselection to meet the specific product selection requirements of individualstores or markets.

 

*Focus on Customer Service.*  We view the personal interactionof our employees with our customers as an integral part of our organizationalculture and point of differentiation from our competitors.  We believe that our culture, together withour established training programs for our hourly employees, store managers andfield management, results in a superior customer experience and higher visitfrequency.  As part of our customerservice initiatives, we maintain a database of approximately 6.0 million activecustomers that captures pertinent customer preferences and purchase history andenables our store associates to provide our customers with useful productrental guidance and offer suggestive selling reminders.  We believe providing prompt, friendly andknowledgeable service helps us ensure higher levels of customer satisfactionand customer loyalty.

 

*Experienced Management Team. *Our executive management team has demonstrated anability to grow our business profitably through both new store openings andacquisitions.  We have a highlyexperienced executive management team with an average of 13 years in home videospecialty retailing and an average of 11 years with us in an industry that isonly approximately 20 years old.  Webelieve this continuity has allowed us to deliver a consistent offering for ourcustomers and in turn generate high levels of customer loyalty.

 

**GrowthStrategy**

 

Thekey objective of our growth strategy is to increase market share in ourexisting and new markets.  The keyelements of our growth strategy are:

 

*Driving Same-Store Revenues and Enhancing Operating Margins.*  We focuson continuous improvement of same-store revenues and profit growth through:

 

•     capitalizing on the continued industry growthdriven by strong DVD trends;

 

•     capitalizing on trends in the video game businesscycle;

 

•     adopting merchandising and pricing initiatives;and

 

•     managing cost through effective budgeting.

 

*Developing New Stores in Attractive Markets.*  Webelieve that the transferability of our standardized retail format, which canbe adapted easily to a variety of locations, and our record of successfullyopening stores provide us with a strong foundation for expansion through newstore development.  Although new storesgenerally require approximately one year for revenues to reach the level ofmature stores, we expect new stores to become profitable within the first sixmonths of operation and produce a positive return on investment withinapproximately 24 months.  We believethere are 2,500 to 3,500 markets available for further potential development inthe United States that fit 

 

6

----

 

our typical market profile.  Additionally, we see expansion opportunitiesin Canada and are researching markets in Mexico, where we operate six stores asof February 28, 2005.  We currentlyexpect to open approximately 400 new stores in 2005 and, subject to market andindustry conditions and the integration of our pending acquisition, ifconsummated, of Hollywood, to continue to open new stores on a similar paceover the next several years.

 

*Pursuing Opportunistic Acquisitions.*  Webelieve that growth through acquisitions is attractive because:

 

•  acquired stores provide an installed base of revenue and cash flow;

 

•  we are able to grow more rapidly, thus providing increased benefits ofscale;

 

•  conversion to our formats and systems provides us with operating efficiencies;and

 

•  acquisitions facilitate rapid expansion into new markets.

 

Inevaluating potential acquisition candidates, we consider a number of factors,including:

 

•  strategic fit and desirability of location;

 

•  price;

 

•  ability to improve productivity and profitability; and

 

•  whether the anticipated return on investment approximates what we expectto generate from expansion through organic growth of new stores.

 

We expectto continue to pursue opportunistic acquisitions, although we anticipate themajority of our growth will be from the opening of new stores.

 

Thefollowing table is a historical summary showing store openings, acquisitionsand store closings since the beginning of fiscal 1999:

 
| ** **                     | ** ** | **Fiscal Year Ended** | ** ** | **January 3 to**       | ** ** |
|--------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                     | ** ** | **January 2,  2000**  | ** ** | **December 31,  2000** | ** ** | **January 6,  2002** | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** | **February 28,  2005** | ** ** |
| ** **                     | ** ** | ** **            | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| New store  openings            |       | 53                    |       | 110                    |       | 77 |   | 145 |   | 241 |   | 314 |   | 36 |   |
|                           |       |                  |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Stores acquired                |       | 131                   |       | 16                     |       | 355 |   | 265 |   | 170 |   | 74 |   | 5 |   |
|                           |       |                  |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Stores closed                  |       | 58                    |       | 69                     |       | 37 |   | 41 |   | 37 |   | 64 |   | 12 |   |
|                           |       |                  |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Total stores at  end of period |       | 963                   |       | 1,020                  |       | 1,415 |   | 1,784 |   | 2,158 |   | 2,482 |   | 2,511 |   |

 

**Products**

 

Weoffer a wide selection of movies and video games for rent and sale.  Our goal is to stock each store with aproduct assortment tailored to that store.  Depending upon location, our stores offer from2,500 to 15,000 movies and from 200 to 1,500 video games for use with mostvideo game platforms.   Our revenues by product category for the lastthree fiscal years were as follows:

 

7

----

 
| ** **                                                 | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                       |       |     |       |     |       |     |       |
| DVD rentals                                                |       | 25       | %          | 38       | %          | 58       | %          |
| VHS rentals                                                |       | 48       | %          | 32       | %          | 12       | %          |
| Video game rentals                                         |       | 10       | %          | 9        | %          | 8        | %          |
| Previously viewed product sales (DVD, VHS and video games) |       | 10       | %          | 12       | %          | 14       | %          |
| Concessions, accessories and other                         |       | 4        | %          | 5        | %          | 5        | %          |
| New movie sales (DVD and VHS)                              |       | 3        | %          | 4        | %          | 3        | %          |

 

Sincefiscal 2000, we have increased our DVD inventory to match demand as ourcustomers transition to the DVD format. Because of the ease of use and durability of DVDs, we expect that DVDswill eventually replace videocassettes. The acquisition costs of DVD hardware have reached levels competitivewith the VCR, and it is estimated that as of the end of 2004, approximately 64%of domestic television households had DVD hardware (Adams Media).  For the fourth quarter of fiscal 2004, DVDrental revenue exceeded 85% of our total movie rental revenue, versusapproximately 65% in the fourth quarter of fiscal 2003 and 40% in the fourthquarter of fiscal 2002.  We monitorconsumers’ acceptance of DVD and adjust purchasing levels as necessary tomaintain the appropriate mix of DVD and VHS inventory in our stores.

 

In 2004, we continuedto refine our video game inventory to achieve an optimum mix of inventoryrelative to the customer demand within each of our markets.  The Sony PlayStation 2 continues to be theleading platform within our stores and generated over 50% of our video gamerevenue in 2004.  We will continue tomonitor inventory mix and make future inventory investments accordingly.  In addition to video games, we offer basicvideo game hardware accessories in many of our stores and we rent and sellvideo game hardware in a select base of stores.

 

In2003, we began testing of Game Zone, a store-in-a-store game concept forselling, renting and trading games.  Wecurrently have approximately 20 test stores open, and, if successful, webelieve this concept could be implemented in approximately 200 of our stores.

 

Wereview our store inventory on an ongoing basis for movies and games that havenot rented for a period of time and offer these previously viewed products forsale.

 

**StoreOperations**

 

Asof February 28, 2005, we operated a total of 2,511 retail stores locatedthroughout North America.

 

Wemaintain a flexible store format, tailoring the size and inventory of each ofour stores to local demographics.  Ourstores average approximately 4,200 square feet, with inventories ranging fromapproximately 2,500 to 15,000 movies and 200 to 1,500 video games for rental.

 

Storeinteriors are designed to create a visually appealing, up-beat ambiance usingbright lighting, vibrant graphics and carpet and coordinating signage.  The inviting atmosphere is augmented by abackground of television monitors displaying MGTV, a customized video program thatplays movie previews and promotions of coming attractions, and by posters andstand-up displays promoting specific movie titles.  Movies are arranged in attractive displayboxes organized into categories by topic, except for new releases, which areassembled alphabetically in their own section for ease of selection bycustomers.  Our stores are open sevendays a week, generally from 10:00 a.m. to 11:00 p.m. on weekends and from 10:00a.m. to 10:00 p.m. on weekdays.

 

We typicallyemploy five to fourteen hourly, part-time associates and one full-time storemanager at our stores.  Store Managersreport to District Managers, who generally supervise the operations of ten to fifteenstores.  The District Managers report toone of 24 Regional Managers, who in turn report to one of five Zone VicePresidents.  The Zone Vice Presidentsreport to one of two Senior Vice Presidents of Store Operations who report to ourExecutive Vice President of Operations and Chief Operating Officer.  We have increased the number of DistrictManagers and Regional Managers over time as necessary to support our growth. Certainmembers of our executive management team conduct regular meetings with the ZoneVice Presidents, and Regional and District Managers to review operations.  Compliance with our policies, procedures andregulations is monitored on a store-by-store basis through exception-basedreporting systems and on-going store and district audits performed by theQuality Assurance department.  Theperformance and results of the quality assurance audits are monitored monthlyby members of executive management.

 

8

----

 

**Site Selection**

 

Wecontinuously search for appropriate markets in which to develop newstores.  In selecting sites for newstores, we use an evaluation process designed to enhance our return oninvestment by focusing on lease terms, demographics, population density,traffic volume, store-front visibility and presence, ease of access, andeconomic development in the market area. We also review the location of competitive stores and customer activityat those stores.

 

We selectboth freestanding sites and sites located in strip centers anchored by majorgrocery or discount drug store chains. Lease terms are a critical element in our site selection process.  In negotiating lease agreements and leaserenewals, we attempt to obtain short lease terms and favorable options toextend terms.  As a result, we have theflexibility necessary to react to changing demographics, competition and othermarket conditions.  To date, we have notexperienced difficulty in obtaining favorable leases or renewals at marketrates in suitable locations.  The currentaverage remaining life of our leases is approximately 3 years, with over 400leases considered for renewal each year.

 

Weactively pursue relocation opportunities to adapt to changes in customershopping patterns and retail market shifts. We regularly review the profitability and prospects of each of ourstores and evaluate whether any underperforming stores should be closed orrelocated to more desirable locations. The cost of closing a store is minimal and usable inventory, signage,fixtures, and equipment are transferred to existing or new locations.

 

**Marketingand Advertising**

 

Weuse market development funds, cooperative allowances from our suppliers andmovie studios, and internal funds to purchase radio, television, direct mail,and newspaper advertising, in-store visual merchandising and in-storemedia.  Through the use of marketdevelopment funds, our trade name is promoted along with a video or gametitle.  Creative copy is prepared by usin conjunction with the movie studios and is placed by our in-house mediabuyers in the appropriate medium.  Wealso prepare a monthly consumer magazine, *Video Buzz*, anda customized video program, *MGTV*, both ofwhich feature Movie Gallery promotional programs and new releases.  Along with these traditional forms ofadvertising, we have developed and implemented a customer loyalty program, *Reel Players. *Theprogram is based on a point system that provides customers the opportunity toearn free rentals and discounts on movie purchases.

 

Fromtime to time we conduct special promotions in our stores to drive customervisits.  For example, periodically weoffer a promotional rental card program similar to a prepaid gift card thatprovides our customers greater discounts on rentals.  We have also conducted nationwide triviagames and we occasionally partner with other major businesses (such asconcession vendors) to help build additional revenue and increase our brandawareness to potential customers.

 

**Studio andDistribution Relationships**

 

We purchasethe majority of our rental and sell-through merchandise directly from moviestudios through revenue sharing and other direct purchase arrangements.  The movies are delivered directly to ourstores by third-party distributors. These distributors function largely as fulfillment agents.  We pay distributors a flat fulfillment feefor packing and shipping product directly to our stores.  Because of our direct relationships with thestudios, we believe that if one of our distributors were unable or unwilling tosatisfy their commitment to us, a viable alternative, such asself-distribution, could be implemented without materially adversely impactingour business.

 

Severalcompanies acquired by us prior to 1997 had pre-existing long-term contractswith Rentrak Corporation under which product would be provided underpay-per-transaction revenue sharing arrangements.  During late 1996, we consolidated existingcontracts with Rentrak into one national agreement which had an expiration datein September 2006.  The contract providedfor minimum gross annual purchase commitments with the ability to satisfy thecumulative obligation as early as December 31, 2003.  In 2004 we satisfied our obligation under thecontract.

 

Wecurrently source our video game inventory through direct relationships withgame manufacturers/publishers and from distributors.

 

9

----

 

**InventoryManagement and Distribution Facility**

 

*Inventory Management.*  We are committed to offering asmany copies and the widest variety of new releases as is necessary to becompetitive within a market, while at the same time keeping our costs as low aspossible.  New DVDs and videocassettesoffered for sale are primarily hit titles promoted by the studios for sell-through,as well as special interest and children’s titles and seasonal titles related to particular holidays.  DVDs, videocassettes and video games utilizedas initial inventory in our newly developed stores consist of excess copies ofolder titles and new release titles from existing stores, supplemented asnecessary by purchases directly from suppliers.

 

Newrelease movie and game products are allocated to individual stores through asystem that considers the revenue levels and customer demographic profiles ofeach store.  Rental history on movietitles is captured for each store and used as a comparison point for futuretitles of a similar genre.

 

*Distribution Facility.*  Inventory for new stores isassimilated at our processing and distribution facility located in Dothan,Alabama.  Excess inventory in existingstores is gathered and supplemented as needed with purchases, and the inventoryis then shipped to our new stores.  Ourdistribution facility also ships store supplies, computer supplies and marketingmaterials to our stores, processes returns to our suppliers and performs stockbalancing for our store chain.

 

**ManagementInformation Systems**

 

Ourstores utilize a proprietary point of sale (POS) system developed by us.  Our POS system provides detailed informationon store operations, including the rental history of titles and dailyoperations for each store, which is telecommunicated to our support center on adaily or weekly basis.  Our POS system isinstalled in all new stores prior to opening and shortly after the closing datefor acquired stores.

 

Allrental and sale information upon customer checkout and return is recorded usingscanned bar code information.  Alltransactional data is transmitted into the management information system at thesupport center.  The data is processedand reports are generated that allow management to effectively monitor storeoperations and inventory, to review rental history by title and location and toassist in making purchasing decisions with respect to new releases.  Our POS system enables us to perform ourmonthly physical inventory using bar code recognition to process human resourceinformation and to provide system-based training modules.

 

Wealso maintain a financial reporting system, relating to the general ledger,human resources/payroll, revenue, and accounts payable functions.  Additional proprietary systems that have beeninternally developed and implemented include a collections system, aprocessing/distribution center system and various other database systems andauditing tools.

 

**Competition**

 

Thehome video specialty retail industry is highly competitive.  We primarily compete with other home videospecialty stores, including stores operated by regional chains and by the twoother national chains, Blockbuster and Hollywood.  From time to time, the two other nationalchains have discussed the implementation of a rural strategy that is focusedmore on the rural and secondary markets that we predominately serve.  Retail pricing strategies for DVDs,videocassettes and video games are a major competitive factor in the home videospecialty industry, and we have fewer financial and marketing resources, lowermarket share and less brand recognition than the two other nationalchains.  We also compete with other businessesoffering DVDs, videocassettes and video games, such as mass merchants,supermarkets, pharmacies, convenience stores, bookstores, online stores, mailorder operations (such as Netflix), and other retailers, as well asnoncommercial sources, such as libraries. We believe the principal competitive factors in the home video specialtyretail industry are store location and visibility, title quality, availabilityand selection, rental period, customer service and pricing.

 

Inaddition to competing with other home video specialty retailers, we competewith all forms of entertainment, such as movie theaters, network and cabletelevision, direct broadcast satellite television, personal video recorders, 

 

10

----

 

internet related activities, live theater,sporting events, and family entertainment centers.  We believe our most significant competitionoutside of the home video specialty retail industry are cable and satellitetelevision providers.  The expandednumber of channels and programming offered by these providers could result inthe rental and purchase of fewer DVDs and videocassettes by consumers.

 

Wealso compete with pay-per-view services offered by cable and satellite providers.  New and recently introduced technologies,such as VOD, enable cable companies and other telecommunication companies tobroadcast a large assortment of movies to homes at scheduled intervalsthroughout the day.  Although VODservices previously offered a limited number of channels and movies atscheduled intervals, developing technologies are enabling providers to transmitsubstantially more movies directly to homes at more frequently scheduled andconvenient intervals throughout the day. Pay-per-view purchases could significantly increase if movies were tobecome available on VOD during the home video rental window or if VOD serviceswere to become more convenient, widely available and accepted.  Further improvements in VOD and othertechnologies, including personal video recorders, could lead to theavailability of a broad selection of movies on demand at a price that iscompetitive with the price of movie rentals and with the functionality of DVDand VHS.  However, we believe moviestudios have a significant interest in maintaining a viable movie rentalbusiness, because the sale of movies to video retail stores and other homevideo outlets currently represents the studios’ largest source of domestic revenue. In addition, we believe that VOD does not represent a material near-termthreat to our business because:

 

•     studios have not yet determined how VOD can enhance revenues instead ofmerely cannibalizing highly lucrative DVD and VHS sales revenue;

 

• VOD does not allowfor the impulse rental opportunities from browsing through lesser-known titlesthat video specialty stores offer;

 

• the technology andinfrastructure to compress and deliver VOD in a scalable, cost-effectivemanner, particularly within our market demographics, has not yet been developedon a significant scale; and

 

•     piracy and other electronic security issues have not yet been adequatelyaddressed.

 

Someretailers 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 toview a DVD an unlimited number of times during a specified period of time, atthe end of which the DVD becomes unplayable. We cannot predict the impact that future technologies will have on ourbusiness.

 

**Seasonality**

 

There is a distinct seasonal pattern to the homevideo business.  Compared to other monthsduring the year, we experience peak revenues during the months of November,December and January due to the holidays in these months as well as inclementweather conditions.  Additionally,revenues generally rise in the months of June, July and August when mostschools are out of session, providing people with additional discretionary timeto spend on entertainment.

 

**IntellectualProperty**

 

We own a number of U.S. and international servicemark registrations, including the marks MOVIE GALLERY and GAME ZONE.

 

**ForeignOperations**

 

For disclosure of enterprise-wide financialinformation by geographic area, refer to Note 9 to our consolidated financialstatements included in Part IV, Item 15 of this Form 10-K.

 

11

----

 

**Employees**

 

Asof February 28, 2005, we employed approximately 23,800 persons, referred to byus as “associates,” including approximately 23,100 in retail stores and theremainder in our support center, field management staff and distributionfacility.  Of our retail associates,approximately 3,300 were full-time and 19,800 were part-time.  None of our associates are represented by alabor union and we believe that our relations with our associates are good.

 

Wehave developed internal hiring, training and retention programs designed toenhance consistent and thorough communication of our operating policies andprocedures as well as increase the rate of internal promotions.  We also have an incentive and discretionarybonus program under which retail management associates receive quarterlybonuses when stores meet or exceed criteria established under the program.  Additionally, we have periodic sales andmarketing programs that provide our associates opportunities to earnincremental bonus compensation based on relative performance to pre-establishedgoals and to actual performance compared to other associates.  We believe our bonus programs rewardexcellence in management, give associates an incentive to improve operations andresult in an overall reduction in the cost of operations.  In addition, certain associates are eligibleto receive bonuses based on individual and overall company performance, andoptions to purchase shares of our common stock, exercisable at the fair marketvalue on the date of grant, subject to service requirements.  Employees meeting prescribed servicerequirements are also eligible to participate in an employee stock purchaseplan established by us.

 

**AvailableInformation**

 

The address of our internet website is *www.moviegallery.com*.  Through links on the Investor Relationsportion of our website, we make available free of charge our Annual Report onForm 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and anyamendments to those reports, filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934. Such material is made available through our website as soon asreasonably practicable after we electronically file or furnish the materialwith the SEC.

 

Youmay also read and copy any materials we file with the SEC at the SEC’s PublicReference Room at 450 Fifth Street, NW, Washington, D.C. 20549.  You may obtain information on the operationof the Public Reference Room by calling the SEC at 1-800-SEC-0330.  Additionally, the SEC maintains a websitethat contains reports, proxy and information statements and other informationregarding Movie Gallery at *www.sec.gov.*

 

**Forward-LookingStatements**

 

This Annual Report on Form 10-K contains forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933, as amended,and Section 21E of the Securities Exchange Act of 1934, as amended, whichrepresent our expectations or beliefs about future events and financial performance.  Forward-looking statements are identifiableby the fact that they do not relate strictly to historical information and mayinclude words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,”“may,” “estimate” or other similar expressions and variations thereof.  In addition, any statements that refer toexpectations, projections or other characterizations of future events orcircumstances are forward-looking statements. Our forward-looking statements are based on management’s current intent,belief, expectations, estimates, and projections regarding our company, ourpending acquisition of Hollywood, and our industry.  Forward-looking statements are subject toknown and unknown risks and uncertainties, including those describedbelow.  In light of these risks,uncertainties and assumptions, the forward-looking events discussed in thisForm 10-K might not occur.  In addition,actual results could differ materially from those suggested by the forward-lookingstatements, and therefore you should not place undue reliance on theforward-looking statements.  We undertakeno obligation to publicly update or revise any forward-looking statements,whether as a result of new information, future events or otherwise.  We desire to take advantage of the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, andin that regard, we caution the readers of this Form 10-K that the followingimportant factors, among others, could affect our actual results of operationsand may cause changes in our strategy with the result that our operations andresults may differ materially from those expressed in any forward-lookingstatements made by us, or on our behalf. We assume no obligation (andspecifically disclaim any such obligation) to update the following cautionarystatements or any other forward-looking statements contained in this Annual Reporton Form 10-K to reflect actual results, changes in assumptions or other factorsaffecting such forward-looking statements.

 

12

----

 

The occurrence of any of the following risks, among others, could have amaterial adverse effect on our financial condition or results of operations:

 

# ***If we are successful in ourefforts to acquire Hollywood, we will incur substantial indebtedness to fundthe acquisition, which could have a material effect on our financial condition.***

# ** **

# **If we acquire Hollywood, we expect to have approximately $1.1billion in long-term indebtedness, as compared to no long-term debt as of January2, 2005.  Our high level of indebtednesscould have significant consequences, including:**

# ** **

•                  our ability to obtain additional financing forworking capital, capital expenditures, additional acquisitions or generalcorporate purposes may be impaired;

•                  we must use a substantial portion of cash flowfrom operations to pay interest and principal on our indebtedness, which willreduce the funds available for other purposes such as capital expenditures anddividends;

•                  if we default on our obligations, our lenders mayforeclose on our assets that secure our indebtedness;

•                  restrictive covenants in the agreements governingour indebtedness and the overall significant amount of indebtedness may reduceour flexibility in planning for, or responding to, changing conditions in ourindustry and making dividend payments and may put us at a competitivedisadvantage; and

•                  we may be more vulnerable to economic downturnsand adverse developments in our business.

 

***The integration of Hollywood and Movie Gallery may strain our resourcesand prove to be difficult and may subject us to liabilities.***

 

Hollywood’srevenue base is significantly larger than Movie Gallery and this merger issubstantially larger than any of our previous acquisitions.  The expansion of our business and operationsresulting from the acquisition of Hollywood, including the differences in thestrategies and infrastructures of our companies, may strain our administrative,operational and financial resources.  Theintegration of Movie Gallery and Hollywood will require substantial time,effort, attention and dedication of management resources and may distractmanagement in unpredictable ways from their other responsibilities.  The integration process could create a numberof potential challenges and adverse consequences, including the possibleunexpected loss of key employees or suppliers, a possible loss of sales, anincrease in operating and other costs and the need to modify operatingaccounting controls and procedures to comply with the Sarbanes-Oxley Act of2002.  In addition, the integration ofHollywood may subject us to liabilities existing at Hollywood, some of whichmay be unknown at the time we consummate the merger.  These types of challenges and uncertaintiescould have a material adverse effect on our business, financial condition,liquidity and results of operation.

 

# ***We may be unable to successfullyimplement our growth strategy.***

# ** **

Ourlong-term strategy is to grow through new store openings and acquisitions ofexisting stores.  Successful implementationof this strategy is contingent upon numerous conditions, and we cannot assureyou that our business plan can be successfully executed.  We require significant capital to open newstores and to acquire existing stores.  Recently,our growth strategy has been funded primarily through proceeds from publicofferings of common stock,  internallygenerated cash flow and bank borrowings. These and other sources of capital, including public or private sales ofdebt or equity securities, may not be available to us in the future on termssatisfactory to us or at all. Additionally, the terms of the instruments governing our existing andfuture indebtedness may limit our ability to make capital expenditures or incurfurther indebtedness in order to open new stores or to acquire existing stores.

 

*New Store Openings.* Our ability to open new stores as planned, and the profitability ofthese new stores, may be adversely affected by a number of factors, including:

 

•                  our ability to identify and secure new sites;

 

13

----

 

•                  our ability to negotiate acceptable leases andtimely implement cost-effective development plans for new stores;

 

•                  the availability of capital;

 

•                  our ability to hire, train and assimilate skilledstore managers and other personnel; and

 

•                  the ability to integrate new stores into existingoperations.

 

Ifwe do not grow as planned, our future earnings expectations could be negativelyimpacted.

 

Ourplanned growth may result in increased pressure on our management andoperations.  We continuously review andmodify our financial controls and management information systems.  There are no assurances that we will be ableto anticipate and respond to, in a timely and sufficient manner, the potentialchanging demands this expansion could have on our operations and business.

 

We also may open storesin markets where we already have significant operations in order to maximizemarket share within these markets.  Ifthis occurs, these newly opened or acquired stores could adversely affect therevenues and profitability of other stores in the same market.  Inaddition, there are no assurances that our new stores will realize revenue orprofitability levels comparable to those of our current stores, or that suchlevels will be achieved within our estimated time frames.

 

*Acquisitions.*  Our ability to acquire stores and operatethem at the desired levels of sales and profitability may be adversely affectedby:

 

•                  our inability to identify acquisition candidatesthat fit our criteria (e.g., size, location and profitability);

 

•                  our inability to consummate identifiedacquisitions due to, among other things, a lack of available capital;

 

•                  a reduction in the number of stores available forpurchase by us due to, among other factors, a decline in the number ofacquisition targets that are willing to sell at prices we consider reasonable;

 

•                  increased competition for acquisitions;

 

•                  misrepresentations and breaches of contracts bysellers;

 

•                  our limited knowledge of the operating history ofthe acquired stores;

 

•                  our failure to rapidly convert the acquiredstores’ operating and informationsystems to our systems and procedures; and

 

•                  our inability to retain and motivate employees ofthe acquired stores.

 

*Pending Acquisition of Hollywood. *Our pending acquisitionof Hollywood is subject to the satisfaction of closing conditions, includingthe approval of the shareholders of Hollywood and our consummation of financingnecessary to fund the acquisition.  As aresult, we may not be successful in acquiring Hollywood.

 

# ***Our business could be adverselyaffected by increased competition.***

# ** **

Fromtime to time, the two other national chains in our industry, includingHollywood, which we have agreed to acquire subject to satisfaction of conditions,have publicly discussed the implementation of a rural strategy that is focusedmore on the rural and secondary markets that we predominately serve.  Therefore, we cannot assure you that Blockbusterand Hollywood (in the event we do not consummate our proposed acquisition) willnot become a more 

 

14

----

 

significant competitive force in our markets.  Even if we complete our proposed acquisitionof Hollywood, Blockbuster could expand its operations in rural markets.  Pricing strategies for movies and video gamesare a major competitive factor in the video retail industry and we have fewerfinancial and marketing resources, lower market share and less name recognitionthan the two larger chains.

 

Othertypes of entertainment, such as theaters, television, personal video recorders,internet related activities, sporting events, and family entertainment centers,also compete with our movie and video game businesses.  If any of our competitors were tosubstantially increase their presence in the markets we serve, our revenuesand/or profitability could decline, our financial condition, liquidity, andresults of operations could be harmed and the continued success of our businesscould be challenged.

 

# ***Our business could be adverselyaffected if we lost key members of our executive management team.***

# ** **

Weare highly dependent on the efforts and performance of our executive managementteam.  If we were to lose any key membersof this team, our business could be adversely affected.  You should read the information under “Directorsand Executive Officers” for a detailed description of our executive managementteam.

 

# ***Our business could be adverselyaffected by the failure of our management information systems to perform as expected.***

# ** **

Wedepend on our management information systems for the efficient operation of ourbusiness.  Our merchandise operations useour inventory utilization system to track rental activity by format for eachindividual movie and video game title to determine appropriate buying,distribution and disposition of our inventory. We also rely on a scalable client-server system to maintain and updateinformation relating to revenue, rental and sales activity, movie and videogame rental patterns, store membership demographics, and individual customerhistory.  These systems, together withour point-of-sale and in-store systems, allow us to control our cash flow, keepour in-store inventories at optimum levels, move our inventory more efficientlyand track and record our performance.  Ifour management information systems failed to perform as expected, our abilityto manage our inventory and monitor our performance could be adverselyaffected, which, in turn, could harm our business and financial condition.

 

***Our financial results could be adversely affected if we are unable tomanage our merchandise inventory effectively.***

 

Our merchandise inventory introduces risksassociated with inventory management, obsolescence and theft.  While most of our retail movie productis returnable to vendors, the investment in inventory necessary to capitalizeon the growing retail market increases our exposure to excess inventories inthe event anticipated sales fail to materialize.  In addition, returns of video game inventory,which is prone to obsolescence risks because of the nature of the industry, aresubject to negotiation with vendors.  Theprevalence of multiple game platforms may make it more difficult to accuratelypredict consumer demand with respect to video games.  The nature of and market for our products,particularly games and DVDs, also makes them prone to risk of theft andloss.  Our exposure is somewhat mitigatedby price protection that is available on certain inventory.  Price protection provides credit for on-handinventory quantities.

 

Our operating results could suffer if we are unableto:

 

•                  maintain theappropriate levels of inventory to support customer demand without buildingexcess inventories;

 

•                  obtain or maintainfavorable terms from our vendors with respect to product returns;

 

•                  control shrinkage resulting from theft, loss orobsolescence; and

 

•                  avoidsignificant inventory excesses that could force us to sell products at adiscount or loss.

 

15

----

 

# ***Our business could be negativelyimpacted if movie studios significantly alter the movie distribution windows.***

# ** **

Studiosdistribute movies in a specific sequence in order to maximize studio revenueson each title they release.  The order ofdistribution of movies is currently: (1) movie theaters; (2) home videoretailers; (3) pay-per-view; and (4) all other sources, including cable andsyndicated television.  Our industry hasan early “window” that is exclusive of most other forms of non-theatrical moviedistribution as noted in “Industry Overview –Home Video Industry– Interdependenceof Movie Studios and Home Video.”  Thelength of the movie rental window varies, but is typically approximately 45 daysprior to the pay-per-view release date. The movie studios are not contractuallyobligated to continue to observe these window periods.  As a result, we cannot be certain that moviestudios will maintain this exclusive window in the future.  We could be adversely affected if the moviestudios shorten or eliminate these exclusive windows, or if the movie rentalwindows were no longer among the first windows following the theatricalrelease, because newly released movies would be made available earlier throughother forms of non-theatrical movie distribution.  As a result, consumers would no longer needto wait until after the home video distribution window to view these moviesthrough other distribution channels. Changes like these could negatively impact the demand for our productsand reduce our revenues and could harm our business, financial condition,liquidity, and results of operations.

 

# ***Our business may be negativelyimpacted by new and existing technologies.***

# ** **

Advances in technologiesthat benefit our competitors may materially and adversely affect ourbusiness.  For example, advances in cableand direct broadcast satellite technologies, including high definition digitaltelevision transmissions offered through those systems, may adversely affectpublic demand for video store rentals. Expanded content available through thesemedia, including movies, specialty programming and sporting events, couldresult in fewer movies being rented.  Inaddition, higher quality resolution and sound offered through these servicesand technologies could require us to increase capital expenditures, forexample, to upgrade our DVD inventories to provide movies in high definition.

 

Cable and directbroadcast satellite technologies offer both movie channels, for whichsubscribers pay a subscription fee for access to movies selected by theprovider at times selected by the provider, and pay-per-view services, forwhich subscribers pay a discrete fee to view a particular movie selected by thesubscriber.  Historically, pay-per-viewservices have offered a limited number of channels and movies and have offeredmovies only at scheduled intervals.  Overthe past five years, however, advances in digital compression and otherdeveloping technologies have enabled cable and satellite companies, and mayenable internet service providers and others, to transmit a significantlygreater number of movies to homes at more frequently scheduled intervalsthroughout the day.  Certain cablecompanies, internet service providers and others are also testing or offeringvideo-on-demand, (VOD) services.  As aconcept, VOD provides a subscriber with the ability to view any movie includedin a catalog of titles maintained by the provider at any time of the day.

 

If pay-per-view, VOD or anyother alternative movie delivery systems achieve the ability to enable consumersto conveniently view and control the movies they want to see, when they want tosee them, such alternative movie delivery systems could achieve a competitiveadvantage over the traditional home video rental industry.  This risk would be exacerbated if thesecompetitors receive the movies from the studios at the same time video storesdo and by the increased popularity and availability of personal digitalrecording systems (such as TiVo) that allow viewers to record, pause, rewind,and fast forward live broadcasts and create their own personal library ofmovies.

 

In addition, we maycompete in the future with other distribution or entertainment technologiesthat are either in their developmental or testing phases now or that may bedeveloped in the future.  For example,some retailers have begun to rent or sell DVDs through kiosks or vendingmachines.  Additionally, the technologyexists to offer disposable DVDs, which would allow a consumer to view a DVD anunlimited number of times during a specified period of time, at the end ofwhich the DVD becomes unplayable.  Wecannot predict the impact that future technologies will have on our business.

 

If any of thetechnologies described above create a competitive advantage for ourcompetitors, our business, financial condition, liquidity, and results ofoperations could be harmed.  Our industryhas experienced negative 

 

16

----

 

same-store revenues in the rental business in recent quarters.  While we cannot ascertain the extent to whichthese declines are attributable to any of the specific technologicaldevelopments described above, we cannot assure you that these declines will notrecur.

 

***Our business could be adversely affected ifconsumers decide to purchase rather than rent movies.***

** **

Historically,studios priced a number of movies they distributed at pricing which wastypically too high to generate significant consumer demand to purchase thesemovies.  A limited number of titles werereleased at a lower price point when consumers were believed to be more likelyto have a desire to purchase a certain title. The penetration of DVD into the market has resulted in a significantincrease in the quantity of newly released movies available for purchase by theconsumer.  These movies are purchased torent by home video specialty retailers, and to sell by both home videospecialty retailers and mass merchants, among others.  Retail margins are generally lower thanrental margins.  Some of our competitors,such as online stores, mass merchants and warehouse clubs may operate atmargins lower than ours and may be able to distribute and sell movies at lowerprice points than us.  These competitorsmay even be willing to sell movies below cost due to their broad inventorymix.  Further decreases in studio pricingand/or sustained or further depressed pricing by competitors could result inincreased consumer desire to purchase rather than rent movies and could resultin increased competition.  If we are notable to derive most of our revenues from our higher margin rental business, ourprofit levels would be adversely impacted and we may not be able to competewith our competitors for the consumer’s sell-through dollar.

 

# ***Our business could be adverselyimpacted if movie studios negatively altered revenue sharing programs.***

# ** **

Priorto studio revenue sharing programs and the advent of DVD, we would typicallypay between $35 and $65 per videocassette for major theatrical releases notpriced as sell-through titles.  Understudio revenue sharing programs, we are able to pay a minimal up-front cost perunit and thereafter pay a percentage of each revenue dollar earned for aspecified period of time to the studios. We currently utilize these types of programs on a significant number ofDVD and VHS movie releases.  Theseprograms have enabled us to significantly increase the number of copies carriedfor each title, thereby enabling us to better meet consumer demand.  After a specified period of time, we offerthem for sale to our customers as “previously viewed movies” at lower pricesthan new copies of the movie.  We couldbe adversely affected if these programs are changed to give the movie studios agreater percentage of each revenue dollar or if they are discontinued.  Further, some of our agreements may beterminated on short notice.

 

***Our gross margins may be adversely affectedif the average sales price for our previously viewed product is not at or abovean expected price.***

 

Weearn rental revenues from video rentals and from the sale of previously viewedmovies to the public.  We need to sellpreviously viewed movies at an expected price in order to achieve our grossmargin targets.  Our gross margins may beadversely affected if the number of rentals we expect to generate does notmaterialize or if the average sales price for previously viewed movies is notat or above our target price.

 

Aconsumer’s desire to own a particular movie and the number of previously viewedmovies available for sale to the public by our competitors are factors that affectour ability to sell previously viewed movies at our target price.  Additionally, sales of previously viewedmovies also compete with newly released movies that are priced forsell-through.  As a result, there are noassurances that we will be able to sell an appropriate quantity of previouslyviewed movies at or above the expected price. If selling prices for previously viewed movies or previously playedgames decline, we may be required to write-down the carrying value of ourrental inventory.

 

# ***The video store industry could beadversely affected by conditions impacting the motion picture industry.***

# ** **

Theavailability of new movies produced by the movie studios is vital to ourindustry.  The quality and quantity ofnew movies available in our stores could be negatively impacted by factors thatadversely affect the motion picture industry, such as financial difficulties,regulatory requirements and work disruptions involving key personnel such aswriters or actors.  A decrease in thequality and quantity of new movies available in our stores could result inreduced consumer demand, which could negatively impact our revenues and harmour business and financial position.

 

17

----

 

# ***Our business could be adversely affectedif video game software and hardware manufacturers do not introduce new productsin a timely manner.***

# ** **

Thevideo game industry is characterized by the significant impact on consumerspending that accompanies the introduction of new game software and hardwareplatforms.  Retail spending in the videogame industry typically grows rapidly with the introduction of new platformsbut declines considerably prior to the release of new platforms.  Consumer demand for video games available inour stores could be adversely affected if manufacturers fail to introduce newgames and systems in a timely manner.  Adecline in consumer demand for video games available in our stores couldnegatively affect our revenues and harm our business and financial position.

 

***Our business may be negatively impacted by our participation in newbusiness initiatives.***

 

Weare currently exploring various new business initiatives.  These new initiatives include a gamestore-within-a-store concept (“Game Zone”), movie and game trading within ourstores, and various other alternatives for delivery of media content.  We cannot assure you that these initiativeswill be either successful or profitable. Our earnings could be negatively impacted by investments in theseinitiatives.

 

***Piracy of the products we offer may adversely affect our results ofoperations.***

 

The development of theinternet and related technologies increases the threat of piracy by making iteasier to duplicate and widely distribute pirated content.  We cannot assure you that movie studios andothers with rights in the product will take steps to enforce their rightsagainst internet piracy or that they will be successful in preventing thedistribution of pirated content. Technological developments and advances of products such as at-home DVDburners also may increase piracy of movies and games.  Increased piracy could negatively affect ourrevenues and results of operations.

 

***The value of our securities may be affected by variances in ourquarterly operating results that are unrelated to our long-term performance.***

 

Historically,our quarterly operating results have varied, and we anticipate that they willvary in the future.  Factors that maycause our quarterly operating results to vary, many of which we cannot control,include:

 

•      consumer demand for our products;

 

•      prices at which we can rent or sell our products;

 

•      timing, cost and availability of newly-released movies, new video gamesand new video game systems;

 

•      competition from providers of similar products,  other forms of entertainment, and specialevents, such as the Olympics or ongoing major news events of significant publicinterest;

 

•      seasonality;

 

•      acquisitions by us of existing stores;

 

•      variations in the timing and number of store openings;

 

•      profitability of new stores;

 

•      weather patterns that can significantly increase business (inclementconditions that prohibit outdoor activities) or decrease business (mildtemperatures and dry conditions that reduce the consumer’s desire to relaxindoors); and

 

18

----

 

•      acts of God (such as the unprecedented hurricane activity that affectedour southeastern market in the fall of 2004) or public authorities, war, civilunrest, fire, floods, earthquakes, acts of terrorism, and other matters beyondour control.

 

***Ourrevenues and operating results fluctuate on a seasonal basis and may suffer ifrevenues during peak seasons do not meet expectations.***

 

The home video retailindustry generally experiences relative revenue declines in April and May, duein part to the change in Daylight Savings Time and due to improved weather, andin September and October, due in part to the start of the traditional schoolyear and the introduction of new television programs.  The industry typically experiences peakrevenues during the months of November,December and January due to the holidays in these months as well as inclementweather conditions.  Additionally,revenues generally rise in the months of June, July and August when mostschools are out of session, providing people with additional discretionary timeto spend on entertainment.** **The game sales business is traditionallystrongest in November and December, as title releases are often clusteredaround the holiday shopping season.

 

In view of seasonalvariations in our revenues and operating results, comparisons of our revenuesand operating results for any period with those of the immediately precedingperiod or the same period of the preceding fiscal year may be of limitedrelevance in evaluating historical financial performance and predicting futurefinancial performance. Our working capital, cash and short-term borrowings alsofluctuate during the year as a result of the factors set forth above.

 

Our operating results maysuffer if revenues during peak seasons do not meet expectations. If revenuesduring these periods do not meet expectations, we may not generate sufficientrevenue to offset increased costs incurred in preparation for peak seasons andoperating results may suffer. Finally, the operational risks describedelsewhere in these risk factors may be exacerbated if the events describedtherein were to occur during a peak season.

 

***The market price for our common stock may fluctuate substantially.***

 

Wehave experienced, and continue to expect, periodic fluctuations in our stockprice due to technological advancements, developments concerning our business,our competitors or the home video specialty retail industry, includingfluctuations in our operating results, the introduction of new products, theperformance of other similar companies, changes in financial estimates byfinancial analysts or our failure to meet these estimates and otherfactors.  In addition, in recent yearsthe stock market has experienced a high level of price and volume volatility,and market prices for the stock of many companies have experienced widefluctuations that have not necessarily been related to the operatingperformance of these companies.  Thesebroad market fluctuations could have a material adverse effect on the marketprice of our common stock, business, and results of operations or financialcondition.  While we have historicallyexperienced relatively low volatility in our stock price, we cannot assure youthat our stock price will not experience significant fluctuations in thefuture.

 

Historically,companies that have experienced market price volatility have been the target ofsecurities class action litigation.  Wecould incur significant costs and our management’s time and resources could bediverted from the operation of our business if we were the target of securitiesclass action litigation.

 

***Terrorism, war or other acts of violencecould have a negative impact on our stock price or our business.***

 

Terroristattacks, as well as the on-going events in Iraq or other acts of violence andcivil unrest in the nation and throughout the world, could influence thefinancial markets and the economy. Consumers’ television viewing habits may be altered as a result of theseevents such that the demand for home video entertainment is reduced.  These factors could have a negative impact onour results of operations or our stock price.

 

19

----

 

**Directorsand Executive Officers**

 

Thefollowing table sets forth the name, age and position held by each of ourexecutive officers and directors, as of February 28, 2005:

** **
| **Name**                | ** ** | **Age** | ** ** | **Position(s) Held**                                                                       |
|-------------------------|------------|---------|------------|--------------------------------------------------------------------------------------------|
| J. T. Malugen           |       | 53      |       | Chairman of the Board,  President and Chief Executive Officer                              |
| H. Harrison Parrish     |       | 56      |       | Vice Chairman of the Board and  Senior Vice President – Concessions                   |
| Jeffrey S. Stubbs       |       | 42      |       | Executive Vice President –  Operations and Chief Operating Officer                    |
| S. Page Todd            |       | 43      |       | Executive Vice President,  Secretary, General Counsel and Chief Compliance Officer         |
| Mark S. Loyd            |       | 49      |       | Executive Vice President –  Product and Distribution and Chief Administrative Officer |
| Keith A. Cousins        |       | 36      |       | Executive Vice President –  Development                                               |
| Ivy M. Jernigan         |       | 34      |       | Senior Vice President and  Chief Financial Officer                                         |
| Michelle K. Lewis       |       | 35      |       | Senior Vice President –  Treasurer                                                    |
| Thomas D. Johnson, Jr.  |       | 41      |       | Senior Vice President –  Corporate Finance and Business Development                   |
| John J. Jump(1)(2)      |       | 53      |       | Director                                                                                   |
| William B. Snow(1)(2)   |       | 73      |       | Director                                                                                   |
| James C. Lockwood(1)(2) |       | 67      |       | Director                                                                                   |

 

----

(1)           Member of our Compensation Committee.

(2)           Member of our Audit Committee.

 

Mr.Malugen co-founded Movie Gallery in 1985 and has been our Chairman of the Boardand Chief Executive Officer since that time. Mr. Malugen was appointed President effective January 4, 2002.  Prior to our initial public offering inAugust 1994, Mr. Malugen had been a practicing attorney in the states ofAlabama and Missouri since 1978 but spent a majority of his time managing theoperations of Movie Gallery beginning in early 1992.  Mr. Malugen received a B.S. degree inBusiness Administration from the University of Missouri-Columbia, his J.D. fromCumberland School of Law, Samford University and his LL.M. (in Taxation) fromNew York University School of Law.

 

Mr.Parrish co-founded Movie Gallery in 1985 and has served as a Director sincethat time.  He was elected Vice Chairmanof the Board in June 2002.  Mr. Parrishserved as President of Movie Gallery from 1985 until his resignation on January4, 2002, at which time Mr. Parrish assumed the position of Senior VicePresident-Concessions.  Mr. Parrishreceived a B.A. degree in Business Administration from the University ofAlabama.

 

Mr.Stubbs joined Movie Gallery in November 1995 and served as Regional Managerover Texas, Louisiana and Mississippi until being elected Senior Vice President- Operations in November 1997.  He waselected Executive Vice President - Operations in April 2001 and Chief OperatingOfficer in April 2004.  Prior to joiningMovie Gallery, Mr. Stubbs served as Vice President and General Manager ofA.W.C. Corporation, a video specialty and restaurant retailer in east Texas,from 1987 to 1995.  He also has eightyears of experience in grocery and convenience store management.  Mr. Stubbs attended Texas A & MUniversity and graduated from Southwest Texas State University, where hereceived a B.B.A. degree in Business Administration and Marketing.

 

Mr.Todd was elected Senior Vice President, Secretary and General Counsel inDecember 1994 and was promoted to Executive Vice President in April 2003. Mr.Todd was named Movie Gallery’s Chief Compliance Officer in April 2004.  Prior to joining Movie Gallery, Mr. Toddpracticed tax and corporate law in Dothan, Alabama.  Mr. Todd received a B.S. degree in BusinessAdministration from the University of Alabama, his J.D. from the University ofAlabama School of Law and his LL.M. (in Taxation) from New York UniversitySchool of Law.

 

Mr. Loyd joined Movie Gallery in August 1986 and hasserved as the retail store coordinator as well as Vice President - Purchasingand Product Management.  In October 1996,he was elected Senior Vice President - Purchasing and Product Management andwas promoted to Executive Vice President in April 2003.  In April 2004, 

 

20

----

 

Mr. Loyd was named Movie Gallery’s ChiefAdministrative Officer.  Mr. Loydattended Southeast Missouri State University, where he majored in BusinessAdministration.

 

Mr. Cousins joined MovieGallery in August 1998 as Senior Director of Development, Planning andAnalysis. Mr. Cousins was elected Senior Vice President -  Development in March 1999 and was promoted toExecutive Vice President in April 2004.  Priorto joining Movie Gallery, Mr. Cousins had four years of management consultingexperience with Computer Sciences Corporation as Program Control Manager;Management Consulting and Research, Inc. as Cost Analyst; and TecoloteResearch, Inc. as Advanced Cost Estimator. He also has seven years of realestate and property management experience as Senior Director of Development forKinderCare Learning Centers, Inc. and as Senior Accountant with Aronov RealtyManagement Co., Inc. Mr. Cousins received a B.S. degree in BusinessAdministration from Auburn University at Montgomery.

 

Ms. Jernigan joined MovieGallery in May 1996 as Assistant Controller and was promoted to Senior VicePresident and ChiefFinancial Officer in April 2004, after serving four years as the company’sVice-President-Controller.  Ms. Jerniganwas an accountant with the firm of Ernst & Young LLP for three years priorto joining Movie Gallery.  Ms. Jerniganis a Certified Public Accountant and received a B.S. degree in BusinessAdministration from Troy University.

 

Ms. Lewis joined Movie Galleryin October 1995 as Assistant Controller and was promoted to Senior VicePresident –Treasurer in April 2004, after serving four years as the company’s VicePresident – Finance.  Prior to joiningMovie Gallery, Ms. Lewis spent four years as an accountant with the firm ofCoopers & Lybrand, LLP.  Ms. Lewis isa Certified Public Accountant and received a B.S. degree in BusinessAdministration from Troy University.

 

Mr. Johnson joined MovieGallery in April 2004 as Senior Vice President – Investor Relations and wasnamed Senior Vice President – Corporate Finance and Business Development in January2005.  Mr. Johnson has more than 15 yearsof experience in the securities industry. He joined Movie Gallery from Russell Corporation (NYSE: RML) in Atlanta,GA where he led their investor relations program.  Prior to Russell, Mr. Johnson directed theinvestor relations for Wolverine Tube, Inc., Blount International, Inc. andKinderCare Learning Centers, Inc.  Inaddition to his responsibilities for investor relations, Mr. Johnson was theassistant treasurer at Wolverine Tube, and while at KinderCare, Mr. Johnsonalso served as the Director of Marketing and the Director of Financial Planningand Analysis.  Prior to that, Mr. Johnsonspent four years as a securities analyst with the Alabama Securities Commission.  Mr. Johnson holds an M.B.A. from theUniversity of Alabama and a B.S. degree in Business Administration from AuburnUniversity at Montgomery.

 

Mr.Jump became a director of Movie Gallery in June 2003.  He is the President and owner of Jump StartPromotions, a specialty advertising business that he founded in September2000.  Since August 2002, he has alsoserved as Business Manager, Operations for Convergys Corporation.  Mr. Jump served as Chairman of the Board ofDirectors of Video Update, Inc. from May 2001 until December 2001, and heserved as its Interim Chief Executive Officer from November 2001 until December2001.  Mr. Jump served as Executive VicePresident, Sales and Marketing of Sight & Sound Distributors, Inc., a homevideo distribution company, from 1985 to 2000. Mr. Jump received a B.A. degreein Psychology from the University of Missouri at St. Louis.

 

Mr.Snow became a director of Movie Gallery in July 1994.  He served as Vice Chairman of the Board fromJuly 1994 until June 2002, and he served as Chief Financial Officer from July1994 until May 1996.  Mr. Snow was theExecutive Vice President and Chief Financial Officer and a Director ofConsolidated Stores Corporation, a publicly held specialty retailer, from 1985until he retired in June 1994.  Mr. Snowis a Certified Public Accountant, and he received his Masters in BusinessAdministration from the Kellogg Graduate School of Management at NorthwesternUniversity and his Masters in Taxation from DePaul University.

 

Mr. Lockwood became a directorof Movie Gallery in June 2004.  He hasserved as Vice President, General Counsel and Secretary of Keystone AutomotiveIndustries, Inc., a publicly held distributor of aftermarket collisionreplacement parts, since 1997. From 1985 until 1997, Mr. Lockwood was a memberof the law firm of Troy & Gould. Mr. Lockwood was an investment banker withMontgomery Securities from 1984 to 1985. Mr. Lockwood received a B.S. degree inChemical Engineering from the Georgia Institute of Technology, and his J.D.from the University of Michigan.

 

21

----

 

Directors are elected to serve until our next annualmeeting of stockholders or until their successors are elected andqualified.  Officers serve at thediscretion of our Board of Directors, subject to any contracts ofemployment.  Non-employee directorsreceive an annual fee of $20,000, a fee of $1,500 for each Board meetingattended and a fee of $1,000 for each committee meeting attended.  We have granted vested options to purchaseshares of our common stock to each of the non-employee directors, in each caseat the fair market value of the common stock on the date of grant.

 

22

----

 

**ITEM 2.  PROPERTIES**

 

*Stores.*  Substantially all of our retail stores areleased. Our new store leases generally provide for an initial lease term of fiveto seven years, with at least one renewal option for an additional two to fiveyears. The following table provides information regarding the number of storeswe operated in each state and country as of February 28, 2005:

 
| **United  States:**   |       |       |       |
|-----------------------|------------|------------|------------|
| Alabama               |       | 187        |       |
| Florida               |       | 142        |       |
| Texas                 |       | 137        |       |
| Ohio                  |       | 129        |       |
| Georgia               |       | 125        |       |
| Virginia              |       | 120        |       |
| North Carolina        |       | 111        |       |
| Pennsylvania          |       | 89         |       |
| Missouri              |       | 86         |       |
| Arkansas              |       | 80         |       |
| South Carolina        |       | 78         |       |
| Indiana               |       | 77         |       |
| Tennessee             |       | 76         |       |
| Kentucky              |       | 65         |       |
| Mississippi           |       | 59         |       |
| Michigan              |       | 58         |       |
| Minnesota             |       | 55         |       |
| Oklahoma              |       | 54         |       |
| Maine                 |       | 51         |       |
| New York              |       | 43         |       |
| Wisconsin             |       | 38         |       |
| Illinois              |       | 36         |       |
| Massachusetts         |       | 32         |       |
| Iowa                  |       | 30         |       |
| Louisiana             |       | 29         |       |
| Washington            |       | 24         |       |
| Kansas                |       | 23         |       |
| Arizona               |       | 21         |       |
| Delaware              |       | 21         |       |
| Colorado              |       | 20         |       |
| New Mexico            |       | 20         |       |
| New Hampshire         |       | 19         |       |
| West Virginia         |       | 19         |       |
| California            |       | 18         |       |
| Montana               |       | 18         |       |
| Maryland              |       | 17         |       |
| Nebraska              |       | 16         |       |
| Connecticut           |       | 15         |       |
| Idaho                 |       | 12         |       |
| South Dakota          |       | 10         |       |
| Utah                  |       | 9          |       |
| Alaska                |       | 5          |       |
| Nevada                |       | 5          |       |
| Oregon                |       | 5          |       |
| Hawaii                |       | 4          |       |
| North Dakota          |       | 4          |       |
| New Jersey            |       | 3          |       |
| Vermont               |       | 3          |       |
| Rhode Island          |       | 2          |       |
| Wyoming               |       | 2          |       |
| Total United  States  |       | 2,302      |       |
| ** **            | ** ** | ** ** | ** ** |
| **Canada:**           |       |       |       |
| British Columbia      |       | 65         |       |
| Alberta               |       | 61         |       |
| Ontario               |       | 33         |       |
| Saskatchewan          |       | 14         |       |
| Nova Scotia           |       | 11         |       |
| Manitoba              |       | 9          |       |
| New Brunswick         |       | 5          |       |
| Newfoundland          |       | 2          |       |
| Prince Edward  Island |       | 2          |       |
| Yukon Territory       |       | 1          |       |
| Total Canada          |       | 203        |       |
|                  |       |       |       |
| **Mexico**            |       | 6          |       |
| ** **            | ** ** | ** ** | ** ** |
| **TOTAL**             | ** ** | **2,511**  | ** ** |

 

*Headquarters and DistributionFacility.*  Our corporate headquarters and inventorydistribution facility are located in an approximately 116,000 square footbuilding in Dothan, Alabama, which we own. We are also leasing approximately 48,000 square feet of off-sitewarehouse space to supplement distribution and to provide record storage.  In fiscal 2004, we began construction on anew 190,000 square foot distribution center located in Dothan, Alabama withcompletion expected in fiscal 2005.

 

**ITEM3.  LEGAL PROCEEDINGS**

 

**We are involved in litigation in the ordinary course of ourbusiness, none of which, if decided adversely to us, individually or in theaggregate, would be material to our business or results of operations.**

** **

**23**

----

** **

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

None.

 

24

----

 

**PART II**

 

**ITEM 5.****           MARKETFOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

Our common stock is listed onthe Nasdaq National Market under the symbol “MOVI.” The prices shown below arethe high and low closing prices for our common stock as reported on the NasdaqNational Market for the fiscal periods indicated.

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
|----------------|------------|----------|------------|---------|------------|--------------|------------|
| 2004:          |       |     |       |    |       |         |       |
| Fourth Quarter |       | $        | 19.30      |    | $          | 15.30        |       | $ | 0.03 |   |
| Third Quarter  |       | 18.54    |       | 16.43   |       | 0.03         |       |
| Second Quarter |       | 20.50    |       | 18.29   |       | 0.03         |       |
| First Quarter  |       | 20.25    |       | 18.38   |       | 0.03         |       |
|           |       |     |       |    |       |         |       |
| 2003:          |       |     |       |    |       |         |       |
| Fourth Quarter |       | $        | 22.44      |    | $          | 17.15        |       | $ | 0.03 |   |
| Third Quarter  |       | 22.50    |       | 18.96   |       | —       |       |
| Second Quarter |       | 19.91    |       | 17.04   |       | —       |       |
| First Quarter  |       | 17.76    |       | 13.38   |       | —       |       |

 

On February28, 2005, the last sale price of our common stock as reported on the NasdaqNational Market was $22.84 per share.  Asof February 28 , 2005, we had approximately 9,300 stockholders, including 60 stockholdersof record.

 

InDecember 2003, our board of directors instituted a new dividend policy underwhich it declared an initial quarterly cash dividend of $0.03 per share.  We currently intend to pay similar quarterlycash dividends on our common stock. However, the payment of future dividends is subject to the discretion ofour board of directors.  Future dividendsmay be increased, decreased or suspended from time to time based on a number offactors, including changes in tax laws related to dividends, our financialcondition, capital requirements, future business prospects, the terms of anydocuments governing our indebtedness and other factors that our board ofdirectors deems relevant.

 

Informationrelating to compensation plans under which equity securities of the Company areauthorized for issuance is set forth in the section captioned “Stock OptionPlans” in our definitive Proxy Statement or other information filed for our2005 Annual Meeting of Stockholders and all such information is incorporatedherein by reference.

 

**ITEM 6.SELECTED FINANCIAL DATA**

 

The followingtable sets forth our historical selected consolidated financial data.  We derived this information from our auditedconsolidated financial statements for each of the five fiscal years endedJanuary 2, 2005.  In addition to theinformation provided below, you should read our consolidated financialstatements and notes thereto included in Part IV, Item 15 and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included in Part II, Item 7 of this Form 10-K. The selected historical consolidated financial data do not necessarilyindicate the results to be expected in the future.

 

25

----

 
| ** **                                   | ** ** | **Fiscal Year Ended****(1)**                     | ** ** |
|----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                   | ** ** | **December 31,  2000**                           | ** ** | **January 6,  2002** | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                                   | ** ** | **($ in thousands, except per share data)** | ** ** |
| **Statements  of Income Data:**              |       |                                             |       |   |   |   |   |   |   |   |   |
| Revenues:                                    |       |                                             |       |   |   |   |   |   |   |   |   |
| Rentals                                      |       | $                                                | 294,298    |   | $ | 347,464 |   | $ | 490,836 |   | $ | 629,793 |   | $ | 729,167 |   |
| Product sales                                |       | 24,638                                           |       | 21,667 |   | 38,152 |   | 62,602 |   | 62,010 |   |
| Total revenues                               |       | 318,936                                          |       | 369,131 |   | 528,988 |   | 692,395 |   | 791,177 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Cost of sales:                               |       |                                             |       |   |   |   |   |   |   |   |   |
| Cost of rental  revenues                     |       | 94,105                                           |       | 108,732 |   | 164,818 | (2) | 184,439 | (2) | 208,160 |   |
| Cost of product  sales                       |       | 19,066                                           |       | 17,715 |   | 29,852 |   | 50,143 |   | 41,942 |   |
| Gross margin                                 |       | 205,765                                          |       | 242,684 |   | 334,318 |   | 457,813 |   | 541,075 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Operating costs  and expenses:               |       |                                             |       |   |   |   |   |   |   |   |   |
| Store operating  expenses                    |       | 153,665                                          |       | 171,409 |   | 253,865 |   | 324,466 |   | 395,425 | (3) |
| General and  administrative                  |       | 24,945                                           |       | 29,288 | (4) | 40,995 | (5) | 46,522 |   | 54,644 |   |
| Amortization of  intangibles                 |       | 7,465                                            |       | 6,656 |   | 1,298 |   | 2,003 |   | 2,601 |   |
| Stock option  compensation(6)                |       | —                                           |       | 8,161 |   | 2,279 |   | 1,481 |   | 831 |   |
| Operating income                             |       | 19,690                                           |       | 27,170 |   | 35,881 |   | 83,341 |   | 87,574 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Interest  expense, net                       |       | (3,779                                           | )          | (3,026 | ) | (1,024 | ) | (468 | ) | (624 | ) |
| Equity in losses  of unconsolidated entities |       | —                                           |       | — |   | — |   | (1,450 | ) | (5,746 | ) |
| Income before  income taxes                  |       | 15,911                                           |       | 24,144 |   | 34,857 |   | 81,423 |   | 81,204 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Income taxes                                 |       | 6,425                                            |       | 9,788 |   | 13,923 |   | 31,987 |   | 31,716 |   |
| Net income                                   |       | $                                                | 9,486      |   | $ | 14,356 |   | $ | 20,934 |   | $ | 49,436 |   | $ | 49,488 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Net income per  share:                       |       |                                             |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | $                                                | 0.37       |   | $ | 0.56 |   | $ | 0.69 |   | $ | 1.53 |   | $ | 1.54 |   |
| Diluted                                      |       | $                                                | 0.37       |   | $ | 0.53 |   | $ | 0.67 |   | $ | 1.48 |   | $ | 1.52 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Weighted average  shares outstanding:        |       |                                             |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | 25,801                                           |       | 25,837 |   | 30,273 |   | 32,406 |   | 32,096 |   |
| Diluted                                      |       | 25,868                                           |       | 27,220 |   | 31,436 |   | 33,370 |   | 32,552 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Cash dividends  per common share             |       | $                                                | —     |   | $ | — |   | $ | — |   | $ | 0.03 |   | $ | 0.12 |   |
|                                         |       |                                             |       |   |   |   |   |   |   |   |   |
| **Cash  flow data:**                         |       |                                             |       |   |   |   |   |   |   |   |   |
| Net cash  provided by operating activities   |       | $                                                | 42,446     |   | $ | 65,581 |   | $ | 69,202 |   | $ | 95,555 |   | $ | 105,489 |   |

 

26

----

 
| ** **                                      |       | **Fiscal Year Ended****(1)**                     |       |
|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                      | ** ** | **December 31,  2000**                           | ** ** | **January 6,  2002** | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                                      | ** ** | **($ in thousands, except per share data)** | ** ** |
| **Balance  Sheet Data (at end of period):**     |       |                                             |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                      |       | $                                                | 7,029      |   | $ | 16,349 |   | $ | 29,555 |   | $ | 38,006 |   | $ | 25,518 |   |
| Rental  inventory, net                          |       | 61,773                                           |       | 88,424 |   | 82,880 |   | 102,479 |   | 126,541 |   |
| Total assets                                    |       | 217,536                                          |       | 270,132 |   | 361,209 |   | 457,884 |   | 492,142 |   |
| Long-term debt,  less current maturities        |       | 40,600                                           |       | 26,000 |   | — |   | — |   | — |   |
| Stockholders’  equity                      |       | 129,209                                          |       | 162,182 |   | 259,051 |   | 320,116 |   | 331,134 |   |
|                                            |       |                                             |       |   |   |   |   |   |   |   |   |
| **Other  Data:**                                |       |                                             |       |   |   |   |   |   |   |   |   |
| Number of stores  at end of period              |       | 1,020                                            |       | 1,415 |   | 1,784 |   | 2,158 |   | 2,482 |   |
| Average revenues  per store (7)                 |       | $                                                | 328        |   | $ | 342 |   | $ | 337 |   | $ | 355 |   | $ | 341 |   |
| Adjusted EBITDA (8)                             |       | $                                                | 39,744     |   | $ | 59,581 |   | $ | 78,260 |   | $ | 109,416 |   | $ | 111,674 |   |
| Increase  (decrease) in same store revenues (9) |       | 3.8                                              | %          | 2.7 | % | 3.2 | % | 7.0 | % | (1.5 | )% |

 

----

(1)                                  Resultsfor fiscal 2001 reflect a 53-week year and include 17 days of operations forVideo Update, Inc., which we acquired out of bankruptcy on December 21,2001.  All other fiscal years presentedreflect 52-week years.

(2)                                  Effective October 7, 2002, we changed theestimates used to amortize rental inventory resulting in a non-cash charge of approximately$27.9 million in the fourth quarter of fiscal 2002, and $5.9 million throughoutfiscal 2003.

(3)                                  Includes pre-tax charge of $6.3 million tocorrect our accounting for leasehold improvements, including $2.9 millionrelated to prior periods, which was accounted for as an immaterial prior periodcorrection (see Note 1 to our consolidated financial statements).

(4)                                  Includes a $1.6 million charge related to theamendment of our supply agreement with Rentrak Corporation.

(5)                                  Includes a $4.0 million charge related to a legalsettlement in the second quarter of fiscal 2002.

(6)                                  Represents compensation expense associated withstock options that were repriced in March 2001 that were subsequently accountedfor as variable stock options and compensation expense for stock options thatwere repurchased from current and former executives in the third quarter of fiscal2004.  (see Note 6 to our consolidatedfinancial statements).

(7)                                  Calculated as total revenues divided by theweighted average number of stores open in each fiscal year.  Results for the fiscal year ended January 6,2002 include approximately $9,000 per store related to the extra fifty-thirdweek.

(8)                                  Adjusted EBITDA is defined as net cashprovided by operating activities before changes in operating assets andliabilities,interest and taxes.  Adjusted EBITDA is presented primarily as an alternative measure ofliquidity, although we also use it as an internal measure of performance formaking business decisions and compensating our executives.  It is also a widely accepted financialindicator in the home video specialty retail industry of a company’s ability toincur and service debt, finance its operations and meet its growth plans.  However, our computation of Adjusted EBITDAis not necessarily identical to similarly captioned measures presented by othercompanies in our industry.  We encourageyou to compare the components of our reconciliation of Adjusted EBITDA to cashflows from operations in relation to similar reconciliations provided by other companiesin our industry.  Our presentation of netcash provided by operating activities and Adjusted EBITDA treats rental inventoryas being expensed upon purchase instead of being capitalized and amortized.  We believe this presentation is meaningful andappropriate because our annual cash investment in rental inventory issubstantial and in many respects is similar to recurring merchandise inventorypurchases considering our operating cycle and the relatively short useful livesof our rental inventory.  Our calculationof Adjusted EBITDA excludes the impact of changes in operating assets andliabilities.  This adjustment eliminatestemporary effects attributable to timing differences between accrual accountingand actual cash receipts and disbursements, and other normal, recurring andseasonal fluctuations in working capital that have no long-term or continuing affecton our liquidity.  Investors shouldconsider our presentation of Adjusted EBITDA in light of its relationship tocash flows from operations, cash flows from investing activities and cash flowsfrom financing activities as shown in our statements of cash flows.  Adjusted EBITDA is not necessarily a measureof “free cash flow” because it does not reflect periodic changes in the level ofour working capital or our investments in new store openings, businessacquisitions, or other long-term investments we may make.  However, it is an important measure usedinternally by the executive management of our company in making decisions aboutwhere to allocate resources to grow our business.

 

27

----

 

Inprior periods, we presented a reconciliation of Adjusted EBITDA to operatingincome.  We changed the format of our reconciliationbeginning in the first quarter of fiscal 2004 to reconcile Adjusted EBITDA tonet cash provided by operating activities. We have recast the reconciliations for prior periods to conform to thenew presentation.  Adjusted EBITDAfor fiscal years  2001 and 2002 has been restatedto include the impact of non-recurring charges of $1.6 million related to asupply contract amendment and $4.0 million related to a legal settlement,respectively, which were added back to the calculation of Adjusted EBITDA inprior year presentations.  Our calculation of adjusted EBITDA isreconciled to net cash provided by operating activities as follows (inthousands):

 
| ** **                                   | ** ** | **Fiscal Year Ended (1)** | ** ** |
|----------------------------------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **December 31,  2000**    | ** ** | **January 6,  2002** | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|                                         |       |                      |       |   |   |   |   |   |   |   |   |
| Net cash  provided by operating activities   |       | $                         | 42,446     |   | $ | 65,581 |   | $ | 69,202 |   | $ | 95,555 |   | $ | 105,489 |   |
| Changes in  operating assets and liabilities |       | (8,235                    | )          | (9,438 | ) | 3,218 |   | 9,189 |   | (2,744 | ) |
| Tax benefit of  stock options exercised      |       | —                    |       | (5,273 | ) | (4,454 | ) | (3,747 | ) | (4,305 | ) |
| Deferred income  taxes                       |       | (4,671                    | )          | (3,703 | ) | (4,653 | ) | (24,036 | ) | (19,106 | ) |
| Interest expense                             |       | 3,779                     |       | 3,026 |   | 1,024 |   | 468 |   | 624 |   |
| Income taxes                                 |       | 6,425                     |       | 9,788 |   | 13,923 |   | 31,987 |   | 31,716 |   |
| Adjusted EBITDA                              |       | $                         | 39,744     |   | $ | 59,981 |   | $ | 78,260 |   | $ | 109,416 |   | $ | 111,674 |   |

 

(9)                                  Same-store revenues are calculated based on theaggregate revenues from stores we have operated for at least 13 months.

 

28

----

 

**ITEM7.**                     MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

** **

**Overview**

 

Weoperate approximately 2,500 home video retail stores that rent and sell moviesand video games, primarily in rural and secondary markets throughout NorthAmerica.  We compete with the other twonational chains (Blockbuster and Hollywood) in approximately one-third of ourstore locations.  We believe that we arethe market leader in the majority of our target markets, where we do notcompete with the other two national chains. We estimate that there are approximately 2,500 to 3,500 markets stillavailable for expansion in rural America, where we do not compete with theother two national chains, as well as additional opportunities throughoutCanada and Mexico.  We currently plan toopen approximately 400 new stores in 2005 and, subject to market and industryconditions, and the integration of our pending acquisition, if consummated, ofHollywood, to continue to open new stores at a similar pace over the nextseveral years.

 

Webelieve the most significant dynamic in our industry is the relationship our industrymaintains with the movie studios.  Thestudios have historically maintained an exclusive window for home videodistribution (packaged goods), which provides the home video industry with anapproximately 45 day period during which they can rent and sell new releasesbefore they are made available on pay-per-view or other distributionchannels.  According to Adams MediaResearch, the home video industry currently provides approximately 57% ofstudio revenue.  For this reason, webelieve movie studios have a significant interest in maintaining a viable homevideo business.  For a more detaileddiscussion of our business and the home video industry, see the Businessdiscussion contained in Part I, Item 1 of this Annual Report on Form 10-K.

 

Ourstrategies are designed to achieve reasonable, moderate and consistent growthin same-store revenues and profitability in a mature industry.  We strive to minimize the operating andoverhead costs associated with our business, which allows us to maximizeprofitability and which has proven to be a successful operating model forus.  Our compound annual growth rate forconsolidated revenue and operating income from 2000 to 2004 is 25.5% and 45.2%,respectively.

 

Inaddition to the relationship between our industry and the movie studios, ouroperating results are driven by revenue, inventory, rent, and payroll.  Given those key factors, we believe that bymonitoring the five operating performance indicators described below, we cancontinue to be successful in executing our operating plans and our growthstrategy.

 

•                  *Revenues.*  Ourbusiness is a cash business with initial rental fees paid upfront by thecustomer.  Our management team constantlyworks with inventory levels, marketing and sales promotions, real estatestrategies, and personnel issues in order to maximize profitable revenues ateach location.  Additionally, our teammonitors revenue performance on a daily basis to quickly identify trends orissues in our store base or in the industry as a whole.

•                  *Product purchasing economics.*  In orderto maintain the desired profit margin in our business, purchases of inventoryfor both rental and sale must be carefully managed.  Our purchasing models are designed to analyzethe impact of the economic factors inherent in the various pricing strategiesemployed by the studios.  We believe thatwe are able to achieve purchasing levels tailored for the customer demographicsof each of our markets and to maximize the return on investment of ourinventory purchase dollars.

•                  *Store level cost control.*  The mostsignificant store expenses are payroll and rent, followed by all other supplyand service expenditures.  We attempt tocontrol these expenses primarily through budgeting systems and centralizationof purchases into the corporate support center. This enables us to measure performance carefully against expectationsand to leverage our purchasing power.  Our rural focus also provides the benefit of reduced labor and realestate costs in the secondary markets we serve versus the costs associated withlarger urban markets.

•                  *Leverage of overhead expenses.*  We applythe same principles of budgeting, accountability and conservatism in ouroverhead spending that we employ in managing our store operating costs.  Our 

 

29

----

 

generaland administrative expenses include the costs to maintain our corporate supportcenter as well as the overhead costs of our field management team.

•                  *Operating cash flows.*  We havegenerated significant levels of cash flow for several years.  We have historically been able to fund themajority of our store growth and acquisitions, as well as ongoing inventorypurchases, from cash flow generated from operations.

 

Thefollowing discussion of our results of operations, liquidity and capitalresources will provide further insight into our performance over the last threeyears.

 

**PendingAcquisitions**

 

OnJanuary 9, 2005, we entered into an Agreement and Plan of Merger (“MergerAgreement”) with Hollywood Corporation (Nasdaq: HLYW) (“Hollywood”) providingfor our acquisition of Hollywood for approximately $850 million in cash plusour assumption of approximately $350 million in debt of Hollywood.  Hollywood is the second largest home videospecialty retailer in the United States, operating approximately 2,000 storesin 47 states and the District of Columbia, some of which contain theapproximately 700 Game Crazy video game specialty retail stores, where gameenthusiasts can buy, sell and trade new and used video game hardware, softwareand accessories.  Pursuant to the MergerAgreement, we will merge a subsidiary of ours with and into Hollywood, withHollywood surviving the merger as our wholly-owned subsidiary.

 

Uponconsummation of the merger, the shareholders of Hollywood will receive $13.25in cash for each outstanding share of Hollywood common stock that they own.  In addition, each option to purchaseHollywood common stock will be cancelled in exchange for an amount equal to$13.25 less the exercise price of the option.

 

Inconnection with the Merger Agreement and the refinancing of substantially allof the existing indebtedness of Hollywood and Movie Gallery (including ourexisting $75.0 million unsecured revolving credit facility with SouthTrust Bank(now Wachovia)), we expect to obtain a senior secured credit facilityguaranteed by Hollywood and all of our material subsidiaries in an aggregateamount of $720.0 million, consisting of a new $75.0 million revolving creditfacility with a $25 million accordion feature and two term loan facilities inan aggregate principal amount of $645.0 million.  Wachovia Bank, National Association andMerrill Lynch Capital Corporation and their affiliates will arrange the seniorsecured credit facility.  We alsoanticipate that Wachovia Capital Markets, LLC will arrange for an offering ofsenior unsecured notes by us in an amount of up to $475 million.  We expect that the maturities in ourrevolving credit facility and term loans will be five or six years from theconsummation of the merger and that the maturity of the senior notes will be sevenor eight years from the consummation of the merger.  As part of the refinancing of Hollywood’sdebt, at our request, Hollywood will commence a tender offer for its $225.0million principal amount 9.625% senior subordinated notes due 2011.

 

Consummationof the Hollywood merger is subject to the satisfaction of a variety of closingconditions, including the approval of the proposed merger by the shareholdersof Hollywood and our consummation of the financing necessary to fund theacquisition.  In addition, both we and Hollywoodhave customary termination rights in some circumstances, including a right byHollywood to terminate the Merger Agreement to accept an unsolicited superioracquisition proposal.  We can make noassurances that we will successfully acquire Hollywood or, if we do acquireHollywood, that we will successfully integrate its business with our business.

 

Thecombination of our company and Hollywood would create the second largest NorthAmerican video rental company with pro-forma combined annual revenue ofapproximately $2.6 billion and approximately 4,500 stores located in all 50U.S. states, Canada and Mexico.  The acquisitionwill substantially increase our presence on the West Coast and in urbanareas.  Hollywood’s predominantly WestCoast urban superstore locations present little overlap with our predominantlyEast Coast rural and suburban store locations. We also believe that there is an opportunity to improve theprofitability of Hollywood because the combined companies will offer potentialgeneral and administrative cost savings and increased purchasing leverage.

 

If weare successful in acquiring Hollywood, we anticipate that we would maintain theHollywood format and brand separately from our Movie Gallery business becauseof Hollywood’s distinct operational model and to ensure customer continuityafter the acquisition. During our integration of the operations of Hollywoodwith ours, we 

 

30

----

 

will evaluate ouroperational, growth, dividend and other strategies and policies discussed inthis report and will modify our strategies and policies as appropriate or requiredby industry and operating conditions.

 

On March 2, 2005,we entered into a definitive agreement with VHQ to commence a tender offer forall of its outstanding common stock at a price of C$1.15 per share.  Total consideration for the transaction isapproximately C$20.4 million (US $16.5 million), including C$17.5 million inequity and C$2.9 million in assumed debt. The common stock of VHQ trades on the Toronto Stock Exchange under thesymbol “VHQ.” VHQ owns and operates 61 video rental stores in secondary andsuburban markets in Alberta, Saskatchewan and the Northwest Territories.

 

TheVHQ transaction is conditioned upon, among other matters, the tender oftwo-thirds of VHQ's outstanding shares into the offer and the receipt ofcertain third party consents. Shareholders of VHQ representing approximately 50% of the outstandingshares have committed to tender their shares into our offer.  The transaction is also subject to customaryregulatory approvals, including receipt of notice from the Minister of Culturethat the acquisition provides a net benefit to Canada, consistent with theconditions of the Investments Canada Act.

 

**LeaseAccounting Charge**

 

Subsequent to the end offiscal 2004, we completed a comprehensive review of our accounting for leasesand leasehold improvements including the recognition of incentive paymentsreceived from landlords.  We determinedthat leasehold improvements, in some cases, were depreciated over a longerperiod than the lease term.  As a result,we recorded a cumulative fourth quarter adjustment to correct depreciationexpense of $6.3 million ($3.9 million after-tax or $0.12 per diluted share), ofwhich $2.9 million ($1.8 million after-tax or $0.05 per diluted share) of theadjustment was related to years prior to 2004 and was not considered materialto any of the prior period financial statements to warrant a restatement ofthose financial statements.  This accounting adjustment does not affectour historical or future cash flows.  This correction will increasedepreciation expense in fiscal 2005 by approximately $2.7 million.

 

31

----

 

**Results ofOperations**

 

**Selected Financial Statement and Operational Data:**

 
| ** **                                   | ** ** | **Fiscal Year Ended**                            | ** ** |
|----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                   | ** ** | **January 5,  2003**                             | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                                   | ** ** | **($ in thousands, except per share data)** | ** ** |
| ** **                                   | ** ** | ** **                                       | ** ** |
| Rental revenues                              |       | $                                                | 490,836    |   | $ | 629,793 |   | $ | 729,167 |   |
| Product sales                                |       | 38,152                                           |       | 62,602 |   | 62,010 |   |
| Total revenues                               |       | 528,988                                          |       | 692,395 |   | 791,177 |   |
|                                         |       |                                             |       |   |   |   |   |
| Cost of rental  revenues                     |       | 164,818                                          |       | 184,439 |   | 208,160 |   |
| Cost of product  sales                       |       |                                             | 29,852     |   |   | 50,143 |   |   | 41,942 |   |
| Total gross  profit                          |       | $                                                | 334,318    |   | $ | 457,813 |   | $ | 541,075 |   |
|                                         |       |                                             |       |   |   |   |   |
| Store operating  expenses                    |       | $                                                | 253,865    |   | $ | 324,466 |   | $ | 395,425 |   |
| General and  administrative expenses         |       | $                                                | 40,995     |   | $ | 46,522 |   | $ | 54,644 |   |
| Stock option  compensation                   |       | $                                                | 2,279      |   | $ | 1,481 |   | $ | 831 |   |
| Equity in losses  of unconsolidated entities |       | $                                                | —     |   | $ | 1,450 |   | $ | 5,746 |   |
|                                         |       |                                             |       |   |   |   |   |
| Operating income                             |       | $                                                | 35,881     |   | $ | 83,341 |   | $ | 87,574 |   |
| Net income                                   |       | $                                                | 20,934     |   | $ | 49,436 |   | $ | 49,488 |   |
| Net income per diluted  share                |       | $                                                | 0.67       |   | $ | 1.48 |   | $ | 1.52 |   |
|                                         |       |                                             |       |   |   |   |   |
| Cash dividends  per common share             |       | $                                                | —     |   | $ | 0.03 |   | $ | 0.12 |   |
|                                         |       |                                             |       |   |   |   |   |
| Rental margin                                |       | 66.4                                             | %          | 70.7 | % | 71.5 | % |
| Product sales  margin                        |       | 21.8                                             | %          | 19.9 | % | 32.4 | % |
| Total gross  margin                          |       | 63.2                                             | %          | 66.1 | % | 68.4 | % |
|                                         |       |                                             |       |   |   |   |   |
| **Percent  of total revenues:**              |       |                                             |       |   |   |   |   |
| Rental revenues                              |       | 92.8                                             | %          | 91.0 | % | 92.2 | % |
| Product sales                                |       | 7.2                                              | %          | 9.0 | % | 7.8 | % |
| Store operating  expenses                    |       | 48.0                                             | %          | 46.9 | % | 50.0 | % |
| General and  administrative expenses         |       | 7.8                                              | %          | 6.7 | % | 6.9 | % |
| Stock option  compensation                   |       | 0.4                                              | %          | 0.2 | % | 0.1 | % |
| Operating income                             |       | 6.8                                              | %          | 12.0 | % | 11.1 | % |
| Net income                                   |       | 4.0                                              | %          | 7.1 | % | 6.3 | % |
|                                         |       |                                             |       |   |   |   |   |
| **Same-store  revenue increase (decrease)**  |       | 3.2                                              | %          | 7.0 | % | (1.5 | )% |
| ** **                                   |       |                                             |       |   |   |   |   |
| **Store  Count:**                            |       |                                             |       |   |   |   |   |
| Beginning of  period                         |       | 1,415                                            |       | 1,784 |   | 2,158 |   |
| New store builds                             |       | 145                                              |       | 241 |   | 314 |   |
| Stores acquired                              |       | 265                                              |       | 170 |   | 74 |   |
| Stores closed                                |       | (41                                              | )          | (37 | ) | (64 | ) |
| End of period                                |       | 1,784                                            |       | 2,158 |   | 2,482 |   |

 

32

----

 

*Revenue.*  For fiscal 2003 and 2004, total revenuesincreased 30.9% and 14.3%, respectively, from the prior years.  The increases were primarily due tosame-store revenue growth of 7.0% in fiscal 2003 and increases in the averagenumber of stores operated in fiscal 2003 and 2004 of 24.0% and 19.0%,respectively. The revenue increase in fiscal 2004 was partially offset by asame-store revenue decrease of 1.5%.

 

Thefollowing factors contributed to a decrease in our same-store revenues forfiscal 2004 versus 2003:

 

•                  A weak home video release schedule in fiscal 2004,primarily in the third and fourth quarters, contributed to flat movie rentalrevenue comps; there were 36% fewer titles in 2004 with box office revenuesgreater than $100 million than in 2003 (most of which were concentrated in thethird and fourth quarters);

•                  A decline in revenue from the game rentalbusiness of approximately 7.0%, reflecting the weakness of the new game titlescurrently being released and industry softness that occurs in anticipation ofthe introduction of new game platforms currently scheduled for a late 2005release; additionally, there was a shortage of PlayStation 2 and Xbox gamehardware in the fourth quarter of 2004;

•                  A decrease in product sales revenue ofapproximately 11.5% due to a reduction in new release sell-through movieinventory;

•                  Disruption of normal daily operations atapproximately 325 stores in Florida and Alabama due to an unprecedentedhurricane season in August and September of 2004; and

•                  The broadcast of the Summer Olympics during thethird quarter of 2004.

 

Theincrease in same-store revenues for fiscal 2003 over fiscal 2002 resulted primarilyfrom:

 

•                  DVD rental revenue growth of approximately 87%,offset partially by a decline in VHS rental revenue of approximately 37% due tothe continuing consumer transition to the DVD format;

•                  Growth of approximately 27% in sales ofpreviously viewed movie inventory;

•                  Video game rental revenue increases ofapproximately 4%;

•                  Growth in product sales revenue of approximately35%, primarily as a result of a significant expansion of new movie inventoryavailable in the stores beginning during the latter half of 2002, as well asthe continuing consumer transition to the DVD format; and

•                  Continued revenue growth in the Video Updatestores we acquired in December 2001 with an overall same-store revenuesincrease of approximately 13%. (The impact of the Video Update growth is alsoincluded in the overall revenue growth by category as described in the previousbullet points.)

 

Themix of total revenue between rental revenue and product sales revenue reflectsan elevated level of product sales revenue in fiscal 2003 as compared to fiscal2002 and 2004.  This elevation was due toa significant expansion of new movie inventory available in our stores in orderto accommodate the increased consumer demand for retail movies and tocomplement our rental business during the height of the transition of ourcustomer base to the DVD format.  Thisexpansion began during the latter half of fiscal 2002 and was maintainedthroughout fiscal 2003.  In the earlypart of fiscal 2004, we began to reduce our levels of new release movieinventory available for sale in the stores in order to focus the mix on highermargin inventory items.  We evaluate ourproduct sales inventory mix and inventory levels on a regular basis and makeperiodic adjustments to our retail inventory mix based on our operatingstrategies and customer trends.  Productsales revenue has been less than 10% of total revenue in each of the last fiveyears.  We expect rental revenue tocontinue to represent the majority of our business.

 

*Cost of Sales.*  The cost of rental revenues includes theamortization of rental inventory, revenue sharing expenses incurred and thecost of previously viewed rental inventory sold.  The gross margin on rental revenue for fiscal2002, 2003 and 2004 was 66.4%, 70.7% and 71.5%, respectively.  In the fourth quarter of 2002, we made astrategic decision to make a portion of our base stock, or catalog, VHS rentalinventory available for sale during the holiday period as previously viewedinventory.  The sale of base stock VHSrental inventory was designed to make room on our store shelves for asignificant investment in base stock DVD rental inventory, which arrived instores in the first quarter of 2003 and did not have a material impact on ourgross margin.  Our decision to make thisinvestment in base stock DVD was primarily driven by the continued growth inconsumer acceptance of the DVD platform in our core markets throughout 2002 andresulted in a corresponding change in the estimates used to 

 

33

----

 

amortize rental inventory.  The rental margin for fiscal 2002 and 2003includes approximately $27.9 million and $5.9 million, respectively, related tothis change in estimate.  (See Note 1 toour consolidated financial statements.)  Excluding the impact of the rental inventoryamortization change, the rental margin for fiscal 2002 and 2003 would have been72.1% and 71.7%, respectively, compared to 71.5% in fiscal 2004.

 

Themost significant factors that impacted the fiscal 2004 rental margin were:

 

•                  An increase in the margin due to the comparisonagainst the impact of the $5.9 million charge related to the fiscal 2002 changein estimate as described above; offset by

•                  Pressure on the rental margin due to negativesame-store revenues of 1.5% and softness in the game industry, as previouslydiscussed.

 

The increase in the fiscal 2003 rental margin was primarily the resultof:

 

•                  Comparison against the impact of the $27.9million charge in fiscal 2002 for a change in estimate as described above;

•                  The increasing shift of movie rentals from VHS toDVD - DVD rentals constituted approximately 34% and 54% of total movie rentalsin fiscal 2002 and 2003, respectively; DVD has a lower cost structure than VHShas historically had, and the acceptance of DVD has influenced reductions instudio pricing of the VHS format during the last year; offset partially by

•                  Amortization of our $5.4 million investment inDVD catalog inventory that took place in the first quarter of 2003 as describedabove.

 

Costof product sales includes the costs of new DVDs, videocassettes, concessions,and other goods sold.  Theatrical newmovie releases typically have a much lower margin than concessions and othergoods.  The gross margin on product salesis subject to fluctuation based on the relative mix of low margin sales oftheatrical new movie inventory to higher margin sales of concessions and otheritems.  The gross margin on product sales for fiscal 2002, 2003 and 2004 was21.8%, 19.9% and 32.4%, respectively.  Thedecrease in the fiscal 2003 product sales margin reflects the expandedselection of lower margin, theatrical new movie releases to complement thetransition of our customer base to the DVD format, as previouslydiscussed.  The product sales marginincrease in fiscal 2004 reflects an overall shift in our inventory mix tohigher margin inventory items as a result of a reduction in the levels of theatricalnew release movie inventory available for sale in the stores.

 

*Operating Costs and Expenses.*  Store operating expenses includestore-level expenses such as lease payments, in-store payroll and start-upcosts associated with new store openings. Store operating expenses as a percentage of total revenue was 48.0%, 46.9%and 50.0% in fiscal 2002, 2003 and 2004, respectively.  In fiscal 2004, we reclassified costsassociated with our investments in various alternative delivery vehicles formovie content from store operating expenses to equity in losses ofunconsolidated entities in our statements of income.  Costs from the prior year have beenreclassified to conform to the current year presentation.

 

Theincrease in store operating expenses as a percentage of total revenue in fiscal2004 is primarily due to:

 

•                  An increase to depreciation expense in the fourthquarter of $6.3 million (of which $2.9 million relates to prior years) relatedto the correction of errors in our historical amortization practice forleasehold improvements;

•                  The 1.5% decrease in same-store revenues in 2004,as certain operating expenses are fixed and result in an increase as apercentage of revenue when revenues decline; and

•                  Continued growth in the number of new storeopenings generating store opening and start-up costs for a larger number ofimmature stores in the revenue base versus the prior year (our store base hasincreased by 15% or more in each of the last three years).

 

Thefollowing factors contributed to a reduction in store operating expenses as apercentage of total revenue in fiscal 2003:

 

34

----

 

•                  Same-store revenues increase of 7.0% in fiscal2003;

•                  Strong performance of new stores;

•                  Continued closure of under-performing units;

•                  Continued initiatives to reduce operating costs;

•                  Leverage from our Video Update transactionagainst the same-store revenue increases; offset slightly by

•                  Growth in the number of new store openingsgenerating store opening and start-up costs for a larger number of immaturestores in the revenue base versus the prior year.

 

Generaland administrative expenses as a percentage of revenue were 7.8%, 6.7% and 6.9%in fiscal 2002, 2003 and 2004, respectively. The increase in general and administrative expenses as a percentage ofrevenue from fiscal 2003 to 2004 is due to:

 

•                  The same-store revenue decrease of 1.5% in fiscal2004; and

•                  Overhead increases to support our future growthplans, which include continued expansion in geographic areas where our marketpenetration is lower and costs associated with some of our new business initiatives.

 

Thedecrease from fiscal 2002 to 2003 is primarily the result of:

 

•                  The same-store revenue increase of 7.0% in fiscal2003;

•                  Comparison against a legal settlement charge of$4.0 million with respect to our extended viewing fee policy in fiscal 2002;and

•                  Elevated costs and expenses in fiscal 2002associated with the conversion of the Video Update stores point of sale system;offset partially by

•                  Overhead increases to support new initiatives andour future growth plans, which include expansion into new geographic areaswhere our market penetration is lower.

 

Stock optioncompensation expense in periods prior to the third quarter of 2004 representsthe non-cash charge associated with certain stock options that were repricedduring the first quarter of fiscal 2001 and are subsequently accounted for asvariable stock options.  Due to therelatively small number of these options that remain outstanding, we expectfuture adjustments to income from non-cash stock option compensation to beimmaterial. Stock option compensation during fiscal 2004 also includes expense relatedto our decision to repurchase 145,900 shares of common stock from current andformer executives, resulting in compensation expense of approximately $767,000being recognized for the intrinsic value of those options (see Note 6 to ourconsolidated financial statements).

 

*Operating Income.*  As a result of the impact of the abovefactors on revenues and expenses, operating income increased by 132% in fiscal2003 and by 5.1% in fiscal 2004.

 

*Interest Expense.* Interest expense includes fees for the unusedborrowings available under our credit facility and amortization of theassociated debt issue costs, as well as the costs of any outstanding borrowingsunder our credit facility, net of interest income.  We repaid all of our outstanding debt in May2002 with the proceeds from our common stock offering, resulting in a reductionof interest expense in fiscal 2003 versus 2002.  Interest expense increased infiscal 2004 versus 2003 as a result of borrowings outstanding for severalmonths during 2004.

 

*Equity in losses of unconsolidated entities.* Duringthe last half of 2003, we began to make some investments in various alternativedelivery vehicles (both retail and digital) for movie content, and we began toexplore other business initiatives within our existing base of stores,including tests of a game store-within-a-store, movie trading and in-storemovie subscriptions.  We do not anticipate that any of these alternativeswill replace our base video rental business.  However, we do believe it isappropriate to make selective investments in synergistic opportunities thatcould potentially provide ancillary sources of revenue and profitability to ourbase rental business.  The expenses associated with our investments inalternative delivery vehicles are reflected as equity in losses ofunconsolidated entities on our statements of income.  ($885,000, net of tax, for 2003 and $3.5million, net of tax, for 2004).  These costs were previously included in storeoperating expenses on the statements of income.

 

35

----

 

*IncomeTaxes.*We had federal and state net operating losscarryforwards at January 2, 2005 of approximately $103 million and $45 million,respectively (see Note 5 to our consolidated financial statements).  These net operating loss carryforwardsresulted primarily from the Video Update acquisition in 2001and expire in years2007 through 2021.  During the year,adjustments were made to the valuation allowance for state net operating lossesthat were not charged to income tax expense in the amount of $1.8 million.  Accordingly, we have adjusted our recordedvaluation allowance to $32.6 million related to the net deferred tax assets of$38.7 million.  This valuation allowancehas been established since there exists uncertainty regarding our ability torealize these net operating losses in their entirety.

 

In forming our conclusionabout the future recoverability of the net operating losses from our 2001acquisition of Video Update, we considered, among other things, the applicableprovisions of the federal tax code, which limit the deductibility of netoperating loss carryforwards to the post-acquisition taxable income (on acumulative basis) of the acquired subsidiary on a separate return basis, aswell as other limitations that may apply to the future deductibility of thesenet operating losses.  We also consideredthe availability of reversing taxable temporary differences during thecarryforward period, the length of the available carryforward period, recentoperating results, and our expectations of future taxable income during thecarryforward period, changes in tax law, IRS interpretive guidance, andjudicial rulings.  If facts andcircumstances in the future should warrant an increase in the net operatingloss carryforwards expected to be realized, a reduction in the valuationallowance would occur and may result in a reduction in our effective income taxrate, which was 40%, 39% and 39% for fiscal 2002, 2003 and 2004, respectively.

 

Deferred income taxliabilities have increased during fiscal 2004. This is primarily the result of a significant acceleration in the taxdepreciation of newly purchased assets since the fourth quarter of 2001.  The acceleration on tax depreciation was dueto special provisions implemented after the events of September 11, 2001 thatexpired on December 31, 2004. Accordingly, it is anticipated that the cumulative excess tax depreciationlevels we currently have will begin to decline. A portion of this decline may continue to be offset by continued newstore growth.

 

We have analyzed eachdeferred tax asset and determined that it is more likely than not that theseassets will be realized.  Accordingly, wehave concluded that, apart from the valuation allowance related to the netoperating losses, no additional valuation allowances are necessary as of theend of fiscal 2004.  In our evaluation ofthe deferred tax assets related to the capital loss carryforward and the equityinvestments, we concluded that there existed viable and feasible tax planningstrategies that we could implement to realize these deferred assets.  It should be noted that a change in thevaluation of certain capital assets may impact the tax planning strategy reliedupon.  Should this occur, it could impactthe analysis and require that a valuation allowance be placed against all or aportion of these deferred tax assets.

 

**GeneralEconomic Trends, Quarterly Results of Operations and Seasonality**

 

Ourbusiness is subject to fluctuations in operating results due to a number offactors, many of which are outside of our control.  These fluctuations may be caused by, amongother things:

 

•                  the number, timing and performance of new oracquired stores;

•                  public acceptance of, interest in, andavailability of newly released movies;

•                  our mix of products rented versus sold;

•                  marketing programs and new release acquisitioncosts;

•                  seasonality - compared to other months during theyear, we experience peak revenues during the months of November, December andJanuary due to the holidays in these months as well as inclement weatherconditions.  Additionally, revenuesgenerally rise in the months of June, July and August when most schools are outof session, providing people with additional discretionary time to spend onentertainment; and

•                  special events, such as the Olympics or ongoingmajor news events of significant public interest.

 

**Liquidity and Capital Resources**

 

Our primary capital needsare for opening and acquiring new stores and for purchasing inventory. Othercapital needs include refurbishing, remodeling and relocating existing storesand refreshing, rebranding and supplying new computer hardware for acquiredstores.  We fund inventory purchases,remodeling, rebranding, and relocation 

 

36

----

 

programs, new store opening costs and acquisitions primarily from cashflow from operations and, as necessary, from loans under our creditfacility.  At January 2, 2005, we had cashand cash equivalents of $25.5 million, no long-term debt and $72.5 million inavailable borrowings under our credit facility.

 
| ** **                                           | ** ** | **Fiscal Year Ended**     | ** ** |
|------------------------------------------------------|------------|---------------------------|------------|
| ** **                                           | ** ** | **January 5,  2003**      | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                                           | ** ** | **($ in thousands)** | ** ** |
| **Statements  of Cash Flow Data:**                   |       |                      |       |   |   |   |   |
| ** **                                           |       |                      |       |   |   |   |   |
| Net cash  provided by operating activites            |       | $                         | 69,202     |   | $ | 95,555 |   | $ | 105,489 |   |
| Net cash used in  investing activities               |       | (99,198                   | )          | (94,490 | ) | (75,085 | ) |
| Net cash  provided by (used in) financing activities |       | 43,428                    |       | 3,333 |   | (45,353 | ) |
|                                                 |       |                      |       |   |   |   |   |
| **Other  Data:**                                     |       |                      |       |   |   |   |   |
| ** **                                           |       |                      |       |   |   |   |   |
| Adjusted EBITDA                                      |       | $                         | 78,260     |   | $ | 109,416 |   | $ | 111,674 |   |
| Adjusted EBITDA  (percent of total revenue)          |       | 14.8                      | %          | 15.8 | % | 14.1 | % |

 

The increases in net cashprovided by operating activities were primarily attributable to the revenuegrowth as a result of the continued expansion of our store base, offsetpartially in fiscal 2004 by a 1.5% decline in same-store revenues.  Net cash provided by operating activitiescontinues to be our primary source of funding for substantially all of ourrental inventory replenishment and capital resource needs.

 

In the first quarter of2004, we began reporting the on-going purchases of new release rental inventoryas an operating activity in the statement of cash flows rather than as aninvesting activity as previously reported.  We believe this classification is appropriate because our annual cashinvestment in rental inventory is substantial and in many respects is similarto recurring merchandise inventory purchases considering our operating cycleand the relatively short useful lives of our rental inventory.  Purchases of rental inventory for new storesor other significant investments in base stock rental inventory continue to beclassified as investing activities in the statements of cash flows as thesepurchases represent a long-term investment in our business.  Rental inventory purchases in the prior yearshave been reclassified to conform to the current year presentation forcomparative purposes.  Thereclassification had no impact on our financial position or results ofoperations as previously reported.

 

The fiscal 2003 balancesheet reflects the reclassification of certain outstanding checks.  The reclassifications were made between cashand cash equivalents, prepaid expenses and accounts payable in order to conformwith current year presentation.  Thecorresponding reclassifications were made in the cash flows for fiscal 2002 and2003.  The reclassifications reduced netcash provided by operating activities by $10.0 million and $5.7 million infiscal 2002 and 2003, respectively.

 

Net cash used ininvesting activities includes the costs of business acquisitions, new store additionsand investments in base stock rental inventory. The decreases in net cash used in investing activities during fiscal2004 and 2003 were primarily due to declining levels of business acquisitions,offset partially by increased new store openings and in fiscal 2003, by thepurchase of a corporate aircraft and lighting retrofits in many of our storesto achieve savings in the cost of utilities.

 

Net cash provided byfinancing activities for fiscal 2002 primarily reflects $66.8 million in netproceeds from a common stock offering, partially offset by the net repayment of$26.0 million in long-term debt.  Infiscal 2004, we repurchased 2,624,712 shares of our common stock at an averageprice of $18.06 per share and paid dividends to shareholders of $3.9 million,offset by proceeds from the exercise of stock options and our employee stockpurchase plan, resulting in net cash used in financing activities of $45.4million.  The only financing activity infiscal 2003 was proceeds from the exercise of stock options of $3.3 million.

 

In each quarter of fiscal2004, our board of directors declared a cash dividend of $0.03 per share under ourdividend policy instituted in December 2003. We currently intend to continue to pay similar quarterly cash dividends 

 

37

----

 

on our common stock.  However,the payment of future dividends is subject to the discretion of our board ofdirectors.  Future dividends may beincreased, decreased or suspended from time to time based on a number offactors, including changes in tax laws related to dividends, our financialcondition, capital requirements, future business prospects, our successfulintegration of Hollywood (assuming we consummate the proposed acquisition), theterms of any documents governing our indebtedness (including the terms of thefinancing we may consummate to fund our proposed acquisition of Hollywood), andother factors that our board of directors considers relevant.

 

Adjusted EBITDA in fiscal2003 and 2004 increased 39.8% and 2.1%, respectively, over the prior years.  The increase was primarily driven by revenue growthas a result of the continued expansion of our store base, offset partially infiscal 2004 by a 1.5% decline in same-store revenues and an increase in theinvestments of alternative delivery vehicles.

 

Adjusted EBITDA isdefined as net cash provided by operating activities before changes inoperating assets and liabilities, interest and taxes.  Adjusted EBITDA is presented primarily as analternative measure of liquidity, although we also use it as an internalmeasure of performance for making business decisions and compensating ourexecutives.  It is also a widely acceptedfinancial indicator in the home video specialty retail industry of a company’sability to incur and service debt, finance its operations and meet its growthplans.  However, our computation of AdjustedEBITDA is not necessarily identical to similarly captioned measures presentedby other companies in our industry.  Weencourage you to compare the components of our reconciliation of AdjustedEBITDA to cash flows from operations in relation to similar reconciliationsprovided by other companies in our industry. Our presentation of net cash provided by operating activities and AdjustedEBITDA treats rental inventory as being expensed upon purchase instead of beingcapitalized and amortized.  We believethis presentation is meaningful and appropriate because our annual cashinvestment in rental inventory is substantial and in many respects is similarto recurring merchandise inventory purchases considering our operating cycleand the relatively short useful lives of our rental inventory.  Our calculation of Adjusted EBITDA excludesthe impact of changes in operating assets and liabilities.  This adjustment eliminates temporary effectsattributable to timing differences between accrual accounting and actual cashreceipts and disbursements, and other normal, recurring and seasonalfluctuations in working capital that have no long-term or continuing affect onour liquidity.  Investors should considerour presentation of Adjusted EBITDA in light of its relationship to cash flowsfrom operations, cash flows from investing activities and cash flows fromfinancing activities as shown in our statements of cash flows.  Adjusted EBITDA is not necessarily a measureof “free cash flow” because it does not reflect periodic changes in the levelof our working capital or our investments in new store openings, businessacquisitions, or other long-term investments we may make.  However, it is an important measure usedinternally by the executive management of our company in making decisions aboutwhere to allocate resources to grow our business.

 

In prior periods, wepresented a reconciliation of Adjusted EBITDA to operating income.  We changed the format of our reconciliationbeginning in the first quarter of fiscal 2004 to reconcile Adjusted EBITDA tonet cash provided by operating activities. We have recast the reconciliations for prior periods to conform to thenew presentation.  Our calculation of AdjustedEBITDA is reconciled to net cash provided by operating activities as follows(in thousands):

 
| ** **                                   | ** ** | **Fiscal Year Ended**    | ** ** |
|----------------------------------------------|------------|--------------------------|------------|
| ** **                                   | ** ** | **January 5,  2003 (1)** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                                   | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash  provided by operating activities   |       | $                        | 69,202     |   | $ | 95,555 | ** ** | **$** | **105,489** | ** ** |
| Changes in  operating assets and liabilities |       | 3,218                    |       | 9,189 | ** ** | **(2,744** | **)** |
| Tax benefit of  stock options exercised      |       | (4,454                   | )          | (3,747 | ) | **(4,305** | **)** |
| Deferred income  taxes                       |       | (4,653                   | )          | (24,036 | ) | **(19,106** | **)** |
| Interest expense                             |       | 1,024                    |       | 468 | ** ** | **624** | ** ** |
| Income taxes                                 |       | 13,923                   | ** ** | 31,987 |   | **31,716** |   |
| Adjusted EBITDA                              | ** ** | $                        | 78,260     | ** ** | $ | 109,416 |   | **$** | **111,674** |   |

 

----

(1)  Note thatAdjusted EBITDA for fiscal 2002 has been restated to include the impact of a $4million non-recurring charge related to a legal settlement which was added backto the calculation of Adjusted EBITDA in the prior year presentation.

 

38

----

 

OnJune 27, 2001, we entered into a credit agreement with a syndicate of banks,led by SouthTrust Bank (now Wachovia), with respect to a revolving creditfacility.  Our credit facility isunsecured and, as amended in September 2004, provides for an increase inborrowings from $65 million up to $75 million and an extended maturity date ofJuly 3, 2006.  The interest rate on ourcredit facility is based on LIBOR plus an applicable margin percentage, whichdepends on cash flow generation and borrowings outstanding.  As of January 2, 2005, there were no outstandingborrowings under our credit facility. The amounts available for borrowing werereduced by standby letters of credit outstanding of $2.5 million and totaled $72.5million as of January 2, 2005.

 

Thefollowing table discloses our contractual obligations and commercialcommitments as of January 2, 2005   (seeNotes 4 and 7 to our consolidated financial statements):

 
| ** **                             | ** ** | **Payments Due by Period  (in thousands)** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| **Contractual Obligations**            | ** ** | **Total**                                  | ** ** | **Less than  1 year** | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After 5  Years** | ** ** |
| Credit facility  – outstanding(1) |       | $                                          | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Operating leases                       |       | 342,867                                    |       | 10,280 |   | 239,680 |   | 65,438 |   | 27,469 |   |
| Total  contractual cash obligations    |       | $                                          | 342,867    |   | $ | 10,280 |   | $ | 239,680 |   | $ | 65,438 |   | $ | 27,469 |   |

 

----

(1)                                  The total commercial commitment under our credit facility is $75 million,which expires on July 3, 2006.  As ofJanuary 2, 2005, there were standby letters of credit outstanding under the creditfacility of $2,537,000, of which $212,000 expires in 2005, and $2,325,000expires in 2006.

 

At January 2, 2005, wehad a working capital deficit of $31.9 million, primarily due to the accountingtreatment of rental inventory.  Rentalinventory is treated as a noncurrent asset under accounting principlesgenerally accepted in the United States because it is a depreciable asset and aportion of this asset is not reasonably expected to be completely realized incash or sold in the normal business cycle within one year. Although the rentalof this inventory generates the major portion of our revenue, theclassification of this asset as noncurrent results in its exclusion fromworking capital. The aggregate amount payable for this inventory, however, isreported as a current liability until paid and, accordingly, is reflected as areduction in working capital. Consequently, we believe that working capital isnot an appropriate measure of our liquidity, and we anticipate that we willcontinue to operate with a working capital deficit.

 

Wegrow our store base through internally developed and acquired stores.  We opened 314 internally developed stores,acquired 74 stores and closed 64 stores during fiscal 2004.  We will continue to evaluate acquisitionopportunities in 2005 as they arise.  Tothe extent available, new stores and future acquisitions may be completed usingfunds available under our credit facility, financing provided by sellers oralternative financing arrangements, such as funds raised in public or privatedebt or equity offerings.  However, wecannot assure you that financing will be available to us on terms which will beacceptable, if at all.

 

Capital requirements tofund new store growth in fiscal 2004, including the base stock rental inventoryinvestment, were $40.9 million. Additionally in fiscal 2004, we incurred $21.2 million in other on-goingcapital expenditure requirements for the existing store base.  Capital requirements to fund new store growthin fiscal 2005, including the base stock rental inventory investment, areestimated at $52 million.  We expectother ongoing capital expenditures for 2005 to approximate $25 million.   Infiscal 2005, we expect capital requirements to fund the acquisitions ofHollywood and VHQ to total approximately $1.1 billion.  We expect to finance the amounts through cashon hand, borrowings under our new senior secured credit facility and ourproposed offering of senior unsecured notes. See “Pending Acquisitions.”

 

We purchase rentalinventory under two different cost structures. Under “fixed cost” arrangements, we pay a flat purchase price with nofurther obligations to our vendor.  Under“revenue sharing” arrangements, we pay a lower fixed cost per unit and then “share”a predetermined portion of the future rental revenues with the studio for anagreed upon period of time following the release date of the product.  Fixed cost purchases are capitalized and 

 

39

----

 

amortized as rental inventory on our balance sheet, in accordance withour stated accounting policies.  Thefixed portion of the cost of revenue-share product is capitalized and amortizedas rental inventory on our balance sheet, while the revenue sharing paymentsare expensed as incurred and reflected in gross profit on our incomestatement.  Rental inventory purchasesincluded in net cash provided by operating activities include the costs of allour fixed cost purchases as well as the fixed portion of costs associated withour revenue-share product, while the revenue sharing expenses are reflected innet cash provided by operating activities through net income.  (Note that rental inventory purchases for newstores or other significant investments in base stock rental inventory are notclassified as operating activities, but instead as investing activities in ourstatements of cash flows.)  Rentalinventory purchases will be higher in periods with more fixed cost purchasesversus revenue share purchases.  The mixof fixed cost and revenue share product purchased in any given period isdependent upon the purchasing economics of the titles released in that periodand is not determined until the monthly orders are placed with oursuppliers.  As such, we are unable toprovide guidance regarding the expected future amounts of rental inventorypurchases as reflected in our statements of cash flows.

 

We believe our projectedcash flow from operations, cash on hand, borrowing capacity under our creditfacility, and trade credit will provide the necessary capital to fund ourcurrent plan of operations, including our anticipated new store openings andacquisition program, excluding our proposed acquisition of Hollywood, throughfiscal 2005.  Our proposed acquisition ofHollywood will require debt financing in an aggregate amount of approximately$1.1 billion and will include a refinancing of our existing revolving creditfacility.  To fund additional majoracquisitions, or to provide funds in the event that our need for funds isgreater than expected, or if the financing sources identified above are notavailable to the extent anticipated, or if we increase our growth plan, we mayneed to seek additional or alternative sources of financing.  This financing may not be available onsatisfactory terms, or at all.  Failureto obtain financing to fund our expansion plans or for other purposes couldhave a material adverse effect on our operating results.

 

Our ability to fund ourcurrent plan of operations and our growth plan will depend upon our futureperformance, (including, if we acquire Hollywood, our successful integrationand operation of its business) which is subject to general economic, financial,competitive, and other factors that are beyond our control.  We cannot assure you that our business willcontinue to generate sufficient cash flow from operations in the future to fundcapital resource needs, cover the ongoing costs of operating the business andservice any debt incurred in the future. If we are unable to satisfy these requirements with cash flow fromoperations and cash on hand, we may be required to sell assets or to obtainadditional financing.  We cannot assureyou that any such sales of assets or additional financing could be obtained.

 

### **RecentlyIssued Accounting Pronouncements**

### ** **

In December 2004,the FASB issued a revised Statement 123, *Share Based Payment*(“Statement 123R”), to address the accounting for stock-based employee plans.  The statement eliminates the ability toaccount for share-based compensation transactions using APB 25 and insteadrequires that such transactions be accounted for using a fair value basedmethod of accounting.  The impact ofadoption of Statement 123R cannot be predicted at this time because it willdepend on levels of share-based payments granted in the future.  However, had we adopted Statement 123R inprior periods, the impact of that standard would have approximated the impactof Statement 123 as described in the disclosure of proforma net income andearnings per share in Note 1 to our consolidated financial statements.  Statement 123R also requires the benefits oftax deductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required undercurrent literature.  This requirementwill reduce net operating cash flows in periods after adoption.  While we cannot estimate what those amountswill be in the future (because they depend on, among other things, whenemployees exercise stock options), the amount of operating cash flows recognizedin prior periods for such excess tax deductions were $4.5 million, $3.7 millionand $4.3 million in 2002, 2003 and 2004, respectively. Statement 123R iseffective for interim and annual reporting periods beginning afterJune 15, 2005.

 

## **Critical Accounting Policies and Estimates**

## ** **

**Our significant accounting policies are described in Note 1to our consolidated financial statements as filed in this Annual Report on Form10-K for the fiscal year ended January 2, 2005. Our discussion and analysis offinancial condition and results of operations are based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of thefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues, expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate the estimates that we have made. These estimates have been based uponhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances. Actual results may differ from theseestimates**

** **

**40**

----

** **

**underdifferent conditions or using different assumptions. We believe our mostcritical accounting estimates include our policies with respect to rentalinventory amortization, impairment of long-lived assets, purchase priceallocation of acquired businesses and deferred income taxes.**

** **

Amajor component of our cost structure is the amortization of our rentalinventory.  Rental inventory is amortizedto an estimated salvage value over an estimated useful life of up to twoyears.  We amortize the cost of rentalinventory using an accelerated method designed to approximate the rate ofrevenue recognition.  This method isbased on historical customer demand patterns from “street date” (the datestudios release various titles for distribution to our stores) through the endof the average useful life.  In order todetermine the appropriate useful lives and salvage values, we analyzed theactual historical performance trends of our rental inventory.  We quantified the average rate of revenuerecognition on our products and developed amortization rates and useful livesthat approximate the rental turns of our inventory.  Our established salvage values are based onan evaluation of the sale prices we are able to realize from our customers onused inventory, prices observed in bulk sale transactions and prices observedin other open market purchases of used inventory, as well as the salvage valuesestablished by competitors in our industry. We believe our estimated useful lives and salvage values areappropriately matched to our current rental business and are consistent withindustry trends.  However, should rentalpatterns of consumers change or should market values of previously viewedinventory decline due to the acceptance of new formats (e.g., ongoing VHStransition to DVD, anticipated transition to high definition DVD within threeto five years, release of new video game formats, etc.), this could necessitatean acceleration in our current rental amortization rates, a reduction insalvage values or a combination of both courses of action.  We believe that any acceleration in therental amortization rates would not have a long-lasting impact, as the majorityof our current rental purchases are substantially depreciated within the firsttwo to three months after “street date” under our existing policy.  We could be required to reduce salvage valuesthat we currently carry on VHS inventory if we are unable to dispose of thatinventory at a rate relatively consistent with the consumers’ transition toDVD.   In the past, we have generallybeen able to anticipate the rate of transition from one format to another andmanage our purchases, as well as inventory mix, to avoid significant losses onthe ultimate disposition of previously viewed movies.  However, we cannot assure you that we will beable to fully anticipate the impact of the transition to DVD or any otherformats in the future, and we could incur losses on the sale of previouslyviewed movies in the future.  As of January4, 2004, and January 2, 2005, we had $102.5 million and $126.5 million,respectively, in rental inventory on our balance sheet.  VHS, DVD and games constituted 55%, 37% and8%, respectively, of total rental inventory units as of January 4, 2004compared to 38%, 55% and 7%, respectively, of total units as of January 2, 2005.  As of January 2, 2005, the net book value ofour VHS rental inventory is approximately 20% of the net book value of ourtotal rental inventory.

 

Weassess the fair value and recoverability of our long-lived assets, including rentalinventory, property, furnishings and equipment, and intangible assets withfinite lives, whenever events and circumstances indicate the carrying value ofan asset may not be recoverable from estimated future cash flows expected toresult from its use and eventual disposition. In doing so, we make assumptions and estimates regarding future cashflows and other factors in order to make our determination. The fair value ofour long-lived assets is dependent upon the forecasted performance of ourbusiness, changes in the video retail industry, the market valuation of ourcommon stock, and the overall economic environment.  When we determine that the carrying value ofour long-lived assets may not be recoverable, we measure any impairment basedupon the excess of the carrying value that exceeds the estimated fair value ofthe assets.  If we do not meet ouroperating forecasts or if the market value of our stock declines significantly,we may have to record impairment charges not previously recognized.

 

We test goodwill forimpairment on an annual basis.  Additionally, goodwill is tested forimpairment between annual tests if an event occurs or circumstances change thatwould more likely than not reduce the fair value of an entity below itscarrying value.  These events orcircumstances would include a significant change in the business climate, legalfactors, operating performance indicators, competition, sale or disposition ofa significant portion of the business or other factors.  We have not recorded any impairment losses ongoodwill since a fiscal 2001 impairment charge of $700,000.  If we do not meet our operating forecasts orif the market value of our stock declines significantly, we may have to recordadditional impairment charges not previously recognized.  As of January 2, 2005, we have $143.8 millionin goodwill on our balance sheet.

 

Weestimate the fair value of assets and liabilities of acquired businesses basedon historical experience and available information at the acquisitiondate.  We engage independent valuationspecialists to assist when necessary.  If

 

41

----

 

informationbecomes available subsequent to the acquisition date that would materiallyimpact the valuation of assets acquired or liabilities assumed in businesscombinations, we may be required to adjust the purchase price allocation. Withthe exception of the Video Update acquisition in 2001, we have not experiencedany significant adjustments to the valuation of assets or liabilities acquiredin business combinations in the last seven years.  Our acquisitions are typically smallbusinesses for which we generally do not assume liabilities and for which theassets acquired consist primarily of inventory, fixtures, equipment, andintangibles.

 

We recognizedeferred tax assets and liabilities based on the differences between thefinancial statement carrying amounts and the tax basis of assets andliabilities. We regularly review our deferred tax assets for recoverability andestablish a valuation allowance based upon historical losses, projected futuretaxable income and the expected timing of the reversals of existing temporarydifferences. As a result of this review, we have established a valuationallowance against our deferred tax assets related to net operating losscarryforwards (NOLs) that we acquired in the 2001 acquisition of VideoUpdate.  In forming our conclusion aboutthe future recoverability of the net operating losses from our 2001 acquisitionof Video Update, we considered, among other things, the applicable provisionsof the federal income tax code, which limit the deductibility of net operatingloss carryforwards to the post-acquisition taxable income (cumulative basis) ofthe acquired subsidiary on a separate return basis, as well as otherlimitations that may apply to the future deductibility of these net operatinglosses.  We also considered theavailability of reversing taxable temporary differences during the carryforwardperiod, the length of the available carryforward period, recent operatingresults, our expectations of future taxable income during the carryforwardperiod, changes in tax law, IRS interpretive guidance and judicial rulings.  If facts and circumstances in the futureshould warrant elimination or reduction of the valuation allowance related tothese NOLs, our effective income tax rate, which was 40%, 39% and 39% forfiscal 2002, 2003 and 2004, respectively, could be reduced.

 

**RelatedParty Transactions**

 

Pleaserefer to Note 8 to our consolidated financial statements for disclosuresregarding our significant related party transactions.

 

**Forward-Looking Statements**

 

Withrespect to forward-looking statements, please refer to the disclosures setforth under “Forward Looking Statements” in Part I, Item 1 of this Form 10-K.

 

**ITEM 7A.****               QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

The market risk inherent in our financial instrumentsrepresents the increased interest costs arising from adverse changes ininterest rates (primarily LIBOR and prime bank rates).  We currently have no amounts outstanding underour credit facility, and thus no exposure to adverse interest rate changes.

 

We are exposed to foreign exchange risks associatedwith our Canadian and Mexican operations.  Historically, the Canadian exchange rates have been relatively stable,and we believe the impact of fluctuations in the currency exchange rates willbe immaterial to our financial position and results of operations.  Based on fiscal 2004 results, a hypothetical10% change in the Canadian exchange rate would not have a significant effect oneither our consolidated financial position or results of operations.  Our Mexican operations are currently limitedto six locations.  Growth in Mexico in 2005is not expected to be significant enough to result in a material impact fromfluctuations in currency exchange rates.

 

**ITEM 8.****                        FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

Referenceis made to Part IV, Item 15 of this Form 10-K for the information required byItem 8.

 

**ITEM 9.****                        CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

### ** **

None.

 

42

----

 

**ITEM 9A.****               CONTROLS ANDPROCEDURES.**

 

**Evaluationof Disclosure Controls and Procedures**

 

Inaccordance with Exchange Act Rules 13a-15 and 15a-15, we carried out anevaluation, under the supervision and with the participation of management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of the end of theperiod covered by this report. Based on that evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures were effective as of January 2, 2005.

 

**Designand Evaluation of Internal Control Over Financial Reporting**

 

Pursuantto Section 404 of the Sarbanes-Oxley Act of 2002, we included a report ofmanagement’s assessment of the design and effectiveness of our internalcontrols as part of this Annual Report on Form 10-K for the fiscal year endedJanuary 2, 2005. Ernst & Young, LLP, our independent registered publicaccounting firm, also attested to, and reported on, management’s assessment ofthe effectiveness of internal control over financial reporting.  Management’s report and the independentregistered public accounting firm’s attestation report are included in aseparate section of this report on pages F-22 and F-23 under the captionsentitled “Management’s Report on Internal Control Over Financial Reporting,”and “Report of Independent Registered Public Accounting Firm on InternalControl Over Financial Reporting,” and are incorporated herein by reference.

 

Therehas been no change in our internal controls over financial reporting thatoccurred during the three months ended January 2, 2005 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlsover financial reporting.

 

**ITEM 9B.****               OTHER INFORMATION.**

 

None.

 

43

----

###### ** **

###### **PART III**

###### ** **

**ITEM 10.****                 DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Theinformation required by this Item (other than the information regardingdirectors and executive officers set forth at the end of Part 1, Item 1 of thisForm 10-K) will be contained in our definitive Proxy Statement for our 2005Annual Meeting of Stockholders, and is incorporated herein by reference.

 

**ITEM 11.****                 EXECUTIVECOMPENSATION**

 

Theinformation required by this Item will be contained in our definitive ProxyStatement for our 2005 Annual Meeting of Stockholders, and is incorporatedherein by reference.

 

**ITEM 12.****                 SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

 

Theinformation required by this Item will be contained in our definitive ProxyStatement for our 2005 Annual Meeting of Stockholders, and is incorporatedherein by reference.

 

**ITEM 13.****                 CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

Theinformation required by this Item will be contained in our definitive ProxyStatement for our 2005 Annual Meeting of Stockholders, and is incorporatedherein by reference.

 

**ITEM 14.****                 PRINCIPALACCOUNTANT FEES AND SERVICES**

 

The informationrequired by this Item will be contained in our definitive Proxy Statement forour 2005 Annual Meeting of Stockholders, and is incorporated herein byreference.

 

**PART IV**

 

**ITEM 15.****                 EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

 

**(a)(1)Financial Statements:**

 

The followingconsolidated financial statements of Movie Gallery, Inc. and the registeredpublic accounting firm’s report thereon, are filed as part of this report inthe section immediately following the signature page, at the page numbersindicated:

 

Audited ConsolidatedFinancial Statements

 
| Consolidated Balance Sheets                                                                                                                                                                                                                      | F-1    |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated  Statements of Income                                                                                                                                                                                                               | F-2    |
| Consolidated  Statements of Stockholders’ Equity                                                                                                                                                                                            | F-3    |
| Consolidated  Statements of Cash Flows                                                                                                                                                                                                           | F-4    |
| Notes to  Consolidated Financial Statements                                                                                                                                                                                                      | F-5    |
| Report  of Independent Registered Public Accounting Firm                                                                                                                                                                                         | F-21   |
|                                                                                                                                                                                                                                             |   |
| Management's  report on internal control over financial reporting and the report of our  independent registered public accounting firm on internal control over  financial reporting are filed herewith on the page numbers indicated below:     |   |
| Management’s  Report on Internal Control Over Financial Reporting                                                                                                                                                                           | F-22   |
| Report  of Independent Registered Public Accounting Firm on Internal Control over  Financial Reporting                                                                                                                                           | F-23   |
|                                                                                                                                                                                                                                             |   |
| **(a)(2)  Schedules:**                                                                                                                                                                                                                      |   |
|                                                                                                                                                                                                                                             |   |
| The following  financial statement schedule is filed herewith on the page number  indicated.  All other schedules are  either not applicable, or the equivalent information is provided in the notes  to consolidated financial statements. |   |
| Schedule  II Valuation and Qualifying Accounts                                                                                                                                                                                                   | F-24   |

 

44

----

 

**(a)(3)Exhibits:**

 

The followingexhibits, which are furnished with this Annual Report or incorporated herein byreference, are filed as part of this Annual Report:

 
| **Exhibit  No.** | ** ** | **Exhibit Description** |
|------------------|------------|-------------------------|
| ** **       | ** ** | ** **              |
|             | 2.1        | -                       | Agreement and  Plan of Merger by and among the Company, TG Holdings, Inc. and Hollywood  Entertainment Inc., dated January 9, 2005. (1) |
|             |       |                    |   |
|             | 3.1        | -                       | Certificate of  Incorporation of the Company. (2) |
|             |       |                    |   |
|             | 3.1.1      | -                       | Certificate of  Amendment of Certificate of Incorporation dated June 6, 1996. (3) |
|             |       |                    |   |
|             | 3.1.2      | -                       | Certificate of  Amendment of Certificate of Incorporation dated July 1, 1999. (3) |
|             |       |                    |   |
|             | 3.1.3      | -                       | Certificate of  Amendment of Certificate of Incorporation dated June 27, 2002. (4) |
|             |       |                    |   |
|             | 3.2        | -                       | Amended and Restated  Bylaws of Movie Gallery, Inc. (4) |
|             |       |                    |   |
|             | 4.1        | -                       | Specimen Common  Stock Certificate. (5) |
|             |       |                    |   |
|             | 10.1       | -                       | 1994 Stock  Option Plan, as amended and form of Stock Option Agreement. (6) |
|             |       |                    |   |
|             | 10.1.1     | -                       | Amendment to  Movie Gallery, Inc. 1994 Stock Plan, as amended dated June 13, 2000. (4) |
|             |       |                    |   |
|             | 10.1.2     | -                       | Amendment to  Movie Gallery, Inc. 1994 Stock Plan, as amended dated September 12, 2002. (7) |
|             |       |                    |   |
|             | 10.2       | -                       | Form of Indemnity  Agreement. (2) |
|             |       |                    |   |
|             | 10.3       | -                       | Employment  Agreement between M.G.A., Inc. and Joe Thomas Malugen. (2) |
|             |       |                    |   |
|             | 10.3.1     | -                       | First Amendment  to Employment Contract between M.G.A., Inc. and J. T. Malugen dated April 3,  2000. (8) |
|             |       |                    |   |
|             | 10.4       | -                       | Employment  Agreement between M.G.A., Inc. and S. Page Todd. (9) |
|             |       |                    |   |
|             | 10.5       | -                       | Employment  Agreement between M.G.A., Inc. and Jeffrey S. Stubbs. (10) |
|             |       |                    |   |
|             | 10.6       | -                       | Credit Agreement  between Movie Gallery, Inc. and SouthTrust Bank dated June 27, 2001. (11) |
|             |       |                    |   |
|             | 10.6.1     | -                       | Amendment to  Credit Agreement between Movie Gallery, Inc. and SouthTrust Bank dated  September 25, 2001. (4) |
|             |       |                    |   |
|             | 10.6.2     | -                       | Amendment to  Credit Agreement between Movie Gallery, Inc. and SouthTrust Bank dated  January 14, 2002. (4) |
|             |       |                    |   |
|             | 10.6.3     | -                       | Amendment to  Credit Agreement between Movie Gallery, Inc. and SouthTrust Bank dated August  15, 2002. (12) |
|             |       |                    |   |
|             | 10.6.4     | -                       | Amendment to  Credit Agreement between Movie Gallery, Inc. and SouthTrust Bank dated May  19, 2003. (13) |
|             |       |                    |   |
|             | 10.6.5     | -                       | Amendment to  Credit Agreement between Movie Gallery, Inc. and SouthTrust Bank dated  September 29, 2004. (17) |
|             |       |                    |   |
|             | 10.7       | -                       | 2003 Stock Plan.  (14) |
|             |       |                    |   |
|             | 10.8       | -                       | 2003 Employee  Stock Purchase Plan. (15) |

 

45

----

 
|   | 10.8.1 | -      | Amendment to  Movie Gallery, Inc. 2003 Employee Stock Purchase Plan, dated December 16,  2004. (18)                                                                                                                                                   |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 10.9   | -      | Credit  Facilities Commitment Letter dated as of January 9, 2005 made by Movie  Gallery, Inc. and Merrill Lynch Capital Corporation, Wachovia Bank, National  Association, Wachovia Capital Investments, Inc., and Wachovia Capital  Markets, LLC (1) |
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 14     | -      | Code of Ethics.  (16)                                                                                                                                                                                                                                 |
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 21     | -      | List of  Subsidiaries. (filed herewith)                                                                                                                                                                                                               |
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 23     | -      | Consent of  Independent Registered Public Accounting Firm. (filed herewith)                                                                                                                                                                           |
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 31.1   | -      | Certification of  Chief Executive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act of 1934, as amended. (filed herewith)                                                                                         |
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 31.2   | -      | Certification of  Chief Financial Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the  Securities Exchange Act of 1934, as amended. (filed herewith)                                                                                         |
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 32.1   | -      | Certification of  Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (filed herewith)                                                                                 |
|   |   |   |                                                                                                                                                                                                                                                  |
|   | 32.2   | -      | Certification of  Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (filed herewith)                                                                                 |

 

----

(1)                      Previously filed withthe Securities and Exchange Commission on January 11, 2005, as an exhibit toour current report on Form 8-K.

(2)                      Previously filed withthe Securities and Exchange Commission on June 10, 1994, as an exhibit to ourRegistration Statement on Form S-1 (File No. 33-80120).

(3)                      Previously filed withthe Securities and Exchange Commission on August 17, 1999, as an exhibit to ourForm 10-Q for the quarter ended July 4, 1999.

(4)                      Previously filed withthe Securities and Exchange Commission on April 7, 2003, as an exhibit to ourForm 10-K for the fiscal year ended January 4, 2004.

(5)                      Previously filed withthe Securities and Exchange Commission on August 1, 1994, as an exhibit toAmendment No. 2 to our Registration Statement on Form S-1.

(6)                      Previouslyfiled with the Securities and Exchange Commission on April 7, 1997, as anexhibit to our Form 10-K for the fiscal year ended January 5, 1997.

(7)                      Previously filed withthe Securities and Exchange Commission on November 20, 2002, as an exhibit toour Form 10-Q for the quarter ended October 6, 2002.

(8)                      Previously filed withthe Securities and Exchange Commission on May 17, 2000, as an exhibit to ourForm 10-Q for the quarter ended April 2, 2000.

(9)                      Previously filed withthe Securities and Exchange Commission on April 6, 1998, as an exhibit to ourForm 10-K for the fiscal year ended January 4, 1998.

(10)                Previously filed withthe Securities and Exchange Commission on April 2, 2001, as an exhibit to ourForm 10-K for the fiscal year ended December 31, 2000.

(11)                Previously filed withthe Securities and Exchange Commission on August 15, 2001, as an exhibit to ourForm 10-Q for the quarter ended July 1, 2001.

(12)                Previously filed withthe Securities and Exchange Commission on August 21, 2002, as an exhibit to ourForm 10-Q for the quarter ended July 7, 2002.

(13)                 Previously filed withthe Securities and Exchange Commission on August 20, 2003, as an exhibit to ourForm 10-Q for the quarter ended July 6, 2003.

(14)                 Previously filed withthe Securities and Exchange Commission on September 29, 2003, as an exhibit toour Registration Statement on Form S-8 (File No. 333-109240).

(15)                 Previously filed withthe Securities and Exchange Commission on September 29, 2003, as an exhibit toour Registration Statement on Form S-8 (File No. 333-109241).

(16)                 Previously filed withthe Securities and Exchange Commission on March 11, 2004, as an exhibit to ourForm 10-K for the fiscal year ended January 4, 2004.

(17)                 Previously filed withthe Securities and Exchange Commission on September 29, 2004, as an exhibit toour current report on Form 8-K.

 

46

----

 

(18)                 Previously filed withthe Securities and Exchange Commission on December 16, 2004, as an exhibit toour current report on Form 8-K.

 

47

----

### ** **

### **SIGNATURES**

### ** **

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|                  | MOVIE GALLERY,  INC. |
|-----------------------|----------------------|
|                  |                 |
|                  |                 |
|                  | By                   |  /s/ J. T.  MALUGEN |   |
|                  |                 | J. T. Malugen |
|                  |                 | *Chairman  of the Board, President  and Chief Executive Officer* |
|                  |                 |
|                  |                 |
| Date: March 18,  2005 |                 |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature**            | ** ** | **Title**                                                     | ** ** | **Date**       |
|--------------------------|------------|---------------------------------------------------------------|------------|----------------|
|                     |       |                                                          |       |           |
| /s/ J. T.  MALUGEN       |       | Chairman of the Board, President and  Chief Executive Officer |       | March 18, 2005 |
| J. T. Malugen            |       |                                                          |       |
|                     |       |                                                          |       |           |
| /s/ H. HARRISON  PARRISH |       | Vice Chairman of the Board                                    |       | March 18, 2005 |
| H. Harrison  Parrish     |       |                                                          |       |           |
|                     |       |                                                          |       |           |
| /s/ WILLIAM B.  SNOW     |       | Director                                                      |       | March 18, 2005 |
| William B. Snow          |       |                                                          |       |           |
|                     |       |                                                          |       |           |
| /s/ JOHN J. JUMP         |       | Director                                                      |       | March 18, 2005 |
| John J. Jump             |       |                                                          |       |           |
|                     |       |                                                          |       |           |
| /s/JAMES C.  LOCKWOOD    |       | Director                                                      |       | March 18, 2005 |
| James C.  Lockwood       |       |                                                          |       |           |
|                     |       |                                                          |       |           |
| /s/ IVY M.  JERNIGAN     |       | Senior Vice President and  Chief Financial Officer            |       | March 18, 2005 |
| Ivy M. Jernigan          |       |                                                          |       |

 

48

----

 

**MovieGallery, Inc.**

 

**Index to ConsolidatedFinancial Statements, Reports on Internal Control, and Schedule**

 

Fiscal years endedJanuary 5, 2003, January 4, 2004 and January 2, 2005

 

**Contents**

 
| Audited Consolidated  Financial Statements                                                             |   |
|--------------------------------------------------------------------------------------------------------|--------|
|                                                                                                   |   |
| Consolidated Balance Sheets                                                                            | F-1    |
| Consolidated  Statements of Income                                                                     | F-2    |
| Consolidated  Statements of Stockholders’ Equity                                                  | F-3    |
| Consolidated  Statements of Cash Flows                                                                 | F-4    |
| Notes to  Consolidated Financial Statements                                                            | F-5    |
|                                                                                                   |   |
| Report  of Independent Registered Public Accounting Firm                                               | F-21   |
| Management’s  Report on Internal Control Over Financial Reporting                                 | F-22   |
| Report  of Independent Registered Public Accounting Firm on Internal Control over  Financial Reporting | F-23   |
|                                                                                                   |   |
| Financial  Statement Schedule                                                                          |   |
| Schedule  II. Valuation and Qualifying Accounts                                                        | F-24   |

 

----

** **

**Movie Gallery, Inc.**

** **

**Consolidated Balance Sheets**

*(in thousands, except per sharedata)*

 
| ** **                                                                                                               | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                                                                               |       |                 |       |                 |       |
| **Assets**                                                                                                               |       |                 |       |                 |       |
| Current assets:                                                                                                          |       |                 |       |                 |       |
| Cash and cash  equivalents                                                                                               |       | $                    | 38,006     |                 | $          | 25,518 |   |
| Merchandise  inventory                                                                                                   |       | 26,473               |       | 27,419               |       |
| Prepaid expenses                                                                                                         |       | 10,686               |       | 12,712               |       |
| Store supplies  and other                                                                                                |       | 11,019               |       | 9,493                |       |
| Deferred income  taxes                                                                                                   |       | 1,631                |       | 3,358                |       |
| Total current  assets                                                                                                    |       | 87,815               |       | 78,500               |       |
|                                                                                                                     |       |                 |       |                 |       |
| Rental  inventory, net                                                                                                   |       | 102,479              |       | 126,541              |       |
| Property,  furnishings and equipment, net                                                                                |       | 114,356              |       | 128,182              |       |
| Goodwill, net                                                                                                            |       | 136,008              |       | 143,761              |       |
| Other  intangibles, net                                                                                                  |       | 8,473                |       | 7,741                |       |
| Deposits and  other assets                                                                                               |       | $                    | 8,753      |                 | 7,417      |   |
| Total assets                                                                                                             |       | 457,884              |       | $                    | 492,142    |   |
|                                                                                                                     |       |                 |       |                 |       |
| **Liabilities  and stockholders’ equity**                                                                           |       |                 |       |                 |       |
| Current  liabilities:                                                                                                    |       |                 |       |                 |       |
| Accounts payable                                                                                                         |       | $                    | 70,939     |                 | $          | 68,977 |   |
| Accrued  liabilities                                                                                                     |       | 26,161               |       | 30,570               |       |
| Deferred revenue                                                                                                         |       | 10,741               |       | 10,843               |       |
| Total current  liabilities                                                                                               |       | 107,841              |       | 110,390              |       |
|                                                                                                                     |       |                 |       |                 |       |
| Other accrued  liabilities                                                                                               |       | 142                  |       | —               |       |
| Deferred income  taxes                                                                                                   |       | 29,785               |       | 50,618               |       |
|                                                                                                                     |       |                 |       |                 |       |
| Stockholders’  equity:                                                                                              |       |                 |       |                 |       |
| Preferred stock,  $.10 par value; 2,000 shares authorized, no shares issued or outstanding                               |       | —               |       | —               |       |
| Common stock,  $.001 par value; 65,000 shares authorized, 32,841 and 31,076 shares issued  and outstanding, respectively |       | 33                   |       | 31                   |       |
| Additional  paid-in capital                                                                                              |       | 225,191              |       | 188,098              |       |
| Retained  earnings                                                                                                       |       | 91,098               |       | 136,750              |       |
| Accumulated  other comprehensive income                                                                                  |       | 3,794                |       | 6,255                |       |
| Total  stockholders’ equity                                                                                         |       |                 | 320,116    |                 | 331,134    |   |
| Total  liabilities and stockholders’ equity                                                                         |       | $                    | 457,884    |                 | $          | 492,142 |   |

 

*See accompanying notes.*

 

F-1

----

 

**Movie Gallery, Inc.**

 

**Consolidated Statements of Income**

*(in thousands, except per share data)*

 
| ** **                                   | ** ** | **Fiscal Year  Ended**    | ** ** |
|----------------------------------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|                                         |       |                      |       |   |   |   |   |
| Revenues:                                    |       |                      |       |   |   |   |   |
| Rentals                                      |       | $                         | 490,836    |   | $ | 629,793 |   | $ | 729,167 |   |
| Product  sales                               |       | 38,152                    |       | 62,602 |   | 62,010 |   |
| Total  revenues                              |       | 528,988                   |       | 692,395 |   | 791,177 |   |
|                                         |       |                      |       |   |   |   |   |
| Cost of  sales:                              |       |                      |       |   |   |   |   |
| Cost of  rental revenues                     |       | 164,818                   |       | 184,439 |   | 208,160 |   |
| Cost of  product sales                       |       | 29,852                    |       | 50,143 |   | 41,942 |   |
| Gross profit                                 |       | 334,318                   |       | 457,813 |   | 541,075 |   |
|                                         |       |                      |       |   |   |   |   |
| Operating  costs and expenses:               |       |                      |       |   |   |   |   |
| Store  operating expenses                    |       | 253,865                   |       | 324,466 |   | 395,425 |   |
| General and  administrative                  |       | 40,995                    |       | 46,522 |   | 54,644 |   |
| Amortization  of intangibles                 |       | 1,298                     |       | 2,003 |   | 2,601 |   |
| Stock option  compensation                   |       | 2,279                     |       | 1,481 |   | 831 |   |
| Operating  income                            |       | 35,881                    |       | 83,341 |   | 87,574 |   |
|                                         |       |                      |       |   |   |   |   |
| Interest  expense, net                       |       | (1,024                    | )          | (468 | ) | (624 | ) |
| Equity in  losses of unconsolidated entities |       | —                    |       | (1,450 | ) | (5,746 | ) |
| Income  before income taxes                  |       | 34,857                    |       | 81,423 |   | 81,204 |   |
|                                         |       |                      |       |   |   |   |   |
| Income taxes                                 |       | 13,923                    |       | 31,987 |   | 31,716 |   |
|                                         |       |                      |       |   |   |   |   |
| Net income                                   |       | $                         | 20,934     |   | $ | 49,436 |   | $ | 49,488 |   |
|                                         |       |                      |       |   |   |   |   |
| Net income  per share:                       |       |                      |       |   |   |   |   |
| Basic                                        |       | $                         | 0.69       |   | $ | 1.53 |   | $ | 1.54 |   |
|                                         |       |                      |       |   |   |   |   |
| Diluted                                      |       | $                         | 0.67       |   | $ | 1.48 |   | $ | 1.52 |   |
|                                         |       |                      |       |   |   |   |   |
| Weighted  average shares outstanding:        |       |                      |       |   |   |   |   |
| Basic                                        |       | 30,273                    |       | 32,406 |   | 32,096 |   |
| Diluted                                      |       | 31,436                    |       | 33,370 |   | 32,552 |   |
|                                         |       |                      |       |   |   |   |   |
|                                         |       |                      |       |   |   |   |   |
| Cash  dividends per common share             |       | $                         | —     |   | $ | 0.03 |   | $ | 0.12 |   |

 

*See accompanyingnotes.*

 

F-2

----

 

**Movie Gallery, Inc.**

 

**Consolidated Statements of Stockholders’ Equity**

*(in thousands, except per share data)*

 
| ** **                                                                      | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
|                                                                            |       |              |       |                             |       |                   |       |                                                 |       |                                  |       |
| Balance at January 6,  2002                                                |       | $                 | 27         |                             | $          | 140,475                |       | $                                                    | 21,713     |                                  | $          | (33 | ) | $ | 162,182 |   |
| Comprehensive  Income:                                                          |       |              |       |                             |       |                   |       |                                                 |       |                                  |       |
| Net income                                                                      |       |              |       |                             |       | 20,934                 |       | —                                               |       | 20,934                                |       |
| Foreign  currency translation                                                   |       |              |       |                             |       | —                 |       | (226                                                 | )          | (226                                  | )          |
| Total  comprehensive income                                                     |       |              |       |                             |       |                   |       |                                                 |       | 20,708                                |       |
| Issuance of  3,900 shares of common stock, net of issuance costs of $4,406      |       | 4                 |       | 66,765                           |       | —                 |       | —                                               |       | 66,769                                |       |
| Exercise of  stock options for 947 shares                                       |       | 1                 |       | 2,658                            |       | —                 |       | —                                               |       | 2,659                                 |       |
| Tax benefit  of stock options exercised                                         |       | —            |       | 4,454                            |       | —                 |       | —                                               |       | 4,454                                 |       |
| Non-cash  stock option compensation                                             |       | —            |       | 2,279                            |       | —                 |       | —                                               |       | 2,279                                 |       |
| Balance at January 5,  2003                                                |       | 32                |       | 216,631                          |       | 42,647                 |       | (259                                                 | )          | 259,051                               |       |
| Comprehensive  Income:                                                          |       |              |       |                             |       |                   |       |                                                 |       |                                  |       |
| Net income                                                                      |       |              |       |                             |       | 49,436                 |       | —                                               |       | 49,436                                |       |
| Foreign  currency translation                                                   |       |              |       |                             |       | —                 |       | 4,053                                                |       | 4,053                                 |       |
| Total  comprehensive income                                                     |       |              |       |                             |       |                   |       |                                                 |       | 53,489                                |       |
| Exercise of  stock options for 779 shares                                       |       | 1                 |       | 3,332                            |       | —                 |       | —                                               |       | 3,333                                 |       |
| Tax benefit  of stock options exercised                                         |       | —            |       | 3,747                            |       | —                 |       | —                                               |       | 3,747                                 |       |
| Non-cash  stock option compensation                                             |       | —            |       | 1,481                            |       | —                 |       | —                                               |       | 1,481                                 |       |
| Dividends  declared, $0.03 per share                                            |       | —            |       | —                           |       | (985                   | )          | —                                               |       | (985                                  | )          |
| Balance at January 4,  2004                                                |       | 33                |       | 225,191                          |       | 91,098                 |       | 3,794                                                |       | 320,116                               |       |
| Comprehensive  Income:                                                          |       |              |       |                             |       |                   |       |                                                 |       |                                  |       |
| Net income                                                                      |       |              |       |                             |       | 49,488                 |       | —                                               |       | 49,488                                |       |
| Foreign  currency translation                                                   |       |              |       |                             |       | —                 |       | 2,461                                                |       | 2,461                                 |       |
| Total  comprehensive income                                                     |       |              |       |                             |       |                   |       |                                                 |       | 51,949                                |       |
| Exercise of  stock options for 876 shares                                       |       | 1                 |       | 5,522                            |       | —                 |       | —                                               |       | 5,523                                 |       |
| Tax benefit  of stock options exercised                                         |       | —            |       | 4,305                            |       | —                 |       | —                                               |       | 4,305                                 |       |
| Non-cash  stock option compensation                                             |       | —            |       | 64                               |       | —                 |       | —                                               |       | 64                                    |       |
| Issuance of  26 shares of common stock pursuant to employee stock purchase plan |       | —            |       | 403                              |       | —                 |       | —                                               |       | 403                                   |       |
| Purchases  and retirement of 2,625 shares of common stock                       |       | (3                | )          | (47,387                          | )          | —                 |       | —                                               |       | (47,390                               | )          |
| Dividends  declared, $0.12 per share                                            |       | —            |       | —                           |       | (3,836                 | )          | —                                               |       | (3,836                                | )          |
| Balance at January 2,  2005                                                |       | $                 | 31         |                             | $          | 188,098                |       | $                                                    | 136,750    |                                  | $          | 6,255 |   | $ | 331,134 |   |
|                                                                                 |            |                   |            |                                  |            |                        |            |                                                      |            |                                       |            |  |  |  |  |  |  |  |

 

*See accompanying notes.*

 

F-3

----

 

**Movie Gallery, Inc.**

 

**Consolidated Statements of Cash Flows**

(*in thousands)*

 
| ** **                                                                         | ** ** | **Fiscal Year Ended**     | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                         | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|                                                                               |       |                      |       |   |   |   |   |
| **Operating  activities :**                                                        |       |                      |       |   |   |   |   |
| Net income                                                                         |       | $                         | 20,934     |   | $ | 49,436 |   | $ | 49,488 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                      |       |   |   |   |   |
| Rental  inventory amortization                                                     |       | 128,300                   |       | 132,978 |   | 144,521 |   |
| Purchases of  rental inventory                                                     |       | (107,546                  | )          | (130,503 | ) | (150,924 | ) |
| Depreciation  and intangibles amortization                                         |       | 19,346                    |       | 23,569 |   | 36,185 |   |
| Non-cash  stock option compensation                                                |       | 2,279                     |       | 1,481 |   | 64 |   |
| Tax benefit  of stock options exercised                                            |       | 4,454                     |       | 3,747 |   | 4,305 |   |
| Deferred  income taxes                                                             |       | 4,653                     |       | 24,036 |   | 19,106 |   |
| Changes in  operating assets and liabilities:                                      |       |                      |       |   |   |   |   |
| Merchandise  inventory                                                             |       | (10,972                   | )          | (7,232 | ) | (491 | ) |
| Other  current assets                                                              |       | (8,072                    | )          | (4,905 | ) | (500 | ) |
| Deposits and  other assets                                                         |       | (1,222                    | )          | (5,085 | ) | 1,336 |   |
| Accounts  payable                                                                  |       | 13,081                    |       | 6,308 |   | (1,962 | ) |
| Accrued  liabilities and deferred revenue                                          |       | 3,967                     |       | 1,725 |   | 4,361 |   |
| Net cash provided  by operating activities                                         |       | 69,202                    |       | 95,555 |   | 105,489 |   |
|                                                                               |       |                      |       |   |   |   |   |
| **Investing  activities :**                                                        |       |                      |       |   |   |   |   |
| Business  acquisitions                                                             |       | (57,675                   | )          | (30,672 | ) | (12,962 | ) |
| Purchases of  rental inventory-base stock                                          |       | (10,207                   | )          | (16,702 | ) | (15,616 | ) |
| Purchases of  property, furnishings and equipment                                  |       | (31,316                   | )          | (47,116 | ) | (46,507 | ) |
| Net cash  used in investing activities                                             |       | (99,198                   | )          | (94,490 | ) | (75,085 | ) |
|                                                                               |       |                      |       |   |   |   |   |
| **Financing  activities :**                                                        |       |                      |       |   |   |   |   |
| Borrowings  on credit facility                                                     |       | 70,610                    |       | 31,450 |   | 129,500 |   |
| Net payments  on credit facility                                                   |       | (96,610                   | )          | (31,450 | ) | (129,500 | ) |
| Net proceeds  from issuance of common stock                                        |       | 66,769                    |       | — |   | — |   |
| Proceeds  from exercise of stock options                                           |       | 2,659                     |       | 3,333 |   | 5,523 |   |
| Proceeds  from employee stock purchase plan                                        |       | —                    |       | — |   | 403 |   |
| Purchases  and retirement of common stock                                          |       | —                    |       | — |   | (47,390 | ) |
| Payment of  dividends                                                              |       | —                    |       | — |   | (3,889 | ) |
| Net cash  provided by (used in) financing activities                               |       | 43,428                    |       | 3,333 |   | (45,353 | ) |
|                                                                               |       |                      |       |   |   |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                      |       | (226                      | )          | 4,053 |   | 2,461 |   |
| Increase  (decrease) in cash and cash equivalents                                  |       | 13,206                    |       | 8,451 |   | (12,488 | ) |
| Cash and  cash equivalents at beginning of fiscal year                             |       | 16,349                    |       | 29,555 |   | 38,006 |   |
| Cash and  cash equivalents at end of fiscal year                                   |       | $                         | 29,555     |   | $ | 38,006 |   | $ | 25,518 |   |
|                                                                               |       |                      |       |   |   |   |   |
| **Supplemental  disclosures of cash flow information:**                            |       |                      |       |   |   |   |   |
| Cash paid  during the fiscal year for interest                                     |       | $                         | 905        |   | $ | 254 |   | $ | 694 |   |
| Cash paid  during the fiscal year for income taxes                                 |       | 2,716                     |       | 4,974 |   | 6,826 |   |

 

*See accompanyingnotes.*

 

F-4

----

 

**Movie Gallery, Inc.**

 

**Notes to Consolidated FinancialStatements**

 

**January 5, 2003, January 4, 2004 and January 2,2005**

 

**1. Accounting Policies**

 

*Principles of Consolidation and Descriptionof Business*

 

**The accompanying financial statements present theconsolidated financial position, results of operations and cash flows of MovieGallery, Inc. and subsidiaries. Investments in unconsolidated subsidiaries where we have significantinfluence but do not have control are accounted for using the equity method ofaccounting for investments in common stock. All material intercompany accounts and transactions have beeneliminated.**

 

**We own and operate video specialty stores locatedthroughout North America.**

 

*Use of Estimates*

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States requires us to make estimates and assumptions that affect theamounts reported in the consolidated financial statements and accompanyingnotes.  The most significant estimatesand assumptions relate to the amortization methods and useful lives of rentalinventory, fixed assets and other intangibles, valuation allowances fordeferred tax assets, estimated cash flows used to test long-lived assets for impairment,and the allocation of the purchase price of acquired businesses.  These estimates and assumptions could changeand actual results could differ from these estimates.

 

*Fiscal Year*

 

Our fiscal year ends on the first Sunday following December 30, whichperiodically results in a fiscal year of 53 weeks.  Results for the fiscal year ended January 5,2003, January 4, 2004 and January 2, 2005 reflect 52-week years. Ourfiscal year includes revenues and certain costs and expenses, such as revenuesharing, payroll and other miscellaneous expenses, on a daily basis.  All other expenses, primarily depreciation,amortization, rent and utilities, are calculated and recorded monthly, withtwelve months included in each fiscal year.

 

*Reclassifications*

 

Certain reclassifications have been made to the prior year financialstatements to conform to the current year presentation.  These reclassifications had no impact onstockholders’ equity or net income.

 

The fiscal 2003 balance sheet reflects the reclassification of certainoutstanding checks.  Thereclassifications were made between cash and cash equivalents, prepaid expensesand accounts payable in order to conform with the current yearpresentation.  The correspondingreclassifications were made in the statements of cash flows for fiscal 2002 and2003.  The reclassifications had noimpact on working capital and reduced net cash provided by operating activitiesby $10.0 million and $5.7 million in fiscal 2002 and 2003, respectively.

 

In the third quarter of 2004, we began classifying losses recognizedunder the equity method of accounting on unconsolidated equity investments inalternative delivery vehicles on a separate line item, “Equity in losses ofunconsolidated entities,” on our statements of income.   These losses were previously grouped withstore operating

 

F-5

----

 

expenses in our statements of income. We reclassified those losses for prior periods to conform to the currentyear presentation.

 

In the first quarter of 2004, we began reporting the on-going purchasesof new release rental inventory as an operating activity in the statement ofcash flows rather than an investing activity as previously reported.   We believe this reclassification isappropriate because our annual cash investment in rental inventory issubstantial and in many respects is similar to recurring merchandise inventorypurchases considering our operating cycle and the relatively short useful livesof our rental inventory.  Purchases ofrental inventory for new stores or other significant investments in base stockrental inventory continue to be classified as investing activities in thestatements of cash flows as these purchases represent a long-term investment inour business.  Rental inventory purchasesin the prior year have been reclassified to conform to the current yearpresentation for comparative purposes. The reclassification had no impact on our financial position or resultsof operations as previously reported.

 

*Cash Equivalents*

 

We consider all highly liquid investments with a maturity of threemonths or less when purchased to be cash equivalents.

 

*Merchandise Inventory*

 

Merchandise inventory consists primarily of new DVDs, videocassettetapes (“VHS”), video games, video accessories and concessions and is stated atthe lower of cost, as determined using the retail inventory method, or market.

 

*Rental Inventory*

 

Rental inventory isstated at cost and amortized over its economic useful life. The up-front feesand minimum costs of rental product purchased under revenue-sharingarrangements are capitalized and amortized in accordance with our rentalinventory amortization policy. Revenue-sharing payments are expensed as incurred and are included in costof rental revenues.  Effective as of thebeginning of the fourth quarter of 2002, the cost of base stock movie inventoryis amortized on an accelerated basis over the first twelve months and then on astraight-line basis over the next twelve months to its salvage value, $4 forDVD and $2 for VHS.  The cost of non-basestock, or new release, movie inventory is amortized to its salvage value on anaccelerated basis over six months.  Videogames are amortized on a straight-line basis to a $5 salvage value over twelvemonths.  The gross cost and accumulatedamortization are written off to cost of rental revenue when rental inventory issold as previously viewed.

 

In the fourth quarter of 2002, we changed the estimates used toamortize rental inventory as a result of a significant shift from VHS to DVDthat occurred in our rental inventory base throughout 2002.  The revised estimates reflect a reduction inthe estimated useful lives of the rental inventory and a reduced salvage valuefor both VHS and game inventory.  Thechanges in our estimates for rental inventory amortization were applied to allinventory held at the beginning of the fourth quarter of fiscal 2002.  The changes were accounted for as a change inaccounting estimate during the fourth quarter ended January 5, 2003.  The change in estimate decreased rentalinventory and increased amortization expense for fiscal 2002 by approximately$27.9 million and reduced net income by $16.7 million, or $0.53 per dilutedshare. The impact of the change in fiscal 2002 was net of a $2.1 million reserveagainst rental inventory that was established in the fourth quarter of 2001 inorder to reflect the impact of the consumer transition to DVD on the saleprices of previously viewed VHS product. For fiscal 2003, rental inventory was decreased and amortization expensewas increased by approximately $5.9 million and net income was reduced by $3.6million, or $0.11 per diluted share.

 

Prior to the fourthquarter of 2002, the cost of base stock movie inventory was amortized on anaccelerated basis to a net book value of $8 over six months and to a $4 salvagevalue over the next thirty months.  Thecost of non-base stock movie inventory was amortized on an accelerated basisover six months to a net book value of $4, which was

 

F-6

----

 

then amortized on astraight-line basis over the next 30 months or until the movie was sold, atwhich time the unamortized book value was charged to cost of rentalrevenues.  Video games were amortized ona straight-line basis to a $10 salvage value over eighteen months or until thegame was sold, at which time the unamortized book value was charged to cost ofrental revenues.

 

Rental inventory consists of the following (in thousands):

 
| ** **                | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|---------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                | ** ** | ** **                | ** ** | ** **                | ** ** |
| Rental inventory          |       | $                         | 217,420    |                      | $          | 240,172 |   |
| Accumulated  amortization |       | (114,941                  | )          | (113,631                  | )          |
|                      |       | $                         | 102,479    |                      | $          | 126,541 |   |

 

*Property, Furnishings and Equipment*

 

Property, furnishings andequipment are stated at cost and depreciated on a straight-line basis over theestimated useful lives of the related assets.  Property, furnishings and equipment consists of the following (inthousands):

 
| ** **                | ** ** | **Useful Life** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|---------------------------|------------|-----------------|------------|---------------------------|------------|---------------------------|------------|
|                      |       |            |       |                      |       |                      |       |
| Land                      |       | —          |       | $                         | 2,970      |                      | $          | 5,822 |   |
| Buildings                 |       | 40 years        |       | 6,826                     |       | 7,756                     |       |
| Furniture  and fixtures   |       | 7 years         |       | 65,374                    |       | 77,827                    |       |
| Equipment                 |       | 5 years         |       | 65,263                    |       | 76,104                    |       |
| Leasehold  improvements   |       | 2-7 years       |       | 57,892                    |       | 69,904                    |       |
| Signs                     |       | 7 years         |       | 25,370                    |       | 31,559                    |       |
|                      |       |            |       | 223,695                   |       | 268,972                   |       |
| Accumulated  depreciation |       |            |       | (109,339                  | )          | (140,790                  | )          |
|                      |       |            |       | $                         | 114,356    |                      | $          | 128,182 |   |
|                           |            |                 |            |                           |            |                           |            |  |  |  |  |

 

*Goodwill and Other IntangibleAssets*

 

**Goodwill is recorded at historical cost and is tested forimpairment annually, or more frequently if events or changes in circumstancesindicate that the asset might be impaired, in accordance with FASB StatementNo. 142, *Goodwill and Other Intangible Assets.*  We have not recognized impairment losses ongoodwill in fiscal 2002, 2003 or 2004.**

** **

**Other intangible assets consist primarily of non-competeagreements and customer lists and are amortized on a straight-line basis overtheir estimated useful lives.**

** **

*Impairment of Long-Lived Assets*

 

Long-lived assets, including rentalinventory, property, furnishings and equipment and intangible assets withfinite lives, are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount may not be recoverable, inaccordance with FASB Statement No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets.*  We use the discounted cash flow method toestimate the fair value of our long-lived assets.  We have not recognized impairment losses onlong-lived assets held for use in fiscal 2002, 2003 or 2004.

 

F-7

----

 

*Income Taxes*

 

We account for income taxes under the provisions of FASB Statement No.109, *Accounting for Income Taxes.*  Under Statement 109, deferred tax assets andliabilities are determined based upon differences between financial reportingand tax bases of assets and liabilities and are measured at the enacted taxrates and laws that will be in effect when the differences are expected toreverse.  We record a valuation allowanceto reduce deferred tax assets if it is more likely than not that some portionor all of the deferred tax assets will not be realized.  We generally consider the earnings of ourforeign subsidiaries to be permanently reinvested for use in those operationsand, consequently, deferred federal income taxes, net of applicable foreign taxcredits, are not provided on the undistributed earnings of foreign subsidiarieswhich are to be so reinvested.

 

*Revenue Recognition*

 

We recognize rental revenue when a movie or video game is rented by thecustomer.  We recognize product salesrevenue at the time of sale.  Revenuefrom extended viewing fees incurred on rentals when the customer chooses tokeep the product beyond the initial rental period is recognized when payment isreceived from the customer.  We recognizerevenue from the sale of previously viewed inventory at the time of sale.  Previously viewed sales revenue is classifiedas rental revenue in our statements of income.  Previously viewed sales revenue was $52,252,000, $81,678,000 and$109,558,000 in fiscal 2002, 2003 and 2004, respectively.

 

We offer return privileges on certain of our products, including alifetime guarantee on previously viewed inventory.    Our sales returns and allowances underthese programs are immaterial.

 

We periodically sell stored value cards in the form of electronic giftcards or discount rental cards.  Werecord deferred revenue from the sale of stored value cards at the time of saleto the customer.  The liability isrelieved and revenue is recognized when the cards are redeemed by thecustomers.

 

*Leases and Leasehold Improvements*

 

Our new store leases generally provide for an initial lease term offive to seven years, with at least one renewal option for an additional two tofive years. We account for leases in accordance with FASB Statement No. 13,*Accounting for Leases,* and other relatedguidance*.* Statement 13 requireslease expense to be recognized on a straight-line basis over the lease term (asdefined within the guidance), including amortization of any lease incentivesreceived from the lessor. Statement 13 also requires that leasehold improvementsbe depreciated over the shorter of the lease term or the estimated useful lifeof the leasehold improvements.

 

Subsequent to the end of fiscal 2004, we completed a comprehensivereview of our accounting for leases and leasehold improvements, including the recognitionof incentive payments received from landlords. We determined that leaseholdimprovements were, in some cases, depreciated over a longer period than thelease term. As a result, we recorded a cumulative fourth quarter adjustment tocorrect depreciation expense of $6.3 million ($3.9 million after-tax or $0.12per diluted share) as an increase in store operating expenses in theaccompanying 2004 consolidated statements of income. Approximately $2.9 million($1.8 million after-tax or $0.05 per diluted share) of the adjustment wasrelated to years prior to 2004 and was not considered material to any of theprior period financial statements to warrant a restatement of those financialstatements.

 

*Advertising Costs*

 

Advertising costs are expensed when incurred.  We receive cooperative reimbursements fromvendors, which are accounted for in accordance with the Emerging Issues TaskForce (“EITF”) Issue No. 02-16, *Accounting by a Customer(Including a Reseller) for Certain Consideration Received from a Vendor. *EITF 02-16 was effective forfiscal years beginning after December 15, 2002, and generally requiresthat cash consideration received from a vendor be considered as a reduction ofthe prices of the vendor’s products, reflected as a reduction of cost of salesin the customer’s income statement.  Thepresumption can be overcome if the vendor receives an identifiable benefit inexchange for the consideration, in which case the consideration should berecorded as revenue, or if the

 

F-8

----

 

consideration represents a reimbursement of a specific identifiableincremental cost incurred by the customer in selling the vendor’s products, asa reduction of that cost.  Advertisingexpense, exclusive of cooperative reimbursements from vendors, accounted for ascost reimbursements, for fiscal 2002, 2003 and 2004 totaled $2,703,000,$7,811,000 and $9,534,000, respectively.

 

*Store Opening and Start-up Costs*

 

Store opening costs, which consist primarily of payroll, advertising andother start-up costs are expensed as incurred.

 

*Fair Value of Financial Instruments*

 

At January 4, 2004 and January 2, 2005, the carrying value offinancial instruments such as cash and cash equivalents and accounts payableapproximated their fair values.

 

*Foreign Currency Translation*

 

Our foreign subsidiaries record transactions using the local currencyas the functional currency.  Inaccordance with FASB Statement No. 52, *Foreign CurrencyTranslation,* the assets and liabilities of the foreign subsidiaryare translated into U. S. dollars using either the exchange rates in effect atthe balance sheet dates or historical exchange rates, depending upon theaccount translated.  Income and expensesare translated at average exchange rates each fiscal period.  The translation adjustments that result fromtranslating the balance sheets at different rates than the income statementsare included in accumulated other comprehensive income or loss, which is aseparate component of consolidated stockholders’ equity.

 

*Earnings Per Share*

 

Basic earnings per share is computed based on the weighted averagenumber of shares of common stock outstanding during the periods presented.  Diluted earnings per share is computed basedon the weighted average number of shares of common stock outstanding during theperiods presented, increased by the effects of shares to be issued from theexercise of dilutive common stock options (1,163,000, 964,000 and 456,000 forfiscal 2002, 2003 and 2004, respectively). No adjustments were made to net income in the computation of basic ordiluted earnings per share.  Becausetheir inclusion would be anti-dilutive, 238,000, 225,000 and 546,000 optionsfor fiscal 2002, 2003 and 2004, respectively, were excluded from thecomputation of the weighted average shares for diluted earnings per share.

 

*Stock Option Plan*

 

At January 2, 2005,we have a stock-based employee compensation plan, which is described more fullyin Note 6.  We account for the plan underthe recognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees,*and relatedInterpretations.  Stock optioncompensation is reflected in net income for variable options outstanding underthe plan that were repriced in March 2001 and for transactions with currentand former executives in fiscal 2004 (see Note 6).  No stock option compensation is reflected innet income for the remaining options outstanding under the plan, as theexercise price was equal to the market value of the underlying common stock onthe date of grant.

 

The following tableillustrates the effect on net income and earnings per share if we had appliedthe fair value recognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation,* to stock-basedemployee compensation.

 

F-9

----

 
| ** **                                                                                               | ** ** | **Fiscal Year  Ended**                     | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                               | ** ** | **January 5,  2003**                  | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                                                                                               | ** ** | **(in  thousands, except per share data)** | ** ** |
|                                                                                                     |       |                                       |       |   |   |   |   |
| Net income,  as reported                                                                                 |       | $                                          | 20,934     |   | $ | 49,436 |   | $ | 49,488 |   |
| Add: Stock option  compensation included in reported net income, net of tax                              |       | 1,367                                      |       | 903 |   | 507 |   |
| Deduct:  Stock option compensation determined under fair value based methods for all  awards, net of tax |       | (1,147                                     | )          | (1,099 | ) | (1,301 | ) |
|                                                                                                     |       |                                       |       |   |   |   |   |
| Pro forma  net income                                                                                    |       | $                                          | 21,154     |   | $ | 49,240 |   | $ | 48,694 |   |
|                                                                                                     |       |                                       |       |   |   |   |   |
| Earnings per  share, as reported:                                                                        |       |                                       |       |   |   |   |   |
| Basic                                                                                                    |       | $                                          | 0.69       |   | $ | 1.53 |   | $ | 1.54 |   |
| Diluted                                                                                                  |       | $                                          | 0.67       |   | $ | 1.48 |   | $ | 1.52 |   |
|                                                                                                     |       |                                       |       |   |   |   |   |
| Pro forma  earnings per share:                                                                           |       |                                       |       |   |   |   |   |
| Basic                                                                                                    |       | $                                          | 0.70       |   | $ | 1.52 |   | $ | 1.52 |   |
| Diluted                                                                                                  |       | $                                          | 0.67       |   | $ | 1.47 |   | $ | 1.49 |   |

 

In December 2004, the FASB issued a revised Statement No. 123, *Share Based Payment* (“Statement 123R”), to address theaccounting for stock based employee plans. The Statement eliminates the abilityto account for share based compensation transactions using APB 25 and insteadrequires that such transactions be accounted for using a fair value basedmethod of accounting. The impact of adoption of Statement 123R cannot bepredicted at this time because it will depend on levels of share-based paymentsgranted in the future. However, had we adopted Statement 123R in prior periods,the impact of that standard would have approximated the impact of Statement 123as described in the table above. Statement 123R also requires the benefits of taxdeductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required undercurrent literature.  This requirementwill reduce net operating cash flows in periods after adoption.  While we cannot estimate what those amountswill be in the future (because they depend on, among other things, whenemployees exercise stock options), the amount of operating cash flowsrecognized in prior periods for such excess tax deductions were $4.5 million,$3.7 million, and $4.3 million in 2002, 2003 and 2004, respectively. Statement123R is effective for interim and annual reporting beginning after June 15,2005.

 

**2. Acquisitions**

 

We periodically make individually immaterial acquisitions of independent video specialty stores as a means of expanding our market share.  A summary of acquisitions completed in each of the last three years is as follows:

 

F-10

----

 
| ** **                  | ** ** | **Fiscal Year  Ended**    | ** ** |
|-----------------------------|------------|---------------------------|------------|
| ** **                  | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                  | ** ** | **($ in millions)**  | ** ** |
|                        |       |                      |       |   |   |   |   |
| Number of  transactions     |       | 34                        |       | 34 |   | 23 |   |
| Number of  stores acquired  |       | 265                       |       | 170 |   | 74 |   |
| Purchase  price             |       | $                         | 60.7       |   | $ | 30.7 |   | $ | 13.0 |   |
|                        |       |                      |       |   |   |   |   |
| Purchase  price allocation: |       |                      |       |   |   |   |   |
| Rental inventory            |       | $                         | 7.7        |   | $ | 5.4 |   | $ | 2.0 |   |
| Other  tangible assets      |       | 5.0                       |       | 2.5 |   | 1.4 |   |
| Goodwill                    |       | 44.0                      |       | 19.9 |   | 7.8 |   |
| Tax  deductible goodwill    |       | 44.0                      |       | 16.2 |   | 7.8 |   |
| Other  intangible assets    |       | 4.3                       |       | 3.8 |   | 1.9 |   |
| Liabilities  assumed        |       | (0.3                      | )          | (0.9 | ) | (0.1 | ) |

 

**3. Intangible Assets**

 

**The components of goodwill and other intangibles are asfollows (in thousands):**

** **
| ** **               | ** ** | ** **                                | ** ** | **January 4,  2004**   | ** ** | **January 2,  2005**     | ** ** |
|--------------------------|------------|-------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **               | ** ** | **Weighted-Average  Amortization Period** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
|                     |       |                                      |       |                        |       |                          |       |   |   |   |   |
| Goodwill                 |       | —                                    |       | $                           | 167,419    |                          | $          | (31,411 | ) | $ | 175,172 |   | $ | (31,411 | ) |
|                     |       |                                      |       |                        |       |                          |       |   |   |   |   |
| Non-compete  agreements  |       | 8 years                                   |       | $                           | 10,908     |                          | $          | (7,696 | ) | $ | 7,426 |   | $ | (4,937 | ) |
| Customer  lists          |       | 5 years                                   |       | 6,385                       |       | (1,124                        | )          | 7,628 |   | (2,376 | ) |
| Total other  intangibles |       |                                      |       | $                           | 17,293     |                          | $          | (8,820 | ) | $ | 15,054 |   | $ | (7,313 | ) |

** **

**Estimated amortization expense for other intangible assetsfor the five succeeding fiscal years and is as follows (in thousands):**

** **
| 2005   |   | $      | 2,268  |   |
|--------|--------|--------|--------|--------|
| 2006   |   | 1,944  |   |
| 2007   |   | 1,802  |   |
| 2008   |   | 1,262  |   |
| 2009   |   | 403    |   |
|   |   |   |   |

**The changes in the carrying amounts of goodwill for theyears ended January 4, 2004 and January 2, 2005, are as follows (inthousands):**

** **
| Balance as  of January 5, 2003      |   | $      | 116,119 |   |
|-------------------------------------|--------|--------|---------|--------|
| Goodwill  acquired                  |   |   | 19,889  |   |
| Balance as  of January 4, 2004 |   |   | 136,008 |   |
| Goodwill  acquired                  |   | 7,753  |    |
| Balance as  of January 2, 2005 |   | $      | 143,761 |   |

 

F-11

----

 

**4. Credit Agreement**

 

On June 27,2001, we entered into a credit agreement with a syndicate of banks, led bySouthTrust Bank (now Wachovia), with respect to a revolving creditfacility.  Our credit facility isunsecured and, as amended in September 2004, provides for an increase inborrowings from $65 million up to $75 million and an extended maturity datethrough July 3, 2006.  The interestrate on our credit facility is based on LIBOR plus an applicable marginpercentage, which depends on cash flow generation and borrowingsoutstanding.  As of January 4, 2004and January 2, 2005, there were no outstanding borrowings under our creditfacility.  The amounts available forborrowing were reduced by standby letters of credit outstanding of $2.5 millionand totaled $72.5 million as of January 2, 2005.

 

F-12

----

 

**5.  Income Taxes**

 

**The components of income before income taxes are as follows(in thousands):**

** **
| ** **     | ** ** | **Fiscal Year Ended**     | ** ** |
|----------------|------------|---------------------------|------------|
| ** **     | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|           |       |                      |       |   |   |   |   |
| U. S.  Federal |       | $                         | 35,082     |   | $ | 76,873 |   | $ | 72,042 |   |
| Foreign        |       | (225                      | )          | 4,550 |   | 9,162 |   |
| Total          |       | $                         | 34,857     |   | $ | 81,423 |   | $ | 81,204 |   |

 

The following reflectsthe components of income tax expense (in thousands):

 
| ** **        | ** ** | **Fiscal Year Ended**     | ** ** |
|-------------------|------------|---------------------------|------------|
| ** **        | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|              |       |                      |       |   |   |   |   |
| Current  payable: |       |                      |       |   |   |   |   |
| U. S.  Federal    |       | $                         | 7,090      |   | $ | 5,537 |   | $ | 9,811 |   |
| State             |       | 2,180                     |       | 2,415 |   | 2,799 |   |
| Total  current    |       | 9,270                     |       | 7,952 |   | 12,610 |   |
|              |       |                      |       |   |   |   |   |
| Deferred:         |       |                      |       |   |   |   |   |
| U. S.  Federal    |       | 5,313                     |       | 20,589 |   | 14,315 |   |
| Foreign           |       | (101                      | )          | 2,011 |   | 3,468 |   |
| State             |       | (559                      | )          | 1,435 |   | 1,323 |   |
| Total  deferred   |       | 4,653                     |       | 24,035 |   | 19,106 |   |
|              |       | $                         | 13,923     |   | $ | 31,987 |   | $ | 31,716 |   |

 

A reconciliation of income tax expense at the federal statutory incometax rate of 35% to our effective income tax provision is as follows (inthousands):

 
| ** **                                                   | ** ** | **Fiscal Year Ended**     | ** ** |
|--------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                   | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|                                                         |       |                      |       |   |   |   |   |
| Income tax  expense at statutory rate                        |       | $                         | 12,200     |   | $ | 28,499 |   | $ | 28,422 |   |
| State income  tax expense, net of federal income tax benefit |       | 1,054                     |       | 2,503 |   | 2,679 |   |
| Other, net                                                   |       | 669                       |       | 985 |   | 615 |   |
|                                                         |       | $                         | 13,923     |   | $ | 31,987 |   | $ | 31,716 |   |

 

F-13

----

 

Deferred income taxes reflect the net tax effects of temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income taxes.  Components of our deferred tax assets andliabilities are as follows (in thousands):

 
| ** **                                   | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|----------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| Deferred tax  assets:                        |       |                      |       |                      |       |
| Non-compete  agreements                      |       | $                         | 3,998      |                      | $          | 3,853 |   |
| Alternative  minimum tax credit carryforward |       | 2,492                     |       | —                    |       |
| Net  operating loss carryforwards            |       | 40,621                    |       | 38,717                    |       |
| Equity  investments                          |       | 551                       |       | 1,558                     |       |
| Accrued  bonus                               |       | 3,075                     |       | 2,205                     |       |
| Other                                        |       | 2,173                     |       | 5,197                     |       |
| Total  deferred tax assets                   |       | 52,910                    |       | 51,530                    |       |
| Valuation  allowance                         |       | (34,444                   | )          | (32,642                   | )          |
| Net deferred  tax assets                     |       | 18,466                    |       | 18,888                    |       |
| Deferred tax  liabilities:                   |       |                      |       |                      |       |
| Property, furnishings  and equipment         |       | (19,605                   | )          | (24,028                   | )          |
| Rental  inventory amortization               |       | (18,891                   | )          | (31,525                   | )          |
| Goodwill                                     |       | (5,784                    | )          | (9,666                    | )          |
| Other                                        |       | (2,340                    | )          | (929                      | )          |
| Total  deferred tax liabilities              |       | (46,620                   | )          | (66,148                   | )          |
| Net deferred  tax liabilities                |       | $                         | (28,154    | )                         | $          | (47,260 | ) |
|                                              |            |                           |            |                           |            |  |  |  |  |

 

We had federal and state net operating loss carryforwards at January 2,2005 of approximately $103 million and $45 million, respectively.  These net operating loss carryforwards resultedprimarily from the Video Update acquisition in 2001 and expire in years 2007through 2021.  During the year,adjustments were made to the valuation allowance for state net operating lossesthat were not charged to income tax expense in the amount of $1.8 million.Accordingly, we have adjusted our recorded valuation allowance to $32.6 millionrelated to the net deferred tax assets of $38.7 million.  This adjustment was primarily related to changesin these net operating losses.  Thisvaluation allowance has been established as there exists uncertainty regardingour ability to realize these net operating losses in their entirety.

 

In forming our conclusion about the future recoverability of the netoperating losses from our 2001 acquisition of Video Update, we consider, amongother things, the applicable provisions of the federal income tax code, whichlimit the deductibility of net operating loss carryforwards to thepost-acquisition taxable income (on a cumulative basis) of the acquiredsubsidiary on a separate return basis, as well as other limitations that mayapply to the future deductibility of these net operating losses.  We also consider the availability ofreversing taxable temporary differences during the carryforward period, thelength of the available carryforward period, recent operating results, ourexpectations of future taxable income during the carryforward period, changesin tax law, IRS interpretive guidance and judicial rulings.

 

**6. Stockholders’ Equity**

 

*Common Stock*

 

**During the second and third quarters of 2004, we completedtwo $25 million common stock repurchase programs.  Under the common stock repurchase programs,we repurchased 2,624,712 shares of our common stock at an average price of$18.06 per share.**

 

F-14

----

 

***Stock Option Plan***

** **

In June 2003, our Board of Directors adopted, and our stockholdersapproved, the Movie Gallery, Inc. 2003 Stock Plan.  The plan provides for the award of stockoptions, restricted stock and stock appreciation rights to employees, directorsand consultants.  Prior to adoption ofthe 2003 plan, stock option awards were subject to our 1994 Stock Plan whichexpired in 2004.  As of January 2,2005, 2,594,706  shares are reserved forissuance under the plans.  Optionsgranted under the plan have a ten-year term and generally vest over four years.

 

In accordance with the provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*, we apply AccountingPrinciples Board Opinion No. 25 and related Interpretations in accounting forthe plans and, accordingly, have not recognized compensation cost in connectionwith the plans, except for the variable options and the transactions withcurrent and former executives, described below. If we had elected to recognize compensation cost based on the fair valueof the options granted at the grant date as prescribed by Statement 123, netincome and earnings per share would have been adjusted to the pro forma amountsindicated in Note 1.  The effect on netincome and earnings per share is not expected to be indicative of the effectson net income and earnings per share in future years.

 

The fair value of each option grant was estimated at the date of grantusing the Black-Scholes option pricing model. The weighted-average assumptionsused and weighted average grant date fair values of options granted were asfollows:

 
| ** **                                        | ** ** | **Fiscal Year Ended**     | ** ** |
|---------------------------------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
|                                              |       |                      |       |   |   |   |   |
| Expected  volatility                              |       | 0.705                     |       | 0.700 |   | 0.632 |   |
| Risk-free  interest rate                          |       | 5.26                      | %          | 4.81 | % | 2.97 | % |
| Expected  life of option in years                 |       | 5.1                       |       | 4.9 |   | 3.4 |   |
| Expected  dividend yield                          |       | 0.0                       | %          | 0.0 | % | 0.6 | % |
| Weighted  average grant date fair value per share |       | $                         | 7.62       |   | $ | 9.84 |   | $ | 8.70 |   |
|                                                   |            |                           |            |  |  |  |  |  |  |  |

 

The Black-Scholes option valuation model was developed for use inestimating the fair value of traded options which have no vesting restrictionsand are fully transferable.  In addition,option valuation models require the input of highly subjective assumptionsincluding the expected stock price volatility. Because our employee stock options have characteristics significantlydifferent from those of traded options, and because changes in the subjectiveinput assumptions can materially affect the fair value estimate, in ouropinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of our employee stock options.

 

In the third quarter of fiscal 2004, we repurchased 145,900 shares ofthe common stock from current and former executives at an average price of$17.89 under our stock repurchase program. Since these individuals obtained these shares through the exercise ofstock options, the company accounted for these transactions as a repurchase ofstock options resulting in compensation expense of approximately $767,000.

 

We repriced 864,000 stock options in March 2001, and reduced theexercise price to $1.78 per share.  Therepriced stock options are accounted for as variable until the stock optionsare exercised, forfeited or expire unexercised. Assuming all repriced stock optionsare exercised, we will ultimately receive $0.6 million less than if norepricing had occurred.  The totalvariable compensation expense recognized under these repriced options was$2,279,000, $1,481,000 and $64,000 in fiscal 2002, 2003 and 2004, respectively.  As of January 2, 2005, approximately28,000 of these options remained outstanding and they will expire, if notexercised or forfeited, in 2008 and 2009. Total

 

F-15

----

 

stock option compensation for fiscal 2004 on the statements of incomeincludes the expense associated with the common stock that was repurchased fromcurrent and former executive as previously described.

 

*EmployeeStock Purchase Plan*

 

Under the 2003 Employee StockPurchase Plan, 250,000 shares of our common stock were made available forpurchase through a series of six month offering periods commencing on or aboutApril 1 and October 1 of each year. The first offering period commenced onOctober 1, 2003. All employees are eligible to participate in the plan. Thepurchase price of each share is 85% of the fair market value of a share ofcommon stock on the offering date or on the purchase date, whichever is lower.Employees purchased approximately 26,000 shares of stock under the plan infiscal 2004. At January 2, 2005, approximately 224,000 shares were availablefor future purchases.

 

F-16

----

 

A summary of our stock option activity and related information is asfollows:

 
| ** **                           | ** ** | **Outstanding  Options** | ** ** | **Weighted-  Average Exercise  Price Per Share** | ** ** |
|--------------------------------------|------------|--------------------------|------------|--------------------------------------------------|------------|
|                                 |       |                     |       |                                             |       |
| Outstanding  at January 6, 2002 |       | 3,445,509                |       | $                                                | 4.71       |   |
| Granted                              |       | 456,250                  |       | 14.61                                            |       |
| Exercised                            |       | (946,935                 | )          | 2.81                                             |       |
| Cancelled                            |       | (43,531                  | )          | 3.25                                             |       |
|                                 |       |                     |       |                                             |       |
| Outstanding  at January 5, 2003 |       | 2,911,293                |       | 6.90                                             |       |
| Granted                              |       | 537,500                  |       | 20.30                                            |       |
| Exercised                            |       | (778,978                 | )          | 4.29                                             |       |
| Cancelled                            |       | (33,722                  | )          | 10.50                                            |       |
|                                 |       |                     |       |                                             |       |
| Outstanding  at January 4, 2004 |       | 2,636,093                |       | 10.36                                            |       |
| Granted                              |       | 102,000                  |       | 19.36                                            |       |
| Exercised                            |       | (875,884                 | )          | 6.31                                             |       |
| Cancelled                            |       | (268,653                 | )          | 13.71                                            |       |
| Outstanding  at January 2, 2005 |       | 1,593,556                |       | 12.59                                            |       |
|                                 |       |                     |       |                                             |       |
| Exercisable  at January 5, 2003 |       | 1,873,068                |       | 6.92                                             |       |
| Exercisable  at January 4, 2004 |       | 1,643,236                |       | 7.74                                             |       |
| Exercisable  at January 2, 2005 |       | 1,024,181                |       | 9.34                                             |       |
|                                      |            |                          |            |                                                  |            |  |

 

Options outstanding as of January 2, 2005 had a weighted-averageremaining contractual life of 6 years and exercise prices ranging from $1.00 to$22.00 as follows:

 
| ** **                                              | ** ** | **Exercise price of** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **$1.00 to $3.00**    | ** ** | **$6.00 to $12.00** | ** ** | **$13.00 to $22.00** | ** ** |
| ** **                                              | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Options  outstanding                                    |       | 458,118               |       | 101,250 |   | 1,034,188 |   |
| Weighted-average  exercise price                        |       | $1.56                 |       | $7.25 |   | $18.00 |   |
| Weighted-average  remaining contractual life            |       | 5.2 years             |       | 1.5 years |   | 7.2 years |   |
| Options  exercisable                                    |       | 454,743               |       | 101,250 |   | 468,188 |   |
| Weighted-average  exercise price of exercisable options |       | $1.56                 |       | $7.25 |   | $17.36 |   |

 

F-17

----

 

**7. Commitments and Contingencies**

 

Rent expense for fiscal 2002, 2003 and 2004 totaled $82,597,000,$103,160,000 and $126,050,000, respectively. Future minimum payments under the remaining noncancellable terms ofoperating leases with remaining terms in excess of one year  (excluding renewal options) at January 2,2005 (in thousands):

 
| 2005       |   | $      | 97,327  |   |
|------------|--------|--------|---------|--------|
| 2006       |   | 82,549 |    |
| 2007       |   | 59,804 |    |
| 2008       |   | 39,763 |    |
| 2009       |   | 25,675 |    |
| Thereafter |   | 27,469 |    |
|       |   | $      | 332,587 |   |

 

Several companies acquired by us prior to1997 had pre-existing long-term contracts with Rentrak Corporation under whichproduct would be provided under pay-per-transaction revenue sharingarrangements.  During late 1996, weconsolidated existing contracts with Rentrak into one national agreement whichhad an expiration date in September 2006. The contract provided for minimum gross annual purchase commitments withthe ability to satisfy the cumulative obligation as early as December 31,2003.  In 2004 we satisfied ourobligation under the contract.

 

In the second quarter offiscal 2002, we obtained a preliminary court order approving a settlementagreement in certain putative class action lawsuits filed against us allegingthat the extended viewing fees charged to our customers for keeping rentalproducts beyond the initial rental period were penalties in violation ofcertain common law and equitable principles. Under the terms of the settlement agreement, we were required to giveclass members certificates with values ranging from $9 to $16, redeemablebetween January 30, 2003 and June 30, 2003, for movie rentals, gamerentals, and non-food purchases in our stores. We also agreed to pay the plaintiffs’ attorneys up to $850,000 infees.  The terms of the settlement wereapproved in a fairness hearing on November 22, 2002.  The settlement is non-appealable and releasedall claims made by all class members in all the pending class actions, otherthan a de minimis number of members who chose not to participate in thesettlement.  We incurred a one-timecharge to our earnings of approximately $4 million in the second quarter of2002 as a result of the settlement, which amount includes $850,000 of plaintiffs’attorneys’ fees.

 

We are occasionally involved in litigation in the ordinary course ofbusiness, none of which, individually or in the aggregate, is material to ourbusiness or results of operations.

 

**8. Related Party Transactions**

 

We hold a one-thirdinterest in ECHO, LLC, a supply sales and distribution company.  We purchase office and store supplies andother business products from ECHO. Transactions with ECHO are as follows:

 
| ** **                 | ** ** | **Fiscal Year Ended**     | ** ** |
|----------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                 | ** ** | **(in thousands)**        | ** ** |
| Purchases  from ECHO       |       | $                         | 6,422      |   | $ | 13,056 |   | $ | 13,962 |   |
| Distributions  from ECHO   |       | 40                        |       | 161 |   | 151 |   |
| Interest  from ECHO        |       | 6                         |       | 5 |   | 5 |   |
| Note  receivable from ECHO |       |                      |       | 125 |   | — |   |
| Accounts  payable to ECHO  |       |                      |       | 309 |   | 193 |   |
|                            |            |                           |            |  |  |  |  |  |  |  |

 

F-18

----

 

**9. Foreign Operations**

 

We operate in one reporting segment for purposes of FinancialAccounting Standards Board (“FASB”) Statement of Financial Accounting Standards(“Statement”) No. 131, *Disclosures about Segmentsof an Enterprise and Related Information.*  The following table sets forth ourconsolidated revenues, operating income and assets by geographic area.  All intercompany balances and transactionshave been eliminated.

 
| ** **                       | ** ** | **Fiscal Year Ended**     | ** ** |
|----------------------------------|------------|---------------------------|------------|
| ** **                       | ** ** | **January 5,  2003** | ** ** | **January 4,  2004** | ** ** | **January 2,  2005** | ** ** |
| ** **                       | ** ** | **(in thousands)**        | ** ** |
| Revenues:                        |       |                      |       |   |   |   |   |
| United  States                   |       | $                         | 505,807    |   | $ | 648,428 |   | $ | 731,851 |   |
| Canada                           |       | 23,181                    |       | 43,967 |   | 58,931 |   |
| Mexico                           |       | —                    |       | — |   | 395 |   |
| Total  revenues                  |       | $                         | 528,988    |   | $ | 692,395 |   | $ | 791,177 |   |
|                             |       |                      |       |   |   |   |   |
| Operating  income:               |       |                      |       |   |   |   |   |
| United  States                   |       | $                         | 36,111     |   | $ | 78,796 |   | $ | 78,871 |   |
| Canada                           |       | (230                      | )          | 4,545 |   | 9,131 |   |
| Mexico                           |       | —                    |       | — |   | (428 | ) |
| Total  operating income          |       | $                         | 35,881     |   | $ | 83,341 |   | $ | 87,574 |   |
|                             |       |                      |       |   |   |   |   |
| Assets (at  end of fiscal year): |       |                      |       |   |   |   |   |
| United  States                   |       |                      |       | $ | 423,118 |   | $ | 441,519 |   |
| Canada                           |       |                      |       | 34,766 |   | 49,390 |   |
| Mexico                           |       |                      |       | — |   | 1,233 |   |
| Total assets                     |       |                      |       | $ | 457,884 |   | $ | 492,142 |   |

 

F-19

----

 

**10. Summary of Quarterly Results of Operations (Unaudited)**

 

The following is a summary of our unaudited quarterly results of operations(in thousands, except per share data):

 
| ** **                  | ** ** | **Thirteen  Weeks Ended** | ** ** |
|-----------------------------|------------|---------------------------|------------|
| ** **                  | ** ** | **April 6,  2003**   | ** ** | **July 6,  2003** | ** ** | **October 5,  2003** | ** ** | **January 4,  2004** | ** ** |
|                        |       |                      |       |   |   |   |   |   |   |
| Revenues                    |       | $                         | 168,649    |   | $ | 160,998 |   | $ | 167,239 |   | $ | 195,509 |   |
| Gross profit                |       | 108,394                   |       | 108,404 |   | 112,675 |   | 128,340 |   |
| Net income(1)               |       | 13,284                    |       | 9,477 |   | 9,215 |   | 17,460 |   |
| Basic  earnings per share   |       | 0.41                      |       | 0.29 |   | 0.28 |   | 0.53 |   |
| Diluted  earnings per share |       | 0.40                      |       | 0.28 |   | 0.28 |   | 0.52 |   |
|                             |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Thirteen  Weeks Ended** | ** ** |
|-----------------------------|------------|---------------------------|------------|
| ** **                  | ** ** | **April 4,  2004**   | ** ** | **July 4,  2004** | ** ** | **October 3,  2004** | ** ** | **January 2,  2005** | ** ** |
|                        |       |                      |       |   |   |   |   |   |   |
| Revenues                    |       | $                         | 203,302    |   | $ | 189,591 |   | $ | 189,855 |   | $ | 208,429 |   |
| Gross profit                |       | 140,617                   |       | 129,551 |   | 130,072 |   | 140,835 |   |
| Net income(2)               |       | 18,252                    |       | 10,634 |   | 9,214 |   | 11,388 |   |
| Basic  earnings per share   |       | 0.55                      |       | 0.32 |   | 0.29 |   | 0.37 |   |
| Diluted  earnings per share |       | 0.54                      |       | 0.32 |   | 0.29 |   | 0.36 |   |
|                             |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

(1)   Fiscal 2003 includes a non-cash chargerelated to a fourth quarter fiscal 2002 change in the estimates used toamortize rental inventory of $2.7 million, $1.4 million, $1.0 million and $0.8million or $0.05, $0.03, $0.02 and $0.01 per diluted share, for the first,second, third and fourth quarters, respectively.  (see Note 1)

 

(2)   The fourth quarter of fiscal 2004 includes anafter-tax charge of $3.9 million, or $0.12 per diluted share, representing acumulative adjustment to reduce the useful lives over which we depreciateleasehold improvements. Of this amount, $1.8 million related to prior fiscalyears and $492,000, $528,000 and $543,000 related to the first, second andthird quarters of fiscal 2004. Excluding the effects of these cumulative errorcorrections, net income for the fourth quarter of 2004 would have been $14.7million and quarterly diluted earnings per share would have been $0.53, $0.30,and $0.27 per diluted share, for the first, second, and third quarters,respectively. (see Note 1)

 

**11. Subsequent Events**

 

On January 9, 2005, we entered into an Agreement and Plan ofMerger (“Merger Agreement”) with Hollywood Corporation (Nasdaq: HLYW)(“Hollywood”) contemplating our acquisition of Hollywood for approximately $850million in cash plus our assumption of approximately $350 million in debt ofHollywood.  Hollywood is the secondlargest home video specialty retailer in the United States, operating approximately2,000 stores in 47 states and the District of Columbia, some of which containthe approximately 700 Game Crazy video game specialty retail stores, where gameenthusiasts can buy, sell and trade new and used video game hardware, softwareand accessories.  Pursuant to the MergerAgreement, we will merge a subsidiary of ours with and into Hollywood, withHollywood surviving the merger as our wholly-owned subsidiary.

 

Consummation of the Hollywood merger is subject to the satisfaction ofa variety of closing conditions, including the approval of the proposed mergerby the shareholders of Hollywood and our consummation of the financingnecessary to fund the acquisition.  Inaddition, both we and Hollywood have customary termination rights in somecircumstances, including a right by Hollywood to terminate the Merger Agreementto accept an unsolicited superior acquisition proposal.

 

On March 2, 2005, we entered into a definitive agreement with VHQEntertainment, Inc. (“VHQ”) to commence a tender offer for all of itsoutstanding common stock at a price of C$1.15 per share. Total considerationfor the transaction is approximately C$20.4 million (US$16.5 million), including C$17.5 million in equity andC$2.9 million in assumed debt. The common stock of VHQ trades on the TorontoStock Exchange under the symbol “VHQ.” VHQ owns and operates 61 video rentalstores in secondary and suburban markets in Alberta, Saskatchewan and theNorthwest Territories. 

 

The VHQ transaction is conditioned upon, among other matters, thetender of two-thirds of VHQ’s outstanding shares into the offer and the receiptof certain third party consents. Shareholders of VHQ Entertainment representingapproximately 50% of the outstanding shares have committed to tender theirshares into our offer. The transaction is also subject to customary regulatoryapprovals, including receipt of notice from the Minister of Culture that theacquisition provides a net benefit to Canada, consistent with the conditions ofthe Investments Canada Act.

 

F-20

----

 

**Report of Independent Registered Public Accounting Firm**

 

 

The Board of Directors and Stockholders

Movie Gallery, Inc.

 

We have audited the accompanying consolidated balance sheets of MovieGallery, Inc. as of January 2, 2005 and January 4, 2004, and therelated consolidated statements of income, stockholders’ equity and cash flowsfor each of the three years in the period ended January 2, 2005.  Our audits also included the financialstatement schedule listed in the Index at Item 15(a).  These financial statements and schedule arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements and schedule based on ouraudits.

 

**We conducted our audits in accordance with standards of thePublic Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.**

** **

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position of MovieGallery, Inc. at January 2, 2005 and January 4, 2004, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended January 2, 2005, in conformity with U.S.generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, whenconsidered in relation to the basic financial statements, taken as a whole,presents fairly in all material respects the information set forth therein.

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the effectiveness of MovieGallery, Inc.’s internal control over financial reporting as of January 2,2005, based on criteria established in Internal Control-Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated March 14, 2005 expressed an unqualified opinionthereon.

 

 
|                | /s/ Ernst & Young LLP |   |
|---------------------|---------------------------|--------|
|                |
| Birmingham, Alabama |
| March 14, 2005 |

 

F-21

----

 

**MANAGEMENT’SREPORT ON INTERNAL CONTROL****OVER FINANCIAL REPORTING**

 

The Company has assessed the effectiveness of itsinternal control over financial reporting as of January 2, 2005 based oncriteria established by *Internal Control –Integrated Framework issued by the Committee of Sponsoring Organizations of theTreadway Commission (“COSO Framework”)*. The Company’s management isresponsible for establishing and maintaining adequate internal controls overfinancial reporting. The Company’s independent registered public accountantsthat audited the Company’s financial statements as of January 2, 2005 haveissued an attestation report on management’s assessment of the Company’sinternal control over financial reporting, which appears on page F-23.

 

Internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. Internal control overfinancial reporting includes those policies and procedures that:(1) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the Company; (2) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the Company are being made only in accordance withauthorizations of management and directors of the Company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the Company’s assets that could have amaterial effect on the financial statements. Because of inherent limitations,internal control over financial reporting may not prevent or detectmisstatements. Also, projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies andprocedures may deteriorate.

 

The Company’s assessment of the effectiveness of itsinternal control over financial reporting included testing and evaluating thedesign and operating effectiveness of its internal controls. In management’sopinion, the Company has maintained effective internal control over financialreporting as of January 2, 2005, based on criteria established in the COSOFramework*.*

 

 
|                      |                      |
|---------------------------|---------------------------|
| */s/ J. T. Malugen*       |                      | */s/ Ivy M. Jernigan* |   |
| J. T. Malugen             | Ivy M. Jernigan           |
| Chairman of the Board and | Senior Vice President and |
| Chief Executive Officer   | Chief Financial Officer   |
|                           |                           |  |  |

 

F-22

----

 

**Report of Independent Registered Public Accounting Firm**

**On Internal Control Over Financial Reporting**

 

**The Board of Directors andStockholders of**Movie Gallery, Inc.

 

We have auditedmanagement’s assessment, included in the accompanying Management’s Report onInternal Control over Financial Reporting, that Movie Gallery, Inc. maintained effective internal control overfinancial reporting as of January 2, 2005 based on criteria established in Internal Control—Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (the COSOcriteria). Movie Gallery, Inc.’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

 

We conducted our auditin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether effective internal controlover financial reporting was maintained in all material respects. Our auditincluded obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we considered necessary in the circumstances. We believethat our audit provides a reasonable basis for our opinion.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to the maintenanceof records that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

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

 

In our opinion, management’s assessment that Movie Gallery, Inc.maintained effective internal control over financial reporting as of January 2,2005, is fairly stated, in all material respects, based on COSO criteria.  Also, in our opinion, Movie Gallery, Inc.maintained, in all material respects, effective internal control over financialreporting as of January 2, 2005, based on****COSO criteria**.**

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheets of Movie Gallery, Inc. as of January 2, 2005 and January 4,2004, and the related consolidated statements of income, stockholders’ equityand cash flows for each of the three years in the period ended January 2,2005, and our report dated March 14, 2005 expressed an unqualified opinionon those consolidated financial statements.

 

 
|                | /s/ Ernst & Young  LLP |   |
|---------------------|----------------------------|--------|
|                |
| Birmingham, Alabama |
| March 14, 2005 |

 

F-23

----

 

**MOVIE GALLERY, INC.**

**Schedule II - Valuation and Qualifying Accounts**

*(in thousands)*

 
| ** **                                    | ** ** | **Balance at**            | ** ** | **Additions**                       | ** ** | ** **                     | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|-------------------------------------|------------|--------------------------------|------------|----------------|------------|
| **Description**                               | ** ** | **Beginning  of  Period** | ** ** | **Charged to  Costs  and Expenses** | ** ** | **Charged to  Other Accounts** | ** ** | **Deductions** | ** ** | **Balance at  End of Period** | ** ** |
| ** **                                    | ** ** | ** **                | ** ** | ** **                          | ** ** | ** **                     | ** ** | ** **     | ** ** | ** ** | ** ** |
| Valuation Allowance for  deferred tax assets: |       |                      |       |                                |       |                           |       |           |       |   |   |
| Fiscal Year  ended January 5, 2003       |       | $                         | 18,412     |                                | $          | —                         |       | $              | 6,541      | (1) | $ | — |   | $ | 24,953 |   |
| Fiscal Year ended January 4,  2004       |       | $                         | 24,953     |                                | $          | —                         |       | $              | 9,491      | (1) | $ | — |   | $ | 34,444 |   |
| Fiscal Year ended January 2,  2005       |       | $                         | 34,444     |                                | $          | —                         |       | $              | —     |   | $ | 1,802 | (2) | $ | 32,642 |   |

 

----

(1)  Revision of allowance to offset true-up ofpreliminary estimated net operating loss carryforwards to actual (not chargedto income tax expense)

(2) Includes $1,291 reductionto true-up preliminary estimated state net operating losses to actual and $411reduction for utilization of net operating losses (not charged to income taxexpense)

 

F-24

----

 

## **Index to Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                               |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                          |
| 21              |       | List of Subsidiaries                                                                                                                                          |
|            |       |                                                                                                                                                          |
| 23              |       | Consent of Independent Registered Public  Accounting Firm                                                                                                     |
|            |       |                                                                                                                                                          |
| 31.1            |       | Certification of Chief Executive Officer  Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act  of 1934, as amended.                  |
|            |       |                                                                                                                                                          |
| 31.2            |       | Certification of Chief Financial Officer  Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act  of 1934, as amended.                  |
|            |       |                                                                                                                                                          |
| 32.1            |       | Certification of Chief Executive Officer  Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |
|            |       |                                                                                                                                                          |
| 32.2            |       | Certification of Chief Financial Officer  Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |

 

----