**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-K**

 

| **(Mark One)** |
|----------------|
|           | **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |   |
|           |   | **For the fiscal year  ended January 4, 2004** |
|           |   |   |
|           |   | **OR** |
|           |   |   |
|           | o | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |   |
|           |   | **For the transition  period from                              to                              .** |

 

**Commissionfile number:  0-24548**

 

**MOVIEGALLERY, INC.**

(Exact name of registrant asspecified 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 mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 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 market value of the common stock held by non-affiliatesof the registrant as of July 6, 2003, was approximately $485,431,795 assumingsolely for purposes of this calculation that all directors and executiveofficers of the registrant and all stockholders beneficially owning more than10% of the registrant’s common stock are “affiliates.”  This determination of affiliate status isnot necessarily a conclusive determination for other purposes.

 

The number of shares of common stock outstanding on February 29, 2004,was 32,970,184 shares.

 

Documents incorporated by reference:

1. Notice of 2004 Annual Meeting and Proxy Statement (Part III of Form10-K).

 

The exhibit index to this report appears atpage 34.

 

 

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**PARTI**

 

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

 

**Our Company**

 

We are the leading home video specialty retailer primarily focused onrural and secondary markets.  We own andoperate approximately 2,200 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.  Since ourinitial public offering in August 1994, we have grown from 97 stores to ourpresent size through acquisitions and new store openings.

 

We believe we are the lowest cost operator among the leading nationalhome video specialty retail chains.  Wehave developed and implemented a flexible and disciplined business strategythat centers 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 productassortment.  We compete directly withthe other two national chains in our industry in approximately one-third of ourstore locations.

 

As a result of our competitive strengths, our operating and growthstrategies and our management team, we have achieved substantial growth overthe past eight fiscal years.  Fromfiscal 1995, the first full year of operations following our initial publicoffering, to fiscal 2003, total revenues have grown from $149.2 million to$692.4 million, a compound annual growth rate of 21.1%, and Adjusted EBITDA(earnings before interest, taxes, depreciation and amortization, non-cashcompensation and nonrecurring items, less purchases of rental inventory,exclusive of new store opening inventory) has grown from $8.8 million to $109.4million, a compound annual growth rate of 37.1%.   For a reconciliation ofAdjusted EBITDA to operating income, see Part II, Item 6 of this Form 10-K.

 

Movie Gallery, Inc. was incorporated in Delaware in June 1994.  Substantially all of our operations areconducted through our wholly-owned subsidiaries, M.G.A., Inc., M. G. Midwest,Inc. and Movie Gallery Canada, Inc.  Ourexecutive offices are located at 900 West Main Street, Dothan, Alabama 36301,and our telephone number is (334) 677-2108.

 

**Industry Overview**

 

***Home Video Industry***

 

*Size andGrowth.*  According to Adams Media Research, thedomestic home video industry grew from an estimated $15.3 billion in revenue in1996 to $24.4 billion in 2003, representing a 6.9% compound annual growth rate,exceeding the 2.3% growth rate of the Consumer Price Index during the sameperiod.  Adams Media expects thisindustry to reach $33.9 billion in revenue by 2008, fueled primarily by DVDpenetration.  At the end of 2003, AdamsMedia estimates that the majority of all domestic television households owned aVCR and approximately 50% owned a DVD player. According to Adams Media, the number of households owning DVD players isexpected to exceed 90% by 2008.  Basedon our experience, we believe that for a period of time after a householdpurchases a DVD player, there is generally an increase in both rentals andpurchases of movies.

 

*Trends.*  The homevideo specialty retail industry continues to experience consolidation,particularly in the rural and secondary markets in which we operate.  It is estimated that there are over 25,000domestic stores in our industry. Further, the three largest video store chains account for approximately9,700 stores, or 37% of total domestic stores, with an estimated 59% of thetotal movie rental market share.  Theremaining 63% of total stores are comprised of independent operators, smallchains and other rental outlets.  Webelieve that the home video specialty retail industry will continue toconsolidate.  Over the past severalyears, the combination of increased product offerings, economies of scale,access to capital and improved marketing efforts have solidified the positionsof the largest retail chains versus independent operators and undercapitalized,second-tier regional chains.

 

*Interdependenceof Movie Studios and Home Video.*  Historically,new technologies, including the development of the VCR and, more recently, DVD,have led to the creation of additional distribution channels for movie studiosbeyond the

 

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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 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 thatbecause the sequential release method has allowed movie studios to increasetheir overall revenues, movie studios will continue the practice of sequentialrelease even as VOD becomes more readily available to consumers.  However, we can provide no assurance thatthe sequential release windows will not be narrowed or eliminated in thefuture.

 

According to industry sources, home video is currently the largestsingle source of domestic revenue for the movie studios, accounting forapproximately 60% of the domestic studio revenue in 2003.  Only a small percentage of the moviesproduced are profitable from the studios’ portion of the theatrical box officereceipts.  As a result, the moviestudios depend on the revenues earned from the home video industry to producesubstantial revenues from not only the hit movies, but the lower grossingnon-hit and direct-to-video movies.  Ofthe over 700 titles purchased by us in 2003, only approximately 5% had boxoffice revenues in excess of $80 million. We spent only 34% of our purchase dollars on these titles, with theremaining 66% spent on the non-hit and direct-to-video movies.  We do not believe that any other existingmovie distribution channel, including VOD, can provide a better market forthese non-hit and non-theatrical titles than the home video retail store.

 

*ProductPricing.*  The home video retail channel is comprisedof both rentals and sales of DVDs and videocassettes.  Movie studios attempt to maximize revenues primarily throughthree standard pricing strategies designed to influence the relative levels ofmovie rentals versus sales:

 

•*Sell-Through Movies.*  Under this pricing strategy, movie studiossell DVDs and videocassettes at relatively low prices, typically less than $20per copy.  These movies are generallypromoted both for rental and sale.

 

•*Revenue Sharing.*  Revenue sharing between retailers and movie studios was embracedby the industry in 1998.  Under revenuesharing, retailers and movie studios share the risks associated with the rentalperformance of individual titles.  Themovie studios receive a fee, based on a predetermined percentage, typicallyless than 50% of the 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 revenuesharing agreements provide significant advantages to retailers, including:

 

• substantial increases in both quantity andselection of newly-released video titles;

 

• potential increases in revenues as a result ofhigher transaction volume; and

 

• further interdependence of movie studios andvideo retailers.

 

•*Rental Priced Movies.*  Before the prominence of revenue sharing in1998, the majority of movie titles were released under this pricingstrategy.  Movies released under rentalpricing typically cost between $35 and $65 per copy, and are promoted primarilyas rental titles because the pricing structure is too high to motivate theconsumer to purchase versus rent.  Withthe industry’s acceptance of revenue sharing and the penetration of DVD intothe customer base, only a limited number of titles on the VHS format arereleased under a rental pricing structure today. All DVDs are released atsell-through pricing and many are available through revenue sharing.  Of the titles that are not available atsell-through pricing or under revenue sharing agreements, many can be obtained directlyfrom the studios at reduced prices made available through volume discountoffers.

 

***Video Game Industry***

 

According to industry reports, domestic sales of video game hardware,software, and accessories totaled approximately $10 billion in 2003, markingtwo consecutive years of $10 billion sales levels.  Although the 2003 sales results reflect a small (less

 

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than 3%) overall decline from the previousyear, the sales levels in 2003 were achieved on higher unit sales at decliningretail price points and included strong growth in software sales of 5% over2002.  Sony PlayStation 2 continues todominate the market, capturing approximately 45.7% of the hardware and softwaresales.  Other industry leaders areMicrosoft Xbox, Nintendo Gameboy, and Nintendo GameCube, each with less than20% of domestic sales.  The number ofdomestic households with a video game system has grown by over 30% from anestimated 34 million in 1994 to 45 million in 2003.

 

The video game industry is characterized by the short lifecycles ofhardware and software due to the rapid changes that tend to occur intechnology.  Growth in this industry isdriven by increases in the installed base of video game hardware systems and isdependent upon the introduction of new hardware platforms and continuedimprovement in systems technology leading to the development of new gametitles.  We believe the video gameindustry will continue to grow as a result of significant technologicaladvancements made in the last few years. These advancements allow for more flexibility and creativity in softwaredevelopment, as well as the introduction of hardware offering capabilitiesbeyond gaming, such as DVD and compact disc play and backward compatibility of gamesoftware.

 

**Competitive Strengths**

 

*Primary Focuson Rural and Secondary Markets.*  We aim to locate newly builtstores in small towns or suburban areas of cities with populations typicallybetween 3,000 and 20,000 where we can be the market leader.  We believe our focus on smaller marketsallows us to achieve a higher return on invested capital than we would obtainin larger urban markets because of the reduced level of competition, loweroperating costs and our expertise in operating in rural and secondarymarkets.  Our principal competitors aresingle store and small chain operators with smaller advertising budgets thanours, limited inventory breadth and depth and less access to capital than wehave.  As a result, we believe we arethe leader in the majority of our markets.

 

We believe our market focus also delays competition arising from newtechnologies such as VOD.  We expectthat the rural and secondary markets in which we operate are likely to be amongthe last markets 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 can achievebetter returns on invested capital.

 

*Low CostOperator.*  We believe that we are a low cost operatorin each of our markets.  In 2003, ouraverage initial investment to build new stores was approximately $126,000 perstore.  This investment includedleasehold improvements, fixtures, signage and inventory (net of payables).  We have developed a strategy to minimizeoperating expenses that includes:

 

• negotiating favorable lease terms;

 

• centralized purchasing;

 

• reduced labor costs;

 

• stringent expense controls; and

 

• sophisticated information systems.

 

*Flexible andDisciplined Business Model.*  We have a flexible anddisciplined business model designed to maximize our revenues and reduce ourcosts.  The components of our businessmodel include:

 

• flexible store formats, which allow us to tailorthe size, inventory and look of each store to fit its locale; our storesaverage approximately 4,400 square feet, and have inventories generally rangingfrom approximately 4,000 to 20,000 movies and 200 to 1,000 video games forrental;

 

• short lease terms that allow us to respondquickly to changing demographics, competition and other market conditions andto close non-performing stores promptly; our remaining lease terms currentlyaverage 3 years with over 400 leases considered for renewal each year;

 

• inventory management; and

 

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• pricing management, including store specificpricing of promotional programs that are managed and modified based uponcompetitive factors, demographic issues and various operating considerations.

 

*ProvenAcquisition Strategy.*  From 1994 to 1996, we grew from97 stores to over 860 stores, primarily as a result of an aggressiveacquisition strategy.  Beginning in1999, we reinitiated our opportunistic acquisition strategy.  From the beginning of fiscal 1999 throughFebruary 29, 2004, we acquired 943 stores in 92 separate transactions.  Historically, acquired stores have beenrapidly integrated into our operations with minimal disruption.  Typically, we are able to increase revenueand cash flow in our acquired stores due to our product purchasing practicesand economies of scale.  The averagecost of converting 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. We believe there are opportunities to continue to improve results insome of our recently acquired locations.

 

*ProprietaryInformation Systems to Drive Revenue and Enhance Profitability.*  Wecompete with other home video specialty retailers to provide our customers witha broad selection of movies and video games for rental at the lowestprice.  To help us manage our inventoryin the most profitable manner, we have developed proprietary managementinformation systems and a point of sale system for our stores designed toenable us to optimize inventory levels, monitor customer purchase patterns andselection preferences, as well as provide comparative revenue and profitabilitydata on a daily basis.  We believe thesecapabilities enable us to efficiently aggregate and manage our existing and newrental inventory as well as reallocate rental inventory and adjust ourmerchandising selection to meet the specific product selection requirements ofindividual stores or markets.

 

*Focus onCustomer Service.*  We view the personal interaction of ouremployees with our customers as an integral part of our organizational cultureand point of differentiation from our competitors.  We believe that our culture, together with our establishedtraining programs for our hourly employees, store managers and fieldmanagement, results in a superior customer experience and higher visitfrequency.  As part of our customerservice initiatives, we maintain a database of approximately 5.5 million activecustomers that captures pertinent customer preferences and purchase history,and enables 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.

 

*ExperiencedManagement 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 14 years in home videospecialty retailing and an average of 11 years with us in an industry that isonly approximately 20 years old.  We believethis continuity has allowed us to deliver a consistent offering for ourcustomers and in turn generate high levels of customer loyalty.

 

**Growth Strategy**

 

The key objective of our growth strategy is to increase market share inour existing and new markets.  The keyelements of our growth strategy are:

 

*Driving SameStore 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 and video game trends;

 

• adopting merchandising and pricing initiatives;and

 

• achieving targeted cost savings.

 

*Developing NewStores in Attractive Markets.*  We believe that thetransferability of our standardized retail format, which can be adapted easilyfor a variety of locations, and our record of successfully opening storesprovide us with a strong foundation for expansion through new storedevelopment.  Although developed storesgenerally require approximately one year for revenues to reach the level ofmature stores, on average they typically become profitable within the first sixmonths of operation and produce a positive return on investment withinapproximately 24 months.  We believethere are 3,000 to 4,000

 

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markets available for further potentialdevelopment in the United States that fit our typical market profile.  Additionally, we see expansion opportunitiesin Canada and are researching markets in Mexico where we expect to operate upto ten stores by the end of 2004.  Wecurrently expect to open between 275 and 300 new stores in 2004 and, subject tomarket and industry conditions, to continue to open new stores on a similarpace over the next several years.

 

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

 

• acquired stores provide an installed base ofrevenue and cash flow;

 

• we are able to grow more rapidly, thus providingincreased benefits of scale;

 

• conversion to our formats and systems providesus with operating efficiencies; and

 

• entry into new markets is facilitated.

 

In evaluating potential acquisition candidates, we consider a number offactors, including:

 

• strategic fit and desirability of location;

 

• price;

 

• ability to improve productivity andprofitability; and

 

• assurances that the anticipated returns oninvestment approximate those generated by newly developed stores.

 

We believe that there is continued opportunity for growth throughacquisitions given the significant percentage of independent operators in theindustry and because we believe that we are currently the most active acquirerin a majority of our target markets.

 

The following table is a historical summary showing store openings,acquisitions and store closings since the beginning of fiscal 1999:

 
|                          |   | **Fiscal Year Ended**  |   | **January 5 to  February 29,  2004** |   |
|-------------------------------|--------|------------------------|--------|--------------------------------------|--------|
| **January 2,  2000**          |   | **December 31,  2000** |   | **January 6,  2002**                 |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                          |   |                   |   |                                 |   |   |   |   |   |   |   |   |   |
| New store openings            |   | 53                     |   | 110                                  |   | 77 |   | 145 |   | 241 |   | 48 |   |
|                          |   |                   |   |                                 |   |   |   |   |   |   |   |   |   |
| Stores acquired               |   | 131                    |   | 16                                   |   | 355 |   | 265 |   | 170 |   | 6 |   |
|                          |   |                   |   |                                 |   |   |   |   |   |   |   |   |   |
| Stores closed                 |   | 58                     |   | 69                                   |   | 37 |   | 41 |   | 37 |   | 17 |   |
|                          |   |                   |   |                                 |   |   |   |   |   |   |   |   |   |
| Total stores at end of period |   | 963                    |   | 1,020                                |   | 1,415 |   | 1,784 |   | 2,158 |   | 2,195 |   |

 

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**Products**

 

We offer a wide selection of movies and video games for rent andsale.  Our goal is to stock each storewith a product assortment tailored to that store.  Our revenues by product category for the last three fiscal yearswere as follows:

 
|                                                        |   | **2001** |   | **2002** |   | **2003** |   |
|-------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                        |   |     |   |     |   |     |   |
| DVD rentals                                                 |   | 10       | %      | 25       | %      | 38       | %      |
| VHS rentals                                                 |   | 65       | %      | 48       | %      | 33       | %      |
| Video game rentals                                          |   | 9        | %      | 10       | %      | 9        | %      |
| Previously viewed product sales  (DVD, VHS and video games) |   | 9        | %      | 10       | %      | 11       | %      |
| Concessions, accessories and  other                         |   | 5        | %      | 4        | %      | 5        | %      |
| New movie sales (DVD and VHS)                               |   | 2        | %      | 3        | %      | 4        | %      |

 

Depending upon location, our stores offer from 4,000 to 20,000 moviesand from 200 to 1,000 video games for use with most video game platforms.  New release movies are displayed alphabeticallyand older titles are displayed alphabetically by category, such as “Action,”“Comedy,” “Drama” and “Children.”  Videogames are displayed alphabetically by platform.

 

From 2000 to 2002, we significantly increased our DVD inventory.  Additionally, during the first quarter of2003 we purchased approximately $7 million in DVD catalog titles to supplementour existing VHS catalog inventory. Because of the ease of use and durability of DVDs, it is anticipatedthat eventually DVDs will replace videocassettes.  The acquisition costs of DVD hardware have reached levelscompetitive with the VCR and it is estimated that as of the end of 2003,approximately 50% of domestic television households had DVD hardware (AdamsMedia).  For the fourth quarter offiscal 2003, DVD rental revenue exceeded 65% of our total movie rental revenue,versus approximately 40% in the fourth quarter of fiscal 2002.  We monitor the consumers’ acceptance of DVDand adjust purchasing levels as necessary to maintain the appropriate mix of DVDand VHS inventory in our stores.  Webelieve we will be able to continue to expand our DVD offerings at sell-throughpricing levels.  However, we can provideno assurance that the studios will not increase DVD prices in the future.

 

In 2003, we continued to refine and increase our video game inventoryby expanding our selection of new available titles for the next generationplatforms such as Sony’s PlayStation 2, Microsoft’s Xbox and Nintendo’sGameCube.  The Sony PlayStation 2 wasthe leading platform within our stores and generated over 50% of our gamerevenue in 2003.  We will continue tomonitor the performance of the newer platforms and intend to make futureinventory investments accordingly.  Inaddition to video games, we offer basic video game hardware accessories in manyof our stores and we rent and sell video game hardware in a select base ofstores.

 

We review our store inventory on an ongoing basis for movies and gamesthat have not rented for a period of time and offer these previously viewedproducts for sale.

 

**Store Operations**

 

As of February 29, 2004, we operated a total of 2,195 retail storeslocated throughout North America.

 

We maintain a flexible store format, tailoring the size, inventory andlook of each of our stores to local demographics.  Our stores average approximately 4,400 square feet, withinventories generally ranging from approximately 4,000 to 20,000 movies and 200to 1,000 video games.

 

Store interiors are designed to create a visually appealing, up-beatambiance using bright lighting, vibrant graphics and carpet and coordinatingsignage.  The inviting atmosphere isaugmented by a background of television monitors displaying MGTV, a customizedvideo program which plays movie previews and promotions of coming attractions,and by posters and stand-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.

 

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Each of our stores typically employs five to 14 hourly, part-timeassociates and one full-time store manager. Store Managers report to District Managers, who supervise the operationsof 10 to 15 stores.  The DistrictManagers report to one of 19 Regional Managers, who report directly to one ofthree Zone Vice Presidents.  The ZoneVice Presidents report directly to our Executive Vice President ofOperations.  We have increased thenumber of District Managers and Regional Managers over time as necessary tosupport our growth.  Executivemanagement conducts regular meetings with the Regional Managers and DistrictManagers to review operations. Compliance with our policies, procedures and regulations is monitored ona store-by-store basis through exception-based reporting systems and quarterlyquality assurance audits performed by District Managers and members of ourtraining department.  The performanceand accuracy of the quarterly District Manager audits is monitored by oursupport operations team.

 

**Site Selection**

 

We continuously 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, trafficvolume, store-front visibility and presence, ease of access and economicdevelopment in the market area.  We alsoreview the location of competitive stores and customer activity at thosestores.

 

We develop both freestanding stores and stores located in strip centersanchored by major grocery or discount drug store chains.  Lease terms are a critical element in oursite selection process.  In negotiatinglease agreements and lease renewals, we attempt to obtain short lease terms andfavorable options to extend terms.  As aresult, we have the flexibility necessary to react to changing demographics,competition and other market conditions. To date, we have not experienced difficulty in obtaining favorableleases or renewals at market rates in suitable locations.  The current average remaining life of ourleases is approximately 3 years with over 400 leases considered for renewaleach year.

 

We actively pursue relocation opportunities to adapt to changes incustomer shopping patterns and retail market shifts.  We regularly review the profitability and prospects of each ofour stores and evaluate whether any underperforming stores should be closed orrelocated to more desirable locations. The cost of closing a unit is minimal and usable inventory, signage, fixturesand equipment is transferred to existing or new locations.

 

**Marketing andAdvertising**

 

We use market development funds, cooperative allowances from oursuppliers and movie studios, and internal funds to purchase radio, television,direct mail and newspaper advertising, in-store visual merchandising andin-store media.  Through the use ofmarket development 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, and a customized videoprogram, MGTV, both of which feature Movie Gallery programs, promotions and newreleases.  Along with these traditionalforms of advertising, we have developed and implemented a customer loyaltyprogram, *ReelPlayers. *The program isbased on a point system that provides customers the opportunity to earn freerentals and discounts on movie purchases.

 

From time to time we conduct special promotions in our stores to drivecustomer visits.  For example,periodically we offer a promotional rental card program similar to a prepaidgift card that provides our customers greater discounts on rentals.  We have also conducted nationwide triviagames and we occasionally partner with other major businesses to help buildadditional revenue and increase our brand awareness to potential customers.

 

To date, our expenditures for advertising in excess of the allowancesfrom our suppliers and movie studios have been less than 1% of annual revenues.

 

**Studio andDistribution Relationships**

 

We negotiate the majority of our movie purchases directly with 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 to

 

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satisfy their commitment to us, a viablealternative, such as self-distribution, could be implemented without materiallyadversely impacting our business.

 

Several companies acquired by us prior to 1997 had pre-existinglong-term contracts with Rentrak Corporation under which product would beprovided under pay-per-transaction revenue sharing arrangements.  During late 1996, we consolidated existingcontracts with Rentrak into one national agreement.  Under this agreement, which expires in September 2006, we have aminimum gross annual purchase commitment in revenue sharing, handling fees,sell-through fees and end-of-term buyouts equal to less than 3% of our annualproduct requirements.  We utilizeRentrak on a selective title-by-title basis and have exceeded the minimumpurchase requirements in each year since 1996.

 

We currently source all our video game inventory through directrelationships with game manufacturers/publishers and from distributors.

 

**Inventory Managementand Distribution Facility**

 

*InventoryManagement.*  We are committed to offering as many copiesand the widest variety of new releases as is necessary to be competitive withina market, while at the same time keeping our costs as low as possible.  New DVDs and videocassettes offered for saleare primarily hit titles promoted by the studios for sell-through, as well asspecial interest and children’stitles and seasonal titles related to particular holidays.  DVDs, videocassettes and video gamesutilized as initial inventory in our newly developed stores consist of excesscopies of older titles and new release titles from existing stores, supplementedas necessary by purchases directly from suppliers.

 

New release movie and game products are allocated to individual storesthrough a system that considers the revenue levels and customer demographicprofiles of each store.  Rental historyon movie titles is captured for each store and used as a comparison point forfuture titles of a similar genre.

 

*DistributionFacility.*  Inventory for newly developed 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 store ready for use.  Our distribution facility is also used to ship store supplies,computer supplies and marketing materials to our stores, process returns to oursuppliers and to stock balance inventory within our chain of stores.

 

**ManagementInformation Systems**

 

Our stores utilize a proprietary point of sale system (POS).  Our system provides detailed information onstore operations, including the rental history of titles and daily operationsfor each store, which is telecommunicated to our support center on a daily orweekly basis.  Our POS system isinstalled in all developed stores prior to opening and in acquired storesshortly after the closing of an acquisition.

 

All rental and sale information upon customer checkout and return isrecorded using scanned bar code information. All transactional data is transmitted into the management informationsystem at the support center.  The datais processed and reports are generated that allow management to effectivelymonitor store operations and inventory, to review rental history by title andlocation and to assist in making purchasing decisions with respect to newreleases.  Our POS enables us to performour monthly physical inventory using bar code recognition, to process humanresource information and to provide system-based training modules.

 

We also maintain a financial reporting system, relating to the generalledger, human resources/payroll, revenue and accounts payable functions,capable of handling our current needs and anticipated growth.  Additional proprietary systems which havebeen internally developed and implemented include a collections system, aprocessing/distribution center system and various other database systems andauditing tools.

 

**Competition**

 

The home video specialty retail industry is highly competitive.  We compete with other home video specialtystores, including stores operated by regional chains and by the other two othernational chains, Blockbuster and Hollywood

 

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Entertainment.  From time to time, the two other national chains have discussedthe implementation of a rural strategy that is focused more on the rural andsecondary markets we predominately serve. Retail pricing strategies for DVDs, videocassettes and video games are amajor competitive factor in the home video specialty industry and we have fewerfinancial and marketing resources, lower market share and less name recognitionthan the two other national chains.  Wealso compete with other businesses offering DVDs, videocassettes and videogames such as mass merchants, supermarkets, pharmacies, convenience stores,bookstores, online stores, mail order operations (such as Netflix) and otherretailers, as well as noncommercial sources, such as libraries.  We believe the principal competitive factorsin the home video specialty retail industry are store location and visibility,title quality, availability and selection, rental period, customer service andpricing.

 

In addition to competing with other home video specialty retailers, wecompete with all forms of entertainment, such as movie theaters, network andcable television, direct broadcast satellite television, personal video recorders,internet related activities, live theater, sporting events and familyentertainment centers.  We believe ourmost significant competition outside of the home video specialty retailindustry is currently cable and satellite television.  The expanded number of channels and programming offered by theseproviders could result in the rental and purchase of fewer DVDs andvideocassettes by consumers.

 

We also compete with pay-per-view in which cable or satellitesubscribers pay a fee to view a movie. New and recently introduced technologies, such as VOD, enable cablecompanies and other telecommunication companies to broadcast a large assortmentof movies to homes at scheduled intervals throughout the day.  Although VOD services previously offered alimited number of channels and movies at scheduled intervals, developingtechnologies are enabling providers to transmit substantially more moviesdirectly to homes at more frequently scheduled and convenient intervalsthroughout the day.  Pay-per-viewpurchases could significantly increase if movies were to become available onVOD during the home video rental window or if VOD services were to become moreconvenient, widely available and accepted. Further improvements in VOD and other technologies, including personalvideo recorders, could lead to the availability of a broad selection of movieson demand at a price that is competitive with the price of movie rentals andwith the functionality of DVD and VHS. However, we believe movie studios have a significant interest inmaintaining a viable movie rental business because the sale of movies to videoretail stores and other home video outlets currently represents the studios’ largest source of domestic revenue.  In addition, we believe that VOD does notrepresent a material near-term threat to our business because:

 

• studios have not yetdetermined how VOD can enhance revenues instead of merely cannibalizing highlylucrative DVD and VHS rental and sale revenues;

 

• VOD does not allow for the impulse rental opportunitiesfrom browsing through lesser-known titles that video specialty stores offer;

 

• the technology and infrastructure to compressand deliver VOD in a scalable, cost-effective manner, particularly within ourmarket demographics, has not yet been developed on a significant scale; and

 

• piracy and other electronic security issues havenot yet been adequately addressed.

 

Limited play DVDs are currently being testedin select markets throughout the United States.  This technology enables a user to view a DVD any number of timeswithin 48 hours, after which time the DVD is programmed to automatically stopworking.  To date, this technology hasnot been widely accepted by consumers or by the movie studios.

 

**Seasonality**

 

There is adistinct seasonal pattern to the home video business.  Compared to other months during the year, we experience peakrevenues during the months of November, December and January due to theholidays in these months as well as inclement weather conditions.  Additionally, revenues generally rise in themonths of June, July and August when most schools are out of session, providingpeople with additional discretionary time to spend on entertainment.

 

**Intellectual Property**

 

We own anumber of U.S. and Canadian service mark registrations, including the marksMOVIE GALLERY and GAME ZONE.

 

10

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**Foreign Operations**

 

Fordisclosure of financial information by geographic area, refer to Note 10 to ourconsolidated financial statements included in Part II, Item 8 of this Form10-K.

 

**Employees**

 

As of February 29, 2004, we employed approximately 18,500 persons,referred to by us as “associates,” including approximately 18,000 in retailstores and the remainder in our support center, field management staff anddistribution facility.  Of our retailassociates, approximately 3,000 were full-time and 15,000 were part-time.  None of our associates are represented by alabor union and we believe that our relations with our associates are good.

 

We have developed internal hiring, training and retention programsdesigned to enhance consistent and thorough communication of our operatingpolicies and procedures as well as increase the rate of internalpromotions.  We also have an incentiveand discretionary bonus program under which retail management associatesreceive quarterly bonuses when stores meet or exceed criteria established underthe program.  Additionally, we haveperiodic sales and marketing programs which provide our associatesopportunities to earn incremental bonus compensation based on relativeperformance to pre-established goals and to actual performance of some of ourassociates.  We believe our bonusprograms reward excellence in management, give associates an incentive toimprove operations, and result in an overall reduction in the cost ofoperations.  In addition, certainassociates are eligible to receive bonuses, based on individual and overallcompany performance, and options to purchase shares of our common stock,generally exercisable at the fair market value on the date of grant, subject toservice requirements.  During 2003, weestablished an employee stock purchase plan available to all employees meetingthe prescribed service requirements.

 

**Available Information**

 

The addressof 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 and current reports on Form 8-K, andany amendments to those reports, filed or furnished pursuant to Section 13(a)or 15(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.

 

**Cautionary Statements**

 

This annual report on Form 10-K containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended, which represent our expectations or beliefs about futureevents and financial performance. Forward-looking statements are identifiable by the fact that they do notrelate strictly to historical information and may include words such as“believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate”or other similar expressions and variations thereof.  In addition, any statements that refer to expectations,projections or other characterizations of future events or circumstances areforward-looking statements.  Ourforward-looking statements are based on management’s current intent, belief,expectations, estimates and projections regarding our company and ourindustry.  Forward-looking statementsare subject to known and unknown risks and uncertainties, including thosedescribed below.  In light of theserisks, uncertainties and assumptions, the forward-looking events discussed inthis Form 10-K might not occur.  Inaddition, actual results could differ materially from those suggested by theforward-looking statements, and therefore you should not place undue relianceon the forward-looking statements.  Weundertake no obligation to publicly update or revise any forward-lookingstatements, whether as a result of new information, future events orotherwise.  We desire totake advantage of the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995 and in that regard we caution the readers of thisForm 10-K that the following important factors, among others, could affect ouractual results of operations and may cause changes in our strategy with theresult that our operations and results may differ materially from thoseexpressed in any forward-looking statements made by us, or on our behalf.  Weassume no obligation (and specifically disclaim any such obligation) to updatethe following cautionary statements or any other forward-looking statementscontained in this annual report on Form 10-K to reflect actual results, changesin assumptions or other factors affecting such forward-looking statements.

 

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

# ** **

Our long-term strategy is to grow through new store openings andacquisitions of existing stores. Successful implementation of this strategy is contingent upon numerousconditions, and we cannot assure you that our business plan can be successfullyexecuted.  We require significantcapital to open new stores and to acquire existing stores.  To date, our growth strategy has been fundedprimarily through proceeds from public offerings of common stock, bankborrowings, internally generated cash flow, use of our common stock asacquisition consideration and seller financing.  These and other sources of capital, including public or privatesales of debt or equity securities, may not be available to us in the future onterms satisfactory to us or at all.

 

*New StoreOpenings.* Ourability to open new stores as planned, and the profitability of these newstores, may be adversely affected by a number of factors, including:

 

• our ability to identify and secure new sites;

 

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

 

• the availability of capital; and

 

• our ability to hire, train and assimilateskilled store managers and other personnel.

 

If we do not grow as planned, our future earnings expectations could benegatively impacted.

 

Our planned growth may result in increased pressure on our managementand operations.  We continuously reviewand modify 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.

 

In addition, our growth strategy contemplates the opening of new storesin markets in which we do not currently operate.  Accordingly, there are no assurances that these new stores willrealize revenue or profitability levels comparable to those of our currentstores, or that such levels will be achieved within our estimated time frames.

 

*Acquisitions.*  Ourability to acquire stores and operate them at the desired levels of sales andprofitability may be adversely affected by:

 

• our ability to identify acquisition candidatesthat fit our criteria, including, among others, size, location andprofitability and that are willing to sell at prices we consider reasonable;

 

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

 

• a reduction in the number of stores availablefor purchase by us;

 

• increased competition for acquisitions;

 

• misrepresentations and breaches of contracts bysellers;

 

• our limited knowledge of the operating historyof the acquired stores;

 

• the integration of the acquired stores’ operating and information systems into oursystems and procedures; and

 

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

 

12

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

 

From time to time, the two other nationalchains in our industry have discussed the implementation of a rural strategythat is focused more on the rural and secondary markets we predominatelyserve.  Therefore, we cannot assure youthat the two other national chains in our industry will not become a moresignificant competitive force in our markets.  Pricing strategies for movies and video games are a major competitive factorin the video retail industry and we have fewer financial and marketingresources, lower market share and less name recognition than the two largerchains.

 

In addition, there is no guarantee thatsmaller regional chains, supermarkets, pharmacies, convenience stores,bookstores, online stores, mail order operations (such as Netflix), massmerchants, franchisees, specialty retailers and other retailers, as well asnoncommercial sources, such as libraries, will not develop an increased marketshare of the home video retail industry in the markets we serve.  Other types of entertainment, such astheaters, television, personal video recorders, internet related activities,sporting events and family entertainment centers, also compete with our videoand video game businesses.  If any ofour competitors were to substantially increase their presence in the markets weserve, our revenues and/or profitability could decline, our financialcondition, liquidity and results of operations could be harmed and the continuedsuccess of our business would be challenged.

 

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

 

We are highly dependent on the efforts and performance of our executivemanagement team.  If we were to lose anykey members of this team, our business could be adversely affected.  You should read the information under“Directors and Executive Officers” for a detailed description of our executivemanagement team.

 

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

 

We depend on our management informationsystems for the efficient operation of our business.  Our merchandise operations use our inventory utilization systemto track rental activity by format for each individual movie and video gametitle to determine appropriate buying, distribution and disposition of ourinventory.  We also rely on a scalableclient-server system to maintain and update information relating to revenue,rental and sales activity, movie and video game rental patterns, storemembership demographics and individual customer history.  These systems, together with ourpoint-of-sale and in-store systems, allow us to control our cash flow, keep ourin-store inventories at optimum levels, move our inventory more efficiently andtrack 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.

 

***Ourfinancial results could be adversely affected if we are unable to manage ourmerchandise inventory effectively***

 

The increasein our merchandise inventory has increased our risks associated with inventorymanagement, obsolescence and theft.  Ouroperating results could suffer if we are unable to:

 

•  maintain the appropriate levels of inventoryto support customer demand without building excess inventories;

 

•  obtainor maintain favorable terms from ourvendors with respect to product returns; and

 

•  controlshrinkage resulting from theft, loss or obsolescence.

 

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

# ** **

Studios distribute movies in a specific sequence in order to maximizestudio revenues on each title they release. The order of distribution of movies is currently: (1) movie theaters;(2) home video retailers; (3) pay-per-view; and (4) all other sources,including cable and syndicated television. Our industry has an early “window” that is exclusive of most other formsof non-theatrical movie distribution as noted above.  The length of the movie rental window varies, but typicallyapproximates 45 days.  We cannot becertain that movie studios will maintain this exclusive window in thefuture.  We could be adversely affectedif the movie studios shorten or eliminate these exclusive windows, or if themovie rental windows were no longer among the first windows following thetheatrical release, because newly released movies would be made availableearlier through other 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.

 

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

# ** **

*NewTechnologies.*  New technologies, including VOD, streamingmovies over the internet and limited-play DVDs, represent a material risk toour company and the home video specialty retail industry.  VOD is intended to afford subscribers theluxury of watching, at any time of the day, any movie included in a list oftitles maintained by the VOD provider. Consumers may prefer alternative movie delivery systems such as VOD overtraditional video rentals or purchases if such alternative systems were toallow the consumers to conveniently choose, watch and control movies at anytime of the day, if the alternative systems were able to be provided at areasonable price and if new releases were made available simultaneously with,or prior to, their availability for rental at the video stores.  Limited play DVDs are programmed to stopworking after 48 hours, during which time the movie can be viewed an unlimitednumber of times.  Although thistechnology is currently being tested in select markets throughout the UnitedStates, it has not been widely accepted by consumers or movie studios.  We could see a significant negative impactto our financial position and survival if these technologies are widelyaccepted by consumers.

 

*ExistingTechnologies.*  Cable, satellite and pay-per-view televisionsystems are expected to continue to increase and expand offerings to consumers.  The cable and satellite television systemsoffer movie channels which require a subscription fee for access to moviesselected by the provider at times selected by the provider.  VOD services require a discrete fee to viewa movie selected by the subscriber. VOD, cable and satellite services allow consumers to avoid trips to thevideo store for movie rentals and returns, and remove the possibility of theirincurring extended viewing fees. Although VOD services previously offered a limited number of channelsand movies at scheduled intervals, developing technologies are enabling cable,satellite, internet service providers and others to transmit substantially moremovies directly to homes at more frequently scheduled and convenient intervalsthroughout the day.  Pay-per-viewpurchases could significantly increase if movies were to become available onVOD during the home video rental window or if VOD services were to become moreconvenient, widely available and accepted, which could adversely affect ourbusiness.  If consumers more widelyaccept satellite and digital cable and/or VOD services, they may rent fewermovies from us in favor of the expanded number of channels and expandedprogramming offered through these existing technologies.

 

***Our business couldbe adversely affected if consumers decide to purchase rather than rent movies***

 

Historically, studios priced a number of movies they distributed at“rental” pricing, which was typically too high a price to generate significantconsumer demand to purchase these movies. A limited number of titles were released at a lower price point whenconsumers were believed to be more likely to have a desire to purchase acertain title.  This pricing method isknown as sell-through pricing.  Whilerelatively few VHS titles were historically released at sell-through prices,all titles currently released on DVD are priced at sell-through prices.  The penetration of DVD into the market hasresulted in a significant increase in the quantity of newly released moviesavailable for purchase by the consumer. Sell-through priced movies are purchased to rent by home video specialtyretailers and to sell by both home video specialty retailers and massmerchants, among others.  Sell-throughretail margins are generally lower than rental margins.  Some of our competitors, such as onlinestores, mass merchants and warehouse clubs, may operate at margins lower thanours and are able to distribute and sell movies at lower price points thanus.  These competitors may even be willingto sell movies below cost due to their broad inventory mix.  Further decreases in studio sell-throughpricing and/or sustained or further depressed pricing by competitors couldresult in increased consumer desire to purchase rather than rent movies andcould result in increased competition. If we are not able to derive most of our revenues from our higher marginrental business, our profit levels would be adversely impacted and we may notbe able to compete with our competitors for the consumer’s sell-through dollar.

 

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

# ** **

Prior to studio revenue sharing programs and the advent of DVD, wewould typically pay between $35 and $65 per videocassette for major theatricalreleases not priced as sell-through titles. Under studio revenue sharing programs we are able to pay a minimalup-front cost per unit and thereafter pay a percentage of each revenue dollarearned for a specified period of time to the studios.  We currently utilize these types of programs on a significantnumber of DVD and VHS movie releases. These programs have enabled us to significantly increase the number ofcopies carried for each title, thereby enabling us to better meet consumerdemand.  After a specified period oftime, we offer them for sale to our customers as “previously viewed movies” atlower prices than new copies of the movie. We could be adversely affected if these programs are changed to give themovie studios a greater percentage of each revenue dollar or if they arediscontinued.  Further, some of ouragreements may be terminated on short notice.

 

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***Our expected gross margins may be adverselyaffected if the average sales price for our previously viewed product is not ator above an expected price***

 

We earn rental revenues from video rentals and from the sale ofpreviously viewed movies to the public. We need to sell previously viewed movies at an expected price in orderto reach our estimated gross margins. Our estimated gross margins may be adversely affected if the number ofrents we expect to generate does not materialize or if the average sales pricefor previously viewed movies is not at or above the expected price.

 

A consumer’s desire to own a particular movie and the number ofpreviously viewed movies available for sale to the public by our competitorsare factors that affect our ability to sell previously viewed movies at theexpected price.  Additionally, sales ofpreviously viewed movies also compete with newly released movies that arepriced for sell-through.  As a result,there are no assurances that we will be able to sell an appropriate quantity ofpreviously viewed movies at or above the expected price.

 

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

 

The availability of new movies produced bythe movie studios is vital to our industry. The quality and quantity of new movies available in our stores could benegatively impacted by factors that adversely affect the motion pictureindustry, such as financial difficulties, regulatory requirements and workdisruptions involving key personnel such as writers or actors.  A decrease in the quality and quantity of newmovies available in our stores could result in reduced consumer demand, whichcould negatively impact our revenues and harm our business and financialposition.

 

# ***Our business could be adverselyaffected if video game software and hardware manufacturers do not introduce newproducts in a timely manner***

 

The video game industry is characterized bythe significant impact on consumer spending that accompanies the introductionof new game software and hardware platforms. Retail spending in the video game industry typically grows rapidly withthe introduction of new platforms but declines considerably prior to therelease of new platforms.  Consumerdemand for video games available in our stores could be adversely affected ifmanufacturers fail to introduce new games and systems in a timely manner.  A decline in consumer demand for video gamesavailable in our stores could negatively affect our revenues and harm ourbusiness and financial position.

 

***Our business may be negatively impacted byour participation in new business initiatives***

 

We are currently exploring various new business initiatives within ourindustry.  These new initiatives includea game store-within-a-store concept (“Game Zone”), movie and game tradingwithin our stores and various other alternatives for delivery of mediacontent.  We cannot assure you thatthese initiatives will be either successful or profitable.  Our earnings could be negatively impacted byinvestments in these initiatives.

 

***Piracy of the products we offer may adverselyaffect our results of operations***

 

The development of the internet and related technologies increases thethreat of piracy by making it easier to duplicate and widely distribute piratedcontent.  We cannot assure you thatmovie studios and others with rights in the product will take steps to enforcetheir rights against internet piracy or that they will be successful inpreventing the distribution of pirated content.  Technological developments and advances of products such asat-home DVD burners 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 affectedby variances in our quarterly operating results that are unrelated to ourlong-term performance***

 

Historically, our quarterly operating resultshave varied and we anticipate that they will vary in the future.  Factors that may cause our quarterlyoperating results to vary, many of which are not in our control, include:

 

•  consumerdemand for our products;

 

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•  pricesat which we can rent or sell our products;

 

•  timing,cost and availability of newly-released movies, new video games and new videogame systems;

 

• competition from providers of similar products and other forms ofentertainment;

 

• 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 increasebusiness (inclement conditions that prohibit outdoor activities) or decreasebusiness (mild temperatures and dry conditions that reduce the consumer’sdesire to relax indoors); and

 

• acts of God or public authorities, war, civilunrest, fire, floods, earthquakes, acts of terrorism and other matters beyondour control.

 

***The market price for our common stock mayfluctuate substantially***

 

Future 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 other factors,could have a significant impact on the market price of our common stock.  In addition, in recent years the stockmarket has experienced a high level of price and volume volatility, and marketprices for the stock of many companies have experienced wide fluctuations thathave not necessarily been related to the operating performance of thesecompanies.  Since our initial publicoffering our stock price has experienced significant volatility.  These broad market fluctuations could have amaterial adverse effect on the market price of our common stock, business, andresults of operations or financial condition.

 

In addition, historically, companies thathave experienced market price volatility have been the target of securitiesclass action litigation.  We could incursignificant costs and our management’s time and resources could be divertedfrom the operation of our business if we were the target of a securities classaction litigation.

 

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

 

Terrorist attacks as well as the on-goingevents in Iraq or other acts of violence and civil unrest in the nation andthroughout the world could influence the financial markets and theeconomy.  Consumers’ television viewinghabits may be altered as a result of these events such that the demand for homevideo entertainment is reduced.  Thesefactors could have a negative impact on our results of operations or our stockprice.

 

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**Directors andExecutive Officers**

 

The following table sets forth the name, age and position held by eachof our executive officers and directors, as of February 29, 2004:

 
| **Name**                  |   | **Age** |   | **Position(s) Held**                                         |   |
|---------------------------|--------|---------|--------|--------------------------------------------------------------|--------|
| J. T. Malugen(1)          |   | 52      |   | Chairman of the Board, President and Chief Executive Officer |   |
| H. Harrison Parrish(1)    |   | 55      |   | Vice Chairman of the Board and Senior Vice President         |   |
| J. Steven Roy             |   | 43      |   | Executive Vice President and Chief Financial Officer         |   |
| Jeffrey S. Stubbs         |   | 41      |   | Executive Vice President - Operations                        |   |
| S. Page Todd              |   | 42      |   | Executive Vice President, Secretary and General Counsel      |   |
| Mark S. Loyd              |   | 48      |   | Executive Vice President - Purchasing and Product Management |   |
| John J. Jump(2)(3)        |   | 52      |   | Director                                                     |   |
| Sanford C. Sigoloff(2)(3) |   | 73      |   | Director                                                     |   |
| William B. Snow(1)(2)(3)  |   | 72      |   | Director                                                     |   |

 

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(1)           Member of our Executive Committee.

(2)           Member of our Compensation Committee.

(3)           Member of our Audit Committee.

 

Mr. Malugen co-founded Movie Gallery in 1985 and has been our Chairmanof the Board and Chief Executive Officer since that time.  Mr. Malugen was appointed Presidenteffective January 4, 2002.  Prior to ourinitial public offering in August 1994, Mr. Malugen had been a practicingattorney in the states of Alabama and Missouri since 1978, but spent a majorityof his time managing the operations of Movie Gallery beginning in early1992.  Mr. Malugen received a B.S.degree in Business Administration from the University of Missouri-Columbia, hisJ.D. from Cumberland School of Law, Samford University and his LL.M. (inTaxation) from New York University School of Law.

 

Mr. Parrish co-founded Movie Gallery in 1985 and has served as aDirector since that time.  He waselected Vice Chairman of the Board in June 2002.  Mr. Parrish served as President of Movie Gallery from 1985 untilhis resignation on January 4, 2002, at which time Mr. Parrish assumed theposition of Senior Vice President.  Mr.Parrish received a B.A. degree in Business Administration from the Universityof Alabama.

 

Mr. Roy was elected Senior Vice President - Finance and PrincipalAccounting Officer in June 1995, was elected Chief Financial Officer in May1996 and was elected Executive Vice President in March 1998.  Mr. Roy was an accountant with the firm ofErnst & Young LLP for the 11 years prior to joining Movie Gallery.  Mr. Roy is currently serving as director andaudit committee chairman of SunSouth Bank, a community bank based in southeastAlabama.  Mr. Roy is a Certified PublicAccountant and received a B.S. degree in Business Administration from theUniversity of Alabama.  In February 2004,Mr. Roy announced his plans to resign at the end of March 2004 to pursueprivate business interests.

 

Mr. Stubbs was elected Executive Vice President - Operations in April2001 after serving as Senior Vice President - Operations since November1997.  He joined Movie Gallery inNovember 1995 and served as Regional Manager over Texas, Louisiana andMississippi.  Prior to joining MovieGallery, Mr. Stubbs served as Vice President and General Manager of A.W.C.Corporation, a video specialty and restaurant retailer in east Texas, from 1987to 1995.  He has an additional eightyears experience in grocery and convenience store management.  Mr. Stubbs attended Texas A & M Universityand graduated from Southwest Texas State University, where he received a B.B.A.degree in Business Administration and Marketing.  Effective with Mr. Roy’s resignation, Mr. Stubbs will assume therole of Chief Operating Officer.

 

Mr. Todd was elected Senior Vice President, Secretary and GeneralCounsel in December 1994 and was promoted to Executive Vice President in April2003.  Prior to joining Movie Gallery,he had been an attorney practicing tax and corporate law in Dothan,Alabama.  Mr. Todd received a B.S.degree in Business Administration from the University of Alabama, his J.D. fromthe University of Alabama School of Law and his LL.M. (in Taxation) from NewYork University School of Law.  Mr. Toddwill be named Chief Compliance Officer in conjunction with Mr. Roy’sresignation.

 

Mr.Loyd joined Movie Gallery in August 1986 and has served as the retail storecoordinator as well as Vice President - Purchasing and Product Management.  In October 1996, he was elected Senior VicePresident - Purchasing and Product Management and was promoted to ExecutiveVice President in April 2003.  Mr. Loydattended Southeast Missouri State

 

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University, where he majored in BusinessAdministration.  Mr. Loyd will serve asChief Administration Officer, effective with Mr. Roy’s resignation.

 

Mr. Jump became a director of Movie Galleryin June 2003.  He is the President andowner of Jump Start Promotions, a specialty advertising business which hefounded in September 2000.  Since August2002, he has also served as Business Manager, Operations for ConvergysCorporation.  Mr. Jump served asChairman of the Board of Directors of Video Update, Inc. from May 2001 untilDecember 2001, and he served as its Interim Chief Executive Officer fromNovember 2001 until December 2001.  Mr.Jump served as Executive Vice President, Sales and Marketing of Sight &Sound Distributors, Inc., a home video distribution company, from 1985 to 2000.Mr. Jump received a B.A. degree in Psychology from the University of Missouriat St. Louis.

 

Mr. Sigoloff became a director of Movie Gallery in September 1994.  Since 1989, Mr. Sigoloff has been Chairmanof the Board, President and Chief Executive Officer of Sigoloff &Associates, Inc., a management consulting company.  In August 1989, LJ Hooker Corporation, a client of Sigoloff &Associates, Inc., appointed Mr. Sigoloff to act as its Chief Executive Officerduring its reorganization under Chapter 11 of the United States BankruptcyCode.  From March 1982 until 1988, Mr.Sigoloff was Chairman of the Board, President and Chief Executive Officer ofWickes Companies, Inc., one of the largest retailers in the United States.  In addition, Mr. Sigoloff is an adjunct fullprofessor at the John E. Anderson Graduate School of Management at theUniversity of California at Los Angeles.

 

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.

 

Directors areelected to serve until our next annual meeting of stockholders or until theirsuccessors are elected and qualified. Officers serve at the discretion of our Board of Directors, subject toany contracts of employment. Non-employee directors receive an annual fee of $20,000, a fee of $1,500for each Board meeting attended and a fee of $500 for each committee meetingattended.  We have granted vestedoptions to purchase shares of our common stock to each of the non-employeedirectors, in each case at or above the fair market value of the common stockon the date of grant.

 

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**ITEM 2.  PROPERTIES**

 

*Stores.* Substantially all of our retail stores are leased. Our new store leasestypically provide for an initial lease term of three to seven years, with atleast one renewal option for an additional one to three years. The followingtable provides information regarding the number of stores we operated in eachstate or province as of February 29, 2004:

 

 
| **United States:**  |   |
|---------------------|--------|
|                |   |   |   |
| Alabama             |   | 176 |   |
| Florida             |   | 140 |   |
| Texas               |   | 122 |   |
| Georgia             |   | 116 |   |
| Ohio                |   | 112 |   |
| Virginia            |   | 110 |   |
| North Carolina      |   | 91 |   |
| Arkansas            |   | 76 |   |
| South Carolina      |   | 74 |   |
| Pennsylvania        |   | 73 |   |
| Missouri            |   | 72 |   |
| Tennessee           |   | 72 |   |
| Indiana             |   | 68 |   |
| Oklahoma            |   | 54 |   |
| Mississippi         |   | 53 |   |
| Kentucky            |   | 51 |   |
| Maine               |   | 51 |   |
| Minnesota           |   | 50 |   |
| Wisconsin           |   | 34 |   |
| Illinois            |   | 32 |   |
| New York            |   | 30 |   |
| Michigan            |   | 28 |   |
| Washington          |   | 24 |   |
| Louisiana           |   | 22 |   |
| Colorado            |   | 21 |   |
| Delaware            |   | 21 |   |
| Iowa                |   | 21 |   |
| Massachusetts       |   | 20 |   |
| Montana             |   | 18 |   |
| California          |   | 17 |   |
| Kansas              |   | 17 |   |
| New Hampshire       |   | 17 |   |
| Maryland            |   | 16 |   |
| Arizona             |   | 16 |   |
| Nebraska            |   | 15 |   |
| Connecticut         |   | 14 |   |
| New Mexico          |   | 13 |   |
| Idaho               |   | 11 |   |
| West Virginia       |   | 11 |   |
| South Dakota        |   | 7 |   |
| Utah                |   | 6 |   |
| Alaska              |   | 5 |   |
| Hawaii              |   | 5 |   |
| Nevada              |   | 5 |   |
| North Dakota        |   | 4 |   |
| Oregon              |   | 3 |   |
| Vermont             |   | 3 |   |
| Wyoming             |   | 2 |   |
| New Jersey          |   | 1 |   |
| Rhode Island        |   | 1 |   |
| Total United States |   | 2,021 |   |

 
| **International:**  | ** ** |
|---------------------|------------|
|                |       |
| Canada              |       | 173 |   |
| Mexico              |       | 1 |   |
| Total International |       | 174 |   |
|                |       |   |   |
| TOTAL               |       | 2,195 |   |

 

*Headquarters and Distribution Facility.*  Ourcorporate headquarters and inventory distribution facility are located in anapproximately 96,000 square foot building in Dothan, Alabama which we own.  We are also leasing approximately 48,000square feet of off-site warehouse space to supplement distribution and toprovide record storage.

 

**ITEM 3.  LEGAL PROCEEDINGS**

 

We are involved in litigation in the ordinarycourse of our business, none of which, if decided adversely to us, individuallyor in the aggregate, would be material to our business or results ofoperations.

 

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

None.

 

19

----

 

**PARTII**

 

**ITEM5.  MARKET FOR REGISTRANT’S COMMONEQUITY AND RELATED STOCKHOLDER MATTERS**

 

Our common stock is listed on the Nasdaq National Market under thesymbol “MOVI.” The prices shown below are the high and low closing prices forour common stock as reported on the Nasdaq National Market for the fiscalperiods indicated.

 
|           |   | **High** |       | **Low** |       |
|----------------|--------|----------|------------|---------|------------|
| **2003:**      |   |     | ** ** |    | ** ** |
| Fourth Quarter |   | $        | 22.44      |    | $          | 17.15 |   |
| Third Quarter  |   | 22.50    |       | 18.96   |       |
| Second Quarter |   | 19.91    |       | 17.04   |       |
| First Quarter  |   | 17.76    |       | 13.38   |       |
|           |   |     |       |    |       |
| **2002:**      |   |     |       |    |       |
| Fourth Quarter |   | $        | 18.56      |    | $          | 12.26 |   |
| Third Quarter  |   | 18.95    |       | 12.81   |       |
| Second Quarter |   | 21.20    |       | 15.49   |       |
| First Quarter  |   | 17.17    |       | 10.07   |       |

 

On February 27, 2004, the last sale price of our common stock asreported on the Nasdaq National Market was $20.00 per share.  As of February 27, 2004, we hadapproximately 9,700 stockholders, including 53 stockholders of record.

 

In December 2003, our board of directorsinstituted a new dividend policy under which it declared an initial quarterlycash dividend of $0.03 per share.  Wecurrently intend to pay similar quarterly cash dividends on our commonstock.  However, the payment of futuredividends is subject to the discretion of our board of directors.  Future dividends may be increased, decreasedor suspended from time to time based on a number of factors, including changesin tax laws related to dividends, our financial condition, capitalrequirements, future business prospects, the terms of any documents governingour indebtedness and other factors that our board of directors deems relevant.

 

**ITEM 6.  SELECTED FINANCIAL DATA**

 

The following table sets forth our historical consolidated financialdata.  We derived this information fromour audited consolidated financial statements for each of the five fiscal yearsended January 4, 2004.  In addition tothe information provided below, you should read our consolidated financialstatements and notes thereto and “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” included in Part II, Item 7 ofthis Form 10-K.  The selected historicalconsolidated financial data do not necessarily indicate the results to beexpected in the future.

 

20

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|                                                                                       |   | **Fiscal  Year Ended (1)** |    |
|--------------------------------------------------------------------------------------------|--------|----------------------------|---------|
|                                                                                       |   | **January 2,  2000**       |    | **December  31,  2000** |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                                                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| **Statements of Income Data:**                                                             |   |                       |    |   |   |   |   |   |   |   |   |
| Revenues:                                                                                  |   |                       |    |   |   |   |   |   |   |   |   |
| Rentals                                                                                    |   | $                          | 253,000 |   | $ | 294,298 |   | $ | 347,464 |   | $ | 490,836 |   | $ | 629,793 |   |
| Product sales                                                                              |   | 23,945                     |    | 24,638 |   | 21,667 |   | 38,152 |   | 62,602 |   |
| Total revenues                                                                             |   | 276,945                    |    | 318,936 |   | 369,131 |   | 528,988 |   | 692,395 |   |
|                                                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| Cost of sales:                                                                             |   |                       |    |   |   |   |   |   |   |   |   |
| Cost of rental revenues                                                                    |   | 79,305                     |    | 94,105 |   | 108,732 |   | 164,818 | (2) | 184,439 | (2) |
| Cost of product sales                                                                      |   | 16,295                     |    | 19,066 |   | 17,715 |   | 29,852 |   | 50,143 |   |
| Gross margin                                                                               |   | 181,345                    |    | 205,765 |   | 242,684 |   | 334,318 |   | 457,813 |   |
|                                                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| Operating costs and expenses:                                                              |   |                       |    |   |   |   |   |   |   |   |   |
| Store operating expenses                                                                   |   | 137,128                    |    | 153,665 |   | 171,409 |   | 253,865 |   | 325,916 |   |
| General and administrative                                                                 |   | 21,403                     |    | 24,945 |   | 29,288 | (3) | 40,995 | (4) | 46,522 |   |
| Amortization of intangibles                                                                |   | 8,452                      |    | 7,465 |   | 6,656 |   | 1,298 |   | 2,003 |   |
| Stock option compensation (5)                                                              |   | —                     |    | — |   | 8,161 |   | 2,279 |   | 1,481 |   |
| Operating income                                                                           |   | 14,362                     |    | 19,690 |   | 27,170 |   | 35,881 |   | 81,891 |   |
|                                                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| Interest expense, net                                                                      |   | (3,349                     | )       | (3,779 | ) | (3,026 | ) | (1,024 | ) | (468 | ) |
| Income before income taxes, extraordinary  item and cumulative effect of accounting change |   | 11,013                     |    | 15,911 |   | 24,144 |   | 34,857 |   | 81,423 |   |
| Income taxes                                                                               |   | 4,615                      |    | 6,425 |   | 9,788 |   | 13,923 |   | 31,987 |   |
| Income before extraordinary item and  cumulative effect of accounting change               |   | 6,398                      |    | 9,486 |   | 14,356 |   | 20,934 |   | 49,436 |   |
| Extraordinary loss on early extinguishment  of debt                                        |   | (682                       | )       | — |   | — |   | — |   | — |   |
| Cumulative effect of accounting change                                                     |   | (699                       | )       | — |   | — |   | — |   | — |   |
| Net income                                                                                 |   | $                          | 5,017   |   | $ | 9,486 |   | $ | 14,356 |   | $ | 20,934 |   | $ | 49,436 |   |
|                                                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| Basic earnings per share:                                                                  |   |                       |    |   |   |   |   |   |   |   |   |
| Income before extraordinary item and  cumulative effect of accounting change               |   | $                          | 0.21    |   | $ | 0.37 |   | $ | 0.56 |   | $ | 0.69 |   | $ | 1.53 |   |
| Extraordinary loss on early extinguishment  of debt                                        |   | (0.02                      | )       | — |   | — |   | — |   | — |   |
| Cumulative effect of accounting change                                                     |   | (0.02                      | )       | — |   | — |   | — |   | — |   |
| Net income per share - basic                                                               |   | $                          | 0.17    |   | $ | 0.37 |   | $ | 0.56 |   | $ | 0.69 |   | $ | 1.53 |   |
|                                                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| Diluted earnings per share:                                                                |   |                       |    |   |   |   |   |   |   |   |   |
| Income before extraordinary item and  cumulative effect of accounting change               |   | $                          | 0.21    |   | $ | 0.37 |   | $ | 0.53 |   | $ | 0.67 |   | $ | 1.48 |   |
| Extraordinary loss on early extinguishment  of debt                                        |   | (0.02                      | )       | — |   | — |   | — |   | — |   |
| Cumulative effect of accounting change                                                     |   | (0.02                      | )       | — |   | — |   | — |   | — |   |
| Net income per share - diluted                                                             |   | $                          | 0.17    |   | $ | 0.37 |   | $ | 0.53 |   | $ | 0.67 |   | $ | 1.48 |   |
|                                                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding:                                                       |   |                       |    |   |   |   |   |   |   |   |   |
| Basic                                                                                      |   | 29,509                     |    | 25,801 |   | 25,837 |   | 30,273 |   | 32,406 |   |
| Diluted                                                                                    |   | 30,083                     |    | 25,868 |   | 27,220 |   | 31,436 |   | 33,370 |   |

 

21

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|                                       |   | **Fiscal  Year Ended (1)** |   |
|--------------------------------------------|--------|----------------------------|--------|
|                                       |   | **January 2,  2000**       |   | **December  31,  2000** |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                                       |   |                       |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data (at end of period):** |   |                       |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                  |   | $                          | 6,970  |   | $ | 7,029 |   | $ | 16,349 |   | $ | 39,526 |   | $ | 53,720 |   |
| Rental inventory, net                      |   | 52,357                     |   | 61,773 |   | 88,424 |   | 82,880 |   | 102,479 |   |
| Total assets                               |   | 209,527                    |   | 217,536 |   | 270,132 |   | 363,574 |   | 464,289 |   |
| Long-term debt, less current maturities    |   | 44,377                     |   | 40,600 |   | 26,000 |   | — |   | — |   |
| Stockholders’ equity                  |   | 125,421                    |   | 129,209 |   | 162,182 |   | 259,051 |   | 320,116 |   |
|                                       |   |                       |   |   |   |   |   |   |   |   |   |
| **Other Data:**                            |   |                       |   |   |   |   |   |   |   |   |   |
| Number of stores at end of period          |   | 963                        |   | 1,020 |   | 1,415 |   | 1,784 |   | 2,158 |   |
| Average revenues per store (6)             |   | $                          | 313    |   | $ | 328 |   | $ | 342 |   | $ | 337 |   | $ | 355 |   |
| Adjusted EBITDA (7)                        |   | $                          | 35,494 |   | $ | 39,744 |   | $ | 61,581 |   | $ | 82,260 |   | $ | 109,416 |   |
| Increase in same store revenues (8)        |   | 0.4                        | %      | 3.8 | % | 2.7 | % | 3.2 | % | 7.0 | % |

 

----

| (1) |   | Results for  fiscal 2001 reflect a 53-week year and include 17 days of operations for  Video Update, Inc., which we acquired out of bankruptcy on December 21,  2001.  All other fiscal years  presented reflect 52-week years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Effective October 7, 2002, we changed the estimates 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 throughout  fiscal 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| (3) |   | Includes a $1.6 million charge related to the amendment of our supply  agreement with Rentrak Corporation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (4) |   | Includes a $4.0 million charge related to a legal settlement in the  second quarter of fiscal 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (5) |   | Represents non-cash compensation expense associated with stock  options that were repriced in March 2001 and are subsequently required to be  accounted for as variable stock options (see Note 7 to our consolidated  financial statements).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (6) |   | Calculated as total revenues divided by the weighted 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-third week.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (7) |   | Adjusted EBITDA is defined as earnings before interest, taxes,  depreciation and amortization, non-cash compensation and nonrecurring items,  less purchases of rental inventory exclusive of rental inventory purchases  specifically for new store openings. Adjusted EBITDA is presented not as an  alternative measure of operating results or cash flow from operations (as  determined in accordance with accounting principles generally accepted in the  United States), but because it is a widely accepted financial indicator in  the home video specialty retail industry of a company’s ability to incur and  service debt assuming rental inventory is expensed upon purchase instead of being  capitalized and amortized.  Our  calculation of Adjusted EBITDA is not necessarily comparable to reported  EBITDA and/or Adjusted EBITDA of other companies due to lack of uniform  definitions of EBITDA and Adjusted EBITDA.   Our calculation of Adjusted EBITDA for the periods indicated is set  forth below: |

 
|                                                                      |   | **Fiscal  Year Ended (1)** |   |
|---------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                      |   | **January 2,  2000**       |   | **December  31,  2000** |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                                                                      |   |                       |   |   |   |   |   |   |   |   |   |
| Operating income                                                          |   | $                          | 14,362 |   | $ | 19,690 |   | $ | 27,170 |   | $ | 35,881 |   | $ | 81,891 |   |
| Rental inventory amortization and non-cash  cost of rental inventory sold |   | 59,097                     |   | 66,078 |   | 80,703 |   | 128,300 |   | 132,978 |   |
| Depreciation and intangibles amortization                                 |   | 21,691                     |   | 22,327 |   | 22,332 |   | 19,346 |   | 23,569 |   |
| Stock option compensation                                                 |   | —                     |   | — |   | 8,161 |   | 2,279 |   | 1,481 |   |
| Legal settlement                                                          |   | —                     |   | — |   | — |   | 4,000 |   | — |   |
| Supply contract amendment                                                 |   | —                     |   | — |   | 1,600 |   | — |   | — |   |
| Purchases of rental inventory                                             |   | (62,842                    | )      | (74,829 | ) | (83,840 | ) | (117,753 | ) | (147,205 | ) |
| DVD catalog investment                                                    |   | —                     |   | — |   | — |   | — |   | 5,421 |   |
| New store rental inventory purchases                                      |   | 3,186                      |   | 6,478 |   | 5,455 |   | 10,207 |   | 11,281 |   |
| Adjusted EBITDA                                                           |   | $                          | 35,494 |   | $ | 39,744 |   | $ | 61,581 |   | $ | 82,260 |   | $ | 109,416 |   |

 

----

| (8) |   | Same store revenues are calculated based on the aggregate revenues  from stores we have operated for at least 13 months. |
|-----|--------|--------------------------------------------------------------------------------------------------------------------------|

 

22

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**ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Overview**

 

We operate approximately 2,200 home videoretail stores that rent and sell movies and video games, primarily in rural andsecondary markets throughout North America. We compete with the other two national chains (Blockbuster and HollywoodEntertainment) in only approximately one-third of our store locations.  We believe that we are the market leader inthe majority of our target markets.  Weestimate that there are approximately 3,000 to 4,000 markets still availablefor expansion in rural America, as well as opportunities throughout Canada andMexico.  We currently plan to open between275 and 300 new stores in 2004 and, subject to market and industry conditions,to continue to open new stores on a similar pace over the next several years.

 

We believe the most significant dynamic inour industry is the relationship our business maintains with the moviestudios.  The studios have historicallymaintained an exclusive window for home video distribution (packaged goods)which provides mass merchants and video retailers approximately a 45 day periodduring which they can sell and rent new releases before they are made availableon pay-per-view or other distribution channels.  The home video distribution channel currently provides over 60%of studio 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.

 

Our strategies are designed to achievereasonable, moderate and consistent growth in same store revenues andprofitability, in a mature industry.  Wefoster a corporate culture of cost control, striving to minimize the operatingand overhead costs associated with our business which allows us to maximize profitabilityand which has proven to be a successful operating model for us.  Our balance sheet reflects $53.7 million incash and cash equivalents as of the end of fiscal 2003 and we have not had anyoutstanding long-term debt since May 2002. Our store base has increased in excess of 20% in each of the last threefiscal years.

 

In addition to the relationship between ourindustry and the movie studios, our operating results are driven by revenue,inventory, rent and payroll.  Giventhose key factors, we believe that by monitoring the five operating performanceindicators described below, we can continue to be successful in executing ouroperating plans and our growth strategy.

•                  *Revenues.*  Our business is a cash business with initialrental fees paid upfront by the customer. Our management team constantly works with inventory levels, marketingand sales promotions, real estate strategies and personnel issues in order tomaximize profitable revenues at each location. Additionally, our team monitors revenue performance on a daily basis toquickly identify trends or issues in our store base or in the industry as awhole.

•                  *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 analyze the impact of theeconomic factors inherent in the various pricing strategies employed by thestudios.  We believe that we are able toachieve purchasing levels tailored for the customer demographics of each of ourmarkets and to maximize the return on investment for our inventory purchasedollars.

•                  *Store level cost control.*  The most significant storeexpenses are payroll and rent, followed by all other supply and service expenditures.  Our fundamental philosophy with respect tostore level expenses is to exercise extreme conservatism in spending.  This is achieved primarily through budgetingsystems and centralization of purchases into the corporate support center.  This enables us to measure performancecarefully against expectations and to leverage our purchasing power.   Our rural focus also provides the benefitof reduced labor and real estate costs in the secondary markets we serve versusthe costs associated with larger 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 general and administrative expensesinclude the costs to maintain our corporate support center as well as theoverhead costs of our field management team.

•                  *Operating cash flows.*  We have generated significantlevels of cash flow for several years. We are generally able to fund the majority of our store growth andacquisitions, as well as ongoing inventory

 

23

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purchases, from cash flow generated from operations.  Cash flow has been sufficient to allow us tomaintain a debt-free balance sheet since May 2002.

 

The following detailed discussion of ourresults of operations, liquidity and capital resources will provide furtherinsight into our performance over the last three years.

 

**Results of Operations**

 

**Selected Financial Statement and Operational Data:**

 
|                             |   | **Fiscal  Year Ended**                      |    | **Fiscal  Year Ended**             |   |
|----------------------------------|--------|---------------------------------------------|---------|------------------------------------|--------|
|                             |   | **January 6,  2002**                        |    | **January 5,  2003**               |   | **January 4,  2004** |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                             |   | **($in  thousands, except per share data)** |    | **(percentage  of total revenue)** |   |
| **Revenues:**                    |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| Rental                           |   | $                                           | 347,464 |                               | $      | 490,836 |   | $ | 629,793 |   | 94.1 | % | 92.8 | % | 91.0 | % |
| Product sales                    |   | 21,667                                      |    | 38,152                             |   | 62,602 |   | 5.9 | % | 7.2 | % | 9.0 | % |
| Total revenues                   |   | 369,131                                     |    | 528,988                            |   | 692,395 |   | 100.0 | % | 100.0 | % | 100.0 | % |
|                             |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| **Cost of sales:**               |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| Rental                           |   | 108,732                                     |    | 164,818                            |   | 184,439 |   | 29.5 | % | 31.2 | % | 26.6 | % |
| Product sales                    |   | 17,715                                      |    | 29,852                             |   | 50,143 |   | 4.8 | % | 5.6 | % | 7.3 | % |
| Total gross margin               |   | $                                           | 242,684 |                               | $      | 334,318 |   | $ | 457,813 |   | 65.7 | % | 63.2 | % | 66.1 | % |
|                             |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| **Store operating expenses**     |   | $                                           | 171,409 |                               | $      | 253,865 |   | $ | 325,916 |   | 46.4 | % | 48.0 | % | 47.1 | % |
| **G&A expenses**             |   | 29,288                                      |    | 40,995                             |   | 46,522 |   | 7.9 | % | 7.8 | % | 6.7 | % |
|                             |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| **Operating income**             |   | 27,170                                      |    | 35,881                             |   | 81,891 |   | 7.4 | % | 6.8 | % | 11.8 | % |
|                             |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| **Net income**                   |   | 14,356                                      |    | 20,934                             |   | 49,436 |   | 3.9 | % | 4.0 | % | 7.1 | % |
| **Net income per diluted share** |   | 0.53                                        |    | 0.67                               |   | 1.48 |   |   |   |   |   |   |   |
|                             |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| **Same store revenues**          |   | 2.7                                         | %       | 3.2                                | %      | 7.0 | % |   |   |   |   |   |   |
|                             |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| **Gross margin percentage:**     |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| Rental                           |   | 68.7                                        | %       | 66.4                               | %      | 70.7 | % |   |   |   |   |   |   |
| Product sales                    |   | 18.2                                        | %       | 21.8                               | %      | 19.9 | % |   |   |   |   |   |   |
| Total gross margin               |   | 65.7                                        | %       | 63.2                               | %      | 66.1 | % |   |   |   |   |   |   |
|                             |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| **Store Count:**                 |   |                                        |    |                               |   |   |   |   |   |   |   |   |   |
| Beginning of period              |   | 1,020                                       |    | 1,415                              |   | 1,784 |   |   |   |   |   |   |   |
| New store builds                 |   | 77                                          |    | 145                                |   | 241 |   |   |   |   |   |   |   |
| Stores acquired                  |   | 355                                         |    | 265                                |   | 170 |   |   |   |   |   |   |   |
| Stores closed                    |   | 37                                          |    | 41                                 |   | 37 |   |   |   |   |   |   |   |
| End of period                    |   | 1,415                                       |    | 1,784                              |   | 2,158 |   |   |   |   |   |   |   |

 

24

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The following table itemizes certain non-cashor nonrecurring items that are included in our operating results for the fiscalyears presented and which are referenced throughout this discussion of ourresults of operations and financial condition:

 
|                              |   | **Fiscal  Year Ended**            |   | **Fiscal  Year Ended**                |   |
|-----------------------------------|--------|-----------------------------------|--------|---------------------------------------|--------|
|                              |   | **January 6,  2002**              |   | **January 5,  2003**                  |   | **January 4,  2004** |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                              |   | **($ in  thousands, before tax)** |   | **($ per  diluted share, after tax)** |   |
|                              |   |                              |   |                                  |   |   |   |   |   |   |   |   |   |
| Rental amortization policy change |   | $                                 | — |                                  | $      | 27,900 |   | $ | 5,900 |   | $ | — |   | $ | 0.53 |   | $ | 0.11 |   |
| Legal settlement                  |   | —                            |   | 4,000                                 |   | — |   | — |   | 0.08 |   | — |   |
| Supply contract amendment         |   | 1,600                             |   | —                                |   | — |   | 0.04 |   | — |   | — |   |
| Stock option compensation         |   | 8,161                             |   | 2,279                                 |   | 1,481 |   | 0.18 |   | 0.04 |   | 0.03 |   |
|                              |   | $                                 | 9,761  |                                  | $      | 34,179 |   | $ | 7,381 |   | $ | 0.22 |   | $ | 0.65 |   | $ | 0.14 |   |

 

*Revenue.*  Forfiscal 2002 and 2003, total revenues increased 43.3% and 30.9%, respectively,from the prior years.  The increaseswere primarily due to same store revenue growth of 3.2% in fiscal 2002 and 7.0%in fiscal 2003 as well as overall growth in the average number of storesoperated in fiscal 2002 of 45.5% and 24.0% in fiscal 2003.  The increases in same store revenuesprimarily resulted from:

 

•                  Continued growth of DVD rental and sales revenue,offset partially by corresponding declines in revenue from VHS products due tothe consumer transition to DVD;

 

•                  Increases in the sales of previously viewedinventory;

 

•                  Higher video game rental revenues driven by ourincreased commitment to our game library, and growth resulting from overallvideo game industry increases and consumer acceptance of new platforms releasedlate in 2001;

 

•                  Fiscal 2003 benefited from increased productsales revenue as a result of a significant expansion of new movie inventoryavailable in the stores beginning during the latter half of 2002;

 

•                  Fiscal 2003 reflects continued revenue growth inthe Video Update stores we acquired in December 2001 and other acquisitions andnew stores built over the last two years; and

 

•                  Fiscal 2002 also benefited from a favorable newmovie release schedule versus fiscal 2001.

 

The increases in same store revenues for fiscal 2002 were partiallyoffset by:

 

•                  Unfavorable weather during the first half of 2002as compared to the first half of 2001;

 

•                  The broadcast of the Winter Olympics during thefirst quarter of 2002; and

 

•                  An extra week of revenues (totaling approximately$10.0 million) in fiscal 2001.

 

*Costof 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 fiscal 2001, 2002 and 2003was 68.7%, 66.4% and 70.7%, respectively. The most significant factors that impacted growth in the gross margin onrental revenue were:

 

•                  The increasing shift of movie rentals from VHS toDVD - DVD rentals constituted approximately 13%, 34% and 54%, of total movierentals in fiscal 2001, 2002 and 2003, respectively; DVD has a lower coststructure than VHS has traditionally had, and the acceptance of DVD hasinfluenced reductions in studio pricing of the VHS format during the last year;and,

 

•                  The purchase price allocation of Video Updatethat produced lower than normal rental inventory amortization in the first halfof 2002.

 

Rental margins were negatively impacted by:

 

•                  A change in estimate related to our amortizationpolicy for rental inventory during the fourth quarter of fiscal 2002 (see Note1 to our consolidated financial statements);

 

•                  Opportunities taken to increase the overallquantity of rental units purchased for our stores as a result of the lower coststructure associated with DVD versus historical VHS pricing;

 

•                  Amortization of our investment in DVD cataloginventory that took place in the first quarter of 2003 in order to satisfyincreasing consumer demand for movies on the DVD format; and

 

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•                  Investments in our video game rental library toprovide significant copy depth of all game platforms in our stores.

 

Cost of product sales includes the costs of new DVDs, videocassettes,concessions and other goods sold.  Thegross margin on product sales is subject to fluctuation based on the relativemix of low margin new movie inventory sales versus higher margin sales ofconcessions and other items.  The gross margin on product sales for fiscal2001, 2002 and 2003 was 18.2%, 21.8% and 19.9%, respectively.  The product sales margin reflects thefollowing trends in inventory mix:

 

•                  Fiscal 2001margins were reduced by significant discounting that was designed to facilitatethe liquidation of older titles and other slow moving inventory;

 

•                  The resultsachieved in fiscal 2002 reflect our reduced levels of low margin cataloginventory that was liquidated in fiscal 2001; and,

 

•                  Fiscal 2003margins are representative of an increase in our mix of new movie sales inorder to accommodate an increased consumer demand for retail movies and tocomplement our rental business as consumers transition to DVD.

 

*Operating Costsand Expenses.*  Store operating expenses include store-levelexpenses such as lease payments and in-store payroll.  Store operating expenses as a percentage of total revenue was46.4%, 48.0% and 47.1% in fiscal 2001, 2002 and 2003, respectively.  The increase in store operating expenses asa percentage of total revenue in fiscal 2002 was primarily due to a higher coststructure associated with the 324 Video Update stores acquired in December 2001and the benefits in fiscal 2001 of an extra week of revenues.  The following factors partially offset theincrease in fiscal 2002 and contributed to a reduction of store operatingexpenses as a percentage of revenues in fiscal 2003:

 

•                  Continued initiatives to reduce operating costs;

 

•                  Strong performance of new stores;

 

•                  Continued closure of under-performing units; and

 

•                  Same store revenues increase of 3.2% in fiscal2002 and 7.0% in fiscal 2003.

 

Additionally,store operating expenses as a percentage of revenues in fiscal 2003 werereduced by leverage from our Video Update transaction against same storerevenue increases and were increased slightly as a result of the large numberof immature stores in our store base that are absorbing the start-up expensesassociated with a new store while the revenue levels are still ramping up.

 

General and administrative expenses as a percentage of revenue were7.9%, 7.8% and 6.7% in fiscal 2001, 2002 and 2003, respectively.  General and administrative expenses includethe following items which have offset the leverage obtained against theincreased revenues associated with the growth in our store base:

 

•                  Fiscal 2001 – a charge of $1.6 million related toan amendment of our supply agreement with Rentrak Corporation;

 

•                  Fiscal 2002 – a legal settlement charge of $4.0million regarding our extended viewing fee policy;

 

•                  Fiscal 2002 – costs and expenses associated withthe conversion of the Video Update stores point of sale system; and

 

•                  Fiscal 2003 – overhead increases to support newinitiatives and our future growth plans, which include expansion into newgeographic areas where our market penetration is lower.

 

Amortization of intangibles declined significantly in fiscal 2002 dueto goodwill no longer being amortized pursuant to the adoption of FASBStatement No. 142, *Goodwill and Other Intangible Assets,*asof the beginning of fiscal 2002.

 

Stock option compensation expense represents the non-cash chargeassociated with certain stock options that were repriced during the firstquarter of fiscal 2001 and are subsequently accounted for as variable stockoptions (see Note 7 to ourconsolidated financial statements)*. *Weexpect to continue to record adjustments to income from stock optioncompensation in future periods.  Due tothe relatively small number of these options that remain outstanding, we expectfuture adjustments to be insignificant.

 

*OperatingIncome.*  As a result of the impact of the abovefactors on revenues and expenses, operating income increased by 32% in fiscal2002 and by 128% in fiscal 2003.

 

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*InterestExpense.* 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.  Interest expense declined significantly in fiscal 2002 and againin fiscal 2003 due to the repayment of all outstanding debt in May 2002 and ourability to maintain a debt-free balance sheet throughout 2003.

 

*Income Taxes.* We had federal and state net operating losscarryforwards at January 4, 2004 resulting primarily from the Video Updateacquisition (see Note 6 to our consolidated financial statements) ofapproximately $103.4 million that expire in years 2007 through 2021.  We have recorded a valuation allowance of$34.4 million related to the deferred tax assets of $40.6 million resultingfrom the net operating loss carryforwards. This valuation allowance has been established as there existsuncertainty regarding our ability to realize these net operating losses intheir entirety.  If facts andcircumstances in the future should warrant an increase in the net operatingloss carryforwards expected to be realized, a reduction in the valuationallowance could occur and may result in a reduction in our effective income taxrate, which was 40%, 40% and 39% for fiscal 2001, 2002 and 2003, respectively.

 

Deferredincome tax liabilities have increased significantly during fiscal 2003.  This is primarily the result of asignificant acceleration in the tax depreciation of newly purchased assetssince the fourth quarter of 2001.  Weanticipate this liability will continue to increase unless we stop orsignificantly slow our new store growth, or until the acceleration provisionsare discontinued.  The acceleration ontax depreciation is a result of special provisions implemented after the eventsof September 11, 2001 and is currently scheduled to be discontinued for assetsplaced in service after January 1, 2005. If the special provisions are not extended, the cumulative excess taxdepreciation levels we currently have will begin to decline.

 

**General EconomicTrends, Quarterly Results of Operations and Seasonality**

 

Our business is subject to fluctuations inoperating results due to a number of factors, many of which are outside of ourcontrol.  These fluctuations may becaused by, among other 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 CapitalResources**

 

Our primary capital needs are for opening and acquiring new stores andfor purchasing inventory. Other capital needs include refurbishing, remodelingand relocating existing stores and refreshing, rebranding and supplying newcomputer hardware for acquired stores. We fund inventory purchases, remodeling, rebranding and relocationprograms, new store opening costs and acquisitions primarily from cash flowfrom operations and, if necessary, loans under revolving creditfacilities.  At January 4, 2004, we hadcash and cash equivalents of $53.7 million, no long-term debt and $63.8 millionin available borrowings under our credit facility.

 

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|                                                 |   | **Fiscal Year Ended** |    |
|------------------------------------------------------|--------|-----------------------|---------|
|                                                 |   | **January 6,  2002**  |    | **January 5,  2003** |   | **January 4,  2004** |   |
| **Statements of Cash Flow Data:**                    |   |                  |    |   |   |   |   |
|                                                 |   |                  |    |   |   |   |   |
| Net cash provided by operating activites             |   | $                     | 143,966 |   | $ | 186,719 |   | $ | 231,801 |   |
| Net cash used in investing activities                |   | (125,229              | )       | (206,744 | ) | (224,993 | ) |
| Net cash (used in) provided by financing  activities |   | (9,384                | )       | 43,428 |   | 3,333 |   |
|                                                 |   |                  |    |   |   |   |   |
| **Other Data:**                                      |   |                  |    |   |   |   |   |
|                                                 |   |                  |    |   |   |   |   |
| Adjusted EBITDA                                      |   | $                     | 61,581  |   | $ | 82,260 |   | $ | 109,416 |   |
| Adjusted EBITDA (percent of total revenue)           |   | 16.7                  | %       | 15.6 | % | 15.8 | % |

 

The increases in net cash provided byoperating activities were primarily attributable to revenue growth andcontinued efforts to maximize economies of scale within our expensestructure.  Net cash provided by operatingactivities continues to be sufficient to cover substantially all of our rentalinventory replenishment and capital resource needs.

 

Net cash used in investing activities includes our operating purchasesof rental inventory, as well as the costs of acquisitions and new storebuilds.  The increases are primarily dueto increased rental inventory purchases to support growth in the store base,the DVD catalog investment in the first quarter of 2003 and increasing levelsof new store builds.  The increase infiscal 2003 was partially offset by a reduction in business acquisitions versus2002.

 

Net cash provided by financing activities includes proceeds from theexercise of stock options and proceeds from our stock offering in May 2002,offset by the repayment of amounts outstanding under our credit facility infiscal 2001 and 2002.

 

In December 2003, our board of directorsinstituted a new dividend policy under which it declared an initial quarterlycash dividend of $0.03 per share.  Wecurrently intend to pay similar quarterly cash dividends on our commonstock.  However, the payment of futuredividends is subject to the discretion of our board of directors.  Future dividends may be increased, decreasedor suspended from time to time based on a number of factors, including changesin tax laws related to dividends, our financial condition, capitalrequirements, future business prospects, the terms of any documents governingour indebtedness and other factors that our board of directors deems relevant.

 

Adjusted EBITDA in fiscal 2002 and 2003 increased 33.6% and 33.0%,respectively, over the prior years. These increases were primarily driven by the revenue increases duringthose periods and continued efforts to maximize economies of scale within ourexpense structure.  Adjusted EBITDA isdefined as earnings before interest, taxes, depreciation and amortization,non-cash stock option compensation and nonrecurring items, less our purchasesof rental inventory which excludes rental inventory purchases specifically fornew store openings. Adjusted EBITDA is presented not as an alternative measureof operating results or cash flow from operations (as determined in accordancewith accounting principles generally accepted in the United States), butbecause, in the home video specialty retail industry, it is a widely acceptedfinancial indicator of a company’s ability to finance its operations and meetits growth plans, in that it treats rental inventory as being expensed uponpurchase instead of being capitalized and amortized.  This measure is also used by us internally to make new store andacquisition investment decisions and to calculate awards under incentive basedcompensation programs.  Our calculationof Adjusted EBITDA is not necessarily comparable to reported EBITDA and/orAdjusted EBITDA of other companies due to the lack of uniform definitions ofEBITDA and Adjusted EBITDA.  (SeeSelected Financial Data in Part II, Item 6 of this Form 10-K for ourcalculation of Adjusted EBITDA.)

 

On June 27, 2001, we entered into a credit agreement with a syndicateof banks, led by SouthTrust Bank, with respect to a revolving creditfacility.  Our credit facility isunsecured and, as amended, provides for borrowings of up to $65 million throughfinal maturity on July 4, 2005.  Theinterest rate on our credit facility is based on LIBOR plus an applicablemargin percentage, which depends on cash flow generation and borrowingsoutstanding. In December 2001, as required by the credit facility, we enteredinto an interest rate swap agreement in order to hedge exposure to interestrate fluctuations on $10 million of outstanding debt at a fixed rate of 3.5%plus an applicable margin percentage. In May 2002, we repaid all amounts outstanding under our credit facilitywith the proceeds from our stock offering and

 

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terminated the interest rate swap agreement.  The costs to terminate the interest rate swap were expensed andwere immaterial to our results of operations. As of January 4, 2004, there were no outstanding borrowings under ourcredit facility.  The amounts availablefor borrowing were reduced by standby letters of credit outstanding of $1.2million and totaled $63.8 million as of January 4, 2004.

 

The followingtable discloses our contractual obligations and commercial commitments as ofJanuary 4, 2004   (see Notes 5 and 8 toour 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                      |   | 299,725                                     |    | 10,287 |   | 208,098 |   | 51,769 |   | 29,571 |   |
| Unconditional purchase obligations(2) |   | 10,838                                      |    | 4,000 |   | 6,838 |   | — |   | — |   |
| Total contractual cash obligations    |   | $                                           | 310,563 |   | $ | 14,287 |   | $ | 214,936 |   | $ | 51,769 |   | $ | 29,571 |   |

 

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(1)     The total commercial commitment under our credit facility is $65million, which expires on July 4, 2005. As of January 4, 2004, there were standby letters of credit outstandingunder the credit facility of $1,172,000, of which $322,000 expires in 2004, and$850,000 expires in 2005.

(2)     Represents our commitment under a supply contract with RentrakCorporation.

 

At January 4, 2004, we had a working capital deficit of $20.0 million,due to the accounting treatment of rental inventory. Rental inventory istreated as a noncurrent asset under accounting principles generally accepted inthe United States because it is a depreciable asset and a portion of this assetis not reasonably expected to be completely realized in cash or sold in thenormal business cycle. Although the rental of this inventory generates themajor portion of our revenue, the classification of this asset as noncurrentresults in its exclusion from working capital. The aggregate amount payable forthis inventory, however, is reported as a current liability until paid and,accordingly, is reflected as a reduction in working capital. Consequently, webelieve that working capital is not an appropriate measure of our liquidity andwe anticipate that we will continue to operate with a working capital deficit.

 

We grow our store base through internally developed and acquiredstores.  We opened 241 internallydeveloped stores during fiscal 2003 and expect to open between 275 and 300 newstores in 2004.  Subject to market and industry conditions, we planto continue to open new stores on a similar pace over the next several years. Weacquired 170 stores during fiscal 2003. We will continue to evaluate acquisition opportunities in 2004 as theyarise.  To the extent available, newstores and future acquisitions may be completed using funds available under ourcredit facility, financing provided by sellers or alternative financingarrangements such as funds raised in public or private debt or equityofferings.  However, we cannot assureyou that financing will be available to us on terms which will be acceptable,if at all.

 

We believe our projected cash flow from operations, cash on hand,borrowing capacity under our credit facility and trade credit will provide thenecessary capital to fund our current plan of operations, including ouranticipated new store openings and acquisition program, through fiscal 2004.However, to fund a major acquisition, or to provide funds in the event that ourneed for funds is greater than expected, or if the financing sources identifiedabove are not available to the extent anticipated or if we increase our growthplan, we may need to seek additional or alternative sources of financing. Thisfinancing may not be available on satisfactory terms. Failure to obtainfinancing to fund our expansion plans or for other purposes could have amaterial adverse effect on our operating results.

 

Our ability tofund our current plan of operations and our growth plan will depend upon ourfuture performance, 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.

 

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### **Recently IssuedAccounting Pronouncements**

 

In November 2002, the Emerging Issues TaskForce (“EITF”) reached a concensus on Issue No. 02-16,  *Accounting by a Customer (Including a Reseller) forCertain Consideration Received from a Vendor,* effective for fiscalyears beginning after December 15, 2002. EITF 02-16 generally requires that cash consideration received from avendor be considered as a reduction of the prices of the vendor’s products,reflected as a reduction of cost of sales in the customer’s incomestatement.  The presumption can beovercome if the vendor receives an identifiable benefit in exchange for theconsideration, in which case the consideration should be recorded as revenue,or if the consideration represents a reimbursement of a specific identifiableincremental cost incurred by the customer in selling the vendor’s productswhere the consideration should be characterized as a reduction of thatcost.  Our adoption of this standard asof January 6, 2003 did not have a material impact on our financial position orresults of operations.

 

In January 2003, the Financial Accounting Standards Board issuedInterpretation No. 46, *Consolidation of Variable Interest Entities, anInterpretation of Accounting Research Bulletin No. 51*(“theInterpretation”).  The Interpretationrequires the consolidation of entities in which an enterprise absorbs amajority of the entity’s expected losses, receives a majority of the entity’sexpected residual returns, or both, as a result of ownership, contractual orother financial interests in the entity. Currently, entities are generally consolidated by an enterprise when ithas a controlling financial interest through ownership of a majority votinginterest in the entity.  TheInterpretation is effective as of December 31, 2003 for all qualifyinginterests in special purpose entities (“SPEs”) in existence as of January 31,2003 and as of February 1, 2003 for all qualifying SPEs obtained after January31, 2003.  We had no qualifyinginterests as of January 31, 2003.  Wehave subsequently made equity investments in other entities during 2003 (noneof which are SPEs).  These investmentsare immaterial, and consolidation is not currently required under theInterpretation.   The provisions of theInterpretation, as revised by the FASB in December 2003, must be applied tosome of our investments in the first quarter of 2004.  Based on our analysis to date, none of our current interests willhave a significant impact on our financial statements upon adoption of theInterpretation’s consolidation rules.

 

In May 2003, the Financial Accounting Standards Board issued StatementNo. 150, *Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity. *Statement 150 clarifies theclassification and measurement of certain financial instruments withcharacteristics of both liabilities and equity, and is effective for financialinstruments entered into or modified after May 31, 2003, or otherwise for thefirst interim period beginning after June 15, 2003.  The adoption of Statement 150 had no material impact on our netearnings, cash flows or financial position.

 

## **CriticalAccounting Policies and Estimates**

 

Our significant accounting policies aredescribed in Note 1 to our consolidated financial statements. Our discussionand analysis of financial condition and results of operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States. Thepreparation of the financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues,expenses, and related disclosure of contingent assets and liabilities. On anon-going basis, we evaluate the estimates that we have made. These estimateshave been based upon historical experience and on various other assumptionsthat we believe to be reasonable under the circumstances. Actual results maydiffer from these estimates under different conditions or using differentassumptions. We believe our most critical accounting estimates include ourpolicies with respect to rental inventory amortization, impairment oflong-lived assets, purchase price allocation of acquired businesses anddeferred income taxes.

 

A major component of our cost structure is based upon the method bywhich we amortize our rental inventory. Rental inventory is amortized to an estimated salvage value over anestimated useful life of up to two years. We amortize the cost of rental inventory using an accelerated methoddesigned to approximate the rate of revenue recognition.  This method is based on our historicalexperience and is dependent upon the net realizable value of our inventory andthe demand patterns of the rental products we provide.  We believe our estimated useful lives andsalvage values are appropriately matched to our current rental business and areconsistent with industry trends. However, should rental patterns of consumers change or should marketvalues of existing inventory decline due to the acceptance of new formats(ongoing VHS transition to DVD, anticipated transition to high definition DVDwithin three to five years, release of new video game formats, etc.), thiscould necessitate an acceleration in our current rental amortization rates or areduction in salvage values.  We believethat any acceleration in the rental amortization rates would not have a long-

 

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lasting impact as the majority of rental purchases are substantiallydepreciated within the first two to three months under our existingpolicy.  We could be required to reducesalvage values that we currently carry on VHS inventory if we are unable todispose of that inventory at a rate relatively consistent with the consumers’transition to DVD.   As of January 4,2004, we had $102.5 million in rental inventory on our balance sheet.

 

We assess the fair value and recoverability of our long-lived assets,including property, furnishings and equipment and intangible assets with finitelives, whenever events and circumstances indicate the carrying value of anasset 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 of our long-livedassets may not be recoverable, we measure any impairment based upon the excessof the carrying value that exceeds the estimated fair value of the assets.  We have not recognized any impairment losseson long-lived assets since fiscal 1996. If we do not meet our operating forecasts or if the market value of ourstock declines significantly, we may have to record impairment charges notpreviously recognized.

 

We test goodwill for impairment on an annual basis.  Additionally, goodwill is tested for impairmentbetween annual tests if an event occurs or circumstances change that would morelikely than not reduce the fair value of an entity below its carryingvalue.  These events or circumstanceswould include a significant change in the business climate, legal factors,operating performance indicators, competition, sale or disposition of asignificant portion of the business or other factors.  We have not recorded any impairment losses on goodwill since afiscal 2001 impairment charge of $700,000. If we do not meet our operating forecasts or if the market value of ourstock declines significantly, we may have to record additional impairmentcharges not previously recognized.  Asof January 4, 2004, we have $136 million in goodwill on our balance sheet.

 

We estimate the fair value of assets and liabilities of acquiredbusinesses based on historical experience and available information at theacquisition date.  We engage independentvaluation specialists to assist when necessary.  If information becomes available subsequent to the acquisitiondate that would materially impact the valuation of assets acquired orliabilities assumed in business combinations, we may be required to adjust thepurchase price allocation.  With theexception of the Video Update acquisition in 2001, we have not experienced anysignificant adjustments to the valuation of assets or liabilities acquired inbusiness combinations in the last seven years. Our acquisitions are typically small businesses for which we generallydo not assume liabilities and for which the assets acquired consist primarilyof inventory, fixtures, equipment and intangibles.

 

We recognize deferred tax assets and liabilities based on thedifferences between the financial statement carrying amounts and the tax basesof assets and liabilities. We regularly review our deferred tax assets forrecoverability and establish a valuation allowance based upon historicallosses, projected future taxable income and the expected timing of thereversals of existing temporary differences. As a result of this review, wehave established a valuation allowance against our deferred tax assets relatedto net operating loss carryforwards that we acquired in the 2001 acquisition ofVideo Update.  If facts andcircumstances in the future should warrant elimination or reduction of thevaluation allowance related to these acquired net operating loss carryforwards,our effective income tax rate, which was 40%, 40% and 39% for fiscal 2001, 2002and 2003, respectively, could be reduced.

 

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**RelatedParty Transactions**

 

Please refer to Note 9 to our consolidated financial statements fordisclosures regarding our significant related party transactions.

 

**Forward-LookingStatements**

 

With respect to forward-looking statements, please refer to thedisclosures set forth under “Cautionary Statements” in Part I, Item 1 of thisForm 10-K.

 

**ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

The market risk inherent in our financial instruments represents theincreased interest costs arising from adverse changes in interest rates(primarily LIBOR and prime bank rates). We currently have no amounts outstanding under our credit facility and,thus, no exposure to adverse interest rate changes.

 

We are exposed to foreign exchange risks associated with our Canadianand Mexican operations.   Historically,the Canadian exchange rates have been relatively stable and we believe theimpact of fluctuations in the currency exchange rates will be immaterial to ourfinancial position and results of operations. Based on fiscal 2003 results, a hypothetical 10% change in the Canadianexchange rate would impact our consolidated financial position and results ofoperations by less than 1%.  Our Mexicanoperations are currently limited to one location.  Growth in 2004 is not expected to be significant enough to resultin a material impact from fluctuations in currency exchange rates.

 

**ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

Reference is made to Part IV, Item 15 of this Form 10-K for theinformation required by Item 8.

 

### **ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A.  CONTROLS AND PROCEDURES**

 

Our management, with the participation of our Chief Executive Officerand Chief Financial Officer, has evaluated the effectiveness of our disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the  Exchange Act )) as of the end of the periodcovered by this report. Based on that evaluation, our Chief Executive Officerand Chief Financial Officer have concluded that, as of the end of such period,our disclosure controls and procedures are effective.

 

There have not been any changes in our internal control over financialreporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) during our fiscal fourth quarter that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

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

###### ** **

**ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

 

The information required by this Item (other than the informationregarding directors and executive officers set forth at the end of Part 1, Item1 of this Form 10-K) will be contained in our definitive Proxy Statement forour 2004 Annual Meeting of Stockholders, and is incorporated herein byreference.

 

**ITEM11.  EXECUTIVE COMPENSATION**

 

The information required by this Item will be contained in ourdefinitive Proxy Statement for our 2004 Annual Meeting of Stockholders, and isincorporated herein by reference.

 

**ITEM12.   SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

The information required by this Item will be contained in ourdefinitive Proxy Statement for our 2004 Annual Meeting of Stockholders, and isincorporated herein by reference.

 

**ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

The information required by this Item will be contained in ourdefinitive Proxy Statement for our 2004 Annual Meeting of Stockholders, and isincorporated herein by reference.

 

**ITEM 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

The information required by this Item will be contained in ourdefinitive Proxy Statement for our 2004 Annual Meeting of Stockholders, and isincorporated herein by reference.

 

**PARTIV**

 

**ITEM 15.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES ANDREPORTS ON FORM 8-K**

 

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

 

The following consolidated financial statements of Movie Gallery, Inc.and independent auditors’ report thereon, are filed as part of this report inthe section immediately following the signature page:

 
| Report of Ernst & Young LLP,  Independent Auditors.                                                                                |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                   |   |
| Consolidated Balance Sheets as of January 5, 2003 and January 4,  2004.                                                                |   |
|                                                                                                                                   |   |
| Consolidated Statements of Income for the Fiscal Years Ended January  6, 2002, January 5, 2003 and January 4, 2004.                    |   |
|                                                                                                                                   |   |
| Consolidated Statements of Stockholders’ Equity for the Fiscal Years  Ended January 6, 2002, January 5, 2003 and January 4, 2004. |   |
|                                                                                                                                   |   |
| Consolidated Statements of Cash Flows for  the Fiscal Years Ended January 6, 2002, January 5, 2003 and January 4, 2004.                |   |
|                                                                                                                                   |   |
| Notes to Consolidated Financial Statements.                                                                                            |   |

 

**(a)(2)Schedules:**

 

All financial statement schedules are either inapplicable or are notrequired under the related instructions and, therefore, have been omitted.

 

33

----

 

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

 

The following exhibits, which are furnishedwith this Annual Report or incorporated herein by reference, are filed as partof this Annual Report:

 

 
| **Exhibit  No.** |   | **Exhibit Description**                                                                                             |
|------------------|--------|---------------------------------------------------------------------------------------------------------------------|
| 3.1              |   | Certificate of Incorporation of the Company. (1)                                                                    |
|             |   |                                                                                                                |
| 3.1.1            | -      | Certificate of Amendment of Certificate of Incorporation dated June  6, 1996. (2)                                   |
|             |   |                                                                                                                |
| 3.1.2            | -      | Certificate of Amendment of Certificate of Incorporation dated July  1, 1999. (2)                                   |
|             |   |                                                                                                                |
| 3.1.3            | -      | Certificate of Amendment of Certificate of Incorporation dated June  27, 2002. (3)                                  |
|             |   |                                                                                                                |
| 3.2              | -      | Amended and Restated Bylaws of Movie Gallery, Inc. (3)                                                              |
|             |   |                                                                                                                |
| 4.1              | -      | Specimen Common Stock Certificate. (4)                                                                              |
|             |   |                                                                                                                |
| 10.1             | -      | 1994 Stock Option Plan, as amended and form of Stock Option  Agreement. (5)                                         |
|             |   |                                                                                                                |
| 10.1.1           | -      | Amendment to Movie Gallery, Inc. 1994 Stock Plan, as amended dated  June 13, 2000. (3)                              |
|             |   |                                                                                                                |
| 10.1.2           | -      | Amendment to Movie Gallery, Inc. 1994 Stock Plan, as amended dated  September 12, 2002. (6)                         |
|             |   |                                                                                                                |
| 10.2             | -      | Form of Indemnity Agreement. (1)                                                                                    |
|             |   |                                                                                                                |
| 10.3             | -      | Employment Agreement between M.G.A., Inc. and Joe Thomas Malugen. (1)                                               |
|             |   |                                                                                                                |
| 10.3.1           | -      | First Amendment to Employment Contract between M.G.A., Inc. and J. T.  Malugen dated April 3, 2000. (7)             |
|             |   |                                                                                                                |
| 10.5             | -      | Employment Agreement between M.G.A., Inc. and J. Steven Roy.  (8)                                              |
|             |   |                                                                                                                |
| 10.6             | -      | Employment Agreement between M.G.A., Inc. and S. Page Todd.  (8)                                               |
|             |   |                                                                                                                |
| 10.7             | -      | Employment Agreement between M.G.A., Inc. and Jeffrey S. Stubbs. (9)                                                |
|             |   |                                                                                                                |
| 10.8             | -      | Credit Agreement between Movie Gallery, Inc. and SouthTrust Bank  dated June 27, 2001. (10)                         |
|             |   |                                                                                                                |
| 10.8.1           | -      | Amendment to Credit Agreement between Movie Gallery, Inc. and  SouthTrust Bank dated September 25, 2001.   (3) |
|             |   |                                                                                                                |
| 10.8.2           | -      | Amendment to Credit Agreement between Movie Gallery, Inc. and  SouthTrust Bank dated January 14, 2002.   (3)   |
|             |   |                                                                                                                |
| 10.8.3           | -      | Amendment to Credit Agreement between Movie Gallery, Inc. and  SouthTrust Bank dated August 15, 2002. (11)          |
|             |   |                                                                                                                |
| 10.8.4           | -      | Amendment to Credit Agreement between Movie Gallery, Inc. and  SouthTrust Bank dated May 19, 2003. (12)             |
|             |   |                                                                                                                |
| 10.9             | -      | 2003 Stock Plan (13)                                                                                                |
|             |   |                                                                                                                |
| 10.10            | -      | 2003 Employee Stock Purchase Plan (14)                                                                              |
|             |   |                                                                                                                |
| 14               | -      | Code of Ethics.  (filed  herewith)                                                                             |
|             |   |                                                                                                                |
| 21               | -      | List of Subsidiaries. (filed herewith)                                                                              |

 

34

----

 
| **Exhibit   No.** |   | **Exhibit  Description**                                                                                                                                              |
|-------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 23                | -      | Consent of Ernst & Young LLP, Independent Auditors.  (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 with the Securities and Exchange Commission on June 10, 1994, as an  exhibit to our Registration Statement on Form S-1 (File No. 33-80120).        |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  |   | Previously  filed with the Securities and Exchange Commission on August 17, 1999, as an  exhibit to our Form 10-Q for the quarter ended July 4, 1999.                |
| (3)  |   | Previously  filed with the Securities and Exchange Commission on April 7, 2003, as an  exhibit to our Form 10-K for the fiscal year ended January 5, 2003.           |
| (4)  |   | Previously  filed with the Securities and Exchange Commission on August 1, 1994, as an  exhibit to Amendment No. 2 to our Registration Statement on Form S-1.        |
| (5)  |   | Previously  filed with the Securities and Exchange Commission on April 7, 1997, as an  exhibit to our Form 10-K for the fiscal year ended January 5, 1997.           |
| (6)  |   | Previously  filed with the Securities and Exchange Commission on November 20, 2002, as an  exhibit to our Form 10-Q for the quarter ended October 6, 2002.           |
| (7)  |   | Previously  filed with the Securities and Exchange Commission on May 17, 2000, as an  exhibit to our Form 10-Q for the quarter ended April 2, 2000.                  |
| (8)  |   | Previously  filed with the Securities and Exchange Commission on April 6, 1998, as an  exhibit to our Form 10-K for the fiscal year ended January 4, 1998.           |
| (9)  |   | Previously  filed with the Securities and Exchange Commission on April 2, 2001, as an  exhibit to our Form 10-K for the fiscal year ended December 31, 2000.         |
| (10) |   | Previously  filed with the Securities and Exchange Commission on August 15, 2001, as an  exhibit to our Form 10-Q for the quarter ended July 1, 2001.                |
| (11) |   | Previously  filed with the Securities and Exchange Commission on August 21, 2002, as an  exhibit to our Form 10-Q for the quarter ended July 7, 2002.                |
| (12) |   | Previously  filed with the Securities and Exchange Commission on August 20, 2003, as an  exhibit to our Form 10-Q for the quarter ended July 6, 2003.                |
| (13) |   | Previously  filed with the Securities and Exchange Commission on September 29, 2003, as  an exhibit to our Registration Statement on Form S-8 (File No. 333-109240). |
| (14) |   | Previously  filed with the Securities and Exchange Commission on September 29, 2003, as  an exhibit to our Registration Statement on Form S-8 (File No. 333-109241). |

 

**(b)  Reports on Form 8-K:**

 

We filed a Form 8-K reporting on Items 7 and 12 dated October 8, 2003.

We filed a Form 8-K reporting on Items 7 and 12 dated November 4, 2003.

We filed a Form 8-K reporting on Items 5 and 7 dated December 16, 2003.

 

**(c)  Exhibits:**

 

See (a)(3) above.

 

35

----

 

### **SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the 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 11, 2004 |                |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**           |   | **Title**                            |   | **Date**       |
|-------------------------|--------|--------------------------------------|--------|----------------|
|                    |   |                                 |   |           |
| /s/ J. T. MALUGEN       |   | Chairman of the Board, President and |   | March 11, 2004 |
| J. T. Malugen           |   | Chief Executive Officer              |   |           |
|                    |   |                                 |   |           |
| /s/ H. HARRISON PARRISH |   | Vice Chairman of the Board           |   | March 11, 2004 |
| H. Harrison Parrish     |   |                                 |   |           |
|                    |   |                                 |   |           |
| /s/ WILLIAM B. SNOW     |   | Director                             |   | March 11, 2004 |
| William B. Snow         |   |                                 |   |           |
|                    |   |                                 |   |           |
| /s/ JOHN J. JUMP        |   | Director                             |   | March 11, 2004 |
| John J. Jump            |   |                                 |   |           |
|                    |   |                                 |   |           |
| /s/ J. STEVEN ROY       |   | Executive Vice President and Chief   |   | March 11, 2004 |
| J. Steven Roy           |   | Financial Officer                    |   |           |
|                    |   |                                 |   |           |
| /s/ IVY M. JERNIGAN     |   | Vice President - Controller          |   | March 11, 2004 |
| Ivy M. Jernigan         |   |                                 |   |           |

 

36

----

 

**MovieGallery, Inc.**

 

**ConsolidatedFinancial Statements**

 

Fiscal years ended January 6, 2002,January 5, 2003 and January 4, 2004

 

**Contents**

 
| Report  of Ernst & Young LLP, Independent Auditors |   |
|--------------------------------------------------------|--------|
|                                                   |   |
| Audited Financial Statements                           |   |
|                                                   |   |
| Consolidated Balance Sheets                            |   |
| Consolidated Statements of Income                      |   |
| Consolidated Statements of Stockholders’ Equity   |   |
| Consolidated Statements of Cash Flows                  |   |
| Notes to  Consolidated Financial Statements            |   |

 

----

 

**Reportof****Ernst & Young LLP, Independent Auditors**

 

Board of Directors and Stockholders

Movie Gallery, Inc.

 

We have audited the accompanying consolidated balance sheets of MovieGallery, Inc. as of January 5, 2003 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 4, 2004.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement.  Anaudit includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve 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 5, 2003 and January 4, 2004, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended January 4, 2004, in conformity with accountingprinciples generally accepted in the United States.

 

As discussed in Note 1 to the consolidated financial statements, infiscal 2002 the Company changed its method of accounting for goodwill.

 
|                   | /s/ Ernst & Young LLP |   |
|------------------------|---------------------------|--------|
|                   |                      |
|                   |                      |
| Birmingham, Alabama    |                      |
| February 13, 2004 |                      |

 

F- 1

----

 

**MovieGallery, Inc.**

 

**Consolidated Balan****ce Sheets**

*(in thousands)*

 
|                                                                                                                     |   | **January 5,  2003** |    | **January 4,  2004** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|---------------------------|---------|---------------------------|--------|
|                                                                                                                     |   |                      |    |                      |   |
| **Assets**                                                                                                               |   |                      |    |                      |   |
| Current assets:                                                                                                          |   |                      |    |                      |   |
| Cash and cash equivalents                                                                                                |   | $                         | 39,526  |                      | $      | 53,720 |   |
| Merchandise inventory                                                                                                    |   | 18,646                    |    | 26,473                    |   |
| Prepaid expenses                                                                                                         |   | 1,533                     |    | 1,377                     |   |
| Store supplies and other                                                                                                 |   | 7,585                     |    | 11,019                    |   |
| Deferred income taxes                                                                                                    |   | —                    |    | 1,631                     |   |
| Total current assets                                                                                                     |   | 67,290                    |    | 94,220                    |   |
|                                                                                                                     |   |                      |    |                      |   |
| Rental inventory, net                                                                                                    |   | 82,880                    |    | 102,479                   |   |
| Property, furnishings and equipment, net                                                                                 |   | 86,993                    |    | 114,356                   |   |
| Goodwill, net                                                                                                            |   | 116,119                   |    | 136,008                   |   |
| Other intangibles, net                                                                                                   |   | 6,677                     |    | 8,473                     |   |
| Deposits and other assets                                                                                                |   | 3,615                     |    | 8,753                     |   |
| Total assets                                                                                                             |   | $                         | 363,574 |                      | $      | 464,289 |   |
|                                                                                                                     |   |                      |    |                      |   |
| **Liabilities and stockholders’  equity**                                                                           |   |                      |    |                      |   |
| Current liabilities:                                                                                                     |   |                      |    |                      |   |
| Accounts payable                                                                                                         |   | $                         | 66,996  |                      | $      | 77,344 |   |
| Accrued liabilities                                                                                                      |   | 23,524                    |    | 26,161                    |   |
| Deferred revenue                                                                                                         |   | 9,636                     |    | 10,741                    |   |
| Deferred income taxes                                                                                                    |   | 742                       |    | —                    |   |
| Total current liabilities                                                                                                |   | 100,898                   |    | 114,246                   |   |
|                                                                                                                     |   |                      |    |                      |   |
| Other accrued liabilities                                                                                                |   | 249                       |    | 142                       |   |
| Deferred income taxes                                                                                                    |   | 3,376                     |    | 29,785                    |   |
|                                                                                                                     |   |                      |    |                      |   |
| 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, 32,062 and 32,841 shares issued and outstanding,  respectively |   | 32                        |    | 33                        |   |
| Additional paid-in capital                                                                                               |   | 216,631                   |    | 225,191                   |   |
| Retained earnings                                                                                                        |   | 42,647                    |    | 91,098                    |   |
| Accumulated other comprehensive income  (loss)                                                                           |   | (259                      | )       | 3,794                     |   |
| Total stockholders’ equity                                                                                          |   | 259,051                   |    | 320,116                   |   |
| Total liabilities and stockholders’ equity                                                                          |   | $                         | 363,574 |                      | $      | 464,289 |   |

 

*See accompanying notes.*

 

F- 2

----

 

**MovieGallery, Inc.**

 

**ConsolidatedStatements of****Income**

*(inthousands, except per share data)*

 
|                                 |   | **Fiscal  Year Ended**    |    |
|--------------------------------------|--------|---------------------------|---------|
|                                 |   | **January 6,  2002** |    | **January 5,  2003** |   | **January 4,  2004** |   |
|                                 |   |                      |    |   |   |   |   |
| Revenues:                            |   |                      |    |   |   |   |   |
| Rentals                              |   | $                         | 347,464 |   | $ | 490,836 |   | $ | 629,793 |   |
| Product sales                        |   | 21,667                    |    | 38,152 |   | 62,602 |   |
| Total revenues                       |   | 369,131                   |    | 528,988 |   | 692,395 |   |
|                                 |   |                      |    |   |   |   |   |
| Cost of sales:                       |   |                      |    |   |   |   |   |
| Cost of rental revenues              |   | 108,732                   |    | 164,818 |   | 184,439 |   |
| Cost of product sales                |   | 17,715                    |    | 29,852 |   | 50,143 |   |
| Gross margin                         |   | 242,684                   |    | 334,318 |   | 457,813 |   |
|                                 |   |                      |    |   |   |   |   |
| Operating costs and expenses:        |   |                      |    |   |   |   |   |
| Store operating expenses             |   | 171,409                   |    | 253,865 |   | 325,916 |   |
| General and administrative           |   | 29,288                    |    | 40,995 |   | 46,522 |   |
| Amortization of intangibles          |   | 6,656                     |    | 1,298 |   | 2,003 |   |
| Stock option compensation            |   | 8,161                     |    | 2,279 |   | 1,481 |   |
| Operating income                     |   | 27,170                    |    | 35,881 |   | 81,891 |   |
|                                 |   |                      |    |   |   |   |   |
| Interest expense, net                |   | (3,026                    | )       | (1,024 | ) | (468 | ) |
| Income before income taxes           |   | 24,144                    |    | 34,857 |   | 81,423 |   |
| Income taxes                         |   | 9,788                     |    | 13,923 |   | 31,987 |   |
|                                 |   |                      |    |   |   |   |   |
| Net income                           |   | $                         | 14,356  |   | $ | 20,934 |   | $ | 49,436 |   |
|                                 |   |                      |    |   |   |   |   |
| Earnings per share:                  |   |                      |    |   |   |   |   |
| Basic                                |   | $                         | 0.56    |   | $ | 0.69 |   | $ | 1.53 |   |
|                                 |   |                      |    |   |   |   |   |
| Diluted                              |   | $                         | 0.53    |   | $ | 0.67 |   | $ | 1.48 |   |
|                                 |   |                      |    |   |   |   |   |
| Weighted average shares outstanding: |   |                      |    |   |   |   |   |
| Basic                                |   | 25,837                    |    | 30,273 |   | 32,406 |   |
| Diluted                              |   | 27,220                    |    | 31,436 |   | 33,370 |   |

 

*See accompanying notes.*

 

F- 3

----

 

**Movie Gallery, Inc.**

 

**Consolidated Statements of Stoc****kholders’ Equity**

**(in thousands)**

 
|                                                                       |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Retained  Earnings** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Total  Stockholders’  Equity** |   |
|----------------------------------------------------------------------------|--------|-------------------|--------|----------------------------------|--------|------------------------|--------|------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                       |   |              |   |                             |   |                   |   |                                                 |   |                                  |   |
| Balance at December 31, 2000                                          |   | $                 | 25     |                             | $      | 121,827                |   | $                                                    | 7,357  |                                  | $      | — |   | $ | 129,209 |   |
| Comprehensive Income:                                                      |   |              |   |                             |   |                   |   |                                                 |   |                                  |   |
| Net income                                                                 |   |              |   |                             |   | 14,356                 |   | —                                               |   | 14,356                                |   |
| Foreign currency translation                                               |   |              |   |                             |   | —                 |   | (33                                                  | )      | (33                                   | )      |
| Total comprehensive income                                                 |   |              |   |                             |   |                   |   |                                                 |   | 14,323                                |   |
| Exercise of stock options for 2,129 shares                                 |   | 2                 |   | 5,214                            |   | —                 |   | —                                               |   | 5,216                                 |   |
| Tax benefit of stock options exercised                                     |   | —            |   | 5,273                            |   | —                 |   | —                                               |   | 5,273                                 |   |
| Stock option compensation                                                  |   | —            |   | 8,161                            |   | —                 |   | —                                               |   | 8,161                                 |   |
| 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                                 |   |
| 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                                 |   |
| 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 |   |

 

See accompanying notes.

 

F- 4

----

 

 

**Movie Gallery, Inc.**

 

**ConsolidatedStatements of Cash Flows**

(*in thousands)*

 
|                                                                               |   | **Fiscal  Year Ended**    |   |
|------------------------------------------------------------------------------------|--------|---------------------------|--------|
|                                                                               |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                                                                               |   |                      |   |   |   |   |   |
| **Operating  activities:**                                                         |   |                      |   |   |   |   |   |
| Net income                                                                         |   | $                         | 14,356 |   | $ | 20,934 |   | $ | 49,436 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                      |   |   |   |   |   |
| Rental inventory amortization and non-cash  cost of rental inventory sold          |   | 80,703                    |   | 128,300 |   | 132,978 |   |
| Depreciation and intangibles amortization                                          |   | 22,332                    |   | 19,346 |   | 23,569 |   |
| Stock option compensation                                                          |   | 8,161                     |   | 2,279 |   | 1,481 |   |
| Tax benefit of stock options exercised                                             |   | 5,273                     |   | 4,454 |   | 3,747 |   |
| Deferred income taxes                                                              |   | 3,703                     |   | 4,653 |   | 24,036 |   |
| Changes in operating assets and  liabilities:                                      |   |                      |   |   |   |   |   |
| Merchandise inventory                                                              |   | 3,436                     |   | (10,972 | ) | (7,232 | ) |
| Other current assets                                                               |   | (2,731                    | )      | (466 | ) | (3,202 | ) |
| Deposits and other assets                                                          |   | 856                       |   | (1,222 | ) | (5,085 | ) |
| Accounts payable                                                                   |   | 5,493                     |   | 15,446 |   | 10,348 |   |
| Accrued liabilities and deferred revenue                                           |   | 2,384                     |   | 3,967 |   | 1,725 |   |
| Net cash provided by operating activities                                          |   | 143,966                   |   | 186,719 |   | 231,801 |   |
|                                                                               |   |                      |   |   |   |   |   |
| **Investing  activities:**                                                         |   |                      |   |   |   |   |   |
| Business acquisitions                                                              |   | (20,047                   | )      | (57,675 | ) | (30,672 | ) |
| Purchases of rental inventory                                                      |   | (83,840                   | )      | (117,753 | ) | (147,205 | ) |
| Purchases of property, furnishings and  equipment                                  |   | (21,342                   | )      | (31,316 | ) | (47,116 | ) |
| Net cash used in investing activities                                              |   | (125,229                  | )      | (206,744 | ) | (224,993 | ) |
|                                                                               |   |                      |   |   |   |   |   |
| **Financing  activities:**                                                         |   |                      |   |   |   |   |   |
| Net proceeds from issuance of common stock                                         |   | —                    |   | 66,769 |   | — |   |
| Proceeds from exercise of stock options                                            |   | 5,216                     |   | 2,659 |   | 3,333 |   |
| Net payments on long-term debt                                                     |   | (14,600                   | )      | (26,000 | ) | — |   |
| Net cash (used in) provided by financing  activities                               |   | (9,384                    | )      | 43,428 |   | 3,333 |   |
|                                                                               |   |                      |   |   |   |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                      |   | (33                       | )      | (226 | ) | 4,053 |   |
|                                                                               |   |                      |   |   |   |   |   |
| Increase in cash and cash equivalents                                              |   | 9,320                     |   | 23,177 |   | 14,194 |   |
| Cash and cash equivalents at beginning of  fiscal year                             |   | 7,029                     |   | 16,349 |   | 39,526 |   |
| Cash and cash equivalents at end of fiscal  year                                   |   | $                         | 16,349 |   | $ | 39,526 |   | $ | 53,720 |   |
|                                                                               |   |                      |   |   |   |   |   |
| **Supplemental  disclosures of cash flow information:**                            |   |                      |   |   |   |   |   |
| Cash paid during the fiscal year for  interest                                     |   | $                         | 3,434  |   | $ | 905 |   | $ | 254 |   |
| Cash paid during the fiscal year for income  taxes                                 |   | 1,461                     |   | 2,716 |   | 4,974 |   |

 

*See accompanying notes.*

 

F- 5

----

 

**Movie Gallery, Inc.**

 

**Notes to Consolidated FinancialStatements**

 

**January 6,2002, January 5, 2003 and January 4, 2004**

 

**1.  Accounting Policies**

 

**Principles ofConsolidation and Description of Business**

 

The accompanyingfinancial statements present the consolidated financial position, results ofoperations and cash flows of Movie Gallery, Inc. and subsidiaries.  All material intercompany accounts andtransactions have been eliminated.

 

We own and operate video specialty stores located throughout NorthAmerica.

 

### **Useof Estimates**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires us to make estimates and assumptionsthat affect the amounts reported in the consolidated financial statements andaccompanying notes.  The mostsignificant estimates and assumptions relate to the amortization methods anduseful lives of rental inventory, fixed assets and other intangibles, valuationallowances for deferred tax assets and the allocation of the purchase price ofacquired businesses.  These estimatesand assumptions could change and actual results could differ from theseestimates.

 

**Fiscal Year**

 

Our fiscal yearends on the first Sunday following December 30, which periodically resultsin a fiscal year of 53 weeks.  Resultsfor the fiscal year ended January 5, 2003 and January 4, 2004 reflect52-week years.  Results for the fiscalyear ended January 6, 2002 reflect a 53-week year.  Our fiscal year includes revenues andcertain operating expenses, such as salaries, wages and other miscellaneousexpenses, on a daily basis.  All otherexpenses, primarily depreciation, amortization, rent and utilities, arecalculated and recorded monthly, with twelve months included in each fiscalyear.

 

**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, on a first-in first-out basis, or market.

 

**Rental Inventory**

 

In the fourth quarter of 2002, we made a strategic decision to make aportion of our base stock, or catalog, VHS rental inventory available for saleduring the holiday period as previously viewed inventory.  The sale of base stock VHS rental inventorywas designed to make room on our store shelves for a significant investment inbase stock DVD rental inventory which arrived in stores in the first quarter of2003.  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 throughout2002.  DVD rental revenue representedapproximately 50% of movie rental revenue as of the end of fiscal 2002 versusapproximately 20% as of the end of fiscal 2001.  As a result of the significant shift from

 

F- 6

----

 

VHS to DVD that occurred in our rental inventory base, we changed theestimates used to amortize rental inventory in the fourth quarter of fiscal2002 as discussed below.  The revisedestimates reflect a reduction in the estimated useful lives of the rentalinventory and a reduced salvage value for both VHS and game inventory.  We believe the revised estimated usefullives and salvage values are better matched to our current rental business andare consistent with industry trends.

 

Rental inventory is stated at cost and amortized over its economicuseful life. The up-front fees and minimum costs of rental product purchasedunder revenue-sharing arrangements are capitalized and amortized in accordancewith our rental inventory amortization policy. Revenue-sharing payments are expensed as incurred and are included incost of rental revenues.  Effective asof the beginning of the fourth quarter of 2002, the cost of base stock movieinventory is amortized on an accelerated basis over the first twelve months andthen on a straight-line basis over the next twelve months to its salvage value,$4 for DVD and $2 for VHS.  The cost ofnon-base stock, or new release, movie inventory is amortized to its salvagevalue on an accelerated basis over six months. Video games are amortized on a straight-line basis to a $5 salvage valueover twelve months.

 

The changes in our estimates for rental inventory amortization wereapplied to all inventory held at the beginning of the fourth quarter of fiscal2002.  The changes were accounted for asa change in accounting estimate during the fourth quarter ended January 5,2003.  The change in estimate decreasedrental inventory and increased depreciation expense for fiscal 2002 byapproximately $27.9 million and reduced net income by $16.7 million, or $0.53per diluted share. The impact of the change in fiscal 2002 was net of a $2.1million reserve against rental inventory that was established in the fourthquarter of 2001 in order to reflect the impact of the consumer transition toDVD on the sale prices of previously viewed VHS product.  For fiscal 2003, rental inventory wasdecreased and depreciation expense was increased by approximately $5.9 millionand net income was reduced by $3.6 million, or $0.11 per diluted share.

 

Prior to the fourth quarter of 2002, the cost of base stock movieinventory was amortized on an accelerated basis to a net book value of $8 oversix months and to a $4 salvage value over the next thirty months.  The cost of non-base stock movie inventorywas amortized on an accelerated basis over six months to a net book value of$4, which was then amortized on a straight-line basis over the next 30 monthsor until the movie was sold, at which time the unamortized book value wascharged to cost of rental revenues. Video games were amortized on a straight-line basis to a $10 salvagevalue over eighteen months or until the game was sold, at which time theunamortized book value was charged to cost of rental revenues.

 

Rental inventory consists of the following (in thousands):

 
|                     |   | **January 5,  2003** |       | **January 4,  2004** |       |
|--------------------------|--------|---------------------------|------------|---------------------------|------------|
|                     |   |                      | ** ** |                      | ** ** |
| Rental inventory         |   | $                         | 202,012    |                      | $          | 217,420 |   |
| Accumulated amortization |   | (119,132                  | )          | (114,941                  | )          |
|                     |   | $                         | 82,880     |                      | $          | 102,479 |   |

 

**Property, Furnishingsand Equipment**

 

Property, furnishings and equipment are stated at cost and includecosts incurred in the construction of new stores.  Depreciation is provided on a straight-line basis over theestimated lives of the related assets.

 

F- 7

----

 

**Business Combinations, Goodwill and Other IntangibleAssets**

** **

**InJune 2001, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“Statement”) No. 141, *BusinessCombinations*, and Statement No. 142, *Goodwill and Other Intangible Assets*.  Statement 141 requires that all businesscombinations be accounted for by the purchase method, and requires allintangible assets acquired in a business combination to be recognized as assetsapart from goodwill if they meet certain contractual-legal criterion orseparability criterion.  The provisionsof Statement 141 apply to all business combinations with an acquisition datesubsequent to June 30, 2001.  Theapplication of Statement 141 did not affect any of the previously reportedamounts included in goodwill or other intangible assets.  Under Statement 142, goodwill and indefinitelived intangible assets are no longer amortized but are reviewed for impairmentannually, or more frequently if impairment indicators arise.  Separable intangible assets that are notdeemed to have an indefinite life will continue to be amortized over theiruseful lives.  We adopted Statement 142as of January 7, 2002.  Theadoption of Statement 142 did not have any impact on the classification ofintangible assets.   We completed thetransitional impairment test and determined that none of the goodwill recordedwas impaired as of January 7, 2002. Application of the nonamortization provisions of Statement 142 wouldhave increased net income by approximately $3,418,000 to $17,774,000, or $0.65per diluted share, for fiscal 2001.**

** **

**Amortizationof intangibles for fiscal 2001 includes an impairment loss of $700,000 towrite-off the net book value of goodwill in excess of its estimated fair marketvalue.* *No impairment loss was recognizedin fiscal 2002 or fiscal 2003 under the provisions of Statement 142.**

 

**Impairment of Long-Lived Assets**

 

Long-lived assets,including property, furnishings and equipment and intangible assets with finitelives, are reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount may not be recoverable.  We use the discounted cash flow method toestimate the fair value of our long-lived assets.  We have not recognized impairment losses on long-lived assetsheld for use in fiscal 2001, 2002 or 2003.

 

**IncomeTaxes**

 

We account for income taxes under the provisions of FASB Statement No.109, *Accountingfor Income Taxes.*  UnderStatement 109, deferred tax assets and liabilities are determined based upondifferences between financial reporting and tax bases of assets and liabilitiesand are measured at the enacted tax rates and laws that will be in effect whenthe differences are expected to reverse. We record a valuation allowance to reduce deferred tax assets if it ismore likely than not that some portion or all of the deferred tax assets willnot be realized.  We generally considerthe earnings of our foreign subsidiaries to be permanently reinvested for usein those operations and, consequently, deferred federal income taxes, net ofapplicable foreign tax credits, are not provided on the undistributed earningsof foreign subsidiaries which are to be so reinvested.

 

**Revenue Recognition**

 

We recognize rental revenue when a movie or video game is rented by thecustomer.  Revenue from extended viewingfees incurred on rentals when the customer chooses to keep the product beyondthe initial rental period is recognized when payment is received from thecustomer.   We recognize product salesrevenue at the time of sale.

 

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.

 

F- 8

----

 

**Advertising Costs**

 

Advertising costs are expensed when incurred.  Advertising expense, exclusive of cooperative reimbursements fromvendors, for fiscal 2001, 2002 and 2003 totaled $2,219,000, $2,703,000 and$1,096,000, respectively.

 

**Store Opening andStart-up Costs**

 

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

 

**Fair Value ofFinancial Instruments**

 

At January 5, 2003 and January 4, 2004, the carrying value offinancial instruments such as cash and cash equivalents and accounts payableapproximated their fair values, calculated using discounted cash flow analysisat our incremental borrowing rate.

 

### **ForeignCurrency Translation**

 

Our foreignsubsidiary records transactions using the local currency as the functionalcurrency.  In accordance with FASBStatement No. 52, *Foreign Currency Translation,* the assets and liabilities ofthe foreign subsidiary are translated into U. S. dollars using either theexchange rates in effect at the balance sheet dates or historical exchangerates, depending upon the account translated. Income and expenses are translated at average exchange rates each fiscalperiod.  The translation adjustmentsthat result from translating the balance sheets at different rates than theincome statements are included in accumulated other comprehensive income orloss, which is a separate 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 (1,383,000, 1,163,000 and 964,000 forfiscal 2001, 2002 and 2003, respectively). No adjustments were made to net income in the computation of basic ordiluted earnings per share.  Becausetheir inclusion would be anti-dilutive, 400,000, 238,000 and 225,000 optionsfor fiscal 2001, 2002 and 2003, respectively, were excluded from thecomputation of the weighted average shares for diluted earnings per share.

 

**Stock Option Plan**

 

At January 4, 2004, we have a stock-based employee compensationplan, which is described more fully in Note 7. We account for the plan under the recognition and measurement principlesof APB Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated Interpretations.  Stock optioncompensation is reflected in net income for variable options outstanding underthe plan (see Note 7).  No stock optioncompensation is reflected in net income for the remaining options outstandingunder the plan, as the exercise price was equal to the market value of theunderlying common stock on the date of grant. The following table illustrates the effect on net income and earningsper share if we had applied the fair value recognition provisions of FASBStatement No. 123, *Accounting for Stock-Based Compensation,*to stock-based employee compensation.

 

F- 9

----

 
|                                                                                                    |   | **Fiscal  Year Ended**    |   |
|---------------------------------------------------------------------------------------------------------|--------|---------------------------|--------|
|                                                                                                    |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                                                                                                    |   |                      |   |   |   |   |   |
| Net income, as reported                                                                                 |   | $                         | 14,356 |   | $ | 20,934 |   | $ | 49,436 |   |
| Add: Stock option compensation included in  reported net income, net of tax                             |   | 4,919                     |   | 1,367 |   | 903 |   |
| Deduct: Stock option compensation  determined under fair value based methods for all awards, net of tax |   | (899                      | )      | (1,147 | ) | (1,099 | ) |
|                                                                                                    |   |                      |   |   |   |   |   |
| Pro forma net income                                                                                    |   | $                         | 18,376 |   | $ | 21,154 |   | $ | 49,240 |   |
|                                                                                                    |   |                      |   |   |   |   |   |
| Earnings per share:                                                                                     |   |                      |   |   |   |   |   |
| Basic                                                                                                   |   | $                         | 0.56   |   | $ | 0.69 |   | $ | 1.53 |   |
| Diluted                                                                                                 |   | $                         | 0.53   |   | $ | 0.67 |   | $ | 1.48 |   |
|                                                                                                    |   |                      |   |   |   |   |   |
| Pro forma earnings per share:                                                                           |   |                      |   |   |   |   |   |
| Basic                                                                                                   |   | $                         | 0.71   |   | $ | 0.70 |   | $ | 1.52 |   |
| Diluted                                                                                                 |   | $                         | 0.68   |   | $ | 0.67 |   | $ | 1.47 |   |

 

### **RecentlyIssued Accounting Pronouncements**

 

**In November 2002, the Emerging Issues Task Force(“EITF”) reached a concensus on Issue No. 02-16,  *Accounting by a Customer (Including a Reseller) for Certain ConsiderationReceived from a Vendor,* effective for fiscal years beginning afterDecember 15, 2002.  EITF 02-16generally requires that cash consideration received from a vendor be consideredas a reduction of the prices of the vendor’s products, reflected as a reductionof cost of sales in the customer’s income statement.  The presumption can be overcome if the vendor receives anidentifiable benefit in exchange for the consideration, in which case theconsideration should be recorded as revenue, or if the consideration representsa reimbursement of a specific identifiable incremental cost incurred by thecustomer in selling the vendor’s products where the consideration should becharacterized as a reduction of that cost. Our adoption of this standard as of January 6, 2003 did not have amaterial impact on our financial position or results of operations.**

** **

In January 2003, the Financial Accounting Standards Board issuedInterpretation No. 46, *Consolidation of Variable Interest Entities, anInterpretation of Accounting Research Bulletin No. 51*(“theInterpretation”).  The Interpretationrequires the consolidation of entities in which an enterprise absorbs amajority of the entity’s expected losses, receives a majority of the entity’sexpected residual returns, or both, as a result of ownership, contractual orother financial interests in the entity. Currently, entities are generally consolidated by an enterprise when ithas a controlling financial interest through ownership of a majority votinginterest in the entity.  TheInterpretation is effective as of December 31, 2003 for all qualifyinginterests in special purpose entities (“SPEs”) in existence as ofJanuary 31, 2003 and as of February 1, 2003 for all qualifying SPEsobtained after January 31, 2003. We had no qualifying interests as of January 31, 2003.  We have subsequently made equity investmentsin other entities during 2003 (none of which are SPEs).  These investments are immaterial, andconsolidation is not currently required under the Interpretation.   The provisions of the Interpretation, asrevised by the FASB in December 2003, must be applied to some of ourinvestments in the first quarter of 2004. Based on our analysis to date, none of our current interests will have asignificant impact on our financial statements upon adoption of theInterpretation’s consolidation rules.

 

F- 10

----

 

In May 2003, the Financial Accounting Standards Board issued StatementNo. 150, *Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity. *Statement 150 clarifies theclassification and measurement of certain financial instruments withcharacteristics of both liabilities and equity, and was effective for financialinstruments entered into or modified after May 31, 2003, or otherwise for thefirst interim period beginning after June 15, 2003.  The adoption of Statement 150 had nomaterial impact on our net earnings, cash flows or financial position.

 

**2.  Acquisitions**

 

During fiscal 2003, we purchased 170 stores in 34separate transactions for approximately $30.7 million and recordedapproximately $19.9 million in goodwill ($16.2 million of which is deductiblefor tax purposes), $2.4 million for customer lists and $1.4 million fornon-compete agreements related to these transactions.

 

During fiscal 2002, we purchased 265 stores in 34separate transactions for approximately $60.7 million and recordedapproximately $44.0 million in goodwill (all of which is deductible for taxpurposes), $3.3 million for customer lists and $1.0 million for non-competeagreements related to these transactions.

 

Effective December 21, 2001, we acquired100% of the newly issued common stock of the reorganized Video Update, Inc.under its plan of reorganization.  VideoUpdate had been operating under Chapter 11 of the United States Bankruptcy Codesince its voluntary filing on September 18, 2000.  The acquisition of the newly issued commonstock of Video Update was in satisfaction of all amounts owed to us by Video Updateunder a $6.5 million debtor-in-possession financing agreement.  In addition, we purchased certain seniorsecured debt of Video Update in May 2001 for $8.5 million, funded amounts dueto secured and unsecured creditors in accordance with confirmation of the plantotaling approximately $6.3 million, and assumed other post-bankruptcy filingliabilities of Video Update as disclosed in the following table.  At the time of acquisition, Video Updateoperated 324 video specialty stores in the United States and Canada.  Our acquisition of Video Update was made asa strategic expansion of our geographic markets in accordance with our growthplan.

 

Due to the Video Updateacquisition occurring near the end of fiscal 2001, the closing of the finalbooks and records of Video Update had not been completed as of the time ourfiscal 2001 consolidated financial statements were prepared.  As a result, we posted adjustments to thepurchase price allocation during fiscal 2002 to reduce the fair value ofassumed liabilities by $4.3 million. The following table summarizes the preliminary estimated fair values ofthe assets acquired and liabilities assumed at the date of acquisition, thepurchase price allocation adjustments made in fiscal 2002, and the finalresulting purchase price allocation. Subsequent adjustments to the purchase price allocation are reflected asa component of net income and were immaterial in fiscal 2003.

 

F- 11

 

**Video Update, Inc.**

**Condensed Balance Sheet**

**As of December 21, 2001**

**(in thousands)**

 
|                                                            |   | **Preliminary** |   | **Adjustments** |   | **Final** |   |
|-----------------------------------------------------------------|--------|-----------------|--------|-----------------|--------|-----------|--------|
|                                                            |   |            |   |            |   |      |   |
| Current assets                                                  |   | $               | 3,017  |            | $      | 10        |   | $ | 3,027 |   |
| Rental  inventory, net                                          |   | 21,801          |   | (2,801          | )      | 19,000    |   |
| Property,  furnishings and equipment, net                       |   | 12,596          |   | (1,514          | )      | 11,082    |   |
| Deferred  income taxes                                          |   | 8,468           |   | —          |   | 8,468     |   |
| Total assets  acquired                                          |   | 45,882          |   | (4,305          | )      | 41,577    |   |
|                                                            |   |            |   |            |   |      |   |
| Accruals for  settlement of liabilities  subject  to compromise |   | 6,253           |   | —          |   | 6,253     |   |
| Current  liabilities and accrued expenses                       |   | 24,669          |   | (4,305          | )      | 20,364    |   |
| Notes payable  to parent                                        |   | 8,460           |   | —          |   | 8,460     |   |
| Total  liabilities assumed                                      |   | 39,382          |   | (4,305          | )      | 35,077    |   |
|                                                            |   |            |   |            |   |      |   |
| Net investment  in common stock                                 |   | $               | 6,500  |            | $      | —    |   | $ | 6,500 |   |

 

In addition to the Video Update acquisition, we purchased 31 stores infive separate transactions for approximately $6.6 million during fiscal 2001and recorded approximately $3.5 million in goodwill (all of which is deductiblefor tax purposes) and $1.0 million in other intangibles related to thesetransactions

 

**3.  Property, Furnishings and Equipment**

 

Property,furnishings and equipment consists of the following (in thousands):

 
|                             |   | **Useful  Life** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|----------------------------------|--------|------------------|--------|---------------------------|--------|---------------------------|--------|
|                             |   |             |   |                      |   |                      |   |
| Land                             |   | —           |   | $                         | 1,959  |                      | $      | 2,970 |   |
| Buildings                        |   | 40 years         |   | 6,547                     |   | 6,826                     |   |
| Furniture and fixtures           |   | 7 years          |   | 53,585                    |   | 65,374                    |   |
| Equipment                        |   | 5 years          |   | 52,382                    |   | 65,263                    |   |
| Leasehold improvements and signs |   | 7 years          |   | 61,947                    |   | 83,262                    |   |
|                             |   |             |   | 176,420                   |   | 223,695                   |   |
| Accumulated depreciation         |   |             |   | (89,427                   | )      | (109,339                  | )      |
|                             |   |             |   | $                         | 86,993 |                      | $      | 114,356 |   |

 

F- 12

----

 

**4.  Intangible Assets**

 

**Thecomponents of goodwill and other intangibles are as follows (in thousands):**

** **
|                     |   |                                      |   | **January 5,  2003**   |    | **January 4,  2004**     |   |
|--------------------------|--------|-------------------------------------------|--------|-----------------------------|---------|-------------------------------|--------|
|                     |   | **Weighted-Average  Amortization Period** |   | **Gross  Carrying  Amount** |    | **Accumulated  Amortization** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   |
|                     |   |                                      |   |                        |    |                          |   |   |   |   |   |
| Goodwill                 |   | —                                    |   | $                           | 147,530 |                          | $      | (31,411 | ) | $ | 167,419 |   | $ | (31,411 | ) |
|                     |   |                                      |   |                        |    |                          |   |   |   |   |   |
| Non-compete agreements   |   | 8 years                                   |   | $                           | 9,492   |                          | $      | (6,493 | ) | $ | 10,908 |   | $ | (7,696 | ) |
| Customer lists           |   | 5 years                                   |   | 3,996                       |    | (318                          | )      | 6,385 |   | (1,124 | ) |
| Total  other intangibles |   |                                      |   | $                           | 13,488  |                          | $      | (6,811 | ) | $ | 17,293 |   | $ | (8,820 | ) |

** **

**Estimatedamortization expense for other intangible assets for the five succeeding fiscalyears is as follows (in thousands):**

 
| 2004 |   | $     | 2,357  |   |
|------|--------|-------|--------|--------|
| 2005 |   | 1,883 |   |
| 2006 |   | 1,556 |   |
| 2007 |   | 1,415 |   |
| 2008 |   | 919   |   |

 

**Thechanges in the carrying amounts of goodwill for the year ended January 4,2004, are as follows (in thousands):**

 
| Balance as of January 5, 2003 |   | $      | 116,119 |   |
|------------------------------------|--------|--------|---------|--------|
| Goodwill acquired                  |   | 19,889 |    |
| Balance as of January 4, 2004 |   | $      | 136,008 |   |

 

**5.  Financing Obligations**

 

On June 27,2001, we entered into a credit agreement with a syndicate of banks, led bySouthTrust Bank, with respect to a revolving credit facility.  Our credit facility is unsecured and, asamended, provides for borrowings of up to $65 million through final maturity onJuly 4, 2005.  The interest rate onour credit facility is based on LIBOR plus an applicable margin percentage,which depends on cash flow generation and borrowings outstanding. InDecember 2001, as required by the credit facility, we entered into aninterest rate swap agreement in order to hedge exposure to interest ratefluctuations on $10 million of outstanding debt at a fixed rate of 3.5% plus anapplicable margin percentage.  In May2002, we repaid all amounts outstanding under our credit facility with theproceeds from our stock offering (see Note 7) and terminated the interest rateswap agreement.  The costs to terminatethe interest rate swap were expensed and were immaterial to our results ofoperations.  As of January 4, 2004,there were no outstanding borrowings under our credit facility.  The amounts available for borrowing werereduced by standby letters of credit outstanding of $1.2 million and totaled$63.8 million as of January 4, 2004.

 

F- 13

----

 

**6.  IncomeTaxes**

** **

**Thecomponents of income from continuing operations before income taxes are asfollows (in thousands):**

** **
|          |   | **Fiscal  Year Ended**    |   |
|---------------|--------|---------------------------|--------|
|          |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|          |   |                      |   |   |   |   |   |
| U. S. Federal |   | $                         | 23,670 |   | $ | 35,082 |   | $ | 76,873 |   |
| Foreign       |   | 474                       |   | (225 | ) | 4,550 |   |
| Total         |   | $                         | 24,144 |   | $ | 34,857 |   | $ | 81,423 |   |

 

The following reflects actual income tax expense (inthousands):

 
|             |   | **Fiscal  Year Ended**    |   |
|------------------|--------|---------------------------|--------|
|             |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|             |   |                      |   |   |   |   |   |
| Current payable: |   |                      |   |   |   |   |   |
| U. S. Federal    |   | $                         | 5,447  |   | $ | 7,090 |   | $ | 5,537 |   |
| State            |   | 641                       |   | 2,180 |   | 2,415 |   |
| Total current    |   | 6,088                     |   | 9,270 |   | 7,952 |   |
|             |   |                      |   |   |   |   |   |
| Deferred:        |   |                      |   |   |   |   |   |
| U. S. Federal    |   | 3,243                     |   | 5,313 |   | 20,589 |   |
| Foreign          |   | 213                       |   | (101 | ) | 2,011 |   |
| State            |   | 244                       |   | (559 | ) | 1,435 |   |
| Total deferred   |   | 3,700                     |   | 4,653 |   | 24,035 |   |
|             |   | $                         | 9,788  |   | $ | 13,923 |   | $ | 31,987 |   |

 

A reconciliation of income tax expense at thefederal income tax rate to our effective income tax provision is as follows (inthousands):

 
|                                                         |   | **Fiscal  Year Ended**    |   |
|--------------------------------------------------------------|--------|---------------------------|--------|
|                                                         |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                                                         |   |                      |   |   |   |   |   |
| Income tax expense at statutory rate                         |   | $                         | 8,450  |   | $ | 12,200 |   | $ | 28,499 |   |
| State income tax expense, net of federal  income tax benefit |   | 576                       |   | 1,054 |   | 2,503 |   |
| Other, net                                                   |   | 762                       |   | 669 |   | 985 |   |
|                                                         |   | $                         | 9,788  |   | $ | 13,923 |   | $ | 31,987 |   |

 

F- 14

----

 

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 5,  2003** |   | **January 4,  2004** |   |
|---------------------------------------------|--------|---------------------------|--------|---------------------------|--------|
| Deferred tax assets:                        |   |                      |   |                      |   |
| Non-compete agreements                      |   | $                         | 4,946  |                      | $      | 3,998 |   |
| Alternative minimum tax credit carryforward |   | 682                       |   | 2,492                     |   |
| Net operating loss carryforwards            |   | 31,944                    |   | 40,621                    |   |
| Accrued liabilities                         |   | 1,456                     |   | 512                       |   |
| Other                                       |   | 2,919                     |   | 5,287                     |   |
| Total deferred tax assets                   |   | 41,947                    |   | 52,910                    |   |
| Valuation allowance                         |   | (24,953                   | )      | (34,444                   | )      |
| Net deferred tax assets                     |   | 16,994                    |   | 18,466                    |   |
| Deferred tax liabilities:                   |   |                      |   |                      |   |
| Furnishings and equipment                   |   | (11,573                   | )      | (19,605                   | )      |
| Rental inventory                            |   | (4,635                    | )      | (18,891                   | )      |
| Goodwill                                    |   | (2,621                    | )      | (5,784                    | )      |
| Other                                       |   | (2,283                    | )      | (2,340                    | )      |
| Total deferred tax liabilities              |   | (21,112                   | )      | (46,620                   | )      |
| Net deferred tax liabilities                |   | $                         | (4,118 | )                         | $      | (28,154 | ) |

 

We had federal and state netoperating loss carryforwards at January 4, 2004 resulting primarily fromthe Video Update acquisition (see Note 2) of approximately $103.4 million thatexpire in years 2007 through 2021.  We have recorded a valuation allowanceof $34.4 million related to the deferred tax assets of $40.6 million resultingfrom the net operating loss carryforwards. During 2003, management performed a detailed analysis to determine theavailable net operating loss carryforwards from Video Update, Inc.  As a result, the valuation allowance hasincreased by $9.5 million to reflect the increase in net operating losscarryforwards from Video Update.  Thisvaluation allowance has been established as there exists uncertainty regardingour ability to realize these net operating losses in their entirety.

 

**7.  Stockholders’ Equity**

 

**Common Stock**

** **

**In May2002, we closed a public offering of our common stock priced at $18.25 pershare.  We sold 3,900,000 shares andreceived the proceeds from 350,000 stock options exercised in conjunction withthe offering for total proceeds, net of expenses of the offering, of approximately$67.6 million.  A portion of the proceedsfrom the offering were used to repay outstanding borrowings under our creditfacility. We are currently using the balance of the proceeds from the offeringfor new store openings, selective acquisitions, working capital and othergeneral corporate purposes.**

** **

**Stock 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 incentive stock options andstock appreciation rights to employees, directors and consultants.  Prior to adoption of the 2003 plan, stockoption activity was subject to our 1994 Stock

 

F- 15

----

 

Plan which will expire in 2004. No further option grants will be issued under the 1994 plan.  A total of 4,167,749 shares are currentlyreserved for issuance under the plans, 697,159 of which have been issued as ofJanuary 4, 2004.  Options grantedunder the plans have a ten-year term and generally vest over four years.

 

In accordance with the provisions of FASBStatement No. 123, *Accounting for Stock-Based Compensation*,we apply Accounting Principles Board Opinion No. 25 and related Interpretationsin accounting for the plans and, accordingly, have not recognized compensationcost in connection with the plans, except for the variable options describedbelow.  If we had elected to recognizecompensation cost based on the fair value of the options granted at the grantdate as prescribed by Statement 123, net income and earnings per share wouldhave been adjusted to the pro forma amounts indicated in Note 1.  The effect on net income and earnings pershare is not expected to be indicative of the effects on net income andearnings per share in future years.

 

The fair value of each option grant was estimated atthe date of grant using the Black-Scholes option pricing model with thefollowing weighted-average assumptions:

 
|                             |   | **Fiscal  Year Ended**    |   |
|----------------------------------|--------|---------------------------|--------|
|                             |   | **January 6,  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                             |   |                      |   |   |   |   |   |
| Expected volatility              |   | 0.706                     |   | 0.705 |   | 0.700 |   |
| Risk-free interest rate          |   | 5.41                      | %      | 5.26 | % | 4.81 | % |
| Expected life of option in years |   | 5.5                       |   | 5.1 |   | 4.9 |   |
| Expected dividend yield          |   | 0.0                       | %      | 0.0 | % | 0.0 | % |

 

The Black-Scholesoption valuation model was developed for use in estimating the fair value oftraded options which have no vesting restrictions and are fullytransferable.  In addition, optionvaluation models require the input of highly subjective assumptions includingthe 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.

 

We repriced 864,000 stock options in March 2001,and reduced the exercise price to $1.78 per share.  The repriced stock options are accounted for as variable untilthe stock options are exercised, forfeited or expire unexercised. Assuming allrepriced stock options are exercised, we will receive $0.6 million less than ifno repricing had occurred.  The totalvariable compensation expense recognized under these repriced options was $8.2million, $2.3 million and $1.5 million in fiscal 2001, 2002 and 2003,respectively.  As of January 4,2004, approximately 44,000 of these options remained outstanding and they willexpire, if not exercised or forfeited, in 2008 and 2009.

 

F- 16

----

 

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

 
|                                             |   | **Outstanding  Options** |   | **Weighted-  Average Exercise   Price Per Share** |   |
|--------------------------------------------------|--------|--------------------------|--------|---------------------------------------------------|--------|
|                                             |   |                     |   |                                              |   |
| Outstanding at December 31, 2000            |   | 5,720,641                |   | $                                                 | 3.91   |   |
| Granted                                          |   | —                   |   | —                                            |   |
| Exercised                                        |   | (2,128,927               | )      | 2.26                                              |   |
| Cancelled                                        |   | (146,205                 | )      | 4.99                                              |   |
|                                             |   |                     |   |                                              |   |
| 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                                             |   |
|                                             |   |                     |   |                                              |   |
|                                             |   |                     |   |                                              |   |
| Exercisable at January 6, 2002              |   | 2,236,021                |   | 6.39                                              |   |
| Exercisable at January 5, 2003              |   | 1,873,068                |   | 6.92                                              |   |
| Exercisable at January 4, 2004              |   | 1,643,236                |   | 7.74                                              |   |
|                                             |   |                     |   |                                              |   |
| Weighted-average fair value of options  granted: |   |                     |   |                                              |   |
| Fiscal 2001                                      |   | $                        | — |                                              |   |   |
| Fiscal 2002                                      |   | 7.62                     |   |                                              |   |
| Fiscal 2003                                      |   | 9.84                     |   |                                              |   |
|                                                  |        |                          |        |                                                   |        |  |  |

 

Options outstanding as of January 4, 2004 had a weighted-averageremaining contractual life of 5.9 years and exercise prices ranging from $1.00to $22.00 as follows:

 
|                                                    |   | **Exercise  price of** |   |
|---------------------------------------------------------|--------|------------------------|--------|
|                                                    |   | **$1.00 to  $3.00**    |   | **$6.00 to  $12.00** |   | **$13.00 to  $22.00** |   |
|                                                    |   |                   |   |   |   |   |   |
| Options outstanding                                     |   | 943,216                |   | 368,750 |   | 1,324,127 |   |
| Weighted-average exercise price                         |   | $                      | 1.61   |   | $ | 7.81 |   | $ | 17.29 |   |
| Weighted-average remaining contractual life             |   | 6.1 years              |   | 1.8 years |   | 6.9 years |   |
| Options exercisable                                     |   | 734,066                |   | 368,750 |   | 540,420 |   |
| Weighted-average exercise price of  exercisable options |   | $                      | 1.66   |   | $ | 7.81 |   | $ | 15.96 |   |

 

F- 17

----

 

**8.  Commitments and Contingencies**

 

Rent expense forfiscal 2001, 2002 and 2003 totaled $50,985,000, $82,597,000 and $103,160,000,respectively.  Future minimum paymentsunder noncancellable operating leases which contain renewal options andescalation clauses with remaining terms in excess of one year consisted of thefollowing at January 4, 2004 (in thousands):

 
| 2004       |   | $      | 83,997  |   |
|------------|--------|--------|---------|--------|
| 2005       |   | 73,598 |    |
| 2006       |   | 50,503 |    |
| 2007       |   | 32,659 |    |
| 2008       |   | 19,110 |    |
| Thereafter |   | 29,571 |    |
|       |   | $      | 289,438 |   |

 

We have a supply contract with Rentrak Corporation which requires us toorder rental inventory under lease sufficient to require an aggregate minimumpayment of $4 million per year in revenue sharing, handling fees, sell throughfees and end-of-term buyout fees.  Theagreement expires in 2006.  We haveexceeded the minimum purchase requirement in each year through fiscal 2003.  In March 2001, we amended the terms ofour existing supply contract with Rentrak. We paid Rentrak $1.6 million in connection with the amendment to thecontract.  Additionally, we prepaidapproximately $0.9 million to be applied over a three-year period againstfuture amounts due under the contract.

 

**In thesecond quarter of fiscal 2002, we obtained a preliminary court order approvinga settlement agreement in certain putative class action lawsuits filed againstus alleging that the extended viewing fees charged to our customers for keepingrental products 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 andreleased all claims made by all class members in all the pending class actions,other than 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 ofplaintiffs’ 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.

 

**9.  Related Party Transactions**

 

We hold a one-third interest in ECHO, LLC, a supply sales anddistribution company.  We purchaseoffice and store supplies and other business products from ECHO.  We believe that this relationship enables usto substantially reduce the retail mark-up that occurs between the wholesalerand the retailer on products we source through ECHO.   Transactions with ECHO are as follows:

 
|                      |   | **Fiscal  Year Ended**   |   |
|---------------------------|--------|--------------------------|--------|
|                      |   | **January 6  2002** |   | **January 5,  2003** |   | **January 4,  2004** |   |
|                      |   | **(in  thousands)**      |   |
| Purchases from ECHO       |   | $                        | 422    |   | $ | 6,422 |   | $ | 13,056 |   |
| Distributions from ECHO   |   | —                   |   | 40 |   | 161 |   |
| Interest from ECHO        |   | 3                        |   | 6 |   | 5 |   |
| Note receivable from ECHO |   |                     |   | 125 |   | 125 |   |
| Accounts payable to ECHO  |   |                     |   | 469 |   | 309 |   |
|                           |        |                          |        |  |  |  |  |  |  |  |

 

F- 18

----

 

Air Conditioning Associates, Inc. (“ACA”) is owned by the father-in-lawand brother-in-law of our Chairman of the Board, President, and Chief ExecutiveOfficer.  ACA administers the repair andmaintenance function for our store base and corporate offices in addition toproviding other HVAC materials and related services.  We have achieved overall cost savings under this managementagreement and have improved our system for managing company-wide repair andmaintenance needs.  We paid ACAapproximately $243,000, $470,000 and $633,000 during fiscal 2001, 2002 and2003, respectively.  We had outstandingaccounts payable to ACA of approximately $157,000 and $75,000 as ofJanuary 5, 2003 and January 4, 2004, respectively.

 

J. Todd, Inc. (“Todd & Sons”) is owned by the brother of ourExecutive Vice President, Secretary and General Counsel.  Todd & Sons supplies us with certainclothing and promotional items on an as needed basis.  We have no minimum purchase requirements or contractualobligations with Todd & Sons.  Wepaid Todd & Sons approximately $127,000, $49,000 and $259,000 during fiscal2001, 2002 and 2003, respectively.  Wehad outstanding accounts payable to Todd & Sons of approximately $1,000 and$7,000 as of January 5, 2003 and January 4, 2004, respectively.

 

**10.  Foreign Operations**

 

The following table sets forth our consolidated revenues, operatingincome and assets by geographic area. All intercompany balances and transactions have been eliminated.

 
|                            |   | **Fiscal  Year Ended**    |    |
|---------------------------------|--------|---------------------------|---------|
|                            |   | **January 6,  2002** |    | **January 5,  2003** |   | **January 4,  2004** |   |
|                            |   | **(in  thousands)**       |    |
| Revenues:                       |   |                      |    |   |   |   |   |
| United States                   |   | $                         | 367,637 |   | $ | 505,807 |   | $ | 648,428 |   |
| Canada                          |   | 1,494                     |    | 23,181 |   | 43,967 |   |
| Total revenues                  |   | $                         | 369,131 |   | $ | 528,988 |   | $ | 692,395 |   |
|                            |   |                      |    |   |   |   |   |
| Operating income:               |   |                      |    |   |   |   |   |
| United States                   |   | $                         | 26,696  |   | $ | 36,111 |   | $ | 77,346 |   |
| Canada                          |   | 474                       |    | (230 | ) | 4,545 |   |
| Total operating income          |   | $                         | 27,170  |   | $ | 35,881 |   | $ | 81,891 |   |
|                            |   |                      |    |   |   |   |   |
| Assets (at end of fiscal year): |   |                      |    |   |   |   |   |
| United States                   |   |                      |    | $ | 342,787 |   | $ | 429,523 |   |
| Canada                          |   |                      |    | 20,787 |   | 34,766 |   |
| Total assets                    |   |                      |    | $ | 363,574 |   | $ | 464,289 |   |

 

F- 19

----

 

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

 

The following is asummary of our unaudited quarterly results of operations (in thousands, exceptper share data):

 
|                              |   | **Thirteen  Weeks Ended** |    |
|-----------------------------------|--------|---------------------------|---------|
|                              |   | **April 7,  2002**   |    | **July 7,  2002** |   | **October 6,  2002** |   | **January 5,  2003** |   |
|                              |   |                      |    |   |   |   |   |   |   |
| Revenue                           |   | $                         | 123,130 |   | $ | 122,578 |   | $ | 130,435 |   | $ | 152,845 |   |
| Gross margin                      |   | 86,833                    |    | 84,219 |   | 90,403 |   | 72,863 |   |
| Net income (loss)                 |   | 9,874                     |    | 5,600 |   | 9,392 |   | (3,932 | ) |
| Basic earnings (loss) per share   |   | 0.36                      |    | 0.19 |   | 0.29 |   | (0.12 | ) |
| Diluted earnings (loss) per share |   | 0.35                      |    | 0.18 |   | 0.29 |   | (0.12 | ) |
|                                   |        |                           |         |  |  |  |  |  |  |  |  |  |  |

 
|                       |   | **Thirteen  Weeks Ended** |       |
|----------------------------|--------|---------------------------|------------|
|                       |   | **April 6,  2003**   |       | **July 6,  2003** |   | **October 5,  2003** |   | **January 4,  2004** |   |
|                       |   |                      | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Revenue                    |   | $                         | 168,649    |   | $ | 160,998 |   | $ | 167,239 |   | $ | 195,509 |   |
| Gross margin               |   | 108,394                   |       | 108,404 |   | 112,675 |   | 128,340 |   |
| Net income                 |   | 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 |   |
|                            |        |                           |            |  |  |  |  |  |  |  |  |  |  |

 

F- 20

----

 

## **Index to Exhibits**

 
| **Exhibit No.** |   | **Description**                                                                                                                                               |
|-----------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                          |
| 14              |   | Code of Ethics                                                                                                                                                |
|            |   |                                                                                                                                                          |
| 21              |   | List of Subsidiaries                                                                                                                                          |
|            |   |                                                                                                                                                          |
| 23              |   | Consent of Ernst & Young LLP, Independent Auditors                                                                                                        |
|            |   |                                                                                                                                                          |
| 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 |

 

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