SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

(Mark One)
         [X]      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                  THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]

                  For the fiscal year ended January 5, 1997

                                       OR

         [ ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                  THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the transition period from ____________ to _______________.

                         Commission File Number: 0-24548


                               MOVIE GALLERY, INC.
             (Exact name of registrant as specified in its charter)

          Delaware                                        63-1120122
(State or other jurisdiction of                       (I.R.S. Employer
 incorporation or organization)                      Identification No.)


 739 W. 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 each class)

     Indicate  by check mark  whether the  registrant  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant  was  required  to file such  reports),  and (2) has been  subject to
filing requirements for the past 90 days. YES X NO

     The aggregate  market value of the voting stock held by  non-affiliates  of
the registrant as of April 1, 1997, was approximately $60,078,322.50. The number
of shares of Common Stock  outstanding on April 1, 1997 was  13,420,791  shares.

     Documents incorporated by reference:

     1. Notice of 1997  Annual  Meeting  and Proxy  Statement  (Part III of Form
10-K).

         Indicate by check mark if disclosure of delinquent  filers  pursuant to
Item 405 of Regulation S-K is not contained  herein,  and will not be contained,
to  the  best  of  Registrant's   knowledge,   in  definitive   proxy  statement
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.



<PAGE>



ITEM 1.  BUSINESS

General

         As of March 14, 1997,  Movie Gallery,  Inc. (the  "Company")  owned and
operated  855 video  specialty  stores  and had 106  franchisees  and  licensees
located in 22 states,  primarily in the eastern half of the United States,  that
rent and sell videocassettes and video games. Since the Company's initial public
offering  in August  1994,  the  Company has grown from 97 stores to its present
size  through  acquisitions  and the  development  of new  stores.  The  Company
believes it is the second  largest video  retailer in the United States in terms
of locations and is among the three largest in terms of revenue.


         The  Company was  incorporated  in Delaware in June 1994 under the name
Movie Gallery, Inc. From March 1985 until the present time, substantially all of
the  Company's   operations  have  been  conducted   through  its   wholly-owned
subsidiary,  M.G.A.,  Inc. The Company's executive offices are located at 739 W.
Main Street, Dothan, Alabama 36301, and its telephone number is (334) 677-2108.


Video Industry Overview


         Video Retail Industry.  According to Paul Kagan Associates, Inc. ("Paul
Kagan"), the videocassette rental and sales industry has grown from $0.7 billion
in revenue in 1982 to a  projected  $15.8  billion in 1996 and is  projected  to
reach $20.5 billion by 2005.  Paul Kagan  estimates  that in 1996 consumers made
more than 3.3 billion  visits to video stores,  rented  approximately  3 billion
videos and purchased more than 580 million videos. In fact, Adams Media Research
estimates  that  85.0%  of  America's  96  million  television  households  have
videocassette recorders, a percentage which is expected to exceed 90% by 2002.

          Reports from industry analysts, including Paul Kagan, demonstrate that
the video retail industry is highly fragmented with  approximately  27,000 video
specialty  stores,  nearly 70% of which  operate  independently  or as part of a
small chain of 10 or fewer  stores.  According to these  sources,  recent trends
toward  consolidation  have been fueled by the impact of  superstores on smaller
retailers,  the need for enhanced access to working capital and  efficiencies of
scale.  The  Company  believes  that  the  video  specialty  store  industry  is
continuing to consolidate into regional and national chains.

         Although the domestic video retail  industry  includes both rentals and
sales,  the consumer  market for prerecorded  videocassettes  has been primarily
comprised of rentals.  By setting the wholesale prices,  movie studios influence
the  relative  levels of  videocassette  rentals  versus  sales.  Videocassettes
released at a relatively  high price,  typically  $60 to $75,  are  purchased by
video   specialty   stores  and  are  promoted   primarily  as  rental   titles.
Videocassettes  released  at  a  relatively  low  price,  typically  $5  to  $25
("sell-through  titles"),  are  purchased  by  video  specialty  stores  and are
generally  promoted as both rental and sales titles.  In general,  movie studios
attempt to maximize total revenue from  videocassette  releases by combining the
release  of most  titles at a high price  point to  encourage  purchase  for the
rental  market,  with the  release of a  relatively  few major hits or  animated
children's  classics at sell-through  pricing to encourage  purchase directly by
the consumer at retail. Video specialty stores will purchase sell-through titles
for both the rental market and for retail sale.


                                       1


<PAGE>

         Movie Studio  Dependence on Video Rental  Industry.  The  videocassette
rental and sales  industry is the largest  single source of domestic  revenue to
movie  studios and,  according  to Paul Kagan,  represented  approximately  $4.3
billion,  or 47%,  of the $9.3  billion of studio  revenue in 1996.  The Company
believes  that of the many movies  produced by major studios and released in the
United States each year,  relatively few are profitable for the studios based on
box office  revenue  alone.  In addition to  purchasing  box office hits,  video
specialty stores provide the movie studios with a reliable source of revenue for
a large number of their movies by purchasing  movies on videocassette  that were
not  successful  at the box office.  The Company  believes  the consumer is more
likely to view movies  which were not box office hits on a rented  videocassette
than on any other medium  because  video  specialty  stores  provide an inviting
opportunity to browse and make impulse  choices among a very broad  selection of
movie titles. In addition, the Company believes the relatively low cost of video
rentals  encourages  consumers  to rent  films  they  might not pay to view at a
theater.

         Historically,  new technologies  have led to the creation of additional
distribution  channels for movie  studios.  Movie studios seek to maximize their
revenue by releasing  movies in  sequential  release  date  "windows" to various
movie  distribution  channels.  These  distribution  channels  include,  in  the
customary  order of release date,  movie  theaters,  airlines and hotels,  video
specialty   stores,   pay-per-view   satellite  and  cable  television   systems
("Pay-Per-View"), premium cable television, basic cable television and, finally,
network  and   syndicated   television.   See  "Business  --   Competition   and
Technological Obsolescence." The Company believes that this method of sequential
release  has  allowed  movie  studios  to  increase  their  total  revenue  with
relatively  little  adverse  effect  on  the  revenue  derived  from  previously
established  distribution channels and it is anticipated that movie studios will
continue  the  practice  of  sequential  release  even as near  video on  demand
("NVOD") and, eventually,  video on demand ("VOD") become more readily available
to the consumer.  According to Paul Kagan,  most movie studios release hit movie
videocassettes to the home video market from 30 days to 80 days (extending up to
120 days for certain  titles  priced for sale rather than  rental)  prior to the
Pay-Per-View release date.

Growth Strategy

          During the fiscal years 1994 through  1996,  approximately  78% of the
Company's  growth  in the  total  number  of stores  has  occurred  through  the
acquisition  of stores and the balance has occurred  through the  development of
new stores.  It is expected that, in the future,  development of new stores will
account for at least half of the  Company's  growth.  The  Company's  ability to
continue  this  growth  strategy  will be  dependent  upon its  ability to raise
additional funds. The key elements of the Company's  development and acquisition
strategy include the following:

         Development.  From January 1, 1994 through March 14, 1997,  the Company
has  developed  166 stores and intends to develop  approximately  30  additional
stores  during  the first  half of  fiscal  1997.  The  Company  utilizes  store
development  to complement its existing base of stores in markets where it finds
attractive  locations and a sufficient  population to support  additional  video
specialty stores.  Although developed stores generally require approximately one
year for revenue to reach the level of a mature  store,  they  typically  become
profitable within the first six months of operations and produce greater returns
on investment than acquired stores.

                                       2

<PAGE>

         The Company's real estate and construction  departments are responsible
for new store development,  including site selection,  market evaluation,  lease
negotiation and construction. The Company usually acts as the general contractor
with respect to the construction of its new stores and, in that regard,  employs
full-time  construction  managers who have  significant  video  specialty  store
construction experience.

         Set  forth  below  is a  historical  summary  showing  store  openings,
acquisitions and store closings by the Company since inception.

<TABLE>
<CAPTION>
                                                  
                                                 Nine Months      Year Ended    
                          Year Ended March 31      Ended          December 31  Year Ended    January 5
                          -------------------    December 31    --------------  January 5   to March 14
                            1985-1992   1993         1993        1994     1995    1997         1997
                            ---------   ----    -------------   -----   ------  ----------  -----------
<S>                            <C>      <C>           <C>        <C>      <C>      <C>           <C>
New Store Openings              13       11            10          25       66       75            5
Stores Acquired                 26       15             1         196      327      174(1)         0
Stores Closed                    2        0             1           2       23       48           13
Total Stores at End   
   of Period                    37       63            73         292      662      863          855
<FN>
     (1)  Includes  98  stores  acquired  on July 1, 1996 and  accounted  for as
poolings-of-interests.  Store counts,  prior to the fiscal year ended January 5,
1997, have not been restated for purposes of this table.  For total store counts
at the end of the fiscal years 1993 through 1996, see "Overview" in Item 7.
</FN>
</TABLE>
                                     
         Acquisitions.  From January 1, 1994 through March 14, 1997, the Company
has acquired 697 stores. Acquisitions have permitted the Company to quickly gain
market share and  experienced  management  in markets that the Company  believes
have potential for growth.  Through a combination of volume purchase  discounts,
larger  advertising  credits,  more  efficient  inventory  management  and lower
average labor costs,  the Company believes it is generally able to operate these
acquired stores more profitably than their prior owners,  typically single store
or small  chain  operators.  During  the last six  months of 1996,  the  Company
suspended  its  acquisition  program,  primarily  in  order  to  concentrate  on
improving  operations  at the stores it had acquired and  developed  from August
1994  through  July 1996.  Subject to the  availability  of funds,  the  Company
expects to resume an acquisition program in the second half of 1997.

         Future store acquisitions will be selected based upon location, quality
of  operations  and  financial  criteria  as  determined  by the  Company  to be
consistent with its growth strategy. In connection with future acquisitions, the
Company  anticipates  that some of the owners and most of the key personnel will
be employed by the Company.  Historically,  the owners of the stores acquired by
the Company have entered into  noncompetition  agreements with the Company which
are generally for a five to ten-year term.


                                       3


<PAGE>


         The Company  continues to have preliminary  discussions with the owners
of video  retail  businesses.  While the Company has no present  understandings,
commitments or agreements with respect to any future acquisition, it anticipates
that acquisition  opportunities will arise in the future.  However, there can be
no assurance that future  acquisition  opportunities  will be available and that
the integration of future  acquisitions will not materially and adversely affect
the Company.


Operating Strategy

         Focus on Smaller Markets.  Generally,  the Company's stores are located
in small towns or suburban areas  surrounding  mid-sized cities. In these areas,
the Company's  principal  competition  usually consists of single store or small
chain  operators, who have less buying  power, smaller advertising  budgets and
generally offer fewer copies of new videocassette releases. The Company attempts
to become the leading  video  retailer in its markets and  believes  that it can
achieve a higher  return on invested  capital in these  smaller  markets than it
could in the larger urban areas because of the reduced level of competition  and
lower operating costs.


         Market  Concentration.  By concentrating  its new store  development in
existing  markets,  the  Company  is able  to  achieve  operating  efficiencies,
primarily consisting of cost savings relating to advertising, training and store
supervision.


          New  Release   Purchases.   The  Company   actively  manages  its  new
videocassette   purchases  in  order  to  balance   customer   demand  with  the
maximization of  profitability.  Buying  decisions are made centrally with input
from store,  district and regional managers.  Centralized  purchasing allows the
Company to obtain volume  discounts,  market  development  funds and cooperative
advertising  credits that are  generally  not available to single store or small
chain operators.

         Centralized Operations. In order to increase operating efficiency,  the
Company centrally  manages labor costs,  real estate costs,  accounting and cash
management and utilizes  centralized  purchasing,  advertising  and  information
systems.  A  Company-wide  quality  assurance  program  insures a high degree of
customer  service and a visually  appealing  store.  The Company  believes  this
program increases customer satisfaction and loyalty.

         Store  Location  and  Format.  The Company  maintains a flexible  store
format,  tailoring  the  size,  inventory  and  look  of  each  store  to  local
demographics.  The Company's stores generally range from approximately  2,000 to
9,000 square feet (averaging 4,750 square feet),  with inventories  ranging from
approximately 3,000 to 15,000 videocassettes. Substantially all of the Company's
stores are located in strip centers,  anchored by major grocery or discount drug
store chains, which provide easy access, good visibility, and high traffic.
 

                                      4
<PAGE>

Movie Gallery Stores

         At March 14, 1997,  the Company owned and operated 855 stores,  all but
one of which were  located in leased  premises.  The  following  table  provides
information  at March 14, 1997 regarding the number of Company stores located in
each state.
                                                       Number
                                                         of
                                                       Stores
                                                       ------
Alabama.....................................             147
Florida.....................................             112
Texas.......................................              91
Georgia.....................................              67
Virginia....................................              54
Ohio........................................              50
Tennessee...................................              46
Maine.......................................              41
South Carolina..............................              33
Wisconsin...................................              32
Indiana.....................................              31
Mississippi.................................              29
North Carolina..............................              22
Missouri....................................              21
Kentucky....................................              19
Kansas......................................              16
Louisiana...................................              15
New Hampshire...............................              11
Illinois....................................              10
Iowa........................................               4
Massachusetts...............................               3
Michigan....................................               1
                                                         ---       

         TOTAL..............................             855
                                                         ===


        The Company's  stores are generally open seven days a week,  from 10:00
a.m. to 11:00 p.m. on  weekends  and from 10:00 a.m. to 10:00 p.m. on  weekdays.
The store fixtures, equipment and layout are designed by the Company to create a
visually-appealing,  up-beat  ambiance,  which is augmented  by a background  of
popular music,  television  monitors  displaying movies and promotions of coming
attractions,  and posters and stand-up displays promoting specific movie titles.
Movies are arranged in attractive  display boxes  organized  into  categories by
topic, except for new releases,  which are assembled alphabetically in their own
section for ease of selection by customers.

          The  Company has  implemented  a quality  assurance  program to ensure
compliance with the Company's customer service and store operating  policies.  A
team of seven employees  located in different store regions make periodic visits
to monitor  compliance  and report  results to the  Company's  Vice  President -
Administration.  District managers and regional managers are expected to quickly
address and resolve any compliance problems.

         It is the Company's  policy to constantly  evaluate its existing  store
base to  determine  where  improvements  may benefit the  Company's  competitive
position. In negotiating its leases and renewals, the Company attempts to obtain
short  lease  terms to allow for the  mobility  necessary  to react to  changing
demographics  and  other  market   conditions.   The  Company  actively  pursues
relocation  opportunities to adapt to market shifts.  Similarly, the Company may
elect to  expand  and/or  remodel  certain  of its  stores  in order to  improve
facilities,  meet customer  demand and maintain the visual appeal of each store.
During the fiscal year ended January 5, 1997, the Company relocated, expanded or
fully remodeled 53 stores.

                                       5

<PAGE>

         In order to maximize  profits,  the Company  varies the quantity of its
new release inventory,  the rental and sales prices for videocassettes and video
games,  and the rental  period for catalog  titles from  location to location to
meet competition and demographic demand in the area. The Company generally has a
one-day rental term for most recent new releases (two days for catalog  titles),
which  tends to keep new  releases  more  readily  available  and  requires  the
purchase of fewer copies of new releases than a two-day rental policy.

         Stores generally offer multiple checkout counters, each with a computer
terminal.  Rental payment is required upon checkout in substantially  all of the
Company's  stores,  with the remainder  requiring payment on return. To generate
goodwill with its customers,  the Company's stores will, upon customer  request,
temporarily reserve in-stock titles.

Franchises and Licenses

         In connection  with certain of its  acquisitions,  the Company  assumed
obligations under franchise  agreements and license agreements.  The Company has
entered  into  additional  license  agreements  with  certain  former  owners of
acquired stores and with existing  licensees.  As of March 14, 1997, the Company
had 106  franchisees and licensees  operating under such agreements  pursuant to
which the Company  receives various royalty and license payments and has certain
non-monetary  obligations to the franchisees and licensees. The Company does not
presently  intend  to  offer  franchises  or  licenses  for sale  and,  whenever
possible,  will purchase  stores  operated by  franchisees  or licensees if they
become  available at  reasonable  prices.  For the fiscal year ended  January 5,
1997, revenues from franchisees and licensees were not material to the Company.


Products

         For the fiscal  year ended  January 5, 1997,  substantially  all of the
Company's rental revenue was derived from the rental of videocassettes, with the
remainder being derived from the rental of video games. Substantially all of the
Company's  revenue from product  sales during these periods was derived from the
sale of new and previously viewed videocassettes and video games. The balance of
product sale revenue was derived from video accessories, such as blank cassettes
and cleaning equipment,  confectionery items and movie memorabilia.  The Company
also sells audio products in a few of its stores.

          The   Company's   stores   generally   offer   from  3,000  to  15,000
videocassettes  (from  2,500 to 8,000  titles) and from 200 to 1,000 video games
(from 150 to 750  titles)  for rental and sale,  depending  upon  location.  New
release  movies are displayed  alphabetically  and catalog  titles are displayed
alphabetically  by  category,   such  as  "Action,"  "Comedy,"   "Children"  and
"Classics." A typical  store's  inventory  consists of 4,000 catalog  selections
(chosen from a core  selection of about 6,000  titles),  plus new release titles
and older titles  which  continue to be in strong  demand.  Each store has a few
special interest titles,  covering such subjects as hunting, golf and education,
selected by  management  to appeal to the  customer  base in the store's  market
area.  Buying  decisions are made centrally with input from store,  district and
regional managers and are based on box office results,  industry newsletters and
management's  knowledge  of the  popularity  of  certain  types of movies in its
markets.

         Management  believes that internal  factors which most affect a typical
store's revenues are its new release title selection and the number of copies of
each new  release  available  for rental as  compared  to the  competition.  The
Company is  committed to offering as many copies of new releases as necessary to
be competitive within a market,  while at the same time keeping its costs as low
as possible.  New  videocassettes  offered for sale are  primarily  "hit" titles
promoted  by the  studios  for sell  through,  as well as special  interest  and
children's titles and seasonal titles connected to particular holidays.

                                       6

<PAGE>

         The Company rents and sells video games,  which are licensed  primarily
by  "Nintendo,"  "Sega  Genesis" and "Sony." Game rentals as a percentage of the
Company's  total  revenues  have  decreased  since 1994 due to the  decrease  in
consumer  demand  pending the release and consumer  acceptance of the new 32-bit
and 64-bit game platforms.  Sega Genesis and Sony released new platforms in late
1995, while Nintendo  released its N64 platform in the fall of 1996. The Company
anticipates  that one or more of the  platforms  will  become  dominant  as more
households in its markets acquire video game hardware. At that time, the Company
expects that the video game rental and sales portion of its business may grow.

Videocassette and Video Game Suppliers

     During the fiscal year ended Janaury 5, 1997,  the Company  purchased  over
80% of its videocassettes and video games from Sight & Sound Distributors,  Inc.
("Sight & Sound")  pursuant  to a  contract  with  Sight & Sound  which has been
renewed  through  March  30,  1998.  Two  other  distributors  were the  primary
suppliers of the balance.

     The Company's  contract with Sight & Sound provides for the direct purchase
of videocassettes and video games at varying prices. These prices are a function
of the wholesale  prices set by the movie  studios,  which depend upon whether a
videocassette  is  initially  priced to  encourage  rental or sale.  The Company
currently  receives  marketing  funds and an advertising  allowance from Sight &
Sound based upon a percentage of videocassette and video game purchases.

         If the  relationship  with Sight & Sound were  terminated,  the Company
believes that it could readily obtain its required  inventory of  videocassettes
and video games from alternative  suppliers at prices and on terms comparable to
those available from Sight & Sound. However, the number of alternative suppliers
has  diminished in recent years and the  termination  of the  Company's  present
relationship  with Sight & Sound could adversely affect the Company's results of
operations  until a suitable  replacement  was found.  There can be no assurance
that  the  replacement  would  provide  service,  support  or  payment  terms as
favorable as those provided by Sight & Sound.

         Several  companies  acquired by the Company had pre-existing  long-term
contracts with Rentrak Corporation ("Rentrak") whereby product would be provided
under  pay-per-transaction  revenue sharing arrangements.  During late 1996, the
Company   consolidated   existing  contracts  with  Rentrak  into  one  national
agreement.  Under this  ten-year  agreement,  the Company  has a minimum  annual
purchase  commitment in revenue  share,  handling  fees,  sell-through  fees and
end-of-term  buyout  fees.  The Company  intends to utilize  Rentrak in specific
marketing campaigns or in very competitive markets. 

Marketing and Advertising

         With advertising  credits and market development funds that it receives
from its video  suppliers  and the movie  studios,  the  Company  uses radio and
television advertising, direct mail, newspaper advertising, discount coupons and
promotional  materials to promote new releases,  its video specialty  stores and
its trade name. Using copy prepared by the Company and the studios,  advertising
is placed by an  advertising  subsidiary of Sight & Sound as well as by in-house
media buyers. Expenditures for marketing and advertising above the amount of the
Company's  advertising  credits from its  suppliers  and movie studios have been
minimal.  The Company  anticipates  that it will  continue  to make  substantial
marketing and advertising expenditures,  but that its primary supplier and movie
studios will  continue to pay most of such cost.  The Company also benefits from
the  advertising  and marketing by studios and theaters in connection with their
efforts to promote films and increase box office revenue. The Company prepares a
monthly marketing  magazine and videotape,  which it sends to all of its stores,
featuring promotions and new releases.

                                       7

<PAGE>

Inventory

         The  videocassette  and video game  inventory in each store consists of
its  catalog  titles  (those in release  for more than one year) and new release
titles.  New releases of videocassettes and video games purchased from suppliers
for existing stores are prepackaged by suppliers,  rental-ready  (except for the
bar codes,  which are applied at the store) to the Company's  specifications and
drop-shipped  to the stores to avoid time  delays in making  videocassettes  and
video games available for rental.

         Videocassettes  and video games  utilized as initial  inventory  in the
Company's  developed  stores  consist of excess copies of catalog titles and new
release  titles from  existing  stores,  supplemented  as necessary by purchases
directly from suppliers.  This inventory for developed stores is packaged at the
Company's processing and distribution facility located in Dothan,  Alabama. Each
videocassette  and video game is removed  from its  original  packaging,  and an
optical bar code label, used in the Company's  computerized inventory system, is
applied to both the packaging and the plastic rental case.  The cassette,  along
with a brief description of the movie or game, is placed in the rental case, and
a display  carton is created by inserting  foam or  cardboard  into the original
packing and  shrink-wrapping  the carton. The repackaged  videocassettes,  video
games and display cartons are then shipped to the developed store ready for use.

Management Information System

          In November  1995, the Company began  development  of its  proprietary
Point of Sale ("POS") system. On January 10, 1996, the first Beta test store was
installed with the new system.  Additional Beta test sites were rolled out until
March 31, 1996,  at which time the Company had 17 Beta test stores.  On April 1,
1996, the Company began the rapid deployment of the POS system in its stores. As
of March 14, 1997, there were 609 Company stores operating on the POS system. By
July 1997, the Company  expects to have all of its stores on the new POS system.
The new system provides  detailed  information  with respect to store operations
(including  the rental  history of titles and daily  operations  for each store)
which is  telecommunicated  to the  corporate  office on a daily basis.  The POS
system is installed in all  developed  stores prior to opening,  and the Company
installs  the system in all  acquired  stores as soon  after the  closing of the
acquisition as practicable.


         The Company's POS system records all rental and sale  information  upon
customer  checkout  using  scanned  bar  code   information,   and  updates  the
information  when the  videocassettes  and video  games are  returned.  This POS
system is linked to a management  information  system  ("MIS") at the  corporate
offices.  Each night the POS system  transmits store data into the MIS where all
data is  processed,  generating  reports which allow  management to  effectively
monitor store  operations and inventory,  as well as to review rental history by
title and location to assist in making purchasing  decisions with respect to new
releases.  The POS system  also  enables  the  Company to  perform  its  monthly
physical  inventory using bar code  recognition,  which is more efficient,  more
accurate and less costly than a manual count.

         In  addition,  during the last two years, the Company  has  installed a
financial  reporting  system relating to the general ledger,  revenue,  accounts
payable and payroll  functions  capable of handling  the  Company's  anticipated
growth.

                                       8

<PAGE>

Competition and Technological Obsolescence

         The video  retail  industry  is  highly  competitive,  and the  Company
competes with other video specialty  stores,  including stores operated by other
regional  chains  and  national  chains  such as  Blockbuster,  and  with  other
businesses  offering  videocassettes  and  video  games  such  as  supermarkets,
pharmacies,   convenience  stores,   bookstores,   mass  merchants,  mail  order
operations  and  other  retailers.  Approximately  35% of the  Company's  stores
compete with stores operated by Blockbuster.  In addition,  the Company competes
with all  forms of  entertainment,  such as movie  theaters,  network  and cable
television, direct broadcast satellite television, Internet-related activities,
live theater,  sporting  events and family  entertainment  centers.  Some of the
Company's   competitors  have  significantly  greater  financial  and  marketing
resources and name recognition than the Company.

         The Company  believes the  principal  competitive  factors in the video
retail industry are store location and visibility,  title selection,  the number
of copies of each new  release  available,  customer  service  and,  to a lesser
extent, pricing. The Company believes it generally offers superior service, more
titles and more copies of new releases than most of its competitors.

         The Company also competes with Pay-Per-View, in which subscribers pay a
fee to view a movie selected by the subscriber.  Recently developed technologies
permit certain cable companies,  direct broadcast  satellite  companies (such as
Direct  TV),  telephone  companies  and other  telecommunications  companies  to
transmit a much greater  number of movies to homes  throughout the United States
at  more  frequent  intervals  (often  as  frequently  as  every  five  minutes)
throughout the day, referred to as NVOD. NVOD does not offer full  interactivity
or VCR  functionality,  such as allowing consumers to control the playing of the
movie (starting,  stopping and rewinding).  Ultimately,  further improvements in
these technologies could lead to the availability of a broad selection of movies
to the  consumer  on  demand,  referred  to as  VOD,  at a  price  which  may be
competitive with the price of videocassette  rentals and with the  functionality
of VCRs.  Certain cable and other  telecommunications  companies have tested and
are  continuing  to test  limited  versions  of NVOD and VOD in various  markets
throughout the United States and Europe.

       The Company  anticipates  that movies  recorded on digital  video discs
("DVD"),  the same size as audio discs,  will be introduced during 1997. At that
time,  playback machines which play both audio discs and DVD will be introduced.
Because  of the  ease  of use and  durability  of DVD,  it is  anticipated  that
eventually  DVD may  begin to  replace  videocassettes.  During  the  transition
period,  the Company's cost to maintain its inventory may increase.  The Company
expects to offer DVD for rental and sale once they are introduced  commercially.
In  addition,  the advent of DVD may result in consumers  purchasing  more films
than in the past,  which could have a material  adverse  effect on the Company's
rental volume and, as a result, on its profit margins.


                                       9

<PAGE>

     The  Company  believes  movie  studios  have  a  significant   interest  in
maintaining a viable movie rental business because the sale of videocassettes to
video retail stores currently represents the studios' largest source of domestic
revenue.  As a result, the Company  anticipates that movie studios will continue
to make movie  titles  available  to  Pay-Per-View,  cable  television  or other
distribution  channels  only after  revenues  have been derived from the sale of
videocassettes  to video  stores.  In addition,  the Company  believes  that for
Pay-Per-View  television  to  match  the  low  price,  viewing  convenience  and
selection available through video rental,  substantial capital  expenditures and
further technological advances will be necessary.  Although the Company does not
believe NVOD or VOD  represent a near-term  competitive  threat to its business,
technological  advances  and  broad  consumer  availability  of NVOD  and VOD or
changes  in the manner in which  movies  are  marketed,  including  the  earlier
release of movie titles to Pay-Per-View,  cable television or other distribution
channels, could have a material adverse effect on the Company's business.

Employees

         As of March 14, 1997, the Company employed approximately 6,300 persons,
referred to by the Company as  "associates,"  including  approximately  6,000 in
retail  stores  and  the  remainder  in  the  Company's  corporate  offices  and
distribution  facility.  Of the  retail  associates,  approximately  1,400  were
full-time  and  4,600  were  part-time.  None  of the  Company's  associates  is
represented by a labor union,  and the Company  believes that its relations with
its associates are good.

         Each of the Company's stores typically employs four to fifteen persons,
including  one manager  and one  assistant  manager.  Store  managers  report to
district managers who supervise the operations of 12 to 15 stores.  The district
managers  report to one of eight regional  managers,  who report directly to the
Company's Senior Vice President - Store Operations. As the Company has grown, it
has increased the number of district  managers and regional  managers,  often by
employing  owners or key employees of acquired  stores.  The  corporate  support
staff has periodic  meetings with the regional  managers,  district managers and
store managers to review  operations.  Compliance  with the Company's  policies,
procedures and regulations is regularly  monitored on a store-to-store  basis by
members of the Company's quality assurance department.

          The Company has an incentive  bonus  program  pursuant to which retail
management  personnel  receive  quarterly  bonuses when store  results  equal or
exceed  established  goals and quality assurance  standards are met.  Management
believes  that its  program  rewards  excellence  in  management,  gives  retail
management  an  incentive  to  improve  operations  and  results  in an  overall
reduction in the cost of  operations.  In  addition,  store  managers,  district
managers,  regional  managers  and other  corporate  personnel  are  eligible to
receive  discretionary  bonuses and options to purchase  shares of the Company's
Common  Stock  (exercisable  at the fair  market  value  on the date of  grant),
subject to service requirements.

Cautionary Statements

         The "BUSINESS" and  "MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF  OPERATIONS"  sections of this Report  contain  certain
forward-looking  statements  regarding the Company.  The Company desires to take
advantage of the "safe harbor" provisions of the Private  Securities  Litigation
Reform Act of 1995 and in that regard is  cautioning  the readers of this Report
that the following important factors,  among others,  could affect the Company's
actual  results of operations  and may cause  changes in the Company's  strategy
with the result that the Company's  operations and results may differ materially
from those expressed in any forward-looking statements made by, or on behalf of,
the Company.

                                       10
<PAGE>


          Growth  Strategy.   The  Company's  strategy  is  to  grow  through  a
combination  of  new  store  openings  and   acquisitions  of  existing  stores.
Successful  implementation of the strategy is contingent on numerous conditions,
some of which  are  described  below,  and there  can be no  assurance  that the
Company's business plan can be executed.  The acquisition of existing stores and
the opening of new stores requires  significant amounts of capital. In the past,
the Company's  growth strategy has been funded  primarily  through proceeds from
public offerings,  bank debt, seller financing,  internally  generated cash flow
and use of the Company's  common stock as acquisition  consideration.  These and
other  sources of capital,  including  public or private sales of debt or equity
securities, may not be available in the future to the Company.

         New Store  Openings.  The  Company's  ability to open new stores may be
adversely affected by the following factors,  among others: (i) its availability
of  capital;  (ii) its  ability to  identify  new sites  where the  Company  can
successfully  compete;  (iii) its  ability to  negotiate  acceptable  leases and
implement  cost-effective  development plans for new stores; (iv) its ability to
hire, train, and assimilate new store managers and other personnel; and, (v) its
ability  to  compete  effectively  against  competitors  for prime  real  estate
locations.

          Acquisitions.  The Company's  ability to consummate  acquisitions  and
operate acquired stores at the desired levels of sales and  profitability may be
adversely affected by: (i) the inability to consummate identified  acquisitions,
which  may  result  from a lack of  available  capital;  (ii) the  inability  to
identify  acquisition  candidates that fit the Company's criteria (such as size,
location  and  profitability)  and who are willing to sell at prices the Company
considers reasonable; (iii) more intensive competition to acquire the same video
specialty  stores the Company  seeks to  acquire;  (iv) an increase in price for
acquisitions;  (v) misrepresentations and breaches of contracts by sellers; (vi)
the Company's limited knowledge of and operating history of the acquired stores;
(vii) the  replacement of purchasing and marketing  systems of acquired  stores;
and (viii) the  integration  of  acquired  stores'  systems  into the  Company's
systems and procedures.

         Same-Store  Revenue  Increases.  The Company's  ability to maintain or
increase  same-store revenues during any period will be directly impacted by the
following  factors,  among  others,  which are often  beyond the  control of the
Company:  (i) the timing of the release of new hit movies by the studios for the
video rental market;  (ii)  competition from special events such as the Olympics
or  a  televised  trial  of  significant  public  interest;  (iii)  the  weather
conditions  in  the  selling  area;  (iv)   competition   from  other  forms  of
entertainment  such  as  movie  theaters,  cable  television,  Internet-related
activities and Pay-Per-View  television,  including direct satellite television;
(v) increased  competition from other video stores,  including large national or
regional chains,  supermarkets,  convenience stores, pharmacies,  mass merchants
and other retailers,  which might include  significant  reductions in pricing to
gain market  share;  and (vi) a reduction in, or  elimination  of, the period of
time (the "release  window") between the release of hit movie  videocassettes to
the home video  market and the  release of these hit movies to the  Pay-Per-View
markets (currently 30 days to 80 days).

         Income Estimates.  The Company's ability to meet its income projections
for any period are dependent upon many factors,  including the following,  among
others:  (i) reductions in revenues caused by factors such as those listed under
"Growth  Strategy" above;  (ii) the extent to which the Company  experiences any
increase in the number of titles released from studios priced for  sell-through,
which may tend to reduce  levels of rental  activity  which carry higher  profit
margins  than  product  sales;  (iii)  changes in the  prices for the  Company's
products or a reduction in, or elimination of, the videocassette  release window

                                       11
<PAGE>

as compared to Pay-Per-View, as determined by the movie studios, could result in
a  competitive   disadvantage  for  the  Company  relative  to  other  forms  of
distribution;  (iv) the  Company's  ability to implement  its new  point-of-sale
management   information  system  and  financial  management  systems;  (v)  the
Company's  ability to control costs and expenses,  primarily rent, store payroll
and general and administrative expenses; (vi) the Company's ability to react and
obtain  other  distribution  sources for its  products in the event that Sight &
Sound  Distributors,  Inc., which supplies over 80% of the Company's product, is
unable  to  meet  the  terms  of  its  contract  with  the  Company;  and  (vii)
advancements and cost reductions in various new  technological  delivery systems
such as (A) pay-per-view  cable television systems and digital satellite systems
offering NVOD or VOD; (B) DVD technology and its anticipated introduction during
1997,  which might result in lower profit margins and increased costs associated
with higher  inventory  requirements;  and,  (C) other forms of new  technology,
which  could  affect the  Company's  profit  margins. 

Directors  and  Executive Officers of the Company


       Name                 Age     Position(s) Held

  Joe Thomas Malugen(1)      45     Chairman of the Board and Chief Executive 
                                     Officer
  H. Harrison Parrish(1)     49     President and Director
  William B. Snow(1)         65     Vice Chairman of the Board
  J. Steven Roy              36     Senior Vice President and Chief Financial 
                                      Officer
  S. Page Todd               35     Senior Vice President, Secretary and
                                      General Counsel
  Richard R. Langford        40     Senior Vice President-Management Information
                                      Systems
  Mark S. Loyd               41     Senior Vice President-Purchasing and 
                                      Product Management
  Craig D. Steeves           38     Senior Vice President-Store Operations
  Curry M. Herring           52     Senior Vice President
  Steven M. Hamil            28     Vice President-Chief Accounting Officer
                                      and Controller
  Sanford C. Sigoloff(2)(3)  66     Director
  Philip B. Smith(2)(3)      61     Director
  Joseph F. Troy (1)(2)(3)   58     Director

  -----------------------
  (1)  Member of Executive Committee.
  (2)  Member of Compensation Committee.
  (3)  Member of Audit Committee.

     Mr. Malugen co-founded the Company in 1985 and has been its Chairman of the
Board and Chief  Executive  Officer  since  that  time.  Prior to the  Company's
initial  public  offering in August  1994,  Mr.  Malugen  had been a  practicing
attorney in the States of Alabama and Missouri  since 1978, but spent a majority
of his time managing the operations of the Company  beginning in early 1992. Mr.
Malugen received a B.S. degree in Business Administration from the University of
Missouri-Columbia,  his J.D. from Cumberland  School of Law, Samford  University
and his LL.M. (in Taxation) from New York University  School of Law. 

     Mr. Parrish co-founded the Company in 1985 and has been its President and a
Director of the Company since that time.  From December 1988 until January 1992,
Mr.  Parrish was Vice  President of Deltacom,  Inc.,  a regional  long  distance
telephone  provider.  Mr. Parrish  received a B.A. degree from the University of
Alabama in Business Administration.
     
     Mr. Snow was elected Vice Chairman of the Board in July 1994, and he served
as Chief Financial  Officer from July 1994 until May 1996. Mr. Snow entered into
a two-year consulting agreement with the Company commencing January 1, 1997. Mr.
Snow was the Executive Vice President and Chief Financial Officer and a Director
of Consolidated Stores  Corporation,  a publicly-held  specialty retailer,  from
1985  until he  retired  in June  1994.  Mr.  Snow is a member  of the  Board of
Directors of Action  Industries,  Inc., a publicly-held  company.  Mr. Snow is a
Certified   Public   Accountant,   and  he  received  his  Masters  in  Business
Administration  from the Kellogg  Graduate  School of Management at Northwestern
University and his Masters of Taxation from DePaul University.

                                       12
<PAGE>

     Mr. Roy was elected Senior Vice  President-Finance and Principal Accounting
Officer in June 1995 and was elected Chief  Financial  Officer in May 1996.  Mr.
Roy was an accountant  with the firm of Ernst & Young LLP for the 11 years prior
to  joining  the  Company,  most  recently  as a  Senior  Manager  in the  Audit
Department.  Mr. Roy is a Certified Public Accountant and received a B.S. degree
in Business Administration from the University of Alabama.

     Mr. Todd was elected Senior Vice  President,  Secretary and General Counsel
in December 1994. For more than the previous five years, 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. from
the  University of Alabama  School of Law and his L.L.M.  (in Taxation) from New
York University School of Law.
 
     Mr.  Langford  joined the Company in August 1995 as Vice  President and was
elected Senior Vice President - Management  Information Systems in October 1996.
From August 1993 until he joined the Company,  Mr.  Langford served as a Manager
for Payroll,  Fixed Assets and Accounts  Payable for Rocky Mountain  Healthcare.
From February 1990 to August 1993, he was Director of Support  Operations for U.
I. Video Stores,  Inc.  ("UIV") of Denver  Colorado.  UIV was one of the largest
Blockbuster franchisees, operating 110 stores in seven states in July 1993, when
UIV was acquired by Blockbuster.

     Mr.  Loyd  joined the  Company in August  1986 and has served as the retail
store coordinator as well as Vice President - Purchasing and Product Management.
In October 1996, he was elected  Senior Vice  President - Purchasing and Product
Management. Mr. Loyd attended Southeast Missouri State University.

     Mr.  Steeves  joined  the  Company  in  March  1995,   became  Senior  Vice
President-Support Services in June 1995 and became Senior Vice President - Store
Operations  in October 1995.  From August 1993 until he joined the Company,  Mr.
Steeves was a  consultant  specializing  in lease review and  leasehold  expense
reduction.  From  September  1989 until July 1993,  Mr.  Steeves  was a regional
manager,  director-support  operations and then Vice President-Support  Services
for UIV.

     Mr.  Herring  joined the  Company in August  1986 and served as  Controller
until May 1994 when he was elected Vice President - Administration.  In December
1996, he was elected Senior Vice  President.  Prior to his  employment  with the
Company,  Mr. Herring was a major in the United States Army,  where he completed
numerous  command and  staff-level  courses for military  officers.  Mr. Herring
received a B.S.  degree from Troy State  University in  Accounting  and Business
Administration.

     Mr.  Hamil was elected  Vice  President  and  Controller  in June 1996.  In
October 1996, he was elected Chief  Accounting  Officer.  From July 1994,  after
receiving  a Masters in Business  Administration  from Duke  University's  Fuqua
School of  Business,  until he joined the Company,  Mr. Hamil was an  Investment
Banking Associate with NationsBanc Capital Markets, Inc. He has also served as a
Staff Auditor with Ernst & Young LLP. Mr. Hamil is a Certified Public Accountant
and received a B.S.  degree in Business  Administration  from the  University of
Alabama.

     Mr.  Sigoloff  became a director  of the  Company in  September  1994.  Mr.
Sigoloff has been Chairman of the Board,  President and Chief Executive  Officer
of Sigoloff & Associates,  Inc., a management  consulting company since 1989. In
August 1989, LJ Hooker  Corporation,  a client of Sigoloff &  Associates,  Inc.,
appointed  Mr.  Sigoloff  to act as  its  Chief  Executive  Officer  during  its
reorganization under Chapter 11 of the United States Bankruptcy Code. From March
1982 until 1988, Mr.  Sigoloff was Chairman of the Board,  President,  and Chief
Executive Officer of Wickes Companies, Inc., one of the largest retailers in the
United  States.  Mr.  Sigoloff  is a  director  of the  following  publicly-held
corporations: ChatCom, Inc.; Digital Video Systems, Inc.; Kaufman and Broad Home
Corporation;  SunAmerica, Inc. and Wickes plc-London,  England. In addition, Mr.
Sigoloff is an adjunct full professor at the John E. Anderson Graduate School of
Management at the University of California at Los Angeles.

                                       13
<PAGE>

     Mr. Smith became a director of the Company in September 1994. Mr. Smith has
been Vice Chairman of the Board of Spencer Trask Securities  Incorporated  since
1991.  He was  formerly a Managing  Director  of  Prudential  Securities  in its
merchant  bank.  Mr.  Smith is a founding  General  Partner of Lawrence  Venture
Associates,  a venture capital  limited  partnership  headquartered  in New York
City.  From 1981 to 1984,  he  served  as  Executive  Vice  President  and Group
Executive of the worldwide  corporations group at Irving Trust Company. Prior to
joining Irving Trust Company,  he was at Citibank for 15 years, where he founded
Citicorp Venture Capital as President and Chief Executive Officer. Since 1988 he
has also been the managing general partner of Private Equity  Partnership,  L.P.
Mr.  Smith is a director of  DenAmerica  Corp.;  Digital  Video  Systems,  Inc.;
ChatCom, Inc. and KLS EnviroResources, Inc., publicly-held companies.

     Mr. Troy became a director of the Company in  September  1994.  Mr. Troy is
the founder  and has been a member of the law firm of Troy & Gould  Professional
Corporation  since May 1970. He is a director of Digital Video Systems,  Inc., a
publicly-held company.

         Directors  are  elected  to serve  until  the next  annual  meeting  of
stockholders of the Company or until their successors are elected and qualified.
Officers  serve at the  discretion  of the Board of  Directors,  subject  to any
contracts  of  employment.  Non-employee  directors  receive  an  annual  fee of
$12,000,  a fee of $1,000 for each Board meeting  attended and a fee of $500 for
each  committee  meeting  attended.  The Company has granted  vested  options to
purchase 85,000 shares of Common Stock to each of Messrs. Sigoloff and Smith and
options to purchase 110,000 shares to Mr. Troy in each case at or above the fair
market value of the Common Stock on the date of grant.

ITEM 2.  PROPERTIES

          At March  14,  1997,  all but one of the  Company's  855  stores  were
located on premises  leased from  unaffiliated  persons  pursuant to leases with
remaining  terms  which vary from  month-to-month  to ten years.  The Company is
generally  responsible  for taxes,  insurance  and  utilities  under its leases.
Rental rates often increase upon exercise of any renewal option, and some leases
have percentage rental  arrangements  pursuant to which the Company is obligated
to pay a base rent plus a  percentage  of the  store's  revenues  in excess of a
stated minimum. In general,  the stated minimums are set at such a high level of
revenues  that the Company is not  obligated  to pay  additional  rents based on
reaching the stated revenue levels,  and it anticipates that any future payments
would be rare  and  would be  minimal  amounts  not  material  to the  Company's
business or results of operations.  The Company  anticipates  that future stores
will also be located in leased premises. The Company owns a family entertainment
center, including a video specialty store, in Meridian, Mississippi.


         The Company's  corporate  campus is located in four buildings at 739 W.
Main Street, Dothan, Alabama, consisting of an aggregate of approximately 13,000
square  feet of space,  and a portion of an office  building  located at 2323 W.
Main Street,  Dothan Alabama,  consisting of approximately 10,000 square feet of
space.  Two of these buildings with an aggregate of  approximately  6,500 square
feet of space  are  owned by the  Company  and are  used for  general  corporate
offices.  Two of these  buildings  which are used  primarily  for  executive and
general corporate  offices have an aggregate of approximately  6,500 square feet
of  space  and are  leased  from  Messrs.  Malugen  and  Parrish  pursuant  to a
three-year lease with two,  two-year options at an initial annual rental rate of
$32,700,  subject to increases based upon increases in the consumer price index.
The office  building space is used for general  corporate  offices and is leased
from  an  unaffiliated   third  party  for  a  one-year  term.  The  Company  is
consolidating   its   videocassette   processing,   distribution  and  warehouse
facilities into a 26,730 square foot facility in Dothan, Alabama,  pursuant to a
three-year lease with three,  three-year options.  The consolidation is expected
to be completed in May 1997. The primary  processing and  distribution  facility
being vacated is subleased by the Company from Mr. Parrish  pursuant to a $1,120
a month sublease, which expires on November 8, 1997.

                                       14
<PAGE>


ITEM 3.  LEGAL PROCEEDINGS

         The  Company  is not  currently  involved  in  legal  proceedings  that
management  believes  could  have a  material  adverse  effect on the  Company's
financial condition or results of operations.  The legal proceeding disclosed in
the Form 10-K for the fiscal year ended  December 31,  1995,  was settled in May
1996 for a nominal  amount which was not material to the  Company's  business or
results of operations.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         None.


                                     PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         The Company's  Common Stock began trading on the Nasdaq National Market
on August 2, 1994 under the symbol  "MOVI." The  following  table sets forth for
the periods  indicated the high and low last sale prices of the Company's Common
Stock as reported on the Nasdaq National Market.
<TABLE>
<CAPTION>

                                           High            Low
<S>                                       <C>            <C> 
1995
First Quarter ........................     $ 27 1/2        $ 21
Second Quarter........................       36              26
Third Quarter.........................       50              34 7/8
Fourth Quarter........................       42              23

1996
First Quarter.........................       30 1/2          19 1/4
Second Quarter........................       36 1/8          19 5/8
Third Quarter.........................       24 1/2          10 3/4
Fourth Quarter........................       15 1/2          12 1/2

1997
First Quarter (through April 1, 1997).       13 3/4           7 1/2
</TABLE>

         The last sale price of the  Company's  Common Stock on April 1, 1997 as
reported on the Nasdaq National Market was $7.50 per share. As of April 1, 1997,
there were 109 holders of record of the Company's Common Stock.

         In March 1993,  December 1993,  August 1994 and April 1995, the Company
paid cash  dividends (in the form of S corporation  distributions)  of $239,864,
$186,561, $2.5 million and $188,000,  respectively, to the existing stockholders
prior to the Company's  initial public offering  (Messrs.  Malugen and Parrish).
The Company  presently  expects to retain its earnings to finance the  expansion
and further development of its business.  The payment of dividends is within the
discretion of the Company's  Board of Directors and will depend on the earnings,
capital requirements, restrictions in future credit agreements and the operating
and financial  condition of the Company,  among other  factors.  There can be no
assurance that the Company will ever pay a dividend in the future.

                                       15

<PAGE>
<TABLE>

Item 6.  Selected Financial Data
<CAPTION>
                                                                                             Nine Months
                                                    Year Ended    Year Ended    Year Ended      Ended     Year Ended
                                                    January 5     December 31   December 31  December 31   March 31
                                                    1997(5)(6)        1995        1994(3)     1993(3)(4)    1993(3)
                                                    ----------    -----------   -----------  -----------   ---------

<S>                                                 <C>          <C>           <C>            <C>         <C>         
Statement of Income Data (1):                       
Revenues:
  Rentals                                            $ 219,002    $ 130,353     $ 47,782       $ 21,133    $ 19,509
  Product sales                                         35,393       18,848        5,441          1,908       1,582
                                                     ---------    ---------     --------       --------    --------
                                                       254,395      149,201       53,223         23,041      21,091
Operating costs and expenses:
  Store operating expenses                             124,456       67,758       24,119         11,891      11,376
  Amortization of videocassette rental inventory        63,544(7)    29,102       10,263          4,541       4,900
  Amortization of intangibles                            7,160        3,380          606            133          --
  Cost of sales                                         21,143       12,600        4,018          1,462       1,120
  Special management bonus                                  --           --           --            560         200
  General and administrative                            20,266       13,525        5,647          2,024       2,437
  Restructuring and other charges                        9,595           --           --             --          --
                                                     ---------    ---------     --------       --------    --------
Operating income                                         8,231       22,836        8,570          2,430       1,058
Non-operating income (expense):
  Interest expense, net                                 (5,619)      (1,528)        (486)          (458)       (427)
  Other, net                                                --           --           58             49          66
                                                     ---------    ---------     --------       --------    --------
Income before income taxes                               2,612       21,308        8,142          2,021         697
Income taxes (2)                                         1,006        7,871        2,991            757         263
                                                     ---------    ---------     --------       --------    --------
Net income                                           $   1,606    $  13,437     $  5,151       $  1,264    $    434
                                                     =========    =========     ========       ========    ========
Net income per share                                 $     .12    $    1.11     $    .63       $    .19    $    .06
                                                     =========    =========     ========       ========    ========
Cash dividends declared per share                    $     0.0    $     0.0     $    .39       $    .04    $    .04
                                                     =========    =========     ========       ========    ========
Shares used in computing net income
  per share                                             13,368       12,153        8,152          6,716       6,716
                                                     =========    =========     ========       ========    ========
Operating Data:
Number of stores at end of period(1)                       863          750          352            108          93
Adjusted EBITDA(8)                                   $  20,542    $   8,766     $  3,902       $    757    $  1,298
Increase (decrease) in same-store revenues (9)            (1.0%)        0.0%        14.3%          13.7%       22.3%
</TABLE>
    

<TABLE>

<CAPTION>
    

                                                                               December 31                   
                                                       January 5      --------------------------------     March 31
                                                         1997         1995         1994          1993      1993(3)
                                                     ---------------------------------------------------------------
<S>                                                 <C>          <C>          <C>             <C>         <C>              
Balance Sheet Data(1):
Cash and cash equivalents                            $   3,982    $   6,255    $   3,723       $    408    $    586
Videocassette rental inventory, net                     89,929       72,979       27,138          7,455       5,054
Total assets                                           261,577      233,479       76,647         13,446       9,552
Long-term debt, less current maturities                 67,883       19,622        6,681          4,104       4,581
Total liabilities                                      114,853       97,340       29,652         10,988       8,655
Stockholders' equity                                   146,724      136,139       46,995          2,458         897

                                       16
<PAGE>
<FN>
----------------------------
          (1)  Statement  of  income  data for all  periods  presented  has been
     restated to include the results of Home Vision Entertainment,  Inc., ("Home
     Vision") and Hollywood Video, Inc. ("Hollywood Video"), which were acquired
     in two separate  pooling-of-interests  transactions  on July 1, 1996.  Home
     Vision  reported on a fiscal year ending  September 30 and Hollywood  Video
     reported on a calendar  year basis.  The  Company's  results for the fiscal
     year ended  January 5, 1997 are  combined  with  results of Home Vision and
     Hollywood  Video  for  the  period  January  1,  1996  to the  date  of the
     acquisitions.  The results of the Company and Hollywood Video for the years
     ending  December 31, 1995 and 1994 are combined with Home Vision's  results
     for the  years  ending  September  30,  1995 and  1994,  respectively.  The
     Company's  results for the nine months ended December 31, 1993 are combined
     with Home  Vision's  results  for the year  ended  September  30,  1993 and
     Hollywood Video's results for the year ended December 31, 1993.  Results of
     the  Company  for the year  ended  March 31,  1993 are  combined  with Home
     Vision's  results for the year ended  September  30,  1992 (the  effects of
     recasting  financial  results  within 93 days of the fiscal year end of the
     Company are not material) and Hollywood  Video's results for the year ended
     December 31, 1992.  Balance  sheet data has also been  restated  consistent
     with the  statement  of income data except the  December  31, 1995  balance
     sheet data  includes  that of Home Vision at December  31, 1995  instead of
     September  30,  1995.  In order to conform  with the fiscal year end of the
     Company,  Home  Vision's  net  loss of  $2,082,000  for the  quarter  ended
     December 31, 1995 is not  reflected in the  statement of income data but is
     reflected in  stockholders'  equity at December 31, 1995. The ending number
     of stores for each period  presented has been restated to include the store
     counts of Home Vision and Hollywood Video.
(2)  The  provision  for income tax  includes pro forma  adjustments  to reflect
     income tax expense which would have been  recognized  if the Company,  Home
     Vision and Hollywood Video had been taxed as C corporations for all periods
     presented.  Historical  operating  results of the Company,  Home Vision and
     Hollywood  Video do not include  any  provision  for income  taxes prior to
     August 2, 1994,  October 1, 1994,  and July 1, 1996,  respectively,  due to
     their S corporation status prior to those dates.
(3)  General and  administrative  expenses  and income  taxes  include pro forma
     adjustments for the change in  compensation  levels arising from employment
     contracts with two stockholders who are executive officers of the Company.
(4)  Effective April 1, 1993, the Company changed its fiscal year end from March
     31 to  December  31 and  adopted a change  in  accounting  relating  to the
     amortization of new release inventory. The change in accounting relating to
     amortization increased operating income by $1.4 million for the nine months
     ended December 31, 1993.
(5)  On July 1, 1996,  the  Company  adopted a fiscal  year  ending on the first
     Sunday following December 30, which  periodically  results in a fiscal year
     of 53 weeks. The 1996 fiscal year, ended on January 5, 1997,  reflects a 53
     week year.
(6)  Includes a  non-recurring charge of approximately $10.4 million for store
     closures, corporate restructuring and merger-related expenses.
(7)  Effective  April 1, 1996,  the  Company  changed  its method of  amortizing
     videocassette rental inventory resulting in a one-time,  non-cash charge of
     approximately $7.7 million.
(8)  "Adjusted  EBITDA" is earnings before  interest,  taxes,  depreciation  and
     amortization,  excluding non-recurring charges, less the Company's purchase
     of videocassette rental inventory.  Included in the Company's videocassette
     rental  inventory  purchases  for the fiscal year ended  January 5, 1997 is
     $5.7 million associated with inventory purchases specifically for new store
     openings.  Adjusted EBITDA does not take into account capital expenditures,
     other  than  purchases  of  videocassette  rental  inventory,  and does not
     represent  cash  generated  from  operating  activities in accordance  with
     generally accepted accounting  principles ("GAAP"), is not to be considered
     as an alternative to net income or any other GAAP measurements as a measure
     of operating  performance  and is not  indicative of cash available to fund
     all cash needs.  The  Company's  definition  of Adjusted  EBITDA may not be
     identical  to similarly  titled  measures of other  companies.  The Company
     believes that in addition to cash flows and net income,  Adjusted EBITDA is
     a useful  financial  performance  measurement  for  assessing the operating
     performance  of the  Company  because,  together  with net  income and cash
     flows,  Adjusted  EBITDA  is  widely  used in the  videocassette  specialty
     retailing  industry  to  provide  investors  with an  additional  basis  to
     evaluate  the  ability of the  Company to incur and service its debt and to
     fund  acquisitions.  To evaluate Adjusted EBITDA and the trends it depicts,
     the components of Adjusted EBITDA, such as net revenues,  cost of services,
     and sales, general and administrative expenses,  should be considered.  See
     "Management's Discussion and Analysis of Financial Condition and Results of
     Operations."
(9)  For periods prior to 1994,  same-store revenue was defined as the aggregate
     revenues  from  stores  operated  by the  Company  for the  entirety of the
     periods  being  compared.  Beginning in 1994,  stores were  included in the
     calculation  once they had been  operated  by the  Company  for at least 13
     months.  Same-store  revenues  for the  Company  have not been  restated to
     include the same-store revenues of Home Vision and Hollywood Video.
</FN>
</TABLE>

                                       17

<PAGE>

ITEM 7.  MANAGEMENT'S  DISCUSSION  AND ANALYSIS OF FINANCIAL  CONDITION AND
         RESULTS OF OPERATIONS

Overview


The  Company  has  experienced  rapid  growth in revenue  and  operating  income
primarily as a result of acquiring stores and opening new stores.  The number of
stores  operated  by the  Company  at the end of each of the  following  periods
increased as follows:


                        December 31, 1993               108
                        December 31, 1994               352
                        December 31, 1995               750
                        January 5, 1997                 863

The results of operations for all periods presented include the combined results
of the Company,  Home Vision  Entertainment,  Inc. ("Home Vision") and Hollywood
Video, Inc.  ("Hollywood  Video").  The combined  98-store  acquisitions of Home
Vision and Hollywood Video were consummated on July 1, 1996 and accounted for as
poolings-of-interests.  The above store count totals reflect the combined totals
of Movie  Gallery,  Inc.,  Home  Vision  and  Hollywood  Video  for all  periods
presented.


During the fiscal year ended  January 5, 1997 ("Fiscal  1996"),  174 stores were
acquired  (including  the 98 stores  acquired in the Home  Vision and  Hollywood
Video  transactions),  85 stores were developed by the Company (75 of which were
developed by Movie Gallery, Inc.) and 48 stores were closed.

As a result of the 697 store  acquisitions  during the  periods  January 1, 1994
through  July 1, 1996,  the  Company  recorded  $95.6  million in  goodwill  and
acquisition-related  costs, which are being amortized over twenty years from the
effective  date of each  acquisition.  The Company also  recorded an  additional
$15.4 million in deferred charges related to  noncompetition  agreements,  which
are being amortized over periods varying from two to ten years.

On July 1, 1996,  the Company  adopted a fiscal year which will end on the first
Sunday following December 30. This change will result in the Company having a 52
or 53-week year. Fiscal 1996 was a 53-week year.


Effective   April  1,  1996,  the  Company  changed  its  method  of  amortizing
videocassette  rental  inventory  (which  includes video games and audio books).
Under the new method, new release  videocassettes are amortized as follows:  (i)
copies one through three of each title per store are  considered  base stock and
are amortized over thirty-six  months on a  straight-line  basis to a $5 salvage
value; and (ii) the fourth and any succeeding copies of each title per store are
amortized on a straight-line  basis over six months to an average net book value
of $5,  which is then  amortized on a  straight-line  basis over the next thirty
months or until the  videocassette  is sold, at which time the unamortized  book
value is  charged  to cost of sales.  Management  believes  that the new  method
results in a better matching of expenses with revenues in the Company's  current
operating  environment  and that it is  compatible  with  changes  made by other
companies in the industry.

During Fiscal 1996, the Company adopted a business  restructuring  plan to close
approximately 50 of its stores and reduce the corporate  organizational staff by
approximately  15%. The  restructuring  plan  resulted in a $9.6 million  pretax
restructuring  charge  recorded  in  the  third  quarter  of  Fiscal  1996.  The
components of the restructuring  charge included  approximately  $5.4 million in
reserves for future cash outlays for lease terminations,  miscellaneous  closing
costs and legal and accounting  costs, as well as approximately  $4.2 million in
asset write downs. Approximately $807,000 of costs were paid and charged against
the  liability  during Fiscal 1996.  Additionally,  during the third quarter the
Company incurred  merger-related costs of approximately  $757,000 related to the
acquisition of Home Vision and Hollywood Video.


                                       18
<PAGE>



The provision for income taxes includes pro forma  adjustments to reflect income
tax expense  which would have been  recognized  if the Company,  Home Vision and
Hollywood  Video had been taxed as C  corporations  for all  periods  presented.
Historical operating results of the Company,  Home Vision and Hollywood Video do
not include any provision  for income taxes prior to August 2, 1994,  October 1,
1994, and July 1, 1996, respectively, due to their S corporation status prior to
those dates.

With  respect to  forward-looking  statements  contained  in this Item 7, please
review the disclosures set forth under "Cautionary Statements" in Item 1 above.

Results of Operations

The following table sets forth, for the periods  indicated,  statement of income
data,  expressed as a percentage of total revenue, and the number of stores open
at the end of each period. The store count and the operating results reflect the
combined operations of Movie Gallery,  Inc., Home Vision and Hollywood Video for
all periods.
<TABLE>

6.  Statement of Income Data
<CAPTION>

                                                                        Year Ended
                                                            ------------------------------------
                                                            January 5   December 31  December 31
                                                              1997         1995         1994(1)
                                                            ------------------------------------
<S>                                                          <C>         <C>          <C>
Revenues:
  Rentals                                                      86.1%       87.4%        89.8%
  Product sales                                                13.9        12.6         10.2
                                                             ------      ------       ------
Total                                                         100.0       100.0        100.0
                                           
Operating Costs and Expenses:
  Store operating expenses                                     48.9        45.4         45.3
  Amortization of videocassette rental inventory(2)            25.0        19.5         19.3
  Amortization of intangibles                                   2.8         2.3          1.1
  Cost of sales                                                 8.3         8.4          7.6
  General and administrative                                    8.0         9.1         10.6
  Restructuring and other charges                               3.8          --           --
                                                             ------      ------       ------
Total                                                          96.8        84.7         83.9
                                                             ------      ------       ------
Operating income                                                3.2        15.3         16.1
Non-operating expense, net                                     (2.2)       (1.0)        (0.8)
                                                             ------      ------       ------
Income before income taxes                                      1.0        14.3         15.3
Income taxes(3)                                                 0.4         5.3          5.6
                                                             ------      ------       ------
Net income                                                      0.6%        9.0%         9.7%
                                                             ======      ======       ======
Number of stores at end of period                               863         750          352
                                                             ======      ======       ======
<FN>
---------------------------
(1)  General and  administrative  expenses  and income  taxes  include pro forma                               
     adjustments for the change in  compensation  levels arising from employment                                            
     contracts with two stockholders who are executive officers of the Company.    
(2)  Effective  April 1, 1996,  the  Company  changed  its method of  amortizing
     videocassette rental inventory resulting in a one-time,  non-cash charge of
     approximately $7.7 million.
(3)  The provision for income taxes  includes pro forma  adjustments  to reflect
     income tax expense which would have been  recognized  if the Company,  Home
     Vision and Hollywood Video had been taxed as C corporations for all periods
     presented.  Historical  operating  results of the Company,  Home Vision and
     Hollywood  Video do not include  any  provision  for income  taxes prior to
     August 2, 1994,  October 1, 1994,  and July 1, 1996,  respectively,  due to
     their S corporation status prior to those dates.
</FN>
</TABLE>

                                       19
<PAGE>


Year ended January 5, 1997 compared to the year ended December 31, 1995 ("Fiscal
1995")

Revenue.  Total revenue  increased  70.5% to $254.4 million for Fiscal 1996 from
$149.2  million  for Fiscal  1995.  The  increase  was due to an increase in the
number of stores in  operation  from 352 at January 1, 1995 to 863 at January 5,
1997, and the  maturation of the developed  store base  throughout  Fiscal 1996,
partially  offset by a decrease in  same-store  revenues of 1%. The  decrease in
same-store  revenues was primarily a result of unusually dry weather  during the
second  quarter,  the  negative  impact of the Summer  Olympics and the negative
impact of a reduction in rental inventory  purchases as a percentage of revenues
during the first three quarters of Fiscal 1996 versus Fiscal 1995. Product sales
increased as a percentage of total  revenues to 13.9% for Fiscal 1996 from 12.6%
for Fiscal 1995, as a result of (i) an increase in the  availability  and number
of major hits (e.g.,  "Independence  Day",  "Mission  Impossible" and "The Nutty
Professor")  and other new  release  titles  priced  by the  movie  studios  for
"sell-through"  merchandising,   (ii)  the  Company's  continued  and  increased
emphasis  on the  sale of  previously  viewed  rental  inventory,  and  (iii) an
increase  in the  variety  of  other  products  sold in  stores,  such as  video
accessories and confectionery items.

Operating  Costs and Expenses.  Store operating  expenses,  which reflect direct
store expenses such as lease payments and in-store  payroll,  increased to 48.9%
of total  revenue for Fiscal 1996 from 45.4% for Fiscal  1995.  The  increase in
store  operating  expenses was primarily  due to (i) higher rental  payments and
other expenses in many of the recently  acquired  stores,  (ii) higher operating
expenses  as a  percentage  of revenues in the  Company's  immature,  internally
developed stores, and (iii) the decrease in same-store revenues for the year.

Amortization  of  videocassette  rental  inventory  increased as a percentage of
revenue to 25.0% for Fiscal 1996 from 19.5% for Fiscal 1995 due primarily to the
change  in  amortization  policy as of April 1, 1996  (described  in  "Overview"
above).  The  application of the new method of amortizing  videocassette  rental
inventory also resulted in a one-time, non-recurring increase in amortization of
$7.7 million during Fiscal 1996. Had the new amortization  policy been in effect
prior to January 1, 1995,  amortization of  videocassette  rental inventory as a
percentage of revenue would have been 23.2% for Fiscal 1995.

Amortization  of  intangibles  as a percentage of revenue  increased to 2.8% for
Fiscal 1996 from 2.3% for Fiscal 1995 due to an increase in goodwill recorded as
a result of the  acquisition  activity  of the Company  accounted  for under the
purchase method of accounting during 1995 and 1996.

Cost of sales includes the costs of new videocassettes,  confectionery items and
other  goods,  as well as the  unamortized  value of  previously  viewed  rental
inventory  sold in the  Company's  stores.  Cost of  sales  increased  with  the
increased  revenue from product  sales and  decreased as  percentage of revenues
from  product  sales from 66.9% for Fiscal  1995 to 59.7% for Fiscal  1996.  The
increase in product sales gross margins resulted  primarily from (i) an increase
in the sale of previously  viewed rental  inventory,  which generally  generates
higher margins than other product categories, and (ii) an increase in margins on
sell-through products.

                                       20
<PAGE>

General and  administrative  expenses decreased as a percentage of revenues from
9.1% for  Fiscal  1995 to 8.0% for Fiscal  1996.  Excluding  $757,000  in merger
related  expenses  associated with the acquisitions of Home Vision and Hollywood
Video, general and administrative  expenses would have been 7.7% of revenues for
Fiscal 1996.  The decrease is primarily due to operating  efficiencies  attained
through a larger revenue base.

As a result of the above,  operating  income decreased to $8.2 million in Fiscal
1996 from $22.8  million in Fiscal 1995.  Excluding  the effects of the business
restructuring  plan,  the one-time  non-recurring  increase in  amortization  of
videocassette  rental inventory due to the change in amortization policy and the
merger-related  expenses from the Home Vision and Hollywood Video  acquisitions,
operating income would have been $26.2 million.

Year ended  December  31,  1995  compared  to the year ended  December  31, 1994
("Fiscal 1994")

Revenue.  Revenue  increased 180.3% to $149.2 million for Fiscal 1995 from $53.2
million for Fiscal  1994.  The  increase was due to an increase in the number of
stores in  operation  from 108 at January 1, 1994 to 750 at December  31,  1995.
Product sales  increased as a percentage  of total  revenues to 12.6% for Fiscal
1995 from 10.2% for Fiscal 1994 as a result of (i) an increased  emphasis on the
sale of previously  viewed rental  inventory,  (ii)  increased  availability  of
"sell-through"  titles,  primarily  due to an  increase of  available  major hit
titles   (including   "The  Lion  King")   priced  by  the  movie   studios  for
"sell-through"  merchandising,  and (iii) an increase in the variety of products
sold in stores,  such as movie  memorabilia and confectionery  items. 

Operating  Costs and Expenses.  Store operating  expenses,  which reflect direct
store expenses such as lease payments and in-store payroll,  increased  slightly
as a percentage  of revenue from 45.3% for Fiscal 1994 to 45.4% for Fiscal 1995.
The net  percentage  change in these  expenses was  primarily  the result of the
positive impact of reduced  in-store payroll costs resulting from more efficient
scheduling  of  store  employees,  counterbalanced  by the  negative  impact  of
increased rent expense due to the  integration of developed and acquired  stores
into the Company's base.

Amortization  of  videocassette  rental  inventory  increased as a percentage of
revenue to 19.5% for Fiscal  1995 from 19.3% for Fiscal  1994 due to an increase
in purchasing levels as a percentage of revenues.

Amortization  of  intangibles  increased as a percentage of revenues to 2.3% for
Fiscal  1995  from  1.1%  for  Fiscal  1994  due to the  substantial  number  of
acquisitions  which occurred  subsequent to August 1994 and which were accounted
for by the purchase method of accounting.

Cost of sales  decreased as a percentage  of product sales from 73.8% for Fiscal
1994 to 66.9% for Fiscal 1995.  The increase in gross margins from product sales
resulted from an increase in margins on hit titles priced for  sell-through  and
from an  increase  in the  sale  of  previously  viewed  rental  inventory,  the
unamortized value of which is expensed to cost of sales and generally  generates
higher margins than other product categories.

General and  administrative  expenses decreased as a percentage of revenues from
10.6% for Fiscal  1994 to 9.1% for  Fiscal  1995 due to  operating  efficiencies
attained through a larger revenue base.

                                       21
<PAGE>

Liquidity and Capital Resources


Historically,  the  Company's  primary  capital  needs have been for opening and
acquiring  new stores and for the  purchase of  videocassette  inventory.  Other
capital  needs  include the  remodeling of existing  stores,  the  relocation of
existing  stores and the continued  upgrading and  installation of the Company's
POS system and management  information systems. The Company has funded inventory
purchases,  remodeling  and  relocation  programs,  new store  opening costs and
acquisitions  primarily  from cash flow from  operations,  the  proceeds  of two
public equity  offerings,  loans under  revolving  credit  facilities and seller
financing.

During  Fiscal 1996,  the Company  generated  $20.5  million in Adjusted  EBITDA
versus  $8.8  million for Fiscal  1995.  "Adjusted  EBITDA" is  earnings  before
interest, taxes, depreciation and amortization,  excluding non-recurring charges
and less the Company's purchase of videocassette  rental inventory.  Included in
the Company's  videocassette  rental inventory purchases for Fiscal 1996 is $5.7
million associated with inventory purchases specifically for new store openings.
Adjusted  EBITDA does not take into  account  capital  expenditures,  other than
purchases  of  videocassette  rental  inventory,  and  does not  represent  cash
generated  from  operating  activities in  accordance  with  generally  accepted
accounting principles ("GAAP"), is not to be considered as an alternative to net
income or any other GAAP measurements as a measure of operating  performance and
is not indicative of cash available to fund cash needs. The Company's definition
of Adjusted  EBITDA may not be identical to similarly  titled  measures of other
companies.  The Company  believes that in addition to cash flows and net income,
Adjusted EBITDA is a useful financial performance  measurement for assessing the
operating performance of the Company because,  together with net income and cash
flows,  Adjusted EBITDA is widely used in the videocassette  specialty retailing
industry to provide  investors with an additional  basis to evaluate the ability
of the Company to incur and service its debt and to fund acquisitions.

Net cash provided by operating  activities  was $91.8 million for Fiscal 1996 as
compared to $61.3  million for Fiscal 1995.  The increase was  primarily  due to
higher  net  income  before  depreciation  and  amortization  and  the  non-cash
restructuring charge discussed above.

Net cash used in  investing  activities  was $104.8  million  for Fiscal 1996 as
compared to $154.8  million  for Fiscal  1995.  This  decrease in funds used for
investing  activities  is  primarily  the result of a decrease in the total cash
expended for stores  acquired  during Fiscal 1996 versus Fiscal 1995,  partially
offset by a net  increase in the  purchase  of  videocassette  rental  inventory
resulting from the Company's growth.

Net cash  provided by  financing  activities  decreased  from $96.3  million for
Fiscal 1995 to $10.7  million for Fiscal 1996.  This  decrease was primarily the
result of a common stock public  offering  during  Fiscal 1995, as well as a net
increase in total debt of $33.8  million in Fiscal  1995 versus a $10.2  million
net increase in debt for Fiscal 1996.

During  Fiscal 1996,  the Company  replaced  its existing $60 million  revolving
credit  facility with a $125 million  reducing  revolving  credit  facility (the
"Facility").  The  Facility has a maturity  date of June 30, 2000.  The interest
rate of the  Facility is  LIBOR-based  and the Company may repay the Facility at
any time without  penalty.  The Facility has covenants  that restrict  borrowing
based upon cash flow  levels.  At January 5, 1997,  $67 million was  outstanding
under the Facility with additional availability of approximately $11.3 million.

The Company  grows its store base  through  internally  developed  and  acquired
stores and  requires  capital  in excess of  internally  generated  cash flow to
achieve its desired growth. To the extent available,  future acquisitions may be
completed  using  funds  available  under the  Facility,  financing  provided by
sellers,  alternative  financing  arrangements such as funds raised in public or
private  debt or  equity  offerings.  However,  there can be no  assurance  that
financing will be available to the Company on terms which will be acceptable, if
at all. During Fiscal 1996, the Company issued an aggregate of 1,273,467  shares
of its common stock in connection with the acquisition of 154 additional stores,
which includes the acquisitions of Home Vision and Hollywood Video.

                                       22
<PAGE>

At January 5, 1997, the Company had a working  capital deficit of $12.6 million,
due  to  the  accounting   treatment  of  its  videocassette  rental  inventory.
Videocassette  rental inventory is treated as a noncurrent asset under generally
accepted  accounting  principles  because it is not an asset which is reasonably
expected to be completely realized in cash or sold in the normal business cycle.
Although  the  rental  of this  inventory  generates  the major  portion  of the
Company's revenue, the classification of this asset as noncurrent results in its
exclusion from working capital. The aggregate amount payable for this inventory,
however,  is reported as a current  liability  until paid and,  accordingly,  is
included in working  capital.  Consequently,  the Company  believes that working
capital is not an appropriate  measure of its liquidity and it anticipates  that
it will continue to operate with a working capital deficit.

The Company believes its projected cash flow from operations, borrowing capacity
with the  Facility,  cash on hand and trade  credit will  provide the  necessary
capital to fund its current plan of  operations  for Fiscal 1997,  including its
anticipated new store openings.  However,  to fund a resumption of the Company's
acquisition  program,  or to provide funds in the event that the Company's  need
for funds is greater  than  expected,  or if certain  of the  financing  sources
identified  above are not available to the extent  anticipated or if the Company
increases  its  growth  plan,  the  Company  will  need  to seek  additional  or
alternative  sources of financing.  This financing may not be available on terms
satisfactory to the Company.  Failure to obtain  financing to fund the Company's
expansion  plans or for other purposes  could have a material  adverse effect on
the Company.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         Reference  is made to Part  IV,  Item  14 of  this  Form  10-K  for the
information required by Item 8.

ITEM 9.  CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                  AND FINANCIAL DISCLOSURE

         None.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         The  information  required  by this Item  (other  than the  information
regarding  executive  officers  set forth at the end of Item 1 of Part I of this
Form 10-K) will be contained in the Company's definitive Proxy Statement for its
1997 Annual Meeting of Stockholders, and is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

         The  information  required  by  this  Item  will  be  contained  in the
Company's   definitive   Proxy   Statement  for  its  1997  Annual   Meeting  of
Stockholders, and is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The  information  required  by  this  Item  will  be  contained  in the
Company's   definitive   Proxy   Statement  for  its  1997  Annual   Meeting  of
Stockholders, and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The  information  required  by  this  Item  will  be  contained  in the
Company's   definitive   Proxy   Statement  for  its  1997  Annual   Meeting  of
Stockholders, and is incorporated herein by reference.

 
                                      23
<PAGE>

                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

         (a)(1) Financial Statements:

             Report of Independent Auditors

             Consolidated  Balance Sheets as of Janaury 5, 1997 and December 31,
         1995.
             Consolidated  Statements  of  Income  for the  Fiscal  Years  Ended
         January 5, 1997 and December 31, 1995 and 1994.

             Consolidated  Statements  of  Stockholders'  Equity  for the Fiscal
         Years Ended Janaury 5, 1997 and December 31, 1995 and 1994.
  
             Consolidated  Statements  of Cash Flows for the Fiscal  Years Ended
         January 5, 1997 and December 31, 1995 and 1994.
     
             Notes to Consolidated Financial Statements

         (a)(2) Schedules:

             None.

         (a)(3) Exhibits

         The following exhibits,  which are furnished with this Annual Report or
incorporated herein by reference, are filed as part of this Annual Report:

Exhibit              Exhibit Description
  No.

 3.1 - Certificate  of  Incorporation  of the  Company.(1) 
 3.2 - Bylaws  of the Company.(1)
 4.1 - Specimen Common Stock Certificate.(2)
10.1 - 1994 Stock  Option Plan,  as amended and form of Stock Option  Agreement.
       (filed herewith) 
10.2 - Form of Indemnity Agreement.(1) 
10.3 - Stock Purchase  Agreement  dated June 30, 1995 between The Movie Shop and
       M.G.A., Inc.(3)
10.4 - Asset  Purchase  Agreement  dated  August 3, 1995 between  Indiana  Video
       Limited Liability  Company and FGS Enterprises,  Inc. d/b/a Box Office
       Video and M.G.A., Inc.(4)
10.5 - Asset Purchase Agreement dated August 15, 1995 between John Day and Jane
       Day, d/b/a The Video Connection, J & J Enterprises and The  Video  
       Connection, Inc. and  M.G.A., Inc.(4)
10.6 - Agreement of Merger dated November 29, 1995 between TSC, Inc. of Virginia
       and Video World of Virginia, Inc., a subsidiary of Movie Gallery, Inc.(5)
10.7 - Agreement of Merger dated November 29, 1995 between TSC, Inc. of Richmond
       and Video World of Virginia, Inc., a subsidiary of Movie Gallery, Inc.(5)
10.8 - Agreement of Merger dated June 5, 1996 between Home Vision Entertainment,
       Inc. and Movie Gallery, Inc. and Amendment to Agreement of Merger dated 
       June 28, 1996. (6)

                                       24

<PAGE>

10.9 - Agreement dated March 13, 1997 between Sight & Sound Distributors, Inc.
       and  Movie  Gallery,  Inc.(filed  herewith)(portions  have  been  omitted
       pursuant to a request for confidential treatment)
10.10- Employment Agreement between M.G.A., Inc. and Joe Thomas Malugen.(1)
10.11- Employment Agreement between M.G.A., Inc. and H. Harrison Parrish. (1)
10.12- Consulting  Agreement  between  William B. Snow and  M.G.A.,  Inc.  dated
       December 12, 1996. (filed herewith)
10.13- Real estate lease dated June 1, 1994 between J.T.  Malugen,  H. Harrison
       Parrish and M.G.A., Inc.(1)
10.14- Real estate  lease dated June 1, 1994  between H.  Harrison  Parrish and
       M.G.A., Inc.(1)
10.15- Tax  Agreement  between  M.G.A.,  Inc.  and Joe T.  Malugen and Harrison
       Parrish.(1)
10.16- Certificate  of Title dated October 6, 1992 and United States Patent and
       Trademark Office Notice of Recordation of Assignment  Document dated 
       January 27, 1993 (relating to the Company's acquisition of the "Movie
       Gallery" service mark, trade name and goodwill associated therewith).(7)
10.17- Credit Agreement between First Union National Bank of North Carolina and
       Movie Gallery, Inc. dated July 10, 1996. (6)
11   - Computation of Earnings Per Share. (filed herewith)
18   - Change in Accounting Principle. (8)
21   - List of Subsidiaries. (filed herewith)
23   - Consent of Ernst & Young LLP. (filed herewith)
27   - Financial Data Schedule. (filed herewith)
---------------
(1) Previously  filed with the  Securities  and Exchange  Commission on June 10,
    1994, as exhibits to the Company's  Registration Statement on Form S-1
    (File No. 33-80120). 
(2) Previously  filed with the  Securities and Exchange  Commission on August 1,
    1994, as an exhibit to Amendment No. 2 to the Company's  Registration
    Statement on Form S-1.
(3) Previously  filed with the  Securities  and Exchange  Commission on July 14,
    1995, as an exhibit to the Company's  Current Report on Form 8-K. 
(4) Previously filed with the  Securities  and Exchange  Commission  on August
    18, 1995, as an exhibit to the Company's Current Report on Form 8-K.
(5) Previously filed with the Securities and Exchange Commission on December 13,
    1995, as an exhibit to the Company's Current Report on Form 8-K.
(6) Previously  filed with the  Securities  and Exchange  Commission on July 15,
    1996, as an exhibit to the Company's Current Report on Form 8-K.
(7) Previously  filed with the  Securities  and Exchange  Commission on July 14,
    1994, as exhibits to Amendment No. 1 to the Company's  Registration
    Statement on Form S-1.
(8) Previously  filed with the Securities and Exchange  Commission on August 14,
    1996, as an exhibit to the Company's  Form 10-Q for the quarter ended 
    September 29, 1996.

         (b)      Reports on Form 8-K:

         The  Company  did not file any  reports on Form 8-K during the  quarter
ended Janaury 5, 1997.

         (c)      Exhibits:

         See (a)(3) above.

                                       25
<PAGE>



SIGNATURES

      Pursuant  to the  requirements  of Section  13 or 15(d) of the  Securities
Exchange  Act of 1934,  the  Registrant  has duly caused this  amendment  to its
annual  report to be signed on its  behalf by the  undersigned,  thereunto  duly
authorized.

                                               MOVIE GALLERY, INC.



                                                By /s/ JOE THOMAS MALUGEN
                                                   Joe Thomas Malugen,
                                                   Chairman of the Board
                                                   and Chief Executive Officer

Date:  April 7, 1997


      Pursuant to the requirements of the Securities  Exchange Act of 1934, this
amendment to report has been signed below by the following  persons on behalf of
the Registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>

                  Signature                      Title                                     Date
                  ---------                      -----                                     ----

<S>                                    <C>                                            <C>

/s/ JOE THOMAS MALUGEN                  Chairman of the Board and Chief                April 7, 1997
-----------------------------------------Executive Officer 
Joe Thomas Malugen                       

 /s/ WILLIAM B. SNOW                                                           
-----------------------------------------Vice Chairman of the Board                    April 7, 1997    
William B. Snow
 
 /s/ J. STEVEN ROY                       Senior Vice President and Chief               April 7, 1997
-----------------------------------------Financial Officer 
J. Steven Roy                            

 /s/ STEVEN M. HAMIL                     Vice President and Chief Accounting           April 7, 1997
-----------------------------------------Officer
Steven M. Hamil                          

 /s/ H. HARRISON PARRISH                                                              
-----------------------------------------Director and President                        April 7, 1997 
H. Harrison Parrish

 /s/ JOSEPH F. TROY                                                             
-----------------------------------------Director                                      April 7, 1997
Joseph F. Troy

</TABLE>

                                       26

<PAGE>








                               Movie Gallery, Inc.

                          Index to Financial Statements

                                                                    Page

Report of Independent Auditors.........................              F-1
Consolidated Balance Sheets............................              F-2
Consolidated Statements of Income......................              F-3
Consolidated Statements of Stockholders' Equity........              F-4
Consolidated Statements of Cash Flows..................              F-5
Notes to Consolidated Financial Statements.............              F-6




<PAGE>








                         Report of Independent Auditors

Board of Directors and Stockholders
Movie Gallery, Inc.

We have audited the accompanying  consolidated  balance sheets of Movie Gallery,
Inc., as of January 5, 1997 and December 31, 1995, and the related  consolidated
statements of income,  stockholders'  equity and cash flows for the fiscal years
ended January 5, 1997,  December 31, 1995 and 1994.  These financial  statements
are the  responsibility of the Company's  management.  Our  responsibility is to
express an opinion on these financial statements based on our audits. We did not
audit the  financial  statements of Home Vision  Entertainment,  Inc., an entity
acquired  and  accounted  for as a  pooling-of-interest  on July 1, 1996,  which
statements  reflect total assets  constituting  8.6% in 1995 and total  revenues
constituting  12% in 1995 and 17% in 1994 of the  related  consolidated  totals.
Those  statements were audited by other auditors whose report has been furnished
to us, and our opinion,  insofar as it relates to data  included for Home Vision
Entertainment,  Inc.  for 1995 and 1994,  is based  solely on the  report of the
other auditors.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.

In our opinion,  based on our audits and, for 1995 and 1994, the report of other
auditors,  the financial  statements  referred to above present  fairly,  in all
material respects, the consolidated financial position of Movie Gallery, Inc. at
Janaury 5, 1997 and  December  31,  1995,  and the  consolidated  results of its
operations  and its cash  flows for the  fiscal  years  ended  January  5, 1997,
December 31, 1995 and 1994, in conformity  with  generally  accepted  accounting
principles.

As discussed in Note 1 to the financial statements,  in 1996 the Company changed
its method of accounting for amortization of videocassette rental inventory.


                                            /s/Ernst & Young LLP

Birmingham, Alabama
February 12, 1997
                                      F-1
<PAGE>
<TABLE>


                               Movie Gallery, Inc.
                     
                           Consolidated Balance Sheets
                                 (in thousands)
<CAPTION>

                                                         January 5  December 31
                                                            1997       1995
                                                         ---------------------- 

<S>                                                      <C>        <C>
Assets
Current assets:     
   Cash and cash equivalents                              $  3,982   $  6,255
   Recoverable income tax                                      224      1,278
   Merchandise inventory                                    11,181     10,989
   Accounts receivable                                         494      1,933
   Store supplies and other                                  2,947      2,113
   Deferred income taxes                                       913         --
                                                          --------   --------
Total current assets                                        19,741     22,568
Videocassette rental inventory, net                         89,929     72,979
Property, furnishings and equipment, net                    50,196     41,437
Deferred charges, net                                       11,151     11,567
Excess of cost over net assets acquired, net                87,822     82,963
Deposits and other assets                                    2,738      1,965
                                                          --------   --------
Total assets                                              $261,577   $233,479
                                                          ========   ========

Liabilities and stockholders' equity
Current liabilities:
   Notes payable                                          $     --   $ 32,052
   Accounts payable                                         24,321     24,332
   Accrued liabilities                                       7,622      4,751
   Current portion of long-term debt                           374      6,390
                                                          --------   --------
Total current liabilities                                   32,317     67,525
Long-term debt                                              67,883     19,622
Other accrued liabilities                                    2,425         --
Deferred income taxes                                       12,228     10,193
Stockholders' equity:
   Preferred stock, $.10 par value; 2,000,000 shares
     authorized, no shares issued and outstanding               --         --
   Common stock, $.001 par value; 30,000,000
     shares authorized, 13,420,791 and 12,877,236
     shares issued and outstanding                              13         13
   Additional paid-in capital                              131,686    122,582
   Retained earnings                                        15,025     13,544
                                                          --------   --------
Total stockholders' equity                                 146,724    136,139
                                                          --------   --------
Total liabilities and stockholders' equity                $261,577   $233,479
                                                          ========   ========

See accompanying notes. 
</TABLE>
                                      F-2
<PAGE>
<TABLE>

                               Movie Gallery, Inc.

                        Consolidated Statements of Income
                      (in thousands, except per share data)


<CAPTION>
                                                                  Year Ended
                                                    -------------------------------------
                                                     January 5   December 31  December 31
                                                       1997         1995         1994
                                                    ------------------------------------
<S>                                                <C>           <C>           <C>   
Revenues:
   Rentals                                          $ 219,002    $ 130,353       $ 47,782
   Product sales                                       35,393       18,848          5,441
                                                    ---------    ---------       -------- 
                                                      254,395      149,201         53,223

Operating costs and expenses:   
   Store operating expenses                           124,456       67,758         24,119
   Amortization of videocassette rental inventory      63,544       29,102         10,263
   Amortization of intangibles                          7,160        3,380            606
   Cost of sales                                       21,143       12,600          4,018
   General and administrative                          20,266       13,525          5,420
   Restructuring and other charges                      9,595           --             --
                                                    ---------    ---------       --------  
Operating income                                        8,231       22,836          8,797

Non-operating income (expense):
   Interest income                                         99          539            211
   Interest expense                                    (5,718)      (2,067)          (697)
   Other, net                                              --           --             58
                                                    ---------    ---------       --------      
Income before income taxes                              2,612       21,308          8,369
Income taxes                                            1,131        8,893          3,348
                                                    ---------    ---------       --------
Net income                                          $   1,481    $  12,415       $  5,021
                                                    =========    =========       ========

Pro forma net income per share (unaudited):
Income before income taxes                          $   2,612    $  21,308       $  8,369
Pro forma increase in compensation expense                 --           --           (227)
                                                    ---------    ---------       --------
Pro forma income before income taxes                    2,612       21,308          8,142
Pro forma income taxes                                  1,006        7,871          2,991
                                                    ---------    ---------       --------
Pro forma net income                                $   1,606    $  13,437       $  5,151
                                                    =========    =========       ========  
Pro forma net income per share                      $     .12    $    1.11       $    .63
                                                    =========    =========       ========

Shares used in computing pro forma
  net income per share (in thousands)                  13,368       12,153          8,152
                                                    =========    =========       ========

See accompanying notes.
 
</TABLE>
                                      F-3
<PAGE>


<TABLE>

                               Movie Gallery, Inc.

                 Consolidated Statements of Stockholders' Equity
                                 (in thousands)
   
<CAPTION>
                                                                  Additional                 Total
                                                       Common      Paid-in     Retained   Stockholders'
                                                        Stock      Capital     Earnings     Equity
                                                     --------------------------------------------------
<S>                                                  <C>           <C>         <C>           <C>
Balance at December 31, 1993                           $  7         $  191      $ 2,308      $  2,506
    Net income                                           --             --        5,021         5,021
    Dividends                                            --             --       (2,688)       (2,688)
    Sale of 3,450,000 shares of common stock,
       net of issuance costs of $1,567                    3         43,348           --        43,351
    Transactions by pooled companies:
      Issuance of 115,513 shares of common stock
         as compensation expense                         --            235           --           235
      Stock repurchase                                   --             --         (930)         (930)
      Dividends                                          --             --         (500)         (500)
                                                       ----       --------       ------      --------
Balance at December 31, 1994                             10         43,774        3,211        46,995
    Net income                                           --             --       12,415        12,415
    Sale of 2,500,000 shares of common stock,
       net of issuance costs of $936                      3         61,389           --        61,392
    Issuance of 279,863 shares of common stock
      for acquisitions, net of issuance costs of $62     --          9,688           --         9,688
    Exercise of stock options for 129,000 shares         --          1,833           --         1,833
    Tax benefit of stock options exercised               --          1,120           --         1,120
    Transactions by pooled companies:
      Issuance of 301,442 shares of common stock
        for acquisitions                                 --          3,921           --         3,921
      Issuance of warrants                               --            857           --           857
    Adjustment for change in fiscal year end of 
       pooled company                                    --             --       (2,082)       (2,082)
                                                       ----       --------      -------      --------   
Balance at December 31, 1995                             13        122,582       13,544       136,139
    Net income                                           --             --        1,481         1,481
    Issuance of 508,455 shares of common stock for
      acquisitions, net of issuance costs of $322        --          8,386           --         8,386
    Exercise of stock options for 35,100 shares          --            524           --           524
    Tax benefit of stock options exercised               --            218           --           218
    Transactions by pooled companies:
       Other                                             --            (24)          --           (24)
                                                       ----       --------      -------      --------  
Balance at January 5, 1997                             $ 13       $131,686      $15,025      $146,724
                                                       ====       ========      =======      ========

See accompanying notes.
</TABLE>


                                      F-4
<PAGE>
<TABLE>

                               Movie Gallery, Inc.

                      Consolidated Statements of Cash Flows
                                 (in thousands)

<CAPTION>
                                                                         Year Ended
                                                            --------------------------------------
                                                             January 5   December 31   December 31
                                                               1997          1995         1994
                                                            --------------------------------------
<S>                                                        <C>          <C>            <C>
Operating activities
Net income                                                  $   1,481    $  12,415       $  5,021
Adjustments to reconcile net income to net cash
  provided by operating activities:
    Depreciation and amortization                              79,625       36,991         12,391
    Deferred income taxes                                         822        7,428          3,034
    Restructuring and other charges                             9,595           --             --
    Other  adjustments                                             --           --            255
 Changes in operating assets and liabilities:
    Recoverable income tax                                      1,272          654           (811)
    Merchandise inventory                                         (43)      (5,185)        (3,270)
    Other current assets                                          339       (2,077)          (562)
    Deposits and other assets                                    (978)      (1,567)           (50)
    Accounts payable                                           (1,649)       9,609          6,815
    Accrued liabilities                                         1,336        3,003            622
                                                             --------     --------       --------    
Net cash provided by operating activities                      91,800       61,271         23,445

Investing activities
Business acquisitions                                          (8,662)     (83,403)       (36,627)
Purchases of videocassette rental inventory                   (77,666)     (51,061)       (17,117)
Purchases of property, furnishings and equipment              (18,438)     (20,355)        (7,627)
                                                             --------     --------       -------- 
Net cash used in investing activities                        (104,766)    (154,819)       (61,371)

Financing activities
Net proceeds from issuance of common stock                        524       63,482         43,431
Net proceeds from (payments on) notes payable                 (32,052)      28,293          3,310
Proceeds from issuance of long-term debt                       72,938       10,070          2,964
Principal payments on long-term debt                          (30,717)      (4,584)        (6,000)
Dividends paid                                                   --           (996)        (2,464)
                                                             --------     --------       --------     
Net cash provided by financing activities                      10,693       96,265         41,241
                                                             --------     --------       --------


(Decrease) increase in cash and cash equivalents               (2,273)       2,717          3,315
Decrease in cash and cash equivalents to conform
   fiscal year end of pooled companies                             --         (185)            --
Cash and cash equivalents at beginning of period                6,255        3,723            408
                                                             --------     --------       --------
Cash and cash equivalents at end of period                   $  3,982     $  6,255       $  3,723
                                                             ========     ========       ======== 


Supplemental disclosures of cash flow
   information
Cash paid during the period for interest                    $   5,377    $   1,834       $    649
Cash paid during the period for income taxes                      203          764          1,156
Noncash investing and financing information:
   Assets acquired by issuance of notes payable                    --       10,012          5,375
   Assets acquired by issuance of common stock                  8,708       13,671             --
   Tax benefit of stock options exercised                         218        1,120             --

See accompanying notes.
</TABLE>

                                      F-5
<PAGE>




                               Movie Gallery, Inc.

                   Notes to Consolidated Financial Statements

                                 January 5, 1997

1.  Accounting Policies

The  accompanying   financial  statements  present  the  consolidated  financial
position,  results of  operations  and cash  flows of Movie  Gallery,  Inc.  and
subsidiaries   (the   "Company").   All  material   intercompany   accounts  and
transactions have been eliminated.

The Company's  historical  financial  statements for all periods  presented have
been restated to include the financial position,  results of operations and cash
flows of Home Vision  Entertainment,  Inc. ("Home Vision") and Hollywood  Video,
Inc.    ("Hollywood    Video"),    merger   transactions    accounted   for   as
poolings-of-interests (see note 2).

The Company owns and operates  video  specialty  stores in 23 states,  generally
located in the eastern half of the United States.

Fiscal Year

On July 1, 1996,  the Company  adopted a fiscal year ending on the first  Sunday
following December 30, which periodically  results in a fiscal year of 53 weeks.
Results for 1996 reflect a 53 week year ended on January 5, 1997.  The Company's
fiscal year includes revenues and certain operating expenses,  such as salaries,
wages and other  miscellaneous  expenses,  on a daily basis  through  January 5,
1997.  All  other  expenses,   primarily  depreciation  and  amortization,   are
calculated  and recorded  monthly,  with twelve  months  included in each fiscal
year.

Reclassifications

Certain  reclassifications have been made to the prior year financial statements
to conform to the current  year  presentation.  These  reclassifications  had no
impact on stockholders' equity or net income.

Cash Equivalents

The Company  considers  all highly liquid  investments  with a maturity of three
months or less when purchased to be cash equivalents.

Merchandise Inventory

Merchandise  inventory consists primarily of videocassette tapes and video games
purchased  for resale and  concessions  and is stated at the lower of cost, on a
first-in first-out basis, or market.

Long-Lived Assets

During the first  quarter of 1996,  the Company  adopted the  provisions of FASB
Statement No. 121,  "Accounting for the Impairment of Long-Lived  Assets and for
Long-Lived  Assets to Be Disposed Of," which  requires  impairment  losses to be
recorded  on  long-lived  assets used in  operations  and  deferred  charges and
goodwill when  indicators of impairment  are present and the  undiscounted  cash
flows  estimated  to be  generated  by those  assets  are less than the  assets'


                                      F-6
<PAGE>




                               Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)



1.  Accounting Policies (continued)

carrying  amounts.  Statement 121 also  addresses the  accounting for long-lived
assets that are  expected to be disposed of. The effect of adoption of Statement
121 was not material.

Videocassette Rental Inventory

Videocassette  rental  inventory  is  recorded  at cost and  amortized  over its
economic useful life. Effective April 1, 1996, the Company changed its method of
amortizing  videocassette rental inventory (which includes video games and audio
books).  Under the new method,  videocassettes  considered  to be base stock are
amortized over thirty-six months on a straight-line basis to a $5 salvage value.
New release  videocassettes  are  amortized  as follows:  (i) the fourth and any
succeeding copies of each title per store are amortized on a straight-line basis
over six months to an average net book value of $5 which is then  amortized on a
straight-line  basis over the next thirty months or until the  videocassette  is
sold, at which time the unamortized  book value is charged to cost of sales; and
(ii)  copies one  through  three of each title per store are  amortized  as base
stock.  Management  believes the new method will result in a better  matching of
expenses with revenues in the Company's current  operating  environment and that
it is compatible with changes made by its primary competitors.

The new method of  amortization  has been applied to all inventory held at April
1, 1996. The adoption of the new method of  amortization  has been accounted for
as a change in accounting estimate effected by a change in accounting principle.
The application of the new method of amortizing  videocassette  rental inventory
increased  depreciation expense and cost of sales for the quarter ended June 30,
1996 by approximately  $7.7 million.  For the fiscal year ended January 5, 1997,
the adoption of the new method of amortization  had the effect of decreasing net
income by approximately $4.9 million or $0.37 per share.

Videocassette rental inventory consists of the following (in thousands):
<TABLE>
<CAPTION>

                                               January 5   December 31
                                                  1997         1995
                                               ---------    ---------

<S>                                           <C>          <C>      
Videocassette rental inventory                 $ 183,264    $ 113,016
Less accumulated amortization                    (93,335)     (40,037)
                                               ---------    ---------
                                               $  89,929    $  72,979
                                               =========    =========
</TABLE>


Property, Furnishings and Equipment

Property,  furnishings  and  equipment  are  stated  at cost and  include  costs
incurred in the  development  and  construction  of new stores.  Depreciation is
provided  on a  straight-line  basis  over the  estimated  lives of the  related
assets, generally five to seven years.

                                      F-7

<PAGE>

                             Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)



1.  Accounting Policies (continued)

Deferred Charges

Deferred charges consist  primarily of non-compete  agreements and are amortized
on a straight-line basis over the lives of the respective agreements which range
from two to ten years.  Accumulated  amortization of deferred charges at January
5, 1997 and December 31, 1995 was $4,128,000 and $1,868,000, respectively.

Excess of Cost Over Net Assets Acquired

The excess of cost over net assets  acquired at January 5, 1997 and December 31,
1995  is  net  of  accumulated   amortization   of  $7,111,000  and  $2,544,000,
respectively, and is being amortized on a straight-line basis over twenty years.

Videocassette Rental Revenue

Rental revenue is recognized when the  videocassette  or video game is rented or
when  returned  by the  customer,  depending  upon the  market  in which a store
operates.

Advertising Costs

Advertising costs,  exclusive of cooperative  reimbursements  from vendors,  are
expensed when incurred.

Store Opening Costs

Store opening costs,  which consist  primarily of payroll and  advertising,  are
expensed as incurred.

Pro Forma Earnings Per Share

Pro forma net income per share is based on the weighted average number of shares
of common  stock and common  stock  equivalents  outstanding  during the periods
presented.  Common stock equivalents  include the effects of shares to be issued
upon the exercise of dilutive common stock options.

Fair Value of Financial Instruments

At January 5, 1997 and  December  31,  1995,  the  carrying  value of  financial
instruments such as cash and cash equivalents,  accounts payable,  notes payable
and long-term debt approximated  their fair values,  calculated using discounted
cash flow analysis at the Company's incremental borrowing rate.

Use of Estimates

The preparation of financial  statements in conformity  with generally  accepted
accounting principles requires management to make estimates and assumptions that
affect  the  amounts  reported  in the  consolidated  financial  statements  and
accompanying notes. The most significant estimates and assumptions relate to the
provision for business  restructuring (see note 3) and the amortization  methods


                                      F-8

<PAGE>

                             Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


1.  Accounting Policies (continued)

and useful lives of videocassette rental inventory,  deferred charges and excess
of cost over net assets acquired.  These estimates and assumptions  could change
and actual results could differ from these estimates.

Unaudited Pro Forma Information

Income  before  income taxes for the year ended  December  31, 1994  reflects an
adjustment  for the change in  compensation  levels  arising from the employment
agreements with certain stockholders which became effective as of the completion
of the Company's initial public offering of common stock on August 2, 1994.

Pro forma  income  taxes  reflect  income  tax  expense  which  would  have been
recognized  if  the  Company,  Home  Vision  and  Hollywood  Video  had  been  C
corporations  for all periods  presented.  Historical  operating  results of the
Company, Home Vision and Hollywood Video do not include any provision for income
taxes prior to August 2, 1994, October 1, 1994, and July 1, 1996,  respectively,
due to their S corporation status prior to those dates.

Weighted  average shares through August 1, 1994 include the assumed  issuance of
196,603  shares  at the  initial  public  offering  price  of $14  to  fund  the
distribution of  undistributed S corporation  earnings  subsequent to the public
offering.

2.  Acquisitions

During 1996, the Company  acquired 76 video specialty  stores in 20 transactions
with unrelated sellers for $21,447,000, including the issuance of 505,094 shares
of common stock.  The excess of the cost over estimated fair value of the assets
acquired was $9,726,000.

During 1995, the Company  acquired 327 video specialty stores in 55 transactions
with unrelated sellers for $99,383,000,  including the issuance of $9,323,000 in
notes payable and 279,863  shares of common  stock.  The excess of the cost over
estimated fair value of the assets acquired was $60,380,000.

During 1994, the Company  acquired 196 video specialty stores in 27 transactions
with unrelated sellers for $42,004,000,  including the issuance of $5,375,000 in
notes payable and options to purchase  210,000  shares of common stock under the
1994 Stock Option Plan (see note 7) at a price equal to the fair market value at
the date of issuance.  The excess of the cost over the  estimated  fair value of
the assets acquired was $19,361,000.

Businesses  acquired during the periods discussed above were accounted for under
the purchase method of accounting and are included in the Company's consolidated
financial statements from the dates of acquisition.

On July 1,  1996,  the  Company  acquired  Home  Vision in a merger  transaction
accounted for as a  pooling-of-interests,  pursuant to which the Company  issued
approximately 731,000 shares of its common stock to Home Vision shareholders and
assumed  approximately $12.5 million in liabilities.  At the time of the merger,
Home Vision  operated 55 video  specialty  stores in Maine,  New  Hampshire  and
Massachusetts.  During  1994  and  1995,  Home  Vision  acquired  various  video
specialty  store chains with an  aggregate  net  purchase  price of  $7,234,000,

                                      F-9

<PAGE>


                             Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


2.  Acquisitions (continued)

including the issuance of $689,000 in notes payable and 301,442 shares of common
stock.  The excess of the cost over estimated fair value of the assets  acquired
was $6,120,000.

On July 1, 1996, the Company  acquired  Hollywood Video in a merger  transaction
accounted for as a  pooling-of-interests,  pursuant to which the Company  issued
approximately  38,000 shares of its common stock to Hollywood Video shareholders
and  assumed  approximately  $11.5  million in  liabilities.  At the time of the
merger,  Hollywood Video operated 43 video specialty  stores in Iowa,  Wisconsin
and Illinois.

Prior to the merger,  Home Vision  reported on a fiscal year ending on September
30 and  Hollywood  Video  reported  on a calendar  year  basis.  The Home Vision
statements  of  operations  for the years ended  September 30, 1995 and 1994 are
combined with the statements of operations  for the Company and Hollywood  Video
for the years ended  December  31, 1995 and 1994.  The  combined  balance  sheet
includes the December  31, 1995 balance  sheet for the Company,  Home Vision and
Hollywood  Video.  In order to conform with the Company's  fiscal year end, Home
Vision's  results of operations  for the quarter  ended  December 31, 1995 which
reflected revenues of $6,506,000,  operating  expenses of $9,374,000  (including
$1,974,000 of costs  associated  with a failed initial public  offering) and net
loss of $2,082,000,  are included in the Company's  retained earnings balance at
December 31, 1995.

Separate  results of operations of the merged  entities for the periods prior to
the merger date are as follows (in thousands) (unaudited):
<TABLE>
<CAPTION>

                          Six Months Ended             Year Ended
                               June 30         December 31     December 31
                                1996              1995             1994
                         ----------------    ------------      -----------
<S>                          <C>               <C>              <C> 
Revenues:
  Movie Gallery               $ 106,307         $ 123,143         $ 38,643
  Home Vision                    11,191            18,024            9,298
  Hollywood Video                 5,307             8,034            5,282
                              ---------         ---------         --------
Combined                      $ 122,805         $ 149,201         $ 53,223
                              =========         =========         ========

Net income (loss):
  Movie Gallery               $   3,106         $  14,486         $  4,965
  Home Vision                       (97)             (366)             545
  Hollywood Video                  (986)           (1,705)            (489)
                              ---------         ---------         --------
Combined                      $   2,023         $  12,415         $  5,021
                              =========         =========         ========

</TABLE>


                                      F-10

<PAGE>


                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


2.  Acquisitions (continued)

Costs of approximately  $757,000  incurred by the Company in connection with the
Home  Vision and  Hollywood  Video  mergers  have been  included  in general and
administrative  expenses in the consolidated  statement of income for the fiscal
year ended January 5, 1997.

The following unaudited pro forma information  presents the consolidated results
of operations of the Company as though the  aforementioned  acquisitions,  which
were  accounted for as purchases and have  occurred  since January 1, 1995,  had
occurred as of the beginning of the year in which the  acquisition  occurred and
the beginning of the immediately preceding year (in thousands,  except per share
data):
<TABLE>
<CAPTION>
                                             Year Ended
                                 -----------------------------------
                                 January 5   December 31 December 31
                                   1997         1995         1994
                                 -----------------------------------                               

<S>                             <C>         <C>         <C>      
Revenues                         $ 261,223   $ 241,815   $ 205,351
Net income                           2,521      20,796      16,454
Net income per share                  0.19        1.61        1.65
</TABLE>

3.  Provision for Business Restructuring

During the third  quarter of 1996 the Company  began and  completed an extensive
analysis of both its store base  performance  and  organizational  structure and
adopted a business  restructuring  plan to close  approximately 50 of its stores
and reduce the  corporate  organizational  staff by  approximately  15  percent.
Management  concluded  that certain stores were  underperforming  and it was not
prudent to continue to operate  these  locations.  These store  closings are not
concentrated in a particular  geographic area. The principal factors  considered
in  identifying  stores for  closure  included:  (i)  whether a store  generated
sufficient  cash flow at the store  level to  provide  an  acceptable  return on
current  investment;  (ii) whether the latest  sales  trends  indicated a likely
improvement in the historical store results; (iii) whether the current or future
competitive  climate had made sales improvements less likely; and (iv) whether a
store's  performance  warranted  lease  renewal where the lease was scheduled to
expire within the next year.

This  analysis  has  resulted in the Company  recording  a $9.6  million  pretax
restructuring  charge  in the  third  quarter  of 1996.  The  components  of the
restructuring  charge include  approximately $5.4 million in reserves for future
cash outlays for lease terminations,  miscellaneous  closing costs and legal and
accounting  costs,  as well as  approximately  $4.2 million in asset write downs
(see below). In some situations, the timing of store closures will depend on the
Company's  ability to negotiate  reasonable lease  termination  agreements.  The
lease commitments associated with the closing stores will be retired entirely or
materially diminished by one of three methods: (i) through the normal expiration
of the lease within the next year;  (ii) through the  subletting of the property
to  another  entity;  or  (iii)  through  a  negotiated  lease  buyout  with the
individual landlord.  The store closures are expected to be completed by the end
of  fiscal  year  1997.  Approximately  $807,000  of  lease  termination  costs,
miscellaneous  closing  costs and legal costs were paid and charged  against the
liability for the fiscal year ended January 5, 1997.  The stores  identified for
closure had revenues and operating losses of approximately $4.5 million and $0.2
million, respectively, for the year ended December 31, 1995 and $6.2 million and
$1.6 million, respectively, for the fiscal year ended January 5, 1997. Operating

                                      F-11

<PAGE>

                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


3.  Provision for Business Restructuring (continued)

results for the year ended  December 31, 1994 are not  comparable as most stores
identified for closure were opened or acquired in late 1994 or 1995.

In  conjunction  with the  business  restructuring,  an  estimated  $4.2 million
impairment  loss was  incurred  for  those  stores  identified  to  close  where
projected operating  performance  indicated an impairment.  This impairment loss
related  primarily  to the  write-off of  leasehold  improvements,  fixtures and
intangibles  and  a  valuation  allowance  for  videocassette  rental  inventory
associated with the stores to be closed.

4.  Property, Furnishings and Equipment

Property, furnishings and equipment consists of the following (in thousands):
<TABLE>
<CAPTION>

                                       January 5   December 31
                                          1997        1995
                                       ----------------------- 

<S>                                    <C>         <C>     
Land and buildings                      $  1,879    $  1,879
Furniture and fixtures                    26,932      20,592
Equipment                                 18,963      14,747
Leasehold improvements and signs          18,766      12,386
                                        --------    --------
                                          66,540      49,604
Accumulated depreciation                 (16,344)     (8,167)
                                        --------    --------
                                        $ 50,196    $ 41,437
                                        ========    ========
</TABLE>

5.  Long-Term Debt

On July 10, 1996, the Company  entered into a Credit  Agreement with First Union
National  Bank of North  Carolina  with respect to a reducing  revolving  credit
facility (the "Facility"). The Facility is unsecured, provides borrowings for up
to $125 million and replaced the  Company's  previously  existing line of credit
agreement.

The available  amount of the Facility will reduce  quarterly  beginning on March
31,  1998 with a final  maturity  of June 30,  2000.  The  interest  rate of the
Facility is LIBOR-based  (7.5% at January 5, 1997) and the Company may repay the
Facility at any time  without  penalty.  The more  restrictive  covenants of the
Facility  restrict  borrowings based upon cash flow levels.  At January 5, 1997,
$67 million was outstanding and approximately  $11.3 million of the $125 million
commitment was available for borrowing  under the Facility.  Based on the amount
currently  outstanding,  scheduled maturities of the facility are $35,750,000 in
fiscal year 1999 and $31,250,000 in fiscal year 2000.

In connection  with certain  acquisitions,  the Company  issued or assumed notes
payable which had outstanding  balances of $1,257,000 and $10,781,000 at January
5,  1997 and  December  31,  1995,  respectively.  Generally,  these  notes  are
unsecured,  require  monthly  or  annual  payments  and have  fixed or  variable
interest rates ranging from 6% to 9%. At December 31, 1995,  long-term debt also
included  balances  totaling  $15,231,000  related to Home Vision and  Hollywood

                                      F-12

<PAGE>

                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


5.  Long-Term Debt (continued)

Video.  Substantially all of these notes were paid subsequent to consummation of
the merger transactions with proceeds from the Facility. Scheduled maturities of
long-term debt are as follows:  $374,000 in 1997,  $395,000 in 1998, $253,000 in
1999, and $235,000 in 2000.

6.  Income Taxes

The Company's  earnings for the period April 1, 1992 through August 1, 1994 were
taxed directly to the Company's stockholders due to the Company's election to be
taxed as an S  corporation  under the Internal  Revenue  Code.  The  Company's S
corporation  status terminated  immediately prior to its initial public offering
of common  stock on August 2, 1994.  Accordingly,  the Company  was  required to
provide for  deferred  taxes,  arising  from  cumulative  temporary  differences
between financial and tax reporting, by recognizing a provision for income taxes
of $1,300,000 in the third quarter of fiscal 1994. Additionally, during portions
of the  periods  presented,  Home  Vision  and  Hollywood  Video were taxed as S
corporations rather than C corporations (see note 1).

The following  reflects  unaudited pro forma income tax expense that the Company
would have  incurred had it, Home Vision and  Hollywood  Video (see note 1) been
subject to federal and state income  taxes for the entire  fiscal years ended as
follows (in thousands):
<TABLE>
<CAPTION>

                                             Year Ended
                                -------------------------------------
                                January 5    December 31   December 31
                                   1997          1995        1994
                                -------------------------------------
                                  (unaudited pro forma information)
<S>                             <C>            <C>         <C>   
Current payable: 
    Federal                      $   90         $1,328      $  444
    State                            --            136          47
                                 ------         ------      ------ 
Total current                        90          1,464         491

Deferred:
    Federal                         831          5,692       2,260
    State                            85            715         240
                                 ------         ------      ------  
Total deferred                      916          6,407       2,500
                                 ------         ------      ------
                                 $1,006         $7,871      $2,991
                                 ======         ======      ======

</TABLE>

                                      F-13
<PAGE>

                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


6.  Income Taxes (continued)

A  reconciliation  of income tax at the federal income tax rate to the Company's
pro forma effective income tax provision is as follows (in thousands):
<TABLE>
<CAPTION>

                                                         Year Ended
                                           -------------------------------------------
                                           Janaury 5     December 31       December 31
                                              1997          1995               1994
                                           -------------------------------------------
                                                  (unaudited pro forma information)

<S>                                         <C>             <C>               <C>   
Income tax at statutory rate                $  888           $7,245            $2,845
State income taxes, net of federal
   income tax benefit                           85              615               146
Other, net                                      33               11                --
                                            --------         ------            ------
                                            $1,006           $7,871            $2,991
                                            ========         ======            ======
</TABLE>


At January  5,  1997,  the  Company  had net  operating  loss  carryforwards  of
$9,531,000  for income taxes that expire in years 2010 through 2011.  $5,564,000
of these  carryforwards  resulted from the Company's  acquisition of Home Vision
(see note 2). Utilization of the net operating loss carryforwards related to the
Home Vision acquisition may be subject to a substantial annual limitation due to
the statutory provisions of the Internal Revenue Code.

Deferred  income  taxes  reflect  the net tax effects of  temporary  differences
between the carrying  amounts of assets and liabilities for financial  reporting
purposes  and the amounts used for income  taxes.  Components  of the  Company's
deferred tax assets and liabilities are as follows (in thousands):
<TABLE>
<CAPTION>
                                                       January 5    December 31
                                                         1997          1995
                                                       ------------------------
<S>                                                   <C>            <C>  
Deferred tax liabilities:
  Videocassette rental inventory                       $ 14,847      $  12,993
  Furnishings and equipment                               4,286          2,236
  Excess of cost over fair value of assets acquired       1,519            710
  Other                                                     694            142
                                                        -------        ------- 
     Total deferred tax liabilities                      21,346         16,081
Deferred tax assets:
  Non-compete agreements                                  4,318          3,559
  Net operating loss carryforwards                        3,527          2,225
  Alternative minimum tax credit carryforward               275             --
  Accrued liabilities                                     1,911            104
                                                        -------        -------
     Total deferred tax assets                           10,031          5,888
                                                        -------        -------
Net deferred tax liabilities                            $11,315        $10,193
                                                        =======        =======
</TABLE>


                                      F-14
<PAGE>


                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


7.  Stockholders' Equity

Common Stock

In 1995, the Company  registered shares of common stock with an aggregate public
offering  price of  $127,000,000.  This  common  stock may be  offered  directly
through  agents,  underwriters  or dealers or may be offered in connection  with
business  acquisitions.  As of January 5, 1997,  common  stock of  approximately
$83,000,000 was available to be issued from this registration.

As of January  5,  1997,  the  Company  had  warrants  outstanding  to  purchase
approximately 100,000 shares of the Company's common stock,  exercisable through
June 30, 2000 at an exercise price of $30.11.

Stock Repurchase

On  September  30, 1994,  Home Vision  reacquired  153,494  shares of its no par
common  stock from its  stockholders  for an  estimated  fair value of $930,000,
which included Home Vision forgiving  $80,000  outstanding on a note receivable,
paying  $450,000 in cash  subsequent  to year end, and issuing a five year,  8%,
related party note payable for $400,000.

Stock Option Plan

On July  1994,  the Board of  Directors  adopted,  and the  stockholders  of the
Company approved, the 1994 Stock Option Plan (the "Plan"). The Plan provides for
the award of incentive stock options,  stock appreciation  rights,  bonus rights
and  other   incentive   grants  to  employees,   independent   contractors  and
consultants.  During 1996 the Company increased the shares reserved for issuance
under the Plan from 1,250,000 to 1,750,000.  Options granted under the Plan have
a 10-year term and generally vest over 5 years.

In October 1995, the Financial  Accounting  Standards Board issued  Statement of
Accounting Standards No. 123,  "Accounting for Stock-Based  Compensation" ("SFAS
123").  In accordance  with the provisions of SFAS 123, the Company  applies APB
Opinion No. 25 and related  Interpretations  in accounting  for its stock option
and purchase plans and,  accordingly,  has not recognized  compensation  cost in
connection with such plans. If the Company had elected to recognize compensation
cost based on the fair value of the options  granted at grant date as prescribed
by SFAS 123,  net income and net income per share would have been reduced to the
pro forma  amounts  indicated in the table  below.  The effect on net income and
earnings per share is not expected to be indicative of the effects on net income
and earnings per share in future years.
<TABLE>
<CAPTION>
                                                  Year Ended
                                        ------------------------------
                                        January 5          December 31
                                            1997               1995
                                        ------------------------------
                                    (in thousands, except per share data)

<S>                                     <C>                <C>      
Pro forma net income                     $   218            $  11,220
Pro forma net income per share               .02                  .92

</TABLE>

                                      F-15
<PAGE>

                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


7.  Stockholders' Equity (continued)

The fair value of each option grant was estimated at the date of grant using the
Black-Scholes   option   pricing  model  with  the  following   weighted-average
assumptions:
<TABLE>
<CAPTION>

                                                         Year Ended
                                                ---------------------------
                                                January 5       December 31
                                                   1997            1995
                                                ---------------------------

<S>                                              <C>              <C>  
Expected volatility                               0.607            0.607
Risk-free interest rate                           6.34%            6.50%
Expected life of options in years                 6.0              6.0
Expected dividend yield                           0.0%             0.0%
</TABLE>

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded  options which have no vesting  restrictions  and are fully
transferable.  In addition,  option valuation models require the input of highly
subjective  assumptions  including the expected stock price volatility.  Because
the  Company's  employee  stock  options  have   characteristics   significantly
different from those of traded  options,  and because  changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion,  the  existing  models do not  necessarily  provide a  reliable  single
measure of the fair value of its employee stock options.

A summary of the Company's stock option activity,  and related information is as
follows:
<TABLE>
<CAPTION>

                                                                             Year Ended
                                        -----------------------------------------------------------------------------------
                                             January 5, 1997              December 31, 1995           December 31, 1994
                                        ---------------------------    ------------------------   -------------------------
                                                   Weighted Average            Weighted-Average            Weighted-Average
                                          Options   Exercise Price     Options  Exercise Price    Options   Exercise Price
                                          -------  ----------------    ------- ----------------   -------- ----------------- 
<S>                                    <C>          <C>             <C>         <C>             <C>         <C>    
Outstanding-beginning
  of year                               1,107,450   $   24.63          699,000   $  14.88              --     $    --
Granted                                   379,500       14.15          578,000      34.19         716,000       14.87
Exercised                                  35,100       14.92          129,000      14.21              --          --
Forfeited                                 133,200       23.58           40,550      25.94          17,000       14.39

Outstanding-end of year                 1,318,650       21.98        1,107,450      24.63         699,000       14.88

Exercisable at end of year                622,125       21.28          424,150      20.41         210,500       14.49

Weighted-average fair value
  of options granted during
  the year                                $  8.84                    $   21.39

</TABLE>


                                      F-16
<PAGE>


                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


7.  Stockholders' Equity (continued)

Options  outstanding  as of  January  5, 1997 had a  weighted-average  remaining
contractual  life of 8.6 years and exercise prices ranging from $14.00 to $42.63
as follows:
<TABLE>
<CAPTION>
                                                             Exercise price of
                                                  $14.00 to $21.25       $21.26 to $42.63
                                                  ---------------------------------------
<S>                                                 <C>                   <C>       
Options outstanding                                    833,950               484,700
Weighted-average exercise price                         $14.65                $34.58
Weighted-average remaining contractual life          8.6 years             8.5 years
Options exercisable                                    401,475               220,650
Weighted-average exercise price of
   exercisable options                                  $15.00                $32.71
</TABLE>
                                               
8.  Commitments and Contingencies

Rent  expense for the fiscal  years ended  January 5, 1997 and December 31, 1995
and 1994 totaled $37,266,000,  $19,960,000 and $6,425,000,  respectively. Future
minimum  payments under  noncancellable  operating  leases which contain renewal
options and escalation clauses (primarily for videocassette  rental stores) with
remaining  terms in excess of one year  consisted of the following at January 5,
1997 (in thousands):

      
                  1997                $  28,547
                  1998                   25,924
                  1999                   19,420
                  2000                   11,710
                  2001                    6,126
                  Thereafter             11,989
                                      ---------
                                      $ 103,716
                                      =========


The Company has entered into a ten year agreement with Rentrak Corporation which
requires  the  Company  to order  videocassette  rental  inventory  under  lease
sufficient  to require an  aggregate  minimum  payment  of  $3,000,000  per year
(beginning  in 1997) in revenue  share,  handling  fees,  sell  through fees and
end-of-term buyout fees.

The Company is occasionally involved in litigation in the ordinary course of its
business,  none of which,  individually or in the aggregate,  is material to the
Company's business or results of operations.

9.  Related Party Transactions

During the years ended December 31, 1995 and 1994, the Company  purchased  signs
totaling  $1,683,000  and  $491,000,  respectively,  from a company in which two
officers who are also stockholders of the Company held a majority interest prior
to January 1, 1996.

The Company paid  $260,000,  $650,000  and$598,000  in legal fees for the fiscal
years ended January 5, 1997 and December 31, 1995 and 1994,  respectively,  to a
law firm of which one of the Company's directors is a member.

                                      F-17
<PAGE>

                              Movie Gallery, Inc.

             Notes to Consolidated Financial Statements (continued)


10.  Summary of Quarterly Results of Operations (Unaudited)

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

                                                                          Fourteen Weeks
                                                Thirteen Weeks Ended           Ended
                                         -----------------------------------------------
                                          March 31    June 30  September 29  January 5
                                            1996       1996       1996         1997
                                         -----------------------------------------------

<S>                                     <C>         <C>         <C>          <C>     
Revenue                                  $ 62,500    $ 60,305    $ 61,728     $ 69,862
Operating income (loss)                     9,475      (3,100)     (5,804)       7,660
Pro forma net income (loss)                 5,160      (2,762)     (4,487)       3,695
Pro forma net income per share                .39        (.21)       (.33)         .28
</TABLE>
<TABLE>
<CAPTION>
                                                           Quarter Ended
                                         ------------------------------------------------
                                          March 31   June 30    September 30  December 31
                                            1995       1995        1995          1995
                                         ------------------------------------------------

<S>                                     <C>         <C>          <C>         <C>      
Revenue                                  $ 28,270    $ 30,494     $ 40,373    $  50,064
Operating income                            4,883       4,596        6,253        7,104
Pro forma net income                        2,842       2,980        3,681        3,934
Pro forma net income per share                .28         .24          .28          .30


</TABLE>





                                      F-18

<PAGE>







                                               Index to Exhibits


Exhibit No.  Description                                                      

    10.1     1994 Stock Option Plan, as amended and
             forms of Stock Option Agreement

    10.9     Agreement dated March 13, 1997 between
             Sight & Sound Distributors, Inc. and  Movie Gallery, Inc.
             (portions have been omitted purusant to a request for confidential
              treatment)

    10.12    Consulting Agreement between William B. Snow
             and M.G.A., Inc. dated December 12, 1996

    11       Computation of Earnings Per Share

    21       List of Subsidiaries

    23       Consent of Ernst & Young LLP

    27       Financial Data Schedule