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 4, 1998

                                       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 March 13, 1998, was approximately  $55,146,581.  The number
of shares of Common Stock outstanding on March 13, 1998, was 13,420,685 shares.

Documents incorporated by reference:

  1. Notice of 1998 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. [X]


                                       1
<PAGE>

ITEM 1.  BUSINESS

General

     As of March  13,  1998,  Movie  Gallery,  Inc.  (the  "Company")  owned and
operated  852 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 is
among the four largest video retailers in the United States.

     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 home video rental and sales industry has grown from $0.7 billion in
revenue in 1982 to a projected  $16.3  billion in 1997 and is projected to reach
$21.1  billion  by 2006.  Paul Kagan  estimates  that in 1997  consumers  rented
approximately  3 billion videos and purchased more than 600 million  videos.  In
fact,  Adams Media  Research  estimates  that 85.0% of  America's  96.6  million
television  households  have  videocassette  recorders,  a  percentage  which is
expected to exceed 90% by 2002.

     The  video  retail  industry  is  highly  fragmented  and  is  experiencing
increased consolidation.  Recent trends toward consolidation have been fueled by
the  competitive  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.

     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.

                                       2
<PAGE>

     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 total number of stores occurred  through the acquisition of
stores and the balance  occurred  through  the  development  of new stores.  The
Company spent all of 1997 and expects to spend much of 1998  absorbing the large
increase  in the number of stores  which began in 1994.  The Company  expects to
begin gradually  accelerating its growth rate in late 1998. It is expected that,
in the future,  development of new stores will account for a substantial portion
of the Company's  growth.  The Company's  ability to resume this growth strategy
will be dependent upon its ability to generate cash flow from  operations and 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 13, 1998,  the Company has
developed 219 stores.  The Company utilizes store  development to complement its
existing base of stores in rural and secondary markets where it finds attractive
locations and a sufficient  population  to support  additional  video  specialty
stores.   The  Company  attempts  to  locate  stores  primarily  in  towns  with
populations from 3,000 to 60,000.  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.

     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 January 1, 1994.

<TABLE>
<CAPTION>
                                        Fiscal        Fiscal
                        Year Ended    Year Ended    Year Ended    January 5
                       December 31     January 5     January 4   to March 13
                       1994   1995       1997          1998         1998
                       ----   ----       ----          ----         ----
<S>                   <C>    <C>        <C>           <C>          <C>

New Store Openings      25     66         75            50            3
Stores Acquired        196    327        174(1)          2            0
Stores Closed            2     23         48            59            7
Total Stores at End
   of Period           292    662        863           856          852

<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>
                                       3
<PAGE>


     Acquisitions.  From  January 1, 1994 through  March 13,  1998,  the Company
acquired 699 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 latter  portion of the third  quarter 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 late 1998,  although  the
Company does not anticipate acquiring stores at its 1994-1996 levels.

     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.

     The Company  continues to have  preliminary  discussions with the owners of
video retail  businesses.  While the Company currently has no formal 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 or 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 release videocassettes. 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 and
around 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 local store
and  district  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  visually  appealing  stores.  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 4,000
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 13, 1998,  the Company owned and operated 852 stores,  all but one
of  which  were  located  in  leased  premises.  The  following  table  provides
information  at March 13, 1998 regarding the number of Company stores located in
each state.
                                             Number
                                               of
                                             Stores
                                             ======

                    Alabama                   144
                    Florida                   110
                    Texas                      88
                    Georgia                    65
                    Virginia                   56
                    Ohio                       49
                    Maine                      44
                    Tennessee                  44
                    Wisconsin                  33
                    Indiana                    32
                    South Carolina             31
                    Mississippi                28
                    North Carolina             23
                    Missouri                   22
                    Kentucky                   19
                    Kansas                     18
                    Louisiana                  15
                    New Hampshire              12
                    Illinois                   10
                    Massachusetts               4
                    Iowa                        3
                    Michigan                    2
                                              ---
                              TOTAL           852
                                              ===

     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
television  monitors  displaying  MGTV (Movie Gallery  Television),  which shows
movie previews and promotions of coming attractions, and by 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 Quality Assurance Auditors located in different  geographic regions make
periodic  visits to monitor  compliance and report results to the Company's Vice
President - Support  Services.  District  Managers  and  Regional  Managers  are
expected to quickly address and resolve any compliance problems.

     The Company's  policy is 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 4, 1998,  the Company  relocated,  expanded or fully  remodeled 31
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.

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 13, 1998, 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.  For the fiscal year
ended January 4, 1998, revenues from franchisees and licensees were not material
to the Company.

Products

     For the  fiscal  year  ended  January  4,  1998,  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 this period was derived from the
sale of new and previously viewed videocassettes,  confectionery items and video
accessories, such as blank cassettes, cleaning equipment and movie memorabilia.

     The Company's  stores  generally offer from 4,000 to 15,000  videocassettes
(from 3,000 to 10,000 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," "Drama" and "Children." 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  managers  and are based on box  office  results,  actual
rental history of comparable titles within each store and industry research.

     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 related to particular holidays.

     In an effort to provide more depth of copy on hit titles to better  satisfy
initial  customer  demand,  certain  movie  studios in late 1997 began  offering
incentives and expanded revenue sharing plans which have lowered the average per
unit cost of rental inventory. These programs permit the Company to carry larger
levels  of  new  release   inventory.   Thus,   the  Company  has  pursued  such
opportunities  and believes that during late 1997 and early 1998 these  programs
had a positive  impact on revenues.  There can be no assurance that studios will
continue to offer such  programs  or that such  programs  will  continue to have
positive results.

     The Company  rents and sells video games,  which are licensed  primarily by
"Nintendo," "Sony" and "Sega."  Game rentals as a  percentage  of the  Company's
total  revenues  have  increased  since  early 1997 due to the  increase  in the
installed base of 32-bit and 64-bit game  platforms.  Sony and Sega released new
platforms in late 1995, while Nintendo  released its N64 platform in the fall of
1996. The Company anticipates that the Sony and Nintendo platforms will continue
to grow as more  households  in its markets  acquire  video game  hardware.  The
Company  expects  that the video game rental and sales  portion of its  business
will grow through 1998 and early 1999.

                                       6
<PAGE>

Videocassette and Video Game Suppliers

     In August 1997, the Company  executed a contract with Major Video Concepts,
Inc.  ("MVC")  by which MVC  became  the  Company's  primary  supplier  of video
inventory requirements.  The contract is effective through March 31, 1999. Until
August 1997,  Sight and Sound  Distributors,  Inc.  had served as the  Company's
primary  supplier.  During Fiscal 1997,  the Company  purchased  over 80% of its
video inventory from its primary suppliers.  Remaining inventory was provided by
three other distributors.

     The  Company's  contract  with MVC  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 MVC based
in part upon a percentage of videocassette and video game purchases.

     If the relationship with MVC 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 MVC.  However, the number of alternative suppliers has diminished in recent
years and the termination of the Company's  present  relationship with MVC 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 MVC.

     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 MVC 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 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  consumer magazine called  "Video  Buzz" and a
customized  video  program  (MGTV),  both of  which  feature  Company  programs,
promotions and new releases.

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 drop-shipped to the stores.

     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


                                       7
<PAGE>


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 the plastic  rental case.  The cassette 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 tested through
March 31, 1996. On April 1, 1996, the Company began the rapid  deployment of the
POS system in its Company stores. By July 1997, the Company had converted all of
its stores to 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 office.  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.

     In  addition,  during the last three  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.  Additional  development and  implementation  of systems during the past
year  includes  an  internal   Accounts   Receivable   Collections   system  and
Processing/Distribution Center system.

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 Video  ("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  33% 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,
referred to as NOVD, 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.  NVOD does not  offer  full  intractivity  or VCR

                                       8
<PAGE>

functionality,  such as allowing  consumers  to control the playing of the movie
(i.e., starting,  stopping and rewinding).  Ultimately,  further improvements in
these  technologies  could lead to the  availability  to the consumer of a broad
selection  of movies 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.

     Movies  recorded  on digital  video discs  ("DVD"),  the same size as audio
discs, were introduced  during the summer of 1997.  Playback machines which play
both audio discs and DVD have also been  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.  Currently,  the Company  offers DVD for
rental and sale in limited, primarily metropolitan, markets. The Company expects
to expand its DVD software availability to other markets once the installed base
will support such an  investment.  Technology  is currently  being  developed to
offer  an  alternative  digital  disk  platform  called  Digital  Video  Express
("Divx").  Divx disks permit 48 hours of viewing from the time playback  begins.
Subsequent  viewings would be available at an additional  charge with access and
payment  handled via modem.  The advent of DVD and Divx 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.
For the near-term,  however,  hardware costs for digital disk  technologies  are
expected to remain high, recordability is likely several years away and products
on digital disks remain available on VHS,  typically at an earlier date. Neither
DVD nor Divx have yet attained universal support from movie studios.

     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, and perhaps digital  disks, 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 13, 1998,  the Company  employed  approximately  5,800 persons,
referred to by the Company as  "associates,"  including  approximately  5,500 in
retail  stores  and  the  remainder  in  the  Company's  corporate  offices  and
distribution  facility  ("Support  Center  Staff").  Of the  retail  associates,
approximately  1,000  were  full-time  and  4,500  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 five to fifteen  persons,
including one Store Manager and, in larger stores, one Assistant Manager.  Store
Managers  report to District  Managers who supervise the  operations of 10 to 15
stores.  The District  Managers  report to one of nine  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 Support  Center  Staff has regular and periodic  meetings  with the
Regional  Managers and District 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.

                                       9
<PAGE>

     The  Company  has an  incentive  bonus  program  pursuant  to which  retail
management  personnel  receive  quarterly  bonuses  when  stores  meet or exceed
criteria  established  under the program.  Management  believes that its program
rewards  excellence  in  management,  gives  associates  an incentive to improve
operations  and results in an overall  reduction in the cost of  operations.  In
addition,  District Managers, Regional Managers and certain Support Center Staff
are eligible to receive discretionary  bonuses,  based on individual and Company
performance,  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.

     Growth  Strategy.  The Company's  long-term  strategy is to grow  primarily
through new store  openings and  secondarily  through  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  through  proceeds
primarily from public  offerings of common stock,  and secondarily  through 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 to the Company in the future.

     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 reduction in the size
of the pool of available  sellers;  (iii) 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;  (iv) more intensive competition to acquire the same video specialty
stores the Company seeks to acquire;  (v) an increase in price for acquisitions;
(vi)  misrepresentations  and  breaches  of  contracts  by  sellers;  (vii)  the
Company's limited knowledge and operating history of the acquired stores; (viii)
the replacement of purchasing and marketing systems of acquired stores; and (ix)
the  integration  of acquired  stores'  systems into the  Company's  systems and
procedures.

     Same-Store  Revenues  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) 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;  (ii) the weather  conditions in the selling area;
(iii) the timing of the  release of new hit movies by the  studios for the video
rental market;  (iv)  competition from special events such as the Olympics or an
ongoing major news event of significant  public  interest;  (v) competition from
other  forms  of  entertainment  such  as  movie  theaters,   cable  television,
Internet-related  activities  and  Pay-Per-View  television,   including  direct
satellite television;  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).

                                       10
<PAGE>

     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
"Same-Store  Revenues  Increases"  above;  (ii) the extent to which the  Company
experiences an increase in the number of new competitive  openings,  which tends
to divide market share and reduce profitability in a given trade area; (iii) 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 increase the
satisfaction  of demand  through  product sales which carry lower profit margins
than rental revenues; (iv) changes in the prices for the Company's products or a
reduction in, or elimination of, the videocassette release window 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;  (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 MVC 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)  development  and  implementation  of DVD and  Divx
technology  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)         46    Chairman of the Board and Chief Executive
                                       Officer
H. Harrison Parrish(1)        50    President and Director
William B. Snow(1)            66    Vice Chairman of the Board
Robert L. Sirkis              46    Executive Vice President and Chief Operating
                                       Officer
J. Steven Roy                 37    Executive Vice President and Chief Financial
                                       Officer
S. Page Todd                  36    Senior Vice President, Secretary and General
                                       Counsel
William G. Guerrette, Jr.     38    Senior Vice President-Sales
Steven M. Hamil               29    Senior Vice President, Chief Accounting
                                       Officer and Controller
Richard R. Langford           41    Senior Vice President-Management Information
                                       Systems
Mark S. Loyd                  42    Senior Vice President-Purchasing and Product
                                       Management
Jeffrey S. Stubbs             35    Senior Vice President-Store Operations
Sanford C. Sigoloff(2)(3)     67    Director
Philip B. Smith(2)(3)         62    Director
Joseph F. Troy (1)(2)(3)      59    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 L.L.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.

                                       11
<PAGE>

     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.

     Mr. Sirkis was elected Executive Vice President and Chief Operating Officer
in September 1997. From 1994 until he joined the Company, Mr. Sirkis founded and
served as President and Chief Executive Officer of Finest  Foodservice,  L.L.C.,
which  developed and operated  Boston  Market  stores in seven states.  Prior to
1994,  he served as  President  and Chief  Executive  Officer of Silo,  Inc.,  a
nationwide  retailer of consumer  electronics  and  subsidiary  of  London-based
Dixons  Group,  plc.  Mr.  Sirkis  received a B.A.  degree  from  Johns  Hopkins
University  and his Masters in Business  Administration  from  Harvard  Business
School.

     Mr. Roy was elected Senior Vice  President-Finance and Principal Accounting
Officer in June 1995,  was elected Chief  Financial  Officer in May 1996 and was
elected  Executive Vice President in March 1998.  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.  Guerrette  joined the Company in April 1997 and, after serving as Vice
President - Retail Sales,  was elected Senior Vice President - Sales in December
1997.  Mr.  Guerrette was President of Sounds Easy Video when it was acquired by
Home Vision Entertainment,  Inc. ("Home Vision") in September 1994 and served as
Executive Vice President and Chief Operating Officer of Home Vision until it was
acquired by the Company.  He was elected to the Maine House of  Representatives,
where he served from November 1994 to 1996. Mr. Guerrette attended Brigham Young
University and majored in Accounting.

     Mr. Hamil was elected  Vice  President  and  Controller  in June 1996,  was
elected  Chief  Accounting  Officer in October 1996 and was elected  Senior Vice
President in March 1998.  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.  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.  Langford  received  a B.A.  degree  in
Communications from Brigham Young University.

     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,  where he
majored in Business Administration.

                                       12
<PAGE>

     Mr. Stubbs was elected Senior Vice President - Store Operations in November
1997. He joined the Company in November 1995 as a District Manager and served as
a Regional Manager prior to his current position. Mr.Stubbs attended Texas A & M
University and Southwest  Texas State  University,  where he received his B.B.A.
degree in Business Administration and Marketing.

     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.

     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 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
$16,000,  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  100,000 shares of Common Stock to each of Messrs.  Sigoloff and Smith,
vested  options to purchase  125,000  shares to Mr.  Troy and vested  options to
purchase  135,000  shares to Mr. Snow,  in each case at or above the fair market
value of the Common Stock on the date of grant.

ITEM 2.  PROPERTIES

     At March 13, 1998,  all but one of the Company's 852 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 does not pay additional  rents based on reaching the
required revenue levels and does not anticipate  paying such additional rents in
the future.  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.

                                       13
<PAGE>

     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.  In Fiscal 1997,  these payments
totaled  $43,800.  The  remaining  office  building  space is used  for  general
corporate offices and is leased from an unaffiliated  third party for a one-year
term with multiple one-year options.  In May 1997, the Company  consolidated 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.

ITEM 3.  LEGAL PROCEEDINGS

     In June 1997, certain former  shareholders of Home Vision (the "Home Vision
Shareholders") filed a complaint against the Company in the U. S. District Court
for  the  District  of  Maine.  According  to the  complaint,  the  Home  Vision
Shareholders  asserted a claim for breach of  contract  in  connection  with the
merger  of the  Company  and  Home  Vision  in  July  1996.  These  shareholders
ultimately  sought  damages in excess of $10 million  plus  costs.  On March 19,
1998,  the  Company  received a jury  verdict  in its favor with  respect to all
claims  brought  against  it and does not  expect  to pay any  monetary  damages
associated with this case.

     The  Company  continues  to  pursue  its  claims  against  the Home  Vision
Shareholders.  The case, which was filed in June 1997, is pending in the Circuit
Court of Houston  County,  Alabama.  However,  the Company does not believe that
this proceeding is material to its business or financial condition.

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

     None.

                                       14
<PAGE>

                                     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>                                               
1998
First Quarter (through March 13, 1998)       $ 7-1/8    $ 2-7/8

1997
First Quarter                                 13-3/4      7-1/2
Second Quarter                                 8          5
Third Quarter                                  6-7/8      3-1/2
Fourth Quarter                                 4-1/8      2-1/2

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
</TABLE>

     The last sale  price of the  Company's  Common Stock on March 13,  1998, as
reported  on the Nasdaq  National  Market  was $7.00 per share.  As of March 13,
1998, there were 126 holders of record of the Company's Common Stock.

     In  December  1993,  August  1994 and April  1995,  the  Company  paid cash
dividends (in the form of S corporation  distributions) of $186,561,  $2,500,000
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>

ITEM 6.  SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
                                                                                                        Nine Months
                                                     Fiscal Year Ended              Year Ended              Ended
                                                 --------------------------  -------------------------  -------------
                                                  January 4      January 5    December 31  December 31   December 31
                                                    1998         1997(2)(3)      1995        1994(5)     1993(5)(6)
                                                 --------------------------------------------------------------------
                                                             (dollars in thousands, except per share data)
Statement of Income Data (1):
<S>                                                <C>           <C>           <C>          <C>            <C>
Revenues:
  Rentals                                          $ 220,787     $ 219,002     $ 130,353    $  47,782      $  21,133
  Product sales                                       39,569        35,393        18,848        5,441          1,908
                                                   ---------     ---------     ---------    ---------      ---------
                                                     260,356       254,395       149,201       53,223         23,041
Operating costs and expenses:
  Store operating expenses                           134,141       124,456        67,758       24,119         11,891
  Amortization of videocassette rental inventory      69,177        63,544        29,102       10,263          4,541
  Amortization of intangibles                          7,206         7,160         3,380          606            133
  Cost of product sales                               24,597        21,143        12,600        4,018          1,462
  Special management bonus                              --            --            --           --              560
  General and administrative                          17,006        20,266        13,525        5,647          2,024
  Restructuring and other charges                       --           9,595          --           --             --
                                                   ---------     ---------     ---------    ---------      ---------
Operating income                                       8,229         8,231        22,836        8,570          2,430
Non-operating income (expense):
  Interest expense, net                               (6,326)       (5,619)       (1,528)        (486)          (458)
  Other, net                                            --            --            --             58             49
                                                   ---------     ---------     ---------    ---------      ---------
Income before income taxes                             1,903         2,612        21,308        8,142          2,021
Income taxes (7)                                         998         1,006         7,871        2,991            757
                                                   ---------     ---------     ---------    ---------      ---------
Net income                                         $     905     $   1,606     $  13,437    $   5,151      $   1,264
                                                   =========     =========     =========    =========      =========
Basic earnings per share                           $     .07     $     .12     $    1.14    $     .64      $     .19
                                                   =========     =========     =========    =========      =========
Diluted earnings per share                         $     .07     $     .12     $    1.11    $     .63      $     .19
                                                   =========     =========     =========    =========      =========
Cash dividends declared per share                  $    --       $    --       $    --      $     .39      $     .04
                                                                                            =========      =========
Shares used in computing earnings per share:
   Basic                                              13,420        13,241        11,795        8,083          6,716
                                                   =========     =========     =========    =========         ======
   Diluted                                            13,421        13,368        12,153        8,152          6,716
                                                   =========     =========     =========    =========         ======

Operating Data:
Number of stores at end of period (1)                    856           863           750          352            108
Adjusted EBITDA (8)                                $  25,568     $  20,542     $   8,766    $   3,902      $     757
Increase (decrease) in same-store revenues (9)           1.1%         (1.0)%         0.0%        14.3%          13.7%


                                                                                            December 31
                                                   January 4     January 5     --------------------------------------
                                                      1998          1997          1995          1994          1993
                                                  -------------------------------------------------------------------
Balance Sheet Data(1):
Cash and cash equivalents                          $  4,459      $  3,982      $  6,255      $  3,723      $     408
Videocassette rental inventory, net                  92,183        89,929        72,979        27,138          7,455
Total assets                                        259,133       261,577       233,479        76,647         13,446
Long-term debt, less current maturities              63,479        67,883        19,622         6,681          4,104
Total liabilities                                   111,504       114,853        97,340        29,652         10,988
Stockholders' equity                                147,629       146,724       136,139        46,995          2,458

                                       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.  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)  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.
(3)  Includes a non-recurring  charge of  approximately  $10.4 million for store
     closures, corporate restructuring and merger-related expenses.
(4)  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.
(5)  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.
(6)  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.
(7)  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.
(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 years ended January 4, 1998 and
     January 5, 1997 is $1.3 million and $5.7 million, respectively,  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

From August 1994 through July 1, 1996, the Company  experienced  rapid growth in
revenue and  operating  income  primarily  as a result of  acquiring  stores and
opening new stores.  Since the fall of 1996, the Company has focused its efforts
on internally  developed  stores and on improving the operations of its existing
store base. The number of stores owned and operated by the Company at the end of
each of the following periods is as follows:

             December 31, 1993                 108
             December 31, 1994                 352
             December 31, 1995                 750
             January 5, 1997                   863
             January 4, 1998                   856

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 acquisitions of Home Vision and Hollywood
Video   were   consummated   on  July  1,  1996  and  were   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 4, 1998  ("Fiscal  1997"),  50
stores were  developed  by the  Company,  two stores were  acquired  and 59 were
closed.

As a result of the 503 store  acquisitions  during the  periods  January 1, 1995
through January 4, 1998, the Company  recorded $74.6 million in goodwill,  which
is  being   amortized  over  twenty  years  from  the  effective  date  of  each
acquisition.  The Company also recorded an  additional  $9.8 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 that ends on the first Sunday
following  December  30.  This  change  results in the  Company  having a 52- or
53-week year. The year ended January 5, 1997 ("Fiscal 1996") was a 53-week year,
while Fiscal 1997 was a 52-week year.

Effective   April  1,  1996,  the  Company  changed  its  method  of  amortizing
videocassette  rental  inventory  (which  includes video games and audio books).
Under this 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 this 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  $2.3  million of costs were paid and charged
against  the  liability  as  of  January  4,  1998.   The  store  closures  were
substantially  completed  by the end of Fiscal  1997.  Additionally,  during the
third  quarter  of Fiscal  1996 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 Hollywood  Video had been taxed
as a C corporation for all periods  presented.  Historical  operating results of
Hollywood  Video do not include any  provision for income taxes prior to July 1,
1996 due to their S corporation status prior to this date.

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>

Statement of Income Data:

<CAPTION>
                                                                  52 Weeks    53 Weeks       Year
                                                                   Ended       Ended        Ended
                                                                 -----------------------------------
                                                                 January 4   January 5   December 31
                                                                    1998        1997        1995
                                                                 -----------------------------------

<S>                                                                <C>         <C>         <C>
Revenues:
  Rentals                                                           84.8%       86.1%       87.4%
  Product sales                                                     15.2        13.9        12.6
                                                                   -----       -----       -----
                                                                   100.0       100.0       100.0
Operating costs and expenses:
  Store operating expenses                                          51.5        48.9        45.4
  Amortization of videocassette rental inventory (1)                26.6        25.0        19.5
  Amortization of intangibles                                        2.8         2.8         2.3
  Cost of  product sales                                             9.4         8.3         8.4
  General and administrative                                         6.5         8.0         9.1
  Restructuring and other charges                                     --         3.8          --
                                                                   -----       -----       -----
                                                                    96.8        96.8        84.7
                                                                   -----       -----       -----
Operating income                                                     3.2         3.2        15.3
Interest expense, net                                               (2.5)       (2.2)       (1.0)
                                                                   -----       -----       -----
Income before income taxes                                           0.7         1.0        14.3
Income taxes (2)                                                     0.4         0.4         5.3
                                                                   -----       -----       -----
Net income                                                           0.3%        0.6%        9.0%
                                                                   =====       =====       =====
Number of stores at end of period                                    856         863         750
                                                                   =====       =====       =====
<FN>
_________________________
(1)  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.
(2)  The provision for income taxes  includes pro forma  adjustments  to reflect
     income tax expense which would have been  recognized if Hollywood Video had
     been  taxed  as a C  corporation  for  all  periods  presented.  Historical
     operating  results of  Hollywood  Video do not  include any  provision  for
     income taxes prior to July 1, 1996 due to its S corporation status prior to
     this date.
</FN>
</TABLE>

                                       19
<PAGE>


Fiscal year ended  January 4, 1998  compared to the fiscal year ended January 5,
1997

     Revenue.  Total revenue  increased  2.3% to $260.4  million for Fiscal 1997
from $254.4  million for Fiscal  1996.  The  increase  was due  primarily  to an
increase in same-store  revenues of 1.1%, as well as the net positive  effect of
closing  lower  volume  stores  while  internally  developing  stores  that have
generated  revenue  results  greater  than the closed  stores.  The  increase in
same-store  revenues was primarily a result of (i) the Company's emphasis in the
last half of Fiscal 1997 to increase the depth of copies of "hit titles"  within
its store base,  (ii) an increase in the game rental  business due to the advent
and consumer  acceptance of the  Nintendo 64 and Sony Playstation game platforms
and (iii) a decrease in the number of competitive  store openings,  particularly
in the last half of Fiscal 1997.  Product  sales  increased  as a percentage  of
total  revenues to 15.2% for Fiscal 1997 from 13.9% for Fiscal 1996, as a result
of (i) the Company's  continued and increased emphasis on the sale of previously
viewed rental  inventory  and  (ii) 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
51.5% of total revenue for Fiscal 1997 from 48.9% for Fiscal 1996.  The increase
in store operating expenses was primarily due to (i) strategic  responses in the
Company's most competitive  markets,  which affected certain  expenses,  such as
labor hours used and advertising costs, (ii) the national minimum wage increases
that were  implemented  on  September 1, 1996 and  September 1, 1997,  and (iii)
increases in rent in  connection  with the normal  renewal of leases in existing
stores.

Amortization  of  videocassette  rental  inventory  increased as a percentage of
revenue to 26.6% for Fiscal 1997 from 25.0% for Fiscal 1996 due primarily to (i)
a  decision  by the  Company to  increase  its level of  expenditures  on rental
inventory  during  the  fourth  quarter  of 1996 and the  first  half of 1997 in
response to industry-wide  competitive  issues, (ii) an increase in the depth of
hit new release titles  purchased  during the year,  which results in more tapes
being  substantially  amortized over six months versus three years  and  (iii) a
marked increase in the quantity of new game release  purchases,  which is due to
the  buildup  of  inventory  related  to the  consumer  acceptance  of new  game
platforms (i.e., Nintendo 64 and Sony Playstation).

Cost of product 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 product sales increased
with the  increased  revenue from product sales and increased as a percentage of
revenues from product sales from 59.7% for Fiscal 1996 to 62.2% for Fiscal 1997.
The  decrease in product  sales gross  margins  resulted  primarily  from (i) an
increase in new tape sales which carry lower margins than other sales items  and
(ii) an  effort  by the  Company  to  market  more  aggressively  its  new  tape
inventory.  These  factors were offset,  in part,  by an increase in the sale of
previously viewed rental  inventory,  the unamortized value of which is expensed
to cost of product  sales and  generally  generates  higher  margins  than other
product categories.

General and  administrative  expenses decreased as a percentage of revenues from
8.0%  for  Fiscal  1996  to  6.5%  for  Fiscal  1997.   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 the  efficiencies
gained from the leveraging of overhead  associated with acquisition  activity in
1996 and a reduction in corporate overhead over the past year.

As a result of the above,  operating income was essentially flat at $8.2 million
in both  Fiscal  1997 and Fiscal  1996.  However,  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 in Fiscal 1996.

                                       20
<PAGE>

Fiscal 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 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 product 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 product sales increased
with the  increased  revenue from product sales and decreased as a 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.

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 in Fiscal 1996.

                                       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  refurbishment,  remodeling and relocation of existing
stores.  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 1997,  the Company  generated  $25.6  million in Adjusted  EBITDA
versus  $20.5  million for Fiscal  1996.  "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 1997 and
Fiscal 1996 are $1.3 million and $5.7  million,  respectively,  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 $83.9 million for Fiscal 1997 as
compared to $91.8  million for Fiscal 1996.  The decrease was  primarily  due to
lower net income,  an increase in  merchandise  inventory  during Fiscal 1997, a
decrease  in  accounts  payable and other  accrued  liabilities  during the same
period, as well as the Fiscal 1996  restructuring  charge discussed above. These
factors are offset,  in part, by higher  depreciation and amortization in Fiscal
1997 versus Fiscal 1996.

Net cash used in  investing  activities  was $83.2  million  for Fiscal  1997 as
compared to $104.8  million  for Fiscal  1996.  This  decrease in funds used for
investing  activities  is  primarily  the result of a decrease in the total cash
expended for acquired  stores,  rental  inventory and property,  furnishings and
equipment during Fiscal 1997 versus Fiscal 1996.

Net cash provided by financing  activities  was $10.7 million for Fiscal 1996 as
compared to net cash used by  financing  activities  of $0.2  million for Fiscal
1997.  This  decrease  was  primarily  the  result of net  borrowings  remaining
unchanged during Fiscal 1997.

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 based on LIBOR plus an  applicable  margin  percentage,
which depends on the Company's cash flow generation and borrowings  outstanding.
The Company may repay the Facility at any time without penalty. The Facility has
covenants that restrict borrowing based upon cash flow levels.  During 1997, the
Company  voluntarily  reduced the commitment to $90 million. At January 4, 1998,
$67 million was outstanding  under the Facility and approximately $23 million of
the $90 million commitment was available for borrowing under the Facility.

The Company  grows its store base  through  internally  developed  and  acquired
stores and may require  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  or shares of the  Company's  stock issued to
sellers.  However, there can be no assurance that financing will be available to
the Company on terms which will be acceptable, if at all.

                                       22
<PAGE>

At January 4, 1998, the Company had a working  capital deficit of $10.9 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 1998,  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.

Other Matters

The Company has  performed  an analysis of its  operating  systems to  determine
systems'  compatibility  with the upcoming year 2000.  Substantially  all of the
Company's  operating  systems are year 2000 compliant,  and the Company does not
believe  that  there  will  be  any  material  exposure  related  to  year  2000
compatibility.

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 1998
Annual Meeting of Stockholders, and is incorporated herein by reference.

                                       23
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

     The  information  required by this Item will be contained in the  Company's
definitive Proxy Statement for its 1998 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 1998 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 1998 Annual Meeting of  Stockholders,  and is
incorporated herein by reference.

                                     PART IV


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

    (a)(1) Financial Statements:

        Report of Ernst & Young LLP, Independent Auditors.

        Consolidated Balance Sheets as of January 4, 1998 and January 5, 1997.

        Consolidated  Statements of Income for the Fiscal Years Ended January 4,
        1998, January 5, 1997 and December 31, 1995.

        Consolidated  Statements  of  Stockholders'  Equity for the Fiscal Years
        Ended January 4, 1998, January 5, 1997 and December 31, 1995.

        Consolidated Statements of Cash Flows for the Fiscal Years Ended January
        4, 1998, January 5, 1997 and December 31, 1995.

        Notes to Consolidated Financial Statements.

    (a)(2) Schedules:

        None.

                                       24
<PAGE>

    (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
  No.         Exhibit Description
-------       -------------------
 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. (3)
10.2   -      Form of Indemnity Agreement. (1)
10.3   -      Employment  Agreement  between  M.G.A.,  Inc.  and Joe  Thomas
              Malugen. (1)
10.4   -      Employment  Agreement  between  M.G.A.,  Inc.  and H.  Harrison
              Parrish. (1)
10.5   -      Consulting  Agreement between William B. Snow and M.G.A.,  Inc.
              dated December 12, 1996. (3)
10.6   -      Employment  Agreement  between M.G. A., Inc. and J. Steven Roy.
              (filed herewith)
10.7   -      Employment  Agreement  between  M.G.A.,  Inc. and S. Page Todd.
              (filed herewith)
10.8   -      Employment  Agreement between M.G.A., Inc. and Steven M. Hamil.
              (filed herewith)
10.9   -      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. (4)
10.10  -      Agreement   dated  March  13,  1997  between   Sight  &  Sound
              Distributors,  Inc. and Movie  Gallery,  Inc. (3) (portions  were
              omitted pursuant to a request for confidential treatment)
10.11  -      Agreement dated August 15, 1997 between Major Video Concepts, Inc.
              and Movie Gallery,  Inc. (5) (portions were omitted pursuant to a
              request for confidential treatment)
10.12  -      Real estate lease dated June 1, 1994 between J. T. Malugen,  H.
              Harrison Parrish and M.G.A., Inc. (1)
10.13  -      Real  estate  lease  dated  June 1, 1994  between  H.  Harrison
              Parrish and M.G.A., Inc. (1)
10.14  -      Tax  Agreement  between  M.G.A.,  Inc.  and Joe T.  Malugen and
              Harrison Parrish. (1)
10.15  -      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). (6)
10.16  -      Credit  Agreement  between  First Union  National Bank of North
              Carolina and Movie Gallery, Inc. dated July 10, 1996. (4)
18     -      Change in Accounting Principle. (7)
21     -      List of Subsidiaries. (filed herewith)
23     -      Consent of Ernst & Young LLP. (filed herewith)
27     -      Financial Data Schedule (filed herewith)
27.1   -      Financial Data Schedule - Restated for January 5, 1997
              (filed herewith)


                                       25
<PAGE>


--------------
(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 April 7,
     1997,  as an exhibit to the  Company's  Form 10-K for the fiscal year ended
     January 5, 1997.
(4)  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.
(5)  Previously  filed with the Securities  and Exchange  Commission on November
     19, 1997 as an exhibit to the  Company's  Form 10-Q for the  quarter  ended
     October 5, 1997.
(6)  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.
(7)  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 January 4, 1998.

     (c)  Exhibits:

        See (a)(3) above.


                                       26
<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 annual report on Form
10-K 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 6, 1998


     Pursuant to the  requirements of the Securities  Exchange Act of 1934, this
annual  report on Form 10-K has been signed  below by the  following  persons on
behalf of the Registrant and in the capacities and on the dates indicated.

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

/s/ JOE THOMAS MALUGEN       Chairman of the Board and Chief     April 6, 1998
------------------------     Executive Officer                   
Joe Thomas Malugen

/s/ WILLIAM B. SNOW          Vice Chairman of the Board          April 6, 1998
------------------------
William B. Snow

/s/ J. STEVEN ROY            Executive Vice President and        April 6, 1998
------------------------     Chief Financial Officer
J. Steven Roy

/s/ STEVEN M. HAMIL          Senior Vice President and           April 6, 1998
------------------------     Chief Accounting Officer
Steven M. Hamil

/s/ H. HARRISON PARRISH      Director and President              April 6, 1998
------------------------
H. Harrison Parrish

 /s/ JOSEPH F. TROY          Director                            April 6, 1998
------------------------
Joseph F. Troy



                                       27
<PAGE>


                               Movie Gallery, Inc.

                              Financial Statements


Fiscal years ended January 4, 1998, January 5, 1997 and December 31, 1995


                                    Contents

Report of Ernst & Young LLP, Independent Auditors...........................F-1

Audited Financial Statements

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 Ernst & Young LLP, 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 4, 1998 and January 5, 1997,  and the  related  consolidated
statements of income,  stockholders'  equity and cash flows for the fiscal years
ended January 4, 1998,  January 5, 1997 and December 31, 1995.  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 revenues
constituting  12% of the  consolidated  total in  1995.  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, 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, 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 January
4, 1998 and January 5, 1997, and the consolidated  results of its operations and
its cash flows for the fiscal years ended  January 4, 1998,  January 5, 1997 and
December 31, 1995, 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, 1998, except for
Note 11 as to which the date
is March 19, 1998

                                      F-1


              
<PAGE>
<TABLE>

                               Movie Gallery, Inc.

                           Consolidated Balance Sheets
                                 (in thousands)


<CAPTION>
                                                       January 4  January 5
                                                         1998       1997
                                                       --------------------

<S>                                                    <C>        <C>
Assets
Current assets:
   Cash and cash equivalents                           $  4,459    $  3,982
   Merchandise inventory                                 13,512      10,737
   Prepaid expenses                                       1,341       1,059
   Store supplies and other                               2,561       3,050
   Deferred income taxes                                    531         913
                                                       --------    --------
Total current assets                                     22,404      19,741
Videocassette rental inventory, net                      92,183      89,929
Property, furnishings and equipment, net                 50,321      50,196
Deferred charges, net                                     8,940      11,151
Excess of cost over net assets acquired, net             83,381      87,822
Deposits and other assets                                 1,904       2,738
                                                       --------    --------
Total assets                                           $259,133    $261,577
                                                       ========    ========

Liabilities and stockholders' equity
Current liabilities:
   Accounts payable                                    $ 21,517    $ 24,321
   Accrued liabilities                                    7,014       7,622
   Current portion of long-term debt                      4,751         374
                                                       --------    --------
Total current liabilities                                33,282      32,317
Long-term debt                                           63,479      67,883
Other accrued liabilities                                 1,899       2,425
Deferred income taxes                                    12,844      12,228
Stockholders' equity:
   Preferred stock, $.10 par value; 2,000,000 shares
     authorized, no shares issued and outstanding          --          --
   Common stock, $.001 par value; 60,000,000 shares
     authorized, 13,418,885 and 13,420,791 shares
     issued and outstanding, respectively                    13          13
   Additional paid-in capital                           131,686     131,686
   Retained earnings                                     15,930      15,025
                                                       --------    --------
Total stockholders' equity                              147,629     146,724
                                                       --------    --------
Total liabilities and stockholders' equity             $259,133    $261,577
                                                       ========    ========

See accompanying notes.
</TABLE>

                                       F-2

     
<PAGE>
<TABLE>
                               Movie Gallery, Inc.

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


<CAPTION>
                                                                Fiscal Year Ended
                                                      -------------------------------------
                                                      January 4     January 5   December 31
                                                         1998          1997        1995
                                                      -------------------------------------

<S>                                                   <C>           <C>           <C>
Revenues:
   Rentals                                            $ 220,787     $ 219,002     $ 130,353
   Product sales                                         39,569        35,393        18,848
                                                      ---------     ---------     ---------
                                                        260,356       254,395       149,201

Operating costs and expenses:
   Store operating expenses                             134,141       124,456        67,758
   Amortization of videocassette rental inventory        69,177        63,544        29,102
   Amortization of intangibles                            7,206         7,160         3,380
   Cost of  product sales                                24,597        21,143        12,600
   General and administrative                            17,006        20,266        13,525
   Restructuring and other charges                         --           9,595          --
                                                      ---------     ---------     ---------
Operating income                                          8,229         8,231        22,836

   Interest income                                           45            99           539
   Interest expense                                      (6,371)       (5,718)       (2,067)
                                                      ---------     ---------     ---------
Income before income taxes                                1,903         2,612        21,308

Income taxes                                                998         1,131         8,893
                                                      ---------     ---------     ---------
Net income                                            $     905     $   1,481     $  12,415
                                                      =========     =========     =========
Basic and diluted earnings per share                  $     .07
                                                      =========

Pro forma earnings per share (unaudited):
Income before income taxes                                          $   2,612     $  21,308
Pro forma income taxes                                                  1,006         7,871
                                                                    ---------     ---------
Pro forma net income                                                $   1,606     $  13,437
                                                                    =========     =========
Basic pro forma earnings per share                                  $     .12     $    1.14
                                                                    =========     =========
Diluted pro forma earnings per share                                $     .12     $    1.11
                                                                    =========     =========

Weighted average shares outstanding (in thousands):
  Basic                                                  13,420        13,241        11,795
  Diluted                                                13,421        13,368        12,153

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, 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
    Other transactions by pooled companies                   --           (24)          --            (24)
                                                         ------     ---------    ---------      ---------
Balance at January 5, 1997                                   13       131,686       15,025        146,724

    Net income                                               --            --          905            905
                                                         ------     ---------    ---------      ---------
Balance at January 4, 1998                               $   13     $ 131,686    $  15,930      $ 147,629
                                                         ======     =========    =========      =========

See accompanying notes.
</TABLE>

                                      F-4



                                       
<PAGE>
<TABLE>

                               Movie Gallery, Inc.

                      Consolidated Statements of Cash Flows
                                 (in thousands)


<CAPTION>

                                                                   Fiscal Year Ended
                                                        -------------------------------------
                                                        January 4      January 5   December 31
                                                           1998          1997         1995
                                                        -------------------------------------
<S>                                                     <C>          <C>            <C>
Operating activities
Net income                                              $     905     $   1,481     $  12,415
Adjustments to reconcile net income to net cash
  provided by operating activities:
    Depreciation and amortization                          88,140        79,625        36,991
    Deferred income taxes                                     998           822         7,428
    Restructuring and other charges                          --           9,595          --
 Changes in operating assets and liabilities:
    Merchandise inventory                                  (3,493)          203        (4,987)
    Other current assets                                      435         1,365        (1,621)
    Deposits and other assets                                 834          (978)       (1,567)
    Accounts payable                                       (2,804)       (1,649)        9,609
    Accrued liabilities                                    (1,134)        1,336         3,003
                                                        ---------     ---------     ---------
Net cash provided by operating activities                  83,881        91,800        61,271

Investing activities
Business acquisitions                                        (474)       (8,662)      (83,403)
Purchases of videocassette rental inventory, net          (70,801)      (77,666)      (51,061)
Purchases of property, furnishings and equipment          (13,072)      (18,438)      (20,355)
Proceeds from disposal of  equipment                        1,170          --            --
                                                        ---------     ---------     ---------
Net cash used in investing activities                     (83,177)     (104,766)     (154,819)

Financing activities
Net proceeds from issuance of common stock                   --             524        63,482
Net (payments on) proceeds from notes payable                --         (32,052)       28,293
Proceeds from issuance of  long-term debt                    --          72,938        10,070
Principal payments on long-term debt                         (227)      (30,717)       (4,584)
Dividends paid                                               --            --            (996)
                                                        ---------     ---------     ---------
Net cash  (used in) provided by financing activities         (227)       10,693        96,265
                                                        ---------     ---------     ---------
Increase (decrease) in cash and cash equivalents              477        (2,273)        2,717
Decrease in cash and cash equivalents to conform
   fiscal  year end of pooled companies                      --            --            (185)
Cash and cash equivalents at beginning of fiscal year       3,982         6,255         3,723
                                                        ---------     ---------     ---------
Cash and cash equivalents at end of fiscal year         $   4,459     $   3,982     $   6,255
                                                        =========     =========     =========

Supplemental disclosures of cash flow
   information
Cash paid during the period for interest                $   5,777     $   5,377     $   1,834
Cash paid during the period for income taxes                 --             203           764
Noncash investing and financing information:
   Assets acquired by issuance of notes payable               200          --          10,012
   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 4, 1998

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 22 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.  The  Company's  fiscal year  includes
revenues  and certain  operating  expenses,  such as  salaries,  wages and other
miscellaneous  expenses,  on  a  daily  basis.  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,  video
accessories  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
Financial  Accounting  Standards Board (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 intangible  assets when  indicators of impairment are present and
the  undiscounted  cash flows estimated to be generated by those assets are less
than the assets' 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.

                                      F-6



                                      
<PAGE>


                               Movie Gallery, Inc.

              Notes to Consolidated Financial Statements (continued)

1.  Accounting Policies (continued)

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 this 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 its primary competitors.

The new method of  amortization  was 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 basic and diluted share.

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

                                                      January 4    January 5
                                                        1998          1997
                                                      ---------    ---------
<S>                                                   <C>          <C>
Videocassette rental inventory                        $ 175,922    $ 183,264
Less accumulated amortization                           (83,739)     (93,335)
                                                      ---------    ---------
                                                      $  92,183    $  89,929
                                                      =========    =========
</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.

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
4, 1998 and January 5, 1997 was $6,397,000 and $4,128,000, respectively.

Excess of Cost Over Net Assets Acquired

The excess of cost over net assets  acquired  at January 4, 1998 and  January 5,
1997  is  net  of  accumulated   amortization  of  $11,864,000  and  $7,111,000,
respectively, and is being amortized on a straight-line basis over twenty years.

                                      F-7



                                       
<PAGE>

                               Movie Gallery, Inc.
              
              Notes to Consolidated Financial Statements (continued)


1.  Accounting Policies (continued)

Income Taxes

The Company accounts for income taxes under the provisions of FASB Statement No.
109, "Accounting for Income Taxes." Under Statement 109, deferred tax assets and
liabilities are determined based upon differences  between  financial  reporting
and tax bases of assets and  liabilities  and are  measured  at the  enacted tax
rates and laws  that will be in effect  when the  differences  are  expected  to
reverse.

Videocassette Rental Revenue

Rental revenue is recognized when the  videocassette  or video game is rented by
the customer.

Advertising Costs

Advertising costs,  exclusive of cooperative  reimbursements  from vendors,  are
expensed when incurred. Advertising costs were $728,000, $1,512,000 and $756,000
for the fiscal  years ended  January 4, 1998,  January 5, 1997 and  December 31,
1995, respectively.

Store Opening Costs

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

Earnings Per Share

Effective January 4, 1998, the Company adopted Statement of Financial Accounting
Standards No. 128,  "Earnings per Share." This statement is effective for fiscal
periods  ending  after  December  15,  1997 and  requires  restatement  of prior
periods'  earnings  per share data.  Under this  Statement  the  calculation  of
primary and fully diluted  earnings per share is replaced with basic and diluted
earnings  per share and  requires  presentation  of both  amounts  on the income
statement.  Unlike primary earnings per share, basic earnings per share excludes
any dilutive effects of common stock equivalents.  Diluted earnings per share is
similar to the previously reported fully diluted earnings per share. Adoption of
this Statement had no significant  impact on earnings per share calculations for
any year presented.

Fair Value of Financial Instruments

At  January  4, 1998 and  January  5,  1997,  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
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.

                                      F-8



                                       
<PAGE>


                               Movie Gallery, Inc.

              Notes to Consolidated Financial Statements (continued)


1.  Accounting Policies (continued)

Unaudited Pro Forma Information

Pro forma  income  taxes  reflect  income  tax  expense  which  would  have been
recognized  by the  Company  as a C  corporation  if  the  1996  acquisition  of
Hollywood Video had been consummated prior to January 1, 1995. Hollywood Video's
historical  operating  results do not include any  provision for income taxes as
Hollywood  Video  was taxed as an S  corporation  for all  periods  prior to the
merger.

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.

The acquisitions 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 1995, Home Vision acquired  various video specialty store
chains  with an  aggregate  net  purchase  price of  $5,509,000,  including  the
issuance of $689,000 in notes payable and 120,577  shares of common  stock.  The
excess  of the cost  over  estimated  fair  value  of the  assets  acquired  was
$4,020,000.

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
statement of operations  for the year ended  September 30, 1995 is combined with
the  statements of operations  for the Company and Hollywood  Video for the year
ended December 31, 1995. 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.


                                      F-9

                                       
<PAGE>


                               Movie Gallery, Inc.
              
             Notes to Consolidated Financial Statements (continued)


2.  Acquisitions (continued)

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
                                                      1996             1995
                                               ---------------------------------

<S>                                                 <C>              <C>
Revenues:
  Movie Gallery                                     $ 106,307        $ 123,143
  Home Vision                                          11,191           18,024
  Hollywood Video                                       5,307            8,034
                                                    ---------        ---------
Combined                                            $ 122,805        $ 149,201
                                                    =========        =========

Net income (loss):
  Movie Gallery                                     $   3,106        $  14,486
  Home Vision                                             (97)            (366)
  Hollywood Video                                        (986)          (1,705)
                                                    ---------        ---------
Combined                                            $   2,023        $  12,415
                                                    =========        =========
</TABLE>

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,  had occurred as of the beginning of the fiscal
year in which the  acquisition  occurred and the  beginning  of the  immediately
preceding year (in thousands, except per share data):
<TABLE>
<CAPTION>

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

<S>                                                  <C>              <C>
Revenues                                             $261,223         $241,815
Net income                                              2,521           20,796
Earnings per share                                       0.19             1.61

</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.
This  analysis   resulted  in  the  Company  recording  a  $9.6  million  pretax
restructuring  charge  in the  third  quarter  of 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.
The store closures were substantially  completed by the end of fiscal year 1997.
Approximately $2.3 million of restructuring  costs were paid and charged against
the  liability  as of January 4, 1998.  The stores  identified  for  closure had
revenues and operating  losses of  approximately  $0.8 million and $0.4 million,
 

                                      F-10


                                  
<PAGE>


                               Movie Gallery, Inc.

              Notes to Consolidated Financial Statements (continued)

3.  Provision for Business Restructuring (continued)

respectively,  for the fiscal year ended January 4, 1998;  $6.2 million and $1.6
million,   respectively,  for  the  fiscal  year  ended  January  5,  1997;  and
approximately $4.5 million and $0.2 million,  respectively,  for the fiscal year
ended December 31, 1995. Results for 1996 and 1995 include all stores identified
for closure  under the  restructuring  plan while  results for 1997 include only
those stores under the plan which had not been closed as of the beginning of the
fiscal year 1997.

4.  Property, Furnishings and Equipment

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

                                                    January 4     January 5
                                                       1998           1997
                                                    ------------------------

<S>                                                 <C>             <C>
Land and buildings                                  $  1,879        $  1,879
Furniture and fixtures                                29,030          26,932
Equipment                                             23,516          18,963
Leasehold improvements and signs                      22,339          18,766
                                                    --------        --------
                                                      76,764          66,540
Accumulated depreciation                             (26,443)        (16,344)
                                                    --------        --------
                                                    $ 50,321        $ 50,196
                                                    ========        ========

</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,  originally  provided
borrowings for up to $125 million and replaced the Company's previously existing
line of credit  agreement.  During  1997,  the Company  voluntarily  reduced the
commitment to $90 million.  In addition,  during the fourth  quarter of 1997 the
Company amended the Facility, primarily by increasing certain debt covenants, to
allow greater borrowing flexibility for the Company.

The available amount of the Facility will reduce  quarterly  beginning March 31,
1998, with a final maturity of June 30, 2000.  The interest rate of the Facility
(8.4%  at  January  4,  1998)  is  based  on  LIBOR  plus an  applicable  margin
percentage,  which depends on the Company's cash flow  generation and borrowings
outstanding. 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 4, 1998, $67 million was outstanding and  approximately
$23 million was available for borrowing under the Facility.  Based on the amount
outstanding  at January 4, 1998,  scheduled  maturities  of the  Facility are $4
million in 1998, $40.5 million in 1999 and $22.5 million in 2000.

The Company has entered into an interest rate swap  agreement  with a commercial
bank which effectively fixes the Company's interest rate exposure on $37 million
of the amount  outstanding under the Facility at 6.22% plus an applicable margin
percentage.  The  interest  rate swap  reduces the risk of increases in interest
rates during the remaining  life of the Facility.  The Company  accounts for its
interest rate swap as a hedge of its debt  obligation.  The Company pays a fixed
rate of interest and receives payment based on a variable rate of interest.  The
difference  in amounts  paid and  received  under the  contract  is accrued  and
recognized  as an  adjustment  to  interest  expense  on the debt.  There are no
termination penalties associated with the interest rate swap agreement; however,
if the swap agreement was terminated at the Company's option,  the Company would
either pay or receive the present value of the remaining  hedge  payments at the


                                      F-11



     
<PAGE>


                               Movie Gallery, Inc.
              
             Notes to Consolidated Financial Statements (continued)

5.  Long Term Debt (continued)

then  prevailing  interest rates for the time to maturity of the swap agreement.
The interest rate swap agreement terminates at the time the Facility matures.

In connection  with certain  acquisitions,  the Company  issued or assumed notes
payable which had  outstanding  balances of $1,230,000 and $1,257,000 at Janaury
4, 1998 and January 5, 1997, respectively. Generally, these notes are unsecured,
require  monthly or annual  payments and have fixed or variable  interest  rates
ranging from 6% to 9%.  Scheduled  maturities of long-term  debt are as follows:
$751,000 in 1998, $248,000 in 1999 and $231,000 in 2000.

6.  Income Taxes

The following  reflects  actual income tax expense  incurred for the fiscal year
ended  January  4, 1998 and  unaudited  pro forma  income tax  expense  that the
Company  would have  incurred had  Hollywood  Video (see Note 1) been subject to
federal and state income taxes for the entire fiscal years ended Janaury 5, 1997
and December 31, 1995 (in thousands):
<TABLE>
<CAPTION>

                                            Fiscal Year Ended
                              -----------------------------------------------
                              January 4         January 5         December 31
                                1998              1997                1995
                              -----------------------------------------------
                                            (unaudited pro forma information)
<S>                           <C>                <C>                   <C>
Current payable:
    Federal                   $   --             $   90                $1,328
    State                         --                 --                   136
                              ------             ------                ------
Total current                     --                 90                 1,464

Deferred:
    Federal                      903                831                 5,692
    State                         95                 85                   715
                              ------             ------                ------
Total deferred                   998                916                 6,407
                              ------             ------                ------
                              $  998             $1,006                $7,871
                              ======             ======                ======
</TABLE>

A  reconciliation  of income tax at the federal income tax rate to the Company's
effective income tax provision is as follows (in thousands):

<TABLE>
<CAPTION>
                                                      Fiscal Year Ended
                                          -------------------------------------------
                                          January 4        January 5      December 31
                                            1998             1997             1995
                                          -------------------------------------------
                                                        (unaudited pro forma information)

<S>                                       <C>              <C>                 <C>
Income tax at statutory rate              $  647           $  888              $7,245
State income taxes, net of federal
   income tax benefit                         63               85                 615
Other, net (primarily goodwill not       
   deductible for tax purposes)              288               33                  11
                                          ------           ------              ------
                                          $  998           $1,006              $7,871
                                          ======           ======              ======
</TABLE>


                                      F-12


                               
<PAGE>


                               Movie Gallery, Inc.

              Notes to Consolidated Financial Statements (continued)


6.  Income Taxes (continued)

At January  5,  1997,  the  Company  had net  operating  loss  carryforwards  of
$21,116,000 for income taxes that expire in years 2010 through 2012.  $5,410,000
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.  The Company has not
recorded a valuation  allowance related to its deferred tax assets as management
considers  it more  likely than not that  available  tax  strategies  and future
taxable income will allow the deferred tax assets to be realized.

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 4     January 5
                                                         1998          1997
                                                       -----------------------

<S>                                                    <C>             <C>
Deferred tax liabilities:
   Videocassette rental inventory                      $17,800         $14,847
   Furnishings and equipment                             5,340           4,286
   Excess of cost over fair value of assets acquired     1,864           1,519
   Other                                                 1,214             694
                                                       -------         -------
     Total deferred tax liabilities                     26,218          21,346
Deferred tax assets:
  Non-compete agreements                                 4,522           4,318
  Net operating loss carryforwards                       7,870           3,527
  Accrued liabilities                                    1,493           1,911
  Alternative minimum tax credit carryforward               20             275
                                                       -------         -------
       Total deferred tax assets                        13,905          10,031
                                                       -------         -------
Net deferred tax liabilities                           $12,313         $11,315
                                                       =======         =======
</TABLE>

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 4, 1998,  common  stock of  approximately
$83,000,000 was available to be issued from this registration.

As of January 4, 1998 and 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.

                                      F-13


                                       
<PAGE>

                               Movie Gallery, Inc.

              Notes to Consolidated Financial Statements (continued)


7.  Stockholders' Equity (continued)

Earnings Per Share

Basic  earnings  per share and basic pro forma  earnings  per share are computed
based on the  weighted  average  number of shares  of common  stock  outstanding
during the periods  presented.  Diluted earnings per share and diluted pro forma
earnings per share are computed  based on the weighted  average number of shares
of common stock outstanding  during the periods  presented,  increased solely by
the effects of shares to be issued from the  exercise of dilutive  common  stock
options (1,000,  127,000 and 358,000 for the fiscal years ended January 4, 1998,
January 5, 1997 and December 31, 1995,  respectively).  No adjustments were made
to net  income or pro forma net  income in the  computation  of basic or diluted
earnings per share.

Stock Option Plan

In 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 1997, the Company increased the shares reserved for issuance
under the Plan from 1,750,000 to 2,250,000.  Options granted under the Plan have
a 10-year term and generally vest over 3 to 5 years.

In October  1995,  the FASB issued  Statement of  Accounting  Standards No. 123,
"Accounting for Stock-Based Compensation."  In accordance with the provisions of
Statement 123, the Company applies  Accounting  Principles  Board Opinion No. 25
and  related  Interpretations  in  accounting  for its  stock  option  plan and,
accordingly,  has not recognized  compensation cost in connection with the Plan.
If the  Company  had elected to  recognize  compensation  cost based on the fair
value of the options  granted at grant date as prescribed by Statement  123, net
income and earnings per share (pro forma amounts for fiscal years 1996 and 1995)
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>
                                                    Fiscal Year Ended
                                           -------------------------------------
                                           January 4    January 5    December 31
                                              1998         1997         1995
                                           -------------------------------------
                                           (in thousands, except per share data)
<S>                                        <C>           <C>          <C>
Pro forma net income (loss)                $  (890)     $   218       $   11,220
Pro forma earnings (loss) per share:
   Basic                                      (.07)         .02              .95
   Diluted                                    (.07)         .02              .92

</TABLE>

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>
                                                    Fiscal Year Ended
                                          -----------------------------------
                                          January 4   January 5   December 31
                                            1998        1997          1995
                                          -----------------------------------

<S>                                       <C>          <C>            <C>
Expected volatility                       0.649        0.607           0.607
Risk-free interest rate                   6.28%        6.34%           6.50%
Expected life of option in years          6.0          6.0             6.0
Expected dividend yield                   0.0%         0.0%            0.0%

</TABLE>

                                      F-14


                                       
<PAGE>

                               Movie Gallery, Inc.

              Notes to Consolidated Financial Statements (continued)


7.  Stockholders' Equity (continued)

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
detailed  below.  During 1997, the Company  modified  505,100 stock options with
exercise prices ranging from $6.00 to $42.63 by cancelling the stock options and
issuing  378,827  new  stock  options  at  an  exercise  price  of  $3.88.  This
modification excluded directors and certain executive senior management.



<TABLE>
<CAPTION>


                                                                       Fiscal Year Ended
                                  --------------------------------------------------------------------------------------------------
                                          January 4, 1998                January 5, 1997                 December 31, 1995
                                  --------------------------------------------------------------------------------------------------
                                                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                          1,318,650        $   21.98      1,107,450       $   24.63         699,000        $   14.88
Granted                            1,256,087             4.04        379,500           14.15         578,000            34.19
Exercised                               --                --          35,100           14.92         129,000            14.21
Forfeited                            679,200            20.50        133,200           23.58          40,550            25.94

Outstanding-end of year            1,895,537            10.62      1,318,650           21.98       1,107,450            24.63

Exercisable at end of year           916,908            14.43        622,125           21.28         424,150            20.41

Weighted-average fair value
  of options granted during
  the year                         $    2.62                       $    8.84                       $   21.39
</TABLE>

Options  outstanding  as of  January  4, 1998 had a  weighted-average  remaining
contractual  life of 8.9 years and exercise  prices ranging from $3.00 to $42.63
as follows:
<TABLE>
<CAPTION>

                                                                   Exercise price of
                                                   $3.00 to $6.00   $14.00 to $22.00   $24.00 to $43.00
                                                   ----------------------------------------------------

<S>                                                  <C>                <C>                 <C>
Options outstanding                                  1,208,587          411,350             275,600
Weighted-average exercise price                          $3.97           $15.08              $33.17
Weighted-average remaining contractual life          9.7 years        7.3 years           7.4 years
Options exercisable                                    374,858          342,550             199,500
Weighted-average exercise price of
   exercisable options                                   $4.25           $15.09              $32.41
</TABLE>

                                      F-15


                                       
<PAGE>

                               Movie Gallery, Inc.

              Notes to Consolidated Financial Statements (continued)


8.  Commitments and Contingencies

Rent  expense for the fiscal  years ended  January 4, 1998,  January 5, 1997 and
December   31,  1995   totaled   $40,788,000,   $37,266,000   and   $19,960,000,
respectively.  Future minimum  payments under  noncancellable  operating  leases
which contain  renewal  options and escalation  clauses with remaining  terms in
excess of one year consisted of the following at January 4, 1998 (in thousands):

<TABLE>
<S>                         <C>               <C>
                            1998              $ 28,418
                            1999                24,851
                            2000                15,926
                            2001                 8,503
                            2002                 5,841
                            Thereafter          10,223
                                              --------
                                              $ 93,762
                                              ========
</TABLE>

The Company has an agreement with Rentrak Corporation which requires the Company
to order  videocassette  rental  inventory under lease  sufficient to require an
aggregate  minimum  payment of $4,000,000  per year in revenue  share,  handling
fees,  sell through fees and end-of-term buyout fees.  The agreement  expires in
2006. The Company met its minimum purchase requirement in 1997.

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 year ended  December 31, 1995, the Company  purchased  signs totaling
$1,683,000 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  $78,000,  $260,000  and $650,000 in legal fees for the fiscal
years  ended   January  4,  1998,   January  5,  1997  and  December  31,  1995,
respectively, to a law firm of which one of the Company's directors is a member.

                                      F-16


                                       
<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).  Earnings per share amounts for 1996 and the
first three  quarters of 1997 have been  restated  to comply with  Statement  of
Financial Accounting Standards No. 128, "Earnings per Share" (see Note 1).
<TABLE>
<CAPTION>

                                                        Thirteen Weeks Ended
                                       ---------------------------------------------------
                                       April 6       July 6        October 5      January 4
                                         1997         1997            1997          1998
                                       ----------------------------------------------------

<S>                                    <C>           <C>           <C>            <C>
Revenue                                $65,678       $61,328       $62,560        $70,790
Operating income (loss)                  4,716          (233)         (901)         4,647
Net income (loss)                        1,996        (1,203)       (1,669)         1,781
Basic and diluted earnings (loss)
   per share                               .15          (.09)         (.12)           .13


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

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
Basic and diluted pro forma
  earnings (loss) per share                .39          (.21)         (.33)             .28
 
</TABLE>

11.  Subsequent Events

The  Company  was  engaged  in  litigation   proceedings   with  certain  former
shareholders  of Home  Vision in  connection  with the merger of the Company and
Home Vision in July 1996. These shareholders ultimately sought damages in excess
of $10  million  plus costs.  On March 19,  1998,  the  Company  received a jury
verdict in its favor with respect to all claims brought  against it and does not
expect to pay any monetary damages associated with this case.



                                      F-17

                                       
<PAGE>



                                Index to Exhibits


Exhibit No.       Description

10.6              Employment Agreement between M.G.A., Inc. and J. Steven Roy.

10.7              Employment Agreement between M.G.A., Inc. and S. Page Todd.

10.8              Employment Agreement between M.G.A., Inc. and Steven M. Hamil.

21                List of Subsidiaries.

23                Consent of Ernst & Young LLP.

27                Financial Data Schedule.

27.1              Financial Data Schedule - Restated for January 5, 1997.