**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

** **

**FORM 10-Q**

 

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

## ** **

### **Commission file number 0-24548**

### ** **

**Movie Gallery, Inc.**

(Exact name ofregistrant as specified in its charter)

 
| **Delaware**                              | ** ** | **63-1120122**       |
|-------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer     |
| incorporation or  organization)           |       | Identification  No.) |
|                                      | ** ** | ** **           |
| **900 West Main Street, Dothan, Alabama** | ** ** | **36301**            |
| (Address of  principal executive offices) |       | (Zip Code)           |

 

**(334)677-2108**

(Registrant’stelephone number, including area code)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to filing requirementsfor the past 90 days.  YES ý NO o

 

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

 

The number ofshares outstanding of the registrant’s common stock as of August 10, 2004was 32,308,558.

 

 

----

 

#### **Movie Gallery,Inc.**

#### **Index**

 
| Part I.  Financial Information                                                                                           |   |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                                          |   |   |
| Item 1.  Consolidated Financial Statements (Unaudited)                                                                   |   |   |
|                                                                                                                          |   |   |
| Consolidated Balance  Sheets  – January 4, 2004 and  July 4, 2004                                         |   |   |
|                                                                                                                          |   |   |
| Consolidated  Statements of Income – Thirteen weeks and twenty-six weeks ended July 6,  2003 and July  4, 2004 |   |   |
|                                                                                                                          |   |   |
| Consolidated  Statements of Cash Flows – Twenty-six weeks ended July 6, 2003 and  July 4, 2004                 |   |   |
|                                                                                                                          |   |   |
| Notes  to Consolidated Financial Statements – July 4, 2004                                                          |   |   |
|                                                                                                                          |   |   |
| Item  2.  Management’s Discussion and  Analysis of Financial Condition and Results of Operations                    |   |   |
|                                                                                                                          |   |   |
| Item 3.   Quantitative and Qualitative Disclosures About Market Risk                                                     |   |   |
|                                                                                                                          |   |   |
| Item 4.   Controls and Procedures                                                                                        |   |   |
|                                                                                                                          |   |   |
| Part II.  Other Information                                                                                              |   |   |
|                                                                                                                          |   |   |
| Item 4.   Submission of Matters to a Vote of Security Holders                                                            |   |   |
|                                                                                                                          |   |   |
| Item 6.  Exhibits and Reports on Form 8-K                                                                                |   |   |

 

----

 

**MovieGallery, Inc.**

**ConsolidatedBalance Sheets**

**(inthousands)**

 
| ** **                                                                                                                           | ** ** | **January 4,  2004** | ** ** | **July 4,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                                                                                                                           | ** ** | ** **                | ** ** | **(Unaudited)**        | ** ** |
| **Assets**                                                                                                                           | ** ** | ** **                | ** ** | ** **             | ** ** |
| Current  assets:                                                                                                                     |       |                      |       |                   |       |
| Cash  and cash equivalents                                                                                                           |       | $                         | 53,720     |                   | **$**      | **26,129** | ** ** |
| Merchandise  inventory                                                                                                               |       | 26,473                    |       | **25,001**             | ** ** |
| Prepaid  expenses                                                                                                                    |       | 1,377                     |       | **1,805**              | ** ** |
| Store  supplies and other                                                                                                            |       | 11,019                    |       | **9,204**              | ** ** |
| Deferred  income taxes                                                                                                               |       | 1,631                     |       | **2,390**              | ** ** |
| Total  current assets                                                                                                                |       | 94,220                    |       | **64,529**             | ** ** |
|                                                                                                                                 |       |                      |       | ** **             | ** ** |
| Rental  inventory, net                                                                                                               |       | 102,479                   |       | **114,254**            | ** ** |
| Property,  furnishings and equipment, net                                                                                            |       | 114,356                   |       | **126,898**            | ** ** |
| Goodwill,  net                                                                                                                       |       | 136,008                   |       | **140,478**            | ** ** |
| Other  intangibles, net                                                                                                              |       | 8,473                     |       | **8,410**              | ** ** |
| Deposits  and other assets                                                                                                           |       | 8,753                     |       | **5,768**              | ** ** |
| Total  assets                                                                                                                        |       | $                         | 464,289    |                   | **$**      | **460,337** | ** ** |
|                                                                                                                                 |       |                      |       | ** **             | ** ** |
| **Liabilities and stockholders’ equity**                                                                                        |       |                      |       | ** **             | ** ** |
| Current  liabilities:                                                                                                                |       |                      |       | ** **             | ** ** |
| Accounts  payable                                                                                                                    |       | $                         | 77,344     |                   | **$**      | **55,780** | ** ** |
| Accrued  liabilities                                                                                                                 |       | 26,161                    |       | **26,998**             | ** ** |
| Deferred  revenue                                                                                                                    |       | 10,741                    |       | **8,200**              | ** ** |
| Total  current liabilities                                                                                                           |       | 114,246                   |       | **90,978**             | ** ** |
|                                                                                                                                 |       |                      |       | ** **             | ** ** |
| Other  accrued liabilities                                                                                                           |       | 142                       |       | **141**                | ** ** |
| Deferred  income taxes                                                                                                               |       | 29,785                    |       | **39,409**             | ** ** |
| Stockholders’  equity:                                                                                                          |       |                      |       | ** **             | ** ** |
| Preferred  stock, $.10 par value; 2,000,000 shares authorized, no shares issued or outstanding                                       |       | —                    |       | **—**             | ** ** |
| Common  stock, $.001 par value; 65,000,000 shares authorized, 32,840,849 and  32,261,154 shares issued and outstanding, respectively |       | 33                        |       | **33**                 | ** ** |
| Additional  paid-in capital                                                                                                          |       | 225,191                   |       | **209,053**            | ** ** |
| Retained  earnings                                                                                                                   |       | 91,098                    |       | **118,013**            | ** ** |
| Accumulated  other comprehensive income                                                                                              |       | 3,794                     |       | **2,710**              | ** ** |
| Total  stockholders’ equity                                                                                                     |       | 320,116                   |       | **329,809**            | ** ** |
| Total  liabilities and stockholders’ equity                                                                                     |       | $                         | 464,289    |                   | **$**      | **460,337** | ** ** |

 

*Seeaccompanying notes.*

 

1

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**MovieGallery, Inc.**

**Consolidated Statements of Income**

**(Unaudited)**

**(inthousands, except per share data)**

 
| ** **                            | ** ** | **Thirteen Weeks Ended** | ** ** | **Twenty-Six Weeks Ended** | ** ** |
|---------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **July 6,  2003**   | ** ** | **July 4,  2004**     | ** ** | **July 6,  2003** | ** ** | **July 4,  2004** | ** ** |
|                                  |       |                     |       |                       |       |   |   |   |   |
| Revenues:                             |       |                     |       |                       |       |   |   |   |   |
| Rentals                               |       | $                        | 148,576    |                       | **$**      | **175,239** | ** ** | $ | 301,757 |   | **$** | **361,996** | ** ** |
| Product  sales                        |       | 12,422                   |       | **14,352**                 | ** ** | 27,890 |   | **30,897** | ** ** |
| Total  revenues                       |       | 160,998                  |       | **189,591**                | ** ** | 329,647 |   | **392,893** | ** ** |
|                                  |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Cost  of sales:                       |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Cost  of rental revenues              |       | 42,823                   |       | **49,908**                 | ** ** | 90,407 |   | **101,653** | ** ** |
| Cost  of product sales                |       | 9,771                    |       | **10,132**                 | ** ** | 22,442 |   | **21,072** | ** ** |
| Gross  profit                         |       | 108,404                  |       | **129,551**                | ** ** | 216,798 |   | **270,168** | ** ** |
|                                  |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Operating  costs and expenses:        |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Store  operating expenses             |       | 79,415                   |       | **97,707**                 | ** ** | 153,899 |   | **193,762** | ** ** |
| General  and administrative           |       | 11,729                   |       | **13,686**                 | ** ** | 22,505 |   | **27,482** | ** ** |
| Amortization  of intangibles          |       | 470                      |       | **675**                    | ** ** | 896 |   | **1,289** | ** ** |
| Stock  option compensation            |       | 1,029                    |       | **(16**                    | **)**      | 1,498 |   | **40** | ** ** |
| Operating  income                     |       | 15,761                   |       | **17,499**                 | ** ** | 38,000 |   | **47,595** | ** ** |
|                                  |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Interest  expense, net                |       | (143                     | )          | **(66**                    | **)**      | (242 | ) | **(165** | **)** |
| Income  before income taxes           |       | 15,618                   |       | **17,433**                 | ** ** | 37,758 |   | **47,430** | ** ** |
|                                  |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Income  taxes                         |       | 6,141                    |       | **6,799**                  | ** ** | 14,997 |   | **18,544** | ** ** |
| Net  income                           |       | $                        | 9,477      |                       | **$**      | **10,634** | ** ** | $ | 22,761 |   | **$** | **28,886** | ** ** |
|                                  |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Net  income per share:                |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Basic                                 |       | $                        | 0.29       |                       | **$**      | **0.32** | ** ** | $ | 0.71 |   | **$** | **0.88** | ** ** |
| Diluted                               |       | $                        | 0.28       |                       | **$**      | **0.32** | ** ** | $ | 0.69 |   | **$** | **0.86** | ** ** |
|                                  |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Weighted  average shares outstanding: |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Basic                                 |       | 32,275                   |       | **32,794**                 | ** ** | 32,186 |   | **32,933** | ** ** |
| Diluted                               |       | 33,310                   |       | **33,254**                 | ** ** | 33,197 |   | **33,495** | ** ** |
|                                  |       |                     |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Cash  dividends per common share      |       | $                        | —     |                       | **$**      | **0.03** | ** ** | $ | — |   | **$** | **0.06** | ** ** |

 

*Seeaccompanying notes.*

 

2

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**Movie Gallery, Inc.**

**ConsolidatedStatements of Cash Flows**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                         | ** ** | **Twenty-Six Weeks Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                         | ** ** | **July 6,  2003**     | ** ** | **July 4,  2004** | ** ** |
|                                                                               |       |                       |       |   |   |
| **Operating activities:**                                                          |       |                       |       |   |   |
| Net income                                                                         |       | $                          | 22,761     |   | **$** | **28,886** | ** ** |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                       |       | ** ** | ** ** |
| Rental  inventory amortization                                                     |       | 65,954                     |       | **69,837** | ** ** |
| Purchases  of rental inventory                                                     |       | (59,741                    | )          | **(72,303** | **)** |
| Depreciation  and intangibles amortization                                         |       | 10,981                     |       | **14,408** | ** ** |
| Stock  option compensation                                                         |       | 1,498                      |       | **40** | ** ** |
| Tax  benefit of stock options exercised                                            |       | 1,607                      |       | **4,079** | ** ** |
| Deferred  income taxes                                                             |       | 2,187                      |       | **8,865** | ** ** |
| Changes in operating  assets and liabilities:                                      |       |                       |       | ** ** | ** ** |
| Merchandise  inventory                                                             |       | (244                       | )          | **1,571** | ** ** |
| Other  current assets                                                              |       | (1,305                     | )          | **1,387** | ** ** |
| Deposits  and other assets                                                         |       | (1,204                     | )          | **2,985** | ** ** |
| Accounts  payable                                                                  |       | (20,306                    | )          | **(21,564** | **)** |
| Accrued  liabilities and deferred revenue                                          |       | 5,374                      |       | **(1,716** | **)** |
| Net  cash provided by operating activities                                         |       | 27,562                     |       | **36,475** | ** ** |
|                                                                               |       |                       |       | ** ** | ** ** |
| **Investing activities:**                                                          |       |                       |       | ** ** | ** ** |
| Business  acquisitions                                                             |       | (16,709                    | )          | **(7,747** | **)** |
| Purchases  of rental inventory-base stock                                          |       | (9,650                     | )          | **(7,822** | **)** |
| Purchases  of property, furnishings and equipment                                  |       | (20,976                    | )          | **(25,167** | **)** |
| Net  cash used in investing activities                                             |       | (47,335                    | )          | **(40,736** | **)** |
|                                                                               |       |                       |       | ** ** | ** ** |
| **Financing activities:**                                                          |       |                       |       | ** ** | ** ** |
| Proceeds  from exercise of stock options                                           |       | 669                        |       | **4,575** | ** ** |
| Proceeds  from employee stock purchase plan                                        |       | —                     |       | **168** | ** ** |
| Purchases  and retirement of common stock                                          |       |                       |       | **(25,000** | **)** |
| Payment  of dividends                                                              |       | —                     |       | **(1,989** | **)** |
| Net  cash provided by (used in) financing activities                               |       | 669                        |       | **(22,246** | **)** |
|                                                                               |       |                       |       | ** ** | ** ** |
| Effect  of exchange rate changes on cash and cash equivalents                      |       | 3,029                      |       | **(1,084** | **)** |
| Decrease  in cash and cash equivalents                                             |       | (16,075                    | )          | **(27,591** | **)** |
| Cash  and cash equivalents at beginning of period                                  |       | 39,526                     |       | **53,720** | ** ** |
| Cash  and cash equivalents at end of period                                        |       | $                          | 23,451     |   | **$** | **26,129** | ** ** |

 

*Seeaccompanying notes.*

 

3

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**MovieGallery, Inc.**

 

**Notesto Consolidated Financial Statements (Unaudited)**

 

**July 4,2004**

 

**1.****              AccountingPolicies**

 

*Principlesof Consolidation*

 

The accompanying unaudited financial statements present theconsolidated financial position, results of operations and cash flows of MovieGallery, Inc. and subsidiaries. Investments in unconsolidated subsidiaries where we have significantinfluence but do not have control are accounted for using the equity method of accountingfor investments in common stock.

 

*Basis ofPresentation*

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete consolidated financial statements.  The balance sheet at January 4, 2004 hasbeen derived from the audited financial statements at that date but does notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the twenty-six week period ended July 4, 2004are not necessarily indicative of the results that may be expected for thefiscal year ending January 2, 2005. For further information, refer to the consolidated financial statementsand footnotes thereto included in our Annual Report on Form 10-K for the fiscalyear ended January 4, 2004.

 

In the first quarter of2004, we began reporting the on-going purchases of new release rental inventoryas an operating activity in the statement of cash flows rather than aninvesting activity as previously reported.  This reclassification is appropriate as the rental of this inventorygenerates the majority of our revenue. Purchases of rental inventory for newstores or other significant investments in base stock rental inventory continueto be classified as investing activities in the statements of cash flows asthese purchases represent a long-term investment in our business.  Rental inventory purchases in the prior yearhave been reclassified to conform to the current year presentation forcomparative purposes.  Thereclassification had no impact on our financial position or results ofoperations as previously reported.

 

*Revenue Recognition*

 

We recognize rentalrevenue when a movie or video game is rented by the customer.  Revenue from extended viewing fees incurredon rentals when the customer chooses to keep the product beyond the initialrental period is recognized when payment is received from the customer.  We recognize product sales revenue at thetime of sale.   We offer returnprivileges on certain of our products, including a lifetime guarantee onpreviously viewed inventory.    Our salesreturns and allowances are immaterial.

 

We periodically sellstored value cards in the form of electronic gift cards or discount rentalcards.  We record deferred revenue fromthe sale of stored value cards at the time of sale to the customer.  The liability is relieved and revenue isrecognized when the cards are redeemed by the customers.

 

*StockOption Plan*

 

We account for stock-based employee compensation under the recognitionand measurement principles of APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related Interpretations.  Stock option compensation is reflected in net

 

4

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income for variableoptions outstanding under the plan.  Nostock option compensation is reflected in net income for fixed optionsoutstanding under the plan where the exercise price was equal to the marketvalue of the underlying common stock on the date of grant.

 

The following table illustrates the effect on net income and earningsper share if we had applied the fair value recognition provision of FASBStatement No. 123, *Accounting for Stock-BasedCompensation*, as amended, to stock-based employee compensation.

 
| ** **                                                                                               | ** ** | **Thirteen Weeks Ended**                  | ** ** | **Twenty-Six Weeks Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                               | ** ** | **July 6,  2003**                    | ** ** | **July 4,  2004**     | ** ** | **July 6,  2003** | ** ** | **July 4,  2004** | ** ** |
| ** **                                                                                               | ** ** | **(in thousands, except per share data)** | ** ** |
|                                                                                                     |       |                                      |       |                       |       |   |   |   |   |
| Net  income, as reported                                                                                 |       | $                                         | 9,477      |                       | **$**      | **10,634** | ** ** | $ | 22,761 |   | **$** | **28,886** | ** ** |
| Add:  Stock option compensation included in reported net income, net of tax                              |       | 622                                       |       | **(10**                    | **)**      | 903 |   | **24** | ** ** |
| Deduct:  Stock option compensation determined under fair value based methods for all  awards, net of tax |       | (140                                      | )          | **(330**                   | **)**      | (272 | ) | **(587** | **)** |
|                                                                                                     |       |                                      |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Pro  forma net income                                                                                    |       | $                                         | 9,959      |                       | **$**      | **10,294** | ** ** | $ | 23,392 |   | **$** | **28,323** | ** ** |
|                                                                                                     |       |                                      |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Net  income per share:                                                                                   |       |                                      |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Basic                                                                                                    |       | $                                         | 0.29       |                       | **$**      | **0.32** | ** ** | $ | 0.71 |   | **$** | **0.88** | ** ** |
| Diluted                                                                                                  |       | $                                         | 0.28       |                       | **$**      | **0.32** | ** ** | $ | 0.69 |   | **$** | **0.86** | ** ** |
|                                                                                                     |       |                                      |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Pro  forma net income per share:                                                                         |       |                                      |       | ** **                 | ** ** |   |   | ** ** | ** ** |
| Basic                                                                                                    |       | $                                         | 0.31       |                       | **$**      | **0.31** | ** ** | $ | 0.73 |   | **$** | **0.86** | ** ** |
| Diluted                                                                                                  |       | $                                         | 0.30       |                       | **$**      | **0.31** | ** ** | $ | 0.70 |   | **$** | **0.84** | ** ** |

 

*Recently Issued AccountingPronouncements*

 

In January 2003, the Financial Accounting Standards Board issuedInterpretation No. 46, *Consolidation of VariableInterest Entities, an Interpretation of Accounting Research Bulletin No. 51*(“theInterpretation”).  The Interpretationrequires the consolidation of entities in which an enterprise absorbs amajority of the entity’s expected losses, receives a majority of the entity’sexpected residual returns, or both, as a result of ownership, contractual orother financial interests in the entity. Currently, entities are generally consolidated by an enterprise when ithas a controlling financial interest through ownership of a majority votinginterest in the entity.  TheInterpretation was effective as of December 31, 2003 for all qualifyinginterests in special purpose entities (“SPEs”) in existence as ofJanuary 31, 2003 and as of February 1, 2003 for all qualifying SPEsobtained after January 31, 2003.  Wehad no qualifying interests as of January 31, 2003.  We have subsequently made equity investmentsin other entities during 2003 (none of which are SPEs).  These investments are immaterial, andconsolidation is not currently required under the Interpretation.   The provisions of the Interpretation, asrevised by the FASB in December 2003, were adopted in the first quarter of2004.   Our adoption of this standard didnot have a material impact on our financial position or results of operations.

 

**2.  Rental Inventory**

 

In the fourth quarter of 2002, we changed the estimates used to amortize rental inventory byreducing  the estimated useful lives ofthe rental inventory and reducing salvage value for both VHS and gameinventory. The change in estimate

 

5

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decreased rental inventoryand increased depreciation expense for the thirteen and  twenty-six weeks ended July 6, 2003 byapproximately $1.4 million and $4.1 million, respectively, and reduced netincome by $0.03 and $0.07 per diluted share, respectively.

 

**3.  Goodwill and Other Intangible Assets**

 

The components of goodwill and amortized other intangible assets are asfollows (in thousands):

 
| ** **                     | ** ** | ** **                                | ** ** | **January 4, 2004**   | ** ** | **July 4, 2004**         | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                     | ** ** | **Weighted-Average  Amortization Period** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
|                           |       |                                      |       |                       |       |                          |       |   |   |   |   |
| Goodwill                       |       | —                                    |       | $                          | 167,419    |                          | $          | (31,411 | ) | **$** | **171,889** | ** ** | **$** | **(31,411** | **)** |
|                           |       |                                      |       |                       |       |                          |       | ** ** | ** ** | ** ** | ** ** |
| Non-compete  agreements        |       | 8 years                                   |       | $                          | 10,908     |                          | $          | (7,696 | ) | **$** | **11,181** | ** ** | **$** | **(8,385** | **)** |
| Customer  lists                |       | 5 years                                   |       | 6,385                      |       | (1,124                        | )          | **7,336** | ** ** | **(1,722** | **)** |
| Total  other intangible assets |       |                                      |       | $                          | 17,293     |                          | $          | (8,820 | ) | **$** | **18,517** | ** ** | **$** | **(10,107** | **)** |

 

Estimated amortization expense for other intangible assets for theremainder of 2004 and the five succeeding fiscal years is as follows (inthousands):

 

| **2004 (remainder)** | ** ** | **$** | **1,282** | ** ** |
|----------------------|------------|-------|-----------|------------|
| 2005                 |       | 2,129 |      |
| 2006                 |       | 1,802 |      |
| 2007                 |       | 1,661 |      |
| 2008                 |       | 1,142 |      |
| 2009                 |       | 343   |      |

 

The changes in the carrying amounts of goodwill for the twenty-sixweeks ended July 4, 2004, are as follows (in thousands):

 

| Balance  as of January 4, 2004 |   | $     | 136,008 |   |
|-------------------------------------|--------|-------|---------|--------|
| Goodwill  acquired                  |   | 4,470 |    |
| Balance  as of July 4, 2004    |   | $     | 140,478 |   |

 

**During the twenty-six weeks endedJuly 4, 2004, we purchased 55 stores in 13 separate transactions forapproximately $7.7 million and recorded approximately $4.5 million in goodwill,$1.0 million for customer lists and $0.3 million for non-compete agreementsrelated to these transactions.**

** **

**4.  Financing Obligations**

** **

On June 27, 2001, we entered into a credit agreement with asyndicate of banks, led by SouthTrust Bank, with respect to a revolving creditfacility.  Our credit facility isunsecured and, as amended, provides for borrowings of up to $65 million throughfinal maturity on July 4, 2005.  Theinterest rate on our credit facility is based on LIBOR plus an applicablemargin percentage, which depends on cash flow generation and borrowingsoutstanding.  As of July 4,  2004, there were no outstanding borrowingsunder our credit facility.  The amountavailable for borrowing, which was reduced by standby letters of creditoutstanding of $1.5 million, was $63.5 million as of July 4, 2004.

 

6

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**5.  Earnings Per Share**

 

Basic earnings per share is computed based on the weighted averagenumber of shares of common stock outstanding during the periods presented.  Diluted earnings per share is computed basedon the weighted average number of shares of common stock outstanding during theperiods presented, increased solely by the effects of shares to be issued fromthe exercise of dilutive common stock options (1,035,000 and 460,000 for thethirteen weeks ended July 6, 2003 and July 4, 2004, respectively;1,011,000 and 562,000 for the twenty-six weeks ended July 6, 2003 andJuly 4, 2004, respectively).  Noadjustments were made to net income in the computation of basic or dilutedearnings per share.

 

During the second quarter of 2004, we completed a $25 million stockbuyback program repurchasing 1,336,312 shares of our common stock at an averageprice of $18.71 per share.  The board ofdirectors also approved an additional stock buyback program authorizingmanagement to repurchase up to an additional $25 million of our commonstock.  As of August 10, 2004, werepurchased 828,000 shares at an average price of $17.69 per share under ournew stock buyback program.

 

**6.  Comprehensive Income**

 

Comprehensive income was as follows (in thousands):

 
| ** **                               | ** ** | **Thirteen Weeks Ended** | ** ** | **Twenty-Six Weeks Ended** | ** ** |
|------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                               | ** ** | **July 6,**         | ** ** | **July 4,**           | ** ** | **July 6,** | ** ** | **July 4,** | ** ** |
| ** **                               | ** ** | **2003**                 | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                     |       |                     |       |                       |       |   |   |   |   |
| Net  income                              |       | $                        | 9,477      |                       | **$**      | **10,634** | ** ** | $ | 22,761 |   | **$** | **28,886** | ** ** |
| Foreign  currency translation adjustment |       | 1,972                    |       | **(416**                   | **)**      | 3,029 |   | **(1,084** | **)** |
| Comprehensive  income                    |       | $                        | 11,449     |                       | **$**      | **10,218** | ** ** | $ | 25,790 |   | **$** | **27,802** | ** ** |

 

7

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**MovieGallery, Inc.**

 

**Management’sDiscussion and Analysis of Financial Condition**

**andResults of Operations**

 

**Overview**

 

We operate over 2,300 home video retail stores that rent and sellmovies and video games, primarily in rural and secondary markets throughoutNorth America.  We compete with the othertwo national chains (Blockbuster and Hollywood Entertainment) in approximatelyone-third of our store locations.  As aresult, we believe that we are the market leader in the majority of our targetmarkets.  We estimate that there areapproximately 3,000 to 4,000 markets still available for expansion in ruralAmerica, as well as opportunities throughout Canada and Mexico.  We currently plan to open approximately 300new stores in 2004, approximately 400 new stores in 2005 and, subject to marketand industry conditions, we expect to continue to open new stores at a similarpace over the next several years.

 

We believe the most significant dynamic in our industry is therelationship our business maintains with the movie studios.  The studios have historically maintained anexclusive window for home video distribution (packaged goods) which providesthe home video industry with an approximate 45 day period during which they cansell and rent new releases before they are made available on pay-per-view or otherdistribution channels.  The home videoindustry currently provides over 60% of studio revenue.  For this reason, we believe movie studioshave a significant interest in maintaining a viable home video business.  For a more detailed discussion of our businessand the home video industry, see the Business discussion contained in Part I,Item 1 of our Annual Report on Form 10-K for the fiscal year endedJanuary 4, 2004.

 

Our strategies are designed to achieve reasonable, moderate andconsistent growth in same-store revenues and profitability, in a matureindustry.  We foster a corporate cultureof cost control, striving to minimize the operating and overhead costsassociated with our business which allows us to maximize profitability andwhich has proven to be a successful operating model for us.  Our balance sheet reflects $26.1 million incash and cash equivalents at July 4, 2004 and we have not had anyoutstanding long-term debt since May 2002. Our store base has increased in excess of 20% in each of the last threefiscal years.

 

In addition to the relationship between our industry and the moviestudios, our operating results are driven by revenue, inventory, rent andpayroll.  Given those key factors, webelieve that by monitoring the five operating performance indicators describedbelow, we can continue to be successful in executing our operating plans andour growth strategy.

 

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

•                  *Product purchasing economics.*  In order to maintain the desired profitmargin in our business, purchases of inventory for both rental and sale must becarefully managed.  Our purchasing modelsare designed to analyze the impact of the economic factors inherent in thevarious pricing strategies employed by the studios.  We believe that we are able to achievepurchasing levels tailored for the customer demographics of each of our marketsand to maximize the return on investment for our inventory purchase dollars.

•                  *Store level cost control.* The most significant store expenses are payroll and rent, followed byall other supply and service expenditures. Our fundamental philosophy with respect to store level expenses is toexercise extreme conservatism in spending. This is achieved primarily through budgeting systems and centralizationof purchases into the corporate support center. This enables us to measure performance carefully against expectationsand to leverage our purchasing power.  Our rural focus also provides the benefit of reduced labor and realestate costs in the secondary markets we serve versus the costs associated withlarger urban markets.

 

8

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•                  *Leverage of overhead expenses.*  We apply the same principles of budgeting,accountability and conservatism in our overhead spending that we employ inmanaging our store operating costs.  Ourgeneral and administrative expenses include the costs to maintain our corporatesupport center as well as the overhead costs of our field management team.

•                  *Operating cash flows.* We have generated significant levels of cash flow for severalyears.  We are generally able to fund themajority of our store growth and acquisitions, as well as ongoing inventorypurchases, from cash flow generated from operations.  Cash flow has been sufficient to allow us tomaintain a debt-free balance sheet since May 2002.

 

The following discussion of our results of operations, liquidity andcapital resources will provide further insight into our performance for thesecond quarter and year-to-date period of 2004 versus the comparable periods of2003.

 

**New Business Initiatives**

 

During the last half of2003, we began to make some investments in various alternative deliveryvehicles (both retail and digital) for movie content, and we began to exploreother business initiatives within our existing base of stores, including testsof a game store-within-a-store, movie trading and in-store moviesubscriptions.  We do not anticipate thatany of these alternatives will replace our base video rental business.  However, we do believe it is appropriate tomake selective investments in synergistic opportunities that could potentiallyprovide ancillary sources of revenue and profitability to our base rentalbusiness.  Our operating expenses andgeneral and administrative expenses in the second quarter and year-to-dateperiod of 2004 include certain costs related to these investments and initiatives..

 

9

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**Results  of Operations**

 

**Selected Financial Statement and Operational Data:**

 
| ** **                           | ** ** | **Thirteen Weeks Ended**                                   | ** ** | **Twenty-Six Weeks Ended** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | **July 6,**                                           | ** ** | **July 4,**           | ** ** | **July 6,** | ** ** | **July 4,** | ** ** |
| ** **                           | ** ** | **2003**                                                   | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                 |       | **($ in thousands, except per share and store data)** |       |
|                                 |       | ** **                                                 |       |
| Rental  revenues                     |       | $                                                          | 148,576    |                       | $          | 175,239 |   | $ | 301,757 |   | $ | 361,996 |   |
| Product  sales                       |       | 12,422                                                     |       | 14,352                     |       | 27,890 |   | 30,897 |   |
| Total  revenues                      |       | 160,998                                                    |       | 189,591                    |       | 329,647 |   | 392,893 |   |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| Cost  of rental revenues             |       | 42,823                                                     |       | 49,908                     |       | 90,407 |   | 101,653 |   |
| Cost  of product sales               |       | 9,771                                                      |       | 10,132                     |       | 22,442 |   | 21,072 |   |
| Total  gross profit                  |       | $                                                          | 108,404    |                       | $          | 129,551 |   | $ | 216,798 |   | $ | 270,168 |   |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| Store  operating expenses            |       | $                                                          | 79,415     |                       | $          | 97,707 |   | $ | 153,899 |   | $ | 193,762 |   |
| General  and administrative expenses |       | $                                                          | 11,729     |                       | $          | 13,686 |   | $ | 22,505 |   | $ | 27,482 |   |
| Stock  option compensation           |       | $                                                          | 1,029      |                       | $          | (16 | ) | $ | 1,498 |   | $ | 40 |   |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| Operating  income                    |       | $                                                          | 15,761     |                       | $          | 17,499 |   | $ | 38,000 |   | $ | 47,595 |   |
| Net  income                          |       | $                                                          | 9,477      |                       | $          | 10,634 |   | $ | 22,761 |   | $ | 28,886 |   |
| Net  income per diluted share        |       | $                                                          | 0.28       |                       | $          | 0.32 |   | $ | 0.69 |   | $ | 0.86 |   |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| Cash  dividends per common share     |       | $                                                          | —     |                       | $          | 0.03 |   | $ | — |   | $ | 0.06 |   |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| Rental  margin                       |       | 71.2                                                       | %          | 71.5                       | %          | 70.0 | % | 71.9 | % |
| Product  sales margin                |       | 21.3                                                       | %          | 29.4                       | %          | 19.5 | % | 31.8 | % |
| Total  gross margin                  |       | 67.3                                                       | %          | 68.3                       | %          | 65.8 | % | 68.8 | % |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| **Percent of total revenues:**       |       |                                                       |       |                       |       |   |   |   |   |
| Rental  revenues                     |       | 92.3                                                       | %          | 92.4                       | %          | 91.5 | % | 92.1 | % |
| Product  sales                       |       | 7.7                                                        | %          | 7.6                        | %          | 8.5 | % | 7.9 | % |
| Store  operating expenses            |       | 49.3                                                       | %          | 51.5                       | %          | 46.7 | % | 49.3 | % |
| General  and administrative expenses |       | 7.3                                                        | %          | 7.2                        | %          | 6.8 | % | 7.0 | % |
| Stock  option compensation           |       | 0.6                                                        | %          | —                     | %          | 0.5 | % | — | % |
| Operating  income                    |       | 9.8                                                        | %          | 9.2                        | %          | 11.5 | % | 12.1 | % |
| Net  income                          |       | 5.9                                                        | %          | 5.6                        | %          | 6.9 | % | 7.4 | % |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| **Same-store revenues**              |       | 6.5                                                        | %          | 1.0                        | %          | 9.0 | % | 1.5 | % |
|                                 |       |                                                       |       |                       |       |   |   |   |   |
| **Store Count:**                     |       |                                                       |       |                       |       |   |   |   |   |
| Beginning  of period                 |       | 1,823                                                      |       | 2,240                      |       | 1,784 |   | 2,158 |   |
| New  store builds                    |       | 47                                                         |       | 75                         |       | 84 |   | 156 |   |
| Stores  acquired                     |       | 72                                                         |       | 31                         |       | 92 |   | 55 |   |
| Stores  closed                       |       | (6                                                         | )          | (15                        | )          | (24 | ) | (38 | ) |
| End  of period                       |       | 1,936                                                      |       | 2,331                      |       | 1,936 |   | 2,331 |   |

 

*Revenue.*   For the thirteen weeks and twenty-six weeksended July 4, 2004, total revenues increased 17.8% and 19.2% from thecomparable periods in 2003.  The increasewas primarily due to over 20% growth in the store base in the

 

10

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2004 periods, as well assame-store revenue growth of 1.0% and 1.5% for the second quarter andyear-to-date period of 2004, respectively. Product sales revenue has decreased as a percentage of total revenue forthe second quarter and year-to-date period of 2004.  This trend is primarily due to a reduction ofnew release theatrical movie inventory available in our stores.  We evaluate our product sales inventory mixand inventory levels on a regular basis and make periodic adjustments to ourretail inventory mix based on our operating strategies and customertrends.  Product sales revenue has notexceeded 10% of total revenue in the last five years.  We expect rental revenue to continue torepresent the majority of our business.

 

The increase in same-store revenues for the second quarter primarilyresulted from:

 

•                  Growthof movie rental revenue, including previously viewed sales, of approximately1.0% due to continued growth in consumer acceptance of the DVD format and astrong movie release schedule with box office revenues approximately 30%higher than the second quarter last year; and

•                  Anincrease in product sales revenue of approximately 2.0%; partially offset by

•                  Adecline in revenue from the game rental business of approximately 4.0%,reflecting the weakness of the new game titles currently being released andindustry softness that occurs in anticipation of the introduction of new gameplatforms.

 

The increase in same-store revenues for the year-to-date periodprimarily resulted from:

 

•                  Growthof movie rental revenue, including previously viewed sales, of approximately2.0% due to continued growth in consumer acceptance of the DVD format;partially offset by

•                  Adecline in product sales revenue of approximately 1.5%; and

•                  Adecline in revenue from the game rental business of approximately 4.0%,reflecting the weakness of the new game titles currently being released andindustry softness that occurs in anticipation of the introduction of new gameplatforms.

 

*Cost of Sales.*  The cost of rental revenues includes theamortization of rental inventory, revenue sharing expenses incurred and thecost of previously viewed rental inventory sold.  The gross margin on rental revenue for thesecond quarter and year-to-date period of 2004 was 71.5% and 71.9%,respectively, versus 71.2% and 70.0% for the comparable quarter andyear-to-date period of 2003.  Theincrease in the gross margin on rental revenue was due to a change in estimaterelated to our amortization policy for rental inventory during the fourthquarter of fiscal 2002 which lowered the rental margin in the second quarterand year-to-date period of 2003 by approximately $1.4 million and $4.1 million,respectively.  Excluding the impact ofthe rental inventory amortization change in 2003, the rental margin for thesecond quarter of 2004 decreased primarily due to softness in the gameindustry.  The rental margin for theyear-to-date period, excluding the impact of the rental inventory amortizationchange in 2003, was consistent with the prior year.

 

Cost of product sales includes the costs of new DVDs, videocassettes,concessions and other goods sold.  Theatrical  new movie releasestypically have a much lower margin than concessions and other goods.  The gross margin on product sales is subjectto fluctuation based on the relative mix of the low margin sales of theatricalnew movie inventory to higher margin sales of concessions and other items.  The gross margin on product sales for thethirteen weeks and twenty-six weeks ended July 4, 2004 was 29.4% and31.8%, respectively, compared to 21.3% and 19.5% for the comparable quarter andyear-to-date period of 2003.  The productsales margin increase reflects an overall shift in the inventory mix to highermargin inventory items.

 

*Operating Costs and Expenses.*  Store operating expenses include store-levelexpenses such as lease payments, in-store payroll, and start-up costsassociated with new store openings, as well as costs associated with some ofour investments in alternative delivery vehicles for movie content.  Store operating expenses as a percentage oftotal revenue was 51.5% and 49.3% for the second quarter and year-to-dateperiod of 2004, respectively, in comparison to 49.3% and 46.7% for 2003,respectively.  The increase in storeoperating expenses as a percentage of total revenue in the second quarter andyear-to-date period of 2004 was primarily due to:

 

11

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•                  Costsassociated with  some of our investmentsin various alternative delivery vehicles for movie content which increasedstore operating expenses by $2.3 million for the quarter and $3.9 millionyear-to-date; and

•                  Asignificant increase in the level of new store openings since last year,generating store opening and start-up costs for a larger number of immaturestores in the revenue base versus last year; (i.e., as of the end of the secondquarter of 2004 we had nearly twice as many stores in the store base that wereless than one year old than we had at the end of the second quarter last year).

 

General and administrative expenses as a percentage of revenue weregenerally flat for the second quarter of 2004 at 7.2% versus 7.3% for thecomparable period in 2003.  Year-to-dategeneral and administrative expenses as a percentage of revenue increased in2004 to 7.0% from 6.8% in 2003.  Theincrease in general and administrative expenses as a percentage of totalrevenue for the year-to-date period was primarily due to:

 

•                  Overheadincreases to support our growth plans, which include continued expansion ingeographic areas where our market penetration is lower; and

•                  Incrementaloverhead costs associated with some of our new business initiatives.

 

Stock option compensation expense represents the non-cash chargeassociated with certain stock options that were repriced during the firstquarter of fiscal 2001 and are subsequently accounted for as variable stockoptions.  Due to the relatively smallnumber of these options that remain outstanding, we expect future adjustmentsto income from stock option compensation to be immaterial.

 

*Operating Income.*  As a result of the impact of the abovefactors on revenues and expenses, operating income increased by 11.0% and 25.3%for the second quarter and year-to-date period of 2004 to $17.5 million and$47.6 million, respectively.

 

**Liquidity and Capital Resources**

 

Our primary capital needs are for opening and acquiring new stores andfor purchasing inventory. Other capital needs include refurbishing, remodelingand relocating existing stores and refreshing, rebranding and supplying newcomputer hardware for acquired stores, as well as repurchases of our commonstock.  We fund inventory purchases,remodeling, rebranding and relocation programs, new store opening costs,acquisitions and stock repurchases primarily from cash flow from operationsand, as necessary, from loans under our credit facility.  At July 4, 2004, we had cash and cashequivalents of $26.1 million, no long-term debt and $63.5 million in availableborrowings under our credit facility.

 
| ** **                                           | ** ** | **Twenty-Six Weeks Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **July 6,**           | ** ** | **July 4,** | ** ** |
| ** **                                           | ** ** | **2003**                   | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **($ in thousands)**  | ** ** |
| **Statements of Cash Flow Data:**                    |       |                       |       |   |   |
| Net  cash provided by operating activites            |       | $                          | 27,562     |   | **$** | **36,475** | ** ** |
| Net  cash used in investing activities               |       | $                          | (47,335    | ) | **$** | **(40,736** | **)** |
| Net  cash provided by (used in) financing activities |       | $                          | 669        |   | **$** | **(22,246** | **)** |

 

12

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The increase in net cashprovided by operating activities was primarily attributable to the increases inoperating income during the first half of 2004 versus the comparable period in2003.   Net cash provided by operatingactivities continues to be sufficient to cover substantially all of our rentalinventory replenishment and capital resource needs.

 

In the first quarter of2004, we began reporting the on-going purchases of new release rental inventoryas an operating activity in the statement of cash flows rather than as aninvesting activity as previously reported.  This reclassification is appropriate as the rental of this inventorygenerates the majority of our revenue. Purchases of rental inventory for new stores or other significantinvestments in base stock rental inventory continue to be classified asinvesting activities in the statements of cash flows as these purchasesrepresent a long-term investment in our business.  Rental inventory purchases in the prior yearhave been reclassified to conform to the current year presentation forcomparative purposes.  Thereclassification had no impact on our financial position or results ofoperations as previously reported.

 

Net cash used ininvesting activities includes the costs of business acquisitions, new storebuilds and investments in base stock rental inventory.   The decrease was primarily due to aninvestment in base stock DVD inventory of approximately $5.4 million in thefirst quarter of 2003 and lower levels of business acquisitions in the firsthalf of 2004 versus 2003,  partiallyoffset by increased expenditures relating to the higher levels of new storebuilds in 2004 versus the first half of 2003.

 

Net cash provided by(used in) financing activities includes proceeds from the exercise of stockoptions offset by dividends paid in the first half of 2004.  In addition, a $25 million stock buybackprogram was completed in the 2004 second quarter with the company repurchasing1,336,312 shares of common stock at an average price of $18.71 per share.  As of August 10, 2004, 828,000 shares atan average price of $17.69 per share have been repurchased under a new $25million stock buyback program.

 

In June 2004, ourboard of directors declared a cash dividend of $0.03 per share under a newdividend policy instituted in December 2003.  We currently intend to continue to paysimilar quarterly cash dividends on our common stock.  However, the payment of future dividends issubject to the discretion of our board of directors.  Future dividends may be increased, decreasedor suspended from time to time based on a number of factors, including changesin tax laws related to dividends, our financial condition, capitalrequirements, future business prospects, the terms of any documents governingour indebtedness and other factors that our board of directors considersrelevant.

 

Adjusted EBITDA in the firsthalf of 2004 increased 5.1% over the comparable period in the prior year to$59.6 million.  The increase wasprimarily driven by the revenue increase of 19.2% in the first half of 2004,offset partially by more significant levels of new store opening and start-upcosts as a result of the higher mix of immature stores in the store base aswell as $3.9 million in costs associated with some of our investments inalternative delivery vehicles

 

Adjusted EBITDA isdefined as net cash provided by operating activities before changes inoperating assets and liabilities, interest and taxes, less purchases of rentalinventory other than rental inventory purchased for new store openings oracquired in business acquisitions.  AdjustedEBITDA is presented primarily as an alternative measure of liquidity, althoughwe also use it as an internal measure of performance for making businessdecisions and compensating our executives. It is also a widely accepted financial indicator in the home videospecialty retail industry of a company’s ability to incur and service debt,finance its operations and meet its growth plans.  However, our computation of Adjusted EBITDAis not necessarily identical to similarly captioned measures presented by othercompanies in our industry.  We encourageyou to compare the components of our reconciliation of Adjusted EBITDA to cashflows from operations in relation to similar reconciliations provided by othercompanies in our industry.  Ourpresentation of Adjusted EBITDA treats rental inventory as being expensed uponpurchase instead of being capitalized and amortized.  We believe this adjustment is meaningful andappropriate because our annual cash investment in rental inventory issubstantial and in many respects is similar to recurring merchandise inventorypurchases considering our operating cycle and the relatively short useful livesof our rental inventory.  Investorsshould consider our presentation of Adjusted EBITDA in light of itsrelationship to cash flows from operations, cash flows from investingactivities and cash flows from financing activities as shown in our statementsof cash flows.  Adjusted EBITDA is notnecessarily a measure of “free cash flow” because it

 

13

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does not reflect periodicchanges in the level of our working capital or our investments in new storeopenings, business acquisitions, or other long-term investments we maymake.  However, it is an importantmeasure used internally by executive management of our Company in makingdecisions about where to allocate resources to grow our business.

 

Our calculation ofAdjusted EBITDA is reconciled to operating cash flow as follows (in thousands):

 
| ** **                                   | ** ** | **Twenty-Six Weeks Ended** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|
| ** **                                   | ** ** | **July 6,**           | ** ** | **July 4,** | ** ** |
| ** **                                   | ** ** | **2003**                   | ** ** | **2004** | ** ** |
|                                         |       |                       |       |   |   |
| Net  cash provided by operating activities   |       | $                          | 27,562     |   | **$** | **36,475** | ** ** |
| Changes  in operating assets and liabilities |       | 17,685                     |       | **17,337** | ** ** |
| Tax  benefit of stock options exercised      |       | (1,607                     | )          | **(4,079** | **)** |
| Deferred  income taxes                       |       | (2,187                     | )          | **(8,865** | **)** |
| Interest  expense                            |       | 242                        |       | **165** | ** ** |
| Income  taxes                                |       | 14,997                     |       | **18,544** | ** ** |
| Adjusted  EBITDA                             |       | $                          | 56,692     |   | **$** | **59,577** | ** ** |

 

OnJune 27, 2001, we entered into a credit agreement with a syndicate ofbanks, led by SouthTrust Bank, with respect to a revolving creditfacility.  Our credit facility isunsecured and, as amended, provides for borrowings of up to $65 million throughfinal maturity on July 4, 2005.  Theinterest rate on our credit facility is based on LIBOR plus an applicablemargin percentage, which depends on cash flow generation and borrowings outstanding.  As of July 4, 2004, there were nooutstanding borrowings under our credit facility.  The amounts available for borrowing, reducedby standby letters of credit outstanding of $1.5 million, totaled $63.5 millionas of July 4, 2004.

 

At July 4, 2004, wehad a working capital deficit of $26.5 million, due to the accounting treatmentof rental inventory. Rental inventory is treated as a noncurrent asset underaccounting principles generally accepted in the United States because it is adepreciable asset and a portion of this asset is not reasonably expected to becompletely realized in cash or sold in the normal business cycle. Although therental of this inventory generates the major portion of our revenue, theclassification of this asset as noncurrent results in its exclusion fromworking capital. The aggregate amount payable for this inventory, however, isreported as a current liability until paid and, accordingly, is reflected as areduction in working capital. Consequently, we believe that working capital isnot an appropriate measure of our liquidity and we anticipate that we willcontinue to operate with a working capital deficit.

 

Wegrow our store base through internally developed and acquired stores.  We opened 156 internally developed stores,acquired 55 stores and closed 38 stores during the first half of 2004.  We will continue to evaluate acquisitionopportunities in 2004 as they arise although we anticipate the majority of ourgrowth to occur through new store development. To the extent available, new stores and future acquisitions may becompleted using funds available under our credit facility, financing providedby sellers or alternative financing arrangements such as funds raised in publicor private debt or equity offerings. However, we cannot assure you that financing will be available to us onterms which will be acceptable, if at all.

 

We believe our projectedcash flow from operations, cash on hand, borrowing capacity under our creditfacility and trade credit will provide the necessary capital to fund ourcurrent plan of operations, including our anticipated new store openings andacquisition program, through fiscal 2004. Capital requirements to fund new store growth in fiscal 2004, includingthe rental inventory investment, are estimated at $40 million.  Additionally in fiscal 2004, we estimate $25million in other on-going capital expenditure requirements for the existingstore base.  However, to fund a majoracquisition, or to provide funds in the event that our need for funds isgreater than expected, or if the financing sources identified above are notavailable to the extent anticipated or if we increase our growth plan, we mayneed to seek additional or alternative sources of financing. This financing maynot be available on satisfactory terms. Failure to obtain financing to fund ourexpansion plans or for other purposes could have a material adverse effect onour operating results.

 

14

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Our ability to fund ourcurrent plan of operations and our growth plan will depend upon our futureperformance, which is subject to general economic, financial, competitive andother factors that are beyond our control. We cannot assure you that our business will continue to generatesufficient cash flow from operations in the future to fund capital resourceneeds, cover the ongoing costs of operating the business and service any debtincurred in the future.  If we are unableto satisfy these requirements with cash flow from operations and cash on hand,we may be required to sell assets or to obtain additional financing.  We cannot assure you that any such sales ofassets or additional financing could be obtained.

 

## **CriticalAccounting Policies and Estimates**

 

Our significant accounting policies are described in Note 1 to ourconsolidated financial statements as filed in our Annual Report on Form 10-Kfor the fiscal year ended January 4, 2004. Our discussion and analysis offinancial condition and results of operations are based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of thefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues, expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate the estimates that we have made. These estimates have been based uponhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances. Actual results may differ from theseestimates under different conditions or using different assumptions. We believeour most critical accounting estimates include our policies with respect to rentalinventory amortization, impairment of long-lived assets, purchase priceallocation of acquired businesses and deferred income taxes.

 

A major component of ourcost structure is the amortization of our rental inventory.  Rental inventory is amortized to an estimatedsalvage value over an estimated useful life of up to two years.  We amortize the cost of rental inventoryusing an accelerated method designed to approximate the rate of revenuerecognition.  This method is based onhistorical customer demand patterns from “street date” (the date studiosrelease various titles for distribution to our stores) through the end of theaverage useful life.  In order todetermine the appropriate useful lives and salvage values, we analyzed theactual historical performance trends of our rental inventory.  We quantified the average rate of revenuerecognition on our products and developed amortization rates and useful livesthat approximate the rental turns of our inventory.  Our established salvage values are based onan evaluation of the sale prices we are able to realize from our customers onused inventory, prices observed in bulk sale transactions and prices observedin other open market purchases of used inventory, as well as the salvage valuesestablished by competitors in our industry. We believe our estimated useful lives and salvage values areappropriately matched to our current rental business and are consistent withindustry trends.  However, should rentalpatterns of consumers change or should market values of previously viewedinventory decline due to the acceptance of new formats (e.g., ongoing VHStransition to DVD, anticipated transition to high definition DVD within threeto five years, release of new video game formats, etc.), this could necessitatean acceleration in our current rental amortization rates, a reduction insalvage values or a combination of both courses of action.  We believe that any acceleration in therental amortization rates would not have a long-lasting impact as the majorityof our current rental purchases are substantially depreciated within the firsttwo to three months after “street date” under our existing policy.  We could be required to reduce salvage valuesthat we currently carry on VHS inventory if we are unable to dispose of thatinventory at a rate relatively consistent with the consumers’ transition toDVD.   In the past we have generally beenable to anticipate the rate of transition from one format to another and manageour purchases, as well as inventory mix, to avoid significant losses on theultimate disposition of previously viewed movies.  However, we cannot assure you that we will beable to fully anticipate the impact of the transition to DVD or any otherformats in the future and we could incur losses on sale of previously viewedmovies in the future.  As of July 4,2004 and January 4, 2004, we had $114.3 million and $102.5 million,respectively, in rental inventory on our balance sheet.  VHS, DVD and games constituted 47%, 45% and8%, respectively, of total rental inventory units as of July 4, 2004;compared to 55%, 37% and 8%, respectively, of total units as of January 4,2004.  As of July 4, 2004, the netbook value of our VHS rental inventory is approximately 27% of the net bookvalue of our total rental inventory.

 

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We assess the fair value and recoverability of our long-lived assets,including property, furnishings and equipment and intangible assets with finitelives, whenever events and circumstances indicate the carrying value of anasset may not be recoverable from estimated future cash flows expected toresult from its use and eventual disposition. In doing so, we make assumptions and estimates regarding future cashflows and other factors in order to make our determination. The fair value ofour long-lived assets is dependent upon the forecasted performance of ourbusiness, changes in the video retail industry, the market valuation of ourcommon stock and the overall economic environment.  When we determine that the carrying value ofour long-lived assets may not be recoverable, we measure any impairment basedupon the excess of the carrying value that exceeds the estimated fair value ofthe assets.  We have not recognized anyimpairment losses on long-lived assets since fiscal 1996.  If we do not meet our operating forecasts orif the market value of our stock declines significantly, we may have to recordimpairment charges not previously recognized.

 

We test goodwill for impairment on an annual basis.  Additionally, goodwill is tested forimpairment between annual tests if an event occurs or circumstances change thatwould more likely than not reduce the fair value of an entity below itscarrying value.  These events orcircumstances would include a significant change in the business climate, legalfactors, operating performance indicators, competition, sale or disposition ofa significant portion of the business or other factors.  We have not recorded any impairment losses ongoodwill since a fiscal 2001 impairment charge of $700,000.  If we do not meet our operating forecasts orif the market value of our stock declines significantly, we may have to recordadditional impairment charges not previously recognized.  As of July 4, 2004, we have $140.5 millionin goodwill on our balance sheet.

 

We estimate the fair value of assets and liabilities of acquiredbusinesses based on historical experience and available information at theacquisition date.  We engage independentvaluation specialists to assist when necessary. If information becomes available subsequent to the acquisition date thatwould materially impact the valuation of assets acquired or liabilities assumedin business combinations, we may be required to adjust the purchase priceallocation. With the exception of the Video Update acquisition in 2001, we havenot experienced any significant adjustments to the valuation of assets orliabilities acquired in business combinations in the last seven years.  Our acquisitions are typically small businessesfor which we generally do not assume liabilities and for which the assetsacquired consist primarily of inventory, fixtures, equipment and intangibles.

 

**We recognize deferred tax assets and liabilitiesbased on the differences between the financial statement carrying amounts andthe tax bases of assets and liabilities. We regularly review our deferred taxassets for recoverability and establish a valuation allowance based uponhistorical losses, projected future taxable income and the expected timing of thereversals of existing temporary differences. As a result of this review, wehave established a valuation allowance against our deferred tax assets relatedto net operating loss carryforwards (NOLs) that we acquired in the 2001acquisition of Video Update.  In formingour conclusion about the future recoverability of the NOLs from our 2001acquisition of Video Update, we consider, among other things, the applicableprovisions of the federal income tax code which limit the deductibility of NOLsto the post-acquisition taxable income (on a cumulative basis) of the acquiredsubsidiary on a separate return basis, as well as other limitations that mayapply to the future deductibility of NOLs. We also consider the availability of reversing taxable temporary differencesduring the carryforward period, the length of the available carryforwardperiod, recent operating results, our expectations of future taxable incomeduring the carryforward period, changes in tax law, IRS interpretive guidanceand judicial rulings.  If facts andcircumstances in the future should warrant elimination or reduction of thevaluation allowance related to these NOLs, our effective income tax rate, whichwas 40%, 40% and 39% for fiscal 2001, 2002 and 2003, respectively, could bereduced.**

** **

##### **Forward Looking Statements**

 

This quarterly report onForm 10-Q contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended, which representour expectations or beliefs about future events and financial performance.  Forward-looking statements are identifiableby the fact that they do not relate strictly to historical information and mayinclude words such as “believe,” “anticipate,” “expect,” “intend,” “plan,”“will,” “may,” “estimate” or other similar expressions and variationsthereof.  In addition, any statementsthat refer to expectations, projections or other characterizations of futureevents or circumstances

 

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are forward-lookingstatements.  Our forward-lookingstatements are based on management’s current intent, belief, expectations,estimates and projections regarding our company and our industry.  Forward-looking statements are subject toknown and unknown risks and uncertainties, including those described in ourAnnual Report on Form 10-K for the fiscal year ended January 4, 2004.  In light of these risks, uncertainties andassumptions, the forward-looking events discussed in this Form 10-Q might notoccur.  In addition, actual results coulddiffer materially from those suggested by the forward-looking statements, andtherefore you should not place undue reliance on the forward-looking statements.  We undertake no obligation to publicly updateor revise any forward-looking statements, whether as a result of newinformation, future events or otherwise. We desire to take advantage of the “safe harbor” provisions of thePrivate Securities Litigation Reform Act of 1995 and in that regard we cautionthe readers of this Form 10-Q that the important factors described in ourAnnual Report on Form 10-K for the fiscal year ended January 4, 2004,among others, could affect our actual results of operations and may causechanges in our strategy with the result that our operations and results maydiffer materially from those expressed in any forward-looking statements madeby us, or on our behalf.

 

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Item3.  Quantitative and Qualitative Disclosures About Market Risk

 

There have been no material changes in our inherent market risk sincethe disclosures made as of January 4, 2004 in our Annual Report on Form10-K.

 

Item4.   Controlsand Procedures

 

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

 

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

 

#### **Part II - Other Information**

 

Item 2.  Changes in Securities and Use of Proceeds

 

A summary of our purchases of our common stock during the secondquarter of 2004 is as follows:

 
| **Fiscal Period**                                   | ** ** | **(a) Total Number  of Shares  Purchased** | ** ** | **(b) Average Price  Paid per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Programs** | ** ** | **(d) Approximate Dollar  Value of Shares that May  Yet Be Purchased Under  the Programs** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|
|                                                |       |                                       |       |                                  |       |                                                                               |       |                                                                                       |
| Period  4   April 5, 2004  to  May 9, 2004     |       | 236,400                                    |       | $19.28                                |       | 236,400                                                                            |       | $20,442,208                                                                                |
|                                                |       |                                       |       |                                  |       |                                                                               |       |                                                                                       |
| Period  5  May 10, 2004  to  June 6, 2004      |       | 1,099,912                                  |       | $18.59                                |       | 1,099,912                                                                          |       | —                                                                                     |
|                                                |       |                                       |       |                                  |       |                                                                               |       |                                                                                       |
| Period  6  June 7, 2004  to  July 4, 2004 |       | —                                     |       | —                                |       | —                                                                             |       | $25,000,000                                                                                |
|                                                |       |                                       |       |                                  |       |                                                                               |       |                                                                                       |
| Total                                               |       | 1,336,312                                  |       | $18.71                                |       | 1,336,312                                                                          |       | $25,000,000                                                                                |

 

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Item4.  Submissionof Matters to a Vote of Security Holders

 

Our Annual Meeting of Stockholders was held on June 15, 2004.  The following action was taken at the AnnualMeeting, for which proxies were solicited pursuant to Regulation 14 under theSecurities Exchange Act of 1934, as amended:

 

1.               The five nomineesproposed by the Board of Directors were elected as directors by the followingvotes:

 
| **Name**            | ** ** | **For**    | ** ** | **Withheld** |
|---------------------|------------|------------|------------|--------------|
| Joe T. Malugen      |       | 20,025,620 |       | 11,450,777   |
| H. Harrison Parrish |       | 19,801,312 |       | 11,675,085   |
| William B. Snow     |       | 19,475,086 |       | 12,001,311   |
| John J. Jump        |       | 28,193,790 |       | 3,282,607    |
| James C. Lockwood   |       | 28,278,790 |       | 3,197,607    |

 

2.               A proposal toratify the appointment of Ernst & Young LLP as our independent auditors forthe 2004 fiscal year was approved by a vote of 30,954,400 for versus 518,563against.  There were 3,434 abstentions.

 

**Item 6. Exhibits and Reports on Form 8-K**

 

a)              Exhibits

31.1         Certification of ChiefExecutive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of theSecurities Exchange Act of 1934, as amended

 

31.2         Certification of ChiefFinancial Officer Pursuant to  Rule13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended

 

32.1         Certification of ChiefExecutive Officer Pursuant to 18 U.S.C 1350, as adopted Pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

32.2         Certification of ChiefFinancial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

b)             Reports on Form 8-K

 

Wefiled a Current Report on Form 8-K reporting on Items 7 and 12 datedApril 8, 2004.

Wefiled a Current Report on Form 8-K reporting on Items 7 and 12 dated May 4,2004.

Wefiled a Current Report on Form 8-K reporting on Items 5 and 7 datedJune 3, 2004.

Wefiled a Current Report on Form 8-K reporting on Items 5 and 7 datedJune 17, 2004.

 

**Signatures**

** **

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                             | Movie Gallery,  Inc.                        |       |
|----------------------------------|---------------------------------------------|------------|
|                             | (Registrant)                                |       |
|                             |                                        |       |
|                             |                                        |       |
| Date:  August 13, 2004 | /s/ Ivy M. Jernigan                         |       |
|                             | Ivy M. Jernigan, Senior  Vice President and |       |
| ** **                       | **Chief Financial Officer**                 | ** ** |

 

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