** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**Washington, D.C.  20549

** **

**FORM 10-Q**

** **

**(MarkOne)**
| **  **ý | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                          |
|------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **             | ** ** | ** **                                                                                                                                                                                       |
| ** **             | ** ** | **For the quarterly period  ended April 3, 2005**                                                                                                                                           |
| ** **             |
| **OR**                 |
| ** **             | ** ** | ** **                                                                                                                                                                                       |
| **  **o      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                        |
| ** **             | ** ** | ** **                                                                                                                                                                                       |
| ** **             | ** ** | **For the transition period from             to             ** |

** **

### **Commissionfile number 0-24548**

### ** **

**MovieGallery, Inc.**(Exact name of registrant as specified in its charter)

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

 

**(334) 677-2108**(Registrant’s telephone number, including area code)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to filingrequirements for 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 May 11, 2005 was31,541,689.

 

 

----

 

#### **MovieGallery, Inc.Index**

#### ** **

| Part I.  Financial  Information                                                               |   |
|--------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                         |   |
| Item 1.  Consolidated Financial Statements (Unaudited)                                                       |   |
|                                                                                                         |   |
| Consolidated  Balance Sheets – January 2, 2005 and April 3, 2005                              |   |
|                                                                                                         |   |
| Consolidated Statements of  Income – Thirteen weeks ended April 4, 2004 and April 3, 2005     |   |
|                                                                                                         |   |
| Consolidated Statements of  Cash Flows – Thirteen weeks ended April 4, 2004 and April 3, 2005 |   |
|                                                                                                         |   |
| Notes to Consolidated  Financial Statements – April 3, 2005                                        |   |
|                                                                                                         |   |
| 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 6. Exhibits                                                                                             |   |

 

----

 

**Movie Gallery, Inc.Consolidated Balance Sheets****(inthousands, except per share data)**

 
| ** **                                                                                                               | ** ** | **January 2,** | ** ** | **April 3,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-------------------|------------|
| ** **                                                                                                               | ** ** | **2005**            | ** ** | **2005**          | ** ** |
| ** **                                                                                                               | ** ** | ** **          | ** ** | **(Unaudited)**   | ** ** |
| **Assets**                                                                                                               |       |                |       |              |       |
| Current assets:                                                                                                          |       |                |       |              |       |
| Cash and cash  equivalents                                                                                               |       | $                   | 25,518     | ** **        | **$**      | **22,609** | ** ** |
| Merchandise  inventory                                                                                                   |       | 27,419              | ** ** | **28,535**        | ** ** |
| Prepaid expenses                                                                                                         |       | 12,712              | ** ** | **16,298**        | ** ** |
| Store supplies  and other                                                                                                |       | 9,493               | ** ** | **12,045**        | ** ** |
| Deferred income  taxes                                                                                                   |       | 3,358               | ** ** | **4,000**         | ** ** |
| Total current  assets                                                                                                    |       | 78,500              | ** ** | **83,487**        | ** ** |
|                                                                                                                     |       |                |       |              |       |
| Rental inventory,  net                                                                                                   |       | 126,541             | ** ** | **130,402**       | ** ** |
| Property,  furnishings and equipment, net                                                                                |       | 128,182             | ** ** | **130,743**       | ** ** |
| Goodwill, net                                                                                                            |       | 143,761             | ** ** | **147,035**       | ** ** |
| Other  intangibles, net                                                                                                  |       | 7,741               | ** ** | **7,583**         | ** ** |
| Deposits and  other assets                                                                                               |       | 7,417               | ** ** | **8,172**         | ** ** |
| Total assets                                                                                                             |       | $                   | 492,142    | ** **        | **$**      | **507,422** | ** ** |
| ** **                                                                                                               | ** ** | ** **          | ** ** | ** **        | ** ** |
| **Liabilities  and stockholders’ equity**                                                                           |       |                |       |              |       |
| Current  liabilities:                                                                                                    |       |                |       |              |       |
| Accounts payable                                                                                                         |       | $                   | 68,977     | ** **        | **$**      | **54,402** | ** ** |
| Accrued  liabilities                                                                                                     |       | 30,570              | ** ** | **35,783**        | ** ** |
| Deferred revenue                                                                                                         |       | 10,843              | ** ** | **8,245**         | ** ** |
| Total current  liabilities                                                                                               |       | 110,390             | ** ** | **98,430**        | ** ** |
|                                                                                                                     |       |                |       |              |       |
| Deferred income  taxes                                                                                                   |       | 50,618              | ** ** | **54,844**        | ** ** |
|                                                                                                                     |       |                |       |              |       |
| Stockholders’  equity:                                                                                              |       |                |       |              |       |
| Preferred stock,  $.10 par value; 2,000 shares authorized, no shares issued or outstanding                               |       | —              | ** ** | **—**        | ** ** |
| Common stock,  $.001 par value; 65,000 shares authorized, 31,076 and 31,499 shares issued  and outstanding, respectively |       | 31                  | ** ** | **31**            | ** ** |
| Additional  paid-in capital                                                                                              |       | 188,098             | ** ** | **197,186**       | ** ** |
| Unearned  compensation                                                                                                   |       | —              | ** ** | **(3,128**        | **)**      |
| Retained  earnings                                                                                                       |       | 136,750             | ** ** | **154,198**       | ** ** |
| Accumulated  other comprehensive income                                                                                  |       | 6,255               | ** ** | **5,861**         | ** ** |
| Total  stockholders’ equity                                                                                         |       | 331,134             | ** ** | **354,148**       | ** ** |
| Total  liabilities and stockholders’ equity                                                                         |       | $                   | 492,142    | ** **        | **$**      | **507,422** | ** ** |
|                                                                                                                          |            |                     |            |                   |            |  |  |  |  |

 

*See accompanying notes.*

 

1

----

 

**Movie Gallery, Inc.Consolidated Statements of Income****(Unaudited)(in thousands, except per share data)**

 
| ** **                                   | ** ** | **Thirteen Weeks Ended** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|
| ** **                                   | ** ** | **April 4,**        | ** ** | **April 3,** | ** ** |
| ** **                                   | ** ** | **2004**                 | ** ** | **2005** | ** ** |
|                                         |       |                     |       |   |   |
| Revenues:                                    |       |                     |       |   |   |
| Rentals                                      |       | $                        | 186,757    |   | **$** | **216,741** | ** ** |
| Product sales                                |       | 16,545                   |       | **17,050** | ** ** |
| Total revenues                               |       | 203,302                  |       | **233,791** | ** ** |
|                                         |       |                     |       |   |   |
| Cost of sales:                               |       |                     |       |   |   |
| Cost of rental  revenues                     |       | 51,745                   |       | **66,360** | ** ** |
| Cost of product  sales                       |       | 10,940                   |       | **12,190** | ** ** |
| Gross profit                                 |       | 140,617                  |       | **155,241** | ** ** |
|                                         |       |                     |       |   |   |
| Operating costs  and expenses:               |       |                     |       |   |   |
| Store operating  expenses                    |       | 94,425                   |       | **108,479** | ** ** |
| General and  administrative                  |       | 13,796                   |       | **15,451** | ** ** |
| Amortization of  intangibles                 |       | 614                      |       | **600** | ** ** |
| Stock  compensation                          |       | 56                       |       | **141** | ** ** |
| Operating income                             |       | 31,726                   |       | **30,570** | ** ** |
|                                         |       |                     |       |   |   |
| Interest  expense, net                       |       | (99                      | )          | **(80** | **)** |
| Equity in losses  of unconsolidated entities |       | (1,630                   | )          | **(337** | **)** |
| Income before  income taxes                  |       | 29,997                   |       | **30,153** | ** ** |
|                                         |       |                     |       |   |   |
| Income taxes                                 |       | 11,745                   |       | **11,760** | ** ** |
| Net income                                   |       | $                        | 18,252     |   | **$** | **18,393** | ** ** |
|                                         |       |                     |       |   |   |
| Net income per  share:                       |       |                     |       |   |   |
| Basic                                        |       | $                        | 0.55       |   | **$** | **0.59** | ** ** |
| Diluted                                      |       | $                        | 0.54       |   | **$** | **0.58** | ** ** |
|                                         |       |                     |       |   |   |
| Weighted average  shares outstanding:        |       |                     |       |   |   |
| Basic                                        |       | 33,071                   |       | **31,199** | ** ** |
| Diluted                                      |       | 33,737                   |       | **31,588** | ** ** |
|                                         |       |                     |       |   |   |
| Cash dividends  per common share             |       | $                        | 0.03       |   | **$** | **0.03** | ** ** |
|                                              |            |                          |            |  |  |  |  |  |  |

 

*Seeaccompanying notes.*

 

2

----

 

**Movie Gallery, Inc.Consolidated Statements of CashFlows****(Unaudited)(in thousands)**

 
| ** **                                                                         | ** ** | **Thirteen Weeks Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                         | ** ** | **April 4,**        |       | **April 3,** | ** ** |
| ** **                                                                         | ** ** | **2004**                 |       | **2005** | ** ** |
|                                                                               |       |                     |       |   |   |
| **Operating  activities:**                                                         |       |                     |       |   |   |
| Net income                                                                         |       | $                        | 18,252     |   | **$** | **18,393** | ** ** |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                     |       |   |   |
| Rental inventory  amortization                                                     |       | 34,073                   |       | **42,930** | ** ** |
| Purchases of  rental inventory                                                     |       | (36,760                  | )          | **(42,942** | **)** |
| Depreciation and  intangibles amortization                                         |       | 6,842                    |       | **8,801** | ** ** |
| Non-cash stock  compensation                                                       |       | 56                       |       | **141** | ** ** |
| Tax benefit of  stock options exercised                                            |       | 2,989                    |       | **2,175** | ** ** |
| Deferred income  taxes                                                             |       | 5,256                    |       | **3,584** | ** ** |
| Changes in  operating assets and liabilities:                                      |       |                     |       |   |   |
| Merchandise  inventory                                                             |       | 530                      |       | **(894** | **)** |
| Other current  assets                                                              |       | 138                      |       | **(6,138** | **)** |
| Deposits and  other assets                                                         |       | 456                      |       | **(755** | **)** |
| Accounts payable                                                                   |       | (10,393                  | )          | **(14,575** | **)** |
| Accrued  liabilities and deferred revenue                                          |       | (382                     | )          | **2,590** | ** ** |
| Net cash  provided by operating activities                                         |       | 21,057                   |       | **13,310** | ** ** |
|                                                                               |       |                     |       |   |   |
| **Investing  activities:**                                                         |       |                     |       |   |   |
| Business  acquisitions                                                             |       | (2,206                   | )          | **(4,654** | **)** |
| Purchases of  rental inventory-base stock                                          |       | (3,883                   | )          | **(3,258** | **)** |
| Purchases of  property, furnishings and equipment                                  |       | (13,065                  | )          | **(10,612** | **)** |
| Net cash used in  investing activities                                             |       | (19,154                  | )          | **(18,524** | **)** |
|                                                                               |       |                     |       |   |   |
| **Financing  activities:**                                                         |       |                     |       |   |   |
| Borrowings on  credit facility                                                     |       | —                   |       | **500** | ** ** |
| Payments on  credit facility                                                       |       | —                   |       | **(500** | **)** |
| Proceeds from  exercise of stock options                                           |       | 2,162                    |       | **3,475** | ** ** |
| Proceeds from  employee stock purchase plan                                        |       | —                   |       | **169** | ** ** |
| Payment of  dividends                                                              |       | (985                     | )          | **(945** | **)** |
| Net cash  provided by financing activities                                         |       | 1,177                    |       | **2,699** | ** ** |
|                                                                               |       |                     |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                      |       | (668                     | )          | **(394** | **)** |
| Decrease in cash  and cash equivalents                                             |       | 2,412                    |       | **(2,909** | **)** |
| Cash and cash  equivalents at beginning of period                                  |       | 38,006                   |       | **25,518** | ** ** |
| Cash and cash  equivalents at end of period                                        |       | $                        | 40,418     |   | **$** | **22,609** | ** ** |

 

*Seeaccompanying notes.*

 

3

----

 

**Movie Gallery, Inc.**

**Notes to Consolidated Financ****ial Statements (Unaudited)**

 

**April 3,2005**

 

**1.****     AccountingPolicies**

 

*Principlesof Consolidation*

 

The accompanying unaudited financial statementspresent the consolidated financial position, results of operations and cashflows of Movie Gallery, Inc. and subsidiaries.  Investments in unconsolidated subsidiarieswhere we have significant influence but do not have control are accounted forusing the equity method of accounting for investments in common stock.  All material intercompany accounts andtransactions have been eliminated.

 

*Basis ofPresentation*

 

The accompanying unaudited consolidated financialstatements have been prepared in accordance with generally accepted accountingprinciples for interim financial information and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do notinclude all of the information and footnotes required by generally accepted accountingprinciples for complete consolidated financial statements.  The balance sheet at January 2, 2005 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 thirteen week period ended April 3, 2005are not necessarily indicative of the results that may be expected for thefiscal year ending January 1, 2006. For further information, refer to the consolidated financial statementsand footnotes thereto included in our Annual Report on Form 10-K for thefiscal year ended January 2, 2005.

 

*Reclassifications*

 

Certainreclassifications have been made to the prior year financial statements toconform to the current year presentation. These reclassifications had no impact on stockholders’ equity or netincome.

 

In the thirdquarter of 2004, we began classifying losses on unconsolidated equityinvestments in alternative delivery vehicles recognized under the equity methodof accounting on a separate line item in our statements of income.  These losses were previously grouped withstore operating expenses in our statements of income, and have beenreclassified to “Equity in losses of unconsolidated entities”.  We reclassified those losses for priorperiods to conform to the current year presentation.

 

*StockPlan*

 

We account for stock-based employee compensation underthe recognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees*, and relatedInterpretations.  Stock compensation isreflected in net income for non-vested stock granted under the plan and variableoptions outstanding under the plan that were repriced in March 2001.  No stock compensation is reflected in netincome for fixed options outstanding under the plan, as the exercise price wasequal to the market value of the underlying common stock on the date of grant.

 

On March 25, 2005, approximately 130,000non-vested shares of common stock were granted to employees and directors forwhich unearned compensation of approximately $3.1 million was recorded in thequarter.  The vesting periods are fromone to four years over which compensation cost is expected to berecognized.  The fair value of thesenon-vested shares was determined based on the closing trading price of ourshares on the grant date, which was $24.06.

 

4

----

 

The following table illustrates the effect on netincome and earnings per share if we had applied the fair value recognitionprovisions of FASB Statement No. 123, *Accounting for Stock-BasedCompensation*, as amended, to stock-based employee compensation.

 
| ** **                                                                                        | ** ** | **Thirteen Weeks Ended**                  | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                        | ** ** | **April 4,**                         | ** ** | **April 3,** | ** ** |
| ** **                                                                                        | ** ** | **2004**                                  | ** ** | **2005** | ** ** |
| ** **                                                                                        | ** ** | **(in thousands, except per share data)** | ** ** |
|                                                                                              |       |                                      |       |   |   |
| Net income, as  reported                                                                          |       | $                                         | 18,252     |   | **$** | **18,393** | ** ** |
| Add: Stock compensation  included in reported net income, net of tax                              |       | 34                                        |       | **86** | ** ** |
| Deduct: Stock  compensation determined under fair value based methods for all awards, net of  tax |       | (257                                      | )          | **(279** | **)** |
|                                                                                              |       |                                      |       |   |   |
| Pro forma net  income                                                                             |       | $                                         | 18,029     |   | **$** | **18,200** | ** ** |
|                                                                                              |       |                                      |       |   |   |
| Net income per  share, as reported:                                                               |       |                                      |       |   |   |
| Basic                                                                                             |       | $                                         | 0.55       |   | **$** | **0.59** | ** ** |
| Diluted                                                                                           |       | $                                         | 0.54       |   | **$** | **0.58** | ** ** |
|                                                                                              |       |                                      |       |   |   |
| Pro forma net  income per share:                                                                  |       |                                      |       |   |   |
| Basic                                                                                             |       | $                                         | 0.55       |   | **$** | **0.58** | ** ** |
| Diluted                                                                                           |       | $                                         | 0.53       |   | **$** | **0.58** | ** ** |

 

*Recently Issued AccountingPronouncements*

 

In December 2004,the FASB issued a revised Statement No. 123, *Share BasedPayment* (“Statement 123R”), to address the accounting forstock-based employee plans.  The Statementeliminates the ability to account for share-based compensation transactionsusing APB 25 and instead requires that such transactions be accounted for usinga fair value based method of accounting. The impact of adoption of Statement 123R cannot be predicted at thistime because it will depend on levels of share-based payments granted in thefuture.  However, had we adoptedStatement 123R in prior periods, the impact of that standard would haveapproximated the impact of Statement 123 as described in the table above.  Statement 123R also requires the benefits oftax deductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required undercurrent literature.  This requirementwill reduce the amount of net operating cash flows recognized in periods afteradoption.  While we cannot estimate whatthose amounts will be in the future (because they depend on, among otherthings, when employees exercise stock options), the amount of operating cashflows recognized in prior periods for such excess tax deductions were $3.0million and $2.2 million in the first quarter of 2004 and 2005, respectively.Statement 123R is required to be adopted no later than the beginning ofthe first fiscal year beginning after June 15, 2005.

 

5

----

 

**2.  Goodwill and Other Intangible Assets**

 

The components of goodwill and other intangible assetsare as follows (in thousands):

 
| ** **                     | ** ** | ** **              | ** ** | **January 2, 2005** | ** ** | **April 3, 2005** | ** ** |
|--------------------------------|------------|-------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                     | ** ** | **Weighted-Average**    | ** ** | **Gross Carrying**       | ** ** | **Accumulated**        | ** ** | **Gross Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                     | ** ** | **Amortization Period** | ** ** | **Amount**               |       | **Amortization**       | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
|                           |       |                    |       |                     |       |                   |       |   |   |   |   |
| Goodwill                       |       | —                  |       | $                        | 175,172    |                   | $          | (31,411 | ) | **$** | **178,446** | ** ** | **$** | **(31,411** | **)** |
|                           |       |                    |       |                     |       |                   |       |   |   |   |   |
| Non-compete  agreements        |       | 8 years                 |       | $                        | 7,426      |                   | $          | (4,937 | ) | **$** | **7,589** | ** ** | **$** | **(5,208** | **)** |
| Customer lists                 |       | 5 years                 |       | 7,628                    |       | (2,376                 | )          | **7,905** | ** ** | **(2,703** | **)** |
| Total other  intangible assets |       |                    |       | $                        | 15,054     |                   | $          | (7,313 | ) | **$** | **15,494** | ** ** | **$** | **(7,911** | **)** |

 

Estimated amortization expense for other intangibleassets for the remainder of 2005 and the five succeeding fiscal years is asfollows (in thousands):

 

| **2005 (remainder)** | ** ** | **$** | **1,744** | ** ** |
|----------------------|------------|-------|-----------|------------|
| 2006                 |       | 2,035 |      |
| 2007                 |       | 1,893 |      |
| 2008                 |       | 1,354 |      |
| 2009                 |       | 483   |      |
| 2010                 |       | 45    |      |

 

The changes in the carrying amount of goodwill for thefiscal year ended January 2, 2005 and the thirteen weeks ended April 3,2005, are as follows (in thousands):

 

| Balance as of January 4, 2004  |   | $       | 136,008 |   |
|-------------------------------------|--------|---------|---------|--------|
| Goodwill  acquired                  |   | 7,753   |    |
| Balance as of  January 2, 2005 |   | 143,761 |    |
| Goodwill  acquired                  |   | 3,274   |    |
| Balance as of  April 3, 2005   |   | $       | 147,035 |   |

 

**During the thirteen weeks ended April 3,2005, we purchased 18 stores in 5 separate transactions for a total ofapproximately $4.7 million and recorded approximately $3.3 million in goodwill,$0.3 million for customer lists and $0.2 million for non-compete agreementsrelated to these transactions.**

** **

**3.  Credit Agreement**

** **

On June 27, 2001, we entered into a creditagreement with a syndicate of banks, led by SouthTrust Bank (now Wachovia),with respect to a revolving credit facility. Our credit facility is unsecured, provides for borrowings of up to $75million, and matures on July 3, 2006. The interest rate on our credit facility is based on LIBOR plus anapplicable margin percentage, which depends on cash flow generation andborrowings outstanding.  As of April 3,2005, there were no outstanding borrowings under our credit facility.  The amount available for borrowing, which wasreduced by standby letters of credit outstanding of $3.4 million, was $71.6million as of April 3, 2005.

 

On April 27, 2005,  we completed our cash acquisition ofHollywood Entertainment Corporation (“Hollywood”), refinanced substantially allof the existing indebtedness of Hollywood, and replaced our existing unsecuredrevolving

 

6

----

 

credit facility.  We obtained a senior secured credit facilityfrom a lending syndicate led by Wachovia and Merrill Lynch.  The new senior secured credit facility is inan aggregate amount of $870.0 million, consisting of a five-year, $75.0 millionrevolving credit facility bearing interest at an initial rate of LIBOR plus2.75%, and two term loan facilities in an aggregate principal amount of $795.0million.  Term Loan A is a $95 million,five-year facility bearing interest at an initial rate of LIBOR plus2.75%.  Term Loan B is a $700 million,six-year facility bearing interest at an initial rate of LIBOR plus 3.00%.  The senior secured credit facility isguaranteed by Hollywood and all of our domestic subsidiaries.  In addition to the senior secured creditfacility, we issued $325.0 million of 11% senior unsecured notes, due 2012.

 

**4.  Earnings Per Share**

 

Basic earnings per share is computed based on theweighted average number of shares of common stock outstanding during theperiods presented.  Diluted earnings pershare is computed based on the weighted average number of shares of commonstock outstanding during the periods presented, increased by the effects ofshares that could be issued from the exercise of dilutive common stock options (666,000and 389,000 for the thirteen weeks ended April 4, 2004 and April 3,2005, respectively) and non-vested stock grants.  No adjustments were made to net income in thecomputation of basic or diluted earnings per share.

 

**5.  Comprehensive Income**

 

Comprehensive income was as follows (in thousands):

 

| ** **                               | ** ** | **Thirteen Weeks Ended** | ** ** |
|------------------------------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **April 4,**        |       | **April 3,** | ** ** |
| ** **                               | ** ** | **2004**                 |       | **2005** | ** ** |
|                                     |       |                     |       |   |   |
| Net income                               |       | $                        | 18,252     |   | **$** | **18,393** | ** ** |
| Foreign currency  translation adjustment |       | (668                     | )          | **(394** | **)** |
| Comprehensive  income                    |       | $                        | 17,584     |   | **$** | **17,999** | ** ** |

 

**6.  Subsequent Events**

 

On April 27, 2005,we completed our cash acquisition of Hollywood.  We paid $862.1 million topurchase all of Hollywood's outstanding common stock and $384.7 million torefinance Hollywood's debt.  Hollywood operates over 2,000 home videoretail stores in the United States.  The combination of our company andHollywood creates the second largest North American video rental company withpro-forma combined annual revenues in excess of $2.5 billion and approximately4,500 stores located in all 50 U.S. states, Canada and Mexico.  Assumingthe acquisition of Hollywood and the related financing (described above) hadoccurred as of the beginning of our fiscal year ended January 2, 2005 (forstatement of income data) or as of January 2, 2005 (for balance sheet data),unaudited pro forma financial information (compared to our historical selectedfinancial data) is as follows (in thousands, except per share data): 

 
| ** **                                             | ** ** | ** **     | ** ** | **Pro-Forma** | ** ** |
|--------------------------------------------------------|------------|----------------|------------|---------------|------------|
| ** **                                             | ** ** | **Historical** | ** ** | **Combined**  | ** ** |
| *As of and for the fiscal year ended January 2, 2005:* |       |           |       |          |       |
|                                                   |       |           |       |          |       |
| Revenues                                               |       | $              | 791,177    |          | $          | 2,571,821 |   |
| Net income                                             |       | 49,488         |       | 78,495        |       |
| Earnings per share                                     |       |           |       |          |       |
| Basic                                                  |       | $              | 1.54       |          | $          | 2.45 |   |
| Diluted                                                |       | $              | 1.52       |          | $          | 2.41 |   |
|                                                   |       |           |       |          |       |
| *At January 2, 2005:*                                  |       |           |       |          |       |
|                                                   |       |           |       |          |       |
| Total assets                                           |       | $              | 491,142    |          | $          | 1,988,282 |   |
| Total liabilities                                      |       | 161,008        |       | 1,659,673     |       |
|                                                        |            |                |            |               |            |  |  |  |  |

 

The unaudited proforma combined financial data reflects a preliminary allocation of the purchaseprice, which is subject to change based on finalization of the fair values ofassets acquired and liabilities assumed and is further subject to changepending final determination of the purchase price, including transaction costsand expenses.  We expect to file more detailed pro forma financialinformation with the Securities and Exchange Commission on Form 8-K no laterthan July 11, 2005, to include updated data for our fiscal year ended January2, 2005 and for the quarter ended April 3, 2005.  We will account for theacquisition of Hollywood using the purchase method of accounting.

 

On March 2,2005, we entered into a definitive agreement with VHQ Entertainment, Inc.(“VHQ”) to commence a tender offer for all of its outstanding common stock at aprice of C$1.15 per share.  The tenderoffer expires on May 16, 2005. Total consideration for the transaction is approximately C$20.4 million(US$16.5 million), including C$17.5 million in equity and C$2.9 million inassumed debt.  VHQ owns and operates 61video rental stores in secondary and suburban markets in Alberta, Saskatchewanand the Northwest Territories.  The VHQtransaction is conditioned upon, among other matters, the tender of two-thirdsof VHQ’s outstanding shares into the offer, the receipt of certain third partyconsents and regulatory approval.

 

7

----

 

**Item 2.****                                                           Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Overview**

 

As of April 3,2005, we operated 2,543 home video retail stores that rent and sell movies andvideo games, primarily in rural and suburban markets.  On April 27, 2005, we completed ouracquisition of Hollywood Entertainment Corporation (“Hollywood”).  This acquisition increased our store count toover 4,500 stores and substantially increased our urban market presence.  We currently plan to maintain the Hollywoodbrand and store format.  However, webelieve the most significant expansion opportunities continue to be in therural and suburban markets.  We estimatethat there are approximately 2,500 to 3,500 markets still available forexpansion in rural America, where there is less competition from other nationaland regional chains, as well as additional opportunities throughout Canada andMexico.  We currently plan to openapproximately 400 new stores in 2005 and, subject to market and industryconditions, and the integration of Hollywood, to continue to open new stores ata similar pace over the next several years.

 

We believe themost significant dynamic in our industry is the relationship our industrymaintains with the movie studios.  Thestudios have historically maintained an exclusive window for home videodistribution (packaged goods), which provides the home video industry with anapproximately 45 day period during which they can rent and sell new releasesbefore they are made available on pay-per-view or other distributionchannels.  According to Kagan Research,the percentage of domestic studio movie revenue provided by the domestic homevideo industry has increased substantially in recent years, from approximately50% in 1998 to approximately 57% in 2004. For this reason, we believe movie studios have a significant interest inmaintaining a viable home video business.

 

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

 

In addition to therelationship between our industry and the movie studios, our operating resultsare driven by revenue, inventory, rent and payroll.  Given those key factors, we believe that bymonitoring the five operating performance indicators described below, we can continueto be successful in executing our operating plans and our growth strategy.

 

•                  *Revenues.*  Ourbusiness is a cash business with initial rental fees paid upfront by thecustomer.  Our management team continuouslyreviews 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 of our inventory purchase dollars.

 

•                  *Store level cost control.* The most significant store expenses are payroll and rent, followed byall other supply and service expenditures.  We attempt to control these expenses primarilythrough budgeting systems and centralization of purchases into the corporatesupport center.  This enables us tomeasure performance carefully against expectations and to leverage ourpurchasing power.  We also have thebenefit of reduced labor and real estate costs in the rural markets we serveversus the costs associated with larger urban markets.

 

•                  *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

 

8

----

 

and administrativeexpenses include the costs to maintain our corporate support center as well asthe overhead costs of our field management team.

 

•                  *Operating cash flows.* We have generated significant levels of cash flow for severalyears.  We have historically been able tofund the majority of our store growth and acquisitions, as well as ongoinginventory purchases, from cash flow generated from operations.

 

The followingdiscussion of our results of operations, liquidity and capital resources isdesigned to provide further insight into our performance for the first quarterof 2005 versus the comparable period of 2004.

 

**Hollywood Acquisition**

 

On April 27,2005, we completed our cash acquisition of Hollywood, refinanced substantiallyall of the existing indebtedness of Hollywood, and replaced our existingunsecured revolving credit facility.  Wepaid $862.1 million to purchase all of Hollywood’s outstanding common stock and$384.7 million to refinance Hollywood’s debt. As part of the refinancing of Hollywood’s debt, Hollywood executed atender offer for its $225.0 million principal amount 9.625% senior subordinatednotes due 2011, pursuant to which $224.6 million were tendered.  The Hollywood acquisition was financed with asenior secured credit facility guaranteed by Hollywood and all of our domesticsubsidiaries in an aggregate amount of $870.0 million, and an issuance of$325.0 million of 11% senior unsecured notes.

 

Thecombination of our company and Hollywood creates the second largest NorthAmerican video rental company with pro-forma combined annual revenue in excessof  $2.5 billion and approximately 4,500stores located in all 50 U.S. states, Canada and Mexico.  The acquisition substantially increases ourpresence on the West Coast and in urban areas. Hollywood’s predominantly West Coast urban superstore locations presentlittle overlap with our predominantly East Coast rural and suburban storelocations.  We also believe that there isan opportunity to improve the profitability of Hollywood because the combinedcompanies will offer potential general and administrative cost savings andincreased purchasing leverage.  However,we can make no assurances that we will successfully integrate Hollywood’sbusiness with our business or that we will achieve the anticipated cost savings.

 

Weanticipate that we will maintain the Hollywood store format and brandseparately from our Movie Gallery business because of Hollywood’s distinctoperational model and to ensure customer continuity after the acquisition.During our integration of the operations of Hollywood with ours, we willevaluate our operational, growth, dividend and other strategies and policiesdiscussed in this report and will modify our strategies and policies asappropriate or required by industry and operating conditions.

 

**Pending Acquisition**

 

On March 2,2005, we entered into a definitive agreement with VHQ Entertainment, Inc.(“VHQ”) to commence a tender offer for all of its outstanding common stock at aprice of C$1.15 per share.  The tenderoffer expires on May 16, 2005. Total consideration for the transaction is approximately C$20.4 million(US$16.5 million), including C$17.5 million in equity and C$2.9 million inassumed debt.  VHQ owns and operates 61video rental stores in secondary and suburban markets in Alberta, Saskatchewanand the Northwest Territories.  The VHQtransaction is conditioned upon, among other matters, the tender of two-thirdsof VHQ’s outstanding shares into the offer, the receipt of certain third partyconsents and regulatory approval.

 

9

----

 

**Results of Operations**

 

**Selected Financial Statement and Operational Data:**

 
| ** **                                   | ** ** | **Thirteen Weeks Ended**                          | ** ** |
|----------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                   | ** ** | **April 4,**                                 | ** ** | **April 3,** | ** ** |
| ** **                                   | ** ** | **2004**                                          | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **($ in  thousands, except per share data)** | ** ** |
|                                         |       |                                              |       |   |   |
| Rental revenues                              |       | $                                                 | 186,757    |   | **$** | **216,741** | ** ** |
| Product sales                                |       | 16,545                                            |       | **17,050** | ** ** |
| Total revenues                               |       | 203,302                                           |       | **233,791** | ** ** |
|                                         |       |                                              |       |   |   |
| Cost of rental  revenues                     |       | 51,745                                            |       | **66,360** | ** ** |
| Cost of product  sales                       |       | 10,940                                            |       | **12,190** | ** ** |
| Total gross  profit                          |       | $                                                 | 140,617    |   | **$** | **155,241** | ** ** |
|                                         |       |                                              |       | ** ** | ** ** |
| Store operating  expenses                    |       | $                                                 | 94,425     |   | **$** | **108,479** | ** ** |
| General and  administrative expenses         |       | $                                                 | 13,796     |   | **$** | **15,451** | ** ** |
| Stock  compensation                          |       | $                                                 | 56         |   | **$** | **141** | ** ** |
| Equity in losses  of unconsolidated entities |       | $                                                 | 1,630      |   | **$** | **337** | ** ** |
|                                         |       |                                              |       |   |   |
| Operating income                             |       | $                                                 | 31,726     |   | **$** | **30,570** | ** ** |
| Net income                                   |       | $                                                 | 18,252     |   | **$** | **18,393** | ** ** |
| Net income per  diluted share                |       | $                                                 | 0.54       |   | **$** | **0.58** | ** ** |
|                                         |       |                                              |       |   |   |
| Cash dividends  per common share             |       | $                                                 | 0.03       |   | **$** | **0.03** | ** ** |
|                                         |       |                                              |       |   |   |
| Rental margin                                |       | 72.3                                              | %          | **69.4** | **%** |
| Product sales  margin                        |       | 33.9                                              | %          | **28.5** | **%** |
| Total gross  margin                          |       | 69.2                                              | %          | **66.4** | **%** |
|                                         |       |                                              |       |   |   |
| **Percent  of total revenues:**              |       |                                              |       |   |   |
| Rental revenues                              |       | 91.9                                              | %          | **92.7** | **%** |
| Product sales                                |       | 8.1                                               | %          | **7.3** | **%** |
| Store operating  expenses                    |       | 46.4                                              | %          | **46.4** | **%** |
| General and  administrative expenses         |       | 6.8                                               | %          | **6.6** | **%** |
| Stock  compensation                          |       | 0.0                                               | %          | **0.1** | **%** |
| Operating income                             |       | 15.6                                              | %          | **13.1** | **%** |
| Net income                                   |       | 9.0                                               | %          | **7.9** | **%** |
|                                         |       |                                              |       |   |   |
| **Same-store  revenue increase**             |       | 2.0                                               | %          | **1.5** | **%** |
|                                         |       |                                              |       |   |   |
| **Store  Count:**                            |       |                                              |       |   |   |
| Beginning of  period                         |       | 2,158                                             |       | **2,482** | ** ** |
| New store builds                             |       | 81                                                |       | **62** | ** ** |
| Stores acquired                              |       | 24                                                |       | **18** | ** ** |
| Stores closed                                |       | (23                                               | )          | **(19** | **)** |
| End of period                                |       | 2,240                                             |       | **2,543** | ** ** |
|                                              |            |                                                   |            |  |  |  |  |  |

 

10

----

 

*Revenue.*  For the thirteen weeks ended April 3, 2005,total revenues increased 15.0% from the comparable period in 2004.  The increase was primarily due to an increaseof 14.1% in the average number of stores operated during the first quarter of2005.  The increase was also due to a same-storerevenue increase of 1.5% for the first quarter of 2005, as a result of growthof movie rental revenue, including previously viewed sales, of approximately 4.5%,partially offset by:

 

•                  Adecline in revenue from the game rental business of approximately 16.0%,reflecting the weakness of the new game titles currently being released andindustry softness that occurs in anticipation of the introduction of new gameplatforms currently scheduled for a late 2005 release; and

•                  Adecrease in product sales revenue of approximately 9.5%.

 

Product salesrevenue has declined slightly as a percentage of total revenue for the firstquarter of 2005 versus the comparable quarter of 2004.  Product sales are dependent upon the levelsof new movies and other ancillary inventory levels available for sale in thestores.  We evaluate our product salesinventory mix and inventory levels on a regular basis and make periodicadjustments to our retail inventory mix based on our operating strategies andcustomer trends.  Product sales revenuehas not exceeded 10% of total revenue in the last five years.  We expect rental revenue to continue torepresent the majority of our business.

 

*Cost ofSales.*  The cost ofrental revenues includes the amortization of rental inventory, revenue sharingexpenses incurred and the cost of previously viewed rental inventory sold.  The gross margin on rental revenue for thefirst quarter of 2005 was 69.4% versus 72.3% for the comparable quarter of 2004. The rental margin for the first quarterof 2005 decreased primarily due to higher than normal promotional activity of previously-viewedproducts and an increase in our rental inventory amortization due to theconcentration of our rental inventory purchases in the beginning of thequarter.

 

Cost of product sales includes the costs of new DVDs,videocassettes, concessions and other goods sold.  The gross margin on product sales for the firstquarter of 2005 was 28.5% compared to 33.9% for the comparable quarter of 2004.  The product sales margin fluctuates with themix of inventory available for sale in the stores.

 

*OperatingCosts and Expenses.* Store operating expenses include store-level expenses such as leasepayments, in-store payroll and start-up costs associated with new storeopenings. Store operating expenses as a percentage of total revenue for thefirst quarter of 2005 were flat with the first quarter of 2004 at 46.4%.  Store operating expenses in the first quarter2005 includes approximately $675,000, or $0.01 per share, of depreciationexpense related to our lease accounting changes made in the fourth quarter of2004.

 

Generaland administrative expenses as a percentage of revenue decreased to 6.6% forthe first quarter of 2005 versus 6.8% for the comparable period of 2004.  General and administrative expenses includethe costs to maintain our corporate support center as well as the overheadcosts of our field management team.

 

Stockcompensation expense represents the non-cash charge associated with non-vestedstock grants and with certain stock options that were repriced during the firstquarter of fiscal 2001 and are subsequently accounted for as variable stockoptions.

 

*OperatingIncome.*  As a result ofthe impact of the above factors on revenues and expenses, operating incomedecreased by 3.6% for the first quarter of 2005 to $30.6 million.

 

*Equity inlosses of unconsolidated entities.* During the last half of 2003, we began to makeinvestments in various alternative delivery vehicles (both retail and digital)for movie content.  We do not anticipate that any of these alternativeswill replace our base video rental business.  However, we do believe it isappropriate to make selective investments in synergistic opportunities thatcould potentially provide ancillary sources of revenue and profitability to our

 

11

----

 

base rentalbusiness.  The expenses associated with our investments in alternativedelivery vehicles are reflected as equity in losses of unconsolidated entitieson our statements of income.  Prior tothe third quarter of 2004, these costs were included in store operating expenseson the statements of income.

 

**Liquidity and Capital Resources**

 

Our primarycapital needs are for opening and acquiring new stores, purchasing inventory,and debt service. Other capital needs include refurbishing, remodeling andrelocating existing stores and refreshing, rebranding and supplying newcomputer hardware for acquired stores. We fund inventory purchases, remodeling, rebranding and relocationprograms, new store opening costs and acquisitions primarily from cash flowfrom operations and, as necessary, from loans under our revolving creditfacility.

 
| ** **                                  | ** ** | **Thirteen Weeks Ended** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|
| ** **                                  | ** ** | **April 4,**        | ** ** | **April 3,** | ** ** |
| ** **                                  | ** ** | **2004**                 |       | **2005** | ** ** |
|                                        |       |                     |       |   |   |
| **Statements  of Cash Flow Data:**          |       |                     |       |   |   |
| Net cash  provided by operating activities  |       | $                        | 21,057     |   | **$** | **13,310** | ** ** |
| Net cash used in  investing activities      |       | (19,154                  | )          | **(18,524** | **)** |
| Net cash  provided by financing activities  |       | 1,177                    |       | **2,699** | ** ** |
|                                        |       |                     |       |   |   |
| **Other  data:**                            |       |                     |       |   |   |
| Adjusted EBITDA                             |       | $                        | 34,307     |   | **$** | **39,163** | ** ** |
| Adjusted EBITDA  (percent of total revenue) |       | 16.9                     | %          | **16.8** | **%** |

 

The decrease innet cash provided by operating activities was primarily attributable to thesignificant reduction in accounts payable, an increase in other current assetsand a decrease in operating income as a result of lower gross margins on ourrevenues during the first quarter of 2005 versus the comparable period in 2004.  Net cash provided by operating activitiescontinues to be our primary source of funding for substantially all of ourrental inventory replenishment and capital resource needs.

 

Net cash used ininvesting activities includes the costs of business acquisitions, new storeadditions and investments in base stock rental inventory.  The decrease of approximately $0.6 million innet cash used in investing activities was primarily due to the timing of newstore builds resulting in fewer new stores in the first quarter of 2005 relativeto the comparable period of 2004, offset partially by an increase in ourinvestments in business acquisitions.

 

Net cash providedby financing activities for the first quarter of 2005 increased due primarilyto a $1.3 million increase in proceeds from the exercise of stock options.

 

Adjusted EBITDAduring the thirteen weeks ended April 3, 2005 increased to $39.2 million,a 14.2% increase over the comparable period in the prior year.  The increase was primarily driven by the increasein revenue and store base, offset partially by a decrease in gross profitmargin for the first quarter of 2005.

 

Adjusted EBITDA isdefined as net cash provided by operating activities before changes inoperating assets and liabilities, interest and taxes.  Adjusted EBITDA is presented primarily as analternative measure of liquidity, although we also use it as an internalmeasure of performance for making business decisions and compensating ourexecutives.  It is also a widely acceptedfinancial indicator in the home video specialty retail industry of a company’sability to incur and service debt, finance its operations and meet its growthplans.  However, our computation of AdjustedEBITDA is not necessarily identical to similarly captioned measures presentedby other companies in our industry.  Weencourage you to compare the components of our reconciliation of Adjusted EBITDAto cash flows from operations in relation to similar

 

12

----

 

reconciliations providedby other companies in our industry.  Ourpresentation of net cash provided by operating activities and Adjusted EBITDAtreats rental inventory as being expensed upon purchase instead of beingcapitalized and amortized.  We believethis presentation is meaningful and appropriate because our annual cashinvestment in rental inventory is substantial and in many respects is similarto recurring merchandise inventory purchases considering our operating cycleand the relatively short useful lives of our rental inventory.  Our calculation of Adjusted EBITDA excludesthe impact of changes in operating assets and liabilities.  This adjustment eliminates temporary effectsattributable to timing differences between accrual accounting and actual cashreceipts and disbursements, and other normal, recurring and seasonalfluctuations in working capital that have no long-term or continuing affect onour liquidity.  Investors should considerour presentation of Adjusted EBITDA in light of its relationship to cash flowsfrom operations, cash flows from investing activities and cash flows fromfinancing activities as shown in our statements of cash flows.  Adjusted EBITDA is not necessarily a measureof “free cash flow” because it does not reflect periodic changes in the levelof our working capital or our investments in new store openings, businessacquisitions, or other long-term investments we may make.  However, it is an important measure used internallyby executive management of our company in making decisions about where toallocate resources to grow our business. Our calculation of Adjusted EBITDA is reconciled to net cash provided byoperating activities as follows (in thousands):

 
| ** **                                   | ** ** | **ThirteenWeeks Ended** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|
| ** **                                   | ** ** | **April 4,**       | ** ** | **April 3,** | ** ** |
| ** **                                   | ** ** | **2004**                | ** ** | **2005** | ** ** |
|                                         |       |                    |       |   |   |
| Net cash  provided by operating activities   |       | $                       | 21,057     |   | **$** | **13,310** | ** ** |
| Changes in  operating assets and liabilities |       | 9,651                   |       | **19,772** | ** ** |
| Tax benefit of  stock options exercised      |       | (2,989                  | )          | **(2,175** | **)** |
| Deferred income  taxes                       |       | (5,256                  | )          | **(3,584** | **)** |
| Interest expense                             |       | 99                      |       | **80** | ** ** |
| Income taxes                                 |       | 11,745                  |       | **11,760** | ** ** |
| Adjusted EBITDA                              |       | $                       | 34,307     |   | **$** | **39,163** | ** ** |

 

As of April 3, 2005, there were no outstandingborrowings under our credit facility. The amounts available for borrowing,reduced by standby letters of credit outstanding of $3.4 million, totaled $71.6million as of April 3, 2005.  On April 27, 2005,we completed our cash acquisition of Hollywood, refinanced substantially all ofthe existing indebtedness of Hollywood, and replaced our existing unsecuredrevolving credit facility.  We obtained asenior secured credit facility from a lending syndicate led by Wachovia andMerrill Lynch.  The new senior securedcredit facility is in an aggregate amount of $870.0 million, consisting of afive-year $75.0 million revolving credit facility bearing interest at aninitial rate of LIBOR plus 2.75%, and two term loan facilities in an aggregateprincipal amount of $795.0 million.  TermLoan A is a $95.0 million, five-year facility bearing interest at an initialrate of LIBOR plus 2.75%.  Term Loan B isa $700.0 million, six-year facility bearing interest at an initial rate ofLIBOR plus 3.00%.  The senior securedcredit facility is guaranteed by Hollywood and all of our domesticsubsidiaries.  In addition to the seniorsecured credit facility, we issued $325.0 million of 11% senior unsecurednotes, due 2012.

 

At April 3,2005, we had a working capital deficit of $14.9 million, primarily due to theaccounting treatment of rental inventory.  Rental inventory is treated as a noncurrentasset under accounting principles generally accepted in the United Statesbecause it is a depreciable asset and a portion of this asset is not reasonablyexpected to be completely realized in cash or sold in the normal business cyclewithin one year. Although the rental of this inventory generates the majorportion of our revenue, the classification of this asset as noncurrent resultsin its exclusion from working capital. The aggregate amount payable for thisinventory, however, is reported as a current liability until paid and,accordingly, is reflected as a reduction in working capital. Consequently, webelieve that working capital is not an appropriate measure of our liquidity andwe anticipate that we will continue to operate with a working capital deficit.

 

13

----

 

We grow our store base through internally developed andacquired stores.  We opened 62 internallydeveloped stores, acquired 18 stores and closed 19 stores during the firstquarter of 2005.  We will continue toevaluate acquisition opportunities in 2005 as they arise.  To the extent available, new stores andfuture acquisitions may be completed using funds available under our revolvingcredit facility, financing provided by sellers or alternative financingarrangements, such as funds raised in public or private debt or equityofferings.  However, we cannot assure youthat financing will be available to us on terms which will be acceptable, if atall.

 

Capital requirements tofund new store growth in fiscal 2005, including the base stock rental inventoryinvestment, are estimated at $52 million. Additionally in fiscal 2005, we estimate $25 million in other on-goingcapital expenditure requirements for the Movie Gallery store base, excludingany capital spending that may be required for the Hollywood stores.  We have spent approximately $9.2 million forthe first quarter of 2005 on new stores ($3.3 million for base stock rentalinventory and $5.9 million for new store build out) and approximately $4.7million for other on-going capital expenditures.

 

We purchase rentalinventory under two different cost structures. Under “fixed cost” arrangements, we pay a flat purchase price with nofurther obligations to our vendor.  Under“revenue sharing” arrangements, we pay a lower fixed cost per unit and then “share”a predetermined portion of the future revenues with the studio for an agreedupon period of time following the release date of the product.  Fixed cost purchases are capitalized and amortizedas rental inventory on our balance sheet, in accordance with our statedaccounting policies.  The fixed portionof the cost of revenue-share product is capitalized and amortized as rentalinventory on our balance sheet, while the revenue sharing payments are expensedas incurred and reflected in gross profit on our income statement.  Rental inventory purchases included in netcash provided by operating activities include the costs of all our fixed costpurchases as well as the fixed portion of costs associated with ourrevenue-share product, while the revenue sharing expenses are reflected in netcash provided by operating activities through net income.  (Note that rental inventory purchases for newstores or other significant investments in base stock rental inventory are notclassified as operating activities, but instead as investing activities in ourstatements of cash flows.)  Rentalinventory purchases will be higher in periods with more fixed cost purchasesversus revenue share purchases.  The mixof fixed cost and revenue share product purchased in any given period isdependent upon the purchasing economics of the titles released in that periodand is not determined until the monthly orders are placed with our suppliers.  As such, we are unable to provide guidanceregarding the expected future amounts of rental inventory purchases asreflected in our statements of cash flows.

 

We believe thatcurrently our projected cash flow from operations, cash on hand, borrowingcapacity under our revolving credit facility, and trade credit will provide thenecessary capital to fund our current plan of operations, including ouranticipated new store openings and acquisition program, and service our debtthrough fiscal 2005.  Our acquisition ofHollywood required debt financing in an aggregate amount of approximately $1.1billion and included a replacement of our existing revolving creditfacility.  To fund additional majoracquisitions, or to provide funds in the event that our need for funds isgreater than expected, or if the financing sources identified above are notavailable to the extent anticipated, or if we increase our growth plan, we mayneed to seek additional or alternative sources of financing.  This financing may not be available onsatisfactory terms, or at all.  Failureto obtain financing to fund our expansion plans or for other purposes couldhave a material adverse effect on our operating results.

 

Our ability tomeet debt service requirements and to fund our current plan of operations andour growth plan will depend upon our future performance (including ourHollywood acquisition and our successful integration and operation of itsbusiness), which is subject to general economic, financial, competitive, andother factors that are beyond our control. While management believes that our business will generate sufficientcash flow from operations in the future to fund capital resource and debtservice needs, as well as to cover the ongoing costs of operating the business,there can be no assurance that factors as described above will not prevent thisfrom happening.  If we are unable tosatisfy these requirements with cash flow from operations, cash on hand, andborrowings under our revolving credit facility, we may be required to sellassets or to obtain additional financing. We cannot assure you that any such sales of assets or additionalfinancing could be obtained.

 

14

----

 

## **Critical Accounting Policies and Estimates**

## ** **

Our significant accounting policies are described inNote 1 to our consolidated financial statements as filed in our Annual Reporton Form 10-K for the fiscal year ended January 2, 2005. Ourdiscussion and analysis of financial condition and results of operations arebased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of the financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues,expenses, and related disclosure of contingent assets and liabilities. On anon-going basis, we evaluate the estimates that we have made. These estimateshave been based upon historical experience and on various other assumptions thatwe believe to be reasonable under the circumstances. Actual results may differfrom these estimates under different conditions or using different assumptions.We believe our most critical accounting estimates include our policies withrespect to rental inventory amortization, impairment of long-lived assets,purchase price allocation of acquired businesses and deferred income taxes.

 

A major component of our cost structure is the amortization of our rentalinventory.  Rental inventory is amortizedto an estimated salvage value over an estimated useful life of up to twoyears.  We amortize the cost of rentalinventory using an accelerated method designed to approximate the rate ofrevenue recognition.  This method isbased on historical customer demand patterns from “street date” (the datestudios release various titles for distribution to our stores) through the endof the average useful life.  In order todetermine the appropriate useful lives and salvage values, we analyzed theactual historical performance trends of our rental inventory.  We quantified the average rate of revenuerecognition on our products and developed amortization rates and useful livesthat approximate the rental turns of our inventory.  Our established salvage values are based onan evaluation of the sale prices we are able to realize from our customers onused inventory, prices observed in bulk sale transactions and prices observedin other open market purchases of used inventory, as well as the salvage valuesestablished by competitors in our industry. We believe our estimated useful lives and salvage values areappropriately matched to our current rental business and are consistent withindustry trends.  However, should rentalpatterns of consumers change or should market values of previously viewedinventory decline due to the acceptance of new formats (e.g., ongoing VHStransition to DVD, anticipated transition to high definition DVD within threeto five years, release of new video game formats, etc.), this could necessitatean acceleration in our current rental amortization rates, a reduction insalvage values or a combination of both courses of action.  We believe that any acceleration in therental amortization rates would not have a long-lasting impact as the majorityof our current rental purchases are substantially depreciated within the firsttwo to three months after “street date” under our existing policy.  We could be required to reduce salvage valuesthat we currently carry on VHS inventory if we are unable to dispose of thatinventory at a rate relatively consistent with the consumers’ transition toDVD.  In the past we have 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 April 3,2005 and January 2, 2005, we had $130.4 million and $126.5 million,respectively, in rental inventory on our balance sheet.  VHS, DVD and games constituted 35%, 58% and 7%,respectively, of total rental inventory units as of April 3, 2005;compared to 38%, 55% and 7%, respectively, of total units as of January 2,2005.  As of April 3, 2005, the netbook value of our VHS rental inventory is approximately 20% of the net bookvalue of our total rental inventory.

 

Weassess the fair value and recoverability of our long-lived assets, includingproperty, furnishings and equipment and intangible assets with finite lives,whenever events and circumstances indicate the carrying value of an asset maynot be recoverable from estimated future cash flows expected to result from itsuse and eventual disposition.  In doingso, we make assumptions and estimates regarding future cash flows and otherfactors in order to make our determination. The fair value of our long-livedassets is dependent upon the forecasted performance of our business, changes inthe video retail industry 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.

 

15

----

 

We test goodwillfor impairment on an annual basis. Additionally, goodwill is tested for impairment between annual tests ifan event occurs or circumstances change that would more likely than not reducethe fair value of an entity below its carrying value.  These events or circumstances would include asignificant change in the business climate, legal factors, operatingperformance indicators, competition, sale or disposition of a significantportion of the business or other factors. We have not recorded any impairment losses on goodwill since a fiscal2001 impairment charge of $700,000.  Ifwe do not meet our operating forecasts or if the market value of our stockdeclines significantly, we may have to record additional impairment charges notpreviously recognized.  As of April 3,2005, we have $147.0 million in goodwill on our balance sheet.

 

Weestimate the fair value of assets and liabilities of acquired businesses basedon historical experience and available information at the acquisitiondate.  We engage independent valuationspecialists to assist when necessary.  Ifinformation becomes available subsequent to the acquisition date that wouldmaterially impact the valuation of assets acquired or liabilities assumed inbusiness 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 smallbusinesses for which we generally do not assume liabilities and for which theassets acquired consist primarily of inventory, fixtures, equipment andintangibles.

 

**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 ofthe reversals 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 net operating losses fromour 2001 acquisition of Video Update, we considered, among other things, theapplicable provisions of the federal income tax code, which limit thedeductibility of net operating loss carryforwards to the post-acquisitiontaxable income (cumulative basis) of the acquired subsidiary on a separatereturn basis, as well as other limitations that may apply to the futuredeductibility of these net operating losses. We also considered the availability of reversing taxable temporarydifferences during the carryforward period, the length of the availablecarryforward period, recent operating results, our expectations of futuretaxable income during the carryforward period, changes in tax law, IRSinterpretive guidance and judicial rulings. If facts and circumstances in the future should warrant elimination orreduction of the valuation allowance related to these NOLs, our effective incometax rate, which was 40%, 39% and 39% for fiscal 2002, 2003 and 2004, respectively,could be reduced.**

 

##### **ForwardLooking Statements**

 

This quarterly report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended, which represent our expectations or beliefsabout future events and financial performance. Forward-looking statements are identifiable by the fact that they do notrelate strictly to historical information and may include words such as “believe,”“anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate” or othersimilar expressions and variations thereof. In addition, any statements that refer to expectations, projections orother characterizations of future events or circumstances 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 2, 2005.  Forward-looking statements include statementsregarding our ability to continue our expansion strategy, our ability to makeprojected capital expenditures and our ability to achieve cost savings inconnection with our acquisition of Hollywood, as well as general marketconditions, competition and pricing.

 

16

----

 

In light of theserisks, uncertainties and assumptions, the forward-looking events discussed inthis Form 10-Q might not occur.  Inaddition, actual results could differ materially from those suggested by theforward-looking statements, and therefore you should not place undue relianceon the forward-looking statements.  Weundertake no obligation to publicly update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise.  We desire to take advantage of the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995 andin that regard we caution the readers of this Form 10-Q that the importantfactors described in our Annual Report on Form 10-K for the fiscal yearended January 2, 2005, among others, could affect our actual results ofoperations and may cause changes in our strategy with the result that ouroperations and results may differ materially from those expressed in anyforward-looking statements made by us, or on our behalf.

 

17

----

 

Item 3.  Quantitativeand Qualitative Disclosures About Market Risk

 

There have been nomaterial changes in our inherent market risk since the disclosures made as of January 2,2005 in our Annual Report on Form 10-K, which was filed with theSecurities and Exchange Commission on March 18, 2005.

 

Item 4.  Controlsand Procedures

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act )) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and 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 financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our first quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

18

----

 

#### **Part II - Oth**er Information

 

Item 6.  Exhibits

 

a)              Exhibits

 
| 31.1   |   | Certification of  Chief Executive Officer Pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                            |
| 31.2   |   | Certification of  Chief Financial Officer Pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |
|   |   |                                                                                                                                                            |
| 32.1   |   | Certification of Chief  Executive Officer Pursuant to 18 U.S.C 1350, as adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                 |
|   |   |                                                                                                                                                            |
| 32.2   |   | Certification of Chief  Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                |

 

**Signatures**

** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|                    | Movie  Gallery, Inc.                   |   |
|-------------------------|---------------------------------------------|--------|
|                    | (Registrant)                                |   |
|                    |                                        |
|                    |                                        |
|                    |                                        |
| Date: May 13, 2005 | /s/ Ivy M. Jernigan                         |   |
|                    | Ivy M. Jernigan, Senior  Vice President and |
| ** **              | **Chief Financial Officer**                 |

 

19

----