**UNITED STATESSECURITIES AND 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 April 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 of registrant as specified in its charter)

 

| **Delaware**                                                    |   | **63-1120122**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **900  West Main Street, Dothan, Alabama**                      |   | **36301**                             |
| (Address of principal executive offices)                        |   | (Zip Code)                            |
|                                                            |   |                                  |
| **(334) 677-2108**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to filing requirements for the past 90 days.  YES   ý      NO    o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

YES   ý      NO    o

 

The number of sharesoutstanding of the registrant’s common stock as of May 11, 2004 was 33,498,816.

 

 

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

#### **Index**

#### ** **

| Part I.                                                                                               | Financial  Information                                                                      |
|-------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|
|                                                                                                  |
| Item 1.                                                                                               | Consolidated  Financial Statements (Unaudited)                                              |
|                                                                                                  |
| Consolidated Balance Sheets  –  January 4, 2004 and April 4, 2004                           |                                                                                        |
|                                                                                                  |                                                                                        |
| Consolidated Statements of Income –  Thirteen weeks ended April 6, 2003 and April   4, 2004 |                                                                                        |
|                                                                                                  |                                                                                        |
| Consolidated Statements of Cash Flows –  Thirteen weeks ended April 6, 2003 and April 4, 2004    |                                                                                        |
|                                                                                                  |                                                                                        |
| Notes to Consolidated Financial Statements  – April 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 6.                                                                                               | Exhibits and Reports on Form 8-K                                                            |   |
|                                                                                                       |                                                                                             |  |  |  |  |

 

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**Movie Gallery, Inc.**

**ConsolidatedBalance Sheets**

**(in thousands)**

 
|                                                                                                                                 |   | **January 4,  2004** |    | **April 4,  2004** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|---------|--------------------|--------|
|                                                                                                                                 |   |                 |    | **(Unaudited)**    |   |
| **Assets**                                                                                                                           |   |                 |    |               |   |
| Current assets:                                                                                                                      |   |                 |    |               |   |
| Cash and cash equivalents                                                                                                            |   | $                    | 53,720  |               | **$**  | **48,524** |   |
| Merchandise inventory                                                                                                                |   | 26,473               |    | **25,947**         |   |
| Prepaid expenses                                                                                                                     |   | 1,377                |    | **1,650**          |   |
| Store supplies and other                                                                                                             |   | 11,019               |    | **10,184**         |   |
| Deferred income taxes                                                                                                                |   | 1,631                |    | **1,870**          |   |
| Total current assets                                                                                                                 |   | 94,220               |    | **88,175**         |   |
|                                                                                                                                 |   |                 |    |               |   |
| Rental inventory, net                                                                                                                |   | 102,479              |    | **109,773**        |   |
| Property, furnishings and equipment, net                                                                                             |   | 114,356              |    | **121,435**        |   |
| Goodwill, net                                                                                                                        |   | 136,008              |    | **136,554**        |   |
| Other intangibles, net                                                                                                               |   | 8,473                |    | **8,551**          |   |
| Deposits and other assets                                                                                                            |   | 8,753                |    | **8,297**          |   |
| Total assets                                                                                                                         |   | $                    | 464,289 |               | **$**  | **472,785** |   |
|                                                                                                                                 |   |                 |    |               |   |
| **Liabilities and stockholders’ equity**                                                                                        |   |                 |    |               |   |
| Current liabilities:                                                                                                                 |   |                 |    |               |   |
| Accounts payable                                                                                                                     |   | $                    | 77,344  |               | **$**  | **58,919** |   |
| Accrued liabilities                                                                                                                  |   | 26,161               |    | **28,185**         |   |
| Deferred revenue                                                                                                                     |   | 10,741               |    | **8,290**          |   |
| Total current liabilities                                                                                                            |   | 114,246              |    | **95,394**         |   |
|                                                                                                                                 |   |                 |    |               |   |
| Other accrued liabilities                                                                                                            |   | 142                  |    | **205**            |   |
| Deferred income taxes                                                                                                                |   | 29,785               |    | **35,280**         |   |
| 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 33,415,788 shares issued and outstanding,  respectively |   | 33                   |    | **34**             |   |
| Additional paid-in capital                                                                                                           |   | 225,191              |    | **230,397**        |   |
| Retained earnings                                                                                                                    |   | 91,098               |    | **108,349**        |   |
| Accumulated other comprehensive income                                                                                               |   | 3,794                |    | **3,126**          |   |
| Total stockholders’ equity                                                                                                      |   | 320,116              |    | **341,906**        |   |
| Total liabilities and stockholders’ equity                                                                                      |   | $                    | 464,289 |               | **$**  | **472,785** |   |

 

*See accompanying notes.*

 

1

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**Movie Gallery, Inc.**

**ConsolidatedStatements of Income**

**(Unaudited)**

**(in thousands, except per share data)**

 
|                                 |   | **Thirteen  Weeks Ended** |    |
|--------------------------------------|--------|---------------------------|---------|
|                                 |   | **April 6,2003**          |    | **April 4,2004** |   |
|                                 |   |                      |    |   |   |
| Revenues:                            |   |                      |    |   |   |
| Rentals                              |   | $                         | 153,181 |   | **$** | **186,757** |   |
| Product sales                        |   | 15,468                    |    | **16,545** |   |
| Total revenues                       |   | 168,649                   |    | **203,302** |   |
|                                 |   |                      |    |   |   |
| Cost of sales:                       |   |                      |    |   |   |
| Cost of rental revenues              |   | 47,584                    |    | **51,745** |   |
| Cost of product sales                |   | 12,671                    |    | **10,940** |   |
| Gross margin                         |   | 108,394                   |    | **140,617** |   |
|                                 |   |                      |    |   |   |
| Operating costs and expenses:        |   |                      |    |   |   |
| Store operating expenses             |   | 74,484                    |    | **96,055** |   |
| General and administrative           |   | 10,776                    |    | **13,796** |   |
| Amortization of intangibles          |   | 426                       |    | **614** |   |
| Stock option compensation            |   | 469                       |    | **56** |   |
| Operating income                     |   | 22,239                    |    | **30,096** |   |
|                                 |   |                      |    |   |   |
| Interest expense, net                |   | (99                       | )       | **(99** | ) |
| Income before income taxes           |   | 22,140                    |    | **29,997** |   |
|                                 |   |                      |    |   |   |
| Income taxes                         |   | 8,856                     |    | **11,745** |   |
| Net income                           |   | $                         | 13,284  |   | **$** | **18,252** |   |
|                                 |   |                      |    |   |   |
| Net income per share:                |   |                      |    |   |   |
| Basic                                |   | $                         | 0.41    |   | **$** | **0.55** |   |
| Diluted                              |   | $                         | 0.40    |   | **$** | **0.54** |   |
|                                 |   |                      |    |   |   |
| Weighted average shares outstanding: |   |                      |    |   |   |
| Basic                                |   | 32,097                    |    | **33,071** |   |
| Diluted                              |   | 33,084                    |    | **33,737** |   |
|                                 |   |                      |    |   |   |
| Cash dividends per common share      |   | $                         | —  |   | **$** | **0.03** |   |

 

*See accompanying notes.*

 

2

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**Movie Gallery, Inc.**

**Consolidated Statements of Cash Flows**

**(Unaudited)**

**(in thousands)**

 
|                                                                               |   | **Thirteen  Weeks Ended** |   |
|------------------------------------------------------------------------------------|--------|---------------------------|--------|
|                                                                               |   | **April 6,2003**          |   | **April 4,2004** |   |
|                                                                               |   |                      |   |   |   |
|                                                                               |   |                      |   |   |   |
| **Operating activities:**                                                          |   |                      |   |   |   |
| Net income                                                                         |   | $                         | 13,284 |   | $ | 18,252 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                      |   |   |   |
| Rental inventory amortization and non-cash  cost of rental inventory sold          |   | 35,775                    |   | 34,073 |   |
| Purchases of rental inventory                                                      |   | (35,242                   | )      | (36,760 | ) |
| Depreciation and intangibles amortization                                          |   | 5,323                     |   | 6,842 |   |
| Stock option compensation                                                          |   | 469                       |   | 56 |   |
| Tax benefit of stock options exercised                                             |   | 382                       |   | 2,989 |   |
| Deferred income taxes                                                              |   | 2,926                     |   | 5,256 |   |
| Changes in operating assets and  liabilities:                                      |   |                      |   |   |   |
| Merchandise inventory                                                              |   | 59                        |   | 530 |   |
| Other current assets                                                               |   | (1,518                    | )      | 562 |   |
| Deposits and other assets                                                          |   | (724                      | )      | 456 |   |
| Accounts payable                                                                   |   | (6,994                    | )      | (18,425 | ) |
| Accrued liabilities and deferred revenue                                           |   | 1,676                     |   | (382 | ) |
| Net cash provided by operating activities                                          |   | 15,416                    |   | 13,449 |   |
|                                                                               |   |                      |   |   |   |
| **Investing activities:**                                                          |   |                      |   |   |   |
| Business acquisitions                                                              |   | (3,725                    | )      | (2,206 | ) |
| Purchases of rental inventory-base stock                                           |   | (7,145                    | )      | (3,883 | ) |
| Purchases of property, furnishings and  equipment                                  |   | (10,722                   | )      | (13,065 | ) |
| Net cash used in investing activities                                              |   | (21,592                   | )      | (19,154 | ) |
|                                                                               |   |                      |   |   |   |
| **Financing activities:**                                                          |   |                      |   |   |   |
| Proceeds from issuance of common stock                                             |   | 125                       |   | 2,162 |   |
| Dividends                                                                          |   | —                    |   | (985 | ) |
| Net cash provided by financing activities                                          |   | 125                       |   | 1,177 |   |
|                                                                               |   |                      |   |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                      |   | 1,057                     |   | (668 | ) |
| Decrease in cash and cash equivalents                                              |   | (4,994                    | )      | (5,196 | ) |
| Cash and cash equivalents at beginning of  period                                  |   | 39,526                    |   | 53,720 |   |
| Cash and cash equivalents at end of period                                         |   | $                         | 34,532 |   | $ | 48,524 |   |

 

*See accompanying notes.*

 

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**Movie Gallery, Inc.**

 

**Notes to Consolidated Financial Statements(Unaudited)**

 

**April 4, 2004**

 

**1. Basis of Presentation**

 

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.  In the opinion of management, alladjustments (consisting of normal recurring accruals) considered necessary fora fair presentation have been included. Operating results for the thirteen week period ended April 4, 2004 arenot necessarily indicative of the results that may be expected for the fiscalyear ending January 2, 2005.  Forfurther information, refer to the consolidated financial statements andfootnotes thereto included in our Annual Report on Form 10-K for the fiscalyear ended January 4, 2004.

 

In the first quarter of 2004, we began reporting the on-going purchasesof new release rental inventory as an operating activity in the statement ofcash flows versus as an investing activity as previously reported.   This reclassification is appropriate as therental of this inventory generates the majority of our revenue. Purchases ofrental inventory for new stores or other significant investments in base stockrental inventory continue to be classified as investing activities in thestatements of cash flows as these purchases represent a long-term investment inour business.  Rental inventorypurchases in the prior year have been reclassified to conform to the current yearpresentation for comparative purposes. The reclassification had no impact on our financial position or resultsof operations as previously reported.

 

*Stock Option Plan*

 

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

 

4

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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-Based Compensation*,as amended, to stock-based employee compensation.

 
|                                                                                                           |   | **Thirteen  Weeks Ended**                 |   |
|----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                                           |   | **April 6,  2003**                        |   | **April 4,  2004** |   |
|                                                                                                           |   | **(in thousands, except per share data)** |   |
|                                                                                                           |   |                                      |   |   |   |
| Net income, as reported                                                                                        |   | $                                         | 13,284 |   | **$** | **18,252** | ** ** |
| Add:   Stock option compensation included in reported net income, net of tax                              |   | 281                                       |   | **34** | ** ** |
| Deduct:   Stock option compensation determined under fair value based methods  for all awards, net of tax |   | (132                                      | )      | **(257** | **)** |
|                                                                                                           |   |                                      |   |   | ** ** |
| Pro forma net income                                                                                           |   | $                                         | 13,433 |   | **$** | **18,029** | ** ** |
|                                                                                                           |   |                                      |   |   | ** ** |
| Net income per share, as reported:                                                                             |   |                                      |   |   | ** ** |
| Basic                                                                                                          |   | $                                         | 0.41   |   | **$** | **0.55** | ** ** |
| Diluted                                                                                                        |   | $                                         | 0.40   |   | **$** | **0.54** | ** ** |
|                                                                                                           |   |                                      |   |   | ** ** |
| Pro forma net income per share:                                                                                |   |                                      |   |   | ** ** |
| Basic                                                                                                          |   | $                                         | 0.42   |   | **$** | **0.55** | ** ** |
| Diluted                                                                                                        |   | $                                         | 0.40   |   | **$** | **0.53** | ** ** |

 

*Recently Issued Accounting Pronouncements*

 

In January 2003, the Financial Accounting Standards Board issuedInterpretation No. 46, *Consolidation of Variable Interest Entities, anInterpretation of Accounting Research Bulletin No. 51*(“theInterpretation”).  The Interpretationrequires the consolidation of entities in which an enterprise absorbs amajority of the entity’s expected losses, receives a majority of the entity’sexpected residual returns, or both, as a result of ownership, contractual orother financial interests in the entity. Currently, entities are generally consolidated by an enterprise when ithas a controlling financial interest through ownership of a majority votinginterest in the entity.  The Interpretationis effective as of December 31, 2003 for all qualifying interests in specialpurpose entities (“SPEs”) in existence as of January 31, 2003 and as ofFebruary 1, 2003 for all qualifying SPEs obtained after January 31, 2003.  We had no qualifying interests as of January31, 2003.  We have subsequently madeequity investments in other entities during 2003 (none of which are SPEs).  These investments are immaterial, and consolidationis not currently required under the Interpretation.   The provisions of the Interpretation, as revised by the FASB inDecember 2003, were applied to some of our investments in the first quarter of2004.   Our adoption of this standarddid not have a material impact on our financial position or results ofoperations.

 

**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.    Thechange in estimate decreased rental inventory and increased depreciationexpense for the thirteen weeks ended April 6, 2003 by approximately $2.7million and reduced net income by $0.05 per diluted share.

 

5

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**3. Goodwill and Other Intangible Assets**

 

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

 
|                          |   |                                    |   | **January 4,  2004**      |    | **April 4,  2004**          |   |
|-------------------------------|--------|-----------------------------------------|--------|---------------------------|---------|-----------------------------|--------|
|                          |   | **Weighted-AverageAmortization Period** |   | **Gross  CarryingAmount** |    | **AccumulatedAmortization** |   | **Gross  CarryingAmount** |   | **AccumulatedAmortization** |   |
|                          |   |                                    |   |                      |    |                        |   |   |   |   |   |
| Goodwill                      |   | —                                  |   | $                         | 167,419 |                        | $      | (31,411 | ) | **$** | **167,965** | ** ** | **$** | **(31,411** | **)** |
|                          |   |                                    |   |                      |    |                        |   |   | ** ** |   | ** ** |
| Non-compete agreements        |   | 8 years                                 |   | $                         | 10,908  |                        | $      | (7,696 | ) | **$** | **11,057** | ** ** | **$** | **(8,037** | **)** |
| Customer lists                |   | 5 years                                 |   | 6,385                     |    | (1,124                      | )      | **6,926** | ** ** | **(1,395** | **)** |
| Total other intangible assets |   |                                    |   | $                         | 17,293  |                        | $      | (8,820 | ) | **$** | **17,983** |   | **$** | **(9,432** | **)** |

 

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

 
| 2004 (remainder) |   | $     | 1,887  |   |
|------------------|--------|-------|--------|--------|
| 2005             |   | 2,017 |   |
| 2006             |   | 1,690 |   |
| 2007             |   | 1,549 |   |
| 2008             |   | 1,033 |   |
| 2009             |   | 302   |   |

 

The changes in the carrying amounts of goodwill for the thirteen weeksended April 4, 2004, are as follows (in thousands):

 
| Balance as of January 4, 2004 |   | $   | 136,008 |       |
|-------------------------------|--------|-----|---------|------------|
| Goodwill acquired             |   | 546 |    |
| Balance as of April 4, 2004   |   | $   | 136,554 | ** ** |

 

During the thirteen weeks ended April 4,2004, we purchased 24 stores in 8 separate transactions for approximately $2.2million and recorded approximately $0.5 million in goodwill, $0.5 million forcustomer lists and $0.2 million for non-compete agreements related to thesetransactions

 

**4.  Financing Obligations**

 

On June 27, 2001, we entered into a credit agreement with a syndicateof banks, led by SouthTrust Bank, with respect to a revolving creditfacility.  Our credit facility isunsecured and, as amended, provides for borrowings of up to $65 million throughfinal maturity on July 4, 2005.  Theinterest rate on our credit facility is based on LIBOR plus an applicablemargin percentage, which depends on cash flow generation and borrowingsoutstanding.  As of April 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 April 4, 2004.

 

**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

 

6

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exercise of dilutive common stock options (987,000 and 666,000 for thethirteen weeks ended April 6, 2003 and April 4, 2004, respectively).  No adjustments were made to net income inthe computation of basic or diluted earnings per share.

 

**6. Comprehensive Income**

 

Comprehensive income was as follows (in thousands):

 
|                                    |   | **Thirteen  Weeks Ended** |   |
|-----------------------------------------|--------|---------------------------|--------|
|                                    |   | **April 6,2003**          |   | **April 4,2004** |   |
|                                    |   |                      |   |   |   |
| Net income                              |   | $                         | 13,284 |   | **$** | **18,252** | ** ** |
| Foreign currency translation adjustment |   | 1,057                     |   | **(668** | **)** |
| Comprehensive income                    |   | $                         | 14,341 |   | **$** | **17,584** | ** ** |

 

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**MovieGallery, Inc.**

 

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

**andResults of Operations**

 

**Overview**

 

We operate approximately 2,200 home video retail stores that rent andsell movies and video games, primarily in rural and secondary marketsthroughout North America.  We competewith the other two national chains (Blockbuster and Hollywood Entertainment) inonly approximately one-third of our store locations.  We believe that we are the market leader in the majority of ourtarget markets.  We estimate that thereare approximately 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 and, subject to market and industry conditions, to continueto open new stores at a similar pace 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 providesmass merchants and video retailers approximately a 45 day period during whichthey can sell and rent new releases before they are made available onpay-per-view or other distribution channels. The home video distribution channel currently provides over 60% ofstudio revenue.  For this reason, webelieve movie studios have a significant interest in maintaining a viable homevideo business.  For a more detaileddiscussion of our business and the home video industry, see the Businessdiscussion contained in Part I, Item 1 of our Annual Report on Form 10-K forthe fiscal year ended January 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 $48.5 million incash and cash equivalents at April 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.*  Our business is a cash business with initialrental fees paid upfront by the customer. Our management team constantly works with inventory levels, marketingand sales promotions, real estate strategies and personnel issues in order tomaximize profitable revenues at each location. Additionally, our team monitors revenue performance on a daily basis toquickly identify trends or issues in our store base or in the industry as awhole.

•                  *Productpurchasing economics.*  Inorder to maintain the desired profit margin in our business, purchases ofinventory for both rental and sale must be carefully managed.  Our purchasing models are designed toanalyze the impact of the economic factors inherent in the various pricingstrategies employed by the studios.  Webelieve that we are able to achieve purchasing levels tailored for the customerdemographics of each of our markets and to maximize the return on investmentfor our inventory purchase dollars.

•                  *Store levelcost control.*  The mostsignificant store expenses are payroll and rent, followed by all other supplyand service expenditures.  Ourfundamental philosophy with respect to store level expenses is to exerciseextreme conservatism in spending.  Thisis achieved primarily through budgeting systems and centralization of purchasesinto the corporate support center.  Thisenables us to measure performance carefully against expectations and toleverage our purchasing power.  Ourrural focus also provides the benefit of reduced labor and real estate costs inthe secondary markets we serve versus the costs associated with larger urbanmarkets.

•                  *Leverage ofoverhead expenses.*  We applythe same principles of budgeting, accountability and conservatism in ouroverhead spending that we employ in managing our store operating costs.  Our general

 

8

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and administrative expenses include the costs to maintain our corporatesupport center as well as the overhead costs of our field management team.

•                  *Operatingcash flows.*  We havegenerated significant levels of cash flow for several years.  We are generally able to fund the majorityof our store growth and acquisitions, as well as ongoing inventory purchases,from cash flow generated from operations. Cash flow has been sufficient to allow us to maintain a debt-freebalance sheet since May 2002.

 

The following discussion of our results of operations, liquidity andcapital resources will provide further insight into our performance for thefirst quarter of 2004 versus the first quarter of 2003.

 

**New BusinessInitiatives**

 

During the last half of 2003, we began to make some investments invarious alternative delivery vehicles (both retail and digital) for moviecontent, and we began to explore other business initiatives within our existingbase of stores, including tests of a game store-within-a-store, movie tradingand in-store movie subscriptions.  We do not anticipate that any of thesealternatives will replace our base video rental business.  However, we dobelieve it is appropriate to make selective investments in synergisticopportunities that could potentially provide ancillary sources of revenue andprofitability to our base rental business.  Our operating expenses in thefirst quarter of 2004 include certain costs related to some of theseinvestments, resulting in a reduction to net income of approximately $0.03 perdiluted share.

 

9

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**Results of Operations**

 

**Selected Financial Statement and Operational Data:**
|                                 |   | **Thirteen  Weeks Ended**                               |       |
|--------------------------------------|--------|---------------------------------------------------------|------------|
|                                 |   | **April 6,  2003**                                 |       | **April 4,  2004** |   |
|                                 |   | **($ in  thousands, except per share and store data )** | ** ** |
| **Revenues:**                        |   |                                                    |       |   |   |   |   |   |   |
| Rental                               |   | $                                                       | 153,181    |   | 90.8 | % | $ | 186,757 |   | 91.9 | % |
| Product sales                        |   | 15,468                                                  |       | 9.2 | % | 16,545 |   | 8.1 | % |
| Total revenues                       |   | 168,649                                                 |       | 100.0 | % | 203,302 |   | 100.0 | % |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Cost of sales:**                   |   |                                                    |       |   |   |   |   |   |   |
| Rental                               |   | 47,584                                                  |       | 28.2 | % | 51,745 |   | 25.5 | % |
| Product sales                        |   | 12,671                                                  |       | 7.5 | % | 10,940 |   | 5.4 | % |
| Total gross margin                   |   | $                                                       | 108,394    |   | 64.3 | % | $ | 140,617 |   | 69.2 | % |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Store operating  expenses**        |   | $                                                       | 74,484     |   | 44.2 | % | $ | 96,055 |   | 47.2 | % |
| **G&A expenses**                 |   | $                                                       | 10,776     |   | 6.4 | % | $ | 13,796 |   | 6.8 | % |
| **Stock option  compensation**       |   | $                                                       | 469        |   | 0.3 | % | $ | 56 |   | — | % |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Operating income**                 |   | $                                                       | 22,239     |   | 13.2 | % | $ | 30,096 |   | 14.8 | % |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Net income**                       |   | $                                                       | 13,284     |   | 7.9 | % | $ | 18,252 |   | 9.0 | % |
| **Net income per  diluted share**    |   | $                                                       | 0.40       |   |   |   |   | $ | 0.54 |   |   |   |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Cash dividends per  common share** |   | $                                                       | —     |   |   |   | $ | 0.03 |   |   |   |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Same-store revenues**              |   | 10.5                                                    | %          |   |   | 2.0 | % |   |   |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Gross margin  percentage:**        |   |                                                    |       |   |   |   |   |   |   |
| Rental                               |   | 68.9                                                    | %          |   |   | 72.3 | % |   |   |
| Product sales                        |   | 18.1                                                    | %          |   |   | 33.9 | % |   |   |
| Total gross margin                   |   | 64.3                                                    | %          |   |   | 69.2 | % |   |   |
|                                 |   |                                                    |       |   |   |   |   |   |   |
| **Store Count:**                     |   |                                                    |       |   |   |   |   |   |   |
| Beginning of period                  |   | 1,784                                                   |       |   |   | 2,158 |   |   |   |
| New store builds                     |   | 37                                                      |       |   |   | 81 |   |   |   |
| Stores acquired                      |   | 20                                                      |       |   |   | 24 |   |   |   |
| Stores closed                        |   | 18                                                      |       |   |   | 23 |   |   |   |
| End of period                        |   | 1,823                                                   |       |   |   | 2,240 |   |   |   |
|                                      |        |                                                         |            |  |  |  |  |  |  |  |  |  |  |

 

10

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*Revenue.*  For the thirteen weeks ended April 4, 2004, total revenuesincreased 20.5% from the comparable period in 2003.  The increase was primarily due to a 21.9% increase from the prioryear in the average number of stores operated during the first quarter of 2004,as well as same-store revenue growth of 2.0% for the first quarter of2004.  The increase in same-storerevenues primarily resulted from:

 

•                  Continued growthof DVD revenue, offset partially by corresponding declines in VHS revenue dueto the consumer transition to DVD; and

•                  Increases in thesales of previously viewed inventory.

 

The same-store revenues increase was partially offset by:

 

•                  A weak releaseschedule during the first quarter of 2004 versus 2003;

•                  A relativelyflat game business reflecting the weakness of the new game titles currentlybeing released and industry softness that occurs in anticipation of theintroduction of new game platforms; and

•                  Declines in thesales of new movies as a result of the weaker box office releases and ourdecision to reduce new movie inventory levels in our stores.

 

*Cost of Sales.*  The cost of rental revenues includes the amortization of rentalinventory, revenue sharing expenses incurred and the cost of previously viewedrental inventory sold.  The gross marginon rental revenue for the thirteen weeks ended April 6, 2003 andApril 4, 2004 was  68.9% and 72.3%,respectively.  The most significantfactors that impacted growth in the gross margin on rental revenue were:

 

•                  A change inestimate related to our amortization policy for rental inventory during thefourth quarter of fiscal 2002 which lowered the gross rental margin in thefirst quarter of 2003 by approximately $2.7 million; and

•                  Slightly lowerpurchasing levels in the first quarter of 2004 versus 2003 due to the weakerbox office.

 

Costof product sales includes the costs of new DVDs, videocassettes, concessionsand other goods sold.  The gross marginon product sales is subject to fluctuation based on the relative mix of lowmargin new movie inventory sales versus higher margin sales of concessions andother items.  The gross margin onproduct sales for the thirteen weeks ended April  6, 2003 andApril 4, 2004  was  18.1% and 33.9%, respectively.  The product sales margin increase reflectsan overall shift in the inventory mix from lower margin new movie inventory toother higher margin inventory items. New release movie titles in the first quarter of 2004 were also weakerin comparison to the prior year, further reducing sales of lower margin newmovie inventory.

 

*Operating Costs and Expenses.*  Store operating expenses include store-levelexpenses such as lease payments and in-store payroll, as well as start-up costsassociated with new store openings. Store operating expenses as a percentage of total revenue was 44.2% and47.2% for the first quarter of 2003 and 2004, respectively.  The increase in store operating expenses asa percentage of total revenue in the first quarter of 2004 was primarily dueto:

 

•                  Costs associatedwith some of our investments in various alternative delivery vehicles for moviecontent; and

•                  Significantincreases in the level of new store openings since last year, generating storeopening and start-up costs for a larger number of immature stores in therevenue base versus last year.

 

11

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General and administrative expenses as a percentage of revenue were6.4% and 6.8% in the first quarter of 2003 and 2004, respectively.  The increase in general and administrativeexpenses as a percentage of total revenue is primarily due to:

 

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

•                  Overhead costsassociated 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. * *We expect to continue to recordadjustments to income from stock option compensation in future periods.  Due to the relatively small number of theseoptions that remain outstanding, we expect future adjustments to be immaterial.

 

*Operating Income.*  As a result of the impact of the above factors on revenues andexpenses, operating income increased by 35.3% in the first quarter of 2004 to$30.1 million.

 

**Liquidity and CapitalResources**

 

Our primary capital needs are for opening and acquiring new stores andfor purchasing inventory. Other capital needs include refurbishing, remodelingand relocating existing stores and refreshing, rebranding and supplying newcomputer hardware for acquired stores. We fund inventory purchases, remodeling, rebranding and relocationprograms, new store opening costs and acquisitions primarily from cash flowfrom operations and, if necessary, loans under revolving creditfacilities.  At April 4, 2004, wehad cash and cash equivalents of $48.5 million, no long-term debt and $63.5million in available borrowings under our credit facility.

 
|                                       |   | **Thirteen  Weeks Ended** |       |
|--------------------------------------------|--------|---------------------------|------------|
|                                       |   | **April 6,  2003**   |       | **April 4,  2004** |   |
|                                       |   | **($ in  thousands )**    | ** ** |
| **Statements of Cash  Flow Data:**         |   |                      |       |   |   |
| Net cash provided by operating activites   |   | $                         | 15,416     |   | $ | 13,449 |   |
| Net cash used in investing activities      |   | (21,592                   | )          | (19,154 | ) |
| Net cash provided by financing activities  |   | 125                       |       | 1,177 |   |
|                                       |   |                      |       |   |   |
| **Other Data:**                            |   |                      |       |   |   |
|                                       |   |                      |       |   |   |
| Adjusted EBITDA                            |   | $                         | 28,564     |   | $ | 34,307 |   |
| Adjusted EBITDA (percent of total revenue) |   | 16.9                      | %          | 16.9 | % |

 

The decrease in net cash provided by operating activities was primarilyattributable to higher reductions in accounts payable during the first quarterof 2004 versus the comparable period in 2003. Net cash provided by operating activities continues to be sufficient tocover substantially all of our rental inventory replenishment and capitalresource needs.

 

In the first quarter of 2004, we began reporting the on-going purchasesof new release rental inventory as an operating activity in the statement ofcash flows versus as an investing activity as previously reported.  This reclassification is appropriate as therental of this inventory generates the majority of our revenue.  Purchases of rental inventory for new storesor other significant investments in base stock rental inventory continue to beclassified as investing activities in the statements of cash flows as thesepurchases 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.

 

12

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Net cash used in investing activities includes the costs of businessacquisitions, new store builds and investments in base stock rentalinventory.  The decrease was primarilydue to an investment in base stock DVD inventory of approximately $5.4 millionin the first quarter of 2003 and lower levels of business acquisitions in thefirst quarter of 2004 versus 2003, partially offset by increased expenditures relating to the higher levelsof new store builds in 2004 versus the first quarter of 2003.

 

Net cash provided by financing activities includes proceeds from theexercise of stock options offset by dividends paid in the first quarter of2004.

 

In March 2004, our board of directors declared a cash dividend of$0.03 per share under a new dividend policy instituted inDecember 2003.  We currently intendto continue to pay similar 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, decreased or suspended fromtime to time based on a number of factors, including changes in tax lawsrelated to dividends, our financial condition, capital requirements, futurebusiness prospects, the terms of any documents governing our indebtedness andother factors that our board of directors deems relevant.

 

Adjusted EBITDA in the first quarter of 2004 increased 20% over thecomparable period in the prior year. The increase was primarily driven by the revenue increase in the firstquarter of 2004, offset partially by more significant levels of new storeopening and start-up costs as well as costs associated with some of our newbusiness initiatives.  Adjusted EBITDAis defined as earnings before interest, taxes, depreciation and amortization,non-cash stock option compensation and nonrecurring items, less our purchases ofrental inventory which excludes rental inventory purchases specifically for newstore openings. Adjusted EBITDA is presented not as an alternative measure ofoperating results or cash flow from operations (as determined in accordancewith accounting principles generally accepted in the United States), butbecause, in the home video specialty retail industry, it is a widely acceptedfinancial indicator of a company’s ability to finance its operations and meetits growth plans, in that it treats rental inventory as being expensed uponpurchase instead of being capitalized and amortized.  This measure is also used by us internally to make new store andacquisition investment decisions and to calculate awards under incentive basedcompensation programs.  Our calculationof Adjusted EBITDA is not necessarily comparable to reported EBITDA and/orAdjusted EBITDA of other companies due to the lack of uniform definitions ofEBITDA and Adjusted EBITDA.

 

13

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

 
|                                        |   | **Thirteen  Weeks Ended** |   |
|---------------------------------------------|--------|---------------------------|--------|
|                                        |   | **April 6,  2003**   |   | **April 4,  2004** |   |
|                                        |   |                      |   |   |   |
| Operating income                            |   | $                         | 22,239 |   | $ | 30,096 |   |
| Rental inventory amortization               |   | 35,775                    |   | 34,073 |   |
| Depreciation and intangibles amortization   |   | 5,323                     |   | 6,842 |   |
| Stock option compensation                   |   | 469                       |   | 56 |   |
| Purchases of rental inventory               |   | (35,242                   | )      | (36,760 | ) |
| Adjusted EBITDA                             |   | $                         | 28,564 |   | $ | 34,307 |   |
|                                        |   |                      |   |   |   |
| Net cash provided by operating activities   |   | $                         | 15,416 |   | $ | 13,449 |   |
| Changes in operating assets and liabilities |   | 7,501                     |   | 17,259 |   |
| Tax benefit of stock options exercised      |   | (382                      | )      | (2,989 | ) |
| Deferred income taxes                       |   | (2,926                    | )      | (5,256 | ) |
| Interest expense                            |   | 99                        |   | 99 |   |
| Income taxes                                |   | 8,856                     |   | 11,745 |   |
| Adjusted EBITDA                             |   | $                         | 28,564 |   | $ | 34,307 |   |

 

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. The interest rate on our credit facility is based on LIBOR plus anapplicable margin percentage, which depends on cash flow generation andborrowings outstanding.  As ofApril 4, 2004, there were no outstanding borrowings under our creditfacility.  The amounts available forborrowing, reduced by standby letters of credit outstanding of $1.5 million,totaled $63.5 million as of April 4, 2004.

 

At April 2004, we had a working capital deficit of $7.2 million,due to the accounting treatment of rental inventory. Rental inventory istreated as a noncurrent asset under accounting principles generally accepted inthe United States because it is a depreciable asset and a portion of this assetis not reasonably expected to be completely realized in cash or sold in thenormal business cycle. Although the rental of this inventory generates themajor portion of our revenue, the classification of this asset as noncurrentresults in its exclusion from working capital. The aggregate amount payable forthis inventory, however, is reported as a current liability until paid and,accordingly, is reflected as a reduction in working capital. Consequently, webelieve that working capital is not an appropriate measure of our liquidity andwe anticipate that we will continue to operate with a working capital deficit.

 

Wegrow our store base through internally developed and acquired stores.  We opened 81 internally developed stores,acquired 24 stores and closed 23 stores during the first quarter of 2004.  We will continue to evaluate acquisitionopportunities in 2004 as they arise.  Tothe extent available, new stores and future acquisitions may be completed usingfunds available under our credit facility, financing provided by sellers oralternative financing arrangements such as funds raised in public or privatedebt or equity offerings.  However, wecannot assure you that financing will be available to us on terms which will beacceptable, if at all.

 

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

 

14

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This financing may not be available on satisfactory terms. Failure toobtain financing to fund our expansion plans or for other purposes could have amaterial adverse effect on our operating results.

 

Our ability to fund our current plan of operations and our growth planwill depend upon our future performance, which is subject to general economic,financial, competitive and other factors that are beyond our control.  We cannot assure you that our business willcontinue to generate sufficient cash flow from operations in the future to fundcapital resource needs, cover the ongoing costs of operating the business andservice any debt incurred in the future. If we are unable to satisfy these requirements with cash flow fromoperations and cash on hand, we may be required to sell assets or to obtainadditional financing.  We cannot assureyou that any such sales of assets or additional financing could be obtained.

 

## **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 torental inventory amortization, impairment of long-lived assets, purchase priceallocation of acquired businesses and deferred income taxes.  These policies are discussed in Item 7 ofour Annual Report on Form 10-K for the fiscal year ended January 4, 2004.

 

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

##### ** **

 This quarterly report on Form10-Q contains forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended, which represent our expectationsor 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 are forward-looking statements.  Our forward-looking statements are based onmanagement’s current intent, belief, expectations, estimates and projectionsregarding our company and our industry. Forward-looking statements are subject to known and unknown risks anduncertainties, including those described in our Annual Report on Form 10-K forthe fiscal year ended January 4, 2004. In light of these risks, uncertainties and assumptions, theforward-looking events discussed in this Form 10-Q might not occur.  In addition, actual results could differmaterially from those suggested by the forward-looking statements, andtherefore you should not place undue reliance on the forward-lookingstatements.  We undertake no obligationto publicly update or revise any forward-looking statements, whether as aresult 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 year endedJanuary 4, 2004, 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.

 

15

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Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

There have been nomaterial changes in our inherent market risk since the disclosures made as ofJanuary 4, 2004 in our Annual Report on Form 10-K.

 

Item 4.  Controls and 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.

 

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

#### ** **

**Item6.  Exhibits and Reports on Form 8-K**

** **

a)              Exhibits

31.1                          Certificationof Chief Executive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of theSecurities Exchange Act of 1934, as amended. (filed herewith)

 

31.2                          Certificationof Chief Financial Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of theSecurities Exchange Act of 1934, as amended. (filed herewith)

 

32.1                          Certification of Chief Executive Officer Pursuant to 18 U.S.C 1350, asadopted Pursuant to Section 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

 

We filed a Form 8-K reporting on Items 7 and 12 dated January 7,2004.

We filed a Form 8-K reporting on Items 5 and 7 dated February 4,2004.

We filed a Form 8-K reporting on Items 7 and 12 dated February 19,2004.

We filed a Form 8-K reporting on Items 5 and 7 dated April 2,2004.

 

16

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**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: May 14, 2004 | /s/ Ivy M. Jernigan                        |   |
|               | Ivy M. Jernigan, Senior Vice President and |
|               | Chief Financial Officer                    |

 

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