** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**(MarkOne)**

**ý**                                         QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**For the quarterly period endedOctober 3, 2004**

 

**OR**

 

**o**                                         TRANSITION REPORT PURSUANT TO SECTION 13OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

** **

**For thetransition period from                     to                       **

 

 

### **Commission file number0-24548**

 

**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 filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to filing requirements for the past 90days.  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 November 9, 2004 was31,074,261.

 

----

 

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

#### **Index**

 

 
| Part I.  Financial  Information                                                                                 |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                      |   |
| Item 1.  Consolidated Financial Statements  (Unaudited)                                                         |   |
|                                                                                                                      |   |
| Consolidated Balance Sheets —  January 4, 2004 and October 3, 2004                                                   |   |
|                                                                                                                      |   |
| Consolidated Statements of Income  — Thirteen weeks and thirty-nine weeks ended October 5, 2003 and October 3,  2004 |   |
|                                                                                                                      |   |
| Consolidated  Statements of Cash Flows — Thirty-nine weeks ended October 5, 2003 and  October 3, 2004                |   |
|                                                                                                                      |   |
| Notes to  Consolidated Financial Statements — October 3, 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  2.  Unregistered Sales of Equity Securities and Use of Proceeds                                           |   |
|                                                                                                                      |   |
| Item  6.  Exhibits                                                                                              |   |

 

 

----

 

**Movie Gallery, Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                              | ** ** | **January 4,** | ** ** | **October 3,**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|----------------|------------|-----------------|------------|
| ** **                                                                                                              | ** ** | **2004**       | ** ** | **2004**        | ** ** |
| ** **                                                                                                              | ** ** | ** **     | ** ** | **(Unaudited)** | ** ** |
| **Assets**                                                                                                              | ** ** | ** **     | ** ** | ** **      | ** ** |
| Current assets:                                                                                                         |       |           |       |            |       |
| Cash and cash equivalents                                                                                               |       | $              | 38,006     | ** **      | **$**      | **19,234** | ** ** |
| Merchandise inventory                                                                                                   |       | 26,473         | ** ** | **25,453**      | ** ** |
| Prepaid expenses                                                                                                        |       | 10,686         | ** ** | **12,071**      | ** ** |
| Store supplies and other                                                                                                |       | 11,019         | ** ** | **10,034**      | ** ** |
| Deferred income taxes                                                                                                   |       | 1,631          | ** ** | **3,063**       | ** ** |
| Total current assets                                                                                                    |       | 87,815         | ** ** | **69,855**      | ** ** |
|                                                                                                                    |       |           |       |            |       |
| Rental inventory, net                                                                                                   |       | 102,479        | ** ** | **116,789**     | ** ** |
| Property, furnishings and equipment, net                                                                                |       | 114,356        | ** ** | **129,465**     | ** ** |
| Goodwill, net                                                                                                           |       | 136,008        | ** ** | **141,742**     | ** ** |
| Other intangibles, net                                                                                                  |       | 8,473          | ** ** | **7,947**       | ** ** |
| Deposits and other assets                                                                                               |       | 8,753          | ** ** | **6,471**       | ** ** |
| Total assets                                                                                                            |       | $              | 457,884    | ** **      | **$**      | **472,269** | ** ** |
|                                                                                                                    |       |           |       |            |       |
| **Liabilities and stockholders’ equity**                                                                           |       |           |       |            |       |
| Current liabilities:                                                                                                    |       |           |       |            |       |
| Accounts payable                                                                                                        |       | $              | 70,939     | ** **      | **$**      | **55,154** | ** ** |
| Accrued liabilities                                                                                                     |       | 26,303         | ** ** | **27,351**      | ** ** |
| Deferred revenue                                                                                                        |       | 10,741         | ** ** | **7,149**       | ** ** |
| Total current liabilities                                                                                               |       | 107,983        | ** ** | **89,654**      | ** ** |
|                                                                                                                    |       |           |       |            |       |
| Long-term debt                                                                                                          |       | —         | ** ** | **20,000**      | ** ** |
| Deferred income taxes                                                                                                   |       | 29,785         | ** ** | **43,713**      | ** ** |
|                                                                                                                    |       |           |       |            |       |
| 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, 32,841 and  31,061 shares issued and outstanding, respectively |       | 33             |       | **31**          |       |
| Additional paid-in capital                                                                                              |       | 225,191        | ** ** | **188,204**     | ** ** |
| Retained earnings                                                                                                       |       | 91,098         | ** ** | **126,294**     | ** ** |
| Accumulated other comprehensive income                                                                                  |       | 3,794          | ** ** | **4,373**       | ** ** |
| Total stockholders’ equity                                                                                         |       | 320,116        | ** ** | **318,902**     | ** ** |
| Total liabilities and stockholders’ equity                                                                         |       | $              | 457,884    | ** **      | **$**      | **472,269** | ** ** |

 

*See accompanying notes.*

 

 

1

----

 

**Movie Gallery, Inc.**

**Consolidated Statements of Income**

**(Unaudited)**

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

 
| ** **                                  | ** ** | **Thirteen Weeks Ended** | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **October 5,**           |       | **October 3,**              | ** ** | **October 5,** | ** ** | **October 3,** | ** ** |
| ** **                                  | ** ** | **2003**                 |       | **2004**                    |       | **2003** |   | **2004** | ** ** |
| Revenues:                                   |       |                     |       |                        |       |   |   |   | ** ** |
| Rentals                                     |       | $                        | 154,565    |                        | **$**      | **176,058** |   | $ | 456,322 |   | **$** | **538,054** | ** ** |
| Product sales                               |       | 12,674                   |       | **13,797**                  |       | 40,564 |   | **44,694** | ** ** |
| Total revenues                              |       | 167,239                  |       | **189,855**                 |       | 496,886 |   | **582,748** | ** ** |
|                                        |       |                     |       |                        |       |   |   |   | ** ** |
| Cost of sales:                              |       |                     |       |                        |       |   |   |   | ** ** |
| Cost of rental revenues                     |       | 44,559                   |       | **51,110**                  |       | 134,966 |   | **152,763** | ** ** |
| Cost of product sales                       |       | 10,005                   |       | **8,673**                   |       | 32,447 |   | **29,745** | ** ** |
| Gross profit                                |       | 112,675                  |       | **130,072**                 |       | 329,473 |   | **400,240** | ** ** |
|                                        |       |                     |       |                        |       |   |   |   | ** ** |
| Operating costs and expenses:               |       |                     |       |                        |       |   |   |   | ** ** |
| Store operating expenses                    |       | 84,202                   |       | **97,962**                  |       | 238,101 |   | **287,788** | ** ** |
| General and administrative                  |       | 11,956                   |       | **14,397**                  |       | 34,461 |   | **41,879** | ** ** |
| Amortization of intangibles                 |       | 493                      |       | **673**                     |       | 1,389 |   | **1,962** | ** ** |
| Stock option compensation                   |       | 128                      |       | **755**                     |       | 1,626 |   | **795** | ** ** |
| Operating income                            |       | 15,896                   |       | **16,285**                  |       | 53,896 |   | **67,816** | ** ** |
|                                        |       |                     |       |                        |       |   |   |   | ** ** |
| Interest expense, net                       |       | (89                      | )          | **(225**                    | )          | (331 | ) | **(390** | **)** |
| Equity in losses of unconsolidated entities |       | (700                     | )          | **(955**                    | )          | (700 | ) | **(4,891** | **)** |
| Income before income taxes                  |       | 15,107                   |       | **15,105**                  |       | 52,865 |   | **62,535** | ** ** |
|                                        |       |                     |       |                        |       |   |   |   | ** ** |
| Income taxes                                |       | 5,892                    |       | **5,891**                   |       | 20,889 |   | **24,435** | ** ** |
| Net income                                  |       | $                        | 9,215      |                        | **$**      | **9,214** |   | $ | 31,976 |   | **$** | **38,100** | ** ** |
|                                        |       |                     |       |                        |       |   |   |   | ** ** |
| Net income per share:                       |       |                     |       |                        |       |   |   |   | ** ** |
| Basic                                       |       | $                        | 0.28       |                        | **$**      | **0.29** |   | $ | 0.99 |   | **$** | **1.17** | ** ** |
| Diluted                                     |       | $                        | 0.28       |                        | **$**      | **0.29** |   | $ | 0.96 |   | **$** | **1.16** | ** ** |
|                                        |       |                     |       |                        |       |   |   |   | ** ** |
| Weighted average shares outstanding:        |       |                     |       |                        |       |   |   |   | ** ** |
| Basic                                       |       | 32,536                   |       | **31,444**                  |       | 32,303 |   | **32,436** | ** ** |
| Diluted                                     |       | 33,499                   |       | **31,807**                  |       | 33,298 |   | **32,933** | ** ** |
|                                        |       |                     |       |                        |       |   |   |   | ** ** |
| Cash dividends per common share             |       | $                        | —     |                        | **$**      | **0.03** |   | $ | — |   | **$** | **0.09** | ** ** |
|                                             |            |                          |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

*See accompanying notes.*

 

 

2

----

 

**Movie Gallery, Inc.**

**Consolidated Statements of Cash Flows**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                         | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                         | ** ** | **October 5,**              |       | **October 3,** | ** ** |
| ** **                                                                         | ** ** | **2003**                    |       | **2004** | ** ** |
| **Operating activities:**                                                          |       |                        |       |   |   |
| Net income                                                                         |       | $                           | 31,976     |   | **$** | **38,100** | ** ** |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                        |       |   |   |
| Rental inventory amortization                                                      |       | 98,620                      |       | **107,690** | ** ** |
| Purchases of rental inventory                                                      |       | (93,623                     | )          | **(109,315** | **)** |
| Depreciation and intangibles amortization                                          |       | 16,911                      |       | **22,151** | ** ** |
| Stock option compensation                                                          |       | 1,626                       |       | **28** | ** ** |
| Tax benefit of stock options exercised                                             |       | 2,793                       |       | **4,689** | ** ** |
| Deferred income taxes                                                              |       | 11,943                      |       | **12,496** | ** ** |
| Changes in operating assets and liabilities (net of business  acquisitions):       |       |                        |       |   |   |
| Merchandise inventory                                                              |       | 1,376                       |       | **1,281** | ** ** |
| Other current assets                                                               |       | (3,038                      | )          | **(400** | **)** |
| Deposits and other assets                                                          |       | (3,315                      | )          | **2,282** | ** ** |
| Accounts payable                                                                   |       | (11,978                     | )          | **(15,785** | **)** |
| Accrued liabilities and deferred revenue                                           |       | (2,097                      | )          | **(2,521** | **)** |
| Net cash provided by operating activities                                          |       | 51,194                      |       | **60,696** | ** ** |
|                                                                               |       |                        |       |   |   |
| **Investing activities:**                                                          |       |                        |       |   |   |
| Business acquisitions                                                              |       | (25,447                     | )          | **(9,599** | **)** |
| Purchases of rental inventory-base stock                                           |       | (12,869                     | )          | **(11,085** | **)** |
| Purchases of property, furnishings and equipment                                   |       | (33,909                     | )          | **(34,699** | **)** |
| Net cash used in investing activities                                              |       | (72,225                     | )          | **(55,383** | **)** |
|                                                                               |       |                        |       |   |   |
| **Financing activities:**                                                          |       |                        |       |   |   |
| Proceeds from exercise of stock options                                            |       | 2,484                       |       | **5,516** | ** ** |
| Proceeds from employee stock purchase plan                                         |       | —                      |       | **168** | ** ** |
| Proceeds from issuance of long-term debt                                           |       | —                      |       | **20,000** | ** ** |
| Purchases and retirement of common stock                                           |       | —                      |       | **(47,390** | **)** |
| Payment of dividends                                                               |       | —                      |       | **(2,958** | **)** |
| Net cash provided by (used in) financing activities                                |       | 2,484                       |       | **(24,664** | **)** |
|                                                                               |       |                        |       |   |   |
| Effect of exchange rate changes on cash and cash equivalents                       |       | 3,031                       |       | **579** |   |
| Decrease in cash and cash equivalents                                              |       | (15,516                     | )          | **(18,772** | **)** |
| Cash and cash equivalents at beginning of period                                   |       | 29,555                      |       | **38,006** | ** ** |
| Cash and cash equivalents at end of period                                         |       | $                           | 14,039     |   | **$** | **19,234** | ** ** |

 

*See accompanying notes.*

 

 

3

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**Movie Gallery, Inc.**

 

**Notesto Consolidated Financial Statements (Unaudited)**

 

**October3, 2004**

 

**1.     AccountingPolicies**

 

*Principlesof Consolidation*

 

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

 

*Basis ofPresentation*

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete consolidated financial statements.  The balance sheet at January 4, 2004 has beenderived from the audited financial statements at that date but does not includeall of the information and footnotes required by generally accepted accountingprinciples for complete financial statements. In the opinion of management, all adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation have beenincluded.  Operating results for thethirty-nine week period ended October 3, 2004 are not necessarily indicative ofthe results that may be expected for the fiscal year ending January 2,2005.  For further information, refer tothe consolidated financial statements and footnotes thereto included in ourAnnual Report on Form 10-K for the fiscal year ended January 4, 2004.

 

*Reclassifications*

 

        Certain reclassifications have been made to the prior yearfinancial statements to conform to the current year presentation.  These reclassifications had no impact onstockholders’ equity or net income.

 

        In the third quarter of 2004, we reclassified the expensesassociated with our investments in alternative delivery vehicles from storeoperating expenses to equity in losses of unconsolidated entities on ourstatements of income.

 

        In the first quarter of 2004, we began reporting the on-goingpurchases of new release rental inventory as an operating activity in thestatement of cash flows rather than an investing activity as previouslyreported.   We believe thisreclassification is appropriate because our annual cash investment in rentalinventory is substantial and in many respects is similar to recurringmerchandise inventory purchases considering our operating cycle and therelatively short useful lives of our rental inventory.  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 year havebeen reclassified to conform to the current year presentation for comparativepurposes.  The reclassification had noimpact on our financial position or results of operations as previouslyreported.

 

*RevenueRecognition*

 

         We recognize rental revenue when a movie or video game isrented by the customer.  Revenue fromextended viewing fees incurred on rentals when the customer chooses to keep theproduct beyond the initial rental period is recognized when payment is receivedfrom the customer.  We recognize revenuefrom the sale of previously viewed inventory at the time of sale.  Previously viewed sales revenue is classifiedas rental revenue in our statements of income. 

 

 

4

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We recognize product salesrevenue at the time of sale.   We offerreturn privileges on certain of our products, including a lifetime guarantee onpreviously viewed inventory.    Our salesreturns and allowances are immaterial.

 

We periodically sell storedvalue cards in the form of electronic gift cards or discount rental cards.  We record deferred revenue from the sale ofstored value cards at the time of sale to the customer.  The liability is relieved and revenue isrecognized when the cards are redeemed by the customers.

 

*StockOption Plan*

 

        We account for stock-based employeecompensation under the recognition and measurement principles of APB OpinionNo. 25, *Accounting for Stock Issued to Employees*,and related Interpretations.  Stockoption compensation is reflected in net income for variable options outstandingunder the plan.  No stock optioncompensation is reflected in net income for fixed options outstanding under theplan where the exercise price was equal to the market value of the underlyingcommon stock on the date of grant.

 

        The following table illustrates theeffect on net income and earnings per share if we had applied the fair valuerecognition provision of FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, as amended, to stock-based employeecompensation.

 
| ** **                                                                                              | ** ** | **Thirteen Weeks Ended**                  | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                              | ** ** | **October 5,**                            | ** ** | **October 3,**              | ** ** | **October 5,** | ** ** | **October 3,** | ** ** |
| ** **                                                                                              | ** ** | **2003**                                  | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                              | ** ** | **(in thousands, except per share data)** | ** ** |
| Net income, as reported                                                                                 |       | $                                         | 9,215      |                        | **$**      | **9,214** | ** ** | $ | 31,976 |   | **$** | **38,100** | ** ** |
| Add: Stock option compensation included in reported net income, net  of tax                             |       | 78                                        |       | **461**                     | ** ** | 981 |   | **485** |   |
| Deduct: Stock option compensation determined under fair value based methods  for all awards, net of tax |       | (540                                      | )          | **(426**                    | **)**      | (812 | ) | **(1,013** | **)** |
|                                                                                                    |       |                                      |       |                        | ** ** |   |   |   |   |
| Pro forma net income                                                                                    |       | $                                         | 8,753      |                        | **$**      | **9,249** | ** ** | $ | 32,145 |   | **$** | **37,572** | ** ** |
|                                                                                                    |       |                                      |       |                        | ** ** |   |   |   |   |
| Net income per share, as reported:                                                                      |       |                                      |       |                        | ** ** |   |   |   |   |
| Basic                                                                                                   |       | $                                         | 0.28       |                        | **$**      | **0.29** | ** ** | $ | 0.99 |   | **$** | **1.17** | ** ** |
| Diluted                                                                                                 |       | $                                         | 0.28       |                        | **$**      | **0.29** | ** ** | $ | 0.96 |   | **$** | **1.16** | ** ** |
|                                                                                                    |       |                                      |       |                        | ** ** |   |   |   |   |
| Pro forma net income per share:                                                                         |       |                                      |       |                        | ** ** |   |   |   |   |
| Basic                                                                                                   |       | $                                         | 0.27       |                        | **$**      | **0.29** | ** ** | $ | 1.00 |   | **$** | **1.16** | ** ** |
| Diluted                                                                                                 |       | $                                         | 0.26       |                        | **$**      | **0.29** | ** ** | $ | 0.96 |   | **$** | **1.14** | ** ** |
|                                                                                                         |            |                                           |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

*Recently Issued AccountingPronouncements*

 

        In January 2003, the Financial Accounting Standards Boardissued Interpretation No. 46, *Consolidation of VariableInterest Entities, an Interpretation of Accounting Research Bulletin No. 51*(“theInterpretation”).  The Interpretationrequires the consolidation of entities in which an enterprise absorbs amajority of the entity’s expected losses, receives a majority of the entity’sexpected residual returns, or both, as a result of ownership, contractual orother financial interests in the entity.  The Interpretation was effective as of December 31, 2003 for allqualifying interests in special purpose 

 

 

5

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entities (“SPEs”) inexistence as of January 31, 2003 and as of February 1, 2003 for all qualifyingSPEs obtained after January 31, 2003.  Wehad no qualifying interests as of January 31, 2003.  We have subsequently made equity investmentsin other entities, none of which are SPEs. These investments are immaterial, and consolidation is not currentlyrequired under the Interpretation.   Theprovisions of the Interpretation, as revised by the FASB in December 2003, wereadopted in the first quarter of 2004.  Our adoption of this standard did not have a material impact on ourfinancial position or results of operations.

 

**2.  Rental Inventory**

 

        In the fourth quarter of 2002,  we changed the estimates used to amortizerental inventory by reducing  the estimateduseful lives of the rental inventory and reducing salvage value for both VHSand game inventory.  The change inestimate increased depreciation expense for the thirteen and  thirty-nine weeks ended  October 5, 2003 by approximately $1.0 millionand $5.1 million, respectively, and reduced net income by $0.02 and $0.09 perdiluted share, respectively.  As a resultof the change in accounting estimate, depreciation expense in 2003 was higherthan it would have been if we had used the current amortization policy in allprior periods.

 

**3.  Goodwill and Other Intangible Assets**

 

        The components of goodwill and amortizedother intangible assets are as follows (in thousands):

 
| ** **                    | ** ** | ** **              | ** ** | **January 4, 2004** |    | **October 3, 2004** | ** ** |
|-------------------------------|------------|-------------------------|------------|---------------------|---------|---------------------|------------|
| ** **                    | ** ** | **Weighted-Average**    | ** ** | **Gross  Carrying** |    | **Accumulated**     |       | **Gross  Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                    | ** ** | **Amortization Period** | ** ** | **Amount**          |    | **Amortization**    |       | **Amount** | ** ** | **Amortization** | ** ** |
| Goodwill                      |       | —                  |       | $                   | 167,419 |                | $          | (31,411 | ) | **$** | **173,153** | ** ** | **$** | **(31,411** | **)** |
|                          |       |                    |       |                |    |                |       |   |   |   |   |
| Non-compete agreements        |       | 8  years                |       | $                   | 10,908  |                | $          | (7,696 | ) | **$** | **11,327** | ** ** | **$** | **(8,744** | **)** |
| Customer lists                |       | 5  years                |       | 6,385               |    | (1,124              | )          | **7,411** | ** ** | **(2,047** | **)** |
| Total other intangible assets |       |                    |       | $                   | 17,293  |                | $          | (8,820 | ) | **$** | **18,738** | ** ** | **$** | **(10,791** | **)** |

 

        Estimated amortization expense for otherintangible assets for the remainder of 2004 and the five succeeding fiscalyears is as follows (in thousands):

** **

| 2004 (remainder) |   | $     | 624    |   |
|------------------|--------|-------|--------|--------|
| 2005             |   | 2,173 |   |
| 2006             |   | 1,846 |   |
| 2007             |   | 1,704 |   |
| 2008             |   | 1,182 |   |
| 2009             |   | 367   |   |

 

        The changes in the carrying amounts ofgoodwill for the thirty-nine weeks ended October 3, 2004, are as follows (inthousands):

 

| Balance as of January 4, 2004 |   | $     | 136,008 |   |
|-------------------------------|--------|-------|---------|--------|
| Goodwill acquired             |   | 5,734 |    |
| Balance as of October 3, 2004 |   | $     | 141,742 |   |

 

        During the thirty-nine weeks endedOctober 3, 2004, we purchased 60 stores in 18 separate transactions forapproximately $9.6 million and recorded approximately $5.7 million in goodwill,$1.0 million for customer lists and $0.4 million for non-compete agreementsrelated to these transactions.

** **

**4.  Financing Obligations**

 

        On June 27, 2001, we entered into acredit agreement with a syndicate of banks, led by SouthTrust Bank, withrespect to a revolving credit facility. Our credit facility is unsecured and, as amended in September 2004,provides for an increase in borrowings from $65 million up to $75 million andan extended maturity date of 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 October 3,2004, there was $20.0 million in outstanding borrowings under our creditfacility.  The amount available forborrowing, which was reduced by standby letters of credit outstanding of $1.5million, was $53.5 million as of October 3, 2004.

 

 

6

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**5.  Earnings Per Share**

 

        Basic earnings per share is computedbased on the weighted average number of shares of common stock outstandingduring the periods presented.  Dilutedearnings per share is computed based on the weighted average number of sharesof common stock outstanding during the periods presented, increased by theeffects of shares that could be issued from the exercise of dilutive commonstock options (963,000 and 363,000 for the thirteen weeks ended October 5, 2003and October 3, 2004, respectively; 995,000 and 497,000 for the thirty-nineweeks ended October 5, 2003 and October 3, 2004, respectively).  No adjustments were made to net income in thecomputation of basic or diluted earnings per share.

 

        During the third quarter of 2004, werepurchased 1,288,400 shares of our common stock at an average price of $17.38per share, pursuant to our previously announced stock buyback program.  For the year-to-date period ended October 3,2004, we have repurchased a total of 2,624,712 shares of common stock at an averageprice of $18.06 per share.

 

**6.  Comprehensive Income**

 

        Comprehensive income was as follows (inthousands):

 
| ** **                              | ** ** | **Thirteen Weeks Ended** | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|-----------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | **October 5,**           | ** ** | **October 3,**              | ** ** | **October 5,** | ** ** | **October 3,** | ** ** |
| ** **                              | ** ** | **2003**                 | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net income                              |       | $                        | 9,215      | ** **                  | **$**      | **9,214** |   | $ | 31,976 | ** ** | **$** | **38,100** | ** ** |
| Foreign currency translation adjustment |       | 2                        | ** ** | **1,663**                   |       | 3,031 | ** ** | **579** | ** ** |
| Comprehensive income                    |       | $                        | 9,217      | ** **                  | **$**      | **10,877** |   | $ | 35,007 | ** ** | **$** | **38,679** | ** ** |
|                                         |            |                          |            |                             |            |  |  |  |  |  |  |  |  |  |

 

 

7

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** **

**Movie Gallery, Inc.**

 

**Management’s Discussion andAnalysis of Financial Condition**

**and Results of Operations**

 

**Overview**

 

Weoperate approximately 2,400 home video retail stores that rent and sell moviesand video games, primarily in rural and secondary markets throughout NorthAmerica.  We compete with the other twonational chains (Blockbuster and Hollywood Entertainment) in approximatelyone-third of our store locations.  As aresult, we believe that we are the market leader in the majority of our targetmarkets.  We estimate that there areapproximately 3,000 to 4,000 markets still available for expansion in ruralAmerica, as well as additional opportunities throughout Canada and Mexico.  We currently plan to open approximately 300new stores in 2004 (221 opened as of October 3, 2004), approximately 400 newstores in 2005 and, subject to market and industry conditions, we expect tocontinue to open new stores at a similar pace over the next several years.

 

Webelieve the most significant dynamic in our industry is the relationship our businessmaintains with the movie studios.  Thestudios have historically maintained an exclusive window for home videodistribution (packaged goods) which provides the home video industry with anapproximate 45 day period during which they can sell and rent new releasesbefore they are made available on pay-per-view or other distributionchannels.  According to Adams MediaResearch, the home video industry currently provides over 60% of studiorevenue.  For this reason, we believemovie studios have a significant interest in maintaining a viable home videobusiness.  For a more detailed discussionof our business and the home video industry, see the Business discussioncontained in Part I, Item 1 of our Annual Report on Form 10-K for the fiscalyear ended January 4, 2004.

 

Ourstrategies are designed to achieve reasonable, moderate and consistent growthin same-store revenues and profitability, in a mature industry.  We foster a corporate culture of costcontrol, striving to minimize the operating and overhead costs associated withour business which allows us to maximize profitability and which has proven tobe a successful operating model for us. Our compound annual growth rate for consolidated revenue and operating incomefrom 1999 to 2003 is 25.7% and 54.5%, respectively.

 

Inaddition to the relationship between our industry and the movie studios, ouroperating results are driven by revenue, inventory, rent and payroll.  Given those key factors, we believe that bymonitoring the five operating performance indicators described below, we cancontinue to be successful in executing our operating plans and our growthstrategy.

 

•                    *Revenues.*  Our business is a cash business with initialrental fees paid upfront by the customer. Our management team constantly evaluates inventory levels, marketing andsales 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 to analyzethe impact of the economic factors inherent in the various pricing strategiesemployed by the studios.  We believe thatwe are able to achieve purchasing levels tailored for the customer demographicsof each of our markets and to maximize the return on investment for ourinventory purchase dollars.

•                    *Storelevel cost control.*  The mostsignificant store expenses are payroll and rent, followed by all other supplyand service expenditures.  Conservatismin spending is our fundamental philosophy with respect to store levelexpenses.  This is achieved primarilythrough budgeting systems and centralization of purchases into the corporatesupport center.  This enables us tomeasure performance carefully against expectations and to leverage ourpurchasing power.   Our rural focus alsoprovides the benefit of reduced labor and real estate costs in the secondarymarkets we serve versus the costs associated with larger urban markets.

 

 

8

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•                    *Leverageof overhead expenses.*  Weapply the same principles of budgeting, accountability and conservatism in ouroverhead spending that we employ in managing our store operating costs.  Our general and administrative expensesinclude the costs to maintain our corporate support center as well as theoverhead 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 majority ofour store growth and acquisitions, as well as ongoing inventory purchases, fromcash flow generated from operations.

 

Thefollowing discussion of our results of operations, liquidity and capitalresources will provide further insight into our performance for the thirdquarter and year-to-date period of 2004 versus the comparable periods of 2003.

 

**New Business Initiatives**

 

Duringthe last half of 2003, we began to make some investments in various alternativedelivery vehicles (both retail and digital) for movie content, and we began toexplore other business initiatives within our existing base of stores,including tests of a game store-within-a-store, movie trading and in-storemovie subscriptions.  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 ourbase rental business.  The expenses associated with our investments inalternative delivery vehicles are reflected as equity in losses ofunconsolidated entities on our statements of income.  Our general and administrative expensesinclude overhead costs associated with our other business initiatives.

 

 

9

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**Results  of Operations**

** **

**Selected Financial Statement and Operational Data:**

 
| ** **                                 | ** ** | **Thirteen Weeks Ended**                         | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------|------------|-----------------------------|------------|
| ** **                                 | ** ** | **October 5,**                                   | ** ** | **October 3,**              | ** ** | **October 5,** | ** ** | **October 3,** | ** ** |
| ** **                                 | ** ** | **2003**                                         | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | **($ in thousands, except per share data)** | ** ** |
| Rental revenues                            |       | $                                                | 154,565    |                        | $          | 176,058 |   | $ | 456,322 |   | $ | 538,054 |   |
| Product sales                              |       | 12,674                                           |       | 13,797                      |       | 40,564 |   | 44,694 |   |
| Total revenues                             |       | 167,239                                          |       | 189,855                     |       | 496,886 |   | 582,748 |   |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| Cost of rental revenues                    |       | 44,559                                           |       | 51,110                      |       | 134,966 |   | 152,763 |   |
| Cost of product sales                      |       | 10,005                                           |       | 8,673                       |       | 32,447 |   | 29,745 |   |
| Total gross profit                         |       | $                                                | 112,675    |                        | $          | 130,072 |   | $ | 329,473 |   | $ | 400,240 |   |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| Store operating expenses                   |       | $                                                | 84,202     |                        | $          | 97,962 |   | $ | 238,101 |   | $ | 287,788 |   |
| General and administrative expenses        |       | $                                                | 11,956     |                        | $          | 14,397 |   | $ | 34,461 |   | $ | 41,879 |   |
| Stock option compensation                  |       | $                                                | 128        |                        | $          | 755 |   | $ | 1,626 |   | $ | 795 |   |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| Operating income                           |       | $                                                | 15,896     |                        | $          | 16,285 |   | $ | 53,896 |   | $ | 67,816 |   |
| Net income                                 |       | $                                                | 9,215      |                        | $          | 9,214 |   | $ | 31,976 |   | $ | 38,100 |   |
| Net income per diluted share               |       | $                                                | 0.28       |                        | $          | 0.29 |   | $ | 0.96 |   | $ | 1.16 |   |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| Cash dividends per common share            |       | $                                                | —     |                        | $          | 0.03 |   | $ | — |   | $ | 0.09 |   |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| Rental margin                              |       | 71.2                                             | %          | 71.0                        | %          | 70.4 | % | 71.6 | % |
| Product sales margin                       |       | 21.1                                             | %          | 37.1                        | %          | 20.0 | % | 33.4 | % |
| Total gross margin                         |       | 67.4                                             | %          | 68.5                        | %          | 66.3 | % | 68.7 | % |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| **Percent of total revenues:**             |       |                                             |       |                        |       |   |   |   |   |
| Rental revenues                            |       | 92.4                                             | %          | 92.7                        | %          | 91.8 | % | 92.3 | % |
| Product sales                              |       | 7.6                                              | %          | 7.3                         | %          | 8.2 | % | 7.7 | % |
| Store operating expenses                   |       | 50.3                                             | %          | 51.6                        | %          | 47.9 | % | 49.4 | % |
| General and administrative expenses        |       | 7.1                                              | %          | 7.6                         | %          | 6.9 | % | 7.2 | % |
| Stock option compensation                  |       | 0.1                                              | %          | 0.4                         | %          | 0.3 | % | 0.1 | % |
| Operating income                           |       | 9.5                                              | %          | 8.6                         | %          | 10.8 | % | 11.6 | % |
| Net income                                 |       | 5.5                                              | %          | 4.9                         | %          | 6.4 | % | 6.5 | % |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| **Same-store revenue increase (decrease)** |       | 5.0                                              | %          | (2.5                        | )%         | 8.0 | % | — | % |
|                                       |       |                                             |       |                        |       |   |   |   |   |
| **Store Count:**                           |       |                                             |       |                        |       |   |   |   |   |
| Beginning of period                        |       | 1,936                                            |       | 2,331                       |       | 1,784 |   | 2,158 |   |
| New store builds                           |       | 79                                               |       | 65                          |       | 163 |   | 221 |   |
| Stores acquired                            |       | 42                                               |       | 5                           |       | 134 |   | 60 |   |
| Stores closed                              |       | (7                                               | )          | (18                         | )          | (31 | ) | (56 | ) |
| End of period                              |       | 2,050                                            |       | 2,383                       |       | 2,050 |   | 2,383 |   |
|                                            |            |                                                  |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

10

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*        Revenue.*  For the thirteen weeks and thirty-nine weeksended October 3, 2004, total revenues increased 13.5% and 17.3% from thecomparable periods in 2003.  Theseincreases were primarily due to increases of 18.5% and 20.2% in the average number of stores open duringthe quarter and  the year-to-date periodof 2004, respectively.  These increaseswere offset by a same-store revenue decrease of 2.5% for the third quarter withflat same-store revenues for the year-to-date period of 2004.  Product sales revenue has decreased as apercentage of total revenue for the third quarter and year-to-date period of2004.  This trend is primarily due to areduction of new release theatrical movie inventory available in ourstores.  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.

 

        The following factors contributed to a decrease in oursame-store revenues for the third quarter of 2004 versus 2003:

 

•                    A weak homevideo release schedule in the third quarter of 2004 contributed to a decreasein movie rental revenue of approximately 1.5%. There were eight titles released in the third quarter of 2003 with boxoffice revenues in excess of $100 million versus only one title in the thirdquarter of 2004;

•                    A decline inrevenue from the game rental business of approximately 6.5%, reflecting theweakness of the new game titles currently being released and industry softnessthat occurs in anticipation of the introduction of new game platforms currentlyscheduled for a late 2005 release;

•                    A decrease inproduct sales revenue of approximately 4.5% due to a reduction in new releasemovie inventory for sell-through;

•                    Disruption ofnormal daily operations at approximately 325 stores in Florida and Alabama dueto an unprecedented hurricane season in August and September; and

•                    The broadcastof the Summer Olympics during the third quarter of 2004.

 

*Cost of Sales.*  Thecost of rental revenues includes the amortization of rental inventory, revenuesharing expenses incurred and the cost of previously viewed rental inventorysold.  The gross margin on rental revenuefor the third quarter and year-to-date period of 2004 was 71.0% and 71.6%,respectively, versus 71.2% and 70.4% for the comparable quarter andyear-to-date period of 2003.  The marginfor 2003 includes approximately $1.0 million and $5.1 million for the quarterand year-to-date period, respectively, related to a change in estimate relatedto our amortization policy for rental inventory during the fourth quarter offiscal 2002. Excluding the impact of the rental inventory amortization changethe rental margin for the third quarter and year-to-date period of 2003 wouldhave been 71.8% and 71.5%, respectively. The rental margin for the third quarter of 2004 decreased primarily dueto softness in the game industry.  Therental margin for the year-to-date period, excluding the impact of the rentalinventory amortization change in 2003, was consistent with the prior year.

 

Cost of product sales includes the costs of new DVDs, videocassettes,concessions and other goods sold. Theatrical  new movie releasestypically have a much lower margin than concessions and other goods.  The gross margin on product sales is subjectto fluctuation based on the relative mix of the low margin sales of theatricalnew movie inventory to higher margin sales of concessions and other items.  The gross margin on product sales for thethirteen weeks and thirty-nine weeks ended October 3, 2004 was 37.1% and 33.4%,respectively, compared to 21.1% and 20.0% for the comparable quarter andyear-to-date period of 2003.  The productsales margin increase reflects an overall shift in the inventory mix to highermargin inventory items as a result of our strategic decision to reduce ourlevels of new release movie inventory available for sale in the stores.

 

*Operating Costs and Expenses.*  Store operating expenses include store-levelexpenses such as lease payments, in-store payroll and start-up costs associatedwith new store openings.  In the thirdquarter of 2004, we reclassified costs associated with our investments invarious alternative delivery vehicles for movie content from store operatingexpenses 

 

 

11

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to a separate line item inour statements of income.  Costs from theprior year have been reclassified to conform to the current year presentation.

 

Storeoperating expenses as a percentage of total revenue was 51.6% and 49.4% for thethird quarter and year-to-date period of 2004, respectively, in comparison to50.3% and 47.9% for 2003, respectively. The following factors contributed to the increases in store operatingexpenses as a percentage of total revenue in the third quarter and year-to-dateperiod of 2004 as compared to 2003:

 

•                    The decrease insame-store revenues for the third quarter of 2004, as certain operatingexpenses are fixed and result in an increase as a percentage of revenue whenrevenues decline; and

•                    A significantincrease in the number 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; (i.e., as of the end of the third quarter of2004 we had approximately 36% more stores in the store base that were less thanone year old than we had at the end of the third quarter last year).

 

Generaland administrative expenses as a percentage of revenue increased for the thirdquarter of 2004 to 7.6% versus 7.1% for the comparable period in 2003.  Year-to-date general and administrativeexpenses as a percentage of revenue increased in 2004 to 7.2% from 6.9% in2003.  The increase in general andadministrative expenses as a percentage of total revenue was primarily due tooverhead increases to support our growth plans, which include continuedexpansion in geographic areas where our market penetration is lower and costsassociated with some of our new business initiatives.

 

Stockoption compensation expense in periods prior to the third quarter of 2004,represents the non-cash charge associated with certain stock options that wererepriced during the first quarter of fiscal 2001 and are subsequently accountedfor as variable stock options.  Due tothe relatively small number of these options that remain outstanding, we expectfuture adjustments to income from non-cash stock option compensation to beimmaterial.  The increase in stock optioncompensation expense during the third quarter of 2004 relates to our decisionto repurchase approximately 146,000 stock options from current and formerexecutives, resulting in compensation expense of $767,000 being recognized forthe intrinsic value of those options.

 

*Operating Income.*  As aresult of the impact of the above factors on revenues and expenses, operatingincome increased by 2.4% and 25.8% for the third quarter and year-to-dateperiod of 2004 to $16.3 million and $67.8 million, respectively.

 

*Equity in losses of unconsolidated entities. *These expenses represent ourportion of the losses associated with our investments in various alternativedelivery vehicles for movie content. These costs were previously included in store operating expenses on thestatements of income.

 

**Liquidity and CapitalResources**

 

Ourprimary capital needs are for opening and acquiring new stores and forpurchasing inventory. Other capital needs include refurbishing, remodeling andrelocating existing stores and refreshing, rebranding and supplying newcomputer hardware for acquired stores, as well as repurchases of our commonstock.  We fund inventory purchases,remodeling, rebranding and relocation programs, new store opening costs,acquisitions and stock repurchases primarily from cash flow from operationsand, as necessary, from loans under our credit facility.

 

 

12

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| ** **                                          | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|-----------------------------------------------------|------------|-----------------------------|------------|
| ** **                                          | ** ** | **October 5,**              |       | **October 3,** | ** ** |
| ** **                                          | ** ** | **2003**                    |       | **2004** | ** ** |
| Net cash provided by operating activities           |       | $                           | 51,194     |   | **$** | **60,696** | ** ** |
| Net cash used in investing activities               |       | (72,225                     | )          | **(55,383** | **)** |
| Net cash provided by (used in) financing activities |       | 2,484                       |       | **(24,664** | **)** |
|                                                     |            |                             |            |  |  |  |  |

 

        The increase in net cash provided by operating activities wasprimarily attributable to the increases in operating income during theyear-to-date period of 2004 versus the comparable period in 2003.  Net cash provided by operating activitiescontinues to be our primary source of funding for substantially all of ourrental inventory replenishment and capital resource needs.

 

        In the first quarter of 2004, we began reporting the on-goingpurchases of new release rental inventory as an operating activity in thestatement of cash flows rather than as an investing activity as previouslyreported.   We believe thisclassification is appropriate because our annual cash investment in rentalinventory is substantial and in many respects is similar to recurringmerchandise inventory purchases considering our operating cycle and therelatively short useful lives of our rental inventory.  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.

 

Netcash used in investing activities includes the costs of business acquisitions,new store builds and investments in base stock rental inventory.  The decrease of $16.8 million in net cashused in investing activities was primarily due to lower levels of businessacquisitions in 2004 versus 2003.

 

Net cash used in financing activities for the year-to-date period of2004 primarily reflects the completion of two $25 million common stockrepurchase programs, offset by borrowings under our recently amended creditfacility and proceeds from stock option exercises.  There were no common stock repurchases ordebt borrowings in the prior year period. Under the common stock repurchase programs, we repurchased 2,624,712shares of our common stock at an average price of $18.06 per share during thesecond and third quarters of 2004.

 

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

 

AdjustedEBITDA during the thirty-nine weeks ended October 3, 2004 increased to $83.5million, an 8.8% increase over the comparable period in the prior year.  The increase was primarily driven by thegrowth in operating income for the year-to-date period of 2004.

 

AdjustedEBITDA is defined as net cash provided by operating activities before changesin operating 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 ofadjusted EBITDA is not necessarily identical to similarly captioned measurespresented by other companies in our industry. We encourage you to 

 

 

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compare the components of our reconciliationof adjusted EBITDA to cash flows from operations in relation to similarreconciliations provided by other companies in our industry.  Our presentation of net cash provided byoperating activities and adjusted EBITDA treats rental inventory as beingexpensed upon purchase instead of being capitalized and amortized.  We believe this presentation is meaningfuland appropriate because our annual cash investment in rental inventory issubstantial and in many respects is similar to recurring merchandise inventorypurchases considering our operating cycle and the relatively short useful livesof our rental inventory.  Our calculationof Adjusted EBITDA excludes the impact of changes in operating assets andliabilities.  This adjustment eliminatestemporary effects attributable to timing differences between accrual accountingand actual cash receipts and disbursements, and other normal, recurring andseasonal fluctuations in working capital that have no long-term or continuingaffect on our liquidity.  Investorsshould consider our presentation of adjusted EBITDA in light of itsrelationship to cash flows from operations, cash flows from investingactivities and cash flows from financing activities as shown in our statementsof cash flows.  Adjusted EBITDA is notnecessarily a measure of “free cash flow” because it does not reflect periodicchanges in the level of our working capital or our investments in new storeopenings, business acquisitions, or other long-term investments we maymake.  However, it is an importantmeasure used internally by executive management of our company in makingdecisions about where to allocate resources to grow our business.

 

Inprior periods, we presented a reconciliation of adjusted EBITDA to operatingincome.  We changed the format of ourreconciliation beginning in the first quarter of fiscal 2004 to reconcileadjusted EBITDA to net cash provided by operating activities.  We have recast the reconciliations for priorperiods to conform to the new presentation. Our calculation of adjusted EBITDA is reconciled to net cash provided byoperating activities as follows (in thousands):

 
| ** **                                  | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **October 5,**              | ** ** | **October 3,** | ** ** |
| ** **                                  | ** ** | **2003**                    |       | **2004** | ** ** |
| Net cash provided by operating activities   |       | $                           | 51,194     |   | **$** | **60,696** | ** ** |
| Changes in operating assets and liabilities |       | 19,052                      |       | **15,143** | ** ** |
| Tax benefit of stock options exercised      |       | (2,793                      | )          | **(4,689** | **)** |
| Deferred income taxes                       |       | (11,943                     | )          | **(12,496** | **)** |
| Interest expense                            |       | 331                         |       | **390** | ** ** |
| Income taxes                                |       | 20,889                      |       | **24,435** | ** ** |
| Adjusted EBITDA                             |       | $                           | 76,730     |   | **$** | **83,479** | ** ** |
|                                             |            |                             |            |  |  |  |  |  |  |

 

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 in September 2004, provides for an increase in borrowings from $65million  up to $75 million and anextended maturity date of July 3, 2006.  The interest rate on our credit facility isbased on LIBOR plus an applicable margin percentage, which depends on cash flowgeneration and borrowings outstanding. As of October 3, 2004, there were $20.0 million of outstandingborrowings under our credit facility. The amounts available for borrowing,reduced by standby letters of credit outstanding of $1.5 million, totaled $53.5million as of October 3, 2004.

 

AtOctober 3, 2004, we had a working capital deficit of $19.8 million, primarilydue to the accounting 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.

 

 

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We grow our store base through internally developed and acquired stores.  We opened 221 internally developed stores,acquired 60 stores and closed 56 stores during the year-to-date period of2004.  We will continue to evaluateacquisition opportunities in 2004 as they arise although we anticipate themajority of our growth to occur through new store development.  To the extent available, new stores andfuture acquisitions may be completed using funds available under our creditfacility, financing provided by sellers or alternative financing arrangementssuch as funds raised in public or private debt or equity offerings.  However, we cannot assure you that financingwill be available to us on terms which will be acceptable, if at all.

 

Capitalrequirements to fund new store growth in fiscal 2004, including the base stockrental inventory investment, are estimated at $40 million.  Additionally in fiscal 2004, we estimate $25million in other on-going capital expenditure requirements for the existingstore base.  We have spent approximately$29 million for the year-to-date period of 2004 on new stores ($11 million forbase stock rental inventory and $18 million for new store build out), andapproximately $17 million for other on-going capital expenditures.

 

Wepurchase rental inventory under two different cost structures.  Under “fixed cost” arrangements, we pay aflat purchase price with no further obligations to our vendor.  Under “revenue sharing” arrangements, we paya lower fixed cost per unit and then “share” a pre-determined portion of thefuture rental revenues with the studio for an agreed upon period of timefollowing the release date of the product. Fixed cost purchases are capitalized and amortized as rental inventoryon our balance sheet, in accordance with our stated accounting policies.  The fixed portion of the cost of revenueshare product is capitalized and amortized as rental inventory on our balancesheet while the revenue sharing payments are expensed as incurred and reflectedin gross profit on our income statement. Rental inventory purchases included in net cash provided by operatingactivities includes the costs of all our fixed cost purchases as well as thefixed portion of costs associated with our revenue share product, while therevenue sharing expenses are reflected in net cash provided by operating activitiesthrough net income.  (Note that rentalinventory purchases for new stores or other significant investments in basestock rental inventory are not classified as operating activities, but insteadas investing activities in our statements of cash flows.)  Rental inventory purchases will be higher inperiods with more fixed cost purchases versus revenue share purchases.  The mix of fixed cost and revenue shareproduct purchased in any given period is dependent upon the purchasingeconomics of the titles released in that period and is not determined until themonthly orders are placed with our suppliers. As such, we are unable to provide guidance regarding the expected futureamounts of rental inventory purchases as reflected in our statements of cash flows.

 

Webelieve our projected cash flow from operations, cash on hand, borrowingcapacity under our credit facility and trade credit will provide the necessarycapital to fund our current plan of operations, including our anticipated newstore openings and acquisition program, through fiscal 2005.  However, to fund a major acquisition, or toprovide funds in the event that our need for funds is greater than expected, orif the financing sources identified above are not available to the extentanticipated or if we increase our growth plan, we may need to seek additionalor alternative sources of financing. This financing may not be available onsatisfactory terms. Failure to obtain financing to fund our expansion plans orfor other purposes could have a material adverse effect on our operatingresults.

 

Ourability to fund our current plan of operations and our growth plan will dependupon 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 and serviceany debt incurred in the future.  If weare unable to satisfy these requirements with cash flow from operations andcash on hand, we may be required to sell assets or to obtain additionalfinancing.  We cannot assure you that anysuch sales of assets or additional financing could be obtained.

 

## **CriticalAccounting Policies and Estimates**

 

Our significantaccounting policies are described in Note 1 to our consolidated financialstatements as filed in our Annual Report on Form 10-K for the fiscal year endedJanuary 4, 2004. Our discussion and analysis of financial 

 

 

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condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted in theUnited States. The preparation of the financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues, expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate the estimates that we havemade. These estimates have been based upon historical experience and on variousother assumptions that we believe to be reasonable under the circumstances.Actual results may differ from these estimates under different conditions orusing different assumptions. We believe our most critical accounting estimatesinclude our policies with respect to rental inventory amortization, impairmentof long-lived assets, purchase price allocation of acquired businesses anddeferred income taxes.

 

A major componentof our cost structure is the amortization of our rental inventory.  Rental inventory is amortized to an estimatedsalvage value over an estimated useful life of up to two years.  We amortize the cost of rental inventoryusing an accelerated method designed to approximate the rate of revenuerecognition.  This method is based onhistorical customer demand patterns from “street date” (the date studiosrelease various titles for distribution to our stores) through the end of theaverage useful life.  In order todetermine the appropriate useful lives and salvage values, we analyzed theactual historical performance trends of our rental inventory.  We quantified the average rate of revenuerecognition on our products and developed amortization rates and useful livesthat approximate the rental turns of our inventory.  Our established salvage values are based onan evaluation of the sale prices we are able to realize from our customers onused inventory, prices observed in bulk sale transactions and prices observedin other open market purchases of used inventory, as well as the salvage valuesestablished by competitors in our industry. We believe our estimated useful lives and salvage values areappropriately matched to our current rental business and are consistent withindustry trends.  However, should rentalpatterns of consumers change or should market values of previously viewedinventory decline due to the acceptance of new formats (e.g., ongoing VHStransition to DVD, anticipated transition to high definition DVD within threeto five years, release of new video game formats, etc.), this could necessitatean acceleration in our current rental amortization rates, a reduction insalvage values or a combination of both courses of action.  We believe that any acceleration in therental amortization rates would not have a long-lasting impact as the majorityof our current rental purchases are substantially depreciated within the firsttwo to three months after “street date” under our existing policy.  We could be required to reduce salvage valuesthat we currently carry on VHS inventory if we are unable to dispose of thatinventory at a rate relatively consistent with the consumers’ transition toDVD.   In the past we have generally beenable to anticipate the rate of transition from one format to another and manageour purchases, as well as inventory mix, to avoid significant losses on theultimate disposition of previously viewed movies.  However, we cannot assure you that we will beable to fully anticipate the impact of the transition to DVD or any otherformats in the future and we could incur losses on sale of previously viewedmovies in the future.  As of October 3,2004 and January 4, 2004, we had $116.8 million and $102.5 million,respectively, in rental inventory on our balance sheet.  VHS, DVD and games constituted 43%, 50% and7%, respectively, of total rental inventory units as of October 3, 2004;compared to 55%, 37% and 8%, respectively, of total units as of January 4,2004.  As of October 3, 2004, the netbook value of our VHS rental inventory is approximately 20% of the net bookvalue of our total rental inventory.

 

We assess the fairvalue and recoverability of our long-lived assets, including property, furnishingsand equipment and intangible assets with finite lives, whenever events andcircumstances indicate the carrying value of an asset may not be recoverablefrom estimated future cash flows expected to result from its use and eventualdisposition.  In doing so, we makeassumptions and estimates regarding future cash flows and other factors inorder to make our determination. The fair value of our long-lived assets isdependent upon the forecasted performance of our business, changes in the videoretail industry, the market valuation of our common stock and the overalleconomic environment.  When we determinethat the carrying value of our long-lived assets may not be recoverable, wemeasure any impairment based upon the excess of the carrying value that exceedsthe estimated fair value of the assets. We have not recognized any impairment losses on long-lived assets sincefiscal 1996.  If we do not meet ouroperating forecasts or if the market value of our stock declines significantly,we may have to record impairment charges not previously recognized.

 

Wetest goodwill for impairment on an annual basis.  Additionally, goodwill is tested forimpairment between annual tests if an event occurs or circumstances change thatwould more likely than not reduce the fair value of an entity below itscarrying value.  These events orcircumstances would include a significant change in the business climate, legal

 

 

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factors, operating performance indicators,competition, sale or disposition of a significant portion of the business orother factors.  We have not recorded anyimpairment losses on goodwill since a fiscal 2001 impairment charge of$700,000.  If we do not meet ouroperating forecasts or if the market value of our stock declines significantly,we may have to record additional impairment charges not previouslyrecognized.  As of October 3, 2004, wehave $141.7 million in goodwill on our balance sheet.

 

We estimate the fair value of assets andliabilities of acquired businesses based on historical experience and availableinformation at the acquisition date.  Weengage independent valuation specialists to assist when necessary.  If information becomes available subsequentto the acquisition date that would materially impact the valuation of assetsacquired or liabilities assumed in business combinations, we may be required toadjust the purchase price allocation. With the exception of the Video Updateacquisition in 2001, we have not experienced any significant adjustments to thevaluation of assets or liabilities acquired in business combinations in thelast seven years.  Our acquisitions aretypically small businesses for which we generally do not assume liabilities andfor which the assets acquired consist primarily of inventory, fixtures,equipment and intangibles.

 

**Werecognize deferred tax assets and liabilities based on the differences betweenthe financial statement carrying amounts and the tax bases of assets andliabilities. We regularly review our deferred tax assets for recoverability andestablish a valuation allowance based upon historical losses, projected futuretaxable income and the expected timing of the reversals of existing temporarydifferences. As a result of this review, we have established a valuationallowance against our deferred tax assets related to net operating losscarryforwards (NOLs) that we acquired in the 2001 acquisition of VideoUpdate.  In forming our conclusion aboutthe future recoverability of the NOLs from our 2001 acquisition of VideoUpdate, we consider, among other things, the applicable provisions of thefederal income tax code which limit the deductibility of NOLs to thepost-acquisition taxable income (on a cumulative basis) of the acquiredsubsidiary on a separate return basis, as well as other limitations that mayapply to the future deductibility of NOLs. We also consider the availability of reversing taxable 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 effectiveincome tax rate, which was 40%, 40% and 39% for fiscal 2001, 2002 and 2003,respectively, could be reduced.**

 

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

 

        This quarterly report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended, which represent our expectations or beliefs about futureevents 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 4, 2004.  In light of these risks, uncertainties andassumptions, the forward-looking events discussed in this Form 10-Q might notoccur.  In addition, actual results coulddiffer materially from those suggested by the forward-looking statements, andtherefore you should not place undue reliance on the forward-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 of operationsand may cause changes in our strategy with the result that our operations andresults may differ materially from those expressed in any forward-lookingstatements made by us, or on our behalf.

 

 

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Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

Therehave been no material changes in our inherent market risk since the disclosuresmade as of January 4, 2004 in our AnnualReport on Form 10-K.

 

Item 4.  Controls and Procedures

 

Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer, hasevaluated the effectiveness of our disclosure controls and procedures (as suchterm is defined in Rules 13a-15(e) and 15d-15(e) under the Securities ExchangeAct of 1934, as amended (the  ExchangeAct )) as of the end of the period covered by this report. Based on thatevaluation, our Chief Executive Officer and Chief Financial Officer have concludedthat, as of the end of such period, our disclosure controls and procedures areeffective.

 

There have not been anychanges in our internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during ourthird quarter that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

Weare in the process of documenting and testing our internal control proceduresin order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act,which requires annual management assessments of the effectiveness of ourinternal controls over financial reporting and a report by our independentauditors addressing these assessments. In this regard, we have been notified byour independent auditors that we are behind schedule in this process and thatwe face a risk of not completing our assessments on a timely basis.  Although we are unaware of any specificdeficiencies with respect to our internal controls and we are taking steps toensure such process is completed in a timely manner, we can provide noassurance that we will meet this objective, in which case our ability to reportfinancial results on a timely basis may be adversely affected.

 

 

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#### **Part II - OtherInformation**

 

Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds

 

        A summary of our purchases of our common stock during thethird quarter of 2004 is as follows:

 
| **Fiscal Period**                                | ** ** | **(a) Total Number of Shares Purchased** | ** ** | **(b) Average Price Paid per Share** | ** ** | **(c) Total Number of Shares Purchased as Part of Publicly Announced  Programs** | ** ** | **(d) Approximate Dollar Value of Shares that May Yet Be Purchased  Under the Programs** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|
| Period 7  July 5, 2004  to  August 8, 2004       |       | 609,500                                  |       | $                                    | 17.79      |                                                                             | 609,500    |                                                                                     | $          | 14,159,975 |   |
|                                             |       |                                     |       |                                 |       |                                                                             |       |                                                                                     |       |
| Period 8  August 9, 2004  to  September 5, 2004  |       | 678,900                                  |       | $                                    | 17.01      |                                                                             | 678,900    |                                                                                     | $          | 2,609,541 |   |
|                                             |       |                                     |       |                                 |       |                                                                             |       |                                                                                     |       |
| Period 9  September 6, 2004  to  October 3, 2004 |       | —                                   |       | —                               |       | —                                                                           |       | $                                                                                        | 2,609,541  |   |
|                                             |       |                                     |       |                                 |       |                                                                             |       |                                                                                     |       |
| Total                                            |       | 1,288,400                                |       | $                                    | 17.38      |                                                                             | 1,288,400  |                                                                                     | $          | 2,609,541 |   |

 

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Item 6.  Exhibits

 

a)              Exhibits

 

31.1                          Certification of Chief Executive OfficerPursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of1934, as amended

 

31.2                          Certification of Chief Financial OfficerPursuant to  Rule 13a-14(a) and Rule15d-14(a) of the Securities Exchange Act of 1934, as amended

 

32.1                          Certification of Chief Executive OfficerPursuant to 18 U.S.C 1350, as adopted Pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

32.2                           Certificationof Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant toSection 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: November 12, 2004 | /s/ Ivy M. Jernigan                         |
|                    | Ivy M. Jernigan, Senior  Vice President and |
|                    | Chief Financial Officer                     |

 

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