<PAGE>   1

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q


(Mark One)
[X]      Quarterly report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934

         For the quarterly period ended January 31, 1998

                                            or

[ ]      Transition report under Section 13 or 15(d) of the Securities Exchange
         Act of 1934

         For the transition period from _____  to  _____

                         Commission file number: 0-24346


                               VIDEO UPDATE, INC.
                               ------------------
             (Exact Name of Registrant as Specified in its Charter)

          DELAWARE                                          41-1461110
          --------                                          ----------
 (State or Other Jurisdiction of                        (I.R.S. Employer
 Incorporation or Organization)                         Identification No.)

                             3100 World Trade Center
                               30 East 7th Street
                            ST. PAUL, MINNESOTA 55101
                            -------------------------
                    (Address of Principal Executive Offices)
                                   (Zip Code)

                                 (612) 222-0006
                                 --------------
              (Registrant's Telephone Number, Including Area Code)

                                 NOT APPLICABLE
                                 --------------
         (Former name, former address and former fiscal year, if changed
                               since last report)

         Indicate by check mark whether the Registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes   X     No
     ---       ---
         The number of shares of Class A Common Stock, $.01 par value,
outstanding at March 6, 1998 is 29,278,518.



<PAGE>   2


                               VIDEO UPDATE, INC.

                                      INDEX

<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION                                                  PAGE NO.
------------------------------                                                  --------
<S>                                                                                <C>
ITEM 1.  Financial Statements

         Consolidated Balance Sheets - April 30, 1997 and January 31, 1998          3

         Consolidated Statements of Income - Three Months and Nine Months
                  Ended January 31, 1997 and January 31, 1998                       4

         Consolidated Statements of Cash Flows - Nine Months Ended 
                  January 31, 1997 and January 31, 1998                             5

         Notes to Consolidated Financial Statements - January 31, 1998              6

ITEM 2.  Management's Discussion and Analysis of Financial
                  Condition and Results of Operations                               8

PART II - OTHER INFORMATION

ITEM 1.           Legal Proceedings                                                14

ITEM 6.           Exhibits and Reports on Form 8-K                                 14

SIGNATURES                                                                         15
</TABLE>
                                    2 of 15
<PAGE>   3

PART I - FINANCIAL INFORMATION
------------------------------
ITEM 1.  FINANCIAL STATEMENTS

                               VIDEO UPDATE, INC.
                           CONSOLIDATED BALANCE SHEETS
               (In thousands, except share and per share amounts)


<TABLE>
<CAPTION>
                                                  ASSETS
                                                                             April 30,         January 31,
                                                                               1997               1998
                                                                      --------------------------------------
                                                                                               (UNAUDITED)
<S>                                                                 <C>                     <C>
Cash and cash equivalents                                           $       2,424           $         1,424
Accounts receivable                                                         3,776                     3,763
Notes receivable from related parties                                       1,394                     1,529
Inventory                                                                   7,318                     7,981
Videocassette rental inventory -- net                                      45,479                    63,029
Property and equipment -- net                                              33,069                    43,012
Prepaid expenses                                                              783                     2,565
Recoverable income taxes                                                        -                       531
Goodwill -- net                                                            37,716                    36,117
Other assets                                                                1,648                     1,839
                                                                      ------------            --------------
Total assets                                                        $     133,607           $       161,790
                                                                      ============            ==============

                                   LIABILITIES AND STOCKHOLDERS' EQUITY

Notes payable                                                       $      20,564           $        33,853
Accounts payable                                                           12,196                    25,212
Accrued expenses                                                            2,415                     3,842
Accrued rent                                                                2,238                     4,226
Accrued compensation                                                        1,779                     2,029
Income taxes payable                                                        1,096                         -
Deferred income taxes                                                       2,327                     3,413

Commitments and contingencies

Stockholders' equity:
Preferred Stock, par value $.01 per share:
    Authorized shares -- 5,000,000
    Issued shares -- none                                                       -                         -
Class A Common Stock, par value $.01 per share:
    Authorized shares -- 60,000,000
    Issued and outstanding shares -- 18,170,341 at April 30,                  182                       181
      1997 and 18,104,591 at January 31, 1998
Class B Common Stock, par value $.01 per share:
    Authorized, issued and outstanding shares --                               20                        20
      2,000,000  at April 30, 1997 and January 31, 1998
    Additional paid-in capital                                             86,085                    84,257
    Retained earnings                                                       6,806                     7,719
    Foreign currency translation                                             (421)                   (1,282)
                                                                      ------------            --------------
                                                                           92,672                    90,895
    Notes receivable from officers for the exercise of options             (1,680)                   (1,680)
                                                                      ------------            --------------
Total stockholders' equity                                                 90,992                    89,215
                                                                      ------------            --------------
Total liabilities and stockholders' equity                          $     133,607           $       161,790
                                                                      ============            ==============

</TABLE>


                             See accompanying notes.


Note: The balance sheet at April 30, 1997 has been derived from the audited
financial statements at that date but does not include all the information and
footnotes required by generally accepted accounting principles for complete
financial statements.


                                    3 of 15

<PAGE>   4

                               VIDEO UPDATE, INC.
                        CONSOLIDATED STATEMENTS OF INCOME
                                   (UNAUDITED)
                    (In thousands, except per share amounts)




<TABLE>
<CAPTION>
                                                Three Months Ended                   Nine Months Ended
                                                   January 31,                          January 31,
                                            1997                 1998              1997             1998
                                         ------------         ------------     -------------     ------------
<S>                                    <C>                  <C>                                <C>
Revenues:
    Rental revenue                     $      24,040        $      36,530    $       59,669    $      93,494
    Service fees                                 136                  179               419              522
    Product sales                              1,967                5,073             4,742           11,703
                                         ------------         ------------     -------------     ------------
                                              26,143               41,782            64,830          105,719

Costs and expenses:
    Store operating expenses                  18,903               31,205            49,329           84,821
    Selling, general and administrative        2,058                3,451             6,080            9,292
    Cost of product sales                      1,206                3,095             2,842            6,946
    Amortization of goodwill                     396                  501             1,139            1,523
                                         ------------         ------------     -------------     ------------
                                              22,563               38,252            59,390          102,582
                                         ------------         ------------     -------------     ------------

Operating income                               3,580                3,530             5,440            3,137

Interest expense                                 (31)                (747)             (349)          (1,923)
Other income                                     298                  403               567              827
                                         ------------         ------------     -------------     ------------
                                                 267                 (344)\             218           (1,096)
                                         ------------         ------------     -------------     ------------

Income before income taxes                     3,847                3,186             5,658            2,041
Income tax expense                             1,568                1,378             2,346            1,128
                                         ------------         ------------     -------------     ------------
Net income                             $       2,279        $       1,808    $        3,312    $         913
                                         ============         ============     =============     ============
Net income per share, 
  basic and diluted                    $        0.12        $        0.10    $         0.22    $        0.05
                                         ============         ============     =============     ============
</TABLE>



                             See accompanying notes.

                                    4 of 15
<PAGE>   5



                               VIDEO UPDATE, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)
                                 (In thousands)


<TABLE>
<CAPTION>
                                                                    Nine Months Ended January 31,
                                                                      1997                 1998
                                                                   ------------        -------------
<S>                                                              <C>                 <C>
Operating activities
    Net income                                                   $       3,312       $          913
    Adjustments to reconcile net income to net                                          
      cash provided by operating activities:
        Depreciation and amortization                                   18,069               31,505
        Accrued rent                                                     1,128                1,988
        Deferred income taxes                                              665                1,086
        Changes in operating assets and liabilities, net                                
          of acquisitions of businesses:
            Accounts receivable                                         (1,282)                  10
            Notes receivable                                               137                    -
            Inventory                                                      746                 (663)
            Other assets                                                  (686)              (2,230)
            Accounts payable                                             2,632               13,016
            Income taxes payable                                           704               (1,627)
            Other liabilities                                            1,825                  776
                                                                   ------------        -------------
Net cash provided by operating activities                               27,250               44,774

Investing activities
    Purchase of videocassette rental inventory                         (26,168)             (42,638)
    Purchase of property and equipment                                  (9,888)             (14,312)
    Investment in businesses, net of cash acquired                      (8,375)                (610)
    Payment of deficiency on stock guarantee                                 -               (1,327)
    Notes receivable from officers                                           -                 (220)
    Payments on notes receivable                                           222                   43
                                                                   ------------        -------------
Net cash used in investing activities                                  (44,209)             (59,064)

Financing activities                                                
    Proceeds from notes payable                                          5,326               15,204
    Payments on notes payable                                           (9,567)              (1,914)
    Proceeds from issuance of common stock, net                         25,032                    -
                                                                   ------------        -------------
Net cash provided by financing activities                               20,791               13,290
                                                                   ------------        -------------

Increase (decrease) in cash and cash equivalents                         3,832               (1,000)
Cash and cash equivalents at beginning of the period                       676                2,424
                                                                   ------------        -------------
Cash and cash equivalents at end of the period                   $       4,508       $        1,424
                                                                   ============        =============
</TABLE>




                             See accompanying notes.

                                    5 of 15
<PAGE>   6




                               VIDEO UPDATE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                JANUARY 31, 1998
                                   (UNAUDITED)

1.        GENERAL

         The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the nine months ended January 31, 1998 are
not necessarily indicative of the results that may be expected for the year
ending April 30, 1998. For further information, refer to the consolidated
financial statements and footnotes thereto included in the Company's annual
report on Form 10-K for the year ended April 30, 1997.

         Reclassification

         Certain prior year items have been reclassified to conform with the
fiscal 1998 presentation.

2.       NET INCOME PER COMMON SHARE

         In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, Earnings per Share. Statement 128
replaced the previously reported primary and fully diluted earnings per share
with basic and diluted earnings per share.  Unlike primary earnings per share,
basic earnings per share excluded any dilutive effect of options, warrants, and
convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods have been presented, and when necessary, restated to
conform to the Statement 128 requirements.




<TABLE>
<CAPTION>
                                                               THREE MONTHS                    NINE MONTHS
                                                             ENDED JANUARY 31,               ENDED JANUARY 31,
                                                           ----------------------         ------------------------
                                                             1997         1998              1997           1998
                                                           ---------    ---------         ---------      ---------
                                                                    (In thousands, except per share amount)
<S>                                                      <C>          <C>               <C>            <C>
Numerator:
     Net income                                          $    2,279   $    1,808        $    3,312     $      913
                                                           ---------    ---------         ---------      ---------
     Numerator for basic and diluted earnings
       per share--income available to common
       stockholders                                      $    2,279   $    1,808        $    3,312     $      913
                                                           ---------    ---------         ---------      ---------



Denominator:
    Denominator for basic earnings per 
      share--weighted-average shares

    Class A common shares                                    18,054       18,105            14,203         18,105
    Class B common shares                                       700          700               700            700
                                                           ---------    ---------         ---------      ---------
                                                             18,754       18,805            14,903         18,805
Effect of dilutive securities:
    Employee stock options                                       13            -               197              -
    Contingent stock acquisition                                177          177               177            177
                                                           ---------    ---------         ---------      ---------
Dilutive potential common shares                                190          177               374            177

Denominator for diluted earnings per share--adjusted
  weighted-average shares and assumed conversions            18,944       18,982            15,277         18,982
                                                           =========    =========         =========      =========

Basic earnings per share                                  $     .12    $     .10         $     .22      $     .05
                                                           =========    =========         =========      =========

Diluted earnings per share                                $     .12    $     .10         $     .22      $     .05
                                                           =========    =========         =========      =========
</TABLE>
                                    6 of 15
<PAGE>   7



3.        DEFICIENCY OBLIGATIONS - ACQUISITIONS

         In connection with the acquisition of the assets of Videoland, Inc.
("Videoland") in November 1995, the Company issued 239,163 shares of its Class A
Common Stock (the "Videoland Shares") to the sellers of the assets of Videoland
(the "Videoland Seller"). With respect to the Videoland Shares, the Company
agreed to make a deficiency payment in October 1996 to the Videoland Sellers if
the gross proceeds received by such sellers from the sale of the Videoland
Shares during the six months from March 1996 through September 1996 is not equal
to the number of shares of Videoland Shares sold multiplied by $12.00. The
Videoland Sellers were subject to certain "lockup" or sale restrictions as a
condition to any deficiency payment. The Videoland Sellers requested a
deficiency payment of approximately $1,220,000 in October 1996 based on a sale
of all of the Videoland Shares. The Company initiated an action in federal
district court in Minnesota for a declaratory judgement that the Videoland
Sellers are not entitled to any deficiency payment. On January 26, 1998, the
court entered a judgment against the Company in the amount of $1,220,000 (which
amount is payable either in cash or in additional shares of Class A Common
Stock, at the Company's option) plus interest from October 1996 and attorneys'
fees . The Company intends to appeal the matter. Although no assurance can be
given as to the outcome of such action, the Company intends to vigorously pursue
the matter.

         With respect to an additional acquisition the Company may be obligated
to pay up to an approximate aggregate amount of $250,000 through October 1998,
based on closing stock price of $2.50 on January 30, 1998.

         In December 1997, a cash deficiency payment was made with regard to an
acquisition in the cash amount of approximately $1,204,000.

4.    STOCKHOLDER'S EQUITY

         In the first quarter of fiscal 1998, the Company canceled 65,750 shares
of Class A Common Stock issued to a seller (reducing paid in capital and
goodwill by approximately $500,000) as part of a purchase price adjustment
related to one of the Company's Canadian acquisitions.

5.    SUBSEQUENT EVENTS

         In March 1998 the Company completed the acquisition of Moovies, Inc. in
a tax-free reorganization, whereby Moovies stockholders received .75 shares of
Video Update Class A common stock in exchange for each share of Moovies common
stock. Video Update issued approximately 9.3 million shares in this transaction.
The acquisition will be accounted for under the purchase method of accounting
and the excess of the cost over the estimated fair value of the assets acquired,
estimated to be approximately $50.0 million will be amortized over 20 years.

         In March 1998, the stockholders approved the termination and
cancellation of the Escrow Agreement by and among American Stock Transfer &
Trust Company, Video Update and certain stockholders of Video Update. As a
result (i) 10% or 130,000 of the 1,300,000 Class B shares of common stock held
in escrow were forfeited and canceled; (ii) the remaining 1,170,000 shares of
common stock were released from escrow, resulting in a one-time charge of
approximately $3.5 million which the Company will record in the fourth quarter
of fiscal 1998; and (iii) all 1,870,000 shares of Class B common stock were
converted into Class A common stock and the preferential voting rights were
eliminated.

         Simultaneous with the closing of the merger, the Company announced that
a syndicate led by Banque Paribas had extended it a $120 million credit/term
loan facility (the "Senior Facility"). The Senior Facility replaces Video
Update's previous $60 million revolving credit facility. The Senior Facility
consists of the following: (i) two term loans totaling $95.0, (ii) a $15.0
million capital expenditure line and (iii) a $10.0 million revolving line. The


                                    7 of 15
<PAGE>   8


Company borrowed the $95.0 million of the two term loans in conjunction with the
closing of the merger and the proceeds were used to refinance the current
indebtedness of Moovies and Video Update and pay transaction expenses. The
capital expenditure line is primarily available to fund the conversion of the
Moovies store and integration costs, the opening of new stores and selected
acquisitions. The revolving line is available for normal working capital needs.
The facility is secured by all of the Company's assets. In connection with the
Senior Facility, the Company also issued five year warrants to Banque Paribas to
purchase one million shares of the Company's Class A common stock at an exercise
price of $2.68.



ITEM 2.           MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                  AND RESULTS OF OPERATIONS.

         The following discussion of the financial condition and results of
operations should be read in conjunction with the Company's unaudited
consolidated financial statements and notes thereto appearing elsewhere herein.

OVERVIEW

         The Company franchised its first store in January 1983 and opened its
first Company-owned store in September 1989. By July 1994, when the Company
completed its initial public offering, the Company had grown to 15 Company-owned
stores and 30 franchised stores. Subsequently, the Company substantially
accelerated its growth and as of January 31, 1998 operated 407 Company-owned
stores in 20 states and six provinces in Canada, and has 35 franchised stores
predominantly in the United States. The majority of the Company's stores located
in the United States are superstores. Superstores are video specialty stores
that carry more than 7,500 rental units.

         As a result of the acquisitions completed prior to January 31, 1998,
the Company had $36,117,000 of goodwill and it expects to record additional
goodwill of approximately $50 million as a result of the Moovies acquisition.
The Company's results of operations will be reduced by the amortization of this
goodwill with anticipated quarterly non-cash charges of approximately
$1,135,000.

         The Company generates revenues primarily from the rental of
videocassettes and video games, from service fees from its franchisees and from
the sale of products. As reflected in the chart below, rental revenues at Video
Update stores have accounted for the substantial majority of the Company's
revenues. The Company expects that this trend will continue.



<TABLE>
<CAPTION>
                                 THREE MONTHS ENDED                  NINE MONTHS ENDED
                                    JANUARY 31,                         JANUARY 31,
                           -------------------------------     ------------------------------
                              1997               1998             1997              1998
                           ------------       ------------     ------------      ------------
                                   (In thousands)                     (In thousands)
<S>                      <C>                <C>              <C>               <C>
Rental revenue           $      24,040      $      36,530    $      59,669     $      93,494
Service fees                       136                179              419               522
Product sales                    1,967              5,073            4,742            11,703
                           ============       ============     ============      ============
                         $      26,143      $      41,782    $      64,830     $     105,719
                           ============       ============     ============      ============
</TABLE>

                                    8 of 15


<PAGE>   9

OPERATING RESULTS

        The table below sets forth the percentage of revenues represented by
certain items included in the Company's statement of operations for the periods
indicated.


<TABLE>
<CAPTION>
                                                    NINE MONTHS ENDED JANUARY 31,
                                                 ----------------------------------
                                                   1997                 1998
                                                 -------------         ------------
<S>                                                    <C>                 <C>
Revenues:
    Rental revenue                                      92.0%               88.4%
    Service fees                                         0.7                 0.5
    Product sales                                        7.3                11.1
                                                  ----------            --------
Total revenues                                         100.0               100.0

Costs and expenses:
    Store operating expenses                            76.1                80.2
    Selling, general and administrative                  9.4                 8.8
    Cost of product sales                                4.4                 6.6
    Amortization of goodwill                             1.7                 1.4
                                                  ----------            --------
Total cost and expenses                                 91.6                97.0
                                                  ----------            --------
Operating income                                         8.4                 3.0

Other income (expense):
    Interest expense                                    (0.5)               (1.8)
    Other income                                         0.8                 0.8
                                                  ----------            --------
Total other income (expense)                             0.3                (1.0)
                                                  ----------            --------
Income before income taxes                               8.7                 2.0
Income tax expense                                       3.6                 1.1
                                                  ----------            --------
Net income                                               5.1%                0.9%
                                                  ==========            ========
</TABLE>



NINE MONTHS ENDED JANUARY 31, 1998 COMPARED TO NINE MONTHS ENDED 
JANUARY 31, 1997

         Rental revenue. Rental revenue was approximately $93,494,000 and
$59,669,000, or 88.4% and 92.0% of total revenues for the nine months ended
January 31, 1998 and 1997, respectively. The increase in rental revenue of
$33,825,000 was derived primarily from video stores acquired during fiscal 1997,
from the opening of 80 Company-owned stores, net of closings, since the third
quarter of fiscal 1997, and from a 6% increase in same store revenues.

         Service fees. Service fees were approximately $522,000 and $419,000, or
 .5% and .7% of total revenues for the nine months ended January 31, 1998 and
1997, respectively. Continuing service fees and royalties from franchisees
accounted for 94.4% and 92.8% of total service fees, respectively.

         Product sales. Product sales were approximately $11,703,000 and
$4,742,000, or 11.1% and 7.3% of total revenues for the nine months ended
January 31, 1998 and 1997, respectively. The increase in product sales of
$6,961,000 was primarily a result of product sales by the video stores acquired
during fiscal 1997, from the opening of 80 Company-owned video stores, net of
closings, since the third quarter of fiscal 1997 and from the increase in sales
of fixed assets to franchisees. The increase as a percentage of total revenues
was primarily due to (i) an increased demand for the purchase of video games,
especially in Canada, (ii) the introduction of confection items in selected
markets and (iii) increased sales of holiday videocassettes. The Company
anticipates that product sales as a percentage of revenue will continue to
increase during the next year as the Moovies stores have historically
experienced higher levels of product sales.

         Store operating expenses. Store operating expenses consist primarily of
compensation and related expenses including regional management expenses,
occupancy expenses, and depreciation and amortization


                                    9 of 15


<PAGE>   10
expenses. Operating expenses were approximately $84,821,000 and $49,329,000, or
80.2% and 76.1% of total revenues for the nine months ended January 31, 1998 and
1997, respectively. The increase in store operating expenses of $35,492,000 was
primarily the result of video stores acquired during fiscal 1997 and the opening
of 80 Company-owned video stores since the second quarter of fiscal 1997.

         Compensation and related expenses were approximately $21,702,000 and
$13,863,000, or 20.5% and 21.4% of total revenues for the nine months ended
January 31, 1998 and 1997, respectively. The increase of $7,839,000 was
primarily due to video stores acquired during fiscal 1997 and from the opening
of 80 Company-owned video stores, net of closings, since the third quarter of
fiscal 1997.

         Occupancy expenses were approximately $24,843,000 and $14,324,000, or
23.5% and 22.1% of total revenues for the nine months ended January 31, 1998 and
1997, respectively. The increase of approximately $10,519,000 was primarily due
to video stores acquired during fiscal 1997 and from the opening of 80
Company-owned stores, net of closings, since the third quarter of fiscal 1997.
The increase as a percentage of total revenues was primarily due to revenues of
new stores not meeting management's expectations due primarily (management
believes) to lack of public acceptance of new release titles and higher costs
associated with the opening of new video stores prior to revenue reaching
maturity during the first two years of operations.

         Depreciation and amortization expenses were approximately $28,933,000
and $16,305,000, or 27.4% and 25.2% of total revenues for the nine months ended
January 31, 1998 and 1997, respectively. Depreciation and amortization expense
reflects the depreciation of store equipment and fixtures and the amortization
of videocassettes. The increase of $12,628,000 was primarily attributable to the
addition of new release videocassette inventory for new, existing and acquired
stores. The increase as a percentage of total revenues was primarily due to
revenues of new and acquired stores not meeting management's expectations due
primarily (management believes) to lack of public acceptance of new release
titles and higher costs associated with the opening of new video stores prior to
revenue reaching maturity during the two years of operations. Amortization
expense as a percentage of revenues for future periods may vary based on the
Company's purchase of videocassette inventory, which is subject to change based
on the Company's rate of expansion, studio release schedules and anticipated
market demand.

         Selling, general and administrative. Selling, general and
administrative expenses were approximately $ 9,292,000 and $6,080,000, or 8.8%
and 9.4% of total revenues for the nine months ended January 31, 1998 and 1997,
respectively. The increase of approximately $3,212,000 was primarily due to
adding management personnel and administrative staff to support the Company's
growth and related expenditures. The decrease as a percentage of total revenues
was due to the increase in total revenues without a proportional increase in
corporate overhead. The Company anticipates that the expense as a percentage of
revenue will continue to decline during the next year as the Moovies locations
are integrated into operations without a corresponding increase in expense and
as the newer stores continue to mature.

         Cost of product sales. Cost of product sales was approximately 
$6,946,000 and $2,842,000, or 6.6% and 4.4% of total revenues for the nine
months ended January 31, 1998 and 1997. The cost of product sales as a
percentage of total product sales revenue was approximately 59.4% and 59.9% for
fiscal 1998 and 1997, respectively. The decrease in the cost of product sales as
a percentage of total product sales was primarily due to a difference in product
mix. The Company anticipates that the cost of product sales as a percentage of
product sales will remain consistent with historical results, but will fluctuate
quarterly based upon customer demands.

         Amortization of goodwill. Amortization of goodwill was approximately
$1,523,000 and $1,139,000 or 1.4% and 1.7% of total revenues for the nine
months ended January 31, 1998 and 1997, respectively. The decrease as a
percentage of total sales was primarily attributable to an increase in sales
from new store openings without a proportional increase in the amortization of
certain intangible assets resulting from the video stores acquired.

         As a result of the acquisitions completed prior to January 31, 1998,
the Company had $36,117,000 of goodwill and it expects to record additional
goodwill of approximately $50 million as a result of the Moovies acquisition.
The Company's results of operations will be reduced by the amortization of this
goodwill with anticipated quarterly non-cash charges of approximately
$1,135,000.

         Interest expense. Interest expense was approximately $1,923,000 and
$349,000, or 1.8% and 0.5% of total revenues for the nine months ended January
31, 1998 and 1997, respectively. The increase of $1,574,000 was primarily
attributable to interest on increased borrowings under the Company's bank line
of credit. The Company
                                    10 of 15

<PAGE>   11
anticipates that interest expense will increase substantially as a result of the
increased borrowing and a slightly higher interest rate.

         Other income. Other income was approximately $827,000 and $567,000, or
0.8% of total revenues for the nine months ended January 31, 1998 and 1997. The
increase of $260,000 was primarily due to an increase in rebates from the
Company's primary video suppliers and interest on notes receivable.

LIQUIDITY AND CAPITAL RESOURCES

         The Company has funded its operations to date through cash from
operations, the proceeds of prior equity and debt offerings, borrowings under
bank facilities, trade credit and equipment leases. The Company's principal
capital requirements are for the opening and build out of new superstores, the
purchase of videocassette rental inventory, and the acquisition of existing
stores each of which varies based on market conditions and expansion plans.

         At January 31, 1998, the Company had cash and cash equivalents of
approximately $1,424,000. The Company uses an unclassified balance sheet in its
financial statements, and as a result, does not classify its assets or
liabilities as current or noncurrent. If the Company were to use a classified
balance sheet, a portion of videocassette rental inventories would be classified
as noncurrent because they are not assets that are reasonably expected to be
completely realized in cash or sold in one year. The acquisition cost of these
inventories, however, would be reflected in current liabilities. The Company
believes that classification of videocassette rental inventories as noncurrent
assets would be misleading because it would not indicate the level of assets
expected to be converted into cash in the next year as a result of rentals or
sales of these videocassettes.

         For the nine months ended January 31, 1998 net cash provided by
operating activities was approximately $44,774,000. Net cash used in investment
activities was approximately $59,064,000 consisting primarily of approximately
$14,312,000 for new and remodeled stores, and conversion costs associated with
acquired stores, and approximately $42,638,000 for the purchase of videocassette
inventory for existing and new stores. Net cash generated from financing
activities was approximately $13,290,000 resulting primarily from proceeds under
the Line of Credit.

         In February 1997, a syndicate led by Bank of America National Trust and
Savings Association (successor by merger to "Bank of America Illinois") extended
a $60 million revolving credit facility (as amended, the "Line of Credit") to
the Company. As of January 31, 1998, approximately $32,000,000 was outstanding
under the Line of Credit.

         In March 1998 the Company completed the acquisition of Moovies, Inc.
(the "Merger") the Company issued approximately 9.3 million shares of Class A
common stock in exchange for Moovies common stock. The transaction will be
treated as a tax-free exchange for Federal income tax purposes and recorded
under the purchase method of accounting.

         Simultaneous with the closing of the Merger, the Company announced that
a syndicate led by Banque Paribas had extended it a $120 million credit/term
loan facility (the "Senior Facility"). This Senior Facility replaces the Line of
Credit. The Senior Facility consists of the following: (i) two term loans
totaling $95.0, (ii) a $15.0 million capital expenditure line and (iii) a $10.0
million revolving line. The Company borrowed the $95.0 million of the two term
loans in conjunction with the closing of the Merger and the proceeds were used
to (i) refinance approximately $35,000,000 of outstanding indebtedness including
accrued interest under the Line of Credit, (ii) refinance approximately
$50,000,000 of indebtedness of Moovies under Moovies' previous credit agreement,
and (iii) pay transaction fees and expenses relating to the Merger of
approximately $10,000,000, (including legal fees, accounting fees, and
registration fees). The capital expenditure line is primarily available to fund
the conversion of the acquired Moovies stores and integration costs, the opening
of new stores and selected acquisitions. The revolving line is available for
normal working capital needs.

         Amounts borrowed under the Senior Facility bear interest at variable
rates based on the "base rate" (i.e. the higher of the federal funds rate, plus
1/2 of 1% or the prime commercial lending rate) or the interbank Eurodollar rate
(approximately 8.5% and 5.68% per annum, respectively as of March 6, 1998),
respectively plus an applicable margin rate that could range from .5% to 3.75%.
Amounts currently outstanding are accruing interest at 9.3%.




                                    11 of 15

<PAGE>   12
         In addition, the Senior Facility includes negative, affirmative and
financial covenants including, but not limited to, minimum pretax earnings,
minimum free cash flow, minimum net worth, maximum indebtedness, maximum
leverage, minimum fixed charge coverage, a prohibition or restriction on capital
expenditures, debt and guarantees, liens and encumbrances on any property,
mergers, consolidations, investments, advances, divesitures, change or business
or conduct of business, joint ventures, partnerships, the creation of new
subsidiaries, dividends, distributions, repurchases or redemptions of
outstanding stock (including options or warrants), the voluntary prepayment,
repurchase redemption or defeasance of debt, and the acquisition, sale or
transfer, lease or sale-leaseback of assets. The Senior Facility is secured by
substantially all of the Company's assets as well as by pledges of its stock in
its subsidiaries, which subsidiaries also have provided guarantees of the
Company's obligations.

         For the remainder of the current year and at least the first half of
fiscal 1999, the Company expects to focus on maximizing the operating
efficiencies of its existing and acquired locations and on completing the
build-out of new stores in locations for which the Company has signed lease
commitments, rather than on aggressively expanding with new superstores in
additional metropolitan areas where it does not presently have locations. The
Company expects to fund its short term capital needs, including the purchase of
videocassette rental inventory and the build-out of new stores, primarily
through cash from operations, trade credit and borrowings under the Senior
Facility.

         Regarding videocassette rental inventory, in connection with the
acquisition of Moovies, the Company also executed a revenue sharing agreement
(the "Rentrak Agreement") with Rentrak Corporation ("Rentrak"), a distributor of
prerecorded videocassettes and other media, which agreement became effective
upon the closing of the Merger. Under the Rentrak Agreement, the Company will be
obligated to obtain a minimum annual dollar amount of new release titles from
Rentrak. The minimum dollar amount is subject to increase or decrease depending
on the Company's gross revenue from video sales/rentals and the number of major
studios participating in Rentrak. Under the Rentrak Agreement, the Company may
choose which stores offer a title from Rentrak, but if a store obtains a copy of
a new release title from Rentrak, it would have to obtain all copies of that
title from Rentrak. The Company believes that Rentrak could be a cost effective
source for larger orders of an individual title. Using Rentrak could enable the
Company to order larger numbers of copies of a particular title to satisfy
customer demand than would be cost-effective if the copies were purchased for
rental. When the Company chooses to offer a title under the Rentrak Agreement a
minimum number of copies for each store is often established by Rentrak based on
prior experience with similar titles. The Company expects to be able to obtain a
wide variety of titles under the Rentrak Agreement because Rentrak has a
supplier relationship with three of the six largest studios.

         To obtain the full benefits of the Rentrak Agreement, the Company must
correctly identify the new release and other titles that it should lease from
Rentrak and the stores that should receive them. To the extent that the Company
obtains new releases or other video products from Rentrak for too many or the
wrong stores, the Company's operations and profits could be adversely affected.
No assurances can be given that the Company will be effective in using Rentrak
as a supplier under the Rentrak Agreement to achieve its intended results. In
addition, certain of the Company's competitors, including some with greater
capital resources than the Company, have entered into revenue sharing
arrangements with Rentrak as well.  Such arrangements, together with any other
similar revenue sharing agreements with movie studios or distributors, could
allow the Company's competitors to order and stock a greater number of new
release and other titles, thus increasing competition in those areas in which
each of the Company and its competitors have retail locations and diminishing
the potential benefits of the Company's agreement with Rentrak, which could have
a material adverse effect on operations.

         The Company expects that its cash and cash equivalents, when combined
with available trade credit and funds available under the Senior Facility, will
be sufficient to fund the integration of acquired Moovies locations, planned
store openings and other operating cash needs of the Company for at least the
next twelve months. However, no assurance can be given that the Company will not
require additional sources of financing prior to such time, as a result of
unanticipated cash needs or opportunities, an expanded growth strategy or
disappointing operating results. In particular, no assurances can be given that
the Company will be successful in timely integrating and managing the operating,
purchasing, marketing and management information systems of Moovies with those
of the Company or that the Company will be able to hire, train, retain and
assimilate selected individuals at newly acquired locations. No assurance can be
given that the additional funds required, whether within the next twelve months
or thereafter, will be available on satisfactory terms, if at all. If the
Company is unable to obtain such additional financing, the Company may be
required to reduce its overall expenditures and the Company's ability to
maintain or expand its level of operation could be materially and adversely
affected.


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<PAGE>   13

         Moreover if the Company is unable to maintain its current level of
operations in subsequent quarters, it will be required to reduce its overall
expenditures and expansion plans to comply with the covenants and requirements
of the Senior Facility. Additionally, any failure by the Company to maintain its
level of operations within the covenants and requirements of the Senior Facility
could cause the Company to be in default under the Senior Facility, allowing the
syndicated lenders under the Senior Facility to take legal action against the
Company, including but not limited to, the immediate acceleration of payment of
borrowed funds under the Senior Facility, which could materially and adversely
affect the Company's operations. The immediate acceleration of debt thereunder
or the cancellation of the Senior Facility, in whole or in part, would have a
material adverse effect on the Company's operations and financial condition.

         The Company has promissory notes (the "Recourse Notes") from the
Company's Chief Executive Officer and from the President for approximately
$2,004,000 and $1,114,000, respectively, including accrued interest through
October 31, 1997. The Recourse Notes were issued by the executives upon their
exercise in August 1995 of 420,000 options granted to them under the Stock
Option Plans in May 1995 at an exercise price of $4.3125, the fair market value
of the stock on the date options were granted. The Recourse Notes represent the
total exercise price of such options plus amounts advanced by the Company to
such executives to satisfy then anticipated tax liabilities. The Recourse Notes,
which provide for full recourse against the respective officer's personal assets
and Company stockholdings, are due and payable in October 1999, and accrue
interest at 8% per annum. In the event that the obligors sell shares of the
Company's stock, the net proceeds thereof will be applied to payment, in part or
in full, of the Recourse Notes.

         In connection with the acquisition of the assets of Videoland, Inc.
("Videoland") in November 1995, the Company issued 239,163 shares of its Class A
Common Stock (the "Videoland Shares") to the sellers of the assets of Videoland
(the "Videoland Seller"). With respect to the Videoland Shares, the Company
agreed to make a deficiency payment in October 1996 to the Videoland Sellers if
the gross proceeds received by such sellers from the sale of the Videoland
Shares during the six months from March 1996 through September 1996 is not equal
to the number of shares of Videoland Shares sold multiplied by $12.00. The
Videoland Sellers were subject to certain "lockup" or sale restrictions as a
condition to any deficiency payment. The Videoland Sellers requested a
deficiency payment of approximately $1,220,000 in October 1996 based on a sale
of all of the Videoland Shares. The Company initiated an action in federal
district court in Minnesota for a declaratory judgement that the Videoland
Sellers are not entitled to any deficiency payment. On January 26, 1998, the
court entered a judgment against the Company in the amount of $1,220,000 (which
amount is payable either in cash or in additional shares of Class A Common
Stock, at the Company's option) plus interest from October 1996 and attorneys'
fees. The Company intends to appeal the matter. Although no assurance can be
given as to the outcome of such action, the Company intends to vigorously pursue
the matter.

         The Company generally does not offer lines of credit or guarantees for
the obligations of its franchisees, although on occasion, the Company has made
short term loans to current franchisees. The Company intends to evaluate the
possibility of providing loans or limited guarantees for certain franchisee
obligations, which in the aggregate are not expected to be material to the
Company's financial condition.

         Substantially all Company-owned stores are in leased premises, except
for three stores that are located on premises owned by the Company. The Company
expects that most future stores will occupy leased premises.

         Reference to Private Securities Litigation Reform Act: Statements made
by the Company that are not historical facts are forward looking statements that
involve risks and uncertainties. Actual results could differ materially from
those expressed or implied in forward looking statements. All such forward
looking statements are subject to the safe harbor created by the Private
Securities Litigation Reform Act of 1995. Important factors that could cause
financial performance to differ materially from past results and from those
expressed or implied in this document include, without limitation, the risks of
acquisition of businesses (including limited knowledge of the businesses
acquired and misrepresentations by sellers), including the acquisition of
Moovies, changes in business strategy or development plans, new store openings,
availability of products, availability of financing, competition, management,
ability to manage growth, loss of customers, weather (particularly on weekends
and holidays), consumer acceptance of new release videocassette titles, and a
variety of other factors. Further information on these and other risks is
included in the Company's Annual Report on Form 10-K for the year ended April
30, 1997, as well as the Company's other filings with the Securities and
Exchange Commission, including the Company's registration statement on Form S-4,
declared effective January 27, 1998.



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<PAGE>   14

INFLATION

         To date, inflation has not had a material effect on the Company's
business. The Company anticipates that its business will be affected by general
economic trends. Although the Company has not operated during a period of high
inflation, it believes that it would generally be able to pass increased costs
resulting from inflation on to customers.

SEASONALITY AND QUARTERLY FLUCTUATIONS

         The video rental industry generally experiences revenue declines in
April and May, due in part to the change to Daylight Savings Time and to
improved weather, and in September and October, due in part to school openings
and the introduction of new network and cable television programs.

         The Company's video rental business may be affected by other factors,
including acquisitions by the Company of existing video stores, additional and
existing competition, marketing programs, weather, special or unusual events,
variations in the number of superstore openings, and other factors that may
affect retailers in general.

         The Company depends significantly on availability and consumer
acceptance of new release videocassette titles available for rental. To the
extent that available new release titles fail to stimulate consumer interest and
retail traffic, operating results could be materially adversely affected.

PART II - OTHER INFORMATION
---------------------------

ITEM 1.  LEGAL PROCEEDINGS

         In connection with the acquisition of the assets of Videoland, Inc.
("Videoland") in November 1995, the Company issued 239,163 shares of its Class A
Common Stock (the "Videoland Shares") to the sellers of the assets of Videoland
(the "Videoland Seller"). With respect to the Videoland Shares, the Company
agreed to make a deficiency payment in October 1996 to the Videoland Sellers if
the gross proceeds received by such sellers from the sale of the Videoland
Shares during the six months from March 1996 through September 1996 is not equal
to the number of shares of Videoland Shares sold multiplied by $12.00. The
Videoland Sellers were subject to certain "lockup" or sale restrictions as a
condition to any deficiency payment. The Videoland Sellers requested a
deficiency payment of approximately $1,220,000 in October 1996 based on a sale
of all of the Videoland Shares. The Company initiated an action in federal
district court in Minnesota for a declaratory judgement that the Videoland
Sellers are not entitled to any deficiency payment. On January 26, 1998, the
court entered a judgment against the Company in the amount of $1,220,000 (which
amount is payable either in cash or in additional shares of Class A Common
Stock, at the Company's option) plus interest from October 1996 and attorneys'
fees. The Company intends to appeal the matter. Although no assurance can be
given as to the outcome of such action, the Company intends to vigorously pursue
the matter.

ITEM 6.           EXHIBITS AND REPORTS ON FORM 8-K

         A.       EXHIBITS.  The following exhibits are filed herewith:

                           EXHIBIT NO.               TITLE
                           -----------               -----

                                27                   Financial Data Schedule

         B.       REPORTS ON FORM 8-K. Listed below are all Current Reports or
                  amendments on Form 8-K that were filed during the fiscal
                  quarter covered by this report, listing the items reported,
                  any financial statements filed, and the dates of such reports.

                           None



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<PAGE>   15





                                   SIGNATURES

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

                                            VIDEO UPDATE, INC.

Date: March 16, 1998:               By:     /S/DANIEL A. POTTER
                                            --------------------------------
                                             DANIEL A. POTTER,
                                             Chief Executive Officer and
                                             Chairman of the Board of Directors


Date: March 16, 1998:               By:     /S/STEPHEN L. REYNOLDS
                                            --------------------------------
                                            STEPHEN L. REYNOLDS,
                                            Chief Financial Officer


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