<PAGE>
 
                                  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 July 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)

                                 (651) 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 September 11, 1998 is 29,278,518.
<PAGE>
 
                               VIDEO UPDATE, INC.

                                      INDEX

PART I - FINANCIAL INFORMATION                                          PAGE NO.
------------------------------                                          --------

ITEM 1.  Financial Statements

         Consolidated Balance Sheets - April 30, 1998 and July 31, 1998     3

         Consolidated Statements of Operations - Three Months ended
                July 31, 1997 and July 31, 1998                             4

         Consolidated Statements of Cash Flows - Three Months ended
                July 31, 1997 and July 31, 1998                             5

         Notes to Consolidated Financial Statements - July 31, 1998         6

ITEM 2.  Management's Discussion and Analysis of Financial
                Condition and Results of Operations                         7

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

ITEM 1.  Legal Proceedings                                                 13

ITEM 2.  Exhibits and Reports on Form 8-K                                  14

SIGNATURES                                                                 14

                                    2 of 14
<PAGE>
 
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,     July 31,
                                                                 1998          1998
                                                               ----------------------
                                                                           (UNAUDITED)
<S>                                                            <C>          <C>      
Cash and cash equivalents                                      $   1,433    $   2,382
Accounts receivable                                                4,737        4,925
Inventory                                                         12,449       15,901
Videocassette rental inventory - net                              94,452       94,813
Property and equipment - net                                      69,720       69,891
Prepaid expenses                                                   4,162        4,234
Income taxes receivable                                            2,430        1,885
Deferred income taxes                                              2,592        2,509
Goodwill - net                                                    80,664       79,752
Other assets                                                       5,792        5,702
                                                               ---------    ---------
         Total assets                                          $ 278,431    $ 281,994
                                                               =========    =========

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Notes payable                                                  $ 104,488    $ 106,426
Accounts payable                                                  39,045       47,615
Accrued expenses                                                  12,841       12,300
Accrued rent                                                       5,073        5,716
Accrued compensation                                               7,685        8,098


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 -- 29,278,518 at April 30,         293          293
      1998 and July 31, 1998
    Additional paid-in capital                                   117,641      117,641
    Retained deficit                                              (7,674)     (14,152)
    Foreign currency translation                                    (961)      (1,943)
                                                               ---------    ---------
         Total stockholders' equity                              109,299      101,839
                                                               ---------    ---------
          Total liabilities and stockholders' equity           $ 278,431    $ 281,994
                                                               =========    =========
</TABLE>

                             SEE ACCOMPANYING NOTES.

Note: The balance sheet at April 30, 1998 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 14
<PAGE>
 
                               VIDEO UPDATE, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (UNAUDITED)
                    (In thousands, except per share amounts)

                                       Three Months Ended July 31,
                                            1997        1998
                                          --------    --------
Revenues:
    Rental revenue                        $ 27,813    $ 55,297
    Service fees                               150         256
    Product sales                            2,843       6,140
                                          --------    --------
                                            30,806      61,693

Costs and expenses:
    Store operating expenses                25,399      54,933
    Selling, general and administrative      2,674       5,919
    Cost of product sales                    1,489       3,643
    Amortization of goodwill                   520         978
                                          --------    --------
                                            30,082      65,473
                                          --------    --------

Operating income (loss)                        724      (3,780)

Interest expense                              (507)     (2,852)
Other income                                   106         154
                                          --------    --------
                                              (401)     (2,698)
                                          --------    --------

Income (loss) before income taxes              323      (6,478)
Income tax expense                             213        --
                                          --------    --------
Net income (loss)                         $    110    $ (6,478)
                                          ========    ========

Net income (loss) per share, basic        $    .01    $  (0.22)
                                          ========    ========
Net income (loss) per share, diluted      $    .01    $  (0.22)
                                          ========    ========



                             SEE ACCOMPANYING NOTES.

                                    4 of 14
<PAGE>
 
                               VIDEO UPDATE, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)
                                 (In thousands)

                                                            Three Months Ended
                                                                 July 31,
                                                             1997        1998
                                                           --------    --------

OPERATING ACTIVITIES
    Net income (loss)                                      $    110    $ (6,478)
    Adjustments to reconcile net income (loss) to net
      cash provided by operating activities:
        Depreciation and amortization                         9,311      19,636
        Accrued rent                                            544         643
        Deferred income taxes                                   158        --
        Loss on disposal of property and equipment             --            46
        Changes in operating assets and liabilities, net
          of acquisitions of businesses:
            Accounts receivable                                 (63)       (188)
            Inventory                                        (1,604)     (3,452)
            Other assets                                       (863)       (273)
            Accounts payable                                  3,430       7,819
            Income taxes                                       (993)        539
            Other liabilities                                   891          42
                                                           --------    --------
Net cash provided by operating activities                    10,921      18,334

INVESTING ACTIVITIES
    Purchase of videocassette rental inventory              (12,775)    (15,688)
    Purchase of property and equipment                       (5,396)     (3,490)
    Investment in businesses, net of cash acquired              (57)       --
    Notes receivable from officers                              (60)       --
    Payments on notes receivable                                  2        --
                                                           --------    --------
Net cash used in investing activities                       (18,286)    (19,178)

FINANCING ACTIVITIES
    Proceeds from notes payable                              10,000       2,000
    Payments on notes payable                                (2,020)       (207)
                                                           --------    --------
Net cash provided by financing activities                     7,980       1,793
                                                           --------    --------

Increase in cash and cash equivalents                           615         949
Cash and cash equivalents at beginning of the period          2,424       1,433
                                                           --------    --------
Cash and cash equivalents at end of the period             $  3,039    $  2,382
                                                           ========    ========


                             SEE ACCOMPANYING NOTES.

                                    5 of 14
<PAGE>
 
                               VIDEO UPDATE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  JULY 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 three months ended July 31, 1998 are
not necessarily indicative of the results that may be expected for the nine
months ending January 31, 1999, (in June 1998, the Company's Board of Directors
approved a resolution changing the Company's fiscal year-end from April 30 to
January 31, effective January 31, 1999). 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, 1998.

     RECLASSIFICATION
     Certain prior year items have been reclassified to conform with the fiscal
1999 presentation.

2.   EARNINGS PER 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 filly 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.

     The following table is a reconciliation of the basic and diluted earnings
per share computation:

<TABLE>
<CAPTION>
                                                                         FISCAL YEAR ENDED JULY 31,
                                                                           --------------------
                                                                             1997        1998
                                                                           --------------------
                                                                          (In thousands, except
                                                                             per share amount)
<S>                                                                        <C>         <C>      
NUMERATOR:
----------
Net income (loss)                                                          $    110    $ (6,478)
                                                                           ========    ========

Numerator for basic and diluted earnings per share -
         income (loss) available to common stockholders                    $    110    $ (6,478)
                                                                           ========    ========

DENOMINATOR:
------------
Denominator for basic earnings per share -- weighted-average shares
    Class A common shares                                                    18,105      29,279
    Class B common shares                                                     2,000        --
    Less:  Class B common shares placed in escrow in connection with the
              initial public offering                                        (1,300)       --
                                                                           --------    --------
Denominator for basic earnings per share                                     18,805      29,279

Effect of dilutive securities:
    Contingent stock acquisition                                                177        --
                                                                           --------    --------
Dilutive potential common shares                                                177        --
                                                                           --------    --------
Denominator for diluted earnings per share--
         adjusted weighted-average shares and assumed conversions            18,982      29,279
                                                                           ========    ========

Basic net income (loss) per share                                          $    .01    $   (.22)
                                                                           ========    ========

Diluted net income (loss) per share                                        $    .01    $   (.22)
                                                                           ========    ========
</TABLE>

                                    6 of 14
<PAGE>
 
3.   COMPREHENSIVE INCOME

     As of May 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, Reporting Comprehensive Income (Statement 130). Statement 130
establishes new rules for the reporting and display of comprehensive income and
its components; however, the adoption of the Statement had no impact on the
Company's net income (loss) or stockholders' equity. Statement 130 requires
unrealized gains or losses on the Company's foreign currency translation
adjustments, which prior to adoption were reported separately in stockholders'
equity to be included in other comprehensive income. Prior years' financial
statements have been reclassified to conform to the requirements of Statement
130. During the first quarter of fiscal 1998 and 1999, total comprehensive
income (loss) amounted to $360,000 and $ (7,460,000), respectively.


4.   INCOME TAX EXPENSE

     At the end of the July 31, 1998 quarter, the Company estimated that its
effective tax rate for the year ended January 31, 1999 would be 0%. The Company
has therefore used this rate in providing for income taxes in the current
quarter. The Company will evaluate and estimate its effective tax rate at the
end of each interim period during fiscal 1999.


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 July 31, 1998 operated 681 Company-owned stores in 31
states and six provinces in Canada, and has 70 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.

     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.

Overall revenues, including same store sales, did not meet management
expectations for the first quarter of fiscal 1999, due in significant part to
certain factors, including: (i) Moovies locations not performing to management's
expectations for the quarter; (ii) the delay in closing the acquisition of
Moovies, which required significant management attention from July 1997, when
initial documents for the transaction were signed until March 1998, when the
transaction was closed; (iii) the revenues of new Company stores opened in
fiscal 1998 not meeting expectations, due primarily (management believes) to new
release titles during the period not generating consumer interest or retail
traffic at a time when the new store revenues have not yet reached a mature (two
years from opening) level of operations; and, (iv) the recent direct studio
revenue sharing arrangements obtained by some of the Company's largest
competitors, including the Blockbuster Entertainment division of Viacom, Inc.
Management is proceeding with immediate actions intended to enhance prospects
for revenue growth for fiscal 1999, including layout and marketing conversion of
the acquired Moovies locations to integrate them into the Company's operations
as quickly as possible, the closing of underperforming locations and the
aggressive pursuit of direct revenue sharing arrangements with major motion
picture studios, two of which have been obtained by August, 1998.

                                    7 of 14
<PAGE>
 
                                    THREE MONTHS ENDED JULY 31,
                                     ------------------------
                                       1997           1998
                                     ---------    -----------
                                         (In thousands)

     Rental revenue                  $  27,813     $  55,297
     Service fees                          150           256
     Product sales                       2,843         6,140
                                     ----------    ---------
                                     $  30,806     $  61,693
                                     ==========    =========

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.

                                     THREE MONTHS ENDED JULY 31,
                                     ---------------------------
                                         1997         1998
                                      -----------  -----------
Revenues:
    Rental revenue                         90.3%    89.6%
    Service fees                            0.5      0.4
    Product sales                           9.2     10.0
                                          -----    -----
Total revenues                            100.0    100.0

Costs and expenses:
    Store operating expenses               82.4     89.0
    Selling, general and administrative     8.7      9.6
    Cost of product sales                   4.8      5.9
    Amortization of goodwill                1.7      1.6
                                          -----    -----
Total cost and expenses                    97.6    106.1
                                          -----    -----
Operating income (loss)                     2.4     (6.1)

Other income (expense):
    Interest expense                       (1.6)    (4.6)
    Other income                            0.3      0.2
                                          -----    -----
Total other income (expense)               (1.3)    (4.4)
                                          -----    -----
Income (loss) before income taxes           1.1    (10.5)
Income tax expense                          0.7     --
                                          -----    -----
Net income (loss)                           0.4%   (10.5)%
                                          =====    =====


THREE MONTHS ENDED JULY 31, 1998 COMPARED TO THREE MONTHS ENDED JULY 31, 1997

     RENTAL REVENUE. Rental revenue was approximately $55,297,000 and
$27,813,000, or 89.6% and 90.3% of total revenues for the three months ended
July 31, 1998 and 1997, respectively. The increase in rental revenue of
$27,484,000 was derived primarily from 267 video stores acquired during fiscal
1998, from the opening of 53 Company-owned stores, net of closings, since the
first quarter of fiscal 1998, and from a 2% increase in same store revenues,
from the core base of Video Update superstores in the United States and Canada.

     SERVICE FEES. Service fees were approximately $256,000 and $150,000, or
0.4% and 0.5% of total revenues for the three months ended July 31, 1998 and
1997, respectively. Continuing service fees and royalties from franchisees
accounted about 89% of total service fees.

     PRODUCT SALES. Product sales were approximately $6,140,000 and $2,843,000,
or 10.0% and 9.2% of total revenues for the three months ended July 31, 1998 and
1997, respectively. The increase in product sales of $3,297,000 was primarily a
result of product sales by the video stores acquired during fiscal 1998, from
the opening of 53 Company-owned video stores, net of closings, since the first
quarter of fiscal 1998.

                                    8 of 14
<PAGE>
 
     STORE OPERATING EXPENSES. Store operating expenses consist primarily of
compensation and related expenses including regional management expenses,
occupancy expenses, and depreciation and amortization expenses. Operating
expenses were approximately $54,933,000 and $25,399,000, or 89.0% and 82.4% of
total revenues for the three months ended July 31, 1998 and 1997, respectively.
The increase in store operating expenses of $29,534,000 was primarily the result
of video stores acquired during fiscal 1998 and the opening of 53 Company-owned
video stores since the first quarter of fiscal 1998. The increase in store
operating expenses as a percentage of total revenues was primarily due to: (i)
revenues of the acquired Moovies stores and new stores not meeting management's
expectations; and, (ii) corresponding higher costs of new video stores prior to
revenue reaching maturity during the first two years of operations.

     Compensation and related expenses were approximately $13,753,000 and
$7,009,000, or 22.3% and 23.0% of total revenues for the three months ended July
31, 1998 and 1997, respectively. The increase of $6,744,000 was primarily due to
video stores acquired during fiscal 1998 and from the opening of 53
Company-owned video stores, net of closings, since the first quarter of fiscal
1999.

     Occupancy expenses were approximately $16,496,000 and $7,677,000, or 26.7%
and 27.5% of total revenues for the three months ended July 31, 1998 and 1997,
respectively. The increase of approximately $8,819,000 was primarily due to
video stores acquired during fiscal 1998 and from the opening of 53
Company-owned stores, net of closings, since the first quarter of fiscal 1998.

     Depreciation and amortization expenses were approximately $17,854,000 and
$8,481,000, or 29.0% and 27.4% of total revenues for the three months ended July
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 $9,373,000 was primarily attributable to the
addition of new release videocassette inventory for new, existing and acquired
stores. 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 $5,919,000 and $2,674,000, or 9.6% and 8.7% of total
revenues for the three months ended July 31, 1998 and 1997, respectively. The
increase of approximately $3,245,000 was primarily due to adding management
personnel and administrative staff to support the Company's growth and related
expenditures. The Company anticipates that the expense as a percentage of
revenue will 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 $3,643,000
and $1,489,000, or 5.9% and 4.8% of total revenues for the three months ended
July 31, 1998 and 1997. The cost of product sales as a percentage of total
product sales revenue was approximately 59.3% and 52.4% for fiscal 1998 and
1997, respectively. The increase 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
$978,000 and $520,000 or 1.6% and 1.7% of total revenues for the three months
ended July 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.

     INTEREST EXPENSE. Interest expense was approximately $2,852,000 and
$507,000, or 4.6% and 1.6% of total revenues for the three months ended July 31,
1998 and 1997, respectively. The increase of $2,345,000 was primarily
attributable to interest on increased borrowings under the Company's Senior
Facility (defined below).

     OTHER INCOME. Other income was approximately $153,000 and $106,000, or 0.2%
and 0.3% of total revenues for the three months ended July 31, 1998 and 1997.
The increase of $47,000 was primarily due to an increase in rebates from the
Company's primary video suppliers.

     INCOME TAXES. At the end of the July 31, 1998 quarter, the Company
estimated that its effective tax rate for the year ended January 31, 1999 would
be 0%. The Company has therefore used this rate in providing for income

                                    9 of 14
<PAGE>
 
taxes in the current quarter. The Company will evaluate and estimate its
effective tax rate at the end of each interim period during fiscal 1999.

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 and the
purchase of videocassette rental inventory, each of which varies based on market
conditions and expansion plans and conversion of the acquired Moovies stores.

     At July 31, 1998, the Company had cash and cash equivalents of
approximately $2,382,000. 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 three months ended July 31, 1998 net cash provided by operating
activities was approximately $18,334,000. Net cash used in investment activities
was approximately $19,178,000 consisting primarily of approximately $3,490,000
for new and remodeled stores, and conversion costs associated with acquired
stores, and approximately $15,688,000 for the purchase of videocassette
inventory for existing and new stores. Net cash generated from financing
activities was approximately $1,793,000 resulting primarily from proceeds under
the Company's Senior Facility.

     In March 1998 the Company completed the acquisition of Moovies, Inc. The
Company issued approximately 9.3 million shares of Class A common stock in
exchange for Moovies common stock. The transaction was 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 Moovies transaction, 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 replaced
the Company's previous line of credit. The Senior Facility consists of the
following: (i) two term loans totaling $95.0 million; (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
Company's previous 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. As of July 31, 1998, the Company had $6.5 million
outstanding under this facility. The revolving line is available for normal
working capital needs. As of July 31, 1998 the Company had $4.0 million
outstanding under this facility.

     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 5.66% per annum, respectively as of July 31, 1998) plus
an applicable margin rate that could range from .5% to 3.75%. Amounts currently
outstanding at July 31, 1998, had a weighted average rate of 9.29%.

     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, divestitures, 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-

                                    10 of 14
<PAGE>
 
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.

     As a result of its expected results for the first quarter of fiscal 1999,
the Company sought and obtained a waiver for the quarter ended July 31, 1998.
Additionally, the Company and the bank syndicate amended the terms of the Senior
Facility to, among other things: (i) revise certain financial covenants; (ii)
increase immediate availability under the Senior Facility by $5 million for
Company operating activities; (iii) increase the overall interest rate by .5%;
and, (iv) reprice warrants held by the bank syndicate to a more current market
price. No assurances can be given that future waivers or amendments will be
obtained if the Company is unable to maintain a level of operations necessary to
meet the covenants and requirements of the Senior Facility. If the Company is
unable to maintain such a level of operations, 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 thereunder, allowing
the lenders to take legal action against the Company, including but not limited
to, the immediate acceleration of payment of borrowed funds, which could
materially and adversely affect the Company's operations. The immediate
acceleration of debt thereunder or the lack of further borrowing capacity, in
whole or in part, would have a material adverse effect on the Company's
operations and financial condition.

     During fiscal 1999, the Company expects to focus on maximizing the
operating efficiencies of its existing and previously 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 has maintained a longstanding and satisfactory
relationship with its primary product vendors and has negotiated extended
payment terms with several of these vendors. The loss of its primary product
vendors could have a material adverse effect on the Company. Assuming the
Company is able to maintain a satisfactory relationship with its selected
vendors and its bank lenders, the Company expects that cash from operations,
trade credits, equipment leases, available revenue sharing arrangements, and
available borrowing under the Senior Facility will be sufficient to fund future
inventory purchases and other working capital needs for the next twelve months,
although no assurances can be given that the Company will not require additional
sources of financing as a result of store openings or build outs currently in
progress, disappointing operating results, unavailability under the Senior
Facility as a result of disappointing operating results, or unanticipated cash
needs or opportunities. Moreover, no assurances can be given that such
additional funds 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 current level of operations could be materially and
adversely affected.

     Each of Messrs. Potter and Bedard have issued notes to the Company (the
"Recourse Notes") in connection with stock option exercises, for approximately
$2,080,147 and $1,155,637, respectively, including accrued interest through
April 30, 1998. 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 the 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 evidenced by promissory notes bearing accrued
interest at a rate of 8% per annum (through April 30, 1998) with payment of
principal and interest due on October 4, 1999. 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 restated employment agreements for Mr. Potter and Mr.
Bedard, the Board has approved an accrual of bonuses that will be directed
primarily to satisfying obligations arising from the Recourse Notes. For fiscal
year 1998, bonus payments aggregating $816,580 were awarded as reimbursement of
previous payments of principal and interest on the recourse notes and
accompanying tax liability to the recipients. In addition, the Board has
approved the subsequent payment of additional aggregate bonuses of approximately
$6,345,000 to be used primarily to satisfy the Recourse Notes as well as the
anticipated income tax liabilities to these executives, subject to any required
approval of the Company's bank lenders. If such bonuses are not effected, the
Recourse Notes will remain outstanding.

     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

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<PAGE>
 
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, 1998.

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.

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<PAGE>
 
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 Sellers"). 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 Company initiated an action in federal
district court in Minnesota for a declaratory judgment that the Videoland
Sellers are not entitled to any deficiency payment. In January, 1998, the court
entered a judgment against Video Update in the amount of $1,220,000 plus
interest from October, 1996, and attorney's fees. Video Update is appealing the
matter. Although no assurances can be given as to the outcome of such action,
the Company intends to vigorously pursue the matter.

     In December, 1997, Valley Record Distributors assignee of Star Video, a
vendor of Moovies, Inc., filed a lawsuit in state court (Court of Common Please,
Greenville, South Carolina) against Moovies, Inc. claiming among other things
that Moovies, Inc. has failed to pay its invoices (approximately $2,900,000) for
product purchased. The parties have reached settlement terms on this matter
which the Company expects will resolve this matter without further litigation.

     In May, 1998, Rousnam Video, Inc., a Michigan corporation and Hani (Al)
Monsour (collectively "Monsour") filed a lawsuit in state court (Macomb County
Michigan) claiming amounts due pursuant to post-closing adjustments contemplated
in connection with an Asset Purchase Agreement among Monsour and Moovies, Inc.
dated as of March 14, 1997, and the alleged default on a Promissory Note among
Monsour and Moovies, Inc. in the amount of $2,000,000 which is currently
reflected in notes payable. The Company has filed an answer in the action, is
contemplating counterclaims and intends to defend the matter vigorously.

     In May, 1998, four stockholders filed suit in the US District Court for the
Central District of California. The Plaintiff stockholders allege that Mr.
Potter and the Company made false and misleading statements or omitted material
information about the Company and the video industry during the period April,
1995 to September, 1996, the date of its subsequent public offering. Plaintiffs
are seeking "at least the sum of $967,967," plus interest, additional damages
and attorneys' fees. The Company and Mr. Potter believe that the claims are
unsubstantiated, without merit and they intend to defend the matter vigorously.
A motion to dismiss the action has been filed.

     Also, in May, 1998, the Company filed suit in federal court in Delaware
against Rentrak corporation, an Oregon Corporation. In August 1998, the Delaware
court dismissed the action on forum grounds and the Company re-filed the action
in Oregon federal court where it is now pending. The Company alleges that its
revenue sharing agreement with Rentrak is in conflict with federal antitrust
law, given Rentrak's position in the market and its exercise of monopoly power.
The parties have not yet entered into discovery in the matter.

     In addition to the above, the Company is involved in various legal
proceedings arising during the normal course of conducting business. Management
believes that the resolution of these proceedings will not have any material
adverse impact on the Company's financial statements.

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<PAGE>
 
ITEM 2. 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.

               1.   Current Report on Form 8-K/A filed May 8, 1998, amending the
                    Company's Form 8-K on March 11, 1998 and containing the
                    following financial statements:

                    (a)  The audited financial statements for Moovies, Inc. for
                         the year ended December, 1996
                    (b)  The pro forma financial information for the Company for
                         the year ended April 30, 1997 and for the six months
                         ended October 31, 1997.

               2.   Current Reports on Form 8-K filed July 7, 1998 reporting the
                    Board of Directors approval of a change in the Company's
                    fiscal year from April 30 to January 31.





                                   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:  September 14, 1998:          By:  /s/Daniel A. Potter
                                        ----------------------------------------
                                              DANIEL A. POTTER,
                                              Chief Executive Officer and
                                              Chairman of the Board of Directors


Date:  September 14, 1998:          By:  /s/Stephen L. Reynolds
                                        ----------------------------------------
                                              STEPHEN L. REYNOLDS,
                                              Chief Financial Officer

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