Movie Gallery swings to loss, says cash and liquidity sufficient to meet needs

By Paul Deckelman

New York, March 23 - Movie Gallery Inc. on Thursday swung to quarterly and full-year losses following what its chief financial officer called a "challenging" year for the Dothan, Ala.-based Number-Two U.S. video sales and rental chain operator and for the home video industry in general.

He blamed the troubles in part to a weak slate of new big-name movies and the growth of alternative delivery channels, such as on-line movie services, which cut into the traditional rental stores' revenues over the past several years.

But CFO Timothy R. Price, chairman and chief executive officer Joe T. Malugen and senior vice president Thomas D. Johnson Jr. told analysts on a conference call following the release of the earnings data that the company - which is continuing to integrate last year's big purchase of larger rival Hollywood Entertainment Inc. - was trying to turn things around by recently obtaining easier terms on key financial performance covenants in its credit facility, as well as by measures such as reducing salaried and administrative headcount, closing redundant stores and exploring the sale of non-core assets.

Mulagen said that even with the growth of alternative means of getting movies to customers - such as the popular Netflix on-line service, or the on-line service started by Movie Gallery's main brick-and-mortar competitor, Number-One U.S. video-rental chain Blockbuster Inc. - traditional in-store sales and rentals "remain the most popular form of movie transactions, by a wide majority."

He also said that the home video industry "continues to serve an important role for the movie studios," and is "a significant component of the studios' revenue and profit stream." Recent meetings with movie studio heads have convinced Mulagen that - even in the face of his company's well publicized problems, which caused its bonds and shares to recently slide precipitously - "they are very interested in the rental industry, they are very interested in the success of Movie Gallery and Hollywood Entertainment.

"It is critical to their success, and they recognize that, and I believe that they are going to do everything they can to make us a successful and very financially viable business."

Hit movies coming

Help could be on the way soon from Hollywood - the studios - to Hollywood - the rental chain, as well as to the company's eponymous and so-far separate Movie Gallery chain, as well as to Blockbuster and other home video competitors - Mulagen said, with the coming release on DVD of such popular theatrical movies from last year as Oscar nominee "Walk The Line," "Harry Potter and the Goblet of Fire," "King Kong," "Chicken Little," "The Chronicles of Narnia" and "Fun With Dick and Jane."

Enough cash, liquidity for 2006

Meanwhile, with Movie Gallery having successfully recently negotiated some breathing room on its bank credit covenants, Price said that the cash flow available from operations and availability under the $75 million revolving credit component of its senior credit facility "will be sufficient to operate the business, satisfy our working capital and capex requirements, and meet our foreseeable liquidity requirements, including debt service, throughout 2006."

Movie Gallery ended the 2005 fiscal fourth quarter and full fiscal year on Jan. 1 of this year with $135.238 million of cash on hand and $41.9 million of revolver availability.

Its long-term obligations, including the current portion, stood at $1.161 billion as of Jan. 1. The company had shown no long-term debt on its balance sheet a year earlier.

At that time, it was in the midst of the acquiring Portland, Ore.-based Hollywood Entertainment, which at the time was the second-largest national video sales and rental chain behind Blockbuster. That acquisition by Movie Gallery, for $850 million in cash plus the assumption of about $350 million of existing Hollywood debt, was completed last April 27. As part of the merger transaction, Hollywood successfully tendered for virtually all $225 million of its then-outstanding 9 5/8% senior subordinated notes due 2011 in a transaction that closed concurrently with its acquisition by Movie Gallery.

To finance the deal, Movie Gallery lined up an $870 million bank financing package from a lending syndicate led by Wachovia and Merrill Lynch and sold $325 million of new 11% senior unsecured notes due 2012. The financing was completed in late April, in time for the completion of the Hollywood acquisition.

The bank debt portion of the financing consisted of a $95 million five-year term loan A carrying an initial interest rate 275 basis points above Libor, a $700 million six-year term loan B at an initial interest rate of Libor plus 300 bps, and a $75 million five-year revolver at an initial rate of Libor plus 275 bps.

Eased terms in September

There things stood until Sept. 21, when Movie Gallery executed its first credit facility amendment, which relaxed certain financial covenants for a one-year period, provided for an additional $50 million of borrowings under the term loan B and increased the letter of credit sub-limit under the revolver to $40 million from $30 million.

The company received four quarters of relief on its leverage, fixed-charge coverage and interest coverage covenants. Under the amended loan terms, its allowable leverage ratio was increased to 4x, the fixed-charge coverage ratio was changed to 1.05x instead of 1.10x, and the interest coverage ratio was changed to 2.75x instead of 3.0x, all for the time period through and including this year's second quarter.

In return, the lenders got increased pricing on all three loan tranches and improved excess cash flow sweep, as well as a 25 basis point amendment fee.

Pricing on the largest tranche, the term B, rose to Libor plus 375 basis points from Libor plus 300 bps originally, and the $50 million term loan B add-on was priced there as well. One year of call protection at 101 against refinancings related to a repricing was also added to the term B.

Pricing was also increased on the other two loan tranches, with the top tier on the pricing grid - in effect when leverage is more than 3.25x - increased to 350 bps over Libor on both from Libor plus 275 bps originally.

Following the first amendment, the credit facility increased to a total of $913.4 million - $90.3 million for the term A, $748.1 million for the term B, and $75 million for the revolver.

Weak Q2, Q3 movies hurt

Even with the easier, amended covenant terms, the company continued to struggle during the 2005 fourth quarter, and on into the current 2006 first quarter.

Mulagen noted on the conference call that although the fourth quarter "included some of the year's biggest titles" which had been resoundingly popular in their theatrical releases earlier in the year - hit films such as "Batman Begins," "Star Wars Episode 3," "War of the Worlds," and "The Fantastic Four" - "the strength of the title slate was more than offset by the carryover of negative momentum caused by the lack of successful movies released in the second and third quarters of 2005."

Company equity and debt investors were further jolted in mid-February by news of the national relaunch of MovieBeam - a home video-on-demand service which entertainment giant Walt Disney Co. had been testing in selected markets since late 2003. MovieBeam was spun off by Disney some time ago and now operates as an independent company - but its former parent is still helping out, breaking with long-time industry practice to allow movies to be shown to home VOD viewers the same day they are released on DVD. Up until now, cable, satellite and other home-TV on-demand services have not been able to offer hot new releases until they have been in movie stores - like Movie Gallery/Hollywood or Blockbuster - for weeks or even months.

The news sent Movie Gallery's already shaky bonds and shares into a prolonged tailspin - from which they have yet to recover - and also took a toll on its bank debt, although downside movement was more restrained in that considerably more conservative market.

The plunge only halted earlier this month, when word got around that Movie Gallery was once again asking its lenders for easier terms. It securities rose solidly on the expectations that the lenders would go along - but then dropped back from those recent peaks once the new terms became a reality, in line with the familiar adage "buy [on] the rumor, sell on the news."

The company came to an agreement with the lenders, completing the process on March 15. Under the terms of the second amendment, its allowable leverage ratio of debt versus earnings was increased from 4x previously to 5x for the 2006 first quarter, to 5.75x for the second quarter, to 6.75x for the third quarter and to 6.5x for the fourth quarter. However, this reverts to a drastically lower 2.25x for next year's first quarter and drops further still to 2x in next year's fourth quarter.

The fixed-charge coverage ratio, at 1.05x before the amendment, stays there through this year's second quarter, then drops to 1x for the third and fourth quarter, and rises back to 1.10x in next year's first quarter and beyond.

The interest coverage ratio test, which was 2.75x before the latest amendment, falls to 2x for this year's first quarter, 1.75x for the second quarter and 1.45x for the third and fourth quarters. It shoots back up to 3x in the 2007 first quarter and beyond.

In return for those covenant breaks, Movie Gallery agreed to stiffer pricing terms. For the period starting from April 1 until the 2006 first-quarter financial results are delivered, the interest rate on the term loan A and revolver tranches - currently Libor plus 350 basis points - jumps to 500 bps, and the rate on the term loan B tranche escalates to 525 bps from 375 bps presently.

After the quarterly results are submitted, pricing for the three tranches will depend on the leverage ratio of debt versus earnings that company maintains. The term loan A and revolver tranches will continue to carry a rate of 500 bps should leverage be over 4x, a rate of 350 bps over Libor for leverage of 3.25x to 4x, a rate of 275 bps over Libor for leverage of 2.75x to 3.25x, a rate of 250 bps over Libor for leverage of 2.25x to 2.75x, a rate of Libor plus 225 bps for leverage of 1.75x to 2.25x, and a rate of Libor plus 200 bps for a leverage ratio of below 1.75x.

The larger term loan B tranche's pricing, after the results, is considerably simpler; it will maintain a rate of Libor plus 525 bps if leverage exceeds four times, otherwise, the rate will revert back to the present Libor plus 375 bps.

Lenders were also paid a 50 bps amendment fee and the company accepted more restrictive operating covenants regarding the company's ability to incur new debt, pay dividends, redeem its capital stock, make capital expenditures and make acquisitions. Certain mandatory prepayment provisions were also modified.

Looking to cut stores

Having gotten temporarily easier terms from its lenders for the second time within six months, Movie Gallery intends to move actively to try to turn things around.

On strategy is real estate optimization. At year-end, the company had 2,675 of its own branded Movie Gallery stores and 2,074 Hollywood Video outlets it had acquired. With Movie Gallery locations primarily in smaller markets and rural areas, there was not much overlap with Hollywood, which is largely centered in larger markets. Still, it managed to close 64 Movie Gallery stores last year that were near more profitable Hollywood locations, and said that it will continue to look for such opportunities for store consolidation.

Malugen noted that the average Hollywood store is about 6,600 square feet, and the average Movie Gallery is about 4,200 square feet. The company recently unveiled plans to plans to sublease space in about half of its stores to other tenants as a means of making more efficient use of its space, boosting revenues and walk-in traffic. Other stores will simply be downsized, period, with the space handed back to the landlord and the lease costs reduced accordingly. Malugen estimated that if total consolidated lease expenses in the $500 million area could be reduced "by, say, 20% to 30% - well you do the math."

Reducing openings, staff

The company will also cut its capital spending to $35 million from $58 million last year, by throttling back the number of new stores that it plans to open. Only 140 are slated for this year - and they had already been in the new-store pipeline for some time.

Hoping to maximize free cash flow, Movie Gallery will further curtail its store openings over the next few years.

It is also continuing to reduce salaried and administrative positions to reach its goal of reducing the number of such jobs at the combined company by 300, or 17% of the level at the time of the Hollywood merger, by the end of the year. It said in October it would cut 100 positions over the next 12 months on top of 80 jobs it had previously cut.

However, one economy measure not immediately in the cards is the combination of Movie Gallery's Alabama headquarters and Hollywood's Oregon base into one central location, since their respective accounting systems and information technology networks are not yet integrated.

"Until we get that accomplished," Malugen said, "it would be impossible to operate out of one office. These things do take some time."

He also said the field organizations of the two divisions - the structure of regional management each company had - will also remain separate for the moment. "We have not seen any real benefit in trying to consolidate," he declared.

For the quarter ended Jan. 1, Movie Gallery reported a net loss of $546.5 million ($17.25 per share) versus a prior-year profit of $11.4 million (36 cents per share). However, the company's revenue rose to $676.4 million from $208.4 million in the year-earlier period, reflecting the 35 weeks of 2005 in which Hollywood's revenues were added in.

CFO Price was asked by an analyst whether Movie Gallery's suppliers - particularly the studios it gets its films from - have toughened payment terms of late as the company has struggled.

"Everybody reads the newspaper," he replied, "and they see that there's a lot of volatility in the industry right now."

He said that Movie Gallery has had some discussions with "a handful of vendors and there's been a little bit of tightening," but said that was already "reflected in our projections, and inclusive of that we can still state that we're confident that from a liquidity and a cash-flow standpoint, we're good to go in '06."

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