Movie Gallery Q1 profit more than doubles; would consider Blockbuster deal

By Paul Deckelman

New York, May 11 - Movie Gallery Inc. did what the entertainment industry newspaper Variety might celebrate as "boffo biz" during the first quarter, blowing right through Wall Street's way-too-low estimates to post net earnings more than double those of a year ago, helped by the additional sales generated from its acquisition last year of former rival video rental chain operator Hollywood Entertainment Corp.

Executives of the Dothan, Ala.-based Number-Two home video rental chain in the United States also said on a conference call with analysts Thursday after the release of the numbers that they would be open to a possible combination with the industry's top player, Dallas-based Blockbuster Inc. - and that such a union might not necessarily run afoul of federal antitrust restrictions, given recent changes in the industry that have empowered other competitors.

They further said that the company has adequate cash and borrowing power to meet its obligations this year, though it is also looking to make changes in its capital structure in preparation for next year when more stringent credit facility financial covenants - temporarily relaxed by its lenders for the remainder of this year - go back into effect.

And they said that they expect that some of the small group of the company's vendors who tightened the terms on which they were willing to do business when Movie Gallery was going through a rough period earlier this year will now be encouraged by the stellar first-quarter numbers to go back to previous easier terms.

Movie Gallery reported net income for the 2006 fiscal first quarter ended April 2 of $40.347 million ($1.27 per share) on revenues of $694.365 million - well up from year-earlier earnings of

$18.393 million (59 cents per share basic, 58 cents per diluted share) in the year-earlier quarter, on revenues of $233.791 million.

Adjusted EBITDA in the latest quarter was $116.8 million; on a pro-forma basis, combining Movie Gallery's results with those of Hollywood Entertainment prior to its acquisition by Movie Gallery, a transaction which was completed on April 27, 2005, consolidated adjusted EBITDA for the fiscal first quarter ended April 3, 2005 would have been $108.6 million.

Same-store revenue off 6.5%

Although the results were clearly skewed upward by the Hollywood acquisition, the gaudy numbers couldn't fully hide the recent deterioration in the company's business due to problems in the home-video industry. Same-store total revenues for instance - comparing sales at stores which have been open at least a year, a key measure of performance in the retailing industry - fell by 6.5% from a year ago, as "the rental business continued to be challenged by a number of factors, including a soft home-video release schedule" by the major movie studios, the company's interim chief financial officer, Mark D. Moreland, declared on the conference call.

Even so, the numbers wowed the financial community, where the analysts had on average been expecting earnings of no more than about 15 cents per share and revenues of about $644 million.

Bond investors took Movie Gallery's 11% notes due 2012 as high as 73.5 bid in morning trading, well up from their Wednesday closing levels around 62, and the bonds came off those highs to settle in around 72 bid, still well up on the session. Those bonds, as well as the company's bank debt, had been moving up solidly over the past several sessions, in anticipation that the company would post excellent numbers.

The term loan moved up on Thursday to around 96.5 bid, 97.5 offered, a gain of more than two points on the day.

On the equity side of the ledger, meantime, the company's Nasdaq-traded shares soared $1.62 (51.27%) to $4.78 - and at one point were as high as $5.35, up more than two dollars from Wednesday's finish - on heavy volume of 39 million shares, nearly 16 times busier than usual.

Moreland said that Movie Gallery ended the quarter with a cash position of $34.5 million, and with $48.8 million of borrowing availability under its credit facility.

He noted a $101 million decline in the company's cash position from the previous quarter, which he attributed to a number of factors, including a seasonal reduction in accounts payable and the payment of a total of $66 million related to the credit facility, consisting of a cash-flow payment, principal amortization, and repayment of outstanding revolving credit loan balances.

He said that about one-third of the roughly $80 million of additional cash drawdown that the company saw, versus its usual $20 million to $25 million of cash spending, was attributable to restrictions that a few of Movie Gallery's smaller vendors placed on extending the company credit - a development which he said was "no surprise, given the amount of negative press the company received during the quarter." With the crisis apparently past, the CFO said, "we expect that with results like these [reported Thursday], we will regain that lost credit."

Working on capital structure

Moreland further noted that, as the company had previously outlined in its last conference call back in March and in its 10-K annual report for the 2005 fiscal year that Movie Gallery filed with the Securities and Exchange Commission, the temporarily relaxed credit facility covenants the company got when its lenders agreed to amend the facility in March, are slated to snap back to more stringent levels in the 2007 first quarter, and the company is thus "actively pursuing modifications to our capital structure" in order to meet the covenant requirements.

He said Movie Gallery "remain[s] confident in our ability to execute projects toward the capital restructuring, and/or obtain further amendments to the credit facility." He noted, however, that in accordance with accounting standards the company is required to reclassify its long-term credit facility debt to the status of a current liability, since its compliance with the more stringent covenant standards that take effect next year "is not certain."

That having been said, though, the CFO - while not giving any ironclad assurances - declared that cash available from operations, borrowings available under its revolver and potential sales of non-core assets "will be sufficient to fund the company's cash needs," including working capital, capital expenditures and debt service, through the end of this year.

No commitment on rights idea

During the question-and-answer portion of the conference call following the official company presentation, an analyst asked about the company's reaction to a large shareholder's suggestion in an SEC filing last month that Movie Gallery could raise funds from existing shareholders via a rights offering - and then use the proceeds to reduce debt or for general corporate purposes. Its head of investor relations, Thomas D. Johnson, Jr., said that "we're always very receptive to any suggestions that our shareholders, or bondholders, or lenders, for that matter, may have regarding our capital structure and things that we should or should not be doing," but was otherwise non-committal.

Schultze Asset Management LLC, a Purchase, N.Y.-based investment company holding 8.6% of the company's shares, said in the April 21 13-D filing that it planned to contact management to propose "a number" of possible shareholder value-enhancing steps, including - but not limited to - the shareholder rights offering idea.

Rentals will remain 'significant'

Movie Gallery's chairman, president and chief executive officer, Joe Malugen, said on the call that "we continue to believe that the home-video industry will remain a significant business for many years to come," despite the difficulties which the industry in general - and Movie Gallery in particular - has suffered recently at the hands of such rivals as conventional movie theaters, pay-per-view options offered by cable television and satellite broadcast operators, the new Movie Beam service spun off by entertainment giant Disney and such internet-based upstart competitors as Netflix Inc. and even traditional brick-and-mortar rival Blockbuster's own new on-line service.

Alluding to such rivals, the Movie Gallery CEO asserted that "while some other entertainment options have grown in their usage, home-video rentals remain the most popular form of movie transactions by a wide majority."

Mulagen said that Movie Gallery was continuing to make progress on its year-long effort to integrate the Hollywood Video operations that it bought a year ago into its own, including the closure of some redundant stores in areas where both companies operated when they were competing separate entities - the stores picked for such elimination are chiefly the smaller Movie Gallery-branded outlets - as well as the consolidation of some back-office functions. When it bought Portland, Ore.-based Hollywood last year, Movie Gallery said that it expected to cash in on at least $50 million of synergies between the two companies, and Mulagen said that it was "on track" to doing so, having reaped about $20 million of synergies last year and expecting another $30 million this year.

Blockbuster merger makes 'sense'

Could further efficiencies and synergies be realized by partnerships or even merger combinations with other video rental operators - particularly with its bigger rival, Blockbuster?

Mulagan said that "everybody has speculated [about such a combination]. It certainly makes a lot of sense, if you were to put the two companies together. We would be receptive to something of that magnitude, and we're going to do whatever makes sense to create the most value for our shareholders."

When another analyst asked whether such a combination might violate antitrust statues, by giving a combined entity control of too much of the video-rental market, Mulagen answered that "the question for the government would have to do with how you define the market."

With the rise of Netflix and other alternative movie-delivery methods, "I think that there would be a much better argument today that this market is a little broader than how the market was viewed a year and a half ago," when Hollywood, seeking refuge from Blockbuster's takeover efforts, agreed to combine with Movie Gallery. "How that would be interpreted would be a critical element."

Malugen said that the first quarter "start[ed] off slowly, and experienced steady improvement in the back half of the quarter, reflecting stronger new-release titles such as "Saw II," "Walk The Line," "Harry Potter and The Goblet of Fire," "Chicken Little" and "King Kong." He said that while that momentum initially carried over into the start of the current second quarter, it has since "tapered off," with a weaker slate of new releases from the studios over the past few weeks. However, he said, the second half of the quarter should be stronger, with the coming release of such titles as "Cheaper By The Dozen II" around the Memorial Day holiday and, in June, "The Pink Panther," "8 Below" and "Failure To Launch."

He said that those titles each did "around $85 million or so at the [theater] box office, give or take," adding that movies grossing in that $60 million to $90 million range usually "do very well in release for us."

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