ITEM 1. BUSINESS.
General
Hastings Entertainment, Inc. (the “Company”) is a leading multimedia entertainment retailer. We operate entertainment stores that buy, sell, trade, and rent various home entertainment products, including books, music, software, periodicals, new and used CDs, DVDs, books, video games and videocassettes, video game consoles and DVD players. As of March 31, 2006, we operated 153 stores in small- to medium-sized markets located in 20 states, primarily in the Western and Midwestern United States. We also operate a multimedia entertainment e-commerce Web site offering a broad selection of books, music, software, videocassettes, video games and DVDs. We operate two wholly-owned subsidiaries: Hastings Properties, Inc. and Hastings Internet, Inc. References herein to fiscal years are to the twelve-month periods, which end in January of each following calendar year. For example, the twelve-month period ended January 31, 2006 is referred to as fiscal 2005.
Industry Overviews
Music. According to the Recording Industry Association of America (“RIAA”), total CD shipments by manufacturers to retailers decreased 8.1% to $10.5 billion in 2005 compared to $11.4 billion in 2004. This decrease is primarily attributable to an increase in digital downloads. Including digital downloads, the retail value of physical and digital formats decreased slightly from $12.34 billion in 2004 to $12.27 billion in 2005, or 0.6%. The music industry has continually tried to battle online piracy, a force that has sparked the negative trend in years prior to 2005.
Books. The Association of American Publishers estimates that total book industry sales rose 9.9% in 2005, to an estimated $25.1 billion, up from approximately $22.8 billion in 2004. The adult hardcover segment increased 1.4% to $2.2 billion and adult paperbound publications increased 9.5% to $1.1 billion. Building upon these gains were strong increases in the juvenile hardcover segment of 59.6% to $3.6 billion, due to a popular Harry Potter release in fiscal 2005, but not in 2004.
Rental Video. According to estimates from Paul Kagan Associates (“Kagan”), consumer spending on rental video, including in-store and online rentals, remained stable at $8.1 billion for both 2005 and 2004. Kagan projects that video rental revenues will decline from $8.1 billion in 2005 to approximately $6.7 billion by 2010; however, due to many variables, it is difficult to project the fluctuations in the industry. We believe rental video will remain a viable revenue source for the following reasons:
(i)
Despite increases in the sale of movies detailed below under “Sale Video and Video Games,” according to Kagan, rental transactions continued to exceed sales transactions during 2005. For the industry, rental transactions represented approximately 64.4% of total rental and sell-through transactions during 2005 compared to approximately 69.6% in 2004. We believe renting videos provides consumers with low-cost entertainment, a factor that will continue to drive rental transactions in the future.
(ii)
DVD continued its accelerated acceptance rate with DVD households as a percentage of U.S. television households approximating 75% in 2005 compared to approximately 65% in 2004. Kagan projects that this number will increase to approximately 84% in 2006 and exceed 94% by 2010. This penetration is moving far beyond consumers that were early adopters of the DVD format, and with price points on DVD hardware continuing to decline, we believe more consumers will be renting classic movies and personal favorites in the DVD format for the first time. We also believe that later-adopting DVD households are less likely to purchase DVDs at the high rates of early-adopters.
(iii)
We believe that the DVD format, with its superior picture and sound quality compared to previous movie formats, as well as extra features such as outtakes, director commentary and scene selection, will drive continued growth in the industry.
(iv)
We believe rental video will continue to be a favored entertainment medium for millions of consumers due to its relatively inexpensive price points, broad selection of new release and catalog (older) movies and ability for “viewer control” of the experience (i.e., start, stop, scene selection, and audio setup).
(v)
We believe video game rentals will continue to play an important role in the rental industry. Due to the relatively high purchase prices for game software, rental pricing is an attractive option for consumers, especially those wanting to preview a game prior to making a purchase.
Sale Video and Video Games. According to Kagan, total industry revenues for the sale of DVD and VHS increased approximately 15.4% to $18.7 billion during 2005 compared to $16.2 billion in 2004. This increase resulted primarily from substantially all DVD products being released at prices low enough that consumers could purchase a title at the same time it becomes available for rent. This lower pricing has enabled consumers to build their video libraries and has helped turn casual movie watchers into collectors.
According to the NPD Group, total sales for the video game industry, including portable and console hardware, software and accessories, increased 6% to $10.5 billion in 2005 compared to $9.9 billion in 2004. In 2005, portable game hardware, software, and accessories experienced strong gains of 96%, 42%, and 88%, respectively, and were primarily attributable to Nintendo’s Game Boy Advance, which accounted for 52% of portable software sales. These gains were partially offset by declining sales of console hardware, software, and accessories of 3%, 12%, and 8%, respectively, due primarily to a widely-publicized hardware inventory shortage during the 2005 holiday season.
Business Strategy
Our goal is to enhance our position as a leading multimedia entertainment retailer primarily in small- to medium-sized communities by expanding and remodeling existing stores, opening new stores in selected markets and to a lesser extent, offering our products through the Internet. Each element of our business strategy is designed to build consumer awareness of the Hastings concept and achieve high levels of customer loyalty and repeat business. We believe the key elements of this strategy are the following:
Superior Multimedia Concept. Our stores present a wide variety of product categories with individual products tailored to local preferences in a dynamic and comfortable store atmosphere with exceptional service. Our diverse product categories allow us to more effectively respond to downturns in individual industries. Our stores average approximately 20,000 square feet of sales space, with our new stores generally ranging in size from 15,000 to 25,000 square feet of sales space. Our stores offer customers an extensive product assortment customized for a specific store. Below is a listing of the approximate minimum and maximum title selections for our stores:
The following table shows our revenue mix as a percentage of total revenues for the last three fiscal years:
All stores carry a core product assortment for each product category that is supplemented with tailored components to accommodate the particular demographic profile of the local market in which the store operates through the utilization of our proprietary purchasing and inventory management systems. We believe that our multimedia format reduces our reliance on and exposure to any particular entertainment segment and enables us to efficiently add exciting new entertainment categories to our product line.
Small to Medium-Sized Market Focus. We target small- to medium-sized markets with populations generally less than 50,000 where our extensive product selection in both new and used products, low pricing strategy, ability to trade-in, efficient operations and superior customer service enable us to become the market’s destination entertainment store. We believe that the small- to medium-sized markets where we operate the majority of our stores present an opportunity to profitably operate and expand our unique entertainment store format. We base our merchandising strategy for our stores on an in-depth understanding of our customers and our individual markets. We strive to optimize each store’s merchandise selection by using our proprietary information systems to analyze the sales history, anticipated demand and demographics of each store’s market. In addition, we utilize flexible layouts that enable each store to present our products according to local interests and to customize the layout in response to new customer preferences and product lines.
Customer-Oriented Format. We design our stores to provide an easy-to-shop, open store atmosphere by offering major product categories in a “store-within-a-store” format. Most of our stores position product with customer affinities together around a wide racetrack aisle or three-across departments (e.g., books, music and video) that are designed to allow customers to view the entire store. Currently 80 stores utilize some form of the three-across format and the Company plans to expand this model to an additional 10 stores in fiscal 2006. This store configuration produces significant cross-marketing opportunities among the various entertainment departments, which we believe results in higher transaction volumes and impulse purchases. To encourage browsing and the perception of Hastings as a community gathering place, we have continued to invest in our line of Hard Back Cafes. At January 31, 2006, we had 60 Hard Back Cafes serving fine gourmet coffee and pastries, many of which allow the customer to place drive-thru orders, and have plans for an additional nine stores to open Hard Back Cafes in Fiscal 2006. Stores without Hard Back Cafes have incorporated other amenities, such as chairs for reading, soft drinks and snacks, music auditioning stations, interactive information kiosks, telephones for free local calls, children’s play areas and in-store promotional events.
Low Pricing. Our pricing strategy is to offer value to our customers by maintaining low prices that are competitive with or lower than the prices charged by other retailers in the market. We determine our prices on a market-by-market basis, depending on the level of competition and other market-specific considerations. We believe that our low pricing structure results in part from (i) our ability to purchase a majority of our products directly from publishers, studios and manufacturers as opposed to purchasing from distributors, (ii) our proprietary information systems, to which we have made improvements that have enabled management to make more precise and targeted purchases and pricing for each store, and (iii) our consistent focus on maintaining low occupancy and operating costs.
Used and Budget-Priced Products. Since 1992, we have bought or traded for customers’ CDs to sell as used product in order to leverage the value of our CD offering. Since 2001, we have added DVDs and video games to our used product offering. In addition to used products, we offer budget-priced products in all of our major product categories to provide enhanced value to our customers. During fiscal 2005 and 2004, we generated approximately 9.4% and 8.3%, respectively, of our total revenues from used and budget-priced products. During fiscal 2005, we tested buying and selling used books in 14 stores. Due to the program’s initial success, we plan to expand the program to an additional 23 stores in fiscal 2006. We believe our multimedia store concept will enhance our offering of used and budget products allowing the customer to choose between a new or a less expensive used copy of the same title.
Internet. Augmenting our store offering, we operate an e-commerce Internet Web site (www.gohastings.com). Our site enables customers to electronically access more than 1,000,000 new and used entertainment products and unique, contemporary gifts. Additionally, we fill Internet orders for used products placed at www.gohastings.com and Amazon Marketplace through Hastings’ iShip program in which 23 stores participate and ship product directly from store inventories. We plan to expand this program to an additional 20 stores in fiscal 2006. Our site features exceptional product and pricing offers, search and auditioning capabilities, and digital downloading of music selections. The Web site is designed to fully integrate into a store kiosk to leverage both the physical and digital shopping experience. The site also features an Investor Relations section with links to past press release information and filings with the Securities and Exchange Commission, including officer certifications of financial information listed as exhibits to such filings.
Expansion Strategy
We plan to open two stores, expand or relocate 12 stores, and remodel 23 stores to accommodate our used book initiatives during fiscal 2006. We have identified potential locations for future stores in under-served, small- to medium-sized markets that meet our new-market criteria. We believe that with our current information systems and distribution capabilities, our infrastructure can support our anticipated rate of expansion and growth for at least the next several years.
Merchandising Strategy
Hastings Entertainment is a leading entertainment retailer. Our core business categories of music, books, videos, video games, boutique, and consumables are unique in the marketplace. These core categories, supplemented by our video and video game rental business and the ability of our customers to buy, sell, and trade used products, create a store environment that appeals to a broad customer base and positions our stores as destination entertainment stores in our targeted small to medium-sized markets.
The specific merchandise mix within our core product categories is continually refined to reflect changing trends and new technologies. Product assortments are tailored to match the local demographic profiles with our customers’ needs at the community level kept in mind. This store level profiling is accomplished through our proprietary purchasing, inventory management, selection, and database management systems.
Information System
Our information system is based on technology that allows for communication and exchange of current information among all locations, corporate and retail, via a wide-area network. The primary components of the information system are as follows:
New Release Allocation. Our buyers use our proprietary new release allocation system to purchase new release products for the stores and have the ability within the system to utilize multiple methods of forecasting demand. By using store-specific sales history, factoring in specific market traits, applying sales curves for similar titles or groups of products and minimizing subjectivity and human emotion from a transaction, the system customizes purchases for each individual store to satisfy customer demand. The process provides the flexibility to allow us to anticipate customer needs, including tracking missed sales and factoring in regional influences. We believe that the new release allocation system enables us to increase revenues by having the optimum levels and selection of products available in each store at the appropriate time to satisfy customers’ entertainment needs.
Rental Asset Purchasing System. Our proprietary rental asset purchasing system uses store-specific performance on individual rental titles to anticipate customer demand for new release rental titles. The system analyzes the first eight weeks’ performance of a similar title and factors in the effect of such influences as seasonal trends, box office draw and prominence of the movie’s cast to customize an optimum inventory for each individual store. The system also allows for the customized purchasing of other catalog rental assets on an individual store basis, additional copy depth requirements under revenue-sharing agreements and timely sell-off of previously viewed tapes. We believe that our rental asset purchasing system allows us to efficiently plan and stock each store’s rental asset inventory, thereby improving performance and reducing exposure from excess inventory.
Store Replenishment. Store replenishment covers three main areas for controlling a store’s inventory.
Selection Management. Selection management constantly analyzes store-specific sales, traits and seasonal trends to determine title selection and inventory levels for each individual store. By forecasting annual sales of products and consolidating recommendations from store management, the system enables us to identify overstocked or understocked items, prompt required store actions and optimize inventory levels. The system tailors each store’s individual inventory to the market, utilizing over 1,200 product categories, configurations and product status.
Model Stock Calculation/Ordering. Model stock calculation uses store-specific sales, seasonal trends and sophisticated-sales curve fitting to forecast orders. It also accounts for turnaround time from a vendor or our distribution center and tracks historical missed sales to adjust orders to adequately fulfill sales potential. Orders are currently calculated on a weekly basis and transmitted by all stores to the corporate office to establish a source vendor for the product.
Inventory Management. Inventory management systems interface with other store systems and accommodate electronic receiving and returns to maintain perpetual inventory information. Cycle counting procedures allow us to perform all physical inventory functions, including the counting of each store’s inventory up to two times per year. The system provides feedback to assist in researching any variances.
Store Systems. Each store has a dedicated server within the store for processing information connected through a wide area network. This connectivity provides consolidation of individual transactions and allows store management and corporate office associates easy access to the information needed to make informed decisions. Transactions at the store are summarized and used to assist in staff scheduling, loss prevention and inventory control. All point of sale transactions utilize scanning technology, allowing for maximum customer efficiency at checkout. During fiscal 2004 we installed chain wide a new labor scheduler software system. The Windows-based software, among other things, requires less time of the store manager to maintain, provides improved measurement and reporting of budget to scheduled and actual labor, and creates review- and exception-based reports at the corporate office for management monitoring.
Accounting and Finance. Our financial accounting software allows us to prepare a variety of management reports covering store and corporate performance. Detailed financial information for each store, as well as for warehouse units, which include our distribution and returns facilities, and the corporate office, are generated on a monthly basis.
Warehouse Management. Our warehouse management system provides for increased product picking and shipping efficiencies, faster product introduction and movement from dock to store shipment. The increased level of detail reporting in our new system allows us to refine product movement within the four walls, effectively manage the cost per unit transactions, and increase on-hand accuracy. It has simplified data sharing across the enterprise, and includes event management, analysis and reporting capabilities.
Distribution and Vendors
Our distribution center is located in a 149,000 square foot facility adjacent to our corporate headquarters in Amarillo, Texas. This central location and the local labor pool enable us to realize relatively low transportation and labor costs. The distribution center is utilized primarily for receiving, storing and distributing approximately 21,000 products offered in substantially every store. The distribution center also is used in distributing large purchases, including forward buys, closeouts and other bulk purchases. In addition, the distribution facility is used to receive, process and ship items to be returned to manufacturers and distributors, as well as the rebalancing of merchandise inventories among our stores. This facility currently provides inventory to all Hastings stores and is designed to support our anticipated rate of expansion and growth for at least the next several years. We ship products weekly to each Hastings store, facilitating quick and responsive inventory replenishment. Approximately 23% of our total product, based on store receipts, is distributed through the distribution center. Approximately 77% of our total product is shipped directly from vendors to the stores.
Our information systems and corporate infrastructure facilitate our ability to purchase products directly from manufacturers, which contributes to our low-pricing structure. In fiscal 2005, we purchased the majority of our products directly from manufacturers, rather than through distributors. Our top three vendors accounted for approximately 19% of total products purchased during fiscal 2005. While selections from a particular artist or author generally are produced by a single studio or publisher, we strive to maintain vendor relationships that can provide alternate sources of supply. Products we purchase are generally returnable to the supplying vendor. Refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation - General” for a description of our returns process.
Store Operations
Most of our stores employ one store manager, one assistant store manager, and one book manager. Store managers and assistant store managers are responsible for the execution of all operational, merchandising and marketing strategies for the store in which they work. Stores also generally have department leaders, who are individually responsible for their respective music, software, video, customer service and stocking departments within each store. Hastings stores are generally open daily from 10:00 a.m. to 11:00 p.m. However, several stores are open 9:00 a.m. to 11:00 p.m. or 10:00 a.m. to 10:00 p.m. The only days our stores are closed are Thanksgiving and Christmas.
Competition
Hastings Entertainment competes, within our trading areas, with all mass and specialty music, book, video, and video game retailers. Additionally, Hastings Entertainment competes with video and video game rental stores and both Internet retail and rental businesses operating in our core product categories.
Trademarks and Servicemarks
We believe our trademarks and servicemarks, including the marks “Hastings Books Music Video;” “Hastings Your Entertainment Superstore;” “Hard Back Café” word mark only, word mark with design in color, and word mark with design in black and white; “Hastings Discover Your Entertainment” word mark with design in color and word mark in black and white have significant value and are important to our marketing efforts. We have registered “Hastings Books Music Video” and “Hastings Your Entertainment Superstore” as servicemarks with the United States Patent and Trademark Office (“USPTO”) and have filed applications for registration with the USPTO with respect to the marks “Hard Back Café” word mark only, word mark with design in color, and word mark with design in black and white; and “Hastings Discover Your Entertainment” word mark with design in color and word mark in black and white. We are currently claiming common law rights in the marks “Buy Sell Trade Rent,” “Hastings Hard Back Café,” and “Hastings Your Entertainment Superstore Hard Back Café.” We maintain a policy of pursuing registration of our principal marks and opposing any infringement of our marks.
Associates
We refer to our employees as associates because of the critical role they play in the success of each Hastings store and the Company as a whole. As of January 31, 2006, we employed approximately 6,344 associates, of which 1,940 are full-time and 4,404 are part-time associates. Of this number, approximately 5,833 were employed at retail stores, 245 were employed at our distribution center and 266 were employed at our corporate offices. None of our associates is represented by a labor union or subject to a collective bargaining agreement. We believe that our relations with our associates are good.
Executive Officers of the Company
Below is certain information about the executive officers of Hastings Entertainment, Inc.
All executive officers are chosen by the Board of Directors and serve at the Board’s discretion. Information concerning the business experience of our executive officers is as follows:
John H. Marmaduke, age 58, has served as President and Chief Executive Officer of the Company since July 1976 and as Chairman of the Board since October 1993. Mr. Marmaduke served as President of the Company’s former parent company, Western Merchandisers, Inc. (“Western”), from 1982 through June 1994, including the years 1991 through 1994 when Western was a division of Wal-Mart Stores, Inc. Mr. Marmaduke also serves on the board of directors of the Interactive Entertainment Merchants Association. Mr. Marmaduke has been active in the entertainment retailing industry with the Company and its predecessor company for over 30 years.
Michael Rigby, age 50, has served as Senior Vice President of Merchandising for the Company since December 7, 2005. Mr. Rigby most recently served for five years as Senior Vice President of Alliance Entertainment Corporation (AEC), the largest wholesale distributor of prerecorded music and movies in the nation. Previously, Mr. Rigby spent four years as President and CEO of Fresh Picks, Inc., a provider of retail music and movie category management services to the supermarket sector, as well as four years as Senior National Buyer with Circuit City Stores, Inc.
Dan Crow, age 59, has served as Vice President of Finance and Chief Financial Officer of the Company since October 2000. From July of 2000 to October 2000, Mr. Crow served as Vice President of Finance. Mr. Crow is a member of the American Institute of Certified Public Accountants and Financial Executives International.
Jeff Ostler, age 42, has served as Vice President of Stores for the Company since August 16, 2005. Mr. Ostler previously served as Division Vice President, Retail Operations of Dollar General Corporation and most recently as Vice President, Store Operations for Denninghouse, Inc., a Canadian corporation operating discount stores under the business name “Buck or Two.”
Alan Van Ongevalle, age 38, has served as Vice President of Information Technology and Distribution since February 2003. From August 2002 to February 2003, Mr. Van Ongevalle served as Vice President of Marketing and Distribution. From May 2000 to August 2002, Mr. Van Ongevalle served as Vice President of Marketing. From August 1999 to May 2000, Mr. Van Ongevalle served as the Senior Director of Marketing and as Director of Advertising from September 1998 to August 1999. Mr. Van Ongevalle joined Hastings in November 1992 and held various store operation management positions including Store Manager, Director of New Stores and the Southern Kansas area through September 1998.
Kevin Ball, age 49, has served as Vice President of Marketing of the Company since May of 2004. From 2001 to 2004, Mr. Ball served as Vice President of Marketing at Organized Living, a specialty retailer of home organization products, headquartered in Kansas City. From 2000 to 2001, Mr. Ball held the position of Vice President of Marketing at Crown Books in Washington, D.C. and from 1995 to 2000 was the Director of Marketing at Trans World Entertainment in Albany, N.Y.
Available Information
We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission. The public may read and copy any materials we file with the SEC at the SEC’s public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is (www.sec.gov).
The address of our Internet Web site is (www.gohastings.com) and through the links on the Investor Relations portion of our Web site, we make available free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other items filed with the SEC pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. Such material is made available through our Web site as soon as reasonably practicable after we electronically file with or furnish the material to the SEC. In addition, links to press releases, our board committee charters and our code of ethics for financial and other executive officers are posted in the Investor Relations section.
ITEM 1A.
ITEM 1A. RISK FACTORS.
CAUTIONARY STATEMENTS
The value of an investment in the Company involves significant risks and uncertainties. The following cautionary statements and other information included in this Annual Report on Form 10-K should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks occur, our business, financial condition, operating results and cash flows could be materially adversely affected.
Our growth is dependent on our ability to execute our expansion strategy.
Our growth strategy is dependent principally on our ability to open new stores and remodel, expand and/or relocate certain of our existing stores and operate them profitably. In general, the rate of our expansion depends, among other things, on general economic and business conditions affecting consumer confidence and spending, the availability of qualified management personnel and our ability to manage the operational aspects of our growth. It also depends upon the availability of adequate capital, which in turn depends in a large part upon the cash flow generated from operations.
Our future results will depend, among other things, on the success in implementing our expansion strategy. If stores are opened more slowly than expected, sales at new stores reach targeted levels more slowly than expected (or fail to reach targeted levels) or related overhead costs increase in excess of expected levels, our ability to successfully implement our expansion strategy would be adversely affected.
Our business is dependent upon renewing or entering into new leases on favorable terms.
All of the Company’s stores are located in leased premises. If the cost of leasing existing stores increases, the Company cannot assure that it will be able to maintain its existing store locations as leases expire. In addition, the Company may not be able to enter into new leases on favorable terms or at all, or it may not be able to locate suitable alternative sites or additional sites for new store expansion in a timely manner. The Company’s revenues and earnings may decline if the Company fails to maintain existing store locations, enter into new leases, locate alternative sites or find additional sites for new expansion.
Our business is highly seasonal.
As is the case with many retailers, a significant portion of our revenues, and an even greater portion of our operating profit, is generated in the fourth fiscal quarter, which includes the holiday selling season. As a result, a substantial portion of our annual earnings has been, and will continue to be, dependent on the results of this quarter. Less than satisfactory net sales for such period could have a material adverse effect on the Company’s financial condition or results of operations for the year and may not be sufficient to cover any losses that may have been incurred in the first three quarters of the year. We experience reduced rental activity in the spring because customers spend more time outdoors. Major world or sporting events, such as the Super Bowl, the Olympic Games or the World Series, also have a temporary adverse effect on revenues. Future operating results may be affected by many factors, including variations in the number and timing of store openings, the number and popularity of new book, music and video titles, the cost of the new release or “best renter” titles, changes in comparable-store revenues, competition, marketing programs, increases in the minimum wage, weather, special or unusual events, and other factors that may affect our operations.
Intense competition from traditional retail sources and the Internet may adversely affect our business.
We operate in highly competitive industries. For all of our product categories, we compete directly with national store operators, as well as regional chains and stores, specialty retailers dealing in our products, independent single store operators, discount stores, warehouse and mail order clubs, and mass merchandisers. In addition, the Internet is a significant channel for retailing for most of the product categories that we offer. In particular, the retailing of books, music and video over the Internet is highly competitive. In addition, we face competition from companies engaged in the business of selling books, music and movies and the renting of movies via electronic means, including the downloading of music content and in-home video delivery. An increase in competition in the physical or electronic markets in which we operate could have a material effect on our operations.
Our business is dependent on consumer spending patterns.
Revenues generated from the sale and rental of books, music, videos and other products we carry have historically been dependent upon discretionary consumer spending, which may be affected by general economic conditions, consumer confidence and other factors beyond our control. A decline in consumer spending on the buying and/or rental of the products we offer could have a material adverse effect on our financial condition and results of operations and our ability to fund our expansion strategy.
We rely on certain key personnel.
Management believes that the Company’s continued success will depend, to a significant extent, upon the efforts and abilities of Mr. John H. Marmaduke, Chairman, President and Chief Executive Officer. The loss of the services of Mr. Marmaduke could have a material adverse effect on our operations. We maintain a “key man” term life insurance policy on Mr. Marmaduke for $10 million. In addition, our success depends, in part, on our ability to retain key management and attract other personnel to satisfy our current and future needs. The inability to retain key management personnel or attract additional qualified personnel could have a material adverse effect on our operations.
Our business could be negatively impacted if the in-store video retailer distribution window is reduced or eliminated.
A competitive advantage that in-store video retailers currently enjoy over most other movie distribution channels, except theatrical release, is the early timing of the in-store video retailer “distribution window.” After the initial theatrical release of a movie, studios generally make their movies available to in-store video retailers (for rental and retail, including by mass merchant retailers) for specified periods of time. This distribution window is typically exclusive against most other forms of non-theatrical movie distribution, such as pay-per-view, video-on-demand, premium television, basic cable and network and syndicated television. The length of this exclusive distribution window for in-store video retailers varies, but has traditionally ranged from 45 to 60 days for domestic video stores. Thereafter, movies are made sequentially available to television distribution channels.
Our business could be negatively affected if (i) in-store video retailer distribution windows were no longer the first following the theatrical release; (ii) the length of the in-store video retailer distribution windows were shortened; or (iii) the in-store video retailer distribution windows were no longer as exclusive as they are now because newly released movies would be made available earlier on these other forms of non-theatrical movie distribution. As a result, consumers would no longer need to wait until after the in-store video retailer distribution window to view a newly released movie on these other distribution channels.
We believe that the studios have a significant interest in maintaining a viable in-store video retail industry. However, the order, length and exclusivity of each window for each distribution channel is determined solely by the studio releasing the movie, and we cannot predict future decisions by the studios, or the impact, if any, of those decisions. In addition, any consolidation or vertical integration of media companies to include both content providers and digital distributors could pose a risk to the continuation of the distribution window.
Our business is subject to changes in current rental video studio pricing policies.
Recent studio pricing for movies released to in-store video retailers has impacted our video business. Historically, studio pricing was based on whether or not a studio desired to promote a movie for both rental and sale to the consumer, or primarily for rental, from the beginning of the in-store video distribution window. In order to promote a movie title for rental, the title would be released to in-store video retailers at a price that was too high to allow for an affordable sales price by the retailer to the consumer at the beginning of the retail in-store video distribution window. As rental demand subsided, the studio would reduce pricing in order to then allow for reasonably priced sales to consumers. Currently, substantially all DVD titles are released at a price to the in-store video retailer that is low enough to allow for an affordable sales price by the retailer to the consumer from the beginning of the retail in-store video distribution window. This low sell-through pricing policy has led to increasing competition from other retailers, including mass merchants and online retailers, who are able to purchase DVDs for sale to consumers at the same time as traditional in-store video retailers, like Hastings, which purchase both DVDs and VHS product for rental. In addition, some retailers sell movies at lower prices in order to increase overall traffic to their stores or businesses, and mass merchants may be more willing to sell at lower prices, and in some instances, below wholesale. These factors have increased consumer interest in purchasing DVDs, which has reduced the significance of the VHS rental window.
We believe that the increased consumer purchases are due in part to consumer interest in building DVD libraries of classic movies and personal favorites and that the studios will remain dependent on the traditional in-store video retailer to generate revenues for the studios from titles that are not classics or current box office hits. Approximately 60% of most studios’ revenues derive from their home entertainment divisions. We therefore believe the importance of the video rental industry to the studios will continue to be a factor in studio pricing decisions. However, we cannot control or predict studio pricing policies with certainty, and we cannot assure you that consumers will not, as a result of further decreases in studio sell-through pricing and/or sustained or further depressed pricing by competitors, increasingly desire to purchase rather than rent movies. Personal DVD libraries could also cause consumers to rent or purchase fewer movies in the future. Our profitability could therefore be negatively affected if, in light of any such consumer behavior, we were unable to (i) grow our rental business, (ii) replace gross profits from generally higher-margin rentals with gross profits from increased sales of generally lower-margin sell-through product; or (iii) otherwise positively affect gross profits, such as through price increases or cost reductions. Our ability to achieve one or more of these objectives is subject to risks, including the risk that we may not be able to compete effectively with other DVD retailers, some of whom may have competitive advantages such as the pricing flexibility described above or favorable consumer perceptions regarding value.
Regardless of the wholesale pricing environment, the extent of our profitability is dependent on our ability to enter into and maintain arrangements with the studios that effectively balance copy depth and cost considerations. Each type of arrangement provides different advantages and challenges for us. The ability to negotiate preferred terms under revenue sharing agreements for the procurement of DVD, video games and VHS titles is crucial to our operations. Our profitability could be negatively affected if studios were to make other changes in their wholesale pricing policies and revenue-sharing agreements.
Our business could be negatively impacted by new technology that provides alternate methods of video delivery.
Advances in technologies such as video-on-demand or certain changes in consumer behavior driven by these or other technologies and methods of delivery, could have a negative effect on our business. In particular, our business could be impacted if (i) newly released movies were to be made widely available by the studios to these technologies at the same time or before they are made available to in-store video retailers for rental; and (ii) these technologies were to be widely accepted by consumers. In addition, advances in direct broadcast satellite and cable technologies may adversely affect public demand for video store rentals. If direct broadcast satellite and digital cable were to become more widely available and accepted, this could cause a smaller number of movies to be rented if viewers were to favor the expanded number of conventional channels and expanded content, including movies, specialty programming and sporting events, offered through these services. If this were to occur, it could have a negative effect on our video store business. Direct broadcast satellite providers transmit numerous channels of programs by satellite transmission into subscribers’ homes. Also, cable providers are taking advantage of digital technology to transmit many additional channels of television programs over cable lines to subscribers’ homes.
Changes to Information Technology Systems May Disrupt the Supply Chain.
We use a number of computerized information systems to manage our new release allocations, selection management, merchandise planning, pricing, markdowns, and inventory replenishment at each store and at our distribution facility. These major systems collectively support our supply chain. Through continuing processes of review and evaluation the Company is implementing modifications, enhancements, and upgrades to its information technology systems. In some cases these changes include replacing legacy systems with successor systems. There are inherent risks associated with modifying or replacing these core systems, including timely accurate movement and processing of data, which could possibly result in supply chain disruptions. We believe that the appropriate processes and procedures are in place through our software development life cycle (“SDLC”), design, testing, and staging implementation, along with obtaining appropriate commercial contracts and application documentation with third-party vendors supplying such replacement technologies. There can be no assurances that we will successfully modify, integrate, or launch these new systems or changes as planned or that they will occur without supply chain or other disruptions or without impacts on inventory valuation. These disruptions or impacts, if not anticipated and appropriately mitigated, could have a negative effect on our financial condition and results of operations.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2.
ITEM 2. PROPERTIES.
As of January 31, 2006, we operated 153 stores in 20 states located as indicated in the following table:
Currently, we lease sites for all our stores. These sites typically are located in pre-existing, stand-alone buildings or strip shopping centers. Our primary market areas are small- and medium-sized communities with populations generally less than 50,000. We have developed a systematic approach using our site selection criteria to evaluate and identify potential sites for new stores. Key demographic criteria for stores include community population, community and regional retail sales, personal and household disposable income levels, education levels, median age, and proximity of colleges or universities. Other site selection factors include current competition in the community, visibility, available parking, ease of access and other neighbor tenants.
We actively manage our existing stores and from time to time close under-performing stores. During fiscal 2005 we did not close any stores and during fiscal 2004 we closed one store.
The terms of our store leases vary considerably. We strive to maintain maximum location flexibility by entering into leases with long initial terms and multiple short-term extension options. We have been able to enter into leases with these terms in part because we generally bear a substantial portion of the cost of preparing the space for a store.
The following table sets forth as of January 31, 2006 the number of stores that have current lease terms that will expire during each of the following fiscal years and the associated number of stores for which we have options to extend the lease term:
We have not experienced any significant difficulty renewing or extending leases on a satisfactory basis.
Our headquarters and distribution center are located in Amarillo, Texas in a leased facility consisting of approximately 45,000 square feet for office space and 149,000 square feet for the distribution center. The leases for this property terminate in September 2008, and we have the option to renew these leases through March 2020.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
During the past fiscal year, we were named as defendants in lawsuits alleging that our extended viewing fees for movie and game rentals are illegal under the Uniform Commercial Code. On October 27, 2005, the Company petitioned the court for summary judgment in one such lawsuit pending in the state of New Mexico. On November 28, 2005, the judge granted the Company’s petition for summary judgment and dismissed all pending claims in that lawsuit. The plaintiff has subsequently appealed the court’s summary judgment.
While we intend to vigorously defend all outstanding legal matters and anticipate favorable results, the ultimate outcome of these matters cannot be estimated at this time. In the event an adverse judgment was rendered, the impact on the Company’s consolidated financial statements could be material.
We are also involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our financial position, results of operations and cash flows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of the security holders during the fourth quarter of fiscal 2005.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
The shares of Hastings Entertainment, Inc. common stock are listed and traded on The Nasdaq National Market (Nasdaq) under the symbol “HAST.” Our common stock began trading on June 12, 1998, following our initial public offering. The following table contains, for the periods indicated, the high and low sales prices per share of our common stock as reported on the Nasdaq:
As of March 31, 2006, there were approximately 342 holders of record of our Common Stock.
The payment of dividends is within the discretion of the Board of Directors and will depend on our earnings, capital requirements, and our operating and financial condition, among other factors. Our current revolving credit facility restricts the payment of dividends. In view of such restrictions, it is unlikely that we will pay a dividend in the foreseeable future.
With respect to equity compensation plan information, please refer to Item 11 of this Annual Report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The data set forth below should be read in conjunction with Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
The following discussion should be read in conjunction with our consolidated financial statements and the related notes thereto and “Item 6. Selected Financial Data” appearing elsewhere in this Annual Report on Form 10-K.
Overview
Hastings Entertainment is a leading multimedia entertainment retailer that buys, sells, trades, and rents various home entertainment products, including books, music, software, periodicals, new and used DVDs, video games and videocassettes, video game consoles and DVD players through its entertainment stores and its Internet Web site. As of January 31, 2006, we operated 153 stores averaging approximately 20,000 square feet in small- to medium-sized markets located in 20 states, primarily in the Western and Midwestern United States. Each of the stores is leased from a third party, wholly-owned by us and operated under the name of Hastings.
Our operating strategy is to enhance our position as a multimedia entertainment retailer by expanding and remodeling existing stores, opening new stores in selected markets, and offering our products through our Internet Web site. References herein to fiscal years are to the twelve-month periods that end in January of the following calendar year. For example, the twelve-month period ended January 31, 2006 is referred to as fiscal 2005.
Critical Accounting Policies
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, the disclosure of contingent liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe the following critical accounting policies affect our more significant estimates and assumptions used in the preparation of our financial statements. Our significant estimates and assumptions are reviewed, and any required adjustments are recorded, on a monthly basis.
Lower of Cost or Market for Merchandise Inventory. Our merchandise inventories are recorded at the lower of cost or market. As with any retailer, economic conditions, cyclical customer demand and changes in purchasing or distribution can affect the carrying value of inventory. As circumstances warrant, we record lower of cost or market inventory adjustments. In some instances, these adjustments can have a material effect on the financial results of an annual or interim period. In order to determine such adjustments, we evaluate the age, inventory turns and estimated fair value of merchandise inventory by product category and record an adjustment if estimated market value is below cost. Through merchandising and an automated-progressive markdown program, we quickly take the steps necessary to increase the sell-off of slower moving merchandise to eliminate or lessen the effect of these adjustments.
Returns Process. Merchandise inventory owned by us is generally returnable based upon return agreements with our merchandise vendors. We continually return merchandise to vendors based on, among other factors, current and projected sales trends, overstock situations, authorized return timelines or changes in product offerings. At the end of any reporting period, cost accruals are required for inventory that has been returned to vendors, is in the process of being returned to vendors, or has been identified to be returned to vendors. These costs can include freight, valuation and quantity differences, and other fees charged by a vendor. In order to appropriately match the costs associated with the return of merchandise with the process of returning such merchandise, we utilize an allowance for cost of inventory returns. To accrue for such costs and estimate this allowance, we utilize historical experience adjusted for significant estimated or contractual modifications. Certain adjustments to the allowance can have a material effect on the financial results of an annual or interim period.
Rental Asset Depreciation. We have established depreciation policies with respect to our rental assets that allow for the matching of product costs with the related revenues. These policies require that we make significant estimates based upon our experience as to the ultimate revenue and the timing of the revenue to be generated by our rental product. We utilize an accelerated method of depreciation because it approximates the pattern of demand for the product, which is generally higher when the product is initially released for rental by the studios and declines over time. In establishing residual values for our rental product, we consider the sales prices and volume of our previously rented product and other used product.
Based upon these estimates, we currently depreciate the cost of our rental assets on an accelerated basis over six months to a salvage value of $4 per unit ($3.50 for VHS units), except for rental assets purchased for the initial stock of a new store, which are being depreciated on a straight-line basis over 36 months to a salvage value of $4 ($3.50 for VHS units). Rental assets purchased for less than established salvage values are not depreciated.
The costs of rental product purchased pursuant to revenue-sharing arrangements typically include a lower initial product cost and a percentage of the net rental revenues to be shared with studios over an agreed period of time. Additionally, certain titles have performance guarantees. Any up-front costs exceeding $4 per unit ($3.50 for VHS units) are amortized on an accelerated basis and revenue-sharing payments pursuant to the applicable arrangement are expensed as the related revenue is earned. The Company analyzes titles that are subject to performance guarantees and recognizes an estimated expense for under-performing titles throughout the applicable period based upon the Company’s analysis of the estimated shortfall. The Company revises these estimates on a monthly basis, according to actual results.
We also review the carrying value of our assets to ensure that estimated future cash flows exceed the carrying value. We record adjustments to the value of previously rented product primarily for estimated obsolete or excess product based upon changes in our original assumptions about future demand and market conditions. If future demand or actual market conditions are less favorable than those estimated by management, additional adjustments, including adjustments to useful lives or residual values, may be required. We continually evaluate the estimates surrounding the useful lives and residual values used in depreciating our rental assets. Changes to these estimates resulting from changes in consumer demand, changes in our customer preferences or the price or availability of retail products may materially impact the carrying value of our rental assets and our rental margins.
Store Closing Reserve. On a quarterly basis, and in the normal course of business, we evaluate our store base to determine if we need to close or relocate a store(s). Management will evaluate, among other factors, current and future profitability, market trends, age of store and lease status. The primary expense items associated with the closure of a store relate to the net present value of minimum lease payments (the present value of remaining lease payments under an active lease) and the accelerated depreciation of leasehold improvements and other assets not remaining in our possession.
In accordance with SFAS No. 146, we recognize lease termination costs at the time the store is closed or relocated. The amount recorded can fluctuate based on the age of the closing store, term and remaining years of the lease and the number of stores being closed or relocated. We actively pursue sublease tenants on all closed or relocated stores and, as part of the final estimation of store closing liability, the impact of any sublease income is estimated. The net of the described charges and sublease income estimates can have a material effect on the financial results of an annual or interim period.
Impairment or Disposal of Long-Lived Assets. In accordance with SFAS No. 144, we evaluate poor performing stores on a quarterly basis to determine whether projected future cash flows over the remaining initial lease term are sufficient to recover the carrying value of the fixed asset investment in each individual store. If projected future cash flows are less than the carrying value of the fixed asset investment, an impairment charge is recognized if the carrying value is less than the fair value of such assets. The carrying value of leasehold improvements as well as certain other property and equipment is subject to impairment write-down.
Revenue Recognition. We generate revenue primarily from retail sales and rental of our products. Merchandise and rental revenues are recognized at the point of sale or rental or at the time merchandise is shipped to the customer. Revenues are presented net of estimated returns and exclude all taxes. Customers may return certain merchandise for exchange or refund within our policies, and an allowance has been established to provide for projected returns. There are no provisions for uncollectible amounts since payment is received at the time of sale. We, as with most retailers, also offer gift cards for sale. Deferred revenue, a current liability, is recognized at the time a gift card is sold with the costs of designing, printing and distributing the cards recorded as an expense as incurred. The deferred revenue liability is relieved and revenue is recognized upon the redemption of the gift cards. From time to time we will offer sales incentives to customers, in the form of rebates. Revenue is reduced by the amount of estimated redemptions, based on experience of similar types of rebate offers, and a deferred revenue liability is established. The deferred revenue liability is relieved when the customer has completed all criteria necessary to file a valid rebate claim. Any remaining portion of deferred revenue is recorded as revenue following the termination of the extended redemption period and following completion of all outstanding rebate claims. The Company reduces its revenue and recognizes a reserve for the estimated utilization of early return credits received by renters for early return of rentals. The liability is relieved upon the redemption of these early return credits. Additionally, we promote the exchange of multiple used products for new product by our customers.
Comparable-Store Revenue. Stores included in the comparable-store revenues calculation are those stores that have been open for a minimum of 60 weeks. Also included are stores that are remodeled or relocated. Sales via the internet are not included and closed stores are removed from each comparable period for the purpose of calculating comparable-store revenues.
Vendor Allowances. In 2003, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”), which addresses the accounting for cash consideration received from a vendor by a reseller for various vendor-funded allowances, including cooperative advertising support. The EITF determined that cash consideration received from a vendor should be presumed to be a reduction of the prices of vendor’s products and, therefore, should be shown as a reduction in the cost of goods sold when recognized in the reseller’s income statements. The only exception to this rule is if the reimbursement is for specific, incremental identifiable costs. If the amount of cash consideration received exceeds the cost being reimbursed, that excess amount should be characterized as a reduction of cost of goods sold when recognized in the reseller’s income statements. In accordance with EITF 02-16, a portion of our vendor advertising allowances have been recorded as a reduction of merchandise inventory and the cost of rental assets and will be recognized in cost of revenues as inventory is sold and as rental assets are rented. Certain amounts that we receive from vendors, such as cooperative advertising payments, are considered reimbursement for specific, identifiable costs and therefore continue to be recorded as a reduction of SG&A.
Results of Operations
The following tables present our statement of operations data, expressed as a percentage of revenue, and the number of stores open at the end of period for the three most recent fiscal years.
Fiscal 2005 Compared to Fiscal 2004
Revenues. Total revenues for fiscal 2005 decreased $4.1 million, or 0.8%, to $537.9 million compared to $542.0 million for the same period in the prior year. The following is a summary of our revenue results (dollars in thousands):
Below is a summary of the comparable-store revenues (“Comp”) results for our merchandise categories:
Our video Comp decrease, including the rental and sell-through revenues from all video and video game products, was -1.5% for the fiscal year ended January 31, 2006. In response to consumers’ migration from VHS to DVDs, we have reduced our inventory of VHS units from approximately 1.2 million at January 31, 2005, to approximately 0.7 million units at January 31, 2006. Furthermore, the Company plans no additional purchases of VHS units for Fiscal 2006 and beyond.
Music Comps decreased 1.8%, primarily due to fewer new CD sales from premier artists, fewer cassette sales, and fewer sales of used CDs. These declines were offset partially by increased sales of music hardware, including iPods and other MP3 players. Book Comps fell 0.2% as a result of a slight decrease in the sales of new releases. Video for sale Comps rose 1.9% due to increased sales of DVDs, partially offset by declining sales of VHS. Video game Comps rose 5.2% on increased sales of new and used hardware. Our Sidelines Comp increase of 5.2% was headlined by increases in sales of t-shirts and action figures.
Generally, it is difficult for us to project future Comp sales. Our Comp sales are to a great extent dependent upon the quantity and quality of new releases from the studios, publishers, and hardware manufacturers. However, for Fiscal 2006, we are projecting positive merchandise and rental Comps of approximately 3% and 2%, respectively.
Rental asset Comps decreased 7.5% from the same period last year reflecting continued in-store rental weakness industry-wide.
Gross Profit. For the twelve months ended January 31, 2006, total gross profit dollars increased approximately $6.0 million, or 3.3%, to $189.1 million from $183.1 million for the same period last year. Our merchandise gross profit rate increased to 29.3% from 26.8% for the same period last year, primarily as a result of improved merchandise margin rates, increased efficiencies in our Distribution Center, and lower costs associated with merchandise
shrinkage and returned product. Rental gross margin rates decreased to 63.2% from 64.2% in the same period in the prior year, primarily due to changing industry conditions in fiscal 2005, including weak title releases, both in video and video games, which lead our rental revenues to decrease more than anticipated relative to our product purchases. As a percentage of total revenues, total gross profit increased to 35.2% for the twelve month period compared to 33.8% for the same period in the prior year.
Selling, General and Administrative expenses (“SG&A”). SG&A increased approximately $5.4 million to $176.7 million for the twelve-month period ended January 31, 2006, compared to $171.3 million for the same period in the prior year, due to $1.1 million in additional advertising, $0.7 million in costs associated with the documentation of controls and procedures related to the pending adoption of Section 404 of the Sarbanes-Oxley Act, severance payouts of approximately $0.5 million, and additional costs associated with the operation of a greater number of new, expanded and relocated superstores. As a percentage of total revenues, SG&A increased to 32.8% for the twelve months ended January 31, 2006, compared to 31.6% for the twelve months ended January 31, 2005.
Interest Expense. As a percentage of total revenues, interest expense rose to 0.5% in fiscal 2005, compared to 0.4% in fiscal 2004, due to rising interest rates.
Income Taxes. For fiscal 2005, the Company recorded income tax expense of approximately $4.5 million, resulting in an effective tax rate of 43.9%. In the prior fiscal year, the Company recorded income tax expense of approximately $4.0 million, resulting in an effective tax rate of 40.9%. The Company’s effective tax rate rose in fiscal 2005 due to increases in state income tax rates.
Fiscal 2004 Compared to Fiscal 2003
Revenues. Total revenues for fiscal 2004 increased $33.7 million, or 6.6%, to $542.0 million compared to $508.3 million for the same period in the prior year, resulting principally from an increase of 5.0% in comparable-store revenues (“Comps”). The following is a summary of our revenue results (dollars in thousands):
The higher merchandise Comps were primarily the result of changes in the following major categories:
Our video Comp increase, including the rental and sell-through revenues from all video and video game products, was 7.9% for the fiscal year ended January 31, 2005.
Music Comps increased 1.8%, primarily due to increased sales of new release CDs and music hardware. Book Comps increased 1.5% as a result of strong sales of new release hardbacks and paperbacks. Video for sale Comps rose 15.4% due to increased sales of new and used DVDs, partially offset by declining sales of VHS. Video game Comps rose 29.6% on increased sales of hardware, Microsoft XBOX games, and previously played games. Our Sidelines Comp increase of 9.8% was headlined by increased sales of t-shirts and board games, including strong sales of poker products, partially offset by decreased sales of collectible cards.
Gross Profit. For the fiscal year 2004, total gross profit dollars increased approximately $11.6 million, or 6.8%, to $183.1 million from $171.5 million for the same period last year, primarily as a result of higher revenues. As a percentage of total revenues, gross profit was 33.8% for the fiscal year ended January 31, 2005, the same as the prior year. Gross profit from merchandise sales increased 0.6% from 26.2% in fiscal 2003 to 26.8% for fiscal 2004. Increased merchandise gross profit resulted from margin improvements occurring in each product department, particularly our books and music departments, partially offset by approximately $2.1 million in incremental costs related to the conversion of our warehouse management system and $2.1 million in decreased favorable vendor settlements. The increase in merchandise gross profit was offset by declining gross profit from rental sales, which primarily resulted from lower rental sales, despite improved rental margin rates.
Selling, General and Administrative expenses (“SG&A”). SG&A increased approximately $8.7 million to $171.3 million for the full fiscal year compared to $162.6 million in the prior year, due primarily to higher human resource and occupancy costs associated with the operation of a greater number of new, expanded and relocated stores. As a percentage of total revenues, SG&A decreased to 31.6% for the fiscal year ended January 31, 2005 compared to 32.0% for prior year.
Interest Expense. For fiscal 2004, when compared to fiscal 2003, interest expense remained constant at 0.4% of total revenues.
Income Taxes. For fiscal 2004, the Company recorded income tax expense of approximately $4.0 million, using an effective tax rate of 40.9% applied against income from operations. In the prior fiscal year, the Company reversed a valuation allowance of $4.4 million associated with a deferred tax asset resulting in a net income tax benefit of $1.4 million.
Liquidity and Capital Resources
We generate cash from operations exclusively from the sale of merchandise and the rental of products and we have substantial operating cash flow because most of our revenue is received in cash and cash equivalents. Other than our principal capital requirements arising from the purchase, warehousing and merchandising of inventory and rental products, opening new stores and expanding existing stores and updating existing and implementing new information systems technology, we have no anticipated material capital commitments, except for the stock buyback programs more fully discussed below. Our primary sources of working capital are cash flow from operating activities, trade credit from vendors and borrowings under our amended revolving credit facility. We believe our cash flow from operations and borrowings under our amended revolving credit facility will be sufficient to fund our ongoing operations, new stores and store expansions through fiscal 2006.
Historically we have experienced an increase in our debt level during the third quarter of our fiscal year. For third quarter of fiscal 2006, we are projecting our debt level to increase to approximately $50.0 million to $54.0 million. However, we expect this balance to reduce to approximately $15.0 million to $19.0 million in the fourth quarter due to a higher level of repayments following the holiday selling season. At January 31, 2006, total outstanding debt (including capital lease obligations) was $28.2 million.
Consolidated Cash Flows
Operating Activities. Net cash flows from operating activities increased $3.8 million, or 21.8%, to $21.2 million in fiscal 2005 from $17.4 million in fiscal 2004. The increase was primarily the result of decreased purchases of rental assets.
Investing Activities. Net cash used in investing activities decreased $7.6 million, or 30.8%, from $24.7 million in fiscal 2004 to $17.1 million in fiscal 2005. This decrease was the result of decreased capital expenditures resulting from fewer store openings during the year.
Financing Activities. Cash provided by or used in financing activities is primarily associated with borrowings and payments made under our revolving credit facility (described below under “Capital Structure“). For fiscal 2005, cash used in financing activities was $7.2 million compared to cash provided by financing activities of $8.0 million for fiscal 2004, resulting from net repayments on our revolving credit facility during fiscal 2005 of approximately $8.4 million compared to net borrowings for fiscal 2004 of approximately $8.5 million.
On September 18, 2001, we announced a stock repurchase program of up to $5.0 million of our common stock. On April 4, 2005, the Board of Directors approved an increase of $2.5 million to the program. During fiscal year 2005, we purchased a total of 344,440 shares of common stock at a cost of approximately $2.0 million, or $5.81 per share. As of January 31, 2006, a total of 1,281,463 shares had been purchased under the program at a cost of approximately $6.7 million, for an average cost of approximately $5.23 per share. On March 15, 2006, the Company’s Board of Directors authorized additional stock repurchases in the amount of $5.0 million.
Capital Structure. On July 11, 2005 and February 28, 2006, we executed amendments to our syndicated secured Loan and Security Agreement with Fleet Retail Finance, Inc. and The CIT Group/Business Credit, Inc., (the “Facility”). The amount outstanding under the Facility is limited by a borrowing base predicated on eligible inventory, as defined in the Facility, and certain rental assets, net of accumulated depreciation less specifically defined reserves and after the February 28, 2006 amendment, is limited to a ceiling of $100 million, less a $10 million availability reserve. The Facility permits borrowings at various interest-rate options based on the prime rate or London Interbank Offering Rate (LIBOR) plus applicable margin depending upon the level of our minimum availability. The borrowing base under the Facility is limited to an advance rate of 65% of eligible inventory and certain rental assets net of accumulated amortization less specifically defined reserves, which can be adjusted to reduce availability under the Facility. Lenders may increase specifically defined reserves to reduce availability in the event of adverse changes in our industry that are projected to impact the value of our assets pledged as collateral. The Facility contains no financial covenants, restricts the payment of dividends and includes certain other debt and acquisition limitations, allows for the repurchase of up to $15 million of our common stock and requires a minimum availability of $10 million at all times. The Facility is secured by substantially all of the assets of the Company and our subsidiaries and is guaranteed by each of our consolidated subsidiaries. Per the amendment executed on February 28, 2006, the Facility matures on August 29, 2011. At January 31, 2006, we had $27.0 million in excess availability, after the $10 million availability reserve, under the Facility. However, excess availability may be reduced in the future as changes in the borrowing base occur or the lenders increase availability reserves. The average rate of interest being charged under the Facility for fiscal years ending January 31, 2006 and 2005 was 5.6% and 3.8%, respectively.
We utilize standby letters of credit to support certain insurance policies. The aggregate amount of the letters of credit at January 31, 2006 was approximately $1.1 million, which reduces the excess availability under the Facility.
From time to time, we enter into interest rate agreements with financial institutions in order to obtain a fixed interest rate on a portion of our outstanding floating rate debt, thereby reducing our exposure to interest rate volatility. On June 29, 2005, the Company agreed to a two-year interest rate cap agreement, expiring June 29, 2007, with a major bank to hedge $20 million of the Company’s variable-rate debt (30-day LIBOR) against interest rate increases. The bank will “cap” the Company’s interest rate at 4.00% for the first $20 million of outstanding debt over the next two years. Should the 30-day LIBOR rate remain at 4.00% or lower, the interest rate cap will result in no settlement. Should the rate climb above 4.00% during the term of the rate cap, the bank will settle with the Company at the end of each month. At January 31, 2006 the 30-day LIBOR was 4.57%. The Company designates this transaction as a
hedge in accordance with SFAS 133, which requires the effective portion of the hedge to be accounted for initially as a component of other comprehensive income on the balance sheet. Subsequently, it will be reclassified into the earnings when the transaction affects earnings. Any ineffective portion of the gain or loss is to be reported in earnings immediately. At January 31, 2006, the Company deemed the hedge to be fully effective. For the fiscal year ended January 31, 2006, the Company recognized approximately $141,000, net of tax, as other comprehensive income related to the hedge agreement.
At January 31, 2006, our minimum lease commitments for fiscal 2006 were approximately $24.6 million. The present value of total existing minimum operating lease commitments for fiscal years 2007 through 2025 discounted at 9.0% was approximately $84.6 million as of January 31, 2006.
Contractual Obligations and Off-Balance Sheet Arrangements. Current accounting standards require us to disclose our material obligations and commitments to make future payments under contracts, such as debt and lease agreements. We disclose our contractual long-term debt repayment and the principal portion of capital lease obligations in Note 6 and our current and future operating and capital lease payments in Note 7 to the consolidated financial statements. In the ordinary course of business, we routinely enter into commitments for various aspects of our operations, such as warehouse and office equipment. However, we do not believe that these commitments will have a material effect on our financial condition, results of operations or cash flows. As of January 31, 2006, other than operating leases and standby letters of credit, we had not entered into any off-balance sheet arrangements or third-party guarantees, nor is it our business practice to do so.
The following summarizes our contractual obligations at January 31, 2006, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in thousands):
(1)
Based on our internal forecasts, we estimate interest payments for FY 2006 to be approximately $3.3 million.
(2)
As of January 31, 2006 we were a party to revenue-sharing arrangements with various studios. These agreements include minimum purchase requirements, based upon the box office results of the title, at a lower initial product cost as compared to non-revenue sharing purchases. In addition, these contracts require net rental revenues to be shared with the studios over an agreed period of time. We have included amounts owed and an estimate of our contractual obligation under these agreements for performance guarantees and minimum purchase requirements for the period in which they can reasonably be estimated, which is approximately two months in the future. Although these contracts may extend beyond the estimated two-month period, we cannot reasonably estimate these amounts due to the uncertainty of purchases that will be made under these agreements. The amounts presented above do not include revenue sharing accruals for rental revenues recorded during fiscal 2005.
Seasonality and Inflation
Our business is highly seasonal, with significantly higher revenues and operating income realized during the fourth quarter, which includes the holiday selling season. Below is a tabular presentation of revenues and operating income by quarter, which illustrates the seasonal effects of our business:
See Footnote 14 to the Consolidated Financial Statements for additional information.
We do not believe that inflation has materially impacted net income during the past three years. Substantial increases in costs and expenses could have a significant impact on our operating results to the extent such increases are not passed along to customers.
Recent Accounting Pronouncements
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (“SFAS 151”), an amendment of Accounting Research Bulletin No. 43, Chapter 44. SFAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The statement will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has evaluated the provisions of SFAS 151 and does not anticipate that adoption will have an impact on its consolidated balance sheets or statements of operations, shareholders’ equity and cash flows.
In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”). This statement replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation,” and supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires all companies to measure compensation cost for all share-based payments, including stock options, at fair value. The statement will be effective for public companies no later than the beginning of the first fiscal year commencing after June 15, 2005, which for the Company is the beginning of fiscal 2006. The Company plans to adopt the modified prospective method and is currently evaluating the effect that SFAS 123R will have on its consolidated balance sheets and its statements of shareholders’ equity and cash flows. The Company believes the adoption of SFAS 123R will not have a material impact on results of operations, unless significant future stock grants occur. SFAS 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce operating cash flows and increase net financing cash flows in periods after the effective date. These future amounts cannot be estimated, because they depend on, among other things, when employees exercise stock options. However, the amount of operating cash flows recognized for such excess tax deductions for the years ended January 31, 2006, 2005, and 2004 was not material.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
In the ordinary course of our business, we are exposed to certain market risks, primarily changes in interest rates. Our exposure to interest rate risk consists of variable rate debt based on the lenders’ base rate or LIBOR plus a specified percentage at our option. The annual impact on our results of operations of a 100 basis point interest rate change on the January 31, 2006 outstanding balance of the variable rate debt, after adjustment for the interest rate hedge agreement, would be approximately $0.1 million. After an assessment of these risks to our operations, we believe that the primary market risk exposures (within the meaning of Regulation S-K Item 305) are not material and are not expected to have any material adverse impact on our financial position, results of operations or cash flows for the next fiscal year.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
HASTINGS ENTERTAINMENT, INC.
Index to Consolidated Financial Statements
and Financial Statement Schedule
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
Hastings Entertainment, Inc.
We have audited the accompanying consolidated balance sheets of Hastings Entertainment, Inc. and subsidiaries as of January 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended January 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hastings Entertainment, Inc. and subsidiaries at January 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended January 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
Fort Worth, Texas
March 28, 2006
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
January 31, 2006 and 2005
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
Years Ended January 31, 2006, 2005 and 2004
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders’ Equity
Years ended January 31, 2006, 2005 and 2004
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended January 31, 2006, 2005 and 2004
(In thousands)
See accompanying notes to consolidated financial statements.
(1)
Operations and Summary of Significant Accounting Policies
(a)
General
Hastings Entertainment, Inc. and subsidiaries operate a chain of retail stores in 20 states, primarily in the Western and Midwestern United States. Revenues are generated from the sale of new and used music, books, DVDs, videogames, and videocassettes, as well as new software, periodicals, consumables, and accessory products. In addition, our revenues include the rental of DVDs, video games and videocassettes.
(b)
Basis of Consolidation
The consolidated financial statements present the results of Hastings Entertainment, Inc. and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
(c)
Basis of Presentation
Certain prior year amounts have been reclassified to conform with the fiscal 2005 presentation. During the fourth quarter of fiscal 2005, we reclassified an in-transit cash item as a reduction in cash and long-term debt. The reclassification at January 31, 2005 was approximately $2.8 million. We also reclassified a portion of our accrued straight-line rent from short-term to long-term. The reclassification at January 31, 2005 was approximately $2.6 million. Additionally, we reclassified costs associated with our previously viewed tapes from cost of rental revenues to cost of merchandise revenues. This reclassification for the years ended January 31, 2005 and 2004 was approximately $3.5
and $1.5 million, respectively.
We consider our retail and internet operations to be our operating segments for purposes of determining reportable segments based on the criteria of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. We determined that the Internet segment was immaterial for segment reporting purposes. Therefore, we combine both operating segments into one reporting segment.
Our fiscal years ended January 31, 2006, 2005 and 2004 are referred to as fiscal 2005, 2004 and 2003, respectively.
(d)
Cash and Cash Equivalents
The Company considers all credit card receivables of $1.0 million for both fiscal 2005 and 2004 from MasterCard, Visa, Discover, and American Express, and all highly liquid investments with an original maturity date of three months or less to be cash equivalents. Negative cash balances are reclassified to trade accounts payable.
(e)
Revenue Recognition
Merchandise and rental asset revenue are recognized at the point of sale or rental or at the time merchandise is shipped to the customer. Additionally, revenues are presented net of estimated returns and exclude all sales taxes. An allowance has been established to provide for projected merchandise returns.
Gift card liabilities are recorded at the time of sale of such cards with the costs of designing, printing and distributing the cards recorded as expense as incurred. The liability is relieved and revenue is recognized upon redemption of the gift cards.
The Company reduces its revenue through reserves for the estimated utilization of early return credits received by renters for early return of rentals. The liability is relieved upon the redemption of these early return credits.
(f)
Merchandise Inventories
Merchandise inventories are recorded at the lower of cost, which approximates the first-in, first-out (FIFO method), or market. Amounts are presented net of the allowance for shrinkage and obsolescence.
Expenses included in cost of revenues include cost of product purchased from vendors; rental asset depreciation expense; shrinkage; inventory markdowns and write-offs; freight charges; receiving costs; inspection costs; and internal transfer costs. In addition, the Company includes in cost of goods sold all expenses associated with our distribution center, including freight, warehouse personnel costs, supplies, maintenance, depreciation, occupancy, property tax, and utility costs; as well as costs associated with our returns center, including vendor refused product, handling charges, return fees, freight, return center personnel costs, supplies, maintenance, depreciation, rent, and utilities. We include occupancy costs for retail locations in SG&A expenses.
The Company transfers rental assets that have been converted to previously viewed tapes for sale, from ‘Property and equipment’ to ‘Merchandise inventories.’ The transfer to ‘Merchandise Inventories’ is recorded at the time of conversion, which is the first date the product is available for sale. During fiscal 2005, 2004, and 2003, $10.8 million, $12.2 million, and $7.5 million, respectively, were transferred from rental assets to merchandise inventory at the lower of net book value or market.
(g)
Property and Equipment
Property and equipment are recorded at cost and depreciated using the straight-line method, except for rental assets, which are depreciated using an accelerated depreciation method. Furniture, fixtures, equipment and software are depreciated over their estimated useful lives of three to seven years. Leasehold improvements are amortized over the shorter of the related lease term or their estimated useful lives. Rental assets, except for the initial purchases for new stores, are depreciated over six months using an accelerated methodology designed to match the revenue stream of the rental asset. The initial purchases of rental assets for new stores are depreciated over 36 months using the straight-line method.
Expenditures for maintenance, repairs and renewals that do not materially prolong the original useful lives of assets are charged to expense as incurred.
Property recorded pursuant to capital lease obligations is stated at the present value of the minimum lease payments at the inception of each lease, not in excess of fair value, and amortized on a straight-line basis over the related lease term.
In accordance with SFAS No. 144, we evaluate poor performing stores on a quarterly basis to determine whether projected future cash flows over the remaining initial lease term are sufficient to recover the carrying value of the fixed asset investment in each individual store. If projected future cash flows are less than the carrying value of the fixed asset investment, an impairment charge is recognized if the carrying value is less than the fair value of such assets. The carrying value of leasehold improvements as well as certain other property and equipment is subject to impairment write-down.
(h)
Financial Instruments
The carrying amount of long-term debt approximates fair value as of January 31, 2006 and 2005 due to the instruments bearing interest at variable market rates. The carrying amount of accounts payable approximates fair value because of its short maturity period.
From time to time, we enter into interest rate agreements with financial institutions in order to obtain a fixed interest rate on a portion of our outstanding floating rate debt, thereby reducing our exposure to interest rate volatility. On June 29, 2005, the Company entered into a two-year interest rate cap agreement, expiring June 29, 2007, with a major bank to hedge $20 million of the Company’s variable-rate debt (30-day LIBOR) against interest rate increases. The bank will “cap” the Company’s interest rate at 4.00% for the first $20 million of outstanding debt over the term of the rate cap. Should the 30-day LIBOR rate remain at 4.00% or lower, the interest rate cap will result in no settlement. Should the rate climb above 4.00% during the term of the rate cap, the bank will settle with the Company at the end of each month. At January 31, 2006 the 30-day LIBOR was 4.57%. The Company designates this transaction as a hedge in accordance with SFAS 133, which requires the effective portion of the hedge to be accounted for initially as a component of other comprehensive income on the balance sheet. Subsequently, it will be reclassified into the earnings when the transaction affects earnings. Any ineffective portion of the gain or loss is to be reported in earnings immediately. At January 31, 2006, the Company deemed the hedge to be fully effective. For the fiscal year ended January 31, 2006, the Company recognized approximately $141,000, net of tax, as other comprehensive income related to the hedge agreement.
(i)
Stock Option Plans
We account for our stock option plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations. Compensation expense is recorded for stock options on the date of grant only if the market price of the underlying stock exceeds the exercise price. Under Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (“SFAS 123”), we may elect to recognize expense for stock-based compensation based on the fair value of the awards, or continue to account for stock-based compensation under APB 25 and disclose in the financial statements the effects of SFAS 123 as if the recognition provisions were adopted. We have elected to continue to apply the provisions of APB 25 and provide the pro forma disclosure provisions of SFAS 123.
On January 27, 2006, the Company’s Board of Directors, upon the recommendation of the Compensation Committee of the Board, unanimously approved the acceleration of the vesting date of all outstanding and unvested options issued on or before January 27, 2006, under all current stock option plans, effective the same day. The Company believes that the decision to accelerate the vesting of these options, many of which have exercise prices that are higher than the Company’s current stock price, will give employees increased performance incentives and will enhance current retention. The Company also implemented the acceleration program to eliminate non-cash compensation expense that would have to be recorded in future periods following the Company’s adoption of Financial Accounting Standards Board Statement No. 123, “Share Based Payment (revised 2004),” (FAS 123R) in the first quarter of fiscal 2006. As a result of this acceleration, the Company recognized a charge to stock compensation expense of approximately $117,000 for the year ended January 31, 2006.
The following schedule reflects the impact on net income and net income per share if we had applied the fair value recognition provisions of SFAS 123 to stock based compensation.
(j)
Advertising Costs
Advertising costs for newspaper, television and other media are expensed as incurred. Gross advertising expenses for the fiscal years 2005, 2004, and 2003 were $9.8 million, $8.6 million and $9.8 million, respectively.
We receive payments and credits from vendors pursuant to cooperative advertising programs and display allowances. During fiscal years 2005, 2004 and 2003, we received a total of approximately $7.8 million, $6.6 million and $6.8 million, respectively for such payments and credits. To the extent such payments are a reimbursement for specific, identifiable costs, such amounts are recorded as a reduction in SG&A expenses. The remainder of these payments and allowances are recorded as a reduction of merchandise inventory and the cost of rental assets in accordance with Emerging Issues Task Force Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”).
(k)
Pre-opening Costs
Pre-opening expenses include human resource costs, travel, rent, advertising, supplies and certain other costs incurred prior to a store’s opening and are expensed as incurred.
(l)
Income Per Share
Basic income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted income per share is similarly computed, but includes the effect, when dilutive, of our weighted average number of stock options outstanding.
(m)
Use of Management Estimates
The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
(n)
Impact of Recently Issued Accounting Standards
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (“SFAS 151”), an amendment of Accounting Research Bulletin No. 43, Chapter 44. SFAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The statement will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has evaluated the provisions of SFAS 151 and does not anticipate that adoption will have an impact on its consolidated balance sheets or statements of operations, shareholders’ equity and cash flows.
In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”). This statement replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation,” and supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires all companies to measure compensation cost for all share-based payments, including stock options, at fair value. The statement will be effective for public companies no later than the beginning of the first fiscal year commencing after June 15, 2005, which for the Company is the beginning of fiscal 2006. The Company plans to adopt the modified prospective method and is currently evaluating the effect that SFAS 123R will have on its consolidated balance sheets and its statements of shareholders’ equity and cash flows. The Company believes the adoption of SFAS 123R will not have a material impact on results of operations, unless significant future stock grants occur. SFAS 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce operating cash flows and increase net financing cash flows in periods after the effective date. These future amounts cannot be estimated, because they depend on, among other things, when employees exercise stock options. However, the amount of operating cash flows recognized for such excess tax deductions for the years ended January 31, 2006, 2005, and 2004 was not material.
(2)
Merchandise Inventories
Merchandise inventories consist of the following:
During fiscal 2005 and 2004, we purchased approximately 19% and 22%, respectively, of all products (defined herein as merchandise inventories and rental assets) from three vendors.
(3)
Property and Equipment
Property and equipment consist of the following:
(4)
Accrued Expenses and Other Current Liabilities
Accrued expenses and other current liabilities consist of the following:
Merchandise inventories that are not sold can normally be returned to the vendors. The allowance for cost of inventory returns represents estimated costs related to merchandise returned or to be returned to vendors for which credit from the vendor is pending. Because the amount of credit to be received requires estimates, it is reasonably possible that our estimate of the ultimate settlement with our vendors may change in the near term.
In the ordinary course of business, we accrue estimated amounts for settlements with certain vendors related to disputed merchandise purchases and returns. Because the ultimate settlement amount requires estimates, it is reasonably possible that our estimate of the ultimate settlement with our vendors may change in the near term. During fiscal 2005, 2004, and 2003 we reduced merchandise cost of revenues by approximately $2.2 million, $2.1 million, and $4.2 million, respectively, related to favorable differences between actual settlements with vendors as compared to amounts accrued.
(5)
Store Closing Reserve
From time to time and in the normal course of business, we evaluate our store base to determine if we need to close a store. Such evaluations include consideration of, among other factors, current and future profitability, market trends, age of store and lease status.
Amounts in “Accrued expenses and other current liabilities” and “Other liabilities” at January 31, 2006 and 2005 include accruals for the net present value of future minimum lease payments, net of estimated sublease income, and other costs attributable to closed or relocated stores. Expenses related to store closings are included in SG&A expenses in our consolidated statement of operations.
The following table provides a rollforward of reserves that were established for these charges for fiscal 2005, 2004 and 2003:
As of January 31, 2006, the reserve balance, which is net of estimated sublease income, is expected to be paid over the next five years.
(6)
Long-term Debt
Long-term debt and capitalized lease obligations consist of the following:
On July 11, 2005 and February 28, 2006, we executed amendments to our syndicated secured Loan and Security Agreement with Fleet Retail Finance, Inc. and The CIT Group/Business Credit, Inc, (the “Facility”). The amount outstanding under the Facility is limited by a borrowing base predicated on eligible inventory, as defined in the Facility, and certain rental assets, net of accumulated depreciation less specifically defined reserves and after the February 28, 2006 amendment, is limited to a ceiling of $100 million, less a $10 million availability reserve. The Facility permits borrowings at various interest-rate options based on the prime rate or London Interbank Offering Rate (LIBOR) plus applicable margin depending upon the level of our minimum availability. The borrowing base under the Facility is limited to an advance rate of 65% of eligible inventory and certain rental assets net of accumulated amortization less specifically defined reserves, which can be adjusted to reduce availability under the Facility. Lenders may increase specifically defined reserves to reduce availability in the event of adverse changes in our industry that are projected to impact the value of our assets pledged as collateral. The Facility contains no financial covenants, restricts the payment of dividends and includes certain other debt and acquisition limitations, allows for the repurchase of up to $15 million of our common stock and requires a minimum availability of $10 million at all times. The Facility is secured by substantially all of the assets of the Company and our subsidiaries and is guaranteed by each of our consolidated subsidiaries. As a result of the amendment executed on February 28, 2006, the Facility matures on August 29, 2011. At January 31, 2006, we had $27.0 million in excess availability, after the $10 million availability reserve, under the Facility. However, excess availability may be reduced in the future as changes in the borrowing base occur or the lenders increase availability reserves. The average rate of interest being charged under the Facility for fiscal years ending January 31, 2006 and 2005 was 5.6% and 3.8%, respectively.
We utilize standby letters of credit to support certain insurance policies. The aggregate amount of the letters of credit at January 31, 2006 was approximately $1.1 million, which reduces the excess availability of the Facility.
The capitalized lease obligation represents one lease on certain retail space with an initial term of 15 years.
The aggregate maturities of long-term debt and capitalized lease obligations for years subsequent to fiscal 2005 are as follows:
(7)
Leases
We lease retail space under operating leases with terms ranging from three to 15 years, with certain leases containing renewal options. Lease agreements generally provide for minimum rentals. Some leases also include additional contingent rental amounts based upon specified percentages of sales above predetermined levels. Operating leases are accounted for in conformity with FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period, which requires rental costs associated with operating leases that are incurred during a construction period to be recognized as rental expense. Rental expense for operating leases is comprised of the following:
Future minimum lease payments under non-cancelable operating leases as of January 31, 2006 are:
A director of the Company is a limited partner in various limited partnerships that lease land and improvements to us under certain lease agreements. During fiscal 2005, 2004 and 2003, we made lease payments of $0.4 million, $0.5 million and $0.6 million, respectively related to these lease agreements.
(8)
Income Taxes
Income tax expense (benefit) is comprised of the following:
The difference between expected federal income tax expense (benefit) (computed by applying the statutory rate of 35% to income before income taxes) and actual income tax expense (benefit) is as follows:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below:
(9)
Income Per Share
The computations of basic and diluted income per share are as follows:
Options to purchase 726,980 shares of Common Stock at exercise prices ranging from $6.095 to $14.03 per share outstanding at January 31, 2006; 523,556 shares of Common Stock at exercise prices ranging from $7.30 per share to $14.03 per share outstanding at January 31, 2005; and 771,800 shares of Common Stock at exercise prices ranging from $3.95 per share to $14.03 per share outstanding at January 31, 2004, were not included in the computation of diluted income per share because their inclusion would have been antidilutive.
Our 401k plan permits full-time employees who have attained age 21 and part-time employees who have worked a minimum of 1,000 hours in a year and have attained age 21 to participate in the 401k plan and elect to contribute up to 25% of their salary, subject to federal limitations, to the plan. Employer contributions include a quarterly guaranteed match of 25% of employee contributions up to a maximum of 6% deferral of compensation and are allocated solely to those employees who are participating in the plan and are employed on the last day of the plan quarter or who became disabled, died, or retired during the plan quarter. Also included is a discretionary match based on specific criteria reviewed every fiscal six-month period by management and approved by the Board of Directors. This discretionary match is allocated solely to those employees who are participating in the plan and are employed on the last day of the six-month period.
Our Associate Stock Ownership Plan (ASOP) permits full-time employees who have attained age 21 and completed one year of service and part-time employees who have worked a minimum of 1,000 hours in a year and have attained age 21 to participate in the ASOP. Employer contributions are determined at the discretion of management. The Board of Directors has determined that the level of contributions will be made based on attaining operational profit goals as set by the Board of Directors. The contribution is based on a percentage of participants’ eligible compensation. Common shares held by the ASOP were 490,997, 459,864, and 385,252 at January 31, 2006, 2005, and 2004, respectively. Shares issued and held under the ASOP plan are included as outstanding shares for the purposes of calculating income per share.
Amounts expensed related to the 401k and ASOP Plans were $1.3 million, $0.6 million, and $1.5 million for fiscal 2005, 2004, and 2003, respectively.
At January 31, 2006, the options outstanding and options exercisable, and their related weighted-average exercise price, and the weighted-average remaining contractual life for the ranges of exercise prices are shown in the table below.
At January 31, 2006, 2005 and 2004, the number of options exercisable was 1,603,867; 959,076; and 886,253, respectively, and the weighted-average exercise price of those options was $6.50, $7.55 and $7.75, respectively.
We apply APB 25 and related interpretations in accounting for our Plans and since we generally grant stock options, except for RSUs as described above, with an exercise price equal to or greater than the current market price of the stock on the grant date, compensation expense is not recorded.
The per share weighted-average exercise price and the per share weighted-average fair value of stock options at the date of grant, using the Black-Scholes option-pricing model for SFAS 123 disclosure purposes, is as follows (in dollars):
The following assumptions were used in the calculation of fair value:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
As required by Exchange Act Rules 13a-15 and 15d-15, an evaluation was conducted under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of January 31, 2006 to determine whether our disclosure controls and procedures were effective as of such date to ensure that information required to be disclosed by us in our reports filed or submitted under the Exchange Act is (a) accumulated and communicated to our management, including our principal executive and financial officers, as appropriate to allow timely decisions regarding required disclosure, and (b) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective as of the end of the period covered by this Annual Report on Form 10-K to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms.
There has not been any change in our internal control over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this item will be set forth in our Proxy Statement for our 2006 Annual Meeting of Shareholders, to be filed within 120 days after the end of fiscal 2006 (our “Proxy Statement”), under the heading “Proposal No. 1: Election of Three Directors,” which information is incorporated herein by reference. The information required by this item regarding our executive officers is set forth under the heading “Executive Officers of the Company” in Part I of this Form 10-K, which information is incorporated herein by reference.
Section 16(a) Beneficial Ownership Reporting Compliance
The information required by this item regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 will be set forth in our Proxy Statement under the heading “Compliance with Section 16(a) of the Securities Exchange Act of 1934,” which is incorporated herein by reference.
Code of Ethics and Other Corporate Governance Information
Information regarding our Code of Ethics and the name of the individual determined by the board to be the “audit committee financial expert” is included in our Proxy Statement, under the heading “Proposal No. 1: Election of Three Directors,” which information is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this item will be set forth in our Proxy Statement under the headings “Executive Compensation,” “Executive Compensation - Director Compensation,” “Executive Compensation - Employee Contracts and Change of Control Arrangements,” and “Executive Compensation - Compensation Committee Interlocks and Insider Participation,” which information is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by this item will be set forth in our Proxy Statement under the headings, “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information,” which information is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item will be set forth in our Proxy Statement under the heading “Certain Relationships and Related Transactions,” which information is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required by this item will be set forth in our Proxy Statement under the heading “Principal Accountant Fees and Services,” which information is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
All other schedules are omitted because they are not applicable, not required or the required information is included in the Consolidated Financial Statements and notes thereto.
3.
The following exhibits are filed herewith or incorporated by reference as indicated as required by Item 601 of Regulation S-K. The exhibits designated by an asterisk are management contracts and/or compensatory plans or arrangements required to be filed as exhibits to this report.
Financial Statement Schedule II -
HASTINGS ENTERTAINMENT, INC.
Valuation and Qualifying Accounts and Reserves
Years Ended January 31, 2006, 2005 and 2004
(Amounts in thousands)
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, on behalf of the registrant, thereunto duly authorized:
POWER OF ATTORNEY
Each person whose signature appears below hereby authorizes and constitutes John H. Marmaduke and Dan Crow, and each of them singly, his true and lawful attorneys-in-fact with full power of substitution and redistribution, for him and in his name, place and stead, in any and all capacities to sign and file any and all amendments to this report with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and he hereby ratifies and confirms all that said attorneys-in-fact or any of them, or their substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.