UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2005.
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number 001-15153
BLOCKBUSTER INC.
(Exact name of registrant as specified in its charter)
DELAWARE | 52-1655102 | |
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification Number) |
1201 Elm Street
Dallas, Texas 75270
(214) 854-3000
(Address, including zip code, and telephone number, including area code, of registrants principal executive offices)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class |
Name of Each Exchange on Which Registered | |
Class A Common Stock, $.01 par value per share | New York Stock Exchange | |
Class B Common Stock, $.01 par value per share | New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Act). Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
As of June 30, 2005, which was the last business day of the registrants most recently completed second fiscal quarter, the aggregate market value of the registrants common stock held by non-affiliates was $1,512,058,109, based on the closing price of $9.12 per share of Class A common stock and $8.58 per share of Class B common stock as reported on the New York Stock Exchange composite tape on that date.
As of March 1, 2006, 119,454,598 shares of Class A common stock, $0.01 par value per share, and 72,000,000 shares of Class B common stock, $0.01 par value per share, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of our definitive proxy statement to be filed for our 2006 annual meeting of stockholders are incorporated by reference into Parts II and III of this Form 10-K. In addition, our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 15, 2005 is incorporated by reference into Item 5 of Part II of this Form 10-K.
THIS ANNUAL REPORT ON FORM 10-K IS BEING DISTRIBUTED TO STOCKHOLDERS IN LIEU OF A SEPARATE ANNUAL REPORT PURSUANT TO RULE 14a-3(b) OF THE ACT AND SECTION 203.01 OF THE NEW YORK STOCK EXCHANGE LISTED COMPANY MANUAL.
BLOCKBUSTER INC.
TABLE OF CONTENTS TO FORM 10-K
DISCLOSURE REGARDING FORWARD-LOOKING INFORMATION
This annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements may also be included from time to time in our other public filings, press releases, our website and oral and written presentations by management. Specific forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts and include, without limitation, words such as may, will, expects, believes, anticipates, plans, estimates, projects, targets, seeks, could, intends, foresees or the negative of such terms or other variations on such terms or comparable terminology. Similarly, statements that describe our strategies, initiatives, objectives, plans or goals are forward-looking.
These forward-looking statements are based on managements current intent, belief, expectations, estimates and projections regarding our company and our industry. These statements are not guarantees of future performance and involve risks, uncertainties, assumptions and other factors that are difficult to predict. Therefore, actual results may vary materially from what is expressed in or indicated by the forward-looking statements. The risk factors set forth below under Item 1A. Risk Factors, and other matters discussed from time to time in subsequent filings with the Securities and Exchange Commission, including the Disclosure Regarding Forward-Looking Information and Risk Factors sections of our Quarterly Reports on Form 10-Q, among others, could affect future results, causing these results to differ materially from those expressed in our forward-looking statements. In that event, our business, financial condition, results of operations or liquidity could be materially adversely affected and investors in our securities could lose part or all of their investments. Accordingly, our investors are cautioned not to place undue reliance on these forward-looking statements since, while we believe the assumptions on which the forward-looking statements are based are reasonable, there can be no assurance that these forward-looking statements will prove to be accurate.
Further, the forward-looking statements included in this Form 10-K and those included from time to time in our other public filings, press releases, our website and oral and written presentations by management are only made as of the respective dates thereof and we undertake no obligation to update publicly any forward-looking statement in this Form 10-K or in other documents, our website or oral statements for any reason, even if new information becomes available or other events occur in the future.
BLOCKBUSTER OVERVIEW
Blockbuster Inc. is a leading global provider of in-home rental and retail movie and game entertainment, with over 9,000 stores in the United States, its territories and 24 other countries as of December 31, 2005.
We operate in the highly competitive home video and home video game industries, which include in-home movie (i.e., theatrical movie, television series and direct-to-video product) and game entertainment offered primarily by traditional (i.e., in-store) retail outlets, online retailers and cable and satellite providers. We believe our offering of both in-store and online movie and game rental and in-store retail products has uniquely positioned us to meet the entertainment needs of our customers. However, the increasing availability of in-home entertainment through delivery methods other than traditional in-store models has led to significant challenges for us. Our 2005 results reflect the decline in the in-store home video rental industry, which we believe was caused by various factors including competition from other sources of in-home entertainment and other leisure activities, in addition to a weak slate of titles released to home video during most of 2005.
During 2004 and 2005, we focused on an investment strategy that we believe is essential to confront the significant challenges facing our company and industry. Specifically, we have invested in various strategic initiatives, which we believe will help offset our declining in-store rental revenues, add incremental future revenues and support future profitability growth. These initiatives include our no late fees program, BLOCKBUSTER Online®, in-store subscription programs, movie and game trading and expanded game concepts. During 2005, we focused our efforts on the no late fees program and BLOCKBUSTER Online. The no late fees program was launched to eliminate our most prevalent customer complaint with the movie rental experience and to combat our competitors use of late fees as a means of differentiating their service offerings. In locations where this program was implemented, we stopped charging extended viewing fees, commonly referred to as late fees, on all movie and game rentals.
Domestic Operations
In-Store
As of December 31, 2005, we had 5,696 stores operating under the BLOCKBUSTER® brand and other brand names in the United States and its territories. Of the 5,696 stores, 1,079 were operated through our franchisees. The stores operating under the BLOCKBUSTER brand offer movie and game rental and new and traded movie and game product to our customers. Our stores operating under other brand names include (i) 94 specialty retail game stores operating under the name RHINO VIDEO GAMES® which offer new and traded games; (ii) 92 stores operating under the Movie Brands Inc. umbrella which offer rental and retail movie and game product; and (iii) 35 MOVIE TRADING CO.® stores which primarily offer movie and game product for sale or trade.
Effective January 1, 2005, we implemented the no late fees program at all of our BLOCKBUSTER-branded company-operated stores and certain participating franchise stores in the United States.
During the fourth quarter of 2005, we completed the sale of our domestic subsidiary, D.E.J. Productions Inc., for consideration of $22.5 million. In addition, we are currently reviewing our asset portfolio with a focus on optimizing profitability through our core Blockbuster-branded businesses.
Online
In mid-2004, we launched BLOCKBUSTER Online in the United States and a smaller online subscription service in the United Kingdom. Our internet-based subscription services allow customers to rent DVDs by mail and offer substantially more titles than our stores, including a wide array of both new release and catalog DVDs.
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We believe that our online offerings allow us to retain and attract additional customers who prefer the convenience of renting online, including those customers located in a geographic area where we do not presently have a convenient store location. Additionally, we believe that our ability to integrate our online service with our in-store offerings provides us with a distinct competitive advantage. To take advantage of this distinction, we have expanded our cross-promotional efforts between our online service and our store locations. For example, BLOCKBUSTER Online subscribers receive two free in-store movie rental coupons each month, providing our customers with an incentive to come to our stores. Beginning in February 2006, new BLOCKBUSTER Online subscribers receive one free in-store movie rental coupon each week that expires weekly. Existing BLOCKBUSTER Online subscribers can elect to opt into this program or continue to receive two free in-store movie rental coupons that expire monthly. We have found that many of our in-store customers spend more with us after joining BLOCKBUSTER Online because of our cross-promotional efforts. To further take advantage of this incremental spending, during 2005, we increased the promotion of our online service in our store locations by offering prepaid online services for purchase by our customers.
During the second quarter of 2005, we began fulfilling some BLOCKBUSTER Online orders through inventory from certain company-operated and franchise store locations and expanded this fulfillment process to approximately 1,000 stores by the end of 2005. We believe this integrated approach, which further combines our online and in-store capabilities, will allow us to get movies to customers faster in remote locations while also allowing us to use our existing in-store labor, product and real estate resources to reduce overall costs.
Our online subscription services require significant ongoing subscriber acquisition investment in order to tap into this growing market and build a customer base large enough to allow this business to be profitable. As of December 31, 2005, we had approximately 1.2 million BLOCKBUSTER Online subscribers and we remain committed to achieving our goal of two million subscribers by the end of 2006.
International Operations
As of December 31, 2005, we also had 3,346 stores operating under the BLOCKBUSTER brand and other brand names owned by us located in 24 markets outside of the United States. Of these stores, 805 were operated through our franchisees. In the Republic of Ireland and Northern Ireland, we operate under the XTRA-VISION® brand name due to its strong local brand awareness. In the United Kingdom, we operate freestanding and store-in-store game locations under the brand name GAMESTATION®. In Australia, Italy, Mexico and Denmark, we also operate freestanding and store-in-store game locations under the GAME RUSH® brand. In 2005, 32.5% of our worldwide revenues were generated outside of the United States, compared to 30.5% in 2004 and 26.2% in 2003. As discussed in more detail below in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, the overall increase in revenues generated outside of the United States reflects the continued growth in international retail sales, the addition of freestanding game stores in certain international markets, the elimination of extended viewing fees in the United States and the impact of favorable foreign exchange rates. Our international operations are more dependent on retail sales and, in particular, the retail game industry. During 2005, retail sales comprised approximately 46% of our international revenues, which were largely driven by the freestanding and store-in-store game locations discussed above. Additional information regarding our revenues and long-lived assets by geographic area is included in Note 12 to the consolidated financial statements.
Effective January 29, 2005, we implemented the no late fees program at all of our stores in Canada. In 2006, we will continue to research and review consumer propositions in our international markets, including testing strategic initiatives that may be appropriate for those markets. In addition, we will continue to evaluate our international markets and make investment decisions based on local market conditions and our desire to better focus on key international markets. As part of our evaluation process, we may also consider the divestiture of or other strategic alternatives with regard to some or all of our international operations upon acceptable terms.
We maintain offices for each major region and most of the countries in which we operate in order to manage, among other things, (i) store development and operations; (ii) marketing; and (iii) the purchase, supply and distribution of product.
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INDUSTRY OVERVIEW
Domestic Home Video IndustryIn-Home Movies
The overall home video industry includes in-home movie entertainment offered through the following distribution channels:
| the retail home video industry; |
| the cable industry; and |
| the satellite industry. |
Of those distribution channels, the retail home video industry includes the sale and rental of movies on DVD and VHS by:
| traditional video store retailers such as Blockbuster and other businesses with video store operations, such as Movie Gallery; |
| online retailers, such as BLOCKBUSTER Online, Netflix and Amazon.com; and |
| other retailers, including mass merchant retailers such as Wal-Mart, Best Buy and Target. |
Consumer Spending. According to estimates from Kagan Research, LLC (Kagan), consumer spending for in-home movie viewing in the overall home video industry increased from about $25.5 billion in 2004 to about $28.2 billion in 2005 and is projected to increase to about $37.0 billion by 2010. Of the $28.2 billion in overall home video industry revenues during 2005, about $26.8 billion were generated by the retail home video industry. The remainder of the revenues for the overall home video industry were generated by pay-per-view and other specialized cable and satellite services.
Of the $26.8 billion in revenues generated by the retail home video industry during 2005, about $18.7 billion were generated by sales of movies and about $8.1 billion were generated by in-store and online rentals of movies. This compared to about $16.2 billion of revenues that were generated by sales of movies and about $8.1 billion that were generated by in-store and online rentals of movies during 2004. While the retail home video industry is projected to grow over the next several years, Kagan projects that movie rental revenues will decline, from approximately $8.1 billion in 2005 to about $6.7 billion in 2010. While Adams Media Research (Adams) also predicts a decline in movie rental revenues over the same period, they do not predict as substantial a decline as Kagan does. Because of the many variables affecting movie rental revenues, it is difficult to predict fluctuations in the movie rental industry with certainty. For example, beginning late in the second quarter of 2005 and continuing through the end of the year, the domestic in-store home video rental industry declined faster than industry analysts had previously anticipated. Adams estimates that the in-store movie rental industry declined approximately 9% in 2005 alone. We believe that this decline was caused primarily by (i) a weak slate of titles released to home video during most of 2005; (ii) increased competition from retail mass merchant sales of low-priced DVDs, online rentals and other sources of in-home entertainment such as digital video recorders and other devices that are capable of downloading content for in-home viewing; and (iii) competition from other forms of leisure entertainment.
The continued growth in the retail home video industry reflects the movie studios continued sell-through pricing to home video retailers for DVDs. As discussed in more detail below under Our OperationsSuppliers and Purchasing Arrangements, unlike the historically high wholesale pricing for VHS product, substantially all DVD product is released at a price to the home video retailer that is low enough to allow for affordable pricing for sales to consumers at the same time as movies are released to consumers for rental. This sell-through pricing has given consumers the option to purchase DVDs instead of, or in addition to, renting them and has enabled consumers to build home film libraries. Yet, while movie sales are estimated to have increased during 2005, rental transactions continued to exceed sales transactions. According to industry statistics, during 2004, rentals represented approximately 69.6% of the total number of industry transactions and sales represented
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approximately 30.4% of the total number of industry transactions. During 2005, rentals represented approximately 64.4% of the total number of industry transactions and sales represented approximately 35.6% of the total number of industry transactions. We believe that rentals continue to provide a compelling proposition for consumers because movie rentals offer relatively low cost entertainment and because video rental stores and online rental websites provide a convenient opportunity for customers to browse from among a very broad selection of movie titles.
In addition, we believe that the increased market penetration of the DVD format has been important for the rental industry. The number of U.S. DVD households is estimated to have increased from 64.8% of U.S. television households at the end of 2004 to 74.9% of U.S. television households by the end of 2005. Kagan projects that this will increase to 83.6% of U.S. television households by the end of 2006 and to 94.5% of U.S. television households by the end of 2010. However, despite increased DVD penetration, according to estimates of ICR CENTRIS, the number of console DVD households (meaning households that have a DVD player connected to their television) that actively purchase DVDs decreased approximately 5% from 31.1 million console DVD households during an average month of the fourth quarter of 2004 to 29.6 million console DVD households during an average month of the fourth quarter of 2005, while the frequency of purchases has declined approximately 6%, from 3.9 units to 3.7 units per console DVD household during an average month. During that same time, the number of console DVD households that actively rent DVDs increased approximately 2% from 27.5 million console DVD households during an average month of the fourth quarter of 2004 to 28.2 million console DVD households during an average month of the fourth quarter of 2005, while the frequency of rentals has not changed, remaining at 4.8 rentals per console DVD household during an average month. We also believe that our efforts to increase consumer satisfaction, such as our no late fees program, our Guaranteed in Stock rental program and our in-store and online rental subscription programs, will enhance the relevance of movie rentals to consumers and help drive rental business in the future.
Kagan projects that the percentage of overall home video industry revenues generated by the retail home video industry will decline somewhat in the future; however, we believe that the DVD format will drive continued growth in the retail home video industry due to increasing popularity of in-home theater systems and related enhanced viewing and sound capabilities, and the anticipated launch of high-definition DVD. In addition, we believe that the superior sound and picture quality of DVD as opposed to VHS, as well as its ease of use as compared with other digital distribution propositions, will help drive growth in the retail home video industry. We also believe that there are continued opportunities in the consumer market for used DVDs.
Studio Release Schedule to Home Video Retailers. A competitive advantage that the U.S. retail home video industry currently enjoys over most other movie distribution channels, except theatrical release, is the early timing of its distribution window. As discussed below under Worldwide Retail Home Video IndustryKey Source of Movie Studio Revenue, the retail home video industry is a critical source of revenue to U.S. movie studios. In order to maximize this revenue, studios currently release their movies to different distribution channels at different points in time. The first major distribution channel after theatrical release is currently home video (rental and retail, including mass merchant retail). The home video 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 home video retailers varies, but, since the mid-1990s, has averaged between 43 and 54 days for domestic home video retailers. Thereafter, movies are made sequentially available to the television distribution channels.
Recently, there has been a great deal of media coverage regarding potential industry-wide changes to the studio release schedule and there has been some experimentation with the current distribution windows, including simultaneous video-on-demand and DVD releases. We believe, however, that while the industrys practice with respect to the home video distribution window may change at any time, the studios have a vested interest in maintaining the home video distribution window so that they are able to maximize revenues generated by the retail home video industry. In addition, a portion of the attention regarding the studio release schedule has centered around the possible shortening of time between theatrical release and release on home video. We believe that if this
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were to occur, it would benefit our business because movies would be made available to consumers for rental or purchase earlier and because rental would provide a cheaper alternative to viewing a movie at the theater.
In addition, although the distribution window is a significant advantage to the U.S. retail home video industry, its advantage to traditional home video retailers with core rental businesses has been diminished due to the sell-through pricing of DVDs. Sell-through pricing is the process by which substantially all DVD titles are released at a price to the home 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 home video distribution window. Sell-through pricing has resulted in significant competition from mass merchant retailers, as movies are released for rental and sale at the same time. Studio pricing is discussed further below under Our OperationsSuppliers and Purchasing Arrangements and Item 1A. Risk FactorsChanges in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability.
International Home Video IndustryIn-Home Movies
Some of the attributes of the home video industry outside of the United States are similar to those of the home video industry within the United States. For example, the major studios generally release movies outside of the United States according to sequential distribution windows. However, other attributes of the home video industry outside of the United States do not necessarily mirror the home video industry within the United States. For example, most countries have different systems of supply and distribution of movies, and competition in many of our international markets tends to be more fragmented. In addition, under the laws of some countries and trading blocs (e.g., the European Union), home video retailers must obtain the right to rent videos to consumers through a licensing arrangement or a purchase-with-the-right-to-rent arrangement. Studios may charge these home video retailers more for product purchased for rental than product purchased solely for sale to consumers. This is commonly referred to as two-tiered pricing, and it affects our European operations. Two-tiered pricing not only results in increased competition from mass merchant retailers in those countries and trading blocs, it also creates increased competition with video rental outlets that operate in violation of the two-tiered pricing contractual limitations by renting product purchased at the lower retail price. The potential impact of studio pricing decisions is discussed under Item 1A. Risk FactorsChanges in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability. The international home video industry also faces high levels of piracy. Although piracy is also a concern in the United States, it is having a more significant adverse affect on the rental and retail video industry in international markets. Piracy is discussed further below under Competition and Item 1A. Risk FactorsPiracy of the products we offer or the disregard of release dates by other retailers may adversely affect our operations.
Worldwide Retail Home Video IndustryKey Source of Movie Studio Revenue
Of the many movies produced by major studios and released in the United States each year, relatively few are profitable for the movie studios based on box office revenues alone. For example, of the more than 500 movies released during 2005, only 19 grossed over $100 million at domestic theaters. As a result, the studios rely upon their distribution windows in order to maximize revenues. According to industry estimates, sales and rentals of DVDs and videos through the retail home video industry, which includes traditional video store retailers such as Blockbuster, as well as online and other retailers such as mass merchant retailers, continue to be the largest source of revenue to U.S. movie studios. In 2005, the worldwide retail home video industry is estimated to have contributed approximately 51.1% of U.S. studios revenues. Industry analysts project that the contribution of retail home video to studios revenues will be approximately the same in 2006.
We believe that sales and rentals by home video retailers will continue to be a key source of revenues for the movie studios. As discussed above, rentals provide particular benefits to the studios, as video rental stores and
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online rental websites acquire and rent movies that did not generate significant revenues in the theatrical box office, thus providing the movie studios with a reliable source of revenue for movies that would not be as popular for purchase. We believe that consumers are more likely to rent movies that were not box office hits because:
| the relatively low cost of a movie rental encourages consumers to rent movies they might not pay to view at a theater or desire to own; and |
| video rental stores and online rental websites provide a convenient opportunity to browse from among a broad selection of movie titles. |
As discussed above under Domestic Home Video IndustryIn-Home MoviesStudio Release Schedule to Home Video Retailers, we believe there is a strong economic incentive to the studios to maintain the retail home video distribution window. However, any consolidation or vertical integration of media companies to include both content providers and digital distributors could pose a risk to this continuation of the distribution window.
Home Video Game Industry
The video game industry is complex and different in many ways from the home video industry. The market for video games is highly cyclical and prone to changes in technology. In addition, video games have significantly higher price points than DVDs, and these price points are expected to increase further with the introduction of games for new hardware platforms. According to industry estimates, during 2005, total hardware unit sales in the United States increased approximately 2%, while hardware sales revenues increased by approximately 31%. The increase in hardware sales revenues was due mainly to the release of the Sony PSP in March of 2005, which currently retails at $299, and the release of the XBox 360 in November of 2005, which currently retails between $299 and $399. In 2006, we expect hardware sales to slow as consumers delay purchases in anticipation of new, more advanced platforms, including the Sony PlayStation 3 and the Nintendo Revolution, which are expected to launch in late 2006 or early 2007.
Game software sales in the United States decreased from approximately $6.2 billion in 2004 to approximately $6.1 billion in 2005. We expect game software sales to continue to decline during 2006. This reflects the cyclical nature of the home video game industry, which has traditionally been affected by changing technology, limited hardware and software lifecycles, frequent introduction of new products and the popularity, price and timing of new hardware platforms and software titles. The home video game industry typically grows with the introduction of new hardware platforms and games, but tends to slow prior to the introduction of new platforms, as consumers hold back their purchases in anticipation of new platform and game enhancements. However, we believe that the cyclical nature of the industry, along with the sizeable number of gaming households and the substantial number of game titles available, has contributed to the creation of a significant market for used games and games trading. Games trading enables consumers to exchange their games for merchandise credit, discounts on other products and, in some international stores, cash.
We also believe that the game rental industry continues to play an important role in the video game cycle, due in part to the relatively high purchase prices for game software. As discussed above, purchase prices for new platform games are expected to increase further, due mainly to an increase in software development costs. Therefore, we believe that the difference between the retail price and the rental price of a popular new video game title is typically high enough to make rentals an attractive alternative for customers. In addition, we believe rental pricing provides an attractive alternative for customers who do not want to buy a game close to the introduction of a new hardware platform. Game rentals also provide a testing ground for many consumers considering a game purchase. However, we believe that increased retail offerings of low-priced catalog, or value, games and increased games trading by us and our competitors compete with game rentals and sales of previously rented game product. We also believe that game rentals will decline during 2006 as the supply and demand for new game titles is currently reduced in anticipation of the new game platforms.
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Competition
We operate in a highly competitive environment. We believe our most significant competition comes from (i) retailers that rent, sell or trade movies and games; (ii) providers of direct delivery home viewing entertainment or other alternative delivery methods of entertainment content; (iii) piracy; and (iv) other competition.
Competition with Retailers that Rent, Sell or Trade Movies and Games. These retailers include, among others:
| mass merchant retailers, such as Wal-Mart, Best Buy and Target; |
| local, regional and national video and game stores, such as Movie Gallery and GameStop; |
| Internet sites, including online movie rental services, such as Netflix and Amazon.com; |
| toy and entertainment retailers; and |
| supermarkets, pharmacies and convenience stores. |
We believe that the principal factors we face in competing with retailers that rent, sell or trade movies and games are:
| consumer preference between purchasing and renting movies and games; |
| alternative product distribution channels and the perceived convenience of such alternative channels to the customer; |
| pricing; |
| convenience and visibility of store locations; |
| quality, quantity and variety of titles in the desired format; and |
| customer service. |
In particular, while the studios promotion of DVDs for simultaneous sale and rental has served to lower the wholesale cost of DVDs to us, it has also resulted in increased competition from mass merchant retailers, as discussed under Item 1A. Risk FactorsChanges in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability.
Competition with Providers of Direct Delivery Home Viewing Entertainment or Other Alternative Delivery Methods of Entertainment Content. These providers include direct broadcast satellite, cable, digital terrestrial, network and syndicated television, Internet content providers and other providers of alternative delivery methods of entertainment content. We believe that a competitive risk to our video store business comes from direct broadcast satellite, digital cable television, high-speed Internet access and other alternatives for delivering videos to consumers. Further growth in the direct broadcast satellite and digital cable subscriber bases could cause a smaller number of movies to be rented from us if viewers were to favor the expanded number of conventional channels and expanded programming, including sporting events, offered through these services. Direct broadcast satellite, digital cable and traditional cable providers not only offer numerous channels of conventional television, they also offer pay-per-view movies, which permit a subscriber to pay a fee to see a selected movie, and other specialized movie services. Some digital cable providers and a limited number of Internet content providers have also implemented technology referred to as video-on-demand, which transmits movies and other entertainment content on demand with interactive capabilities such as start, stop and rewind. Other examples of alternative delivery methods of entertainment content include personal video recorders, downloadable DVDs, video vending machines, disposable DVDs and video downloads to portable devices. Any consolidation or vertical integration of media companies to include both content providers and digital distributors
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could pose additional competitive risk to our business. The risks associated with this competition are discussed further under Item 1A. Risk FactorsWe cannot predict the impact that the following may have on our business: (i) new or improved technologies or video formats, (ii) alternative methods of content delivery or (iii) changes in consumer behavior facilitated by these technologies or formats and alternative methods of content delivery. We also compete generally for the consumers entertainment dollar and leisure time. and Item 1A. Risk FactorsOur video business would lose a competitive advantage if the movie studios were to shorten or eliminate the home video retailer distribution window or otherwise adversely change their current practices with respect to the timing of the release of movies to the various distribution channels.
Piracy. We compete against the illegal copying and sale of movies and video games. Because piracy is an illegal activity, it is difficult to quantify its exact impact on the home video industry. The primary methods of piracy affecting the home video industry are (i) the illegal copying of theatrical films at the time they are first run, (ii) the illegal copying of DVDs that are authorized by the studios solely for retail sale and/or rental by authorized retailers and (iii) the illegal online downloading of movies. These methods of piracy enable the low-cost sale of DVDs, as well as free viewing and sharing of DVDs, both of which compete with rentals and sales by authorized retailers like us. Competition from piracy has increased in recent years, in particular in our international markets, due in part to developments in technology that allow for faster copying and downloading of DVDs. Piracy has had a lesser effect on the video game industry in the United States, but has been a significant hindrance to the development of the home video game industry in many international markets, particularly in Latin America and Asia.
Other Competition. We also compete generally for the consumers entertainment dollar and leisure time with, among others, (i) movie theaters; (ii) Internet browsing, online gaming and other Internet-related activities; (iii) consumers existing personal movie libraries; (iv) live theater; and (v) sporting events.
We cannot assure you that the competitive pressures we face will not have a material adverse effect on our company.
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OUR OPERATIONS
Stores and Store Operations
Store Operations. Our U.S. company-operated stores generally operate under substantially similar hours of operation. Domestic stores are generally open 365 days a year, with daily hours from approximately 10:00 a.m. to 12:00 midnight. The hours of operation for franchised stores will vary depending on the franchisee, but generally, franchisees follow the store hours of our company-operated stores. Our U.S. company-operated stores each employs an average of 11 people, including one store manager. Staffing for franchised stores will vary and is the sole responsibility of our franchisees. International store operations vary by country.
Site Selection. We have developed a comprehensive model that we use to find suitable locations for company-operated stores and to assist our franchisees with finding suitable locations for franchised stores in the United States and in some of our larger international markets. In our smaller international markets, while we have specific site selection criteria, the lack of availability, access and reliability of local demographic, geographic and statistical data sometimes makes it difficult to develop a model that is as comprehensive as that mentioned above. Within each targeted market, we identify potential sites for new and replacement stores by evaluating market dynamics, some of which include population demographics, customer concentration levels and possible competitive factors. We seek to place stores in locations that are convenient and visible to the public. We also seek to locate our stores in geographic areas with population and customer concentrations that enable us to better allocate available resources and manage operating efficiencies in inventory management, advertising, marketing, distribution, training and store supervision. We use our extensive membership transaction and real estate databases to monitor market conditions, select strategic store locations and maximize revenues without significantly decreasing the revenues of our nearby stores. We also periodically examine whether the size and formats of our existing stores are optimal for their location and may adjust the size of or relocate existing stores as conditions require. Our franchise program provides us with an additional avenue for maximizing our consumer reach.
As part of our efforts to reduce our cost structure, we anticipate opening fewer new company-operated stores in 2006 than in recent years. We are also currently reviewing many of our store leases and selecting sites to close or downsize based on store profitability. As a result, we could potentially close up to 10% of our store base over the next several years.
Store Development. The following table sets forth our store count information for both company-operated and franchised stores, domestic and international, during 2005:
Company-Operated | Franchised Stores | Total | |||||||||||||||||||||||||
U.S. | Intl.(1) | Total | U.S. | Intl.(1) | Total | U.S. | Intl. | Total | |||||||||||||||||||
December 31, 2004 |
4,708 | 2,557 | 7,265 | 1,095 | 734 | 1,829 | 5,803 | 3,291 | 9,094 | ||||||||||||||||||
Opened/purchased |
103 | 68 | 171 | 10 | 83 | 93 | 113 | 151 | 264 | ||||||||||||||||||
Sold/closed |
(194 | ) | (84 | ) | (278 | ) | (26 | ) | (12 | ) | (38 | ) | (220 | ) | (96 | ) | (316 | ) | |||||||||
Net additions/closures |
(91 | ) | (16 | ) | (107 | ) | (16 | ) | 71 | 55 | (107 | ) | 55 | (52 | ) | ||||||||||||
December 31, 2005 |
4,617 | 2,541 | 7,158 | 1,079 | 805 | 1,884 | 5,696 | 3,346 | 9,042 | ||||||||||||||||||
(1) | During 2005, we refranchised 47 stores in Australia. |
Store Locations. At December 31, 2005, in the United States and its territories, we operated 4,617 stores and our franchisees operated 1,079 stores. The following table sets forth, by state or territory, the number of domestic stores operated by us and our franchisees as of December 31, 2005.
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STATE OR TERRITORY |
Number of Company- Operated Stores |
Number of Franchised |
Total(1) | |||
Alaska |
| 17 | 17 | |||
Alabama |
40 | 39 | 79 | |||
Arkansas |
1 | 19 | 20 | |||
Arizona |
126 | 7 | 133 | |||
California |
610 | 55 | 665 | |||
Colorado |
124 | 4 | 128 | |||
Connecticut |
41 | 21 | 62 | |||
District of Columbia |
6 | | 6 | |||
Delaware |
7 | 8 | 15 | |||
Florida |
376 | 58 | 434 | |||
Georgia |
178 | 33 | 211 | |||
Guam |
3 | | 3 | |||
Hawaii |
25 | | 25 | |||
Iowa |
45 | 3 | 48 | |||
Idaho |
1 | 14 | 15 | |||
Illinois |
245 | 3 | 248 | |||
Indiana |
72 | 48 | 120 | |||
Kansas |
22 | 35 | 57 | |||
Kentucky |
38 | 46 | 84 | |||
Louisiana |
58 | 32 | 90 | |||
Massachusetts |
66 | 59 | 125 | |||
Maryland |
107 | 22 | 129 | |||
Maine |
6 | | 6 | |||
Michigan |
161 | 22 | 183 | |||
Minnesota |
67 | 19 | 86 | |||
Missouri |
96 | 13 | 109 | |||
Mississippi |
14 | 32 | 46 | |||
Montana |
| 8 | 8 | |||
North Carolina |
160 | 1 | 161 | |||
North Dakota |
| 6 | 6 | |||
Nebraska |
30 | 5 | 35 | |||
New Hampshire |
15 | 5 | 20 | |||
New Jersey |
133 | 24 | 157 | |||
New Mexico |
| 35 | 35 | |||
Nevada |
49 | 8 | 57 | |||
New York |
271 | 9 | 280 | |||
Ohio |
187 | 2 | 189 | |||
Oklahoma |
65 | 5 | 70 | |||
Oregon |
79 | 16 | 95 | |||
Pennsylvania |
187 | 15 | 202 | |||
Puerto Rico |
| 39 | 39 | |||
Rhode Island |
| 25 | 25 | |||
South Carolina |
70 | 8 | 78 | |||
South Dakota |
2 | 14 | 16 | |||
Tennessee |
54 | 58 | 112 | |||
Texas |
397 | 116 | 513 | |||
Utah |
65 | 4 | 69 | |||
Virginia |
102 | 32 | 134 | |||
Virgin Islands |
| 2 | 2 | |||
Vermont |
7 | 1 | 8 |
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STATE OR TERRITORY |
Number of Company- Operated Stores |
Number of Franchised |
Total(1) | |||
Washington |
126 | 4 | 130 | |||
Wisconsin |
71 | 11 | 82 | |||
West Virginia |
12 | 7 | 19 | |||
Wyoming |
| 10 | 10 | |||
Domestic Store Totals |
4,617 | 1,079 | 5,696 | |||
(1) | This does not include non-operating stores that are leased or owned. |
At December 31, 2005, outside of the United States, we operated 2,541 stores, including 204 specialty games stores operating under the name GAMESTATION in the United Kingdom and 9 operating under the name GAME RUSH in Australia and Italy. In addition, our franchisees operated 805 stores outside of the United States. The following table sets forth, by country, the number of stores operated by us and by our franchisees as of December 31, 2005.
COUNTRY |
Number of Company- Operated Stores |
Number of Franchised Stores |
Total(1)(2) | |||
Great Britain |
915 | | 915 | |||
Canada |
443 | | 443 | |||
Australia |
64 | 345 | 409 | |||
Mexico |
310 | 5 | 315 | |||
Italy |
187 | 69 | 256 | |||
Ireland (Republic) and Northern Ireland |
200 | | 200 | |||
Brazil |
| 136 | 136 | |||
Taiwan |
89 | 39 | 128 | |||
Spain |
93 | 13 | 106 | |||
Argentina |
83 | 1 | 84 | |||
Chile |
82 | | 82 | |||
Denmark |
72 | | 72 | |||
New Zealand |
| 39 | 39 | |||
Portugal |
| 27 | 27 | |||
Thailand |
| 22 | 22 | |||
Colombia |
| 21 | 21 | |||
Venezuela |
| 20 | 20 | |||
Panama |
| 16 | 16 | |||
Israel |
| 15 | 15 | |||
Dominican Republic |
| 12 | 12 | |||
Peru |
| 12 | 12 | |||
Guatemala |
| 8 | 8 | |||
El Salvador |
| 5 | 5 | |||
Uruguay |
3 | | 3 | |||
International Store Totals |
2,541 | 805 | 3,346 | |||
United States |
4,617 | 1,079 | 5,696 | |||
Domestic and International Store Totals |
7,158 | 1,884 | 9,042 | |||
(1) | This does not include non-operating stores that are leased or owned. |
(2) | In addition to the stores listed in the table, as of December 31, 2005, there were 21 video vending machines in Spain. |
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Franchised Operations
We believe our franchising program is an effective way to expand our consumer reach. At December 31, 2005, approximately 225 domestic franchisees operated 1,079 stores in the United States and approximately 270 international franchisees operated 805 stores outside of the United States. Our $5.9 billion in revenues during 2005 does not include the actual revenues of our franchisees, as we only record royalty revenues generated from our franchised operations. Under our current U.S. franchising program, we enter into a development agreement and subsequent franchise agreement(s) with the franchisee. This process may vary with respect to our current international franchising program. Pursuant to the terms of a typical development agreement, we grant the franchisee the right to develop one or a specified number of stores at a permitted location or locations within a defined geographic area and within a specified time. We generally charge the franchisee a development fee at the time of execution of the development agreement for each store to be developed during the term of the development agreement. A development agreement is not, however, typically entered into when a franchisee acquires an existing store from us or another franchisee. The typical franchise agreement is a long-term agreement that governs, among other things, the operations of the store to protect our brand. We generally require the franchisee to pay us a one-time franchise fee and continuing royalty fees, service fees and monthly payments for, among other things, maintenance of our proprietary software. In addition, from time to time we provide optional programs and product and support services to our franchisees for which we sometimes receive fees. We also require our franchisees to contribute funds for national advertising and marketing programs and also require that franchisees spend an additional amount for local advertising or other marketing efforts. The amounts our franchisees are required to contribute for national advertising and marketing efforts have been reduced for 2006 to allow our franchisees to reinvest funds into their businesses. Additionally, as an alternative to the national advertising and marketing contributions, starting in 2006, franchisees may opt to spend amounts equal to those they would have contributed to our national advertising and marketing fund on their own regional advertising and marketing activities.
Our franchisees have control over all operating and pricing decisions at their respective locations. For example, our franchisees have control over whether or not to eliminate extended viewing fees and the specific rental terms underlying any elimination of extended viewing fees. This has resulted in variations of rental terms, selling terms and restocking fees between company-operated and franchised BLOCKBUSTER stores, as well as variations in these terms among franchised BLOCKBUSTER stores. In the United States, approximately 550 franchise stores implemented the no late fees program on January 1, 2005. As of March 1, 2006, approximately 340 of our franchisees in the United States were participating in the no late fees program. We also do not require our franchisees to purchase inventory from us. Generally, a franchisee has sole responsibility for all financial commitments relating to the development, opening and operation of its stores, including rent, utilities, payroll and other capital and incidental expenses. We cannot offer assurances that our franchisees will be able to achieve profitability levels in their businesses sufficient to pay our franchise fees, as discussed in more detail below under Item 1A. Risk FactorsOur results of operations could be materially adversely affected if our franchisees failed to pay our franchise fees. Furthermore, we cannot offer assurances that we will be successful in marketing and selling new franchises, that we will continue to actively pursue new franchisees or that any new franchisees will be able to obtain desirable locations and acceptable leases. Finally, we cannot predict the impact that our franchisees decisions with respect to product depth and pricing may have on our overall business results.
Marketing and Advertising
We design our marketing and advertising campaigns in order to maximize opportunities in the marketplace and thereby increase the return on our marketing and advertising expenditures. We obtain information from our membership transaction database, our real estate database and outside research agencies to formulate and adjust our marketing and advertising campaigns based on:
| membership behavior and transaction trends; |
| our market share in the relevant market; |
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| our financial position; |
| our evaluation of industry trends; |
| local demographics; and |
| other competitive issues. |
This enables us to focus our resources in areas that we believe will generate the best return on our investment.
During 2005, we continued to focus on offering programs that are an alternative to the programs offered by mass merchant retailers and other online subscription service providers. For example, in the United States, we introduced our no late fees program in January of 2005, reintroduced our Guaranteed in Stock rental program in June of 2005 and continued to offer our in-store movie and game subscription services, the BLOCKBUSTER Movie Pass® and the BLOCKBUSTER Game Pass®. Additionally, we continued our BLOCKBUSTER Rewards® program, expanded DVD and game trading significantly in our U.S. locations and offered in-store rental coupons to our BLOCKBUSTER Online subscribers. Each of these is discussed below.
| No Late Fees. The no late fees program eliminates extended viewing fees on movies and games at all of our company-operated BLOCKBUSTER stores in the United States and Canada and at certain participating franchise locations in the United States. |
| Guaranteed in Stock. The Guaranteed in Stock program offers customers the assurance that certain popular newly released video titles will be in stock or the customer will receive a coupon that can be redeemed for a free rental of that movie within the following 30 days. |
| BLOCKBUSTER Movie Pass and BLOCKBUSTER Game Pass. These programs allow customers to rent a select number of titles for one price and keep them for whatever period of time that they desire during the term of the pass, subject to certain limitations. |
| BLOCKBUSTER Rewards. This premium in-store membership program is designed to offer benefits to our customers and enhance customer loyalty by encouraging our customers to rent movies and games only from our stores. |
| DVD and Game Trading. DVD and game trading allows our customers to trade in used product for merchandise credit, discounts on other products and, in some international stores, cash. |
| In-Store Movie Rental Coupons for BLOCKBUSTER Online Subscribers. This promotion offers BLOCKBUSTER Online subscribers free in-store movie rental coupons, providing them with an incentive to come to our stores. |
We continued our customer relations management (CRM) business strategy to build relationships with specific customer segments in order to maintain our high-value customers and introduce our customers to our strategic initiatives. By segmenting our customer base and targeting our direct marketing channel communications, we believe we are improving the effectiveness and efficiency of our direct marketing efforts in traditional channels such as direct mail, as well as non-traditional channels such as e-mail and point of sale. Specific to our strategic initiatives, we believe our existing capabilities help drive customers to both our in-store and online subscription services. In addition to using our existing CRM systems, we have built and are continuing to build new CRM systems specific to online subscription that will help us understand online consumer behavior in regards to web traffic and rental patterns.
We believe that our CRM activities positively impact our ability to drive incremental store visits, consumer spending and customer retention rates. We are communicating with customers at critical junctions in the customer lifecycle, and we believe we are driving changes to their activity to enhance our business. Additionally, we continue frequent and consistent relationship-building activities with customers via e-mail, an extremely low-cost communication channel, and by leveraging our direct mail database.
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In 2005, our advertising expenses remained relatively flat as compared to those in 2004. During 2005, we focused our advertising on growing BLOCKBUSTER Online and on our no late fees program. Worldwide, during 2005, we incurred $255.3 million in advertising expenses, which included $208.0 million in the United States and $47.3 million outside of the United States, compared to $257.4 million in advertising expenses during 2004, which included $203.9 million in the United States and $53.5 million outside of the United States. Of the $208.0 million in advertising expenses that we incurred domestically during 2005, approximately $60 million was incurred during the first two quarters of 2005 in connection with the marketing and implementation of our no late fees program. In addition, we incurred approximately $30 million of additional selling and advertising expenses, including subscriber acquisition costs, in support of the growth of BLOCKBUSTER Online during 2005. Our advertising focus during 2006 will primarily be in support of growing BLOCKBUSTER Online. Meanwhile, we anticipate that the studios will continue their spending to advertise new DVD releases. In addition, some of our business alliances, including some of those with the studios, allow us to direct a portion of their home video advertising expenditures. For example, we often receive cooperative advertising funds from the studios that might be used for direct mail or point-of-purchase advertising.
During 2006, we will continue to take advantage of studio advertising of new releases and our use of cost effective direct marketing tools. We also expect to reduce our selling, general and administrative expenses by approximately $100 million from 2005 to 2006 and anticipate that a significant portion of these savings will be realized through lower marketing expenses. As such, we will continue to evaluate our advertising and marketing expenses in 2006 and determine the appropriate spending to support our strategic initiatives. We will also continue to adjust our core advertising and marketing spend as necessary depending on market opportunities.
Suppliers and Purchasing Arrangements
We purchase our movie rental inventory for our U.S. company-operated stores directly from the studios on both a title-by-title basis through purchase orders and through various revenue-sharing arrangements. The number of domestic movie rental inventory units purchased under revenue-sharing arrangements increased during 2005 to approximately 71.0% of our total units purchased, up from approximately 66.3% during 2004. Revenue-sharing arrangements for movie rental inventory require us to share an agreed upon percentage of our rental revenues with a studio for a limited period of time. Revenue-sharing arrangements also generally provide for a lower initial payment for product, with the remainder of revenue-sharing product payments becoming due as rental revenues are earned. In addition to the revenue-sharing component, each arrangement also provides for the method of disposition of the product at the conclusion of the rental cycle. The number of domestic game software rental inventory units purchased under revenue-sharing arrangements increased slightly from 43.0% in 2004 to 43.3% in 2005. Revenue-sharing arrangements for rental game software are generally negotiated on a title-by-title basis, but are otherwise similar to our movie arrangements.
Revenue-sharing arrangements were significant to us historically due to otherwise relatively high wholesale prices for VHS rental product, which made it difficult for home video retailers to purchase enough copy depth to satisfy consumer demand. Studio pricing for movies released to home video retailers historically 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 home video distribution window. In order to promote a movie title for rental, the title would be released to home 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 home video distribution window. As rental demand subsided, the studio would reduce pricing in order to then allow for reasonably priced sales to consumers. The initial period during which the movie was released with higher pricing was referred to as the rental window.
Currently, substantially all DVD titles are released at a price to the home 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 home video distribution window. When the home video market shifted towards the sell-through priced DVD format, the overall significance to us of revenue-sharing arrangements generally declined, as the lower sell-through pricing for DVD product enabled us to acquire significant quantities of product with or without revenue-sharing. However, the success of our movie and game passes and our elimination of extended viewing fees has put a
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strain on the availability of the newest releases, and we are working to improve this availability through new revenue-sharing and other copy depth programs. During 2005, we continued to increase our use of revenue- sharing arrangements for DVD product as an important part of our focus on increasing rental margins by allowing us the flexibility to increase our copy depth, while providing a lower degree of risk to our movie rental gross margin than purchases under traditional arrangements. However, product not returned at the end of the rental and goodwill periods is automatically purchased by the customer and might trigger an additional payment under certain revenue-sharing agreements for the early sale of the product, which increases the cost of the revenue-sharing arrangement. Based on market conditions and current economics, we may adjust the use of revenue-sharing arrangements in the future.
We currently purchase most of our movie rental inventory for BLOCKBUSTER Online from a third-party distributor. During 2005, we began purchasing some of this rental product from the studios through revenue-sharing arrangements. Additionally, we began fulfilling some of our online rentals from our non-revenue sharing stock in store locations during 2005.
In our international markets, more than half of our movie and game rental inventory units are purchased on a title-by-title basis through purchase orders directly from the studios or through sub-wholesalers appointed by the studios to distribute the studios product in particular countries. The remainder of our international rental product is purchased under revenue-sharing arrangements similar to those discussed above. Our purchasing arrangements vary by country and studio depending on factors such as the availability of the rental window and revenue-sharing terms.
New retail movie and game inventory is purchased from the studios or their designated sub-wholesalers on a title-by-title basis through purchase orders. We also acquire retail movie and game inventory through our trading programs. We purchase general merchandise that is complementary to our rental and retail movie and video game inventory, such as confection, game and other accessories and consumer electronics, from a variety of suppliers on a product-by-product basis through purchase orders.
We require each franchisee to comply with basic guidelines that set forth the minimum amount and selection of movies to be kept in its store inventory. Franchisees typically obtain movies from their own suppliers and are also responsible for obtaining some of the other complementary products from their own suppliers. However, if we have purchased the distribution rights to a movie or if a franchisee participates with us under our revenue-sharing arrangements, the franchisee may obtain the applicable product from us.
Distribution and Inventory Management
In the United States, we receive substantially all of our movies and some of our games for our U.S. company-operated stores at our 850,000 square foot distribution center in McKinney, Texas. The distribution center is a highly automated, centralized facility that we use to mechanically repackage newly-released movies and games to make them suitable for rental at our stores. We also use our distribution center to restock products and process returns, as well as to provide some office space. We use a network of third-party delivery agents for delivery of products to our U.S. stores. We ship our products to these delivery agents, located strategically throughout the United States, which in turn deliver them to our stores. We receive the majority of our game product through a third-party distributor in order to receive and distribute newly released game products to select stores as quickly as possible following their initial release.
We believe our distribution center gives us a significant advantage over some of our competitors that primarily use third-party distributors because we are able to process and distribute a greater quantity of products while reducing costs and improving services to our stores. The distribution center supports substantially all of our company-operated stores in the United States and operates 24 hours a day, six days a week. As of December 31, 2005, we employed about 955 employees at our distribution center.
In addition to our distribution center in McKinney, we also have 30 distribution centers spread strategically throughout the United States to support BLOCKBUSTER Online. These online distribution centers are spread
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across the country because we use the United States Postal Service to distribute our online product, and the closer the distribution center is to a customer, the faster the customer receives the product. During 2005, we also began fulfilling online rental product orders from approximately 1,000 stores. We believe this integration will reduce overall product costs and improve margin.
Franchisees generally obtain their products directly from third-party suppliers, except for their point-of-sale systems hardware and software, some accessories and supplies, movies for which we have exclusive distribution rights and movies for franchisees that participate in our franchisee revenue-sharing programs, which domestic franchisees receive from our distribution center.
In our international markets, our stores generally receive rental product directly from the studios or sub-wholesalers. Retail product is generally distributed through a central warehouse for the market or through a third-party distributor.
Management Information Systems
We believe that the accurate and efficient management of purchasing, inventory and sales records is important to our future success. We maintain information, updated daily, regarding revenues, current and historical sales and rental activity, demographics of store customers and rental patterns. This information can be organized by store, region, state, country or for all operations.
All of our BLOCKBUSTER-branded company-operated stores use our point-of-sale system. Our national point-of-sale system in the United States is linked with a data center located in our distribution center. The point-of-sale system tracks all of our products distributed from the distribution center to each U.S. store using scanned bar code information. All domestic rental and sales transactions are recorded by the point-of-sale system when scanned at the time of customer checkout. At the end of each day, the point-of-sale system transmits store data from operations to the data center and the membership transaction database.
During 2005, we implemented a new enterprise resource planning system, which included Financial, Human Resource and Payroll modules, to replace certain of our existing finance, accounting, payroll and benefits administrative systems.
In 2005, we continued significant investment in our strategic initiatives, including BLOCKBUSTER Online, where we implemented systems that allow us to fulfill online rental product orders from our stores, thereby enabling us to get movies to customers faster in remote locations.
Regulation
Domestic Regulation
We are subject to various federal, state and local laws that govern the access to and use of our video stores by disabled customers and the disclosure and retention of customer records, including laws pertaining to the use of our membership transaction database. We also must comply with various regulations affecting our business, including federal, state or local securities, advertising, consumer protection, credit protection, franchising, licensing, zoning, land use, construction, second-hand dealer, environmental, health and safety, minimum wage, labor and employment, trading activities and other regulations.
We are also subject to the Federal Trade Commissions Trade Regulation Rule entitled Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures and state laws and regulations that govern the offer and sale of franchises and franchise relationships. If we want to offer and sell a franchise, we are required to furnish to each prospective franchisee a current franchise offering circular prior to the offer or sale of a franchise. In addition, a number of states require us to comply with registration or filing requirements prior to offering or selling a franchise in the state and to provide a prospective franchisee with a current franchise offering circular complying with the states laws, prior to the offer or sale of the franchise. We intend to maintain a franchise offering circular that complies with all applicable federal and state franchise sales
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and other applicable laws. However, if we are unable to comply with federal franchise sales and disclosure laws and regulations, we will be unable to offer and sell franchises anywhere in the United States. In addition, if we are unable to comply with the franchise sales and disclosure laws and regulations of any state that regulate the offer and sale of franchises, we will be unable to offer and sell franchises in that state.
We are also subject to a number of state laws and regulations that regulate some substantive aspects of the franchisor-franchisee relationship, including:
| those governing the termination or non-renewal of a franchise agreement, such as requirements that: |
(a) good cause exist as a basis for such termination; and
(b) a franchisee be given advance notice of, and a right to cure, a default prior to termination;
| requirements that the franchisor deal with its franchisees in good faith; |
| prohibitions against interference with the right of free association among franchisees; and |
| those regulating discrimination among franchisees in charges, royalties or fees. |
Compliance with any of the regulations discussed above is costly and time-consuming, and we cannot assure you that we will not encounter difficulties, delays or significant costs in connection with such compliance.
International Regulation
We are subject to various international laws that govern the disclosure and retention of customer records. For example, the laws pertaining to the use of our membership transaction database in some markets outside of the United States are more restrictive than the relevant laws in the United States and may restrict data flow across international borders.
We must also comply with various other international regulations affecting our business, including advertising, consumer protection, access to and use of our video stores by disabled customers, credit protection, film and game classification, franchising, licensing, zoning, land use, construction, second-hand dealer, environmental, health and safety, minimum wage and other labor and employment regulations. Some foreign countries have copyright and other intellectual property laws that differ from the laws of the United States. These laws may prevent or limit certain types of business activity in the affected markets.
Similar to the United States, some foreign countries have franchise registration and disclosure laws affecting the offer and sale of franchises within their borders and to their citizens. They are often not as extensive and onerous as U.S. laws and regulations. However, as in the United States, failure to comply with such laws could limit or preclude our ability to expand in those countries through franchising or could affect the enforceability of franchise agreements.
Historical Information
Our business and operations were previously conducted by Blockbuster Entertainment Corporation, which was incorporated in Delaware in 1982 and entered the movie rental business in 1985. Blockbuster Inc., formerly an indirect subsidiary of Viacom Inc. (Viacom) was incorporated under a different name on October 16, 1989 in Delaware. On September 29, 1994, Blockbuster Entertainment Corporation was merged with and into Viacom. Subsequent to the merger, our business and operations were conducted by various indirect subsidiaries of Viacom. Over the year and a half prior to our initial public offering in August 1999, our business and operations were either (1) merged into Blockbuster Inc. or (2) purchased by Blockbuster Inc. and/or one of its subsidiaries. In October 2004, Blockbuster Inc. split-off from Viacom and became a fully independent company.
Intellectual Property
Trademarks. We own various existing trademark registrations and have trademark applications pending registration with respect to our services and products offered worldwide. These include BLOCKBUSTER®,
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BLOCKBUSTER VIDEO®, TORN TICKET Logos, blockbuster.com®, BLOCKBUSTER Online®, BLOCKBUSTER Night®, BLOCKBUSTER GiftCard/s®, BLOCKBUSTER Game Pass® and BLOCKBUSTER Movie Pass® word marks and logos, BLOCKBUSTER Rewards® and the related BLOCKBUSTER Family of Marks, GAME RUSH® word mark and logo, LIFE AFTER LATE FEES.THE START OF MORE, BE KIND RETURN ON TIME, THE MOVIE STORE AT YOUR DOOR®, RENTING IS BETTER THAN EVER, THE GIFT OF ENTERTAINMENT®, MAKE IT A BLOCKBUSTER NIGHT®, QUIK DROP®, MOVIE TRADING CO.®, MR. MOVIES®, RHINO VIDEO GAMES®, GAMESTATION®, and XTRA-VISION®, among others, and trade dress elements including the blue and yellow awning outside our stores. In addition, we own the domain name registration for blockbuster.com and various blockbuster top level and country domain names, and a wide variety of other domain names registrations worldwide. We consider our intellectual property rights to be among our most valuable assets.
Copyrights. In addition to our own intellectual property rights, the scope of the rights of those who own copyrights in the products we rent also are of importance to us. The copyright first sale doctrine provides that, in the United States, the owner of a legitimate copy of a copyrighted work may, without the consent of the copyright owner, sell, rent or otherwise transfer possession of that copy. The first sale doctrine does not apply to sound recordings or computer software (other than software made for a limited purpose computer, such as a video game platform) for which the U.S. Copyright Act vests the right to control the rental of the copy in the copyright holder. The first sale doctrine does not exist in most countries outside of the United States where the copyright owner retains the rental rights to a copyrighted work. In these countries, home video retailers must obtain the right to rent videos to consumers through a licensing arrangement or a purchase-with-the-right-to-rent arrangement. Studios may charge these home video retailers more for product purchased for rental than product purchased solely for sale to consumers. This is commonly referred to as two-tiered pricing. The potential impact of studio pricing decisions in countries where two-tiered pricing is allowed is discussed under Item 1A. Risk FactorsChanges in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability. The risk of changes in U.S. and international copyright laws is discussed under Item 1A. Risk FactorsWe are subject to governmental regulation particular to the retail home video industry and changes in U.S. or international laws may adversely affect us.
Seasonality
There is a distinct seasonal pattern to the home video and video games business, with slower business in April and May, due in part to improved weather and Daylight Saving Time, and in September and October, due in part to the start of school and the introduction of new television programs. The months of November and December have historically been our highest revenue months. While we expect these months to continue to make the largest contributions to our rental revenues, we believe the strength of rental revenues in these months has been and will continue to be negatively affected, to some degree, by consumers purchasing DVDs during the holiday season. The popularity of our rental subscription passes has helped us mitigate, to some extent, the impact of seasonality on our business by providing a steady revenue stream across all months.
Employees
As of December 31, 2005, we employed about 72,600 persons, including about 50,300 within the United States and about 22,300 outside of the United States. Of the total number of U.S. employees, about 17,300 were full-time, about 30,700 were part-time and about 2,300 were seasonal employees. We believe that our employee relations are good.
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Executive Officers of the Registrant
The following information regarding our executive officers is as of March 1, 2006.
Name |
Age | Position | ||
John F. Antioco |
56 | Chairman of the Board of Directors and Chief Executive Officer | ||
Frank G. Paci |
48 | Executive Vice President, Strategic Planning and Business Development | ||
Nicholas P. Shepherd |
47 | Executive Vice President and President, Blockbuster North America | ||
Christopher J. Wyatt |
49 | Executive Vice President and President, International | ||
Larry J. Zine |
51 | Executive Vice President, Chief Financial Officer and Chief Administrative Officer |
Set forth below is a description of the background of each of our executive officers.
John F. Antioco has served as our chairman of the board of directors and chief executive officer since 1997 and served as our president from 1997 until 2001. Mr. Antioco serves as chairman of the board of directors of Main Street Restaurant Group, Inc. and is a member of the board of governors of the Boys & Girls Clubs of America.
Frank G. Paci has served as our executive vice president, strategic planning and business development since February 2006 and served as our executive vice president, finance and accounting, strategic planning and development from January 2005 until February 2006. He served as our executive vice president, finance, strategic planning and development from 2003 to 2005 and as senior vice president, strategic planning and finance operations from 2001 to 2003. Mr. Paci also served as our senior vice president, strategy and planning from 2000 to 2001 and senior vice president international finance and worldwide mergers and acquisitions from April 2000 until October 2000. Mr. Paci served as senior vice president of international finance and administration from 1999 to 2000.
Nicholas P. Shepherd has served as our executive vice president and president, Blockbuster North America since May 2005 and served as our executive vice president and president, U.S. store operations from November 2004 until May 2005. He also served as our executive vice president, chief marketing and merchandising officer from 2003 until 2004 and as our executive vice president, merchandising and chief concept officer from 2001 until 2003. Mr. Shepherd also served as our senior vice president and chief concept officer from April 2001 until September 2001. From 1998 until 2001, Mr. Shepherd served as our senior vice president, international.
Christopher J. Wyatt has served as our executive vice president and president, international, since 2001 and served as our president, international, from March 2001 until October 2001. Mr. Wyatt served as our senior vice president, international, from 1999 until 2001.
Larry J. Zine has served as our executive vice president and chief financial officer since 1999 and as our chief administrative officer since September 2001. Mr. Zine currently serves as a director of Petro Stopping Centers, L.P. and is also a member of the board of trustees for the National Urban League.
Available Information, Investor Relations and NYSE Certifications
We file annual, quarterly and current reports, information statements and other information with the Securities and Exchange Commission (SEC). The public may read and copy any materials we file with the SEC at the SECs 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 http://www.sec.gov.
The address of our Internet website is www.blockbuster.com, and the Investor Relations section of Blockbusters website may be accessed directly at http://investor.blockbuster.com. Through links on the Investor
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Relations portion of our website, 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 any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. Such material is made available through our website as soon as reasonably practicable after we electronically file the material with, or furnish it to, the SEC. The information contained on our website does not constitute part of this annual report on Form 10-K.
Stock Transfer Agency
Computershare Trust Company, N.A.
P.O. Box 43023
Providence, RI 02940-3023
Questions and inquiries via telephone or Computershares website:
(877) 282-1168
http://www.computershare.com
Independent Registered Public Accounting Firm
PricewaterhouseCoopers LLP
2001 Ross Avenue
Suite 1800
Dallas, TX 75201
Stock Listing
Blockbuster Inc. Class A and Class B common stock trades on the New York Stock Exchange under the symbols BBI and BBI.B, respectively.
NYSE Certifications
We have submitted to the New York Stock Exchange the certification of our Chief Executive Officer, dated as of June 9, 2005, as required by Section 303A.12(a) of the New York Stock Exchange Listed Company Manual.
We have filed with the SEC the certifications of our Chief Executive Officer and our Chief Financial Officer required under Section 302 of the Sarbanes-Oxley Act of 2002 with respect to this Annual Report on Form 10-K. The certifications are attached hereto as Exhibits 31.1 and 31.2.
In addition to the other information set forth elsewhere, the factors described below should be considered carefully in making any investment decisions with respect to our securities. These factors could materially affect our business, financial condition, results of operations or liquidity and cause investors in our securities to lose part or all of their investments.
Changes in studio pricing policies have resulted in increased competition, in particular from mass merchant retailers, which has impacted consumer rental and purchasing behavior. We cannot control or predict future studio decisions or resulting consumer behavior, and future changes could negatively impact our profitability.
We operate in the highly competitive home video industry, which includes in-home movie entertainment offered through the following distribution channels:
| the retail home video industry; |
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| the cable industry; and |
| the satellite industry. |
The retail home video industry includes the sale and rental of movies on DVD and VHS by:
| traditional home video retailers, such as Blockbuster and other businesses with video store operations, such as Movie Gallery; |
| online retailers, such as BLOCKBUSTER Online, Netflix and Amazon.com; and |
| other retailers, including mass merchant retailers such as Wal-Mart, Best Buy and Target. |
The studios current practice is generally to sequentially release their movies to different distribution channels. After the initial theatrical release of a movie, studios generally make their movies available to home video retailers (for rental and retail, including by mass merchant retailers) for a specified period of time. This distribution channel is typically exclusive against other forms of non-theatrical movie distribution, including cable and satellite distribution, and is commonly referred to as the home video retailers distribution window. This practice could change at any time, which would negatively impact our business. Recently, there has been some experimentation with the current distribution windows, including simultaneous video-on-demand and DVD releases.
Historically, at the beginning of a particular movie titles distribution window, the movie would be priced to home video retailers based on the applicable studios decision to promote the movie to the consumer either primarily for rental, or for both rental and sale, at the beginning of the distribution window. In order to promote a movie title primarily for rental at the beginning of the distribution window, a studio would initially release the title to home video retailers at a price that was too high to enable them to sell the title to consumers at an affordable price. As rental demand subsided, the studio would reduce the pricing for the movie, which would then enable retailers to sell the title to consumers at an affordable price. The time during which the studios released the title at the higher pricing was commonly referred to as the rental window. Currently, substantially all DVD titles are initially released to home video retailers at a price that is low enough to allow them to offer movies at affordable prices to the consumer from the beginning of the home video retailers distribution window. This method of pricing is commonly referred to as sell-through pricing, and has improved our ability to purchase rental product at lower prices. However, the studios sell-through pricing policy has also led to increasing competition from other retailers, in particular mass merchants such as Wal-Mart, Best Buy and Target. It has also led to increased competition from online retailers. These other retailers are able, due to the lower sell-through prices, to purchase DVDs for sale to consumers at the same time as traditional home video retailers, who, like us, purchase product for rental. In addition, some retailers lower their sales prices in order to increase overall traffic to their stores or businesses, and mass merchants may be more willing to sell at lower, or even below wholesale, prices to drive traffic and thereby increase sales of their other inventory items. All of these factors have increased consumer interest in purchasing DVDs, which has resulted in increased competition and reduced the significance of the historical rental window.
We believe that the increased consumer purchases of movies have been due in part to consumer interest in building DVD libraries of classic movies and personal favorites and that the studios will remain dependent on traditional home video retailers to generate revenues for the studios from titles that are not classics or current box office hits. 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 further if, in light of any such consumer behavior, we were unable to (i) maintain or increase 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
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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.
Our profitability is also dependent on our ability to enter into arrangements with the studios that effectively balance cost considerations and the number of copies of a title stocked by us. Each type of arrangement provides different advantages and challenges for us. For example, we have benefited from sell-through pricing of DVDs because the lower cost associated with DVD product has resulted in higher rental margins than product purchased under our historical VHS revenue-sharing arrangements. Our profitability could be negatively affected if studios were to make other changes in their pricing policies, which could include changes in revenue sharing arrangements, pricing or rental windows for DVDs or expanded exploitation by studios of international two-tiered pricing laws, which allow studios to charge different prices for movies intended for rental to consumers, as opposed to sale. In addition, we cannot predict what use the studios might make of current or future alternative supply methods, such as downloading to stores or consumers, or what impact the use of such supply chain changes by us or our competitors might have on our profitability.
Our video business would lose a competitive advantage if the movie studios were to shorten or eliminate the home video retailer distribution window or otherwise adversely change their current practices with respect to the timing of the release of movies to the various distribution channels.
A competitive advantage that home video retailers currently enjoy over most other movie distribution channels, except theatrical release, is the early timing of the home video retailers distribution window. As noted above, after the initial theatrical release of a movie, the studios current practice is to generally make their movies available to home 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 home video retailers varies, but since the mid-1990s, has averaged between 43 and 54 days for domestic home video retailers. Thereafter, movies are made sequentially available to television distribution channels. The studios practices with respect to the distribution windows could change at any time. Recently, there has been some experimentation with the current distribution windows, including simultaneous video-on-demand and DVD releases.
Our business could be negatively affected if:
| the home video retailer distribution windows were no longer the first following the theatrical release; |
| the length of the home video retailer distribution windows were shortened; or |
| the home video retailer distribution windows were no longer as exclusive as they are now. |
This is because newly released movies would be made available earlier on these other forms of non-theatrical movie distribution, and consumers might no longer need to wait until after the home video retailer distribution window to view a newly released movie on one or more of these other distribution channels. In such event, we would need to address additional competition. According to industry statistics, more movies are now being released to pay-per-view at the shorter end of the home video retailer distribution window range than at the longer end. In addition, many of the major movie studios have entered into various ventures to provide video-on-demand or similar services of their own. Increased studio participation in or support of these types of services could impact their decisions with respect to the timing and exclusivity of the home video retailer distribution window.
We believe that the studios have a significant interest in maintaining a viable home video retail industry. However, because the order, length and exclusivity of each window for each distribution channel is determined solely by the studio releasing the movie, we cannot predict the impact, if any, of any future decisions by the
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studios. 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 home video retailer distribution window.
We cannot predict the impact that the following may have on our business: (i) new or improved technologies or video formats, (ii) alternative methods of content delivery or (iii) changes in consumer behavior facilitated by these technologies or formats and alternative methods of content delivery. We also compete generally for the consumers entertainment dollar and leisure time.
Advances in technologies such as video-on-demand, new video formats, downloading or alternative methods of content delivery 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 adversely impacted if:
| newly released movies were to be made widely available by the studios to these technologies or these formats at the same time or before they are made available to home video retailers for rental; and |
| these technologies or new formats were to be widely accepted by consumers. |
The widespread availability of additional channels on satellite and digital cable systems may significantly reduce public demand for our products. Advances in direct broadcast satellite and cable technologies may also adversely affect consumer demand for video store rentals and sales. Direct broadcast satellite providers transmit numerous channels of programs by satellite transmission into subscribers homes. In addition, cable providers are taking advantage of digital technology to transmit many additional channels of television programs over cable lines to subscribers homes. Because of their increased availability of channels, direct broadcast satellite and digital cable providers have been able to enhance their pay-per-view businesses by:
| substantially increasing the number and variety of movies they can offer their subscribers on a pay-per-view basis; and |
| providing more frequent and convenient start times for the most popular movies. |
In addition, pay-per-view allows the consumer to avoid trips to the video store for rentals and returns of movies. However, newly released movies are currently made available by the studios for rental prior to being made available on a pay-per-view basis. In addition, pay-per-view does not currently provide the same start, stop and rewind capabilities as DVD or video. If, however, direct broadcast satellite and digital cable services, including enhanced pay-per-view services, were to become more widely available and accepted, this could have a negative effect on our video store business. This is because a smaller number of movies may be rented or sold 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. Additionally, increases in the size of the pay-per-view market could lead to an earlier distribution window for movies on pay-per-view if the studios were to perceive this to be a better way to maximize their revenues.
The availability of content through personal video recorders, video-on-demand and similar other technologies may significantly reduce the demand for our products or otherwise negatively affect our business. Any method for delivery of entertainment content that serves as an alternative to obtaining product or services from us can impact our business. Examples of delivery methods that have impacted, or could impact, our business are personal video recorders, video-on-demand, downloadable DVDs, video vending machines, disposable DVDs and video downloads to portable devices.
Personal video recorders. Personal video recorders allow consumers to automatically and digitally record programs to create a customized television line-up for viewing at any time. They also enable consumers to pause, rewind, fast forward, instant replay and playback in slow motion any live television broadcast and are increasingly being used to download movies. Personal movie libraries and other television entertainment recorded via personal video recorders has caused and could continue to cause consumers to rent or purchase fewer movies in the future.
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Video-on-demand. Some digital cable providers and a limited number of Internet content providers have implemented technology referred to as video-on-demand. This technology transmits movies and other entertainment content on demand with interactive capabilities such as start, stop and rewind. In addition, some cable providers have introduced subscription video-on-demand, which allows consumers to pay a flat fee per month for access to a selection of content with fast-forward, stop and rewind capabilities. These developments could cause studios to alter the home video retailer distribution window. As discussed above, there has been some recent experimentation with the current distribution windows, including simultaneous video-on-demand and DVD releases. In addition to being available from most major cable providers in select markets, video-on-demand has been introduced over the Internet, as high-speed Internet access has greatly increased the speed and quality of viewing content, including feature-length movies, on personal computers. Moreover, one of the major studios has recently launched a video-on-demand service whereby movies are delivered to a set-top box. We have, from time to time, tested an entertainment-on-demand service, which delivered video-on-demand to consumers television sets via digital subscriber lines and fiber optic connections, and we may conduct similar tests from time to time. The future of video-on-demand services, including any services provided by us, is uncertain. Video-on-demand could have a negative effect on our video store business if:
| video-on-demand could be provided at a reasonable price to the customer; and |
| newly released movies were made available at the same time, or before, they were made available to the home video retailers for rental and sale. |
Downloadable DVDs. The technology now exists for consumers to pay for and download movies and other content via the Internet. While the future of downloadable DVDs is uncertain, if the studios overcome their reluctance to license content in this manner or decide to offer product through this channel themselves, consumers might rent or buy fewer movies via the traditional in-store or online channels in the future, and our business would be negatively impacted.
Video Vending Machines. McDonalds recently announced that they have begun renting DVDs from vending machines located on their premises for $0.99 per day. Any time movies or games are offered to consumers at a deeply discounted price, we view this as competition for our customers entertainment dollars. In addition, Movie Gallery has recently announced that it is experimenting with branded DVD vending machines in grocery and convenience stores. Other companies may also offer video vending machines. We cannot predict how broad the selection of movies offered via video vending machines will become or their impact on our business.
Disposable DVDs. The technology also exists for retailers to offer disposable DVDs, which allow a consumer to view a DVD for an unlimited number of times during a specified period of time, at the end of which the DVD becomes unplayable as a result of chemistry technology. We cannot predict the impact that this or other similar technologies will have on our business.
Video Downloads to Portable Devices. Apple Computer recently began offering its customers the ability to download music videos and certain television shows from its iTunes music store. Customers can purchase the videos and watch them on their computers or on a portable iPod device. We cannot predict whether Apples offering will expand to include movies, how broad the selection of any movies could become or whether other companies may offer video downloads to portable devices that could provide an alternative method of delivery for movies.
Other Competition for Consumer Dollars and Leisure Time. We compete generally for the consumers entertainment dollar and leisure time with, among others, (i) movie theaters; (ii) Internet browsing, online gaming and other Internet-related activities; (iii) live theater; and (iv) sporting events. Our results can therefore fluctuate depending on the desirability of other forms of entertainment.
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We believe that some degree of industry consolidation will be necessary in the in-store home video rental industry over the coming years. Should we not be successful in capitalizing on this industry consolidation, our financial results may be adversely affected.
Based upon current industry projections, we believe that over-capacity exists in the video rental market and that, as a result, many video stores, including some of our own stores, will be forced to close in the future. If we are unable to capitalize on the store closings of our competitors, we may be unable to grow our market share and our financial results may be adversely affected. In addition, we have historically closed underperforming video stores and will continue to consider the closure of underperforming stores. We are currently reviewing many of our store leases and selecting sites to close or downsize based on store profitability. As a result, we could potentially close up to 10% of our store base over the next several years.
Our revenues could be adversely affected due to the variability in consumer appeal of the movie titles and game software released for rental and sale.
The quality of movie titles and game software released for rental and sale is not within our control, and our results of operations have from time to time reflected the variability in consumer appeal for such items. We cannot assure you that future releases of movie titles and game software will appeal to consumers and, as a result, our revenues and profitability may be adversely affected.
We are dependent on the introduction and supply of new and enhanced game platforms and software to attract and retain our video game customers.
The home video game industry has traditionally been a hit-driven business characterized by short product lifecycles and frequent introduction of new products. Historically, the lifecycle for game platforms has been about five years, with a limited number of platforms achieving success at any given time. The industry typically grows with the introduction of new hardware platforms and games, but tends to slow prior to the introduction of new platforms, as consumers hold back their purchases in anticipation of new platform and game enhancements. Additionally, during the slow period prior to the introduction of new game platforms, vendors often reduce their prices on existing game platforms and corresponding games, thereby reducing our gross profits for these items. Our video games business is, therefore, dependent on the introduction of new and enhanced game platforms and software in order to attract and retain our video game customers. Delays in the introduction and/or shipment of hardware or software or any failure to obtain sufficient product from our suppliers on favorable terms could negatively affect our business or increase fluctuations in our results of operations.
Piracy of the products we offer or the disregard of release dates by other retailers may adversely affect our operations.
Although piracy is illegal, it is a significant threat to the home video industry. The primary methods of piracy affecting the home video industry are (i) the illegal copying of theatrical films at the time they are first run; (ii) the illegal copying of DVDs that are authorized by the studios solely for retail sale and/or rental by authorized retailers; and (iii) the illegal online downloading of movies. These methods of piracy enable the low-cost sale of DVDs as well as the free viewing and sharing of DVDs, both of which compete with rentals and sales by authorized retailers like us. Competition from piracy has increased in recent years due in part to developments in technology that allow for faster copying and downloading of DVDs.
Although piracy is a concern in the United States, it is having a more significant adverse affect on the home video industry in international markets. We cannot assure you that movie studios and others with rights in the product that we rent or sell can, or will, take steps to enforce their rights against piracy or that they will be successful in preventing the distribution of pirated content. Increases in piracy could continue to negatively affect our revenues.
Another risk that we face is the disregard by other home video retailers of the studios specified release dates for their titles. If other home video retailers rent or sell product before the specified release dates
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(i.e., before us), we can be adversely affected, as the first weeks after a movie titles release typically represent a significant portion of the demand for that title. We cannot assure you that the studios can or will control such distribution and release practices, particularly in countries outside of the United States.
We made significant investments in our business during 2005 by eliminating extended viewing fees and investing in BLOCKBUSTER Online. Our investment in BLOCKBUSTER Online, together with weakness in the rental industry, has adversely affected and may continue to adversely affect our profitability. Further, our financial results have been, and may continue to be, adversely affected by our elimination of extended viewing fees.
During 2005, we made significant investments in two strategic initiatives designed to improve our overall rental offering. First, we eliminated extended viewing fees on movie and game rentals at all of our company-operated BLOCKBUSTER stores in the United States and Canada. Second, we invested heavily in BLOCKBUSTER Online. We believe that these and other of our strategic initiatives will allow us to take advantage of emerging trends in home entertainment. However, some of our strategic initiatives have been, or are, at the beginning of what we believe are their potential growth curves and will continue to require significant start-up costs, including BLOCKBUSTER Online in which we intend to continue to invest during 2006.
As mentioned above, we eliminated extended viewing fees on movie and game rentals at all of our company-operated BLOCKBUSTER stores in the United States effective January 1, 2005. In addition, approximately 340 of our franchise stores in the United States have eliminated extended viewing fees as of March 1, 2006. Our Canadian operations adopted a similar program at all of its stores effective January 29, 2005. In connection with our no late fees program, we incurred approximately $60 million in marketing and implementation costs during 2005 and reduced rental revenues by over $500 million. If the loss of revenues and operating income associated with the elimination of extended viewing fees is not offset by continued growth in base rental revenues resulting from increased store traffic, less promotional and marketing activity and increased focus on managing operating expenses, our financial results will be significantly adversely affected. In addition, we cannot control the pricing decisions of our franchisees and therefore cannot predict the impact that such pricing decisions could have on our overall business results. Our franchisees control over operating and pricing decisions is discussed in more detail under Item 1. BusinessOur OperationsFranchised Operations in this Form 10-K.
In addition, our online subscription services require considerable ongoing investments in order to increase our subscriber base and implement our plan to fulfill BLOCKBUSTER Online orders from our stores. Since its launch in August 2004, BLOCKBUSTER Online has built a subscriber base of approximately 1.2 million subscribers. Additionally, we began fulfilling some BLOCKBUSTER Online orders from certain company-operated and franchise store locations in the second quarter of 2005 and continued to expand this fulfillment process during the remainder of 2005. If we are unable to integrate our in-store and online capabilities fully, our gross margin will be adversely impacted because we will be required to purchase more product to support our online operations. Both our plan to fulfill BLOCKBUSTER Online orders from our stores and our goal of increasing our online subscriber base require significant investment. During 2005, BLOCKBUSTER Online incurred significant operating losses and approximately $25 million in capital expenditures. We expect to incur additional costs in the future and cannot assure you when or if BLOCKBUSTER Online will become profitable.
Further, we have experienced challenges caused by the faster than anticipated decline in the worldwide in-store home video rental industry. We believe that this decline has been caused primarily by (i) a weak slate of titles released to home video during most of 2005; (ii) increased competition from retail mass merchant sales of low-priced DVDs, online rentals and other sources of in-home entertainment such as digital video recorders and other devices that are capable of downloading content for in-home viewing; (iii) competition from piracy in certain international markets; and (iv) competition from other forms of leisure entertainment.
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The significant investments required to develop and implement our initiatives, together with the faster than anticipated decline in the worldwide in-store home video rental industry, adversely affected our 2005 financial results and could adversely affect our financial results thereafter. For example, our financial results would be impacted by:
| our ability to effectively and timely prioritize and implement these and other initiatives; |
| the extent and timing of our continued investment of incremental operating expenses and capital expenditures to continue to develop and implement our initiatives, and our corresponding ability to effectively control operating expenses; |
| our ability to timely implement and maintain the necessary information technology systems and infrastructure to support shifts in consumer preferences and any corresponding changes to our initiatives; and |
| the impact of competitor pricing and product and service offerings. |
We have had limited experience with certain new customer proposition initiatives and cannot assure you when or if these or future initiatives will have a positive impact on our profitability.
We have implemented and expect to continue to implement initiatives that are designed to enhance efficiency, customer convenience and our product offerings, including initiatives to expand our online offerings to customers. The implementation of new initiatives has involved, and will continue to involve, significant investments by us of time and money and could be adversely impacted by (i) our inability to timely implement and maintain the necessary information technology systems and infrastructure to support shifts in consumer preferences and any corresponding changes to our operating model, including continued support for our initiatives and (ii) the extent and timing of our continued investment of incremental operating expenses and capital expenditures to continue to develop and implement our initiatives and our corresponding ability to effectively control operating expenses. Because we have limited experience with some of our strategic initiatives, we cannot assure you that they will be successful or profitable, including success in retaining customers. Our ability to effectively and timely prioritize and implement our initiatives will also affect when and if they will have a positive impact on our profitability.
If the average sales and rental prices for our product are not at or above expected prices, our expected gross margins may be adversely affected.
To achieve our expected revenues and gross margins, we need to sell and rent, as applicable, our product, including previously rented, retail and rental (whether in-store or online) product at or above expected prices. If the average sales or rental prices of such product are not at or above these expected prices, our revenues and gross margins may be adversely affected. For example, our U.K. games business experienced some gross margin erosion during 2005 as a result of the drastically reduced price offerings of a competitor. In an effort to compete, we and a number of mass merchant retailers in the U.K. were forced to meet the competitors reduced price offerings. As a result of the fact that prices for games in the U.K. have not yet risen to the level they were at prior to these reduced price offerings, our gross margin with respect to our U.K. games business has suffered and may continue to suffer.
It is also important that we maximize our gross margins through our allocation of store space. We may need to turn our inventory of previously rented and retail product more quickly in the future in order to make room in our stores for additional DVDs or strategic initiatives. Therefore, we cannot assure you that in the future we will be able to rent or sell, on average, our product at or above the expected price.
Other factors that could affect our ability to rent or sell our product at expected prices include:
| consumer desire to rent any of our movies and games; |
| consumer desire to own a particular movie or game; |
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| the amount of product available for rental or sale by others to the public; and |
| changes in the price of product by the studios or changes by other retailers, particularly mass merchant retailers. |
Our business plan contemplates significant cost reductions over the next two years. Should we not achieve our cost cutting objectives, our financial results could be adversely affected.
Our business plan and expectations for the future are based on managements assessments regarding significant cost reductions through 2007, including aggressive reductions in operating expenses and capital expenditures. These cost cutting objectives may not be fully achievable, and should we not reduce costs to the full extent currently contemplated, our financial results may be adversely affected.
Our level of indebtedness may make it more difficult for us to pay our debts and more necessary for us to divert our cash flow from operations to debt service payments.
Our total indebtedness as of December 31, 2005 was approximately $1,158.0 million. Our debt service obligations could have an adverse impact on our earnings and cash flows for as long as the indebtedness is outstanding.
Our indebtedness could have important consequences for our business. For example, it could:
| make it more difficult for us to pay our debts as they become due during general adverse economic and market or industry conditions because any related decrease in revenues could cause us to not have sufficient cash flows from operations to make our scheduled debt payments; |
| limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate, including limiting our ability to invest in our strategic initiatives, and, consequently, place us at a competitive disadvantage to our competitors with less debt; |
| require a substantial portion of our cash flows from operations to be used for debt service payments, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, acquisitions and other general corporate purposes; |
| cause our trade creditors to change their terms for payment on goods and services provided to us, thereby negatively impacting our ability to receive products and services on acceptable terms; and |
| result in higher interest expense in the event of increases in interest rates since some of our borrowings are, and will continue to be, at variable rates of interest. |
Additionally, we could incur additional indebtedness in the future and, if new debt is added to our current debt levels, the risks above could intensify. Additional debt would further increase the possibility that we may not generate sufficient cash to pay, when due, interest on and other amounts due in respect of our indebtedness, and would further reduce our funds available for operations, working capital, capital expenditures, acquisitions and other general purposes. Additional debt may also decrease our ability to refinance or restructure our indebtedness, and further limit our ability to adjust to changing market conditions. If we or our subsidiaries add new debt to our current debt levels, the related risks that we and they now face could increase.
We may not have sufficient cash flows from operating activities, cash on hand and available borrowings under our credit facilities to service our indebtedness.
Our ability to make payments on and to refinance our indebtedness will depend on our ability to generate cash in the future. This, to some extent, is subject to general economic, financial, competitive, industry and other factors that are beyond our control. We cannot assure you that our future cash flow will be sufficient to meet our obligations and commitments. If we are unable to generate sufficient cash flow from operations in the future to service our indebtedness and to meet our other commitments, we will be required to adopt one or more
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alternatives, such as refinancing or restructuring our indebtedness, selling material assets or operations or seeking to raise additional debt or equity capital. We cannot assure you that any of these actions could be effected on a timely basis or on satisfactory terms or at all, or that these actions would enable us to continue to satisfy our capital requirements. In addition, our existing debt agreements, including the indenture governing our senior subordinated notes and our credit agreement, contain restrictive covenants which may prohibit us from adopting one or more of these alternatives, and any future debt agreements may contain similar restrictive covenants. Our failure to comply with these covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our debts, which we may be unable to repay.
Any failure by us to comply with any of the restrictions in our debt agreements could result in acceleration of our debt. Were this to occur, we might not have, or be able to obtain, sufficient cash to pay our accelerated indebtedness.
The operating and financial restrictions and covenants in our debt agreements, including our credit agreement and the indenture governing our senior subordinated notes, may adversely affect our ability to finance future operations or capital needs or to engage in new business activities. The debt agreements restrict our ability to, among other things:
| declare dividends or redeem or repurchase capital stock; |
| prepay, redeem or repurchase other debt; |
| incur liens; |
| make loans, guarantees, acquisitions and investments; |
| incur additional indebtedness; |
| engage in sale and leaseback transactions; |
| amend or otherwise alter debt and other material agreements; |
| engage in mergers, acquisitions or asset sales; and |
| transact with affiliates. |
In addition, our debt covenants require that we maintain certain financial measures and ratios. As a result of these covenants and ratios, we are limited in the manner in which we can conduct our business, and we may be unable to engage in favorable business activities or finance future operations or capital needs. Accordingly, these restrictions may limit our ability to successfully operate our business. A failure to comply with these restrictions or to maintain the financial measures and ratios contained in the debt agreements could lead to an event of default that could result in an acceleration of the indebtedness. During 2005, we were required to enter into three amendments to our credit agreement to modify or seek waivers for our financial covenants thereunder. For an additional discussion of these amendments, please refer to Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital ResourcesCapital Structure.
Should the outstanding obligations under our credit agreement be accelerated and become due and payable because of our failure to comply with the applicable debt covenants in the future, we would be required to search for alternative measures to finance current and ongoing obligations of our business. If amounts outstanding under the credit agreement were called by the lenders due to a covenant violation, amounts under other agreements, such as the indenture governing our senior subordinated notes, could also become due and payable immediately. There can be no assurance that such financing will be available on acceptable terms, if at all. Our ability to obtain future financing or to sell assets could be adversely affected because a very large majority of our assets have been secured as collateral under the credit agreement. In addition, our recent financial results, our substantial indebtedness, our credit ratings and the declining rental industry in which we operate could adversely affect the availability and terms of our financing. Further, as discussed below, uncertainty surrounding our ability to finance our obligations has caused some of our trade creditors to impose increasingly less favorable terms and
29
continuing uncertainty could result in even more unfavorable terms from our trade creditors. In addition, there are other situations (including a change in the composition of our board of directors, whereby the majority of directors who were serving on the board at the time we entered into our credit agreement and indenture (or their successors or nominees) are no longer serving on the board) where our debt may be accelerated and we may be unable to repay such debt. Any of these scenarios could adversely impact our liquidity and results of operations or force us to file for protection under the U.S. Bankruptcy Code.
Uncertainty surrounding our ability to meet our financial obligations has adversely impacted and could continue to adversely impact our ability to obtain sufficient product on favorable terms.
During 2005, we entered into three amendments of our credit agreement pursuant to which certain covenants in our credit agreement were amended or waived. This, coupled with the continued declines and uncertainty in the rental industry, has caused negative publicity surrounding our business. As a result, our flexibility with our suppliers has been affected, both domestically and internationally. We cannot assure you that our trade creditors will not further change their terms for payment on goods and services provided to us or that we will continue to be able to receive products and services on acceptable terms.
Our financial results could be adversely affected if we are unable to manage our inventory effectively or if we are unable to obtain or maintain favorable terms from our suppliers.
Our purchasing decisions are influenced by many factors, including, among others, gross margin considerations and supplier product return policies. While much of our retail movie product in the United States, but not outside the United States, is returnable to vendors, our investments in retail movie inventory may result in excess inventories in the event anticipated sales fail to materialize. In addition, returns of our games inventory, which is prone to obsolescence risks because of the nature of the industry, are subject to negotiation with vendors.
Our purchasing decisions also involve predictions of consumer demand. While the growth of our in-store and online subscription programs and our elimination of extended viewing fees have increased consumer demand for our products, these programs, along with the recent reintroduction of our Guaranteed in Stock program for select new release titles (whereby if a Guaranteed in Stock title is unavailable, customers will be given a rain check for a free rental of that title good for 30 days at the same store), have increased the complexity of our purchasing decisions. In addition, the prevalence of multiple game platforms adds to the difficulty of accurately predicting consumer demand with respect to video games. The nature of and market for our products, particularly games and DVDs, also makes them prone to risk of theft and loss.
Our operating results could therefore suffer if we are not able to:
| obtain or maintain favorable terms from our suppliers with respect to such matters as copy depth, use of product, including without limitation fulfillment of online orders, and product returns; |
| maintain adequate copy depth to maintain customer satisfaction; |
| control shrinkage resulting from theft or loss; or |
| avoid significant inventory excesses that could force us to sell products at a discount or loss. |
Further, as discussed above, uncertainty surrounding our ability to finance our obligations has caused some of our trade creditors to impose increasingly less favorable terms and continuing uncertainty could result in even more unfavorable terms from our trade creditors.
Our results of operations could be materially adversely affected if our franchisees failed to pay our franchise fees.
A portion of our revenues are derived from royalty fees through our franchising program. We may experience difficulties in collecting our franchise fees on a timely basis, or at all, for a variety of reasons,
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including the inability of our franchisees to achieve sufficient revenues and cash flows from their stores or to otherwise effectively operate their stores under challenging industry conditions. Lawsuits and other disputes with our franchisees may also reduce the amount of our royalties from franchise fees. Any failure by our franchisees to pay their franchise fees to us on time or at all could materially adversely affect our results of operations.
Any failure or inadequacy of our information technology infrastructure could harm our business.
The capacity, reliability and security of our information technology hardware and software infrastructure and our ability to expand and update this infrastructure in response to our changing needs are important to the continued implementation of our new customer proposition initiatives, as well as the operation of our business generally. To avoid technology obsolescence and enable future cost savings and customer enhancements, we are continually updating our information technology infrastructure. In addition, we intend to add new features and functionality to our products, services and systems that could result in the need to develop, license or integrate additional technologies. Our inability to add additional software and hardware or to upgrade our technology infrastructure could have adverse consequences, which could include the delayed implementation of our new customer proposition initiatives, service interruptions, impaired quality or speed of the users experience and the diversion of development resources. Our failure to provide new features or functionality to our systems also could result in these consequences. We may not be able to effectively upgrade and expand our systems, or add new systems, in a timely and cost effective manner and we may not be able to smoothly integrate any newly developed or purchased technologies with our existing systems. These difficulties could harm or limit our ability to improve our business. In addition, any failure of our existing information technology infrastructure could result in significant additional costs to us.
Our business model is substantially dependent on the functionality of our distribution centers.
Our domestic distribution system for our store-based operations is centralized. We ship a substantial portion of the products to our U.S. company-operated stores through our distribution center. We also have 30 regional U.S. distribution centers to support BLOCKBUSTER Online, our domestic online DVD subscription service. If our distribution centers became non-operational for any reason, we could incur significantly higher costs and longer lead times associated with distributing our movies and other products. In international markets, we utilize a variety of distribution methodologies with similar risks to those in the United States.
Our financial results have been and could further be negatively impacted by impairments of goodwill or other intangible assets required by SFAS 142, our ability to realize our deferred income tax assets required by SFAS 109, the application of future accounting policies or interpretations of existing accounting policies.
In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets referred to as SFAS 142, we test goodwill and other intangible assets for impairment during the fourth quarter of each year and on an interim date should factors or indicators become apparent that would require an interim test. In 2002, 2003 and 2004 we took significant charges relating to the impairment of goodwill. See Notes 2 and 3 to the consolidated financial statements and Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsCritical Accounting Estimates in this Form 10-K.
In addition, in conjunction with the decline in the worldwide in-store home video rental industry and the resulting decline in our stock price, we performed an impairment test on our goodwill balances during the third quarter of 2005 and determined that the goodwill balance was impaired, thereby recognizing non-cash charges of $332.0 million to impair goodwill in accordance with SFAS 142. See Notes 2 and 3 to the consolidated financial statements and Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsCritical Accounting Estimates in this Annual Report on Form 10-K.
Additionally, SFAS No. 109, Accounting for Income Taxes referred to as SFAS 109, requires us to periodically assess whether it is more likely than not that we will generate sufficient taxable income to realize our
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deferred income tax assets. In making this determination, we consider all available positive and negative evidence and make certain assumptions. We consider, among other things, our deferred tax liabilities, the overall business environment, our historical earnings and losses, our industrys current trends and our outlook for future years.
In the third quarter of 2005, we determined that it was unclear as to the timing of when we will generate sufficient taxable income to realize deferred tax assets. This was primarily due to the negative trends in our industry which caused our actual and anticipated financial performance to be significantly worse than we originally projected. Accordingly, during the third quarter of 2005, we recorded a valuation allowance against deferred tax assets in our domestic and certain foreign jurisdictions, which resulted in a provision for income taxes of $115.0 million in that quarter. Until we determine that it is more likely than not that we will generate sufficient taxable income to realize our deferred income tax assets in these markets, income tax benefits associated with current period losses will not be recognized. At the end of 2005, we had net deferred tax assets of $177.0 million related primarily to timing differences of depreciation and amortization, net operating losses and other tax credits for certain foreign jurisdictions where it is more likely than not that deferred tax assets will be realized. We have a valuation allowance of $149.9 million set against these deferred tax assets in jurisdictions where it is more likely than not that the deferred tax assets will not be recognized. If we do not generate sufficient taxable income in certain foreign jurisdictions, we may not realize the remaining deferred tax assets that do not have a valuation allowance.
A downward revision in the fair value of one of our reporting units could result in additional impairments of goodwill under SFAS 142 and additional non-cash charges. Additionally, an expectation that future taxable income in a particular jurisdiction will be insufficient to realize our deferred tax assets could result in additional valuation allowances under SFAS 109. Any charge resulting from the application of SFAS 142 or SFAS 109 could have a significant negative effect on our reported net income. In addition, our financial results could be negatively impacted by the application of existing and future accounting policies or interpretations of existing accounting policies, including without limitation the impact of accounting policies related to our rental library and our recent related restatement, any continuing impact of SFAS 142 or SFAS 109 or any interpretation issued in connection with Statement of Financial Accounting Standards No. 123R, Share-Based Payment.
We are subject to various litigation matters that could, if judgments were to be rendered against us, have an adverse effect on our operating results.
We are a defendant in various lawsuits and may become subject to additional lawsuits in the future. If judgments were to be rendered against us in these lawsuits, our results of operations could be adversely affected. See Note 9 to the consolidated financial statements for a discussion of certain pending litigation matters relating to our business.
Our business and operations have been, and could further be, negatively impacted as a result of the proxy fight during 2005 and election of three dissident nominees to our board of directors. Further, if a subsequent proxy fight is waged against us and is successful, we could be in default under our credit agreement and may be unable to finance a change of control offer under the indenture governing our senior subordinated notes or repay our bank debt should it become accelerated.
On April 8, 2005, we were notified that a slate of dissident nominees would be proposed for election at our 2005 annual stockholders meeting. On May 11, 2005, the dissident nominees were elected by our stockholders to serve on our board of directors. As a result of the proxy contest and the subsequent elections of the dissident nominees, our business and operations have been, and may further be, negatively impacted. For example:
| we incurred substantial costs associated with the proxy contest; |
| the proxy contest was disruptive to our operations; and |
| dissention on our board of directors may impact our ability to effectively and timely implement our initiatives and to retain and attract experienced executives and employees. |
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Further, under the terms of our credit agreement and the indenture governing our senior subordinated notes, a change in the composition of our board of directors, including as a result of one or more director resignations, whereby the majority of directors who were serving on the board at the time we entered into our credit agreement and indenture (or their successors or nominees) are no longer serving on the board, could constitute a change of control. If a subsequent proxy contest is waged against us and is successful, an event of default could result under our credit agreement, and under the indenture, we may be required to make an offer for cash to purchase the notes at 101% of their principal amount, plus accrued and unpaid interest and additional interest, if any. We cannot assure you that we will have the financial resources necessary to purchase the notes upon a change of control or that we will have the ability to obtain the necessary funds on satisfactory terms, if at all. Further, our credit agreement prohibits the purchase of all of the outstanding notes prior to repayment of the borrowings under our credit agreement and any exercise by the holders of the notes of their right to require us to repurchase the notes will also cause an event of default under our credit agreement. We may be unable to repay any acceleration of our debts that may arise under this scenario.
If we lose key senior management or are unable to attract and retain the talent required for our business, our operating results could suffer.
Our performance depends largely on the efforts and abilities of our members of senior management. Our executives have substantial experience and expertise in our business and have made significant contributions to our growth and success. We have experienced senior management departures recently. The unexpected future loss of services of one or more of members of our senior management team could have an adverse effect on our business. We will need to attract and retain additional qualified personnel and develop, train and manage management-level employees. We cannot assure you that we will be able to attract and retain personnel as needed in the future.
We are subject to governmental regulation particular to the retail home video industry and changes in U.S. or international laws may adversely affect us.
Any finding that we have been, or are, in noncompliance with respect to, or otherwise liable under, the laws affecting our business could result in costs, including, among other things, governmental penalties or private litigant damages, which could have a material adverse effect on us. We are subject to various international and U.S. federal and state laws that govern the offer and sale of our franchises because we act as a franchisor. In addition, because we operate video stores and develop new video stores, we are subject to various international and U.S. federal and state laws that govern, among other things, the disclosure and retention of our video rental records and access to and use of our video stores by disabled persons, and are subject to various international, U.S. federal, state and local advertising, consumer protection, credit protection, franchising, licensing, zoning, land use, construction, trading activities, second-hand dealer, minimum wage and labor and other employment regulations, as well as laws and regulations relating to the protection and cleanup of the environment and health and safety matters. The international home video and video game industry varies from country to country due to, among other things, legal standards and regulations, such as those relating to foreign ownership rights; unauthorized copying; intellectual property rights; movie ratings, which in many countries are legal standards unlike the voluntary standards of the United States; labor and employment matters; trade regulation and business practices; franchising and taxation; environmental matters; and format and technical standards. Our obligation to comply with, and the effects of, the above governmental regulations are increased by the magnitude of our operations.
Changes in existing laws, including environmental and employment laws, adoption of new laws or increases in the minimum wage, may increase our costs or otherwise adversely affect us. For example, the repeal or limitation in the United States of certain favorable copyright laws would have an adverse impact in the United States on our rental business. Similarly, the adoption or expansion of laws in any other country to allow copyright owners to charge retailers more for rental product than for sell-through product could have an adverse impact on our rental business in that country.
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Any acquisitions we make involve a degree of risk.
We have in the past, and may in the future, engage in acquisitions to expand our domestic and international rental and retail presence. For example, during the past several years, we have made asset acquisitions of stores in the United States and in markets outside of the United States. If these or any future acquisitions are not successfully integrated with our business, our ongoing operations could be adversely affected. Additionally, acquisitions may not achieve desired profitability objectives or result in any anticipated successful expansion of the acquired businesses or concepts. Although we review and analyze assets or companies we acquire, such reviews are subject to uncertainties and may not reveal all potential risks. Additionally, although we attempt to obtain protective contractual provisions, such as representations, warranties and indemnities, in connection with acquisitions, we cannot assure you that we can obtain such provisions in our acquisitions or that they will fully protect us from unforeseen costs of the acquisition. We may also incur significant costs in connection with pursuing possible acquisitions, even if the acquisition is not ultimately consummated.
We have assumed obligations pursuant to agreements with Viacom relating to certain real estate leases guaranteed by Viacom, which obligations may adversely affect our ability to negotiate renewals or modifications to a subset of such leases.
In October 2004, we completed our divestiture from Viacom. We entered into an amended and restated initial public offering and split-off agreement with Viacom in connection with this divestiture. This agreement, which is referred to as the IPO agreement, imposes various restrictions and limitations on our ability to renew or modify, in a manner that increases Viacoms potential liability, a subset of the leases guaranteed by Viacom, which could make it more difficult and expensive, and in some cases impossible, to renew or modify certain of these leases.
We have also assumed obligations pursuant to the IPO agreement to maintain letters of credit in favor of Viacom, which obligations reduce our borrowing capacity.
Pursuant to the IPO agreement, we have provided letters of credit, at Viacoms expense, for the benefit of Viacom to support Viacoms potential liability for certain real estate lease obligations of ours. The letters of credit reduce our borrowing capacity under the terms of our credit facilities by $150 million. Until the letters of credit or any renewals thereof are terminated, we anticipate any future or additional lenders may treat our letter of credit obligation as if it were outstanding indebtedness when assessing our borrowing capacity. Furthermore, if we are unable to renew or otherwise replace the letters of credit prior to their expiration as required by the IPO agreement, Viacom has the right to draw down the full amount of the outstanding letters of credit, which may cause us to borrow funds under our credit facility to reimburse the issuing bank. In either case, our obligation to maintain the letters of credit may restrict or prevent us from being able to borrow amounts necessary to engage in favorable business activities, consummate strategic acquisitions or otherwise fund capital needs.
Our tax matters agreement with Viacom prohibits us from engaging in certain corporate transactions, and we may not have adequate funds to perform our indemnity obligations under this agreement.
In connection with our split-off from Viacom, we and Viacom entered into an amended and restated tax matters agreement, dated as of June 18, 2004, which is referred to as the tax matters agreement. The tax matters agreement contains restrictions that, among other things, prohibit us from voluntarily entering into certain transactions for a period of two years following the split-off from Viacom, including certain merger transactions or transactions involving the sale of a significant amount of our capital stock or assets, without Viacoms consent. In addition, we agreed under the tax matters agreement to indemnify Viacom for any tax liability incurred as a result of the failure of the split-off to qualify as a tax-free transaction due to a takeover of us or any other transaction involving our capital stock, assets or businesses, regardless of whether such transaction is within our control. We may not, however, have adequate funds to perform these indemnification obligations should they arise. These restrictions and potential liabilities may make us less attractive to a potential
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acquiror and reduce the possibility that an acquiror will propose or seek to effect certain transactions with us during the restricted two-year period.
We, along with Viacom and certain of Viacoms related entities, are a party to a judgment sharing agreement arising out of two revenue sharing antitrust cases. Should we, Viacom or Viacoms related entities incur liability with respect to such cases, we would be responsible for satisfying a portion of that liability.
On November 9, 2001, we entered into a judgment sharing agreement with Viacom, Paramount Home Entertainment, Inc. (Paramount), Sumner Redstone and certain studio defendants in Cleveland, et al. v. Viacom Inc., et al, No. SA-99-CA-0783 in the United States District Court for the Western District of Texas and in Merchant, et al. v. Redstone, et al., No. BC 244 270 in the Superior Court for the State of California, County of Los Angeles, whereby we, Viacom, Paramount and Mr. Redstone agreed to be responsible for any liability that arises out of either of the two revenue sharing antitrust cases. No liability will arise from the Cleveland case as judgment was entered in favor of us and the other defendants and all appeals by plaintiffs failed. The Merchant case was appealed following judgment in our favor and remanded back to the trial court for further proceedings. On June 18, 2004, in connection with our split-off from Viacom, we entered into an agreement with Viacom, Paramount and Mr. Redstone, which we refer to as the Viacom entities, whereby we agreed to pay a percentage allocation of any liability arising from the November 9, 2001 judgment sharing agreement of 33.33% and the Viacom entities agreed to pay 66.67% of any such liability. We cannot assure you that we will not be held liable in the Merchant case. Therefore, we may become responsible for contributing one-third of any judgment arising from such case.
Provisions in our charter documents, Delaware law and our tax matters agreement could make it more difficult to acquire our company.
Our second amended and restated certificate of incorporation (certificate of incorporation) and amended and restated bylaws (bylaws) contain provisions that may discourage, delay or prevent a third party from acquiring us, even if doing so would be beneficial to our stockholders. Our bylaws limit who may call special meetings of stockholders to any officer at the request of a majority of our board of directors, the chairman of the board or the chief executive officer of the company. Our certificate of incorporation and bylaws provide that the bylaws may be altered, amended or repealed by the board of directors.
Pursuant to our certificate of incorporation, the board of directors may by resolution establish one or more series of preferred stock, having such number of shares, designation, relative voting rights, dividend rates, liquidation or other rights, preferences and limitations as may be fixed by the board of directors without any further stockholder approval. Such rights, preferences, privileges and limitations as may be established could have the effect of impeding or discouraging the acquisition of control of us, which could adversely affect the price of our equity securities.
In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting us from engaging in a business combination with an interested stockholder for a period of three years after the person becomes an interested stockholder.
Further, our tax matters agreement contains provisions that make us less attractive to a potential acquiror and reduce the possibility that an acquiror will propose or seek to effect certain transactions with us. See Our tax matters agreement with Viacom prohibits us from engaging in certain corporate transactions, and we may not have adequate funds to perform our indemnity obligations under this agreement.
Item 1B. Unresolved Staff Comments
None.
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Our corporate headquarters are located at 1201 Elm Street, Dallas, Texas 75270 and consist of about 245,000 square feet of space leased pursuant to an agreement that expires on June 30, 2007, although we are currently in negotiations to extend the lease through 2017. Our primary distribution center is located at 3000 Redbud Blvd., McKinney, Texas 75069 and consists of about 850,000 square feet of space leased pursuant to an agreement that expires on December 31, 2012. We have set up our payroll and benefits center in Spartanburg, South Carolina. We also lease and operate 30 online distribution centers spread strategically throughout the United States to support BLOCKBUSTER Online.
We have an office in Uxbridge, England that manages most of our international operations. We also have country head offices in Buenos Aires, Argentina; Melbourne, Australia; Toronto, Canada; Santiago, Chile; Dublin, Ireland; Milan, Italy; Mexico City, Mexico; and Taipei, Taiwan. For most countries in which we have company-operated stores, we maintain offices to manage our operations within that country.
We lease substantially all of our existing store sites. These leases generally have a term of five to ten years and provide options to renew for between five and ten additional years. We expect that most future stores will also occupy leased properties.
Information regarding our material legal proceedings is set forth in Note 9 to the consolidated financial statements, in Item 8 of Part II of this Form 10-K, which information is incorporated herein by reference.
Item 4. Submission of Matters to a Vote of Security Holders
None.
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Item 5. | Market for Our Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |
The shares of Blockbuster Class A and Class B common stock are listed and traded on the New York Stock Exchange, or NYSE, under the symbols BBI and BBI.B, respectively. Our Class A common stock began trading on August 11, 1999, following our initial public offering and our Class B common stock began trading on October 14, 2004 in conjunction with our divestiture from Viacom Inc. (Viacom). The following table contains, for the periods indicated, the high and low sales prices per share of our Class A and Class B common stock as reported on the NYSE composite tape and the cash dividends per share of our Class A and Class B common stock:
Blockbuster Class A Common Stock Sales Price |
Blockbuster Class B Common Stock Sales Price |
Cash Dividends per share of Common Stock(3) | |||||||||||||
High | Low | High | Low | ||||||||||||
Year Ended December 31, 2004: |
|||||||||||||||
Quarter Ended March 31, 2004 |
$ | 19.37 | $ | 15.60 | | | $ | 0.02 | |||||||
Quarter Ended June 30, 2004 |
$ | 17.58 | $ | 14.61 | | | $ | 0.02 | |||||||
Quarter Ended September 30, 2004(1) |
$ | 15.12 | $ | 7.24 | | | $ | 5.02 | |||||||
Quarter Ended December 31, 2004(2) |
$ | 10.49 | $ | 6.50 | $ | 9.85 | $ | 6.31 | $ | 0.02 | |||||
Year Ended December 31, 2005: |
|||||||||||||||
Quarter Ended March 31, 2005 |
$ | 10.04 | $ | 8.35 | $ | 9.49 | $ | 8.12 | $ | 0.02 | |||||
Quarter Ended June 30, 2005 |
$ | 10.65 | $ | 8.76 | $ | 10.18 | $ | 8.32 | $ | 0.02 | |||||
Quarter Ended September 30, 2005 |
$ | 9.21 | $ | 4.17 | $ | 8.65 | $ | 4.00 | $ | | |||||
Quarter Ended December 31, 2005 |
$ | 5.74 | $ | 3.19 | $ | 5.40 | $ | 2.96 | $ | |
(1) | On August 20, 2004, Blockbuster announced the declaration of a special distribution of $5.00 per share (approximately $905.6 million in the aggregate), which was paid on September 3, 2004 to stockholders of record at the close of business on August 27, 2004. On August 25, 2004, Blockbusters Class A common stock began trading ex-dividend, reflecting the special distribution. |
(2) | Blockbusters Class B common stock was not listed for trading until October 14, 2004. |
(3) | Blockbuster historically paid a quarterly recurring cash dividend of $0.02 per share on both its Class A and Class B common stock, however, it has not paid a dividend since the second quarter of 2005. Blockbusters board of directors will evaluate declaring quarterly cash dividends in the future. |
The terms of our debt agreements, as discussed in Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources, limit Blockbusters ability to repurchase common stock and pay dividends. Subject to these limitations, Blockbusters board of directors may change Blockbusters dividend practices from time to time and decrease or increase the dividend paid, or not pay a dividend, on Blockbusters common stock based on factors such as results of operations, financial condition, cash requirements and future prospects and other factors deemed relevant by Blockbusters board of directors.
The number of holders of record of shares of our Class A and Class B common stock as of March 1, 2006 was 1,246 and 907, respectively.
For information regarding Blockbusters equity compensation plans, refer to the proxy statement to be filed for our 2006 annual meeting of stockholders incorporated by reference into Item 12 of Part III of this Form 10-K.
Information regarding Blockbusters recent sale of unregistered 7 1/2% Series A cumulative convertible perpetual preferred securities (the Series A convertible preferred stock) is incorporated herein by reference from Blockbusters current report on Form 8-K, filed with the Securities and Exchange Commission (SEC) on
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November 15, 2005. The initial purchasers for the offering of the Series A convertible preferred stock were Citigroup Global Markets Inc., J.P. Morgan Securities Inc. and Credit Suisse First Boston LLC.
Item 6. Selected Financial Data
The following table sets forth our selected consolidated historical financial data as of the dates and for the periods indicated. The selected statement of operations and balance sheet data for the years ended December 31, 2001 through 2005 are derived from our consolidated financial statements. The financial information herein may not necessarily reflect our results of operations, financial position and cash flows in the future or what our results of operations, financial position and cash flows would have been had Viacom not owned a large majority of our equity and voting interest during some of the periods presented.
BLOCKBUSTER SELECTED CONSOLIDATED HISTORICAL
FINANCIAL DATA
The following data should be read in conjunction with, and is qualified by reference to, the consolidated financial statements and related notes, and Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this document.
Year Ended or at December 31, | ||||||||||||||||||||
2005(1)(2) | 2004(3)(4)(5) | 2003(6)(7) | 2002(8) | 2001(9) | ||||||||||||||||
(In millions, except per share amounts) | ||||||||||||||||||||
Statement of Operations Data: |
||||||||||||||||||||
Revenues |
$ | 5,864.4 | $ | 6,053.2 | $ | 5,911.7 | $ | 5,565.9 | $ | 5,156.7 | ||||||||||
Gross profit |
$ | 3,217.3 | $ | 3,611.8 | $ | 3,521.9 | $ | 3,207.2 | $ | 2,736.0 | ||||||||||
Impairment of goodwill and other long-lived assets |
$ | 356.8 | $ | 1,504.4 | $ | 1,304.9 | $ | | $ | | ||||||||||
Operating income (loss) |
$ | (426.5 | ) | $ | (1,253.2 | ) | $ | (836.7 | ) | $ | 347.7 | $ | (217.2 | ) | ||||||
Income (loss) before cumulative effect of change in accounting principle |
$ | (588.1 | ) | $ | (1,248.8 | ) | $ | (974.3 | ) | $ | 195.9 | $ | (238.8 | ) | ||||||
Income (loss) per share before cumulative effect of change in accounting principlebasic |
$ | (3.20 | ) | $ | (6.89 | ) | $ | (5.41 | ) | $ | 1.10 | $ | (1.36 | ) | ||||||
Income (loss) per share before cumulative effect of change in accounting principlediluted |
$ | (3.20 | ) | $ | (6.89 | ) | $ | (5.41 | ) | $ | 1.08 | $ | (1.36 | ) | ||||||
Cumulative effect of change in accounting principle |
$ | | $ | | $ | (4.4 | ) | $ | (1,817.0 | ) | $ | | ||||||||
Net loss |
$ | (588.1 | ) | $ | (1,248.8 | ) | $ | (978.7 | ) | $ | (1,621.1 | ) | $ | (238.8 | ) | |||||
Net loss per sharebasic |
$ | (3.20 | ) | $ | (6.89 | ) | $ | (5.43 | ) | $ | (9.08 | ) | $ | (1.36 | ) | |||||
Net loss per sharediluted |
$ | (3.20 | ) | $ | (6.89 | ) | $ | (5.43 | ) | $ | (8.93 | ) | $ | (1.36 | ) | |||||
Cash dividends per common share |
$ | 0.04 | $ | 0.08 | $ | 0.08 | $ | 0.08 | $ | 0.08 | ||||||||||
Special distribution per share |
$ | | $ | 5.00 | $ | | $ | | $ | | ||||||||||
Weighted average shares outstandingbasic |
183.9 | 181.2 | 180.1 | 178.6 | 175.6 | |||||||||||||||
Weighted average shares outstandingdiluted |
183.9 | 181.2 | 180.1 | 181.6 | 175.6 | |||||||||||||||
Balance Sheet Data: |
||||||||||||||||||||
Cash and cash equivalents |
$ | 276.2 | $ | 330.3 | $ | 233.4 | $ | 152.5 | $ | 200.2 | ||||||||||
Total assets (10) |
$ | 3,179.6 | $ | 3,994.6 | $ | 4,918.1 | $ | 6,268.9 | $ | 7,771.0 | ||||||||||
Long-term debt, including capital leases |
$ | 1,121.6 | $ | 1,119.7 | $ | 75.1 | $ | 408.7 | $ | 546.4 | ||||||||||
Stockholders equity |
$ | 631.6 | $ | 1,062.9 | $ | 3,188.4 | $ | 4,100.9 | $ | 5,676.1 |
(1) | During 2005, as described in Note 2 to the consolidated financial statements, we recognized non-cash charges totaling approximately $356.8 million to impair goodwill and other long-lived assets, in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), and SFAS No. 144, Accounting |
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for the Impairment or Disposal of Long-Lived Assets (SFAS 144). These charges are reflected as a separate item on the Consolidated Statements of Operations. |
(2) | During 2005, we recognized $39.1 million of compensation expense related to share-based compensation as required by Statement of Financial Accounting Standards (SFAS) 123 (revised), Share-Based Payments (SFAS 123R). |
(3) | During the fourth quarter of 2004, in conjunction with our adoption SFAS 123R, as described in Note 1 to the consolidated financial statements, we recognized $18.3 million of compensation expense related to share-based compensation. Also, as described in Note 1 to the consolidated financial statements, we adopted the expense recognition provisions of FIN 28 as of January 1, 2004. Because we applied the disclosure-only provisions of SFAS 123, Accounting for Stock-Based Compensation (SFAS 123), through September 30, 2004, the cumulative effect of change in accounting principle of $23.1 million, net of tax, recognized upon adoption of the expense recognition provisions of FIN 28 has not been reflected in our Consolidated Statements of Operations for the year ended December 31, 2004. |
(4) | During the third quarter of 2004, as described in Note 2 to the consolidated financial statements, we recognized non-cash charges totaling approximately $1.50 billion to impair goodwill and other long-lived assets, in accordance with SFAS 142 and 144. These charges are reflected as a separate item on the Consolidated Statements of Operations. |
(5) | During the third quarter of 2004, as described in Note 1 to the consolidated financial statements, we paid a $5.00 special distribution per share prior to our divestiture from Viacom. |
(6) | During the fourth quarter of 2003, as described in Note 2 to the consolidated financial statements, we recognized non-cash charges totaling approximately $1.30 billion to impair goodwill and other long-lived assets, in accordance with SFAS 142 and SFAS 144. These charges are reflected as a separate item on our Consolidated Statements of Operations for the year ended December 31, 2003. |
(7) | During the first quarter of 2003, we adopted SFAS No. 143, Accounting for Asset Retirement Obligations (SFAS 143), which requires the capitalization of any retirement costs as part of the total cost of the related long-lived asset and the subsequent allocation of the total expense to future periods. The application of this new accounting standard required us to record a $4.4 million cumulative effect of change in accounting principle, net of tax, as described in Note 1 to the consolidated financial statements. |
(8) | During the first quarter of 2002, we adopted SFAS 142, which eliminates the amortization of goodwill and intangible assets with indefinite lives and requires instead that those assets be tested for impairment annually. The application of the transition provisions of this new accounting standard required us to reduce our goodwill by approximately $1.82 billion, net of tax, as described in Note 2 to the consolidated financial statements. |
(9) | During the third quarter of 2001, we recognized charges of $195.9 million in cost of sales, $54.5 million in incremental selling, general and administrative expenses, $2.6 million in depreciation expense and $1.9 million in equity in income (loss) of affiliated companies related to the execution of a strategic re-merchandising plan to allow for an expansion of store space for DVD and other strategic product offerings. Additionally, in connection with this strategic re-merchandising plan, we re-evaluated and changed our accounting estimates related to our rental library. As a result of the changes in estimate, cost of rental revenues was $141.7 million higher during 2001 than it would have been under the previous method. |
(10) | During the fourth quarter of 2005, as described in Note 1 to the consolidated financial statements, we restated our previously issued financial statements to adjust the classification of our rental library and related deferred income taxes. This restatement resulted in adjustments to our total assets at December 31, 2001 through 2004. |
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Dollars in Millions)
The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this document.
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Overview
Blockbuster Inc. is a leading global provider of in-home rental and retail movie and game entertainment, with over 9,000 stores in the United States, its territories and 24 other countries as of December 31, 2005.
Restatement of Previously Issued Financial Statements
As disclosed on our Form 8-K filed on March 9, 2006, beginning in late 2005, we engaged in discussions with the SEC with respect to our accounting practices surrounding our rental library and rental library activities. We have historically classified rental library purchases as an investing cash outflow in our Consolidated Statements of Cash Flows and rental library assets as a non-current asset in our Consolidated Balance Sheets. As a result of these discussions, we have determined that rental library purchases should be classified as an operating cash outflow on our Consolidated Statements of Cash Flows and that rental library assets should be classified as a current asset on our Consolidated Balance Sheet. Because the classification of our deferred income tax liability associated with the rental library follows the classification of the rental library, we have also changed the presentation of our deferred income taxes on our Consolidated Balance Sheet. The adjustments do not affect our previously reported revenues, net income, stockholders equity, total cash flows or cash.
We have restated our consolidated financial statements for the years ended December 31, 2004 and 2003. See Note 1 to the consolidated financial statements for a summary of the effects of these changes on our Consolidated Balance Sheet as of December 31, 2004 and in our Consolidated Statements of Cash Flows for the years ended December 31, 2004 and 2003. See Note 14 to the consolidated financial statements for a summary of the effects of these changes on our unaudited quarterly financial information for 2005 and 2004. This annual report on Form 10-K gives effect to these restatements.
2005 Overview
Our 2005 results reflect both the significant challenges facing the in-store rental industry, which intensified in the second and third quarters, as well as encouraging results from our strategic initiatives. As more fully described in Item 1A. Risk Factors, we believe the decline in the worldwide in-store home video rental industry has been caused primarily by (i) a weak slate of titles released to home video during most of 2005; (ii) increased competition from retail mass merchant sales of low-priced DVDs, online rentals and other sources of in-home entertainment such as digital video recorders and other devices that are capable of downloading content for in-home viewing; (iii) competition from piracy in certain international markets; and (iv) competition from other forms of leisure entertainment. While these factors negatively impacted our results for the year, we believe that our strategic initiatives allowed us to counteract some of the decline in the in-store rental industry.
Over the past two years, we have focused on an investment strategy that we believe is essential to confront the significant challenges facing our industry. Specifically, we have invested in various strategic initiatives, which we believe will help offset our declining movie rental revenues, add incremental future revenues and support future profitability growth. These initiatives include the no late fees program in the United States and Canada, BLOCKBUSTER Online®, in-store subscription programs, movie and game trading and expanded game concepts. During 2005, we focused our efforts on the no late fees program and BLOCKBUSTER Online. Effective January 1, 2005, we stopped charging extended viewing fees, commonly referred to as late fees, on movie and game rentals at all of our BLOCKBUSTER-branded company-operated stores and certain participating franchise stores in the United States. Our Canadian operations adopted a similar program at all of its stores effective January 29, 2005. The no late fees program was designed to eliminate our most prevalent customer complaint with the movie rental experience and to combat our competitors use of late fees as a means of differentiating their service offerings. While the industry has been undergoing significant change, we believe that Blockbuster is well positioned within the industry because we are one of the only retailers that can leverage our store locations, traffic and infrastructure to provide a customer offering both in-store and online. Due to the integrated nature of the online pass, revenues generated from BLOCKBUSTER Online are included in our same-store rental revenues. Additionally, we have increased our promotion of BLOCKBUSTER Online in
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our stores and improved our online offering in an effort to bring our online customers to our stores more often. We believe that our ability to integrate our online service with our in-store offering provides us with a distinct competitive advantage.
We believe the success of our strategic initiatives during 2005 can be evidenced by several positive trends, including:
| No Late FeesDespite the elimination of extended viewing fees, which accounted for approximately 14% of our rental revenues during 2004, and a declining in-store rental industry, we experienced only a 5.0% decline in our rental revenues from 2004. We believe this accomplishment was due, in large part, to positive consumer responses to the no late fees program, as evidenced by the active member trends in our domestic company-operated stores, which continue to outperform those in our domestic franchise stores that have not eliminated extended viewing fees. As a result, we experienced a 4.7% increase from 2004 in our worldwide in-store base rental revenues, which consist of in-store movie and game rentals excluding extended viewing fees. |
| BLOCKBUSTER OnlineOur approximately 1.2 million subscribers to BLOCKBUSTER Online have helped to offset the negative in-store industry trends and boost our same-store rental revenues. While BLOCKBUSTER Online experienced relatively slow growth in the third and fourth quarters of 2005, we remain committed to achieving our goal of two million online subscribers by the end of 2006. During the second quarter of 2005, we began to leverage our in-store infrastructure by fulfilling some BLOCKBUSTER Online orders through inventory from certain company-operated and franchise store locations and expanded this fulfillment process to approximately 1,000 stores by the end of 2005. We believe this integrated approach, which further combines our online and in-store capabilities, will allow us to get movies to customers faster in remote locations while also enabling us to use our existing in-store labor, product and real estate resources to reduce overall costs. |
| Movie and game trading initiatives and expanded game conceptsTotal retail sales in 2005 increased 3.5% as compared with 2004. This increase was driven by an over 70% increase in worldwide unit sales of traded movies and games, which primarily occurred during the first half of 2005 and resulted from our movie and game trading initiatives. In addition, we experienced a 14.9% increase in sales of new games during 2005 due to the addition of freestanding games stores and an increase in the average selling price resulting from sales of higher-priced new platforms. These positive results helped to offset the overall decline in worldwide unit sales of new movies during 2005 as a result of the continued competition from mass merchant sales of low-priced DVDs. |
While we believe that these programs will give us a critical advantage in the highly competitive rental industry, they also require us to make significant investments. These investments, when combined with the decline in the in-store rental industry during most of 2005, have negatively impacted our gross profit, operating expenses and cash flow. The decline in our gross profit primarily resulted from a decline in our rental gross margin and a reduction in rental revenues from 2004. The decline in our rental gross margin was due to the impact of several factors. In mid-2004, we launched two new subscription programs, the BLOCKBUSTER Movie Pass® and BLOCKBUSTER Online, which each charge a fixed fee for multiple rentals, and we launched our no late fees program at the beginning of 2005. During 2005, we increased our product purchases in order to grow BLOCKBUSTER Online and support the increased product demand resulting from these new in-store rental offerings. However, as a result of changing industry conditions in 2005, including a weak slate of titles released to home video, our total rental revenues decreased more than anticipated relative to our product purchases. In addition, the shipping costs incurred by BLOCKBUSTER Online are included in the cost of rental revenues.
During 2005, we also incurred approximately $25 million in capital expenditures in support of BLOCKBUSTER Online in order to improve our website performance and to facilitate the fulfillment of some BLOCKBUSTER Online orders from certain company-operated and franchise stores locations, which began late in the second quarter of 2005. In addition, we incurred significant operating expenses during 2005 in order to
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grow our BLOCKBUSTER Online subscriber base. During the first and second quarters of 2005, we also incurred approximately $60 million in initial marketing and implementation costs in connection with the launch of our no late fees program.
In light of the difficult environment in which we are operating and in order to support continued investment in our initiatives, we are aggressively reducing our operating expenses and capital expenditures. During 2005, we implemented a cost-reduction strategy, which included a reduction-in-force and other measures targeted at reducing our operating expenses. We incurred approximately $11.2 million in severance costs during 2005 as a result of implementing these changes. We also reduced our capital expenditures by approximately $150 million during 2005, as compared with 2004, primarily because the initial capital expenditure outlay necessary to support our strategic initiatives and systems and infrastructure improvements occurred during 2004.
In conjunction with the decline in the industry and the resulting decline in our stock price, we performed an impairment test on our goodwill balances during the third quarter of 2005 and determined that the goodwill balance related to our international reporting unit was impaired. We recognized non-cash charges of approximately $332.0 million to impair goodwill in accordance with SFAS 142. In addition, we recognized non-cash charges of approximately $24.8 million to impair certain other long-lived assets in accordance with SFAS 144 during 2005. We also determined during the third quarter of 2005 that it was unclear as to the timing of when we will generate sufficient taxable income to realize our deferred tax assets. Accordingly, during the third quarter of 2005, we recorded a valuation allowance against our deferred tax assets in the United States and one international market, which resulted in a provision for income taxes of $64.6 million for the year. Until we determine that it is more likely than not that we will generate sufficient taxable income to realize our deferred income tax assets in these markets, income tax benefits associated with current period losses will not be recognized.
As discussed above, the faster than expected decline of the in-store rental industry that occurred during 2005 negatively impacted our financial results. As a result, we entered into three separate amendments to our credit agreement during the year, which provided for covenant relief during the second and third quarters of 2005, modified our ongoing financial covenants through 2007 and made other modifications to the credit agreement, in exchange for certain additional restrictions and increased interest rates, among other things. In addition, in order to provide us with improved operating flexibility, on November 15, 2005, we completed a private offering of 150,000 shares of Series A convertible preferred stock for net proceeds of $144.0 million. We used the net proceeds from the offering to repay a portion of the outstanding borrowings under our revolving credit facility and for general corporate purposes. As of December 31, 2005, we were in compliance with our debt covenants. See further discussion in Liquidity and Capital Resources.
Outlook
We are committed to improving our profitability and are taking steps that we believe will enable us to achieve that goal. These steps include lowering operating expenses, selectively marketing in-store programs with a focus on profitability rather than top-line revenue and, subject to market conditions, raising prices as necessary to offset increasing expenses, such as utilities. In addition, we are currently reviewing our asset portfolio with a focus on optimizing profitability through our core Blockbuster-branded rental businesses. For example, during the fourth quarter of 2005, we completed the sale of our subsidiary D.E.J. Productions Inc. for cash consideration of $22.5 million. As part of our asset portfolio review, we may also consider the divestiture of or other strategic alternatives with regard to some or all of our international operations upon acceptable terms. Moreover, as part of our focus on store profitability, we are currently reviewing many of our store leases and selecting sites to close or downsize. As a result, we could potentially close up to 10% of our store base over the next several years. Based on current industry projections, we believe that some degree of industry consolidation may be necessary in order to stabilize the in-store rental business. We believe that our focus on profitability will allow us to be a beneficiary of any such industry consolidation by increasing our market share.
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We also expect to begin implementing additional cost-saving measures aimed at further reducing our operating expenses, primarily including general and administrative and advertising expenses, by approximately $100 million from 2005 to 2006 and an incremental $50 million in 2007. We expect to realize these savings through a reduction in both corporate and store level overhead expenses, lower advertising expenses and operational savings from the optimization of store labor hours and the divestiture of certain non-core assets and store closures. In addition, while we will continue to make capital expenditures in BLOCKBUSTER Online at approximately the same levels as we did in 2005, we plan to significantly lower our total capital expenditures in 2006 to approximately $90 million primarily due to fewer new store openings.
The steps we took to improve liquidity and better position ourselves financially and operationally during late 2005, as discussed above, enabled us to reduce the outstanding balance on our revolving credit facility by $75 million from the end of 2005 through March 1, 2006 and allowed us to further reduce our accounts payable balance. With the significant investment in most of the previously discussed strategic initiatives behind us, we expect that our 2006 financial results will be positively impacted by lower operating costs as discussed above, lower operating income impact year-over-year from BLOCKBUSTER Online and optimization of our store portfolio. We believe that the rental industry will remain under pressure in 2006. However, we believe that our no late fees program and BLOCKBUSTER Online will have a positive impact on our domestic same-store rental revenues and enable us to outperform the domestic rental industry in 2006. Our 2006 results, however, are subject to risks, including those discussed in Item 1A. Risk Factors.
Critical Accounting Estimates
The preparation of our consolidated financial statements, in conformity with accounting principles generally accepted in the United States, requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to the useful lives and residual values surrounding our rental library, estimated accruals related to revenue-sharing titles subject to performance guarantees, merchandise inventory reserves, revenues generated by customer programs and incentives, useful lives of property and equipment, income taxes, impairment of our long-lived assets, including goodwill, share-based compensation and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may materially differ from these estimates under different assumptions or conditions.
We believe the following accounting policies require our more significant judgments and estimates and that changes in these estimates or the use of different estimates could have a material impact on our results of operations or financial position.
Revenue Recognition
Rental revenues are generally recognized at the time of rental or sale. Rental revenues are generated from the rental of movies and video games, any eventual sale of previously rented movies and video games (PRP revenues) and restocking fees.
As discussed in Note 1 to the consolidated financial statements, on January 1, 2005, we implemented the no late fees program in certain markets. Under this new policy, rental transactions continue to have two-day or weekly rental periods, depending on the specific rental, with all transactions having a one-week goodwill period from the due date. If the product has not been returned by the end of the goodwill period, it is purchased by the customer under the terms of our standard membership agreement. The purchase price is the lower of (i) the full retail price or (ii) the price for previously-rented product at the time of the rental, if the product was available from us as a previously-rented product. In addition, the purchase price is reduced by the amount of the rental fee paid. If the product is subsequently returned within 30 days from the date the customer is charged for the
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product, the customer receives a full credit to his or her account, less a minimal restocking fee, which is $1.25 at our company-operated stores in the United States. Where extended viewing fees have been eliminated, revenues generated from sales to customers for product that has not been returned by the end of the original rental and goodwill periods is recognized after expiration of the 30-day return period. Revenues generated from restocking fees are recognized upon return of the product within the 30-day return period. Revenues are reduced by an estimate of the amounts that we do not anticipate collecting based upon historical experience.
Merchandise sales include the sales of new movies and games and other general merchandise, including confections. In addition, we offer movie and game trading, pursuant to which we purchase used movies and game software from our customers in exchange for merchandise credit, discounts on other products and, in some international stores, cash. The sales of traded product are also included in merchandise sales. Sales of merchandise are recognized at the time of sale and a provision for sales returns and allowances on merchandise sales is estimated and recorded based on historical trends. Due to the nature of the products sold, sales returns and allowances are minimal.
We have agreements with certain companies that allow these companies to purchase free rental cards from us, which can then be awarded at their discretion. We defer revenue for the estimated number of free rental cards that will ultimately be redeemed and recognize the amounts deferred as revenue upon redemption. Revenue for estimated non-redemptions is generally recognized when the cards are issued. A 10% change in the estimate of non-redemptions would not have had a material impact on our revenues for 2005. If the actual number of free rentals redeemed is significantly different than our estimate, an adjustment to the revenues recorded in a particular period may be required. We also sell gift cards, which generally expire after two years, and are available in various denominations. Gift card liabilities are recorded at the time of sale and the costs of designing, printing and distributing the cards are recorded as advertising expense at the time of sale. The liability is relieved and revenue is recognized upon redemption of the gift cards. Revenue for unredeemed gift cards is recognized when our liability has been extinguished, which is generally upon expiration of the gift card.
Rental Library Amortization
We have established amortization policies with respect to our rental library that most closely allow for the matching of product costs with the related revenues generated by the utilization of our rental library product. 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 library product. We utilize the accelerated method of amortization because it approximates the pattern of demand for the product, which is generally high when the product is initially released for rental by the studios and declines over time. In establishing residual values for our rental library product, we consider the sales prices and volume of our previously rented product and other used product.
Based upon these estimates and our current customer propositions and offerings, we currently amortize the cost of our in-store and online rental library, which includes movies and games, over periods ranging from three months to twenty-four months to estimated residual values ranging from $0 to $5 per unit, according to the product category.
We also review the carrying value of our rental library 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 rental amortization periods or residual values, may be required. We continually evaluate the estimates surrounding the useful lives and residual values used in amortizing our rental library. Changes to these estimates resulting from changes in consumer demand, changes in our customer propositions or the price or availability of retail video product may materially impact the carrying value of our rental library and our rental margins.
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For example, as discussed in Note 1 to the consolidated financial statements, during the first quarter of 2005, we re-evaluated our estimates surrounding the useful life and residual value of our rental libraries due to recent changes in our rental business, including the launch of the BLOCKBUSTER Movie Pass and BLOCKBUSTER Online in 2004 as well as the elimination of extended viewing fees under our no late fees program in 2005. Each of these initiatives has changed the delivery method, pricing and cost structure of the rental programs that we offer to our customers as well as the customers rental habits. These new programs allow customers to keep rental product for longer periods of time and generate increased rental transactions and overall rentals per piece of library product. Beginning in the first quarter of 2005, we changed the estimated useful life of our online new release DVDs from six months to twelve months and the estimated useful life of our online catalog inventory from 12 months to 24 months. In addition, we reduced the residual value of our online catalog inventory from $4 to $0 in the first quarter of 2005. We also changed the estimated useful life of our in-store DVD catalog inventory in the United States from 12 months to 24 months. These changes in estimates related to the useful lives and residual values of our rental libraries decreased our cost of rental revenues and net loss by approximately $7.6 million, or $0.04 per share, for the year ended December 31, 2005. As our business continues to change as a result of our initiatives and market dynamics, we will continue to evaluate the reasonableness of the estimates surrounding our rental library.
Merchandise Inventory
Our merchandise inventory, which includes new and traded movies and games and other general merchandise, including confections, is stated at the lower of cost or market. We include an allocation of costs incurred in our distribution center to prepare new products for our stores in the cost of our merchandise inventory. We record adjustments to the value of inventory primarily for estimated obsolete or excess inventory equal to the difference between the carrying value of inventory and the estimated market value based upon assumptions about future demand and market conditions. If future demand or actual market conditions are less favorable than those projected by management, additional inventory adjustments may be required. Our accrual for inventory shrinkage is based on the actual historical shrink results of our most recent physical inventories adjusted, if necessary, for current economic conditions. These estimates are compared with actual results as physical inventory counts are taken and reconciled to the general ledger. DVD and video game products are susceptible to shrink due to their portability and popularity.
Income Taxes
In determining net income for financial statement purposes, we make certain estimates and judgments in the calculation of tax expense and the resulting tax liabilities and in the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense.
In the ordinary course of business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. We establish reserves for tax contingencies when, despite the belief that our tax return positions are fully supported, certain positions are likely to be challenged and may not be fully sustained. The tax contingency reserves are analyzed on a quarterly basis and adjusted based on changes in facts and circumstances, such as the progress of international, federal and state audits, case law and enacted legislation. We establish tax reserves based upon managements assessment of exposure associated with permanent tax differences and certain tax sharing agreements. While we believe that the amount of our estimated tax reserve is reasonable, it is possible that the ultimate outcome of current or future examinations may exceed current reserves or a favorable settlement of tax audits may result in a reduction of future tax provisions. The favorable or unfavorable outcome of tax examinations could have a material impact on our results of operations. Any tax benefit from favorable settlement of tax audits would be recorded upon final resolution of the audit or expiration of the statute of limitations.
We record valuation allowances to reduce our deferred tax assets to amounts that are more likely than not to be realized. In 2005, we determined that it was unclear as to the timing of when we will generate sufficient taxable income to realize our deferred tax assets. This was primarily due to the negative industry trends, which caused our actual and anticipated financial performance to be significantly worse than we originally projected.
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Accordingly, we recorded a valuation allowance against our deferred tax assets in the United States and certain foreign jurisdictions. Until we determine that it is more likely than not that we will generate sufficient taxable income to realize our deferred income tax assets in certain markets, income tax benefits associated with current period losses will not be recognized.
Impairment of Goodwill and Other Long-Lived Assets
In accordance with SFAS 142, we test goodwill and other intangible assets for impairment during the fourth quarter of each year and on an interim date should factors or indicators become apparent that would require an impairment test.
Goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is to identify a potential impairment by comparing the book value of our reporting units, domestic and international, to their estimated fair values. The estimates of fair value of our reporting units are computed using the present value of estimated future cash flows. This analysis utilizes a multi-year forecast of estimated cash flows and a terminal value at the end of the cash flow period. The forecast period growth assumptions consist of internal projections that are based on our budget and long-range strategic plan. The discount rate used at the testing date is our weighted-average cost of capital. The assumptions included in the discounted cash flow analysis require judgment, and changes to these inputs could materially impact the results of the calculation.
If the fair value of a reporting unit exceeds its book value, goodwill of the reporting unit is not deemed impaired and the second step of the impairment test is not performed. If the book value of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting units goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating the estimated fair value of Blockbuster to the estimated fair value of our existing tangible assets and liabilities as well as existing identified intangible assets and previously unrecognized intangible assets. The unallocated portion of the estimated fair value of Blockbuster is the implied fair value of goodwill. If the carrying amount of the reporting units goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.
As discussed in Note 2 to the consolidated financial statements, beginning late in the second quarter of 2005 and continuing through the end of the year, the in-store home video industry declined at a rate that exceeded our and industry analysts forecasted expectations and has negatively impacted our future outlook on the industry. We believed the decline in the overall industry and the resulting decline in our stock price to be factors that would require us to perform an interim impairment test in accordance with SFAS 142. As a result, in connection with the preparation of our third quarter financial statements, we performed an interim impairment test on our goodwill balances. In estimating the fair value of each of our reporting units, we included the impact of trends in the business and industry noted in 2005, primarily including the accelerated decline in the in-store home video industry caused by (i) increased competition from retail mass merchant sales of low-priced DVDs, online rentals and other sources of in-home entertainment such as digital video recorders and other devices that are capable of downloading content for in-home viewing; (ii) competition from piracy in certain international markets and (iii) competition from other forms of leisure entertainment. As a result of these factors and the related risks associated with our business, the fair value was negatively impacted. The estimated fair value of our domestic unit was more than its related book value, so we determined that it was not necessary to perform step two of the goodwill impairment test for the domestic reporting unit. However, the estimated fair value of our international reporting unit was less than its related book value and we determined that the international goodwill balance was impaired. As such, step two of the goodwill impairment test was completed for the international reporting unit. Accordingly, we recorded an impairment charge totaling approximately $332.0 million during the third quarter of 2005. We also recorded goodwill impairment charges related to our domestic and international reporting units of approximately $1.50 billion and approximately $1.29 billion during the third quarter of 2004 and the fourth quarter of 2003, respectively.
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We performed our annual impairment test as of October 31, 2005 and updated the test for events occurring through December 31, 2005, which resulted in the estimated fair values of each of our reporting units exceeding their book values. We will perform our annual impairment test for 2006 during the fourth quarter, and on an interim date in 2006 should factors or indicators become apparent that would require an interim test.
Also as discussed in Note 2 to the consolidated financial statements, during the third quarters of 2005 and 2004 and the fourth quarter of 2003, in conjunction with the goodwill impairments discussed above, we reviewed our long-lived assets for impairment as required by SFAS 144. During the third quarter of 2005, we determined that the carrying value of fixed assets and tradenames in certain of our domestic markets and domestic subsidiaries exceeded the estimated undiscounted future cash flows to be generated by those assets. Accordingly, we recorded an impairment charge of approximately $15.6 million during the third quarter of 2005. During the third quarter of 2004 and the fourth quarter of 2003, we recorded impairment charges related to impairment of long-lived assets in certain of our international markets of approximately $1.7 million and $18.5 million, respectively.
Additionally, during the second quarter of 2005, we performed an impairment analysis for long-lived assets in certain of our international markets based on impairment indicators present, including current period operating and cash flow losses combined with revised forecasts that project continuing losses associated with the use of the long-lived assets. As a result of this analysis, we recorded an impairment charge of approximately $9.2 million in the second quarter of 2005.
Share-Based Compensation
We adopted SFAS 123R as of October 1, 2004 in conjunction with the Stock Option Exchange Offer discussed in Note 4 to the consolidated financial statements. SFAS 123R requires us to recognize compensation expense for all share-based payments made to employees based on the fair value of the share-based payment on the date of grant. We elected to use the modified prospective method for adoption, which requires compensation expense to be recorded for all unvested stock options and restricted shares beginning in the first quarter of adoption. For all unvested options outstanding as of October 1, 2004, the previously measured but unrecognized compensation expense, based on the fair value at the original grant date, is recognized on an accelerated basis in the Consolidated Statements of Operations over the remaining vesting period. For share-based payments granted subsequent to October 1, 2004, compensation expense, based on the fair value on the date of grant, is recognized in the Consolidated Statements of Operations on an accelerated basis over the vesting period. In determining the fair value of stock options, we use the Black-Scholes option pricing model that employs the following assumptions:
| Expected volatilitybased on the weekly historical volatility of our stock price, over the expected life of the option. |
| Expected term of the optionbased on historical employee stock option exercise behavior, the vesting terms of the respective option and a contractual life of ten years. |
| Risk-free ratebased upon the rate on a zero coupon U.S. Treasury bill, for periods within the contractual life of the option, in effect at the time of grant. |
| Dividend yieldcalculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant. |
Our stock price volatility and option lives involve managements best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option.
The fair value of most of our restricted shares is based on the price of a share of our Class A common stock on the date of grant. The fair value of our grants of restricted shares and restricted share units that are subject to hold provisions is discounted for the lack of marketability due to such post-vesting restrictions. Our grants of
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restricted share units that are payable in cash are based on the average closing prices of a share of each of our Class A and B common stock on the date of grant, recorded as a liability on the Consolidated Balance Sheets and marked-to-market at the end of each reporting period. A $1.00 increase in our stock price would not have a material impact on our results of operations.
SFAS 123R also requires that we recognize compensation expense for only the portion of options or restricted shares that are expected to vest. Therefore, we apply estimated forfeiture rates that are derived from historical employee termination behavior using a stratified model based on the employees position within the company and the vesting period of the respective stock options or restricted shares. If the actual number of forfeitures differs from those estimated by management, additional adjustments to compensation expense may be required in future periods.
Results of Operations
Consolidated Results
The following table sets forth a summary of consolidated results of certain operating and other financial data.
Year Ended December 31, | ||||||||||||||||||||
2005 | 2004 | 2003 | 2002 | 2001 | ||||||||||||||||
(In millions, except worldwide store data) | ||||||||||||||||||||
Statement of Operations Data: |
||||||||||||||||||||
Revenues |
$ | 5,864.4 | $ | 6,053.2 | $ | 5,911.7 | $ | 5,565.9 | $ | 5,156.7 | ||||||||||
Cost of sales |
2,647.1 | 2,441.4 | 2,389.8 | 2,358.7 | 2,420.7 | |||||||||||||||
Gross profit |
3,217.3 | 3,611.8 | 3,521.9 | 3,207.2 | 2,736.0 | |||||||||||||||
Operating expenses(1) |
3,643.8 | 4,865.0 | 4,358.6 | 2,859.5 | 2,953.2 | |||||||||||||||
Operating income (loss) |
(426.5 | ) | (1,253.2 | ) | (836.7 | ) | 347.7 | (217.2 | ) | |||||||||||
Interest expense |
(98.7 | ) | (38.1 | ) | (33.1 | ) | (49.5 | ) | (78.2 | ) | ||||||||||
Interest income |
4.1 | 3.6 | 3.1 | 4.1 | 6.1 | |||||||||||||||
Other items, net |
(2.4 | ) | 1.6 | (0.4 | ) | 2.9 | (5.2 | ) | ||||||||||||
Income (loss) before income taxes |
(523.5 | ) | (1,286.1 | ) | (867.1 | ) | 305.2 | (294.5 | ) | |||||||||||
Benefit (provision) for income taxes(2) |
(64.6 | ) | 37.3 | (106.5 | ) | (107.1 | ) | 55.2 | ||||||||||||
Equity in income (loss) of affiliated companies, net of tax |
| | (0.7 | ) | (2.2 | ) | 0.5 | |||||||||||||
Income (loss) before cumulative effect of change in accounting principle |
(588.1 | ) | (1,248.8 | ) | (974.3 | ) | 195.9 | (238.8 | ) | |||||||||||
Cumulative effect of change in accounting principle, net of tax |
| | (4.4 | ) | (1,817.0 | ) | | |||||||||||||
Net loss |
$ | (588.1 | ) | $ | (1,248.8 | ) | $ | (978.7 | ) | $ | (1,621.1 | ) | $ | (238.8 | ) | |||||
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Year Ended December 31, | ||||||||||||||||||||
2005 | 2004 | 2003 | 2002 | 2001 | ||||||||||||||||
(In millions, except worldwide store data) | ||||||||||||||||||||
Cash Flow Data: |
||||||||||||||||||||
Cash flows provided by (used for) operating activities(3) |
$ | (70.5 | ) | $ | 417.0 | $ | 593.7 | $ | 401.4 | $ | 554.0 | |||||||||
Cash flows used for investing activities(3) |
$ | (114.2 | ) | $ | (313.9 | ) | $ | (188.0 | ) | $ | (253.7 | ) | $ | (104.1 | ) | |||||
Cash flows provided by (used for) financing activities |
$ | 138.3 | $ | (18.8 | ) | $ | (335.5 | ) | $ | (199.2 | ) | $ | (441.2 | ) | ||||||
Other Data: |
||||||||||||||||||||
Depreciation and intangible amortization |
$ | 230.9 | $ | 249.7 | $ | 268.4 | $ | 240.8 | $ | 438.4 | ||||||||||
Impairment of goodwill and other long-lived assets |
$ | 356.8 | $ | 1,504.4 | $ | 1,304.9 | $ | | $ | | ||||||||||
Margins: |
||||||||||||||||||||
Rental margin(4) |
66.4 | % | 71.8 | % | 70.0 | % | 66.1 | % | 57.7 | % | ||||||||||
Merchandise margin(5) |
22.1 | % | 22.3 | % | 19.8 | % | 17.1 | % | 18.9 | % | ||||||||||
Gross margin(6) |
54.9 | % | 59.7 | % | 59.6 | % | 57.6 | % | 53.1 | % | ||||||||||
Worldwide Store Data: |
||||||||||||||||||||
Same-store revenues increase (decrease)(7) |
(4.9 | )% | (3.2 | )% | (2.2 | )% | 5.1 | % | 2.5 | % | ||||||||||
Company-operated stores at end of year |
7,158 | 7,265 | 7,105 | 6,907 | 6,412 | |||||||||||||||
Franchised and joint venture stores at end of year |
1,884 | 1,829 | 1,762 | 1,638 | 1,569 | |||||||||||||||
Total stores at end of year |
9,042 | 9,094 | 8,867 | 8,545 | 7,981 |
(1) | Operating expenses include non-cash charges to impair goodwill and other long-lived assets in accordance with SFAS 142 and SFAS 144 totaling approximately $356.8 million, $1.50 billion and $1.30 billion for the years ended December 31, 2005, 2004 and 2003, respectively. |
(2) | The provision for income taxes of $64.6 million in 2005 includes a valuation allowance recorded on our deferred tax assets in various jurisdictions. During the third quarter of 2005, we recorded a valuation allowance against our deferred tax assets in the United States and certain foreign jurisdictions because we determined that it was unclear as to the timing of when we will generate sufficient taxable income to realize these deferred tax assets. It was still unclear as to the timing of when we will generate sufficient taxable income to realize these deferred tax assets at the end of 2005. |
(3) | During the fourth quarter of 2005, as described in Note 1 to the consolidated financial statements, we restated our previously issued financial statements to adjust the classification of our rental library and rental library purchases. This restatement resulted in adjustments to our cash flow data for the years ended December 31, 2001 through 2004. |
(4) | Rental gross profit (rental revenues less cost of rental revenues) as a percentage of rental revenues. |
(5) | Merchandise gross profit (merchandise sales less cost of merchandise sold) as a percentage of merchandise sales. |
(6) | Gross profit as a percentage of total revenues. |
(7) | A store is included in the same-store revenues calculation after it has been opened and operated by us for more than 52 weeks. An acquired store becomes part of the same-store base in the 53rd week after its acquisition and conversion. The percentage change is computed by comparing total net revenues for same-stores at the end of the applicable reporting period with total net revenues from these same-stores for the comparable period in the prior year. The same-store revenues calculation does not include the impact of foreign exchange. Due to the integrated nature of the online pass, beginning in the third quarter of 2004, revenues generated from BLOCKBUSTER Online have been and will continue to be included in same-store rental revenues. |
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Comparison of 2005 to 2004
Revenues. Revenues decreased $188.8 million, or 3.1%, from 2004 to 2005. The following is a summary of revenues by category:
Year Ended December 31, | |||||||||||||||||||
2005 | 2004 | Increase/(Decrease) | |||||||||||||||||
Consolidated Revenues |
Percent of Total |
Consolidated Revenues |
Percent of Total |
||||||||||||||||
Dollar | Percent | ||||||||||||||||||
Rental revenues |
$ | 4,205.2 | 71.7 | % | $ | 4,428.6 | 73.2 | % | $ | (223.4 | ) | (5.0 | )% | ||||||
Merchandise sales |
1,586.5 | 27.1 | % | 1,532.6 | 25.3 | % | 53.9 | 3.5 | % | ||||||||||
Other revenues |
72.7 | 1.2 | % | 92.0 | 1.5 | % | (19.3 | ) | (21.0 | )% | |||||||||
Total revenues |
$ | 5,864.4 | 100.0 | % | $ | 6,053.2 | 100.0 | % | $ | (188.8 | ) | (3.1 | )% | ||||||
Same-Store Revenues Increase/(Decrease) | |||||||||
Worldwide | Domestic | International(1) | |||||||
Rental revenues |
(5.7 | )% | (5.4 | )% | (6.6 | )% | |||
Merchandise sales |
(2.6 | )% | (8.3 | )% | 2.6 | % | |||
Total revenues |
(4.9 | )% | (6.0 | )% | (2.6 | )% |
(1) | International same-store revenues do not include the impact of foreign exchange. |
The decrease in overall revenues primarily reflects a 4.9% decrease in worldwide same-store revenues during the year, which was partially offset by an increase in the average number of company-operated stores and the impact of favorable foreign exchange rates. The decrease in overall worldwide same-store revenues was primarily the result of the elimination of extended viewing fees, a decline in the overall rental industry during 2005 and continued competition from mass merchant sales of low-priced DVDs. In addition, we experienced a 21.0% decline in other revenues resulting from lower revenues from our marketing partnerships and lower royalties and fees from our franchisees, who are experiencing similar trends as our company-operated stores.
Rental Revenues. As discussed above, we implemented the no late fees program during 2005. However, the no late fees program does not apply at our non-Blockbuster branded stores in the United States or at our international locations excluding stores in Canada. In these locations, our membership agreement provides that the customer pays for any continuations of rentals past the initial rental period. Therefore, revenues generated from rental transactions in these locations include revenues received in connection with the initial rentals of product, as well as revenues associated with any continuations of such rentals past the initial rental period (extended viewing fees or EVF).
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Rental revenues decreased $223.4 million, or 5.0%, from 2004 to 2005, due to decreased rental revenues of both movies and games. The following is a summary of rental revenues by product category:
Year Ended December 31, | |||||||||||||||||||
2005 | 2004 | Increase/(Decrease) | |||||||||||||||||
Consolidated Revenues |
Percent of Total |
Consolidated Revenues |
Percent of Total |
||||||||||||||||
Dollar | Percent | ||||||||||||||||||
Movie rental revenues: |
|||||||||||||||||||
Base movie rental revenues-in-store |
$ | 3,002.3 | 71.4 | % | $ | 2,857.3 | 64.5 | % | $ | 145.0 | 5.1 | % | |||||||
Base movie rental revenues-online |
144.9 | 3.4 | % | 8.4 | 0.2 | % | 136.5 | 1,625.0 | % | ||||||||||
Movie PRP revenues |
521.2 | 12.4 | % | 512.0 | 11.6 | % | 9.2 | 1.8 | % | ||||||||||
Movie EVF revenues |
82.8 | 2.0 | % | 552.1 | 12.4 | % | (469.3 | ) | (85.0 | )% | |||||||||
Total movie rental revenues |
3,751.2 | 89.2 | % | 3,929.8 | 88.7 | % | (178.6 | ) | (4.5 | )% | |||||||||
Game rental revenues: |
|||||||||||||||||||
Base game rental revenues |
373.1 | 8.9 | % | 365.6 | 8.3 | % | 7.5 | 2.1 | % | ||||||||||
Game PRP revenues |
73.4 | 1.7 | % | 62.9 | 1.4 | % | 10.5 | 16.7 | % | ||||||||||
Game EVF revenues |
7.5 | 0.2 | % | 70.3 | 1.6 | % | (62.8 | ) | (89.3 | )% | |||||||||
Total game rental revenues |
454.0 | 10.8 | % | 498.8 | 11.3 | % | (44.8 | ) | (9.0 | )% | |||||||||
Total rental revenues |
$ | 4,205.2 | 100.0 | % | $ | 4,428.6 | 100.0 | % | $ | (223.4 | ) | (5.0 | )% | ||||||
Same-Store Revenues Increase/(Decrease) | |||||||||
Worldwide | Domestic | International(1) | |||||||
Movie rental revenues |
(5.2 | )% | (4.8 | )% | (6.4 | )% | |||
Game rental revenues |
(9.6 | )% | (9.8 | )% | (8.9 | )% | |||
Total rental revenues |
(5.7 | )% | (5.4 | )% | (6.6 | )% |
(1) | International same-store rental revenues do not include the impact of foreign exchange. |
The decrease in overall rental revenues primarily reflects a 5.7% decrease in worldwide same-store rental revenues, which was partially offset by the impact of favorable foreign exchange rates and an increase in the average number of company-operated stores. The decline in same-store rental revenues occurred both domestically and internationally and resulted primarily from the changes discussed below.
Movie Rental Revenues. Movie rental revenues decreased $178.6 million, or 4.5%, in 2005 as compared with 2004, primarily due to the elimination of extended viewing fees, which accounted for approximately 14% of our movie rental revenues in 2004. In addition, beginning late in the second quarter of 2005 and continuing through the end of the year, we experienced challenges caused by negative industry trends currently facing the video rental industry, which we believe include (i) a weak slate of titles released to home video during most of 2005; (ii) increased competition from retail mass merchant sales of low-priced DVDs, online rentals and other sources of in-home entertainment such as digital video recorders and other devices that are capable of downloading content for in-home viewing; (iii) competition from piracy in certain international markets; and (iv) competition from other forms of leisure entertainment. However, we believe that the changes we have made in our in-store business, including the elimination of extended viewing fees and the launch of the BLOCKBUSTER Movie Pass and BLOCKBUSTER Online, helped to offset the impact of the declining industry conditions and drive a $281.5 million, or 9.8%, increase in our base movie rental revenues since 2004. This growth in base movie rental revenues during 2005 primarily occurred domestically, where we have implemented all of the programs mentioned above, and can be attributed mostly to an increase in domestic movie rental transactions and increased rental pricing, which includes a significant reduction in promotional credits.
In mid-2004, we launched BLOCKBUSTER Online, which allows customers to rent a wide array of both new release and catalog movies by mail. The increase in online base movie rental revenues primarily reflects the growth in our average subscriber base from zero in mid-2004 to approximately 1.2 million
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subscribers at the end of 2005. We view BLOCKBUSTER® as one brand and believe that our ability to integrate our online service with an in-store offering provides us with a distinct competitive advantage. We have leveraged our in-store operations to grow BLOCKBUSTER Online, including promotion of the online subscription service in our domestic stores. Likewise, our BLOCKBUSTER Online customers receive coupons for free in-store rentals, which drive some of our online customers into our stores. As a result, we believe that the cross-promotion will enhance the BLOCKBUSTER brand and help to set us apart from our competition.
The changes in movie rental revenues, discussed above, resulted in a 5.2% decrease in total worldwide same-store movie rental revenues, including the elimination of extended viewing fees.
Industry analysts currently believe that the trends experienced in the worldwide in-store movie rental industry during 2005 will continue through the first part of 2006 with sequential improvements throughout the remainder of the year. We also believe that the in-store movie rental industry will remain under pressure in 2006 and, therefore, expect total movie rental revenues to decrease year-over-year. However, we believe that our no late fees program and BLOCKBUSTER Online will have a positive impact on our domestic same-store rental revenues and will enable us to outperform the domestic rental industry during 2006.
Game Rental Revenues. Game rental revenues decreased $44.8 million, or 9.0%, in 2005 as compared with 2004. This decrease primarily reflects the elimination of extended viewing fees in the United States and Canada, which reduced our game rental revenues by $62.8 million from 2004. The decrease in extended viewing fee revenues was partially offset by a $10.5 million increase in sales of previously played games and a $7.5 million increase in base game rental revenues primarily due to an increase in game rental pricing domestically in 2005. New game platforms were released during 2005 and additional game platforms are expected to be released in late 2006 or early 2007. We believe customers view the availability of previously played games as a value alternative to buying higher-priced new games while waiting for the release of new game platforms. We expect 2006 to be a challenging year for game rental revenues because they will be contingent upon our ability to generate significant rental and sale activity on existing formats, which will be highly dependent upon the release of strong new titles throughout the year. However, the supply and demand for new game titles is currently reduced in anticipation of the new platforms.
Merchandise Sales. Merchandise sales increased $53.9 million, or 3.5%, from 2004 to 2005, due primarily to increased sales of games. The following is a summary of merchandise sales by product category:
Year Ended December 31, | |||||||||||||||||||
2005 | 2004 | Increase/(Decrease) | |||||||||||||||||
Consolidated Revenues |
Percent of Total |
Consolidated Revenues |
Percent of Total |
||||||||||||||||
Dollar | Percent | ||||||||||||||||||
Movie sales |
$ | 563.8 | 35.6 | % | $ | 623.4 | 40.7 | % | $ | (59.6 | ) | (9.6 | )% | ||||||
Game sales |
676.3 | 42.6 | % | 546.7 | 35.7 | % | 129.6 | 23.7 | % | ||||||||||
General merchandise sales |
346.4 | 21.8 | % | 362.5 | 23.6 | % | (16.1 | ) | (4.4 | )% | |||||||||
Total merchandise sales |
$ | 1,586.5 | 100.0 | % | $ | 1,532.6 | 100.0 | % | $ | 53.9 | 3.5 | % | |||||||
Note: Certain prior period amounts have been reclassified to conform to current period presentation.
Same-Store Revenues Increase/(Decrease) | |||||||||
Worldwide | Domestic | International(1) | |||||||
Movie sales |
(11.8 | )% | (17.5 | )% | (0.7 | )% | |||
Game sales |
10.2 | % | 19.3 | % | 6.9 | % | |||
General merchandise sales |
(6.1 | )% | (9.3 | )% | (3.2 | )% | |||
Total merchandise sales |
(2.6 | )% | (8.3 | )% | 2.6 | % |
(1) | International same-store merchandise sales do not include the impact of foreign exchange. |
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The increase in overall merchandise sales resulted primarily from the addition of approximately 60 freestanding games stores and the impact of favorable foreign exchange rates. The increase was offset by a 2.6% decline in same-store merchandise sales. Merchandise sales continued to grow as a percent of our total business, representing 27.1% of total revenues in 2005 as compared to 25.3% in 2004, primarily as a result of growth in international retail sales and the elimination of extended viewing fees in the United States and Canada.
Movie Sales. Movie sales, which include sales of both new and traded DVDs and VHS tapes, decreased $59.6 million or 9.6% from 2004 to 2005. This change was primarily the result of an 11.8% decrease in worldwide same-store movie sales which was slightly offset by an increase in the average number of company-operated stores and the impact of favorable foreign exchange rates. The decline in worldwide same-store movie sales was mainly due to reduced sales of new movies during 2005 resulting from our efforts to reduce our merchandise inventory levels of deep catalog titles as well as product availability constraints in the second half of the year. The decline in sales of new movies was partially offset by strong sales of traded movies due to the implementation of trading in an additional 2,100 locations worldwide during 2005. By the end of 2005, we were offering movie trading in approximately 6,000 stores worldwide. While these additional trading locations increased our overall unit sales of movies worldwide by 6.0%, it also reduced the average retail selling price of movies by 14.7%, since traded movies generally have a lower average selling price than new retail product. We expect that our reduced levels of merchandise inventory as well as less advertising on our trading initiatives will negatively impact our retail movie sales in 2006.
Game Sales. Game sales, including sales of new and traded game software, hardware consoles and accessories, increased $129.6 million, or 23.7%, from 2004 to 2005. This change primarily resulted from the addition of approximately 60 company-operated freestanding RHINO VIDEO GAMES® and GAMESTATION® stores and a 10.2% increase in worldwide same-store game sales. In addition, by the end of 2005, we were offering games trading in approximately 6,000 stores worldwide as compared with 3,900 stores worldwide at the end of 2004. The addition of these freestanding game stores and store-in-store trading locations contributed to a 23.0% improvement in the worldwide unit sales of retail games in 2005 as compared to 2004. In addition, we experienced a slight increase in the average selling price of retail games during 2005. While the increase in sales of traded product, which generally have a lower average selling price than new games, reduced the average selling price of retail games, our game sales benefited from the launch of Sonys PSP model in early 2005 and XBOX 360 in late 2005 and helped drive an increase in the average selling price of new retail games. Additional game platforms are expected to be released in late 2006 or early 2007. The home video game industry tends to slow prior to the introduction of new platforms as consumers hold back their purchases in anticipation of new platforms and game enhancements. During 2006, we also anticipate a further reduction in our merchandise inventory levels and a decrease in our marketing activities surrounding our game concepts. As a result of all of these factors, we expect game sales to decline during 2006.
General Merchandise Sales. General merchandise sales, which include sales of confections, other movie and game-related products and sales to franchisees, decreased $16.1 million, or 4.4%, from 2004 to 2005, primarily as a result of a 6.1% decline in worldwide same-store general merchandise sales. This decline was partially offset by an increase in the average number of company-owned stores and the impact of favorable foreign exchange rates. The decrease in same-store sales was primarily the result of the discontinuation of sales of various movie-related products domestically during the latter part of 2004.
Cost of Sales. Cost of sales of $2,647.1 million in 2005 increased $205.7 million, or 8.4%, from $2,441.4 million in 2004, primarily as a result of changes in gross margin discussed below.
Gross Profit. Gross profit of $3,217.3 million in 2005 decreased $394.5 million, or 10.9%, from $3,611.8 million in 2004. The decrease in gross profit was caused by a decrease in our gross margin to 54.9% in 2005 from 59.7% in 2004 and a 3.1% decrease in total revenues. The total gross margin for 2005 was negatively impacted by a decline in our rental gross margin, as further discussed below, and a shift in our revenues from higher margin rental revenues to lower margin merchandise sales.
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Rental Gross Profit. Rental gross profit of $2,793.3 million in 2005 decreased $384.6 million, or 12.1%, from $3,177.9 million in 2004. The decrease in rental gross profit was primarily due to a decrease in our rental gross margin from 71.8% in 2004 to 66.4% in 2005 and a $223.4 million decrease in rental revenues. The decrease in our rental gross margin was due to the impact of several factors. In mid-2004, we launched two new subscription programs, the BLOCKBUSTER Movie Pass and BLOCKBUSTER Online, which each charge a fixed fee for multiple rentals, and we launched our no late fees program at the beginning of 2005. During 2005, we increased our product purchases in order to grow BLOCKBUSTER Online and support the increased product demand resulting from these new in-store rental offerings. However, as a result of changing industry conditions in 2005, including a weak slate of titles released to home video, our total rental revenues decreased more than anticipated relative to our product purchases. In addition, the shipping costs incurred by BLOCKBUSTER Online are included in the cost of rental revenues.
Merchandise Gross Profit. Merchandise gross profit of $351.3 million in 2005 increased $9.4 million, or 2.7%, from merchandise gross profit of $341.9 million in 2004. The increase in merchandise gross profit was primarily attributable to growth in merchandise sales. Merchandise gross margin of 22.1% in 2005 remained relatively flat with 2004.
Operating Expenses. Total operating expenses, which include compensation expenses, selling and advertising expenses, occupancy costs, other corporate and store expenses, depreciation and intangible amortization and impairment of goodwill and other long-lived assets, totaled $3,643.8 million in 2005, a decrease of $1,221.2 million, or 25.1%, from $4,865.0 million in 2004. Total operating expenses and operating expenses as a percent of total revenues decreased primarily as a result of non-cash impairment charges which totaled approximately $356.8 million in 2005 as compared with approximately $1.5 billion in 2004 and the following other items:
Selling, General and Administrative Expense. Selling, general and administrative expense, which includes expenses incurred in-store and online and at the regional and corporate levels, of $3,056.1 million in 2005, decreased $54.8 million, or 1.8%, from $3,110.9 million in 2004. Selling, general and administrative expense as a percentage of total revenues increased to 52.1% in 2005 as compared with 51.4% in 2004 as a result of a decrease in total revenues in 2005. The change in selling, general and administrative expense in 2005 resulted from the following items:
| Other general and administrative expenses decreased $84.4 million, or 15.2%, due primarily to reduced expenses related to decreased extended viewing fees and other in-store strategic initiatives implemented in 2004, increased focus on operating expense management and reduced legal settlements. These decreases were partially offset by approximately $12.6 million of costs incurred related to our efforts to acquire Hollywood Entertainment Corporation, additional general and administrative expenses incurred in support of the growth of BLOCKBUSTER Online during 2005 and approximately $6.9 million of additional bad debt expense from our franchisees, including approximately $4.5 million related to a note receivable. |
| Occupancy costs increased $38.9 million, or 4.4%, primarily as a result of the increase in our average store base and the addition of 30 distribution centers to support the growth of BLOCKBUSTER Online since mid-2004, increased foreign exchange rates and the impact of general inflation on lease renewals and utilities. |
| Compensation expense in 2005 remained consistent with 2004 resulting from the cost-saving measures implemented during the year, offset by additional compensation expenses incurred from 2004. We experienced a decrease in compensation expense related to lower bonus accruals attributed to lower operating results for 2005 and labor savings resulting from our cost-saving initiatives in 2005, including the reduction-in-force discussed above. However, during 2005 we also incurred additional compensation expenses from 2004 for additional personnel needed to support the growth of BLOCKBUSTER Online during 2005, incremental share-based compensation expense, additional store labor in support of our growth in freestanding games stores, severance costs as a result of a reduction-in-force during 2005 and increased foreign exchange rates. |
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| Advertising expense remained relatively flat with 2004. During 2005, we focused our advertising on growing BLOCKBUSTER Online and on our no late fees program. To accomplish this, we reduced our advertising for our in-store business and shifted the remaining dollars from spending on various campaigns throughout the year as in 2004 to larger campaigns designed to promote our no late fees program. As a result, we incurred approximately $60 million during the first two quarters of 2005 in connection with the marketing and implementation of our no late fees program and very little advertising expense during the back half of the year. We also incurred approximately $30 million of additional selling and advertising expenses, including subscriber acquisition costs, in support of the growth of BLOCKBUSTER Online during 2005. |
As discussed in Note 11 to the consolidated financial statements, we completed the sale of our subsidiary D.E.J. Productions Inc. on November 14, 2005. As a result of the sale, we recorded a gain on sale of approximately $5.8 million which is included in General and administrative on the Consolidated Statement of Operations for the year ended December 31, 2005.
We are committed to improving our profitability and are taking steps that we believe will enable us to achieve that goal. These steps include lowering operating expenses, selectively marketing in-store programs with a focus on profitability rather than top-line revenue and, subject to market conditions, raising prices as necessary to offset increasing expenses, such as utilities. During 2005, we implemented a cost-reduction strategy, which included a reduction-in-force and other measures targeted at reducing our operating expenses. Our focus for 2006 will be on continuing to reduce operating expenses in light of the accelerated decline of the in-store rental industry that began late in the second quarter of 2005. To accomplish this, we are implementing additional cost-saving measures aimed at further reducing our operating expenses, primarily including general and administrative and advertising expenses, by approximately $100 million from 2005 to 2006 and an incremental $50 million in 2007. We expect to realize these savings through a reduction in corporate and store level overhead expenses, lower advertising expenses, operational savings from the optimization of store labor hours, the divestiture of certain non-core assets and store closures. As a result of the reduction in corporate personnel, we expect to incur approximately $10 million in severance charges during the first quarter of 2006.
Depreciation and Intangible Amortization. Depreciation and intangible amortization of $230.9 million in 2005 decreased $18.8 million, or 7.5%, as compared with $249.7 million in 2004. The decrease was primarily the result of an increase in fully depreciated property and equipment and lower capital expenditures, which was partially offset by increased foreign exchange rates.
Impairment of Goodwill and Other Long-Lived Assets. As described above and in Note 2 to the consolidated financial statements, we recorded non-cash impairment charges totaling approximately $332.0 million in 2005 to impair goodwill in our international reporting unit and approximately $1.5 billion in 2004 to impair goodwill in both our domestic and international reporting units in accordance with SFAS 142. We also recognized non-cash impairment charges of approximately $24.8 million in 2005 and approximately $1.7 million in 2004 to impair other long-lived assets in accordance with SFAS 144.
Operating Loss. Operating loss of $426.5 million in 2005 represents a decrease in operating loss of $826.7 million, or 66.0%, from an operating loss of $1,253.2 million in 2004. This decrease was due to the non-cash charges to impair goodwill and other long-lived assets and other changes discussed above.
Interest Expense. Interest expense of $98.7 million in 2005 increased $60.6 million, or 159.1%, as compared with $38.1 million in 2004. The increase in interest expense was primarily related to the net borrowing of $950.0 million during the third quarter of 2004, in conjunction with the funding of the special distribution of $5.00 per share paid to stockholders as a result of the divestiture from Viacom, additional borrowings under our credit agreement during 2005 and rising interest rates on our variable rate debt.
Benefit (Provision) for Income Taxes. We recognized a provision for income taxes of $64.6 million in 2005 primarily as a result of a valuation allowance recorded on our deferred tax assets. In 2004, we recognized a benefit for income taxes of $37.3 million. The income tax benefit in 2004 was primarily the result of a $37.1
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million tax benefit recorded as a result of specific federal income tax audit issues resolved during the first quarter of 2004. See Note 8 to the consolidated financial statements for further discussion of income taxes.
Net Loss. Net loss of $588.1 million in 2005 reflects a decrease in losses of $660.7 million from a net loss of $1,248.8 million in 2004. The decrease in net loss was attributable to the non-cash charges to impair goodwill and other long-lived assets and other changes discussed above.
Comparison of 2004 to 2003
Revenues. Revenues increased $141.5 million, or 2.4%, from 2003 to 2004 as a result of growth in rental revenues and merchandise sales. The following is a summary of revenues by category:
Year Ended December 31, | |||||||||||||||||||
2004 | 2003 | Increase/(Decrease) | |||||||||||||||||
Consolidated Revenues |
Percent of Total |
Consolidated Revenues |
Percent of Total |
||||||||||||||||
Dollar | Percent | ||||||||||||||||||
Rental revenues |
$ | 4,428.6 | 73.2 | % | $ | 4,533.5 | 76.7 | % | $ | (104.9 | ) | (2.3 | )% | ||||||
Merchandise sales |
1,532.6 | 25.3 | % | 1,281.6 | 21.7 | % | 251.0 | 19.6 | % | ||||||||||
Other revenues |
92.0 | 1.5 | % | 96.6 | 1.6 | % | (4.6 | ) | (4.8 | )% | |||||||||
Total revenues |
$ | 6,053.2 | 100.0 | % | $ | 5,911.7 | 100.0 | % | $ | 141.5 | 2.4 | % | |||||||
Same-Store Revenues Increase/(Decrease) | |||||||||
Worldwide | Domestic | International(1) | |||||||
Rental revenues |
(5.7 | )% | (6.4 | )% | (3.0 | )% | |||
Merchandise sales |
5.6 | % | (0.6 | )% | 13.5 | % | |||
Total revenues |
(3.2 | )% | (5.5 | )% | 3.0 | % |
(1) | International same-store revenues do not include the impact of foreign exchange. |
The increase in overall revenues primarily reflected the impact of favorable foreign exchange rates and the addition of company-operated stores, which were partially offset by a 3.2% decrease in worldwide same-store revenues during the year. The decrease in overall worldwide same-store revenues resulted from the continued decrease in both domestic and international same-store rental revenues. The worldwide rental industry continued to be negatively impacted in 2004 by competition from mass merchant sales of DVDs, and the international rental industry was further impacted by the effects of piracy. These factors caused the rental industry to experience lighter traffic industry-wide, which caused our active member base to decrease during 2004 as compared with 2003. While rental demand continued to slow during 2004, retail demand for DVDs and games continued to increase and, during the year, we enhanced our presence in these areas to take advantage of this increased demand. Worldwide same-store merchandise sales increased during the year primarily as a result of substantial growth in international movie and game sales and domestic game sales.
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Rental Revenues. Rental revenues decreased $104.9 million, or 2.3%, from 2003 to 2004, due primarily to decreased rentals of movies. The following is a summary of rental revenues by product category:
Year Ended December 31, | |||||||||||||||||||
2004 | 2003 | Increase/(Decrease) | |||||||||||||||||
Consolidated Revenues |
Percent of Total |
Consolidated Revenues |
Percent of Total |
||||||||||||||||
Dollar | Percent | ||||||||||||||||||
Movie rental revenues: |
|||||||||||||||||||
Base movie rental revenues |
$ | 2,865.7 | 64.7 | % | $ | 2,900.5 | 64.0 | % | $ | (34.8 | ) | (1.2 | )% | ||||||
PRP revenues |
512.0 | 11.6 | % | 492.2 | 10.8 | % | 19.8 | 4.0 | % | ||||||||||
Movie EVF revenues |
552.1 | 12.4 | % | 642.7 | 14.2 | % | (90.6 | ) | (14.1 | )% | |||||||||
Total movie rental revenues |
3,929.8 | 88.7 | % | 4,035.4 | 89.0 | % | (105.6 | ) | (2.6 | )% | |||||||||
Game rental revenues: |
|||||||||||||||||||
Base game rental revenues |
365.6 | 8.3 | % | 353.0 | 7.8 | % | 12.6 | 3.6 | % | ||||||||||
Game PRP revenues |
62.9 | 1.4 | % | 65.7 | 1.4 | % | (2.8 | ) | (4.3 | )% | |||||||||
Game EVF revenues |
70.3 | 1.6 | % | 79.4 | 1.8 | % | (9.1 | ) | (11.5 | )% | |||||||||
Total game rental revenues |
498.8 | 11.3 | % | 498.1 | 11.0 | % | 0.7 | 0.1 | % | ||||||||||
Total rental revenues |
$ | 4,428.6 | 100.0 | % | $ | 4,533.5 | 100.0 | % | $ | (104.9 | ) | (2.3 | )% | ||||||
Same-Store Revenues Increase/(Decrease) | |||||||||
Worldwide | Domestic | International(1) | |||||||
Movie rental revenues |
(6.1 | )% | (6.8 | )% | (3.5 | )% | |||
Game rental revenues |
(2.8 | )% | (3.9 | )% | 2.9 | % | |||
Total rental revenues |
(5.7 | )% | (6.4 | )% | (3.0 | )% |
(1) | International same-store revenues do not include the impact of foreign exchange. |
The decrease in overall rental revenues primarily reflected a 5.7% decrease in worldwide same-store rental revenues, which was partially offset by the impact of favorable foreign exchange rates and the addition of company-operated stores. The decrease in same-store rental revenues occurred both domestically and internationally and reflected generally lighter traffic in the in-store rental industry, which continued to be negatively impacted by increased competition from mass merchant sales of DVDs. Our revenues in 2004 were also impacted by the national rollout of the BLOCKBUSTER Movie Pass, which reduced our EVF revenues in exchange for growth in our rental subscription sales. Our domestic operations represented 76.4% of our rental revenues for 2004 as compared with 78.6% of our rental revenues for 2003, primarily as a result of the impact of favorable foreign exchange rates.
Movie Rental Revenues. Movie rental revenues decreased $105.6 million, or 2.6%, in 2004 as compared with 2003, due primarily to a 6.1% decline in our worldwide same-store movie rental revenues. This decline was partially offset by the impact of favorable foreign exchange rates and the addition of company-operated stores. The decline in worldwide same-store movie rental revenues resulted from the continued decline in the overall in-store rental industry, which was negatively impacted by continued competition from mass merchant sales of DVDs and decreasing extended viewing fees caused by the national launch of the BLOCKBUSTER Movie Pass in May 2004. While the national launch of the BLOCKBUSTER Movie Pass negatively impacted EVF revenues, sales of these passes helped increase our rental revenues during 2004. In addition to the ongoing subscription revenue, we found that customers who purchased the pass also increased their store visits and total in-store spending while a pass member. The overall decrease in same-store movie rental revenues was also partially offset by a 4.0% increase in total rental revenues generated by the sales of previously rented movies during 2004 as compared with 2003, resulting from increases both domestically and internationally. Sales of previously rented movies were primarily driven by pricing and promotional activities designed to position our used movie offerings as a
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value-based alternative to new retail product. These activities resulted in a 4.5% increase in unit sales of previously rented movies during the year, which was partially offset by a slight decrease in the average selling price of previously rented movies. DVD rental revenues continued to increase as a percentage of total rental revenues during 2004, caused by increasing DVD penetration, while VHS rental revenues continued to decline.
Game Rental Revenues. Game rental revenues increased $0.7 million, or 0.1%, in 2004 as compared with 2003, due to the impact of favorable foreign exchange rates and the addition of new company-operated stores which were partially offset by a 2.8% decrease in worldwide same-store game rental revenues. The decrease in worldwide same-store game rental revenues in 2004 was the result of a 3.9% decrease in domestic same-store game rental revenues caused primarily by the increased retail offering of low-priced catalog, or value, games and increased games trading, by us and our competitors. We believe both of these offerings competed with our rental and previously played game product. This decrease was partially offset by a 2.9% increase in international same-store game rental revenues driven by growth in game rentals and rental revenues generated by the sales of previously played games in several international markets.
Merchandise Sales. Merchandise sales increased $251.0 million, or 19.6%, from 2003 to 2004, due to increases in movie and game sales. The following is a summary of merchandise sales by product category:
Year Ended December 31, | |||||||||||||||||||
2004 | 2003 | Increase/(Decrease) | |||||||||||||||||
Consolidated Revenues |
Percent of Total |
Consolidated Revenues |
Percent of Total |
||||||||||||||||
Dollar | Percent | ||||||||||||||||||
Movie sales: |
|||||||||||||||||||
VHS sales |
$ | 25.9 | 1.7 | % | $ | 66.7 | 5.2 | % | $ | (40.8 | ) | (61.2 | )% | ||||||
DVD sales |
597.5 | 39.0 | % | 526.4 | 41.1 | % | 71.1 | 13.5 | % | ||||||||||
Total movie sales |
623.4 | 40.7 | % | 593.1 | 46.3 | % | 30.3 | 5.1 | % | ||||||||||
Game sales |
546.7 | 35.7 | % | 306.6 | 23.9 | % | 240.1 | 78.3 | % | ||||||||||
General merchandise sales |
362.5 | 23.6 | % | 381.9 | 29.8 | % | (19.4 | ) | (5.1 | )% | |||||||||
Total merchandise sales |
$ | 1,532.6 | 100.0 | % | $ | 1,281.6 | 100.0 | % | $ | 251.0 | 19.6 | % | |||||||
Note: Certain prior period amounts have been reclassified to conform to current period presentation.
Same-Store Revenues Increase/(Decrease) | |||||||||
Worldwide | Domestic | International(1) | |||||||
Movie sales |
(0.1 | )% | (7.5 | )% | 20.5 | % | |||
Game sales |
32.5 | % | 63.1 | % | 22.4 | % | |||
General merchandise sales |
(7.4 | )% | (9.6 | )% | (5.0 | )% | |||
Total merchandise sales |
5.6 | % | (0.6 | )% | 13.5 | % |
(1) | International same-store merchandise sales do not include the impact of foreign exchange. |
The increase in overall merchandise sales resulted primarily from the addition of new company-operated stores, including approximately 125 freestanding games stores, the impact of favorable foreign exchange rates and a 5.6% increase in worldwide same-store merchandise sales. The increase in worldwide same-store merchandise sales during 2004 was driven primarily by a 13.5% increase in international same-store merchandise sales, reflecting increased sales of movies and games. Domestic same-store merchandise sales decreased slightly as compared with 2003 due primarily to a 7.5% decrease in same-store movies sales. This decrease was partially offset by the increase in the sale of new and traded games, driven in part by the addition of approximately 450 domestic game store-in-store locations since late 2003. Merchandise sales continued to grow as a percent of our business during 2004, representing 25.3% of total revenues in 2004, compared with 21.7% of total revenues in 2003. Our domestic operations represented 48.8% of our merchandise sales in 2004 as compared with 56.1% of
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our merchandise sales in 2003. This decrease was attributable to the continued retail revenue growth internationally, including the impact of favorable exchange rates.
Movie Sales. Movie sales, including sales of both new and traded DVDs and VHS tapes, increased $30.3 million or 5.1% from 2003 to 2004, primarily as a result of the addition of company-operated stores, a 20.5% increase in international same-store movie sales and favorable foreign exchange rates, which were partially offset by a 7.5% decrease in domestic same-store movie sales. The increase in international movie sales was the result of the increased popularity of retail DVD internationally. The decrease in domestic same-store merchandise sales was caused by the elimination of retail VHS sales in substantially all of our domestic stores during the first quarter of 2004, lighter rental traffic and pricing pressure on DVDs from the studios and mass merchant retailers. These factors were partially offset by an increase in the sales of traded movies, which have a lower average selling price than new retail product. The growth in international movie sales was the primary driver behind an increase in the overall unit sales of retail movies worldwide. The average retail selling price of movies decreased from 2004 to 2003 partially as a result of increased sales of lower-priced traded movies, including sales of traded VHS internationally.
Game Sales. Game sales, including sales of new and traded game software, hardware consoles and accessories, increased $240.1 million, or 78.3%, from 2003 to 2004, primarily as a result of a 32.5% increase in worldwide same-store game sales, the addition of new company-operated freestanding RHINO VIDEO GAMES and GAMESTATION stores, and favorable foreign exchange rates. The increase in worldwide same-store game sales was due, in part, to the addition of approximately 450 domestic game store-in-store locations and approximately 30 international game store-in-store locations since late 2003. These store-in-store locations offer an assortment of new and traded retail game software, hardware and accessories. In addition, during 2004, we began offering games trading in approximately 3,400 stores worldwide that do not have a game store-in-store concept. International same-store retail game sales grew as the international markets increased their game offerings to accommodate the growing demand for games internationally. These factors, and the addition of new freestanding games stores, led to a significant improvement in the overall unit sales of retail games worldwide. In addition, the overall average selling price of retail games increased in 2004, driven, in part, by an increase in the average selling price of new games, including increased sales of premium-priced new releases, or front-line games. Front-line games have a higher average selling price than value-priced games and, therefore, are primarily sold through our new specialty freestanding and store-in-store game concepts. These factors were partially offset by the increased sales of traded games, which generally have a lower average selling price than new games.
General Merchandise Sales. General merchandise sales, which include sales of confections, other movie and game-related products and sales to franchisees, decreased $19.4 million, or 5.1%, from 2003 to 2004, primarily due to a 7.4% decrease in our worldwide same-store general merchandise sales, partially offset by the impact of favorable foreign exchange rates. The decrease in our worldwide same-store general merchandise sales due to the discontinuation of sales of various movie-related products domestically during the latter part of 2004, which was partially offset by increased sales of confections, and lower sales to franchisees.
Cost of Sales. Cost of sales of $2,441.4 million in 2004 increased $51.6 million, or 2.2%, from $2,389.8 million in 2003, primarily as a result of increased revenues, as discussed above, and the changes in gross profit discussed below.
Gross Profit. Gross profit of $3,611.8 million in 2004 increased $89.9 million, or 2.6%, from $3,521.9 million in 2003. The increase in gross profit was primarily driven by increased sales from 2003 to 2004. Total gross margin for 2004 totaled 59.7% as compared with 59.6% in 2003. The total gross margin for 2004 was negatively impacted by a shift in our revenues from higher margin rental revenues to lower margin merchandise sales. This impact of this shift in our product mix was offset by improvements in both rental and retail gross margins.
Rental Gross Profit. Rental gross profit of $3,177.9 million in 2004 increased $6.5 million, or 0.2%, from $3,171.4 million in 2003. The increase in rental gross profit primarily resulted from an increase in
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rental gross margin from 70.0% in 2003 to 71.8% in 2004. The continued improvement in our rental gross margin was primarily due to the following:
| As a result of improved product buying and inventory management, rental product purchase costs, in total and on an average store basis, were lower during 2004 as compared with 2003. Our focus on profitability was implemented in the first quarter of 2003 and, as a result, the rate of growth in gross margins recognized during late 2003 and the first quarter of 2004 slowed during the second, third and fourth quarters of 2004. |
| During late 2003 and early 2004, we increased the proportion of rental product purchased under revenue-sharing arrangements. This provided flexibility in our rental copy depth, while also providing the ability to maintain a favorable level of movie rental gross margin. |
| With the increasing penetration of the DVD format, VHS rentals declined. As a result, we decreased our purchases of rental VHS tapes while managing the copy depth necessary to meet customer demand. Successful management of this continued transition improved our results in VHS rental margins. |
Merchandise Gross Profit. Merchandise gross profit of $341.9 million in 2004 increased $88.0 million, or 34.7%, from merchandise gross profit of $253.9 million in 2003. The increase in merchandise gross profit was primarily attributable to growth in merchandise sales and continued improvement in our merchandise gross margin, which increased to 22.3% in 2004 compared with 19.8% in 2003. The increase in merchandise gross margin was primarily caused by growth in higher margin international game sales and increased merchandise sales from traded movies and games. Traded movies and games have higher average gross margins than new retail product.
Operating Expenses. Total operating expenses, including compensation expenses, selling and advertising expenses, occupancy costs, other corporate and store expenses, depreciation and intangible amortization, totaled $4,865.0 million in 2004, an increase of $506.4 million, or 11.6%, from $4,358.6 million in 2003. Total operating expenses increased as a percentage of total revenues to 80.4% in 2004 from 73.7% in 2003. Total operating expenses and operating expenses as a percent of total revenues increased primarily as a result of non-cash impairment charges which totaled approximately $1.5 billion in 2004 as compared with non-cash impairment charges totaling approximately $1.3 billion in 2003 and the following other items:
Selling, General and Administrative Expense. Selling, general and administrative expense, including expenses incurred at the store, regional and corporate levels, of $3,110.9 million in 2004, increased $325.6 million, or 11.7%, from $2,785.3 million in 2003. Selling, general and administrative expense as a percentage of total revenues increased to 51.4% in 2004 as compared with 47.1% in 2003. The change in selling, general and administrative expense in 2004 resulted from the following items:
| Compensation expense increased $130.4 million, or 10.2%, primarily as a result of increased foreign exchange rates, additional personnel needed to support our store growth and strategic initiatives, $18.3 million in share-based compensation expense primarily resulting from our adoption of SFAS 123R, increasing payroll and insurance costs due to general inflation and approximately $8.6 million in severance costs incurred during late 2004. |
In conjunction with our Stock Option Exchange Offer, we adopted SFAS 123R as of October 1, 2004. SFAS 123R requires us to recognize compensation expense for all share-based payments made to employees based on the fair value of the share-based payment at the date of grant. For all unvested options outstanding as of October 1, 2004, the previously measured but unrecognized compensation expense, based on the fair value at the original grant date, is being recognized in the Consolidated Statements of Operations over the remaining vesting period. For share-based payments granted subsequent to October 1, 2004, compensation expense, based on the fair value on the date of grant, is being recognized in the Consolidated Statements of Operations from the date of grant. For the year ended December 31, 2004, we recognized $18.3 million of compensation expense in the Consolidated Statements of Operations for share-based payments to employees, which is discussed further in Note 4 to the consolidated financial statements.
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Additionally, effective January 1, 2004, we adopted the expense recognition provisions of FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (FIN 28). FIN 28 requires unearned compensation associated with share-based awards with graded vesting periods to be amortized on an accelerated basis over the vesting period of the option or award. Prior to the adoption of the expense recognition provisions of FIN 28, which has been accounted for as a change in accounting principle, we amortized the unearned compensation on a straight-line basis over the vesting period. We applied the disclosure-only provisions of SFAS 123 through September 30, 2004; therefore, the cumulative effect of change in accounting principle of $23.1 million, net of tax, has not been reflected in our Consolidated Statements of Operations for the year ended December 31, 2004 but has been appropriately reflected in the SFAS 123 pro forma disclosures in Note 1 to the consolidated financial statements.
| Advertising expense, including online subscriber acquisition costs, increased $78.0 million, or 43.5%, reflecting increased spending in support of our strategic initiatives, including the launch of BLOCKBUSTER Online during the third quarter of 2004, the rollout of DVD and games trading in approximately 3,500 stores worldwide in 2004, the continued rollout of our game store-in-stores and other promotional activity and customer service initiatives. |
| Occupancy costs increased $60.6 million, or 7.3%, primarily as a result of increased foreign exchange rates, the net addition of new company-operated stores, the renewal of certain domestic store leases at generally higher rates and increased repair and maintenance costs. |
| Other general and administrative corporate and store expenses increased $56.6 million, or 11.3%, due primarily to expenses related to our strategic initiatives and related systems and infrastructure improvements, increased costs as a result of our divestiture from Viacom, increased foreign exchange rates, and the addition of new company-operated stores. |
Other general and administrative expenses were negatively impacted in the fourth quarter of 2004 by the settlement of a complaint filed by Buena Vista Home Entertainment, Inc. Buena Vista claimed that Blockbuster had breached the revenue-sharing agreement between the two parties and claimed damages in excess of $120 million. The parties agreed to binding arbitration of their dispute and, as a result, we accrued $18 million in connection with such arbitration, of which $12 million was recorded in 2004.
Depreciation Expense. Depreciation expense of $247.4 million in 2004 decreased $18.6 million, or 7.0%, as compared with $266.0 million in 2003. The decrease was primarily the result of an increase in fully depreciated property and equipment, which was partially offset by increased foreign exchange rates and the addition of new company-operated stores.
Impairment of Goodwill and Other Long-Lived Assets. During the third quarter of 2004 and fourth quarter of 2003, as described above and in Note 2 to the consolidated financial statements, we recorded non-cash impairment charges totaling approximately $1.5 billion and approximately $1.3 billion, respectively, to impair goodwill in both our domestic and international reporting units in accordance with SFAS 142. During the third quarter of 2004 and the fourth quarter of 2003, we also recognized non-cash impairment charges of approximately $1.7 million and approximately $18.5 million, respectively, to impair other long-lived assets in accordance with SFAS 144.
During 2004, we incurred approximately $120 million in incremental operating expenses for our strategic initiatives, which negatively impacted our operating income. These costs primarily included incremental advertising costs, costs to make incremental improvements in systems and infrastructure and personnel costs, as discussed above. In addition, as a result of our divestiture from Viacom, we incurred approximately $10 million in incremental operating expenses during 2004 due to the replacement of services and contracts previously provided through Viacom.
Interest Expense. Interest expense of $38.1 million in 2004 increased $5.0 million, or 15.1%, as compared with $33.1 million in 2003. The increase in interest expense was primarily related to the net borrowing of $950.0 million during the third quarter of 2004, in conjunction with the funding of the special distribution.
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Provision for Income Taxes. We recognized an income tax benefit of $37.3 million in 2004 as compared with a provision of $106.5 million in 2003. The income tax benefit in 2004 primarily reflected a $37.1 million tax benefit as a result of the resolution of specific federal income tax audit issues during the first quarter of 2004. Additionally, a large portion of the charges to impair goodwill and other long-lived assets in 2003 and 2004 were non-deductible.
Cumulative Effect of Change in Accounting Principle, Net of Tax. Effective January 1, 2003, we adopted SFAS 143 which requires us to provide for estimated long-lived asset retirement obligations that will be incurred upon future store closings. The initial adoption of SFAS 143 required us to record a cumulative effect of change in accounting principle, net of tax, of $4.4 million in our income statement in the first quarter of 2003. The initial adoption of this statement did not affect operating income or cash flow.
Net Loss. Net loss of $1,248.8 million in 2004 reflects additional losses of $270.1 million from a net loss of $978.7 million in 2003. The increase in net loss was attributable to the changes discussed above.
Liquidity and Capital Resources
General
We generate cash from operations predominately from the rental and retail sale of movies and games and most of our revenue is received in cash and cash equivalents. Working capital requirements, including rental library purchases, and normal capital expenditures are generally funded with cash from operations. We expect cash on hand, cash from operations and available borrowings under our revolving credit facility to be sufficient to fund the anticipated cash requirements for working capital purposes, rental library purchases and capital expenditures under our normal operations as well as commitments and payments of principal and interest on borrowings and dividends on our Series A convertible preferred stock for at least the next twelve months. As discussed below, our outstanding debt and our ability to borrow additional funds under our credit facilities are subject to compliance with various covenants. We expect to be in compliance with these covenants over the next twelve months. However, our recent financial results, our substantial indebtedness and the declining in-store rental industry in which we operate could adversely affect our ability to comply with these covenants. Further, uncertainty surrounding our ability to finance our obligations has caused some of our trade creditors to impose increasingly less favorable terms and continuing uncertainty could result in even more unfavorable terms from our trade creditors. See further discussion of these risk factors under Item 1A. Risk Factors.
As described more fully in Notes 7 and 9 to the consolidated financial statements, at December 31, 2005 our contractual obligations, were as follows:
Contractual Obligations |
< 1 Year | 1-3 Years | 3-5 Years | After 5 Years | Total | ||||||||||
Operating leases |
$ | 597.4 | $ | 893.0 | $ | 483.1 | $ | 520.7 | $ | 2,494.2 | |||||
Capital lease obligations(1) |
22.1 | 30.6 | 22.2 | 28.7 | 103.6 | ||||||||||
Purchase obligations(2) |
271.7 | 54.4 | 11.6 | 20.2 | 357.9 | ||||||||||
Revenue-sharing obligations(3) |
72.3 | | | | 72.3 | ||||||||||
Long-term debt |
20.5 | 63.4 | 378.4 | 617.6 | 1,079.9 | ||||||||||
Interest expense on long-term debt(4) |
90.4 | 174.2 | 135.8 | 61.8 | 462.2 | ||||||||||
Preferred stock dividends(5) |
11.3 | 22.5 | 22.5 | | 56.3 | ||||||||||
$ | 1,085.7 | $ | 1,238.1 | $ | 1,053.6 | $ | 1,249.0 | $ | 4,626.4 | ||||||
(1) | Includes both principal and interest. |
(2) | Purchase obligations include agreements to purchase goods or services as of December 31, 2005 that are legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. Purchase obligations that can be cancelled without penalty have been excluded. In addition, these amounts exclude revenue-sharing obligations, which are included on the Revenue-sharing obligations line above, and outstanding accounts payable or accrued liabilities. For information about outstanding accounts payable and accrued liabilities, see the Consolidated Balance Sheets and Note 5 to the consolidated financial statements. |
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(3) | As of December 31, 2005, we were a party to revenue-sharing arrangements with various studios that expire between March 2006 and December 2007. These contracts include minimum purchase requirements, based upon the box office results of the title, at a lower initial product cost as compared to traditional purchases. In addition, these contracts require net rental revenues to be shared with the studios over an agreed upon period of time. We have included an estimate of our contractual obligation under these agreements for minimum purchase requirements and performance guarantees for the period in which they can reasonably be estimated, which is usually two to four months in the future. Although these contracts may extend beyond the estimated two to four 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 2005. For information on revenue-sharing accruals as of December 31, 2005 and 2004, see Note 5 to the consolidated financial statements. |
(4) | As of December 31, 2005, $779.9 million of our long-term debt outstanding under our senior secured credit facility was subject to variable rates of interest. Interest expense on these variable rate borrowings for future years was calculated using a weighted-average interest rate of 8.2% based on the LIBOR rate in effect at December 31, 2005. |
(5) | Our shares of preferred stock do not mature; therefore, amounts are provided for the next five years only. |
Capital Structure
On August 20, 2004, we entered into $1,150.0 million in senior secured credit facilities, consisting of (i) a five-year $500.0 million revolving credit facility, of which $150.0 million is reserved for issuance of the Viacom Letters of Credit, described in Note 6 to the consolidated financial statements; (ii) a five-year $100.0 million term loan A facility; and (iii) a seven-year $550.0 million term loan B facility, and we issued $300.0 million aggregate principal amount of 9% senior subordinated notes due 2012. These borrowings are described in Note 7 to the consolidated financial statements. The proceeds from the credit facilities and the senior subordinated notes were used (i) to fund the payment of the special distribution in August 2004; (ii) to finance transaction costs and expenses in connection with our divestiture from Viacom and the special distribution; (iii) to repay amounts outstanding under our prior credit agreement; and (iv) for working capital and other general corporate purposes. As of December 31, 2005, $135.0 million of borrowings were outstanding under the revolving credit facility, $644.9 million was outstanding under the term loan portions of our credit facilities and $300.0 million was outstanding under the senior subordinated notes. The available borrowing capacity under our credit facilities, excluding the $150.0 million reserved for issuance of the Viacom Letters of Credit and $46.5 million reserved to support other letters of credit, totaled $168.5 million at December 31, 2005.
The borrowing availability under the revolving credit facility will be automatically reduced by quarterly installments of 5% of the original borrowing availability from October 2007 through July 2009 and will terminate in full in August 2009. The Term A Loan Facility is payable in quarterly installments of 3.75% of the original principal balance from October 2005 through July 2008, and 13.75% beginning October 2008 through August 2009. The Term B Loan Facility is payable in quarterly installments of 0.25% of the original principal balance from October 2005 through July 2008, 2.5% beginning October 2008 through July 2010 and 19.25% beginning October 2010 through August 2011. The term loans are subject to mandatory prepayments from a portion of proceeds from asset sales and excess cash flow, as defined by the credit facilities. Interest payments on the senior subordinated notes are due semi-annually through 2012, when the bonds mature.
Under a registration rights agreement as part of the offering of the senior subordinated notes, we are obligated to use our reasonable best efforts to file with the SEC a registration statement with respect to an offer to exchange the senior subordinated notes for substantially similar notes that are registered under the Securities Act of 1933 (the Securities Act). Alternatively, if the exchange offer for the senior subordinated notes is not available or cannot be completed, we will be required to use our reasonable best efforts to file a shelf registration statement to cover resales of the senior subordinated notes under the Securities Act. Because an exchange offer for the senior subordinated notes was not completed before May 18, 2005, we were required to pay additional interest on the senior subordinated notes of 0.25% per annum for the first 90-day period after May 18, 2005 and are required to pay an additional 0.25% per annum with respect to each subsequent 90-day period, up to a
63
maximum aggregate increase of 1% per annum, until an exchange offer is completed or, if required, a shelf registration statement is declared effective. As a result, we incurred additional interest expense of 0.25% per annum for the 90-day period from May 19, 2005 through August 18, 2005, 0.50% per annum for the 90-day period from August 19, 2005 through November 18, 2005, 0.75% per annum for the 90-day period from November 19, 2005 through February 18, 2006 and began incurring additional interest expense of the maximum of 1.0% per annum subsequent to February 18, 2006. We expect to file a registration statement with respect to an exchange offer with the SEC during the first quarter of 2006. The interest rate on the senior subordinated notes will revert back to 9.0% per annum upon completion of the exchange offer.
On May 4, 2005, we and the syndicate of lenders for the credit facilities amended the credit agreement in certain respects (the first amendment). As part of the first amendment, our obligations with respect to maintaining a maximum leverage ratio were amended for the second and third quarters of 2005, and our obligations for maintaining a minimum fixed charge coverage ratio were amended for the second, third and fourth quarters of 2005. We paid a standard amendment fee in the second quarter of 2005 in connection with the first amendment.
On August 8, 2005, we entered into a further amendment to the credit agreement (the second amendment), which provided for a waiver of our then current second and third quarter 2005 leverage ratio covenant and our then current third quarter 2005 fixed charge coverage covenant. Without the benefit of the lenders waiver of the leverage ratio covenant for the second and third quarters of 2005 that was contained in the second amendment, we would have been in default of such covenant. The second amendment made various changes to the credit agreement, which included (i) modification of the applicable margins based on the applicable credit rating, from time to time, of our senior, secured long-term indebtedness; (ii) granting the syndicate of lenders a security interest in substantially all of our domestic assets (other than our real estate leasehold interests); (iii) compliance with minimum consolidated EBITDA and maximum capital expenditure covenants for the third and fourth quarters of 2005; and (iv) other changes described in Note 7 to the consolidated financial statements. In connection with the second amendment, the applicable margin on our borrowings under our credit facility increased 50 basis points through the end of the waiver period and we paid a standard amendment fee during the third quarter of 2005.
In order to provide us with improved operating flexibility, on November 4, 2005, we entered into another amendment to the credit agreement (the third amendment) with our lenders to modify the financial covenants and make other modifications. Upon the effectiveness of the third amendment, the interim waiver period provisions contained in the second amendment ceased to be in effect and certain changes were made to the credit agreement, including (i) modification of the applicable margins to reflect adjustments to such applicable margins based on our gross leverage ratio from time to time; (ii) execution of account control agreements covering substantially all of our deposit accounts and securities accounts to perfect the security interest of the syndicate lenders in substantially all of our available cash (including cash held in our domestic concentration accounts as defined in the third amendment); (iii) compliance with a minimum consolidated EBITDA covenant through December 31, 2007, compliance with a maximum capital expenditure covenant for the remaining term of the credit agreement, and compliance with maximum leverage ratio and minimum fixed charge coverage ratio covenants for the remaining term of the credit agreement after December 31, 2007; and (iv) other changes described in Note 7 to the consolidated financial statements. In connection with the third amendment, the applicable margin for borrowings under our credit facilities increased 50 basis points and commitment fees on the unused portion of the revolving credit facility increased from 0.375% per annum to 0.500% per annum. The increase in the annual commitment fee rate is subject to reduction based on the applicable credit rating, from time to time, of our senior secured long-term indebtedness. We also paid a standard amendment fee to the administrative agent and the syndicate of lenders during the fourth quarter of 2005.
The credit facilities currently require compliance with a minimum EBITDA covenant through December 31, 2007, a maximum capital expenditure covenant for the remaining term of the credit agreement and maximum leverage ratio and minimum fixed charge coverage ratio covenants from 2008 through 2011. Additionally, the
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credit facilities and senior subordinated notes contain certain restrictive covenants, which, among other things, limit, during the terms of the facilities and the notes, (i) the amount of dividends that we may pay, (ii) the amount of our common stock that we may repurchase and (iii) the amount of other distributions that we may make in respect of our common stock. Without the benefit of the lenders waiver of the leverage ratio and fixed charge coverage ratio covenants for the fourth quarter of 2005, we would have been in default of such covenants. However, we were in compliance with the required minimum EBITDA covenant, the maximum capital expenditure covenant and all other applicable covenants as of December 31, 2005.
On November 15, 2005, we completed a private placement of $150 million in Series A convertible preferred stock. The aggregate discounts and commissions to the initial purchasers and fees paid to third parties in conjunction with the preferred stock issuance were approximately $6.0 million. We used the net proceeds from the offering to repay a portion of our borrowings under our revolving credit facility and for general corporate purposes. See Note 4 to the consolidated financial statements for a description of the Series A convertible preferred stock.
The following table sets forth the current portion of our long-term debt and capital lease obligations:
At December 31, | ||||||
2005 | 2004 | |||||
Credit Facilities: |
||||||
Term A loan, interest rate ranging from 7.8% to 8.3% at December 31, 2005 |
$ | 15.0 | $ | 3.7 | ||
Term B loan, interest rate ranging from 7.9% to 8.7% at December 31, 2005 |
5.5 | 1.4 | ||||
Current maturities of all other obligations |
| 0.7 | ||||
Total current portion of long-term debt |
20.5 | 5.8 | ||||
Current portion of capital lease obligations |
15.9 | 19.7 | ||||
$ | 36.4 | $ | 25.5 | |||
The following table sets forth our long-term debt and capital lease obligations, less current portion:
At December 31, | ||||||
2005 | 2004 | |||||
Credit Facilities: |
||||||
Revolving credit facility, interest rate ranging from 7.8% to 8.0% at December 31, 2005 |
$ | 135.0 | $ | 100.0 | ||
Term A loan, interest rate ranging from 7.8% to 8.3% at December 31, 2005 |
81.3 | 96.3 | ||||
Term B loan, interest rate ranging from 7.9% to 8.7% at December 31, 2005 |
543.1 | 548.6 | ||||
Senior Subordinated Notes, interest rate of 9.75% at December 31, 2005 |
300.0 | 300.0 | ||||
Total long-term debt, less current portion |
1,059.4 | 1,044.9 | ||||
Capital lease obligations, less current portion |
62.2 | 74.8 | ||||
$ | 1,121.6 | $ | 1,119.7 | |||
Subsequent to December 31, 2005, we have made payments of $75.0 million on our revolving credit facility. Additional information on our capital structure can be found in Note 7 to the consolidated financial statements.
Consolidated Cash Flows
Operating Activities. Net cash flow for operating activities decreased $487.5 million, or 116.9%, from $417.0 million provided by operating activities in 2004 to $70.5 million used for operating activities in 2005 due to several factors. We experienced a $349.1 million decrease in net income as adjusted for non-cash items, including depreciation and intangible amortization, impairment of goodwill and other long-lived assets, share-based compensation and deferred income taxes and other items during 2005. Additionally, changes in working capital, excluding rental library, used cash of $160.7 million during 2005 as compared with providing cash of
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$44.5 million in 2004. As discussed above, uncertainty surrounding our ability to finance our obligations caused some of our creditors to impose increasingly less favorable terms on us in the second half of 2005. This limitation on our resources caused us to focus on improving profitability and cash flows and, as a result, we used cash of approximately $340 million to decrease our accounts payable balances since December 31, 2004. Due to these constraints, we also chose to reduce our level of merchandise inventory during 2005, which provided cash of approximately $190 million.
During 2005, we increased our rental library purchases to provide increased product availability in support of our new in-store rental offerings and the growth of BLOCKBUSTER Online. However, our non-cash rental library amortization also increased from 2004 to 2005 due to the timing and composition of our purchases. As a result, our rental library purchases, net of rental library amortization, caused an increase in our cash flows from operating activities of approximately $66.8 million during 2005.
Investing Activities. Net cash flow used for investing activities decreased $199.7 million from $313.9 million in 2004 to $114.2 million in 2005. This decrease was primarily due to a reduction of $149.7 million in cash used for capital expenditures during 2005 primarily because the initial capital expenditure outlay necessary to support our strategic initiatives and systems and infrastructure improvements occurred during 2004. We also reduced our spending for acquisitions by $23.0 million in 2005 as compared with 2004 and sold our subsidiary, D.E.J. Productions Inc., which provided cash of $22.5 million during 2005.
We plan to decrease our capital expenditures further in 2006 as compared with 2005, primarily by reducing our new store openings. We expect total capital expenditures for 2006 to be approximately $90.0 million as compared with $139.4 million in 2005.
Financing Activities. Net cash flow for financing activities increased $157.1 million from cash used of $18.8 million in 2004 to cash provided of $138.3 million in 2005. This change was primarily due to net proceeds of $144.0 million from the issuance of the Series A convertible preferred stock during 2005 and a decrease in cash dividends paid of $912.3 million. The decrease in dividends during the year resulted from the special distribution paid during the third quarter of 2004 and the declaration by our board of directors of only two dividend payments during 2005. These amounts were partially offset by a decrease in net proceeds from long-term debt of $897.0 million primarily as a result of borrowings under our credit facilities and senior subordinated notes during 2004.
Other Financial Measurements: Working Capital
At December 31, 2005, we had cash and cash equivalents of $276.2 million. Working capital was $105.9 million at December 31, 2005 as compared with $118.7 million at December 31, 2004.
Related Party Transactions
Prior to our divestiture from Viacom during the fourth quarter of 2004, our primary related party transactions were with Viacom and included, among others, arrangements providing insurance, audit, legal and other services, purchases from companies owned by or affiliated with Viacom and tax related agreements. These transactions are discussed in more detail in Note 6 to the consolidated financial statements.
In connection with our divestiture from Viacom, we entered into an amended and restated initial public offering and split-off agreement with Viacom. This amended agreement provides, among other things, (i) for Viacom to pay various expenses related to the transaction; (ii) for an allocation of expenses and liabilities related to the transaction and to Blockbusters business operations; and (iii) for Blockbuster to provide Viacom with letters of credit, at Viacoms expense, in an amount up to $150.0 million to secure a portion of Viacoms contingent liabilities with respect to certain store lease guarantees originally entered into before our August 1999 initial public offering. In conjunction with this agreement, we recognized a $7.0 million capital contribution for
66
the year ended December 31, 2004, representing Viacoms reimbursement of a portion of the deferred financing costs incurred in conjunction with our $1,150.0 million in senior secured credit facilities, which are discussed in Note 7 to the consolidated financial statements.
As of December 31, 2005, no amounts were receivable from or payable to Viacom in conjunction with these and other related divestiture agreements.
General Economic Trends, Quarterly Results of Operations and Seasonality
We anticipate that our business will be affected by general economic and other consumer trends. Our business is subject to fluctuations in future operating results due to a variety of factors, many of which are outside of our control. These fluctuations may be caused by, among other things, a distinct seasonal pattern to the home video and video games business, particularly weaker business in April and May, due in part to improved weather and Daylight Saving Time, and in September and October, due in part to the start of school and the introduction of new television programs, and those factors set forth above under Item 1A. Risk Factors. The months of November and December have historically been our highest revenue months. While we expect these months to continue to make the largest contributions to our rental revenues, we believe the strength of rental revenues in these months has been and will continue to be negatively affected, to some degree, by consumers purchasing DVDs during the holiday season. The popularity of our rental subscription programs has helped us mitigate, to some extent, the impact of seasonality on our business by providing a steady revenue stream across all months.
Market Risk
We are exposed to various market risks including interest rates on our debt and foreign exchange rates, and we monitor these risks throughout the normal course of business. As of December 31, 2005 and 2004, we did not have any interest rate or foreign exchange hedging instruments in place.
Interest Rate Risk
Our primary exposure to interest rate risk results from outstanding borrowings under our credit agreement. Interest rates for the credit agreement are based on LIBOR plus an applicable margin or the prime rate or the federal funds rate plus applicable margins, at our option at the time of borrowing. The applicable margins vary based on the borrowing and specified leverage ratios. Our borrowings under the credit agreement totaled $779.9 million as of December 31, 2005, and the weighted-average interest rate for these borrowings was 8.2%. Our vulnerability to changes in LIBOR or other applicable rates could result in material changes to our interest expense, as a one percentage point increase or decrease in LIBOR or the other applicable rates would have a $7.8 million impact on our interest expense annually. In addition, a change in our leverage ratio, which could be driven by a change in our debt balance or our income, could result in an increase or decrease in the applicable margins on our Term A loan, Term B loan and revolving credit facility, thereby impacting our annual interest expense.
As discussed above and in Note 7 to our consolidated financial statements, we are obligated to use our reasonable best efforts to file with the SEC a registration statement with respect to an offer to exchange our senior subordinated notes for substantially similar notes that are registered under the Securities Act. Because an exchange offer for the senior subordinated notes was not completed before May 18, 2005, we are required to pay additional interest on the senior subordinated notes of 0.25% per annum every 90 days thereafter, up to a maximum aggregate increase of 1% per annum, until the exchange offer is completed or, if required, the shelf registration statement is declared effective. An increase of 1% in the interest rate on our senior subordinated notes would increase our interest expense by approximately $3 million per year.
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Foreign Exchange Risk
Operating in international markets involves exposure to movements in currency exchange rates. Currency exchange rate movements typically also reflect economic growth, inflation, interest rates, government actions and other factors. As currency exchange rates fluctuate, translation of the statements of operations of our international businesses into U.S. dollars may affect year-over-year comparability and could cause us to adjust our financing and operating strategies. Revenues and operating income would have decreased by $28.8 million and $1.3 million, respectively, for 2005 if foreign exchange rates in 2005 were consistent with 2004.
Our operations outside the United States constituted approximately 33%, 31% and 26% of our total revenues in 2005, 2004 and 2003, respectively. Our operations in Europe constituted approximately 21%, 20% and 16% of our total revenues in 2005, 2004 and 2003, respectively.
Recent Accounting Pronouncements
In March 2005, the Financial Accounting Standards Board (FASB) issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligationsan interpretation of FASB Statement No. 143 (FIN 47). FIN 47 clarifies the term conditional asset retirement obligation and requires a liability to be recorded if the fair value of the obligation can be reasonably estimated. The types of asset retirement obligations that are covered by FIN 47 are those for which an entity has a legal obligation to perform an asset retirement activity; however, the timing and/or method of settling the obligation are conditional on a future event that may or may not be within the control of the entity. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Our adoption of FIN 47 did not have a material impact on our consolidated financial statements.
FASB Staff Position (FSP) No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2), provides guidance under SFAS 109, Accounting for Income Taxes, with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act) on enterprises income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. FSP 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS 109. Our adoption of FSP 109-2 did not have a material impact on our consolidated financial statements.
In November 2004, the FASB issued SFAS No. 151, Inventory CostsAn Amendment of ARB No. 43, Chapter 4 (SFAS 151). SFAS 151 amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing (ARB 43) to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of so abnormal as stated in ARB 43. Additionally, SFAS 151 requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal years beginning after June 15, 2005. We do not expect the adoption of SFAS 151 to have a material impact on our consolidated financial statements.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154). This new standard replaces APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. Among other changes, SFAS 154 requires retrospective application of a voluntary change in accounting principle with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS 154 also requires that a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for prospectively as a change in estimate, and correction of errors in previously issued financial statements should be termed a restatement. The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after
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December 15, 2005. We do not expect the adoption of SFAS 154 to have a material impact on our consolidated financial statements.
In June 2005, the FASB issued Staff Position No. 143-1, Accounting for Electronic Equipment Waste Obligations (FSP 143-1), which provides guidance on the accounting for obligations associated with the Directive on Waste Electrical and Electronic Equipment (the WEEE Directive), which was adopted by the European Union. FSP 143-1 provides guidance on accounting for the effects of the WEEE Directive with respect to historical waste, which is waste associated with products on the market on or before August 13, 2005. FSP 143-1 requires commercial users to account for their WEEE obligation as an asset retirement liability in accordance with FASB Statement No. 143, Accounting for Asset Retirement Obligations. FSP 143-1 was required to be applied beginning in the later of the first reporting period ending after June 8, 2005 or the date of the adoption of the WEEE Directive into law by the applicable European Union member country. We will apply the guidance of FSP 143-1 as it relates to the European Union member countries in which we operate when those countries have adopted the WEEE Directive into law. We do not expect the adoption of FSP 143-1 to have a material impact on our consolidated financial statements.
In September 2005, the Emerging Issues Task Force (EITF) reached a consensus on Issue 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty (EITF 04-13). The FASB Task Force concluded that inventory purchases and sales transactions with the same counterparty should be combined for accounting purposes if they were entered into in contemplation of each other. The Task Force provided indicators to be considered for purposes of determining whether such transactions are entered into in contemplation of each other. The Task Force also provided guidance on the circumstances under which nonmonetary exchanges of inventory within the same line of business should be recognized at fair value. EITF 04-13 will be effective in reporting periods beginning after March 15, 2006. We do not expect the adoption of EITF 04-13 to have a material impact on our consolidated financial statements.
In October 2005, the FASB issued FSP No. FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period (FSP FAS 13-1). FSP FAS 13-1 requires rental costs associated with operating leases that are incurred during a construction period to be recognized as rental expense. FSP FAS 13-1 is effective for reporting periods beginning after December 15, 2005. We do not expect FSP FAS 13-1 to have a material impact on our consolidated financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The response to this item is included in Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsMarket Risk.
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Item 8. Financial Statements and Supplementary Data
BLOCKBUSTER INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page | ||
71 | ||
Audited Consolidated Financial Statements: |
||
Consolidated Statements of OperationsYears Ended December 31, 2005, 2004 and 2003 |
73 | |
74 | ||
75 | ||
Consolidated Statements of Cash FlowsYears Ended December 31, 2005, 2004 and 2003 |
76 | |
77 |
All supplementary financial statement schedules have been omitted
because the information required to be set forth therein is either not applicable
or is shown in the consolidated financial statements or notes thereto.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Stockholders of Blockbuster Inc.:
We have completed integrated audits of Blockbuster Inc.s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Blockbuster Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements 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. An audit of financial statements 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.
As discussed in Note 1 to the consolidated financial statements, the Company has restated its 2004 and 2003 financial statements.
As discussed in Notes 1 and 4 to the consolidated financial statements, the Company adopted the expense recognition provisions of Financial Accounting Standards Board Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, as of January 1, 2004. As discussed in Notes 1 and 4 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share Based Payment, as of October 1, 2004. As discussed in Note 1 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations, as of January 1, 2003.
Internal control over financial reporting
Also, in our opinion, managements assessment, included in Managements Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework issued by the COSO. The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on managements assessment and on the effectiveness of the Companys internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting 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 effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting
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includes obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PricewaterhouseCoopers LLP
Dallas, Texas
March 15, 2006
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CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except per share amounts)
Year Ended December 31, | ||||||||||||
2005 | 2004 | 2003 | ||||||||||
Revenues: |
||||||||||||
Base rental revenues |
$ | 3,520.3 | $ | 3,231.3 | $ | 3,253.5 | ||||||
PRP revenues |
594.6 | 574.9 | 557.9 | |||||||||
Extended viewing fee revenues |
90.3 | 622.4 | 722.1 | |||||||||
Total rental revenues |
4,205.2 | 4,428.6 | 4,533.5 | |||||||||
Merchandise sales |
1,586.5 | 1,532.6 | 1,281.6 | |||||||||
Other revenues |
72.7 | 92.0 | 96.6 | |||||||||
5,864.4 | 6,053.2 | 5,911.7 | ||||||||||
Cost of sales: |
||||||||||||
Cost of rental revenues |
1,411.9 | 1,250.7 | 1,362.1 | |||||||||
Cost of merchandise sold |
1,235.2 | 1,190.7 | 1,027.7 | |||||||||
2,647.1 | 2,441.4 | 2,389.8 | ||||||||||
Gross profit |
3,217.3 | 3,611.8 | 3,521.9 | |||||||||
Operating expenses: |
||||||||||||
General and administrative |
2,800.8 | 2,853.5 | 2,605.9 | |||||||||
Advertising |
255.3 | 257.4 | 179.4 | |||||||||
Depreciation and intangible amortization |
230.9 | 249.7 | 268.4 | |||||||||
Impairment of goodwill and other long-lived assets |
356.8 | 1,504.4 | 1,304.9 | |||||||||
3,643.8 | 4,865.0 | 4,358.6 | ||||||||||
Operating loss |
(426.5 | ) | (1,253.2 | ) | (836.7 | ) | ||||||
Interest expense |
(98.7 | ) | (38.1 | ) | (33.1 | ) | ||||||
Interest income |
4.1 | 3.6 | 3.1 | |||||||||
Other items, net |
(2.4 | ) | 1.6 | (0.4 | ) | |||||||
Loss before income taxes |
(523.5 | ) | (1,286.1 | ) | (867.1 | ) | ||||||
Benefit (provision) for income taxes |
(64.6 | ) | 37.3 | (106.5 | ) | |||||||
Equity in loss of affiliated companies, net of tax |
| | (0.7 | ) | ||||||||
Loss before cumulative effect of change in accounting principle |
(588.1 | ) | (1,248.8 | ) | (974.3 | ) | ||||||
Cumulative effect of change in accounting principle, net of tax |
| | (4.4 | ) | ||||||||
Net loss |
$ | (588.1 | ) | $ | (1,248.8 | ) | $ | (978.7 | ) | |||
Loss per share before cumulative effect of change in accounting principle: |
||||||||||||
Basic and diluted |
$ | (3.20 | ) | $ | (6.89 | ) | $ | (5.41 | ) | |||
Cumulative effect of change in accounting principle per share: |
||||||||||||
Basic and diluted |
$ | | $ | | $ | (0.02 | ) | |||||
Net loss per share: |
||||||||||||
Basic and diluted |
$ | (3.20 | ) | $ | (6.89 | ) | $ | (5.43 | ) | |||
Weighted average shares outstanding: |
||||||||||||
Basic and diluted |
183.9 | 181.2 | 180.1 | |||||||||
Cash dividends per common share |
$ | 0.04 | $ | 0.08 | $ | 0.08 | ||||||
Special distribution per common share |
$ | | $ | 5.00 | $ | | ||||||
The accompanying notes are an integral part of these consolidated financial statements.
73
CONSOLIDATED BALANCE SHEETS
(In millions, except per share amounts)
December 31, | ||||||||
2005 | 2004 | |||||||
Restated | ||||||||
Assets |
||||||||
Current assets: |
||||||||
Cash and cash equivalents |
$ | 276.2 | $ | 330.3 | ||||
Receivables, less allowances of $6.4 and $14.5 for 2005 and 2004, respectively |
127.8 | 177.8 | ||||||
Merchandise inventories |
310.3 | 516.6 | ||||||
Rental library, net |
475.5 | 457.6 | ||||||
Deferred income taxes |
15.6 | 24.0 | ||||||
Prepaid and other current assets |
218.4 | 193.0 | ||||||
Total current assets |
1,423.8 | 1,699.3 | ||||||
Property and equipment, net |
723.5 | 854.0 | ||||||
Deferred income taxes |
159.6 | 194.2 | ||||||
Intangibles, net |
26.9 | 34.5 | ||||||
Goodwill |
809.2 | 1,138.5 | ||||||
Other assets |
36.6 | 74.1 | ||||||
$ | 3,179.6 | $ | 3,994.6 | |||||
Liabilities and Stockholders Equity |
||||||||
Current liabilities: |
||||||||
Accounts payable |
$ | 368.1 | $ | 721.8 | ||||
Accrued expenses |
765.3 | 697.3 | ||||||
Current portion of long-term debt |
20.5 | 5.8 | ||||||
Current portion of capital lease obligations |
15.9 | 19.7 | ||||||
Deferred income taxes |
148.1 | 136.0 | ||||||
Total current liabilities |
1,317.9 | 1,580.6 | ||||||
Long-term debt, less current portion |
1,059.4 | 1,044.9 | ||||||
Capital lease obligations, less current portion |
62.2 | 74.8 | ||||||
Other liabilities |
108.5 | 231.4 | ||||||
2,548.0 | 2,931.7 | |||||||
Commitments and contingencies (Note 9) |
||||||||
Stockholders equity: |
||||||||
Series A convertible preferred stock, par value $0.01 per share: 100.0 shares authorized; 0.15 shares issued and outstanding for 2005 with liquidation preference of $1,000 per share. No shares issued or outstanding for 2004 |
150.0 | | ||||||
Class A common stock, par value $0.01 per share; 400.0 shares authorized; 114.6 and 111.7 shares issued and outstanding for 2005 and 2004, respectively |
1.1 | 1.1 | ||||||
Class B common stock, par value $0.01 per share; 500.0 shares authorized; 72.0 shares issued and outstanding for 2005 and 2004 |
0.7 | 0.7 | ||||||
Additional paid-in capital |
5,360.9 | 5,336.7 | ||||||
Retained deficit |
(4,836.4 | ) | (4,248.3 | ) | ||||
Accumulated other comprehensive loss |
(44.7 | ) | (27.3 | ) | ||||
Total stockholders equity |
631.6 | 1,062.9 | ||||||
$ | 3,179.6 | $ | 3,994.6 | |||||
The accompanying notes are an integral part of these consolidated financial statements.
74
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY AND COMPREHENSIVE LOSS
(In millions)
Year Ended December 31, | |||||||||||||||||||
2005 | 2004 | 2003 | |||||||||||||||||
Shares | Amount | Shares | Amount | Shares | Amount | ||||||||||||||
Series A convertible preferred stock: |
|||||||||||||||||||
Balance, beginning of year |
| | | | | | |||||||||||||
Issuance of Series A convertible preferred stock |
0.15 | $ | 150.0 | | | | | ||||||||||||
Balance, end of year |
0.15 | $ | 150.0 | | | | | ||||||||||||
Class A common stock: |
|||||||||||||||||||
Balance, beginning of year |
111.7 | $ | 1.1 | 36.9 | $ | 0.4 | 35.6 | $ | 0.4 | ||||||||||
Exercise of stock options and issuance of restricted shares |
2.9 | | 2.8 | | 1.3 | | |||||||||||||
Conversion from Class B common stock |
| | 72.0 | 0.7 | | | |||||||||||||
Balance, end of year |
114.6 | $ | 1.1 | 111.7 | $ | 1.1 | 36.9 | $ | 0.4 | ||||||||||
Class B common stock: |
|||||||||||||||||||
Balance, beginning of year |
72.0 | $ | 0.7 | 144.0 | $ | 1.4 | 144.0 | $ | 1.4 | ||||||||||
Conversion to Class A common stock |
| | (72.0 | ) | (0.7 | ) | | | |||||||||||
Balance, end of year |
72.0 | $ | 0.7 | 72.0 | $ | 0.7 | 144.0 | $ | 1.4 | ||||||||||
Additional paid-in capital: |
|||||||||||||||||||
Balance, beginning of year |
$ | 5,336.7 | $ | 6,227.3 | $ | 6,220.8 | |||||||||||||
Issuance of Class A common stock |
0.3 | 0.1 | 0.1 | ||||||||||||||||
Preferred stock issuance costs |
(6.0 | ) | | | |||||||||||||||
Exercise/vesting and expense of share-based compensation, net of tax benefit |
37.7 | 20.7 | 20.8 | ||||||||||||||||
Acceleration of Viacom stock options |
| 1.7 | | ||||||||||||||||
Viacom capital contribution |
| 7.0 | | ||||||||||||||||
Cash dividends on common stock |
(7.8 | ) | (14.5 | ) | (14.4 | ) | |||||||||||||
Special distribution |
| (905.6 | ) | | |||||||||||||||
Balance, end of year |
$ | 5,360.9 | $ | 5,336.7 | $ | 6,227.3 | |||||||||||||
Accumulated other comprehensive loss: |
|||||||||||||||||||
Balance, beginning of year |
$ | (27.3 | ) | $ | (41.2 | ) | $ | (100.9 | ) | ||||||||||
Other comprehensive income (loss): |
|||||||||||||||||||
Change in fair value of interest rate swaps, net of taxes |
| | 6.3 | ||||||||||||||||
Foreign currency translation, net of taxes |
(17.4 | ) | 13.9 | 53.4 | |||||||||||||||
Balance, end of year |
$ | (44.7 | ) | $ | (27.3 | ) | $ | (41.2 | ) | ||||||||||
Retained deficit: |
|||||||||||||||||||
Balance, beginning of year |
$ | (4,248.3 | ) | $ | (2,999.5 | ) | $ | (2,020.8 | ) | ||||||||||
Net loss |
(588.1 | ) | (1,248.8 | ) | (978.7 | ) | |||||||||||||
Balance, end of year |
$ | (4,836.4 | ) | $ | (4,248.3 | ) | $ | (2,999.5 | ) | ||||||||||
Total stockholders equity |
$ | 631.6 | $ | 1,062.9 | $ | 3,188.4 | |||||||||||||
Comprehensive loss: |
|||||||||||||||||||
Net loss |
$ | (588.1 | ) | $ | (1,248.8 | ) | $ | (978.7 | ) | ||||||||||
Other comprehensive income (loss): |
|||||||||||||||||||
Change in fair value of interest rate swaps, net of taxes |
| | 6.3 | ||||||||||||||||
Foreign currency translation, net of taxes |
(17.4 | ) | 13.9 | 53.4 | |||||||||||||||
Total comprehensive loss |
$ | (605.5 | ) | $ | (1,234.9 | ) | $ | (919.0 | ) | ||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
75
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
Year Ended December 31, | ||||||||||||
2005 | 2004 | 2003 | ||||||||||
Restated | Restated | |||||||||||
Cash flows from operating activities: |
||||||||||||
Net loss |
$ | (588.1 | ) | $ | (1,248.8 | ) | $ | (978.7 | ) | |||
Adjustments to reconcile net loss to net cash flow provided by operating activities: |
||||||||||||
Depreciation and intangible amortization |
230.9 | 249.7 | 268.4 | |||||||||
Impairment of goodwill and other long-lived assets |
356.8 | 1,504.4 | 1,304.9 | |||||||||
Rental library purchases |
(855.4 | ) | (798.4 | ) | (836.6 | ) | ||||||
Rental library amortization |
871.8 | 748.0 | 954.8 | |||||||||
Non-cash share-based compensation expense |
38.9 | 17.0 | | |||||||||
Excess tax benefit from share-based compensation |
| (5.1 | ) | | ||||||||
Cumulative effect of change in accounting principle, net of tax |
| | 4.4 | |||||||||
Deferred income taxes and other |
35.3 | (94.3 | ) | (73.5 | ) | |||||||
Change in operating assets and liabilities: |
||||||||||||
Decrease in receivables |
34.9 | 8.6 | 5.9 | |||||||||
Decrease in receivable from Viacom |
2.5 | 0.8 | 14.0 | |||||||||
(Increase) decrease in merchandise inventories |
190.9 | (84.2 | ) | 55.1 | ||||||||
Increase in prepaid and other assets |
(25.8 | ) | (97.5 | ) | (4.8 | ) | ||||||
Increase (decrease) in accounts payable |
(341.3 | ) | 125.4 | (221.9 | ) | |||||||
Increase (decrease) in accrued expenses and other liabilities |
(21.9 | ) | 91.4 | 101.7 | ||||||||
Net cash flow provided by (used for) operating activities |
(70.5 | ) | 417.0 | 593.7 | ||||||||
Cash flows from investing activities: |
||||||||||||
Capital expenditures |
(139.4 | ) | (289.1 | ) | (191.0 | ) | ||||||
Cash used for acquisitions, net |
(2.5 | ) | (25.5 | ) | (3.4 | ) | ||||||
Proceeds from notes receivable and other |
5.2 | 1.2 | 4.5 | |||||||||
Proceeds from sale of non-core investment |
22.5 | | | |||||||||
Investments in affiliated companies |
| (0.5 | ) | 1.9 | ||||||||
Net cash flow used for investing activities |
(114.2 | ) | (313.9 | ) | (188.0 | ) | ||||||
Cash flows from financing activities: |
||||||||||||
Proceeds from credit agreements |
255.0 | 820.0 | 140.0 | |||||||||
Proceeds from senior subordinated notes |
| 300.0 | | |||||||||
Repayments on credit agreements |
(225.1 | ) | (170.0 | ) | (450.0 | ) | ||||||
Net repayments on other notes and lines of credit |
(0.7 | ) | (23.8 | ) | (5.8 | ) | ||||||
Net proceeds from the issuance of preferred stock |
144.0 | | | |||||||||
Net proceeds from the exercise of stock options |
0.8 | 2.8 | 18.1 | |||||||||
Cash dividends on common stock |
(7.8 | ) | (920.1 | ) | (14.4 | ) | ||||||
Payment of debt financing costs |
(8.1 | ) | (18.7 | ) | | |||||||
Capital lease payments |
(19.8 | ) | (21.0 | ) | (23.4 | ) | ||||||
Capital contributions received from Viacom |
| 6.9 | | |||||||||
Excess tax benefit from share-based compensation |
| 5.1 | | |||||||||
Net cash flow provided by (used for) financing activities |
138.3 | (18.8 | ) | (335.5 | ) | |||||||
Effect of exchange rate changes on cash |
(7.7 | ) | 12.6 | 10.7 | ||||||||
Net increase (decrease) in cash and cash equivalents |
(54.1 | ) | 96.9 | 80.9 | ||||||||
Cash and cash equivalents at beginning of year |
330.3 | 233.4 | 152.5 | |||||||||
Cash and cash equivalents at end of year |
$ | 276.2 | $ | 330.3 | $ | 233.4 | ||||||
Supplemental cash flow information: |
||||||||||||
Cash payments for interest |
$ | 89.5 | $ | 23.2 | $ | 34.3 | ||||||
Cash payments for taxes, net of refunds |
11.2 | 44.4 | 98.1 | |||||||||
Non-cash financing and investing activities: |
||||||||||||
Retail stores acquired under capital leases |
3.7 | 20.4 | 15.4 |
The accompanying notes are an integral part of these consolidated financial statements.
76
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Tabular dollars in millions except per share amounts)
Note 1Description of Business and Summary of Significant Accounting Policies
Basis of Presentation
Blockbuster Inc. and its subsidiaries (the Company or Blockbuster) primarily operate and franchise entertainment-related stores in the United States and a number of other countries. The Company offers pre-recorded videos, as well as video games, for in-store rental, sale and trade and also sells other entertainment-related merchandise. Blockbuster also operates BLOCKBUSTER Online®, an online service offering rental of movies delivered by mail.
Use of Estimates
The preparation of Blockbusters consolidated financial statements, in conformity with accounting principles generally accepted in the United States, requires the Company to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, the Company evaluates its estimates, including those related to the useful lives and residual values surrounding the Companys rental library, estimated accruals related to revenue-sharing titles subject to performance guarantees, merchandise inventory reserves, revenues generated by customer programs and incentives, useful lives of property and equipment, income taxes, impairment of its long-lived assets, including goodwill, share-based compensation and contingencies. The Company bases its estimates on historical experience and on various other assumptions that the Company believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may materially differ from these estimates under different assumptions or conditions.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and investments of more than 50.0% in subsidiaries and other entities. Investments in affiliated companies over which the Company has a significant influence or ownership of more than 20.0% but less than or equal to 50.0% are accounted for using the equity method. Investments of 20.0% or less are accounted for using the cost method. All significant intercompany transactions have been eliminated. Additionally, the Company adopted Financial Accounting Standards Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, as revised (FIN 46R), effective January 1, 2004. FIN 46R requires an entity determined to be a variable interest entity to be consolidated by the enterprise that absorbs the majority of the entitys expected losses, receives a majority of the entitys expected residual returns or both. The adoption of FIN 46R did not have a material impact on the Companys financial position, results of operations or cash flows.
Restatement of Previously Issued Financial Statements
As disclosed in the Companys Form 8-K filed on March 9, 2006, the Company has been engaged in discussions with the Securities and Exchange Commission (the SEC) with respect to its accounting practices surrounding its rental library and rental library activities. The Company has historically classified rental library purchases as an investing cash outflow in its Consolidated Statements of Cash Flows and rental library assets as a non-current asset in its Consolidated Balance Sheets. As a result of these discussions, the Company has determined that rental library purchases should be classified as an operating cash outflow in its Consolidated Statements of Cash Flows and that rental library assets should be classified as a current asset in its Consolidated
77
BLOCKBUSTER INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)
(Tabular dollars in millions except per share amounts)
Balance Sheet. Because the classification of the Companys deferred income tax liability associated with the rental library follows the classification of the rental library, the Company has also changed the presentation of its deferred income taxes on the Consolidated Balance Sheet. The adjustments do not affect the Companys previously reported revenues, net income, stockholders equity, total cash flows or cash.
The Company has restated its consolidated financial statements for the years ended December 31, 2004 and 2003. Following is a summary of the effects of these changes on the Companys Consolidated Balance Sheet as of December 31, 2004 and in the Companys Consolidated Statements of Cash Flows for the years ended December 31, 2004 and 2003. See Note 14 for a summary of the effects of these changes on the Companys unaudited quarterly information for 2005 and 2004.
Year Ended or at December 31, 2004 | Year Ended December 31, 2003 | |||||||||||||||||||||||
As Previously Reported |
Adjustments | As Restated |
As Previously Reported |
Adjustments | As Restated |
|||||||||||||||||||
Consolidated Balance Sheet |
||||||||||||||||||||||||
Rental library, net (current) |
$ | | $ | 457.6 | $ | 457.6 | ||||||||||||||||||
Deferred income taxes (current asset) |
| 24.0 | 24.0 | |||||||||||||||||||||
Total current assets |
1,217.7 | 481.6 | 1,699.3 | |||||||||||||||||||||
Rental library, net (non-current) |
457.6 | (457.6 | ) | | ||||||||||||||||||||
Deferred income taxes (non-current asset) |
87.0 | 107.2 | 194.2 | |||||||||||||||||||||
Total assets |
3,863.4 | 131.2 | 3,994.6 | |||||||||||||||||||||
Deferred income taxes (current liability) |
4.8 | 131.2 | 136.0 | |||||||||||||||||||||
Total liabilities |
2,800.5 |