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HASTINGS ENTERTAINMENT INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our consolidated financial statements and the related notes thereto and "Item 6. Selected Financial Data" appearing elsewhere in this Annual Report on Form 10-K. Overview Hastings is a leading multimedia entertainment and lifestyle retailer that buys, sells, trades and rents various home entertainment products, including books, music, software, periodicals, new and used CDs, movies on DVD and Blu-ray, video games, video game consoles and electronics. We also offer consumables and trends products such as apparel, t-shirts, action figures, posters, greeting cards and seasonal merchandise through our entertainment stores and our Internet web site. As of March 31, 2014, we operated 126 stores averaging approximately 24,000 square feet in medium-sized markets located in 19 states, primarily in the Western and Midwestern United States. Each of the stores, operated on leased premises, is wholly-owned by us and is operated under the name of Hastings. We also operate three concept stores, Sun Adventure Sports, located in Amarillo, Texas and Lubbock, Texas, and TRADESMART, located in Littleton, Colorado, which are wholly-owned by us. Over the past several years, our financial performance has been adversely impacted by a number of factors, including the economic downturn and the expanding digital delivery of entertainment. Our book business continues to be negatively impacted by the transition of certain categories to digital formats, but at a lesser rate than anticipated, therefore we expect the negative trends in sales of new books to continue and expect a single digit decrease in Book Comp sales for fiscal 2014. We expect Music Comp sales, which have had mid-single to double digit decreases for the last five years driven primarily by digital content delivery, to have a high single digit decrease for fiscal 2014. Movie Comps have been negatively impacted by a weak schedule of new releases during fiscal 2013 which has directly impacted new movie sales. We expect total Movie Comps for fiscal 2014 to be flat. Rental Comps have decreased the past several years due to competition from rental kiosks and subscription-based rental services. We expect Rental Comps for fiscal 2014 to have a single digit decrease. We expect Electronic Comp sales, which have had single to double digit increases for the last several years, to have a high single digit increase for fiscal 2014. With the launch of the new game consoles, we expect a high double digit increase in Video Game Comp sales. Trends Comps, which include lifestyle products, have seen high single to double digit increases during the last two years. We expect that increase to continue for Trend Comp sales in fiscal 2014 with a mid-single digit increase. As the economy improves, along with the continued success of our reset stores and expanded product lines which we plan to continue through fiscal 2014, we expect our comp revenues to improve. On March 17, 2014, the Company entered into the Merger Agreement with Parent and Merger Sub. Upon the effective time of the Merger, the Company will be merged with and into Merger Sub, with the Company surviving the Merger as a wholly-owned subsidiary of Parent. Our operating strategy is to continue to enhance our position as a multimedia entertainment and lifestyle retailer by resetting existing stores and offering our products through our Internet web site. We are also focused on shifting our business model more toward lifestyle and consumer electronics products to become less dependent on entertainment products. Some examples of such products include tablet expansions for reading, watching movies, hobby, crafts and playing games and phone app products to be used with your smart phone for fun, health and fitness. References in this Annual Report on Form 10-K to fiscal years are to the twelve-month periods that end in January of the following calendar year. For example, the twelve-month period ended January 31, 2014 is referred to as fiscal 2013. Merger Agreement As described under the heading "Merger Agreement" in Item 1 of this Annual Report on Form 10-K, on March 17, 2014, we entered into the Merger Agreement with Parent and its wholly owned subsidiary. Pursuant to the Merger Agreement, subject to satisfaction or waiver of certain closing conditions, Merger Sub will merge with and into the Company, with the Company continuing its existence under Texas law as the surviving entity in the Merger. Upon the completion of the Merger, the Company will be a wholly owned subsidiary of Parent. 22 -------------------------------------------------------------------------------- If the Merger is completed, at the effective time of the Merger, each share of common stock of the Company issued and outstanding as of immediately prior to the effective time (excluding any shares of common stock held by Parent or its affiliates (including Merger Sub and NECA)), any shares of common stock held by the Company in treasury or by any direct or indirect wholly owned subsidiary of the Company) will be automatically cancelled and converted into the right to receive the Merger Consideration of $3.00 per share. Critical Accounting Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe the following critical accounting estimates comprise our more significant estimates and assumptions used in the preparation of our financial statements. Our significant estimates and assumptions are reviewed, and any required adjustments are recorded, on a monthly or quarterly basis. Lower of Cost or Market for Merchandise Inventory. Our merchandise inventories are recorded at the lower of cost, which approximates the first-in, first-out ("FIFO") method, or market. Inventory costing requires certain significant estimates and judgments involving the allocation of costs and vendor allowances. These practices affect ending inventories at cost, as well as the resulting gross margins and inventory turnover ratios. As with any retailer, economic conditions, cyclical customer demand and changes in purchasing or distribution can also affect the carrying value of inventory. As circumstances warrant, we record lower of cost or market inventory adjustments. In some instances, these adjustments can have a material effect on the financial results of an annual or interim period. In order to determine such adjustments, we evaluate the age, inventory turns and estimated market value and returnability of merchandise inventory by product category and record an adjustment if estimated market value is below cost. Rental Asset Depreciation. We have established rental asset depreciation policies that match rental product costs with the related revenues. These policies require that we make significant estimates, based upon our experience, as to the ultimate amount and timing of revenue to be generated from our rental product. We utilize an accelerated method of depreciation because it approximates the pattern of demand for the product, which is higher when the product is initially released by the studios for rental and declines over time. In establishing salvage values for our rental product, we consider the sales prices and sales volume of our previously rented product and other used product. We currently depreciate the cost of our rental assets on an accelerated basis over six months or nine months, except for rental assets purchased for the initial stock of a new store, which are depreciated on a straight-line basis over 36 months. Rental assets, which include DVDs, Blu-rays and Video Games, are depreciated to salvage values ranging from $4 to $15. Rental assets purchased for less than established salvage values are not depreciated. We also review the carrying value of our rental assets to ensure that estimated future cash flows exceed the carrying value. We periodically record adjustments to the value of previously rented product primarily for estimated obsolescence 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 our original estimates, additional adjustments, including adjustments to useful lives or salvage values, may be required. We continually evaluate the estimates surrounding the useful lives and salvage values used in depreciating our rental assets. Changes to these estimates resulting from changes in consumer demand, changes in customer preferences or the price or availability of retail products may materially impact the carrying value of our rental assets and our rental margins. The costs of rental product purchased pursuant to revenue-sharing arrangements, which are recorded in rental cost of sales on the consolidated statements of operations, typically include a lower initial product cost than traditional rental purchases with a certain percentage of the net rental revenues shared with studios over an agreed period of time. Any up-front costs exceeding the designated salvage value are amortized on an accelerated basis and revenue-sharing payments pursuant to the applicable arrangement are expensed as rental cost of sales as the related revenue is earned. Additionally, certain titles have performance guarantees. We analyze titles that are subject to performance guarantees and recognize an estimated expense for under-performing titles throughout the applicable period based 23 --------------------------------------------------------------------------------upon our analysis of the estimated rental revenue shortfall. We revise these estimates on a monthly basis, based on actual results. Impairment or Disposal of Long-Lived Assets. We evaluate under-performing stores on a quarterly basis to determine whether projected future cash flows over the remaining lease term are sufficient to recover the carrying value of the fixed asset investment in each individual store. If projected future cash flows are less than the carrying value of the fixed asset investment, an impairment charge is recognized if the estimated fair value is less than the carrying value of such assets. The carrying value of leasehold improvements as well as certain other property and equipment is subject to impairment write-down. Income Taxes. In determining net income (loss), 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. We record deferred tax assets and liabilities for future income tax consequences that are attributable to differences between financial statement carrying amounts of assets and liabilities and their income tax bases. We base the measurement of deferred tax assets and liabilities on enacted tax rates that we expect will apply to taxable earnings in the year when we expect to settle or recover those temporary differences. We recognize the effect on deferred tax assets and liabilities on any change in income tax rates in the period that includes the enactment date. A valuation allowance is established if it is more likely than not that a deferred tax asset will not be realized. In determining the appropriate valuation allowance, we consider all available positive and negative evidence, including our ability to carry back operating losses to prior periods, projected future taxable income, tax planning strategies and the reversal of deferred tax liabilities. We reassess the valuation allowance quarterly, and, if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. The tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood, on a cumulative basis, of being realized upon ultimate settlement. We recognize interest and penalties relating to any uncertain tax positions as a component of income tax expense. Share-Based Compensation. Determining the amount of share-based compensation to be recorded in the statement of operations requires us to develop estimates that are used in calculating the grant-date fair value of stock options. In determining the fair value of stock options, we use the Black-Scholes valuation model, which requires us to make estimates of the following assumptions: · Expected volatility - The estimated stock price volatility is derived based upon our historical stock prices over the expected life of the option. · Expected life of the option - The estimate of an expected life is calculated based on historical data relating to grants, exercises and cancellations, as well as the vesting period and contractual life of the option. · Risk-free interest rate - The risk-free interest rate is based on the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected life of the option. · Expected dividend yield - The estimated rate based on the stock's current market price and forecasted dividend payout. Our stock price volatility and expected option lives involve management's best estimates at the grant date, both of which impact the fair value of the option calculated under the Black-Scholes pricing model and, ultimately, the expense that will be recognized over the vesting period of the option. We recognize compensation expense only for the portion of options that are expected to vest. Therefore, we apply estimated forfeiture rates that are derived from historical employee termination behavior. If the actual number of forfeitures differs from those estimated by management, additional adjustments to compensation expense may be required in future periods. 24 -------------------------------------------------------------------------------- In addition to stock options, we have awarded restricted stock awards, including restricted stock units and performance-based restricted stock awards. The grant date fair value of restricted stock awards is equal to the average of the opening and closing stock price on the day on which they are granted. For performance-based restricted stock awards, compensation expense is recognized if management deems it probable that the performance conditions will be met. Management must use its judgment to determine the probability that a performance condition will be met. If actual results differ from management's assumptions, future results could be materially impacted. Under the Merger Agreement, we may not grant or award any options, restricted stock or other share based compensation without the consent of Parent. Gift Card Breakage Revenue. We sell gift cards through each of our stores and through our web site www.goHastings.com. The gift cards we sell have no stated expiration dates or fees and are subject to potential escheatment rights in some of the jurisdictions in which we operate. Gift card liabilities are recorded as deferred revenue at the time of sale of such cards with the costs of designing, printing and distributing the cards recorded as expense as incurred. Gift card breakage revenue is recognized as gift cards are redeemed, based upon an analysis of the aging and utilization of gift cards, our determination that the likelihood of future redemption is remote and our determination that such balances are not subject to escheatment laws applicable to our operations. Results of Operations The following tables present our statement of operations data, expressed as a percentage of revenue, and the number of stores open at the end of period for the three most recent fiscal years. Fiscal Year 2013 2012 2011 Merchandise revenue 87.7 % 87.1 % 85.6 % Rental asset revenue 12.2 12.9 14.2 Gift card breakage revenue 0.1 (0.0 ) 0.2 Total revenues 100.0 100.0 100.0 Merchandise cost of revenue 68.6 68.3 69.5 Rental asset cost of revenue 36.0 34.7 38.6 Total cost of revenues 64.6 64.0 65.0 Gross profit 35.4 36.0 35.0 Selling, general and administrative expenses 37.5 37.7 37.3 Operating income (loss) (2.1 ) (1.7 ) (2.3 ) Other income (expense): Interest expense (0.3 ) (0.3 ) (0.3 ) Other, net 0.1 0.0 0.1 (0.2 ) (0.3 ) (0.2 ) Income (loss) before income taxes (2.3 ) (2.0 ) (2.5 ) Income tax expense (benefit) (0.1 ) 0.0 1.0 Net income (loss) (2.2 )% (2.0 )% (3.5 )% Fiscal Year 2013 2012 2011 Hastings Stores(1): Beginning number of stores 137 140 146 Openings - - 1 Closings (10 ) (3 ) (7 ) Ending number of stores 127 137 140 (1) We operate three concept stores, including two Sun Adventure Sports and one TRADESMART, which are not included in the above summary of Hastings Stores activity. 25 --------------------------------------------------------------------------------Fiscal 2013 Compared to Fiscal 2012 Revenues. Total revenues for the fiscal year ended January 31, 2014 decreased approximately $26.5 million, or 5.7%, to $436.0 million compared to $462.5 million for the fiscal year ended January 31, 2013. The following is a summary of our revenues results (dollars in thousands): Fiscal Year Ended January 31, 2014 2013 Decrease Percent Percent Revenues Of Total Revenues of Total Dollar Percent Merchandise revenue $ 382,578 87.8 % $ 402,735 87.1 % $ (20,157 ) -5.0 % Rental revenue 53,043 12.2 % 59,846 12.9 % (6,803 ) -11.4 % Gift card breakage revenue 341 0.1 % (80 ) 0.0 % 421 NM Total Revenues $ 435,962 100.0 % $ 462,501 100.0 % $ (26,539 ) -5.7 % Stores open at period end 130 140 (10 ) -7.1 % Comparable-store revenues ("Comp") Total -2.8 % Merchandise -2.0 % Rental -7.7 % Below is a summary of the Comp results for our major merchandise categories: Fiscal Year Ended January 31, 2014 2013 Trends 15.2 % 8.7 % Electronics 9.9 % 12.9 % Movies 2.2 % -1.1 % Hardback Café 1.1 % 11.1 % Consumables -2.5 % 1.5 % Video Games -2.9 % -21.8 % Books -10.7 % -1.3 % Music -12.5 % -12.0 % Trends Comps increased 15.2% for fiscal 2013, primarily due to strong sales in toys and gifts, action figures, comic books, licensed and branded products and recreational and lifestyle products. Licensed and branded products for which we experienced strong sales during the period were Walking Dead, Star Wars and Doctor Who. The Trends department also includes recreation and lifestyles products whose growth was driven by the addition of hobby products, pet accessories and outdoor accessories to reset stores as well as growth in the existing categories of skateboards and disc golf. Hobby products showed significant growth during fiscal 2013 led by sales of remote control vehicles and model kits. Electronics Comps increased 9.9% for fiscal 2013, primarily due to increased sales in hardware categories, such as televisions, turntables and speaker systems; strong growth was also realized in refurbished electronics. Movies Comps increased 2.2% for fiscal 2013, primarily due to increased sales of new and used Blu-ray, traditional and boxed set DVDs, partially offset by new, previously viewed and used Midline DVDs. Hardback Café Comps increased 1.1%, due to higher sales of iced and hot specialty café drinks, partially offset by a decrease in retail products such as mugs and baked goods. Consumables Comps decreased 2.5%, primarily due to decreased sales in popcorn, candies, and fountain drinks. Video Games Comps decreased only 2.9% for fiscal 2013, primarily due to the release of the PlayStation 4 and the Xbox One game consoles in the fourth quarter as well as increased sales in new and used games. Books Comps decreased 10.7%, primarily due to a weaker release schedule for new books and a decrease in trade paperback and hardback sales, as compared to fiscal 2012, which included strong sales from the Fifty Shades and Hunger Games trilogies. In addition, sales of digital hardware decreased significantly for fiscal 2013 as compared to fiscal 2012. Music Comps decreased 12.5% for the period, primarily 26 --------------------------------------------------------------------------------due to a significant reduction in retail space in the 36 stores that were reset in fiscal 2013 as well as the increasing popularity of digital delivery, partially offset by the increased sales of new and used vinyl albums. Rental Comps decreased 7.7% for fiscal 2013 primarily resulting from fewer rentals of traditional DVDs and video games, partially offset by an increase in rentals of Blu-ray movies. Rental Movie Comps decreased 6.3% primarily due to competition from rental kiosks and subscription-based rental services. Rental Video Game Comps decreased 19.8%. Gross Profit - Merchandise. For fiscal 2013, total merchandise gross profit dollars decreased approximately $7.6 million, or 6.0%, to $119.9 million from $127.5 million for the same period in the prior year primarily due to a decrease in revenue which is primarily attributed to operating fewer superstores compared to the prior year. As a percentage of total merchandise revenue, merchandise gross profit slightly decreased to 31.4% for fiscal 2013, compared to 31.7% for fiscal 2012, primarily due to a shift in mix of revenues by category and higher markdown expenses, partially offset by lower freight expense, lower expense to return products and lower shrinkage. Gross Profit - Rental. For fiscal 2013, total rental gross profit dollars decreased approximately $5.1 million, or 13.0%, to $34.0 million from $39.1 million for the same period in the prior year primarily due to a decrease in revenue which is partially attributed to operating fewer superstores for the same period in the prior year. As a percentage of total rental revenue, rental gross profit decreased to 64.0% for fiscal 2013 compared to 65.3% for the same period in the prior year, primarily due to an increase in revenues under revenue sharing agreements, which generally have lower margins when compared to traditional agreements. The rate decrease is partially offset by a decrease in depreciation and shrink expense. Selling, General and Administrative Expenses ("SG&A"). As a percentage of total revenue, SG&A decreased to 37.5% for fiscal year 2013 compared to 37.7% for fiscal year 2012, due to a significant reduction in SG&A expenses. SG&A decreased approximately $10.8 million, or 6.2%, to $163.7 million compared to $174.5 million for the same period last year. The majority of the decrease results primarily from a $3.3 million reduction in store labor expense, a $2.3 million reduction in depreciation expense, a decrease of $1.7 million in store advertising expense and a decrease of $0.6 million in store supplies, all of which were primarily the result of operating fewer superstores during this fiscal year compared to last fiscal year. There was a $1.9 million reduction in corporate salary expense due to lower bonus payouts and the restructuring that took place in the first quarter of fiscal 2013. Several other SG&A expenses had smaller decreases or increases during the year which netted to an additional $1.0 million decrease for fiscal 2013. Interest Expense. For fiscal 2013, interest expense increased approximately $0.1 million, or 8.3%, to $1.3 million, compared to $1.2 million for fiscal 2012. The increase results primarily from higher debt levels. Interest rates for both periods averaged 2.5%. Income Taxes. During fiscal 2013, the Company recorded a discrete tax benefit of approximately $0.5 million from the recognition of a tax position due to a change in state administrative practices. No discrete items were recorded during fiscal 2012. As the Company has a net operating loss and a net deferred tax asset, which has been offset by a full valuation allowance at the end of fiscal 2013, there is no tax liability, with the exception of Texas state income tax, which is based primarily on gross margin; therefore, considering the discrete tax benefit described above and the Texas state income tax, the effective tax rate for fiscal year 2013 is 2.3%. The valuation allowance is approximately $14.3 million as of January 31, 2014. We reassess the valuation allowance quarterly, and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. Fiscal 2012 Compared to Fiscal 2011 Revenues. Total revenues for the fiscal year ended January 31, 2013 decreased approximately $33.9 million, or 6.8%, to $462.5 million compared to $496.4 million for the fiscal year ended January 31, 2012. The following is a summary of our revenues results (dollars in thousands): 27 -------------------------------------------------------------------------------- Fiscal Year Ended January 31, 2013 2012 Decrease Percent Percent Revenues Of Total Revenues of Total Dollar Percent Merchandise revenue $ 402,735 87.1 % $ 425,142 85.6 % $ (22,407 ) -5.3 % Rental revenue 59,846 12.9 % 70,426 14.2 % (10,580 ) -15.0 % Gift card breakage revenue (80 ) 0.0 % 819 0.2 % (899 ) NM Total Revenues $ 462,501 100.0 % $ 496,387 100.0 % $ (33,886 ) -6.8 % Stores open at period end 140 143 (3 ) -2.1 % Comparable-store revenues ("Comp") Total -5.1 % Merchandise -3.7 % Rental -12.9 % Below is a summary of the Comp results for our major merchandise categories: Fiscal Year Ended January 31, 2013 2012 Electronics 12.9 % 3.7 % Hardback Café 11.1 % 4.8 % Trends 8.7 % 10.4 % Consumables 1.5 % -6.3 % Movies -1.1 % -8.2 % Books -1.3 % -4.8 % Music -12.0 % -4.5 % Video Games -21.8 % -5.1 % Electronics Comps increased 12.9% for fiscal 2012, primarily due to the success of the 44 stores participating in the consumer electronics reset. Sales of tablets, tablet accessories, turntables and headphones were strong during the fiscal year. Hardback Café Comps increased 11.1% for fiscal 2012, primarily due to higher sales of coffee and specialty drinks. Trends Comps increased 8.7% for fiscal 2012, primarily due to strong sales in boutique apparel, toys and gifts, comic books, as well as skateboarding equipment and other action sports items. Consumables Comps increased 1.5% for fiscal 2012, primarily due to increased sales in candies, snacks and bottled beverages. Movies Comps decreased 1.1% for fiscal 2012, primarily due to decreased sales in used and previously viewed movies, partially offset by increased sales in new DVDs and Blu-ray movies. Books Comps decreased 1.3%, primarily due to lower sales in new and bargain books and magazines, partially offset by strong sales of the 50 Shades series, Nextbook tablets and used books. Books Comps, excluding digital sales, decreased 2.3% for fiscal 2012. Music Comps decreased 12.0% for fiscal 2012, primarily due to decreased sales in new and used CDs which can be attributed to consumers increasingly using digital delivery of their music purchases. Video Games Comps decreased 21.8% for fiscal 2012, primarily due to decreased sales of new and used video games and video game hardware and accessories, primarily resulting from the longevity of the current console cycle, as well as the fact that overall industry sales of Nintendo's Wii U system were weaker than expected. Rental Comps decreased 12.9% for fiscal 2012, primarily due to fewer rentals of DVDs and video games, partially offset by increased rentals of Blu-ray movies. Rental Movie Comps decreased 10.6%, as sales were negatively impacted by competitor rental kiosks and subscription-based rental services, while Rental Video Game Comps, which were impacted by the longevity of the current console cycle, decreased 28.4%. Gross Profit - Merchandise. For fiscal 2012, total merchandise gross profit dollars decreased approximately $2.1 million, or 1.6%, to $127.5 million from $129.6 million for fiscal 2011, primarily due to lower revenues, partially offset by higher merchandise margin rates. As a percentage of total merchandise revenue, merchandise gross profit increased to 31.7% for fiscal 2012, compared to 30.5% for fiscal 2011, primarily due to a shift in mix of revenues by 28 --------------------------------------------------------------------------------category and lower merchandise shrinkage and merchandise markdown expenses, partially offset by increased freight costs as a result of increased internet sales. Gross Profit - Rental. For fiscal 2012, total rental gross profit dollars decreased approximately $4.2 million, or 9.7%, to $39.1 million from $43.3 million for fiscal 2011, primarily due to lower revenues, partially offset by higher rental margin rates. As a percentage of total rental revenue, rental gross profit increased to 65.3% for fiscal 2012 compared to 61.4% for fiscal 2011, primarily as a result of lower rental shrinkage expense and lower rental asset depreciation expense. Selling, General and Administrative Expenses ("SG&A"). As a percentage of total revenue, SG&A increased to 37.7% for fiscal year 2012 compared to 37.3% for fiscal year 2011, primarily due to deleveraging resulting from lower revenues. SG&A decreased approximately $10.6 million, or 5.7%, to $174.5 million compared to $185.1 million for the same period last year. This is primarily due to a $4.1 million decrease in store labor costs, a $2.1 million reduction in abandoned lease expense, a $2.1 million decrease in depreciation, a $1.7 million decrease in store occupancy costs and a $1.2 million decrease in store advertising expense, partially offset by an increase of $1.4 million in bonuses under our corporate officer and management bonus incentive program. The reduction in depreciation and occupancy expenses are primarily the result of operating fewer stores. Interest Expense. For fiscal 2012, interest expense decreased approximately $0.1 million, or 7.7%, to $1.2 million, compared to $1.3 million for fiscal 2011, primarily as a result of lower average debt levels during the current fiscal year, along with lower interest rates. The average rate of interest charged for fiscal 2012 decreased to 2.5% compared to 2.7% for fiscal 2011. Income Taxes. As the Company has a net operating loss and a net deferred tax asset, which has been offset by a full valuation allowance at the end of fiscal 2012, there is no tax liability, with the exception of Texas state income tax; therefore, the effective tax rate for fiscal year 2012 is (3.3%). The valuation allowance is approximately $11.0 million as of January 31, 2013. We reassess the need for a valuation allowance quarterly, and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. Liquidity and Capital Resources We generate cash from operations from the sale of merchandise and the rental of products, most of which is received in cash and cash equivalents. Our primary sources of working capital are cash flows from operating activities, including trade credit from vendors, and borrowings under our revolving credit facility, with the most significant source in fiscal 2013 being cash flows from borrowings under our revolving credit facility and fiscal 2012 being cash flows from operating activities. Other than our principal capital requirements arising from the purchasing, warehousing and merchandising of inventory and rental products, opening new stores and expanding or reformatting existing stores and updating existing and implementing new information systems technology, we have no anticipated material capital commitments, except for the stock buyback programs more fully discussed below. We believe our cash flows from operations and borrowings under our revolving credit facility will be sufficient to fund our ongoing operations, store reformations and other capital commitments. At January 31, 2014, total outstanding debt was $51.7 million. We project our outstanding debt level at January 31, 2015 will be in the range of $56.0 to $60.0 million. At January 31, 2014, we had approximately $49.7 million in excess availability, after the $10 million availability reserve, under the Credit Agreement (as defined herein). The Merger Agreement, as described under the heading "Merger Agreement" in Item 1 of this Annual Report on Form 10-K, places certain limitations on our ability to, among other things, repurchase shares, declare dividends and make capital expenditures in excess of certain thresholds. In addition, the Merger Agreement places certain limitations on the amount of additional debt we can assume outside of our Credit Agreement. 29 -------------------------------------------------------------------------------- Consolidated Cash Flows Operating Activities. Net cash used in operating activities totaled $1.0 million for fiscal 2013, compared to cash provided by operating activities of $22.2 million for fiscal 2012. Net loss for fiscal 2013 was approximately $10.2 million compared to a net loss of $9.3 million for fiscal 2012. Purchases of rental assets decreased approximately $3.3 million to $7.8 million during fiscal 2013 from $11.1 million during fiscal 2012 in anticipation of lower rental revenues. Consequently, rental asset depreciation expense decreased approximately $2.3 million to $3.9 million during fiscal 2013 from $6.2 million during fiscal 2012. Property and equipment depreciation expense decreased approximately $2.3 million to $12.6 million during fiscal 2013 from $14.9 million during fiscal 2012. This decrease is the result of having less depreciable fixed assets on the balance sheet for fiscal 2013 compared to fiscal 2012. Merchandise inventories increased approximately $2.4 million during fiscal 2013, compared to a decrease of $11.2 million during fiscal 2012, primarily due to an increase of inventories in the new product categories of our reset stores. Merchandise inventories, net of trade accounts payable, increased approximately $1.5 million for fiscal 2013 compared to a decrease of approximately $9.3 million for fiscal 2012. Trade accounts payable increased approximately $0.9 million during fiscal 2013 compared to an increase of approximately $1.9 million during fiscal 2012. The increase in merchandise inventories, net of trade accounts payable, and the increase in trade accounts payable are primarily due to a variance in the timing of payments to vendors. This primarily results from the fact that several of our new product vendors currently have relatively shorter payment terms in comparison to our traditional media product vendors. Prepaid expenses and other current assets decreased approximately $2.0 million during fiscal 2013 compared to a decrease of approximately $4.8 million during fiscal 2012. The larger decrease in fiscal 2012 was due primarily to a receipt of a $5.4 million federal income tax receivable. Accrued expenses and other liabilities decreased approximately $0.6 million during fiscal 2013 compared to an increase of approximately $1.2 million during fiscal 2012 due to a reduction in the store closing reserve and changes to various other balance sheet accounts. During fiscal 2014, we estimate net cash provided by operations of approximately $4.0 to $6.0 million. The expected increase from fiscal 2013 net cash used in operations to estimated fiscal 2014 net cash provided by operations results primarily from lower merchandise inventories for fiscal 2014. Investing Activities. Net cash used in investing activities increased approximately $1.3 million, or 14.4%, from $9.0 million in fiscal 2012 to $10.3 million in fiscal 2013. This increase was primarily due to increased capital expenditures relating to the reset stores. In fiscal 2014, the Company projects capital expenditures to be approximately $8.0 to $9.0 million, as we continue to manage discretionary spending during fiscal 2014. Financing Activities. Cash provided by or used in financing activities is primarily associated with borrowings and payments made under our revolving credit facility (described below under "Capital Structure"). For fiscal 2013, cash provided by financing activities was approximately $11.3 million compared to cash used in financing activities of approximately $13.6 million for fiscal 2012. Net borrowings to our revolving credit facility during fiscal 2013 were approximately $9.9 million compared to net repayments of approximately $11.5 million during fiscal 2012. The Company purchased approximately $0.1 million of treasury stock in fiscal 2013, as compared to $0.5 million in fiscal 2012. Changes in our cash overdraft position decreased from cash provided of approximately $1.8 million for fiscal 2012 to cash provided of approximately $1.4 million for fiscal 2013. The increase in net borrowings and the decrease in our cash overdraft position are primarily due to the decrease in cash from operating activities and also due to the timing of payments issued to vendors during the period. No dividends were paid in fiscal 2013. The total amount of dividends paid in fiscal 2012 was approximately $3.1 million. On September 18, 2001, we announced a stock repurchase program of up to $5.0 million of our common stock. As of January 31, 2014, the Board of Directors has approved increases in the program totaling $32.5 million. During fiscal year 2013, we purchased a total of 38,600 shares of common stock at a cost of $127,253, or $3.30 per share. As of January 31, 2014, a total of 5,626,149 shares had been purchased under the program at a cost of approximately $31.9 million, for an average cost of approximately $5.67 per share. As of January 31, 2014, approximately $5.6 million remained available for repurchases under the stock repurchase program. Under the Merger Agreement, we may not purchase shares of our common stock without the consent of Parent. On December 4, 2009, we entered into a stock transfer agreement with the Marmaduke Family Limited Partnership (the "Partnership"). Under the stock transfer agreement, for a period of three years following the death of Mr. John H. Marmaduke, the Company's Chief Executive Officer, the Partnership may tender for purchase to the Company, and, if so tendered, the Company will be required to purchase, the number of shares of the Company's 30 -------------------------------------------------------------------------------- common stock belonging to the Partnership that equal an aggregate fair market value of $5.0 million. During this three year period, the Partnership may elect to tender portions of such shares in various lots and parcels, at any time and from time to time, and any tender shall not exhaust or limit the Partnership's right to tender an additional amount of such shares, subject to the limitations set within the stock transfer agreement. Under the stock transfer agreement, the Company is not obligated to purchase, and the Partnership does not have the right to tender, any amount of such shares with an aggregate fair market value in excess of $5.0 million. In the event that Mr. Marmaduke resigns as an officer or director of the Company prior to his death, the Partnership's right to tender the shares to the Company shall terminate. The stock transfer agreement shall terminate on the earlier of February 9, 2019, or four years after the death of Mr. Marmaduke. The Company is currently the beneficiary of a $10 million key-man life insurance policy on Mr. Marmaduke; a portion of the proceeds of which would be used to complete any purchases of shares resulting from the stock transfer agreement. Capital Structure. We have entered into an Amended and Restated Loan and Security Agreement with Bank of America, N.A., as agent (as subsequently amended, the "Credit Agreement"). The Credit Agreement provides a revolving credit facility of $115 million, allows for the payment of dividends, has a maturity date of January 4, 2017 and provides that we may repurchase up to $10.0 million worth of our common stock. The Credit Agreement also provides that we may repurchase additional shares of our common stock in the event we meet certain criteria set forth in the Credit Agreement. The Credit Agreement includes certain debt and acquisition limitations and requires a minimum Availability (as defined in the Credit Agreement) that is greater than or equal to $10.0 million at all times. Our obligations under the Credit Agreement are secured by a pledge of substantially all of the assets of the Company and our subsidiary and are guaranteed by our subsidiary. The amount outstanding under the Credit Agreement is limited by a borrowing base predicated on the sum of (a) 85% of Eligible Credit Card Receivables plus (b) either (i) at all times during the year, other than those stated in (ii), 90% of the liquidation value of eligible inventory or (ii) from September 1st through and including December 27th of each year, 92.5% of the liquidation value of eligible inventory, less (c) Availability Reserves and is limited to a ceiling of $115 million, less a minimum availability reserve that is greater than or equal to 10% of the lesser of (a) the Borrowing Base, or (b) the Revolving Credit Ceiling (each term as defined in the Credit Agreement), provided however that we must also maintain Availability that is greater than or equal to $10 million at all times. The lender may increase specifically defined reserves to reduce availability in the event of adverse changes in our industry or our financial condition that are projected to impact the value of our assets pledged as collateral. The lender must exercise reasonable judgment and act in good faith with respect to any changes in the specifically defined reserves. Interest under the Credit Agreement will accrue, at our election, at a Base Rate or Libor Rate, plus, in each case, an Applicable Margin, which is determined by reference to the level of Availability as defined in the Credit Agreement, with the Applicable Margin for Libor Rate loans ranging from 2.00% to 2.50% and the Applicable Margin for Base Rate loans ranging from 1.00% to 1.50% (each term as defined in the Credit Agreement). In addition, unused line fees ranging from 0.30% to 0.375% (determined by reference to the level of usage under the Credit Agreement) are also payable on unused commitments. At January 31, 2014 we had approximately $49.7 million in excess availability, after the $10 million availability reserve and outstanding letters of credit, under the Credit Agreement. We expect to have approximately $47.0 million to $51.0 million in excess availability, after the $10 million availability reserve and outstanding letters of credit, at January 31, 2015. However, excess availability may be reduced in the future as changes in the borrowing base occur or the lenders increase availability reserves. The average rates of interest incurred for the fiscal years ended January 31, 2014 and 2013 was 2.5%. Deferred financing costs that were amortized into interest expense during the fiscal years ended January 31, 2014 and 2013 are excluded from the calculation of the average rate of interest for the period. We utilize standby letters of credit to support certain insurance policies. The aggregate amount of the letters of credit at January 31, 2014, was approximately $0.8 million, which reduces the excess availability under the Credit Agreement. 31 -------------------------------------------------------------------------------- Contractual Obligations and Off-Balance Sheet Arrangements. In the ordinary course of business, we routinely enter into purchase commitments for various aspects of our operations, such as warehouse equipment and office equipment. However, we do not believe that these commitments will have a material effect on our financial condition, results of operations or cash flows. As of January 31, 2014, other than operating leases and standby letters of credit, we had not entered into any off-balance sheet arrangements or third-party guarantees, nor is it our business practice to do so. At January 31, 2014, our minimum lease commitments for fiscal 2013 were approximately $25.7 million. Total existing minimum operating lease commitments for fiscal years 2014 through 2026 were approximately $128.6 million as of January 31, 2014. The following summarizes our contractual obligations at January 31, 2014, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in thousands): Payments due by period Less than 1 to 3 3 to 5 More than Contractual Obligations Total 1 year Years Years 5 Years Long-term debt (principal only) (1) $ 51,749 - 51,749 - - Operating leases (2) 128,633 25,724 43,594 33,919 25,396 Revenue sharing (3) 1,080 1,080 - - - Total (4) $ 181,462 26,804 95,343 33,919 25,396 (1) Based on our internal forecasts, we estimate interest payments for fiscal 2014 to be approximately $1.5 million. (2) Amounts include the direct lease obligations, excluding any taxes, insurance, maintenance and other related expenses. For the fiscal year ended January 31, 2014, payments for taxes, insurance, maintenance, and other related expenses, which are variable in nature, were approximately $5.6 million. (3) As of January 31, 2014, we were a party to revenue-sharing arrangements with various studios. These agreements include minimum purchase requirements, based upon the box office results of the title, at a lower initial product cost as compared to non-revenue sharing purchases. In addition, these contracts require net rental revenues to be shared with the studios over an agreed period of time. We have included amounts owed and an estimate of our contractual obligation under these agreements for performance guarantees and minimum purchase requirements for the period in which they can reasonably be estimated, which is approximately two months in the future. Although these contracts may extend beyond the estimated two month period, we cannot reasonably estimate these amounts due to the uncertainty of purchases that will be made under these agreements. The amounts presented above do not include revenue sharing accruals for rental revenues that will be recognized during fiscal 2014. (4) Uncertain tax position obligations, including unrecognized tax benefits of approximately $5,000 as of January 31, 2014, were not included in this table. Due to the uncertainty surrounding the timing of any future cash outflows related to uncertain tax position liabilities, we are not able to reasonably estimate the period of cash settlement with the respective taxing authority. Seasonality and Inflation Our business is highly seasonal, with significantly higher revenues and operating income realized during the fourth quarter, which includes the holiday selling season. Below is a tabular presentation of revenues and operating income by quarter, which illustrates the seasonal effects of our business: Fiscal year 2013: Quarter First Second Third Fourth Total revenues $ 109,128 $ 95,781 $ 94,672 $ 136,381 Operating income (loss) $ (1,955 ) $ (3,769 ) $ (6,397 ) $ 2,675 % of full year: Total revenues 25.0 % 22.0 % 21.7 % 31.3 % Operating income (loss) (20.7 %) (39.9 %) (67.7 %) 28.3 % 32 -------------------------------------------------------------------------------- Fiscal year 2012: Quarter First Second Third Fourth Total revenues $ 115,488 $ 104,053 $ 101,320 $ 141,640 Operating income (loss) $ 1,152 $ (3,070 ) $ (7,690 ) $ 1,618 % of full year: Total revenues 25.0 % 22.5 % 21.9 % 30.6 % Operating income (loss) 14.4 % (38.4 %) (96.2 %) 20.3 % We do not believe that inflation has materially impacted the results of operations during the past three years. Substantial increases in costs and expenses could have a significant impact on our operating results to the extent such increases are not passed along to customers. Recent Accounting Pronouncements During February 2013, the Financial Accounting Standards Board ("FASB") issued ASU 2013-02: Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles ("GAAP") to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is reclassified to a balance sheet account (for example, inventory) instead of directly to income or expense in the same reporting period. The Company adopted ASU 2013-02 beginning with the first quarter of fiscal 2013 and reclassified approximately $43,000 from Other Comprehensive Income to Other Income as of January 31, 2014. The remaining balance will be released during the first quarter of 2014. In July 2013, the Financial Accounting Standards Board issued ASU No. 2013-11: Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, which requires unrecognized tax benefits to be presented as a decrease in a net operating loss, similar tax loss or tax credit carryforward if certain criteria are met. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of ASU 2013-11 is not expected to have a material impact on the Company's consolidated financial statements. |