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April 21, 2005 Research Digest Editor:Ian Madsen, MBA, CFA [email protected] Tel:1-800-767-3771,ext 417

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Movie Gallery Inc. (MOVI – NASDAQ) $27.44

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Overview Headquartered in Dothan, Alabama, Movie Gallery, Inc. (MOVI) is a home video specialty retailer primarily focused on rural and secondary markets. The Company owns and operates approximately 2,500 retail stores, located throughout North America, which rent and sell digital video discs (DVDs), video cassettes, and video games. Movie Gallery's target markets are small towns and suburban areas of cities with populations generally between 3,000 and 20,000. Substantially all of its operations are conducted through its wholly owned subsidiaries, Movie Gallery U.S. and Movie Gallery Canada.

On January 9, 2005, the Company entered into an agreement and plan of merger (Merger Agreement) with Hollywood Entertainment, Inc. (Hollywood) providing for the Company's acquisition of Hollywood. Hollywood is a home video specialty retailer in the United States. But on February 2nd, Blockbuster Inc., the world's largest video rental chain, filed with the Securities and Exchange Commission to launch a hostile bid for all outstanding shares of rival Hollywood Entertainment Corp. at $14.50 per share in cash and stock. However on 25th March, BBI had dropped Hollywood Entertainment bid. Therefore, the combined company will be the second largest North American video rental company with annual revenue of approximately $2.50 billion and approximately 4,500 stores located in all 50 U.S. states, Canada, and Mexico. Management noted that this transformational merger creates a leading North American rentailer with outstanding prospects for future growth. With a broader geographic presence and greatly improved distribution capabilities and scale, the combined company will be a strong competitor, well-positioned for continued success in urban, suburban, and rural markets. Based on this, majority of the analysts maintain a positive rating on the stock.

Key Positive Arguments Key Negative Arguments  The acquisition of HLYW by MOVI would be  Home video retailers (HVR) rely on movie studios extremely accretive to its earnings. to provide a 30-90 day window of exclusive  All the analysts are of the opinion that this merger distribution. If the movie studios were to reduce this creates outstanding prospects for the company. window, these companies could face increased competition from pay-per-view and cable operators,  MOVI is sheltered from emerging technologies which would cut into sales and profits. such as video on demand because its core customers in rural areas are usually late adopters  The movie rental business’ peak season is in the of new technology. winter months when consumers have the most free time and stay indoors. If the movie release  MOVI now offers customers the ability to buy, sell, schedule is weak during this period, it will adversely or trade video games with its store-within-store affect MOVI’s results. concept, Game Zone.  If the company is unable to successfully open new stores or integrate acquired stores, it will adversely affect the company’s sales and earnings growth.

Sales The analysts (Aperion, BB&T, SWS, Wells Fargo) expect Movie Gallery to increase sales by 13.1% in 2005 and 9.3% in 2006.

2002A 2003A 2004A 2005E Net Sales $529 $692 $791 $895 Same-store sales 3.1% 7.0% -1.5% 1.4% Store growth 20.7% 21.0% 15.0% 12.1%

MOVI reported a same-store sales increase of 1.5% for Q1’05 (ended March 31, 2005) vs. a same- store sales increase of 2% last year. This was at the high end of company guidance of 0.5%-1.5%.

Fourth quarter summary: Fourth-quarter revenue rose 6.6% to $208.4mm, driven by a 15% increase in the store base to 2,482 from 2,158 last year, partially offset by a 6% decline in same-store sales. The growth in the store base may be attributed to internal development as well as acquisitions of small chains and independents.

Same-store sales in the fourth quarter fell 6%, at the lower end of management’s previous guidance of down 4%–6%. Several factors negatively impacted the quarter, including a difficult comparison against a 6% comp increase last year, a weak home video release schedule, both Christmas and New Year’s falling on Saturday, and a planned reduction in inventory of new release movies for sell through. DVD rental revenue as a percentage of total movie rental revenue was just under 88% a year ago. Same-store rental revenue declined 2.5%, but a 12.5% decrease in game rental same-store sales and 21% decrease in product sales caused total comps to fall 6%. Product sales were weak because the company intentionally reduced its in-store inventory of new release movies available for sale. One analyst (BB&T) is of the opinion that the weakness in game rentals is consistent with typical industry softness that occurs prior to the introduction of new game platforms, which is expected in late 2005 or early 2006. They add that they are encouraged that comps have improved so far in Q1’05 and expect that it should be up 0.5%–1.5% for the full quarter.

For 1Q05, the company expects total revenues of $228MM-$233MM vs. $203.3MM in 1Q04. MOVI anticipates a same store sales gain of 0.5%-1.5%. Total 2005 revenues are expected to reach $875MM-$900MM, with new store expansion complemented by a same-store sales expansion of 0%- 3%. Comp guidance for all of 2005 is flat to up 3% versus down 1.4% in FY'04.

Analysts are of the opinion that with or without HLYW, MOVI continues to pursue both organic and acquisition-fueled growth in 2005. The company plans to complement low-single digit same-store sales expansion with 400 new store openings and potential additional acquisitions in 2005. MOVI expects to close its acquisition of VHQ entertainment, a 61-store rentailer in Canada, on April 18, 2005, for $16.5MM. Given that approximately half of the video rental market is shared by independent rentailers, one analyst (Bear Sterns) believes that plenty of opportunity remains for MOVI to continue bolstering low-single digit same-store sales growth in a mature industry with both organic and acquisitive expansion.

See the MOVI earnings model spreadsheet for more detail on the company’s revenues.

Zacks Investment Research Page 2 www.Zackspro.com Margins Analysts (BB&T, Bear Stearns, SWS, Lehman, Wed bush and Wells Fargo) expect Movie Gallery’s margins to remain essentially the same in 2005 and 2006.

Margins 2002A 2003A 2004A 2005E Gross 68.5% 66.9% 68.4% 67.4% Operating 13.3% 12.9% 11.1% 11.1% Net 7.8% 7.8% 6.3% 6.5%

Fourth quarter summary: Q4’04 gross margin rose 193 bps to 67.6%. Cost of rental revenue rose 47 bps to 29%, but this was more than offset by a significant decline in the cost of product sales from 80.3% to 70.4%. Gross margin from product sales only contributed about 4% of total gross margin in the fourth quarter. Adjusted operating income (which excludes a change in lease accounting and stock option compensation expense) declined 10.9% to $26.1MM as operating margin dropped 247 bps to 12.5% of sales. G&A expense growth in the quarter was limited to only 5.8%. G&A was also down about 10% sequentially. Management declined to quantify specific items that caused the sequential decline, but one analyst (Bear Stearns) suspects that some bonuses accruing earlier in the year were reversed in Q4.

Analysts contend that MOVI would report better gross margins in Q1’05 due to higher percentage of revenues from rentals. However, they also add that this would be offset by increased SG&A spending on new stores and growth initiatives.

See the MOVI earnings model spreadsheet for more detail.

Earnings Per Share The Digest EPS Average for Q105 and FY05 are $0.58 and $1.84 respectively.

FY ends December 2QA 3QA 4QA 2004A 1QE 2005E Zacks Consensus $0.32 $0.29 $0.50 $1.66 $0.58 $1.86 Digest High $0.32 $0.29 $0.48 $1.65 $0.60 $1.88 Digest Low $0.32 $0.29 $0.48 $1.65 $0.56 $1.82 Digest Avg. $0.32 $0.29 $0.48 $1.65 $0.58 $1.84 Digest YoY growth -3.0% -3.3% -9.4% 1.9% 7.7% 11.6% Mgmt Guidance nf nf nf nf nf $1.78-$1.88

MOVI reported 4Q04 adjusted EPS of $0.48 vs. $0.53 last year, two cents below the consensus, and on the low end of management guidance of $0.48-$0.52. Q4’04 GAAP EPS was $0.36 vs. $0.52 last year.

MOVI provided Q105 EPS guidance of $0.56-$0.60. This is based on same-store sales growth of 0.5%- 1.5% and revenue of $228-$233 million. For FY05, MOVI anticipate EPS of $1.78-$1.88.

Two analysts (BB&T and Bear Stearns) have lowered their 2005 EPS estimates to reflect higher expenses from the lease accounting change, gradually declining losses from the company’s investments in alternative movie delivery vehicles, and slightly lower store-level margins, while one analyst (Wells Fargo) has raised its 2005 EPS estimate based on its updated store count and the company’s guidance.

See the MOVI earnings model spreadsheet for more detail on the EPS estimates.

Zacks Investment Research Page 3 www.Zackspro.com Target Price / Valuation Some of the analysts (Bear Stearns, and Wed bush) have raised their price targets following the 4Q04 earnings release. The range of target prices has changed to $20-$32 from the previous range of $14 to $25. The average target price is $27.67.

The analyst (Wells Fargo) with the lowest target price has rated the stock as Hold and has valued it by using a P/E multiple of 11x 2005 EPS estimates, while the analyst (SWS) with the highest target price has also rated it as Buy and has valued it using a P/E multiple of 10x 2005 EPS estimates.

One analyst (SWS) has upgraded their rating on MOVI from Neutral to Long term buy, based on the increased likelihood that MOVI will likely be successful in acquiring HLYW, resulting in significant accretion to earnings.

Another analyst (Well Fargo) has lowered their rating from ‘Buy’ to ‘Hold’ as there are risks that the pending acquisitions of Hollywood Entertainment and VHQ entertainment may not close on time.

Rating Distribution Positive 67% Neutral 33% Negative 0% Avg. Target Price $27.67 Digest High $32.00 Digest Low $20.00

Go to the valuation tab of the MOVI earnings model spreadsheet for more detail on the brokers’ valuation methodologies and individual price targets.

Long-Term Growth Overall, analysts have high expectations for its long-term growth. Out of the six analysts, four have published a long-term growth estimate, showing that many of them are bullish on MOVI’s long-term growth prospects. Analysts believe long-term growth will fall within the range of 12% (BB&T) to 18.5% (Bear Stearns). The Digest average of the company’s long-term growth rate is a robust 15.1%.

Analysts are of the opinion that the transformational merger of MOVI with HYWD creates a leading North American retailer with outstanding prospects for future growth.

According to a few analysts, the industry-wide weakness in video rentals and stiff competition from emerging technologies have rekindled the idea of traditional video retailers soon becoming obsolete. However, these analysts believe the traditional video rental model remains intact; it just needs some tweaking to stay ahead of the emerging technologies that would like to take its place.

There are two main factors that are driving MOVI’s growth: DVDs and video games. The shift from VHS format to DVD is the driving force behind the growth of Movie Gallery’s core rental business. DVDs offer improved picture quality and bonus features that create a more enjoyable viewing experience for the consumer. This is leading to customers replacing their current VHS library in favor of DVDs as well as buying new and previously-viewed DVDs.

What’s more, Movie Gallery has begun selling video games in a store-within-a-store concept called Game Zone. Game Zone will offer customers the ability to buy, sell, or trade video games. This should be a boon to Movie Gallery’s sales growth as it becomes a bigger part of the company’s overall operations.

Zacks Investment Research Page 4 www.Zackspro.com MOVI plans to continue its expansion in FY05 by opening an additional 400 stores, which does not include the pending acquisitions of VHQ in Canada or Hollywood Entertainment. Net of store closing, analysts expect MOVI to open 332 stores.

Additional Conversation

BBI announced the expiration of its tender offer and its decision not to further pursue the acquisition of HLYW, clearing the way for MOVI to acquire HLYW. Analyst believes that the acquisition of HLYW will be extremely accretive to MOVI EPS.

Individual Analyst Opinions POSITIVE RATINGS

BB&T Capital – Buy ($30): report date 03/21/05 The analyst maintains a Buy (1) rating on MOVI. They contend that the stock has had an impressive run since the merger agreement was reached with Hollywood Entertainment, but the risk reward remains favorable in their view because of the significant accretion potential if the acquisition closes.

Bear Stearns – Outperform ($27): report date 03/20/05 Price target raised from $23 to $27. Even though MOVI is certainly up against the same industry challenges as its peer group, the analyst believes that the company has done a superb job managing the business, which has resulted in the relative outperformance of MOVI’s video rental comps versus its competitors. Although the company has grown mostly through acquisition, they anticipate that future growth will be more skewed toward organic store openings; something that they believe bodes well for future profit prospects.

Lehman – Overweight ($30): report date 04/08/05 The analyst raises the target price from $28 to $30 and believes that the acquisition of HLYW will be extremely accretive to MOVI EPS.

SWS – Buy ($32): report date 03/28/05 This particular analyst has raised their rating on MOVI from Neutral to Long-term buy based on their belief of an increased likelihood that MOVI will likely be successful in acquiring HLYW, resulting in significant accretion to earnings.

NEUTRAL RATINGS

Wed bush – Hold ($27): report date 03/18/05 The analyst has raised their price target from $19 to $27 to reflect a reversal of rental decline and a higher peer group multiple.” We consider the company fairly valued, trading above its average historical P/E ratio of 11x, and near our price target. Should MOVI complete its acquisition of Hollywood, we expect substantial earnings accretion, and would revise our estimates. Until we have greater visibility, we are maintaining our HOLD rating.”

Wells Fargo – Hold ($20): report date 03/30/05 “Following Blockbuster's announcement that it would not renew its bid to acquire Hollywood Entertainment, shares of Movie Gallery have run up considerably, as investors appear to assume the deal between Movie Gallery and Hollywood Entertainment will go through. Since shares of video retailers historically trade between 10x and 11x out-year EPS estimates, we believe a share price of $30, or 10x our 2006 estimates of about $3.02 for the combined company, is appropriate. At yesterday's closing price of $29.33, shares of Movie Gallery are trading at close to what we consider to be the fair price of the combined company. As such, we are lowering our rating of MOVI from Buy to Hold.”

NEGATIVE RATINGS

Zacks Investment Research Page 5 www.Zackspro.com