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Movie Gallery (MOVI) stock has defied the recent market downturn since reporting blowout Q1 earnings of $1.27 (.97 after one-time charges) on May 10th. Investors have responded by pushing the stock from the low 3s to over $7 a share. Are they on to the next big thing? On a P/E basis the stock isn't expensive, management talks of a $50 mil cash savings to be achieved by year end through the continued integration of Hollywood Video, and they put up that big earnings number in a challenging home video store-rental environment. So, what could be wrong with this picture?

In a word - debt.

Company Overview

Movie Gallery, Inc. is the second-largest North American home entertainment specialty retailer with more than 4,700 stores located in all 50 U.S. states, Mexico and Canada. Since the Company’s initial public offering in August 1994, Movie Gallery has grown from 97 stores to its present size through acquisitions and new store openings. In April 2005, Movie Gallery acquired industry peer Hollywood Entertainment bringing total annual revenue for the Company to over $2.5 billion.
Business Description

Movie Gallery US, Inc. is a home video specialty retailer primarily focused on the rental and sale of DVD and VHS movies and video games. The Company owns and operates approximately 4,700 retail stores throughout North America under the subsidiaries Movie Gallery US, Inc. and Hollywood Entertainment Corp.

The Movie Gallery subsidiary stores, operating under the Movie Gallery brand, primarily target small towns and rural areas. By focusing on rural and secondary markets, the Company is able to compete effectively against independently-owned stores and small regional chains in these areas. The Hollywood Entertainment subsidiary stores, operating under the Hollywood Video and Game Crazy brands, primarily target urban centers and surrounding suburban neighborhoods. The combined companies create a national organization with a strong presence in both rural and urban markets.

However, the bricks and mortar video rental market is experiencing a secular decline at the hands of online rental, video on demand, and internet downloads. Worse still, MOVI has close to $1.1 Billion of debt. Q1 interest expense was a tidy $27.4 mil, which annualizes out to over $109 mil per year, pre-tax. With 31.8 mil shares out, MOVI has to generate operating income of over $3.40 per share, just to pay their interest expense this year - not to pay back any principal, let alone generate any excess cash flow. Before taking on Hollywood Entertainment, MOVI didn't have this onerous debt obligation. They stayed busy competing effectively in the rural niche, generating steady profits, growing their cash, increasing their store base. They then decided they wanted to move into urban markets, and they borrowed heavily to do it. Doesn't this sound a little like one of those "interest only" real estate loans that someone may have taken out to buy a $2 mil apartment that they couldn't afford (but enjoyed living in and "owning"), only to watch the real estate market stall while experiencing a little job insecurity?

So, back on March 15th, Movie Gallery bought themselves a little time with their lenders, more specifically, the rest of this year, so that they shouldn't be in jeopardy of violating any of their bank covenants until Q1 2007. But, at Q1 '07, MOVI's debt leverage ratio (Debt minus cash/trailing 12 mo. operating cash flow) stipulates nothing higher than 2.25. Right now that ratio hovers around 5. So, not only is the first $109 million of operating income flying out the window on interest expense - but in just a short 6-7 months - unless the company can somehow lop a few hundred million of principal off their debt (highly unlikely, unless they get a large cash infusion from somebody) while increasing operating cash flow dramatically (not likely, with a weak movie release schedule slated through the end of Sept.), Movie Gallery is heading toward violating their bank covenants. If this occurs, the company will be facing higher interest rates (again), a restructuring (rationalizing of the store base; more layoffs), or worse.

In the meantime, the company is taking steps to cut costs, enhance revenue streams, and raise cash. They are working on sub-leasing space in up to 2200 stores, and are looking to re-negotiate leases at up to another 1100 stores. There's the possibility of divesting non-core assets like GameCrazy; there have been rumors of a cash infusion; a shareholder rights offering could be in the offing. But the debt cloud hovers heavily overhead, and it also jacks the enterprise value of MOVI to around $1.27 Bil, or more than 6x trailing 12 month EBITDA. It is noteworthy that MOVI paid closer to 5.4x 2005 EV/EBITDA for Hollywood Entertainment in April 2005, and that was before video rental sales slumped later last year. Will a white knight come along with a cash infusion at higher prices in a declining industry one year later, today? Or, for that matter, for individual investors, Is MOVI stock really all that cheap today?

We are not enthusiastic about MOVI stock's prospects despite the strong earnings number in Q1. We caution longs in the name to examine their premises in regard to their ownership positions in the stock.

Read the 10-q

Source: Movie Gallery: What's Wrong With This Picture?