Understanding Movie Gallery's Surge

| About: Movie Gallery (MVGRQ)

Movie Gallery (MOVI) shares continue their recent tear, apparently in anticipation of some major move by the company to improve its balance sheet.

Movie Gallery, which owns both the Movie Gallery and Hollywood Entertainment video store chains, is deeply in debt: as of July 2, it had long-term debt of $1.14 billion, or nearly 10x the company’s $124 million market cap. In March, the company cut a deal with its lenders to relax the financial covenants under its credit facility for four fiscal quarters. The plan announced at the time called for the company to close unprofitable stores, divest non-core assets, consolidate back-office operations and otherwise improve its financial stability.

The speculation on the Street is that the company will take some action to address the coming expiration of the loosened debt covenants; the theory is that there is news coming before year-end. Debtwire, a subscription-based service for credit market players, is reporting that there are rumors of “an imminent balance sheet fix,” triggering a rally in Movie Gallery bonds. The Debtwire story says that the company has hired Goldman Sachs to assist in a restructuring. According to the Debtwire story, the company could launch a $150 million to $200 million “second lien deal” to pay down part of its $795 million in first lien debt. The story says another possibility would be a debt-for-equity swap; that would not be a good outcome for stockholders, since it would involve a massive dilution of the current equity investors. Other rumored possibilities include some kind of transaction with Blockbuster (BBI), the leader in video retailing, or potentially with Netflix (NASDAQ:NFLX).

moviIn a comment on my previous post on Movie Gallery, there is discussion about the possibility that the stock’s rise is the result of a short squeeze; that is possible, but seems unlikely to be the sole answer, given that Movie Gallery’s short-interest position has fallen in each of the last five months, dropping to 9.9 million shares in mid-November from 16.6 million in mid-June, but it could be helping to fan the flames.

A spokesman for the company declined to comment on the stock’s recent rise.

Meanwhile, Citigroup’s Tony Wilbe today dropped his rating on Blockbuster to Hold from Buy, seeing limited upside for the shares at current levels.

Movie Gallery shares today have jumped 36 cents, or 10%, to $3.87. The stock is up 29% this week, and 77% since November 1. Blockbuster is down 7 cents at $5.37.

ADDENDUM: On October 16, 2006, The New York Times reported that Movie Gallery shares dropped sharply in early March after a pair of March 6 conference calls with lenders to talk about how badly the company did in 2005. As I noted above, the company and its lenders negotiated loosened credit covenants. Two weeks after the conference call, Movie Gallery announced its 2005 results. The Times says the SEC is looking into whether any hedge funds used insider information from the conference call to trade in the common stock. You would assume the company remains in contact with its lenders; could a similar scenario be playing out this time, in the opposite direction?