Movie Gallery a Horror Show

Avoid Movie Gallery (MOVI - commentary - Cramer's Take) like the plague.

That is how I sum up my feelings about this beleaguered video rental chain, which is finding it hard to grow sales in the face of competitive threats from technologies like video-on-demand and services such as Netflix (NFLX - commentary - Cramer's Take), while struggling with an ill-conceived acquisition.

Management's actions to date, marked most prominently by an ill-timed acquisition of Hollywood Video earlier in the year, have done little to ameliorate investor disdain for its shares, which were recently trading at $5.11, down about 80% in 2005.

In the quarter ended Oct. 3, Movie Gallery disappointed investors on both the top and bottom lines with sales and EPS of $572 million and a loss of 16 cents a share. In addition, management guided for fourth-quarter revenue of $675 million to $705 million, the midpoint of which is about $40 million shy of most analyst forecasts.

Costs continue to run ahead of most forecasts, and management does little to instill confidence that the trend of negative same-store sales results, which have been a glaring warning sign for much of 2005, are nearing a turning point.

Things began to unwind for Movie Gallery earlier in the year. Faced with competitive and secular challenges, Movie Gallery announced plans to take over competitor Hollywood Video in January, and the deal closed in April. In hindsight, what Movie Gallery should have done was look for ways to cut costs, improve its balance sheet and offer more competitive pricing to ward off emerging threats. Unfortunately for shareholders, management took the road often traveled and attempted to hide its anemic growth by making an (unmanageable) acquisition.

The decision to finance the Hollywood acquisition with debt instead of its inflated equity has exacerbated matters. At the time of the announcement, Movie Gallery's shares were trading near $20, but management chose to take on some $1.1 billion in debt to finance the deal, adding an astounding $80 million in annual interest payments. Although Movie Gallery still has about $69 million in cash and should remain profitable in the near term, its cash flow from operations net of capital expenditures was barely positive in the most recent quarter. And the expected cost savings from the Hollywood deal are still a few quarters away from being realized.

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William Gabrielski is a research associate at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabrielski welcomes your feedback; click here to send him an email.

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