Movie Gallery

Information available from Movie Gallery's 2005 10-K and second quarter 2006 10-Q were used in preparing this assessment. The website to locate Movie Gallery's 2005 10-K and second quarter 2006 (10-Q) can be located in the "investor relations" section on Movie Gallery's website at www.moviegallery.com.

Movie Gallery, Inc.'s (the Company) most recent annual report was for the year-ended January 1, 2006 (the 2005 annual report year). The Company operates on a 52 / 53 week year with the year-end date being the Sunday following December 30. This results in some years having 53 weeks of income recorded even though the Company reflects depreciation on a twelve month basis (52 weeks).

For the most recent year-end, the Company incurred a net loss before taxes of almost $550 million. This loss is non consistent with historical amounts reported by the Company. Two significant factors contribute to the loss.

One was the acquisition of Hollywood Video. Hollywood was strapped with large amounts of debt resulting in the Company's interest expense charge increasing almost $68 million from the prior fiscal year. Also, as a result of acquiring Hollywood, the Company wrote-off the pre-acquisition deferred tax balances of Hollywood and set-up new deferred tax balances. These new balances were based on the differences between the amounts of assets and liabilities recorded for financial statement purposes and the underlying tax basis of those assets and liabilities, including amounts assigned to Hollywood's carryover tax attributes. The net impact of this resulted in a decrease to deferred tax assets by $13.1 million.

Additionally, all acquisition transactions initiated after June 30, 2001, require the use of purchase accounting for financial reporting purposes. FAS 141 discusses purchase accounting and requires the price to be allocated to all assets acquired and liabilities assumed based on their fair market values. The excess purchase price is then allocated to goodwill and instead of being amortized, is tested for impairment each year.

This leads us into the other major factor contributing to the net loss for 2005. It was a significant write-down of $523 million for goodwill and other intangible assets to fair market value in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets". Since most acquisitions by the Company, including the Hollywood acquisition, are completed by acquiring the stock of the target company, the tax attributes of the target companies carry over to the Company. As a result, goodwill is recorded for book purposes (pursuant to FAS 141 above) on these transactions and not recorded for tax purposes. Accordingly, when this goodwill is impaired and written-down for book purposes, there is no related tax deduction. It ends up being a permanent difference which has a significant effect on the effective tax rate of the Company.

As you can see in the financial statements, the income tax provision for the recent year-end is $2.8 million on a $550 million loss, as compared to a $32 million income tax provision on $81 million of pre-tax income in each of the previous two years. This, in turn, adversely impacts the effective tax rate. Of the current income tax expense, $2.4 million is current taxes payable and $0.3 million is related to an $18.8 million change in deferred tax assets and liabilities from the prior year.

The Company's effective tax rate for 2005 is a negative 0.5%. This is not anywhere near historical results with effective tax rates of 39.3% and 39.1% for 2003 and 2004. As stated above, the dramatic change was primarily due to the goodwill impairment charges, much of which was nondeductible for tax purposes. The other major factor to the dramatic decrease to the effective tax rate was an increase to the valuation allowance on deferred tax assets of $88.5 million. The goodwill impairment and valuation allowance resulted in a negative 21.1% and 15.5% impact to the effective tax rate, respectively, based on the federal statutory rate of 35%.

Pursuant to the rules provided in FAS 109, Accounting for Income Taxes, requires a review of all available evidence to determine whether or not a reduction in deferred tax assets is necessary. A valuation allowance will then be deemed necessary if the evidence supports the conclusion that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Some of the evidence that was looked at in determining if sufficient taxable income would be available to decide if the deferred tax asset would be realizable was: a) whether and to what extent existing taxable temporary differences will reverse in the future, b) the amount of future taxable income before any adjustments for future taxable temporary difference reversals, and c) tax planning strategies.

As a result of this review, it was determined to increase the valuation allowance of the Company in 2005. If this valuation allowance reverses in future periods due to the Company becoming more profitable, the effective tax rate will continue to be lower. Conversely, if net losses before taxes continue to be realized, the valuation allowance in future years may need to be increased thereby also resulting in a lower than historical effective tax rate.

The Company has significantly large net operating loss carryforwards of approximately $429 million for federal and $359 million for state purposes. These were almost entirely the result of loss carryforwards