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Unlike a lot of horror flicks, Movie Gallery doesn't build any suspense before diving into the scary stuff. Right in the second paragraph, the company confesses that its net loss for the quarter totaled $17.25 per share. The loss is more than seven times the company's share price today, which is something I don't see very often.
The company classifies the largest part of the loss as a non-cash impairment of goodwill of $14.50 per share after taxes and $527.9 million before taxes. Along with some charges for store closings, there is another non-cash valuation allowance on some of the company's deferred tax assets amounting to $2.69 a share or $85.2 million. The two items labeled as non-cash are worth discussing because Movie Gallery's description of them doesn't do them justice and what the company's actions are telling us are very interesting.
Non-cash here is a funny term. It's true that the specific accounting entries for impairment of goodwill are not cash-related. It's also true that a change in the valuation allowance for deferred tax assets is also a non-cash activity. But for shareholders in a company, that is a very shortsighted view to take, particularly in this case, because there was real cash that was spent to create the goodwill and deferred tax asset balances.
If you peruse the previous few years of filings for Movie Gallery, you'll see that it regularly made small acquisitions. Last year, it worked up the nerve to try to swallow a fish much larger than itself when it paid $850 million in cash and assumed $350 million in debt for Hollywood Video. It's interesting to note that at the end of Movie Gallery's fiscal 2004 fourth quarter (Jan. 2, 2005), the total goodwill balance was $143.8 million, whereas at the end of the fiscal 2005 third quarter (Oct. 2, 2005), the goodwill balance had ballooned to $625.9 million.
If you're guessing that the company acquired Hollywood Video sometime during the first three quarters of fiscal 2005, and that the large goodwill balance is largely a result of this cash acquisition, you'd be right. Because some of the cash Movie Gallery paid for Hollywood Video was above the book value of Hollywood Video's assets, it was accounted for as goodwill. But now $527.9 million of the $625.9 million is being impaired, which is more than all the goodwill recognized since Hollywood Video was acquired for cash. What's unique in this situation is that the whole cycle is taking place one year after the acquisition. Generally, goodwill impairment comes along a few years after the acquisition.
But it's the $85.2 million valuation allowance on the company's deferred tax assets that tells us something more interesting. At the end of the third quarter, the company had a combined (short-term and long-term) deferred tax asset balance of $29 million. It appears that it is not only adjusting these balances, but also losses it incurred in the fourth quarter. Most importantly, however, deferred tax assets are only adjusted down when a company believes it will not be able to realize them in the future -- meaning that Movie Gallery doesn't expect to have profits large enough to take advantage of the deferred tax assets.
The company also provides an adjusted EBITDA figure (earnings before interest, taxes, depreciation, and amortization) that removes all of these non-cash charges and interest and depreciation. My advice is to ignore this number entirely. Instead, scrutinize Movie Gallery's cash flow statement, interest payments, and debt position in its just-filed 10-K. If you find it interesting that the company only provided limited balance sheet and cash flow data in its press release, but provided the whole deal a few hours later in its annual 10-K filing, you're not alone.
I'm not scared off by businesses that have slightly high amounts of debt or are in decline, so long as they have tremendous free cash flows. I own a couple of international telecom stocks for this reason, and I consider Iowa Telecommunications Services
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