HASTINGS ENTERTAINMENT INC – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 Forward-looking Statements Certain written and oral statements set forth below or made by Hastings with the approval of an authorized executive officer constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The words "believe," "expect," "intend," "anticipate," "project," "will" and similar expressions identify forward-looking statements, which generally are not historical in nature. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future including statements relating to the business, expansion, merchandising and marketing strategies of Hastings, industry projections or forecasts, inflation, effect of critical accounting policies including lower of cost or market for inventory adjustments, the returns process, rental asset depreciation, store closing reserves, impairment or disposal of long-lived assets, revenue recognition, and vendor allowances, sufficiency of cash flow from operations and borrowings under our revolving credit facility and statements expressing general opinions about future operating results are forward-looking statements. Such statements are based upon our management's current estimates, assumptions and expectations, which are based on information available at the time of the disclosure, and are subject to a number of factors and uncertainties, including, but not limited to, consumer appeal of our existing and planned product offerings, and the related impact of competitor pricing and product offerings; overall industry performance and the accuracy of our estimates and judgments regarding trends; our ability to obtain favorable terms from suppliers; our ability to respond to changing consumer preferences, including with respect to new technologies and alternative methods of content delivery, and to effectively adjust our offerings if and as necessary; the application and impact of future accounting policies or interpretations of existing accounting policies; whether our assumptions turn out to be correct; our inability to attain such estimates and expectations; a downturn in market conditions in any industry relating to the products we inventory, sell or rent; the degree to which we enter into and maintain vendor relationships; the challenging times that the U.S. and global economies are currently experiencing, the effects of which have had and will continue to have an adverse impact on spending by Hastings' current retail customer base and potential new customers, and the possibility that general economic conditions could deteriorate further; volatility of fuel and utility costs; acts of war or terrorism inside the United States or abroad; unanticipated adverse litigation results or effects; the effect of inclement weather on the ability of consumers to reach our stores and other factors which may be outside of our control; any of which could cause actual results to differ materially from those described herein. We undertake no obligation to affirm, publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The following discussion should be read in conjunction with the unaudited consolidated financial statements of the Company and the related notes thereto appearing elsewhere in this Quarterly Report on Form 10-Q. General Incorporated in 1972, Hastings Entertainment, Inc. (the "Company," "Hastings," or "Hastings Entertainment") is a leading multimedia entertainment retailer. We operate entertainment superstores that buy, sell, trade and rent various home entertainment products, including books, music, software, periodicals, movies on DVD and Blu-ray, video games, video game consoles and consumer electronics. We also offer consumables and trends products such as apparel, t-shirts, action figures, posters, greeting cards and seasonal merchandise. As of October 31, 2011, we operated 143 superstores principally in medium-sized markets located in 20 states, primarily in the Western and Midwestern United States. We also operate three concept stores, Sun Adventure Sports, located in Amarillo, Texas and Lubbock, Texas, and TRADESMART, located in Littleton, Colorado. We also operate a multimedia entertainment e-commerce web site offering a broad selection of books, software, video games, movies on DVD and Blu-ray, music, trends, and consumer electronics. We fill orders for new and used product placed at this website and also through Amazon Marketplace using our proprietary goShip program, which allows us to ship directly from stores. We have one wholly-owned subsidiary, Hastings Internet, Inc. References herein to fiscal years are to the twelve-month periods that end in January of each following calendar year. For example, the twelve-month period ending January 31, 2012 is referred to as fiscal 2011.                                           10

--------------------------------------------------------------------------------

Table of Contents

  Critical Accounting Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe the following critical accounting estimates comprise our more significant estimates and assumptions used in the preparation of our financial statements. Our significant estimates and assumptions are reviewed, and any required adjustments are recorded, on a monthly or quarterly basis. Lower of Cost or Market for Merchandise Inventory. Our merchandise inventories are recorded at the lower of cost, which approximates the first-in, first-out ("FIFO") method, or market. As with any retailer, economic conditions, cyclical customer demand and changes in purchasing or distribution can affect the carrying value of inventory. As circumstances warrant, we record the lower of cost or market inventory adjustments. In some instances, these adjustments can have a material effect on the financial results of an annual or interim period. In order to determine such adjustments, we evaluate the age, inventory turns and estimated market value and returnability of merchandise inventory by product category and record an adjustment if estimated market value is below cost. Rental Asset Depreciation. We have established rental asset depreciation policies that match rental product costs with the related revenues. These policies require that we make significant estimates, based upon our experience, as to the ultimate amount and timing of revenue to be generated from our rental product. We utilize an accelerated method of depreciation because it approximates the pattern of demand for the product, which is higher when the product is initially released by the studios for rental and declines over time. In establishing salvage values for our rental product, we consider the sales prices and sales volume of our previously rented product and other used product. We currently depreciate the cost of our rental assets on an accelerated basis over six months or nine months, except for rental assets purchased for the initial stock of a new store, which are depreciated on a straight-line basis over 36 months. Rental assets, which include DVDs, Books on CD and Video Games, are depreciated to salvage values ranging from $4 to $10. Rental assets purchased for less than established salvage values are not depreciated. We also review the carrying value of our rental assets to ensure that estimated future cash flows exceed the carrying value. We periodically record adjustments to the value of previously rented product primarily for estimated obsolescence or excess product based upon changes in our original assumptions about future demand and market conditions. If future demand or actual market conditions are less favorable than our original estimates, additional adjustments, including adjustments to useful lives or salvage values, may be required. We continually evaluate the estimates surrounding the useful lives and salvage values used in depreciating our rental assets. Changes to these estimates resulting from changes in consumer demand, changes in customer preferences or the price or availability of retail products may materially impact the carrying value of our rental assets and our rental margins. The costs of rental product purchased pursuant to revenue-sharing arrangements, which are recorded in rental cost of sales on the consolidated statements of operations, typically include a lower initial product cost than traditional rental purchases with a certain percentage of the net rental revenues shared with studios over an agreed period of time. Any up-front costs exceeding the designated salvage value are amortized on an accelerated basis, and revenue-sharing payments pursuant to the applicable arrangement are expensed as rental cost of sales as the related revenue is earned. Additionally, certain titles have performance guarantees. We analyze titles that are subject to performance guarantees and recognize an estimated expense for under-performing titles throughout the applicable period based upon our analysis of the estimated rental revenue shortfall. We revise these estimates on a monthly basis, based on actual results. Impairment or Disposal of Long-Lived Assets. We evaluate under-performing stores on a quarterly basis to determine whether projected future cash flows over the remaining lease term are sufficient to recover the carrying value of the fixed asset investment in each individual store. If projected future cash flows are less than the carrying value of the fixed asset investment, an impairment charge is recognized if the estimated fair value is less than the carrying value of such assets. The carrying value of leasehold improvements, in addition to certain other property and equipment, is subject to impairment write-down.                                           11

--------------------------------------------------------------------------------

Table of Contents

  Income Taxes. In determining net income (loss), we make certain estimates and judgments in the calculation of the tax provision and the resulting tax liabilities and in the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense. We record deferred tax assets and liabilities for future income tax consequences that are attributable to differences between financial statement carrying amounts of assets and liabilities and their income tax bases. We base the measurement of deferred tax assets and liabilities on enacted tax rates that we expect will apply to taxable earnings in the year when we expect to settle or recover those temporary differences. We recognize the effect on deferred tax assets and liabilities on any change in income tax rates in the period that includes the enactment date. The tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood, on a cumulative basis, of being realized upon ultimate settlement. We recognize interest and penalties relating to any uncertain tax positions as a component of income tax expense. Share-Based Compensation. Determining the amount of share-based compensation to be recorded in the statement of operations requires us to develop estimates that are used in calculating the grant-date fair value of stock options. In determining the fair value of stock options, we use the Black-Scholes valuation model, which requires us to make estimates of the following assumptions:     •    Expected volatility - The estimated stock price volatility is derived          based upon our historical stock prices over the expected life of the          option.       •    Expected life of the option - The estimate of an expected life is          calculated based on historical data relating to grants, exercises and          cancellations, as well as the vesting period and contractual life of the          option.       •    Risk-free interest rate - The risk-free interest rate is based on the          yield on zero-coupon U.S. Treasury securities for a period that is          commensurate with the expected life of the option.   Our stock price volatility and expected option lives involve management's best estimates at the grant date, both of which impact the fair value of the option calculated under the Black-Scholes pricing model and, ultimately, the expense that will be recognized over the vesting period of the option. We recognize compensation expense only for the portion of options that are expected to vest. Therefore, we apply estimated forfeiture rates that are derived from historical employee termination behavior. If the actual number of forfeitures differs from those estimated by management, additional adjustments to compensation expense may be required in future periods. In addition to stock options, we award restricted stock awards, including restricted stock units and performance-based restricted stock awards. The grant date fair value of restricted stock awards is equal to the average of the opening and closing stock price on the day on which they are granted. For performance-based restricted stock awards, compensation expense is recognized if management deems it probable that the performance conditions will be met. Management must use its judgment to determine the probability that a performance condition will be met. If actual results differ from management's assumptions, future results could be materially impacted. Gift Card Breakage Revenue. We sell gift cards through each of our stores and through our web site www.goHastings.com. The gift cards we sell have no stated expiration dates or fees and are subject to potential escheatment rights in some of the jurisdictions in which we operate. Gift card liabilities are recorded as deferred revenue at the time of sale of such cards, with the costs of designing, printing and distributing the cards recorded as expense as incurred. Prior to the fourth quarter of fiscal 2009, the liability was relieved and revenue was recognized only upon redemption of the gift cards. Beginning in the fourth quarter of fiscal 2009, we had sufficient historical data to analyze gift card redemption patterns and a final determination of the escheatment laws applicable to our operations. As a result, during the fourth quarter of fiscal 2009, we recorded approximately $8.5 million of revenue related to the initial change in estimated breakage on gift cards we previously issued and sold. Subsequent to the initial change in estimate related to gift card breakage, gift card breakage revenue is recognized as gift cards are redeemed, based upon an analysis of the aging and utilization of gift cards, our determination that the likelihood of future redemption is remote and our determination that such balances are not subject to escheatment laws applicable to our operations.                                           12

--------------------------------------------------------------------------------

Table of Contents

  Results of Operations The following tables present our statement of operations data, expressed as a percentage of revenue, and the number of superstores open at the end of the periods presented herein.                                             Three Months Ended                Nine Months Ended                                                October 31,                      October 31,                                           2011             2010             2011            2010  Merchandise revenue                          85.3 %           84.1 %           84.5 %          83.5 % Rental revenue                               14.6             15.8             15.4            16.3 Gift card breakage revenue                    0.1              0.1              0.1             0.2  Total revenues                              100.0            100.0            100.0           100.0  Merchandise cost of revenue                  70.4             68.9             69.4            68.5 Rental cost of revenue                       39.8             36.5             38.8            37.0  Total cost of revenues                       65.8             63.7             64.6            63.3   Gross profit                                 34.2             36.3             35.4            36.7  Selling, general and administrative expenses                                     42.5             40.7             39.2            37.7 Pre-opening expenses                            -                -              0.1               -   Operating loss                               (8.3 )           (4.4 )           (3.8 )          (1.0 )  Other income (expense): Interest expense                             (0.4 )           (0.2 )           (0.3 )          (0.1 ) Other, net                                    0.1                -                -               -   Loss before income taxes                     (8.6 )           (4.6 )           (4.0 )          (1.1 )  Income tax benefit                           (3.5 )           (1.9 )           (1.4 )          (0.5 )   Net loss                                     (5.1 )%          (2.7 )%          (2.7 )%         (0.6 )%   

Summary of Superstore Activity (1)

                                   Three Months Ended                Nine Months Ended            Year Ended                                       October 31,                      October 31,              January 31,                                  2011             2010            2011             2010             2011  Beginning number of stores           145              147             146              149               149 Openings                               -                -               1                -                 - Closings                              (2 )             (1 )            (4 )             (3 )              (3 )  Ending number of stores              143              146             143              146               146   

(1) As of October 31, 2011, we operated three concept stores, including two Sun

Adventure Sports and one TRADESMART, which were not included in the summary

      of superstore activity. TRADESMART was opened August 2011. Our two Sun       Adventure Sports stores were opened June 2010 and October 2011.                                            13 

--------------------------------------------------------------------------------

Table of Contents

Financial Results for the Third Quarter of Fiscal Year 2011 Revenues. Total revenues for the third quarter decreased approximately $3.7 million, or 3.3%, to $108.6 million compared to $112.3 million for the third quarter of fiscal 2010. As of October 31, 2011, we operated three fewer Hastings superstores, as compared to October 31, 2010. The following is a summary of our revenues results (dollars in thousands):

                                            Three Months Ended October 31,                                         2011                          2010                       Decrease                                               Percent                       Percent                               Revenues       Of Total       Revenues       Of Total        Dollar       Percent Merchandise Revenue           $  92,638           85.3 %    $  94,462           84.1 %    $ (1,824 )        -1.9 % Rental Revenue                   15,841           14.6 %       17,673           15.8 %      (1,832 )       -10.4 % Gift Card Breakage Revenue          145            0.1 %          149            0.1 %          (4 )        -2.7 %  Total Revenues                $ 108,624          100.0 %    $ 112,284          100.0 %    $ (3,660 )        -3.3 %   

Comparable-store revenues ("Comp")

                               Total            -4.4 %                               Merchandise      -2.9 %                               Rental          -11.8 %   Below is a summary of the Comp results for our major merchandise categories:                                     Three Months Ended October 31,                                      2011                   2010                 Trends                    11.1 %                 19.0 %                 Hardback Café              6.7 %                  7.2 %                 Electronics                3.6 %                 -0.4 %                 Music                     -2.6 %                 -6.2 %                 Movies                    -3.4 %                  5.6 %                 Books                     -4.5 %                 -6.2 %                 Consumables               -6.6 %                  3.4 %                 Video Games               -9.4 %                  6.7 %   Stores included in the Comps calculation are those stores that have been open for a minimum of 60 weeks. Also included are stores that were remodeled or relocated during the comparable period. Gift card breakage revenues are not included, and closed stores are removed from each comparable period for the purpose of calculating Comps. Trends Comps increased 11.1% for the quarter, primarily due to increased sales of apparel, action figures, novelty items, new comics and collectible card games such as Magic: The Gathering. Key drivers in the apparel category included hats, jewelry and bags. Key drivers in the novelty category included assorted tween merchandise, movie memorabilia merchandise and barware. Hardback Café Comps increased 6.7% during the quarter resulting from increased sales of blended, iced and hot specialty café drinks, partially offset by increased promotional pricing during the quarter. Electronics Comps increased 3.6% for the quarter primarily due to increased sales of headphones, computer accessories and MP3 player accessories, partially offset by lower sales of refurbished iPods. Sales of refurbished iPods were impacted by lower inventory due to reduced availability in the supply chain. Music Comps decreased 2.6% for the quarter primarily resulting from lower sales of used and new CDs. Movie Comps decreased 3.4% for the quarter primarily due to lower sales of new and used DVDs and DVD boxed sets, partially offset by increased sales of Blu-ray movies. Books Comps decreased 4.5% for the quarter resulting from increased promotional pricing during the quarter along with decreased sales of new mass market books and hardbacks and magazines, partially offset by increased sales of used hardbacks, trade paperbacks and mass market books. Sales of new books were negatively impacted by a weaker slate of new releases for the current quarter and by the increasing popularity of electronic book readers. Consumables Comps decreased 6.6% for the quarter primarily due to lower sales of assorted candies, popcorn and bottled drinks. Video Game Comps decreased 9.4% for the quarter primarily as a result of lower sales of video game consoles, new video games for the Nintendo Wii and Microsoft XBOX 360, and older generation video games. These decreases were partially offset by increased sales of used video game accessories and new Sony Playstation 3 video games. Sales of new video games were negatively impacted by a significantly weaker slate of new releases during the current quarter.                                           14 

--------------------------------------------------------------------------------

Table of Contents

  Rental Comps decreased 11.8% for the third quarter, primarily resulting from fewer rentals of DVDs, along with increased promotional pricing during the quarter, partially offset by increased rentals of Blu-ray movies. Rental Video Comps decreased 12.7% during the quarter, and units rented decreased 9.4%. Rental Video Comps were negatively impacted by a lower quality of new releases during the current period and by competitor rental kiosks and subscription-based rental services. Rental Video Game Comps decreased 5.1% for the quarter, and units rented decreased 8.4%. Gross Profit - Merchandise. For the third quarter, total merchandise gross profit dollars decreased approximately $1.9 million, or 6.5%, to $27.5 million from $29.4 million for the same period in the prior year, primarily due to lower merchandise margin rates along with lower revenues. As a percentage of total merchandise revenue, merchandise gross profit decreased to 29.6% for the quarter compared to 31.1% for the same period in the prior year, resulting primarily from increased promotional pricing during the quarter and a shift in mix of revenues by category as compared to the prior year, along with increased freight costs, partially offset by lower shrinkage expense, lower costs to return products and lower markdown expense. The decrease in shrinkage expense is a direct result of our comprehensive store audit program that assesses store level execution and controls designed to reduce shrink, with a strong focus on our high-shrinkage stores. Gross Profit - Rental. For the third quarter, total rental gross profit dollars decreased approximately $1.7 million, or 15.2%, to $9.5 million from $11.2 million for the same period in the prior year, primarily due to lower revenues along with lower rental margin rates. As a percentage of total rental revenue, rental gross profit decreased to 60.2% for the quarter compared to 63.5% for the same period in the prior year, also primarily due to lower revenues, partially offset by lower shrinkage expense. Selling, General and Administrative Expenses ("SG&A"). As a percentage of total revenue, SG&A increased to 42.5% for the third quarter compared to 40.7% for the same period in the prior year due to deleveraging resulting from lower revenues. SG&A increased approximately $0.5 million during the quarter, or 1.1%, to $46.2 million compared to $45.7 million for the same quarter last year. The main drivers increasing SG&A included an increase in store labor costs of approximately $0.3 million, an increase of approximately $0.1 million in store maintenance costs and an increase of approximately $0.1 million in store supplies. These increases were primarily offset by a decrease in store utility costs of approximately $0.2 million and a decrease in occupancy costs of approximately $0.2 million. Interest Expense. For the third quarter, interest expense remained consistent at $0.4 million. Higher average debt levels during the quarter were offset by a lower average rate of interest incurred during the quarter. The average rate of interest charged for the third quarter decreased to 2.7% compared to 3.0% for the same period in the prior year.                                           15

--------------------------------------------------------------------------------

Table of Contents

  Financial Results for the Nine Months Ended October 31, 2011 Revenues. Total revenues for the nine months ended October 31, 2011 decreased approximately $17.2 million, or 4.8%, to $343.3 million compared to $360.5 million for the nine months ended October 31, 2010. The following is a summary of our revenues results (dollars in thousands):                                            Nine Months Ended October 31,                                         2011                          2010                   Increase (Decrease)                                               Percent                       Percent                               Revenues       Of Total       Revenues       Of Total          Dollar         Percent Merchandise Revenue           $ 289,929           84.5 %    $ 301,175           83.5 %    $    (11,246 )        -3.7 % Rental Revenue                   52,792           15.4 %       58,801           16.3 %          (6,009 )       -10.2 % Gift Card Breakage Revenue          575            0.1 %          537            0.2 %              38           7.1 %  Total Revenues                $ 343,296          100.0 %    $ 360,513          100.0 %    $    (17,217 )        -4.8 %   

Comparable-store revenues ("Comp")

                               Total            -5.3 %                               Merchandise      -4.2 %                               Rental          -10.8 %   Below is a summary of the Comp results for our major merchandise categories:                                      Nine Months Ended October 31,                                      2011                   2010                 Trends                    10.9 %                 12.9 %                 Hardback Café              5.1 %                 10.9 %                 Electronics                1.8 %                  1.7 %                 Music                     -2.3 %                 -6.2 %                 Video Games               -3.6 %                 18.4 %                 Movies                    -7.1 %                  8.8 %                 Books                     -7.8 %                 -3.0 %                 Consumables               -7.3 %                  5.7 %   Trends Comps increased 10.9% for the period primarily due to increased sales of apparel, new comics, novelty items, action figures and collectible card games such as Magic: The Gathering. Key drivers in the apparel category included hats, jewelry and bags. Key drivers in the novelty category included assorted tween merchandise, movie memorabilia merchandise, barware and lighting. Hardback Café Comps increased 5.1% for the period primarily resulting from increased sales of specialty café drinks, primarily blended and iced drinks. Electronics Comps increased 1.8% during the period due to increased sales of headphones, computer accessories and refurbished iPods, partially offset by lower sales of Blu-ray players. Music Comps decreased 2.3% during the period resulting from lower sales of used CDs, partially offset by a slight increase in vinyl album sales. Video Game Comps decreased 3.6% for the period, primarily due to lower sales of new video games for the Nintendo Wii, new and used video game consoles and older generation video games. These decreases were partially offset by an increase in sales for used video gaming accessories and new and used video games for the Microsoft XBOX 360. Movie Comps decreased 7.1% during the period, primarily resulting from decreased sales of DVD boxed sets, along with new and used DVDs, partially offset by strong sales of Blu-ray movies. Consumable Comps decreased 7.3% during the period due to lower sales of bottled drinks, promotional and assorted candies and fountain drinks. Book Comps decreased 7.8% during the period primarily resulting from lower sales of new mass market books, hardbacks and trade paperbacks, along with magazines. Sales of new books were negatively impacted by the increasing popularity of electronic book readers. These decreases were partially offset by a slight increase in sales of used hardbacks and value books. Rental Comps decreased 10.8% during the period primarily due to fewer rentals of DVDs partially offset by an increase in rentals of Blu-ray movies and a slight increase in video game rentals. Rental Video Comps decreased 12.2% for the period and units rented decreased 11.9%. Rental Video Comps were negatively impacted by a lower quality of new releases during the current period and by competitor rental kiosks and subscription-based rental services. Rental Video Game Comps increased 1.2%, while units rented decreased 2.6%.                                           16

--------------------------------------------------------------------------------

Table of Contents

  Gross Profit - Merchandise. For the current nine months, total merchandise gross profit dollars decreased approximately $6.1 million, or 6.4%, to $88.7 million from $94.8 million for the same period in the prior year, primarily due to lower revenues, along with lower merchandise margin rates. As a percentage of total merchandise revenue, merchandise gross profit decreased to 30.6% for the current nine months, compared to 31.5% for the same period in the prior year, primarily due to increased promotional pricing, increased freight costs and increased costs to return products, partially offset by lower shrinkage expense and lower markdown expense. The decrease in shrinkage expense is a direct result of our comprehensive store audit program that assesses store level execution and controls designed to reduce shrink, with a strong focus on our high-shrinkage stores. Gross Profit - Rental. For the current nine months, total rental gross profit dollars decreased approximately $4.7 million, or 12.7%, to $32.3 million from $37.0 million for the same period in the prior year primarily due to lower revenues, along with lower rental margin rates. As a percentage of total rental revenue, rental gross profit decreased to 61.2% for the current nine month period compared to 63.0% for the same period in the prior year, also primarily as a result of lower rental revenues. Selling, General and Administrative Expenses ("SG&A"). As a percentage of total revenue, SG&A increased to 39.2% for the current nine months compared to 37.7% for the same period in the prior year primarily due to deleveraging resulting from lower revenues. SG&A decreased approximately $1.2 million, or 0.9%, to $134.6 million compared to $135.8 million for the same period last year. The main drivers of the decrease in SG&A included a decrease in bonuses under our bonus incentive programs of approximately $0.7 million, a decrease in associate health insurance costs of approximately $0.5 million, and a decrease in advertising expenses of approximately $0.6 million. These decreases were partially offset by an increase in store maintenance costs of approximately $0.5 million. Interest Expense. For the current nine months, interest expense increased approximately $0.2 million, or 28.6%, to $0.9 million, compared to $0.7 million for the same period in the prior year primarily as a result of higher interest rates. The average rate of interest charged for the current nine months increased to 2.6% compared to 2.4% for the same period in the prior year. Income Tax Benefit. The effective tax rate for the nine months ended October 31, 2011 was 33.9%, as compared to 45.7% for the same period in the prior year. This rate difference resulted primarily from the relationship between permanent book to tax differences incurred in comparison to the level of book income or loss before taxes for the respective periods. The rate was also affected by certain state margin and other franchise related taxes that are not based on income or loss before taxes and as such remain consistent between the periods while the Company's loss before taxes was significantly more than the same period in the prior year. Additionally, during the nine months ended October 31, 2010, we recorded a discrete tax benefit of approximately $0.2 million related to amended state returns resulting from an Internal Revenue Service audit of our previously filed Federal tax returns. Store Closures During the third quarter, we closed two underperforming stores which gave us a total of four superstore closures for the nine months ended October 31, 2011. We have decided to close two additional stores during the fourth quarter. These stores, which have previously been impaired, will have future lease payments remaining that will require the recording of additional abandoned lease charges. These charges will be recorded in our financial statements in the month they actually close, and depending on our ability to find subtenants or negotiate buyouts with the landlords, they could have a material impact on our earnings for the fourth quarter and full fiscal year. The closing of under performing stores is expected to have a favorable impact on future store operating profit. Liquidity and Capital Resources We generate cash from operations from the sale of merchandise and the rental of products, most of which is received in cash and cash equivalents. Our primary sources of working capital are cash flow from operating activities including trade credit from vendors and borrowings under our revolving credit facility, with the most significant source during the first nine months of fiscal 2011 and 2010 being borrowings under our revolving credit facility. Other than our principal capital requirements arising from the purchasing, warehousing and merchandising of inventory and rental products, opening new stores and expanding or reformatting existing stores and updating existing and implementing new information systems technology, we have no anticipated material capital commitments, except for the stock buyback programs discussed more fully in Item 2 of Part II of this Quarterly Report on Form 10-Q. We believe our cash flow from operations and borrowings under our revolving credit facility will be sufficient to fund our ongoing operations, new stores, store expansions, and store reformations for the next twelve months.                                           17

--------------------------------------------------------------------------------

Table of Contents

At October 31, 2011, total outstanding debt was approximately $54.9 million. We project our outstanding debt level will be in the range of $45.0 million to 47.0 million by the end of fiscal 2011. At October 31, 2011, we had approximately $46.2 million in excess availability, after the $10 million availability reserve, under the Amended Agreement (as defined below). Consolidated Cash Flows

Operating Activities. Net cash used by operating activities totaled

approximately $12.7 million for the nine months ended October 31, 2011,

     compared to cash provided by operating activities of $7.0 million for the      nine months ended October 31, 2010. Net loss for the current period was

approximately $9.2 million compared to $2.1 million for same period in fiscal

2010. Merchandise inventories increased approximately $27.6 million for the

current period, compared to $11.0 million during the same period in fiscal

2010 primarily due to differences in the timing and amount of inventory

build-up based on anticipated sales for the holiday season, along with the

build of inventory for our new TRADESMART store which opened August 1, 2011

and the build of inventory related to our roll-out of electronic book reader

tablets. Trade accounts payable increased $21.8 million for the current

period compared to an increase of $21.3 million during the same period in

fiscal 2010. Merchandise inventories, net of trade accounts payable,

increased approximately $5.8 million for the current period compared to a

decrease of $10.2 million for the same period in the prior year primarily due

to the higher increase in merchandise inventories in the current period and

differences of timing of payments to vendors surrounding the holiday

purchases in the current year compared to the prior year. Accrued expenses

and other liabilities increased approximately $0.2 million during the current

period compared to a decrease of $1.2 million during the same period in

fiscal 2010 primarily due to the timing of payments of property taxes, along

     with higher salary accruals as compared to the prior year.        Investing Activities. Net cash used in investing activities increased      approximately $3.6 million from $9.3 million for the nine months ended      October 31, 2011, to $12.9 million for the nine months ended October 31,

2011. This increase was primarily due to increased expenditures related to

two new stores opened during fiscal 2011. For fiscal 2011, we project capital

expenditures to be approximately $16.1 million. The planned increase is

primarily due to increased expenditures related to the opening of three

stores, the remodeling of two stores, and the relocating of one store planned

     to take place during the fourth quarter.        Financing Activities. Cash provided by or used in financing activities is

primarily associated with borrowings and payments made under our revolving

credit facility (described below under "Capital Structure"). For the nine

months ended October 31, 2011, cash provided by financing activities was

approximately $24.6 million compared to $0.1 million for the nine months

ended October 31, 2010. For the current nine months, net borrowings from our

revolving credit facility were approximately $23.2 million compared to net

borrowings of approximately $5.9 million for same period in the prior year.

Changes in our cash overdraft position increased from cash provided of

approximately $3,000 for the nine months ended October 31, 2010 to cash

provided of $3.0 million for the nine months ended October 31, 2011, due to

the timing of payments issued to vendors during the period. The Company

purchased approximately $1.6 million of treasury stock during the nine months

ended October 31, 2011 compared to $5.5 million during the nine months ended

October 31, 2010.

   On December 4, 2009, we entered into a stock transfer agreement with the Marmaduke Family Limited Partnership (the "Partnership"). Under the stock transfer agreement, for a period of three years following the death of Mr. John H. Marmaduke, the Company's President and Chief Executive Officer, the Partnership may tender for purchase to the Company, and, if so tendered, the Company will be required to purchase, the number of shares of the Company's common stock belonging to the Partnership that equal an aggregate fair market value of $5.0 million. During this three year period, the Partnership may elect to tender portions of such                                           18 

--------------------------------------------------------------------------------

Table of Contents

  shares in various lots and parcels, at any time and from time to time, and any tender shall not exhaust or limit the Partnership's right to tender an additional amount of such shares, subject to the limitations set within the stock transfer agreement. Under the stock transfer agreement, the Company is not obligated to purchase, and the Partnership does not have the right to tender, any amount of such shares with an aggregate fair market value in excess of $5.0 million. In the event that Mr. Marmaduke resigns as an officer or director of the Company prior to his death, the Partnership's right to tender the shares to the Company shall terminate. The stock transfer agreement shall terminate on the earlier of February 9, 2019, or four years after the death of Mr. Marmaduke. The Company is currently the beneficiary of a $10 million key-man life insurance policy on Mr. Marmaduke, a portion of the proceeds of which would be used to complete any purchases of shares resulting from the stock transfer agreement. Capital Structure. On July 22, 2010, we entered into the Amended and Restated Loan and Security Agreement (as amended, modified or otherwise supplemented from time to time, the "Amended Agreement") with Bank of America, N.A., as agent, which amended and restated our Loan and Security Agreement dated as of August 29, 2000, as otherwise amended (the "Prior Agreement"), and on July 21, 2011, we entered into an amendment (the "First Amendment") to the Amended Agreement with Bank of America, N.A (collectively, the "Amended Agreement"). The First Amendment increased the revolving credit facility from $100 million to $115 million, increased our borrowing base, lowered our interest rates, and allowed for the payment of dividends, which was previously prohibited under the Amended Agreement. The Amended Agreement is substantially the same as the Prior Agreement, extends the maturity date of the Prior Agreement from August 29, 2011 to July 22, 2014, and provides that we may repurchase up to $10.0 million worth of our common stock. The Amended Agreement also provides that we may repurchase additional shares of our common stock in the event we meet certain criteria set forth in the Amended Agreement. The Amended Agreement includes certain debt and acquisition limitations and requires a minimum availability of 10% of the lesser of (a) the Borrowing Base, and (b) the Revolving Credit Ceiling, provided however that we must also maintain Availability that is greater than or equal to $10 million at all times. Our obligations under the Amended Agreement are secured by a pledge of substantially all of the assets of the Company and our subsidiary and are guaranteed by our subsidiary. The amount outstanding under the Amended Agreement is limited by a borrowing base predicated on the sum of (a) 85% of Eligible Credit Card Receivables plus (b) either (i) at all times during the year, other than those stated in (ii), 90% of the liquidation value of eligible inventory or (ii) from September 1st through and including December 27th of each year, 92.5% of the liquidation value of eligible inventory, less (c) Availability Reserves (each term as defined in the Amended Agreement), and is limited to a ceiling of $115 million, less a minimum availability reserve that is greater than or equal to 10% of the lesser of (a) the Borrowing Base, and (b) the Revolving Credit Ceiling, provided however that we must also maintain Availability that is greater than or equal to $10 million at all times. The lender may increase specifically defined reserves to reduce availability in the event of adverse changes in our industry or our financial condition that are projected to impact the value of our assets pledged as collateral. The lender must exercise reasonable judgment and act in good faith with respect to any changes in the specifically defined reserves. Interest under the Amended Agreement will accrue, at our election, at a Base Rate or Libor Rate, plus, in each case, an Applicable Margin, which is determined by reference to the level of Availability as defined in the Amended Agreement, with the Applicable Margin for Libor Rate loans ranging from 2.00% to 2.50% and the Applicable Margin for Base Rate loans ranging from 1.00% to 1.50%. In addition, unused line fees ranging from 0.30% to 0.375% (determined by reference to the level of usage under the Amended Agreement) are also payable on unused commitments. At October 31, 2011, we had approximately $46.2 million in excess availability, after the availability reserve, under the Amended Agreement. We expect to have approximately $58.0 million to $60.0 million in excess availability, after the availability reserve and outstanding letters of credit, at January 31, 2012. However, excess availability may be reduced in the future as changes in the borrowing base occur or the lenders increase availability reserves. The average rates of interest incurred for the three months ended October 31, 2011 and 2010 were 2.7% and 3.0%, respectively. The average rates of interest incurred for the nine months ended October 31, 2011 and 2010 were 2.6% and 2.4%, respectively. Deferred financing costs that were amortized into interest expense during the three and nine months ended October 31, 2011 and 2011 are excluded from the calculation of the average rate of interest for each respective period.                                           19

--------------------------------------------------------------------------------

Table of Contents

  We utilize standby letters of credit to support certain insurance policies. The aggregate amount of the letters of credit at October 31, 2011, was approximately $0.7 million, which reduces the excess availability under the Amended Agreement. At October 31, 2011, our minimum lease commitments for the remainder of fiscal 2011 were approximately $4.6 million. Total existing minimum operating lease commitments for fiscal years 2011 through 2026 were approximately $156.5 million as of October 31, 2011. Contractual obligations and off-balance sheet arrangements. We have contractual obligations associated with ongoing business and financing activities, which will result in cash payments in future periods. These obligations include long-term debt, operating leases and certain revenue-sharing agreements. As of October 31, 2011, other than operating leases and standby letters of credit, we had not entered into any off-balance sheet arrangements or third-party guarantees, nor does our business ordinarily require us to do so. At October 31, 2011, there have been no material changes in our contractual obligations or off-balance sheet arrangements from those reported in our Annual Report on Form 10-K for the fiscal year ended January 31, 2011. Seasonality As is the case with many retailers, a significant portion of our revenues, and an even greater portion of our operating income, is generated in the fourth fiscal quarter, which includes the holiday selling season. As a result, a substantial portion of our annual earnings has been, and will continue to be, dependent on the results of the fourth quarter. Less than satisfactory net sales for such period could have a material adverse effect on the Company's financial condition or results of operations for the year and may not be sufficient to cover any losses that may have been incurred in the first three quarters of the year. We experience reduced rental activity in the spring because customers spend more time outdoors. Major world or sporting events, such as the Super Bowl, the Olympic Games and the World Series, also have a temporary adverse effect on revenues. Future operating results may be affected by many factors, including variations in the number and timing of store openings, the number and popularity of new book, music, video and video game titles, as well as the popularity of electronics and trends merchandise, the cost of new release or "best renter" titles, changes in comparable-store revenues, competition, marketing programs, increases in the minimum wage, weather, special or unusual events and other factors that may affect our operations.