HASTINGS ENTERTAINMENT INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT
OF 1934
For the fiscal year ended January 31, 2003

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF SECURITIES
EXCHANGE ACT
OF 1934
For the transition period from __________________ to _________________

COMMISSION FILE NUMBER: 000-24381

HASTINGS ENTERTAINMENT, INC.
(Exact name of registrant as specified in its charter)

TEXAS 75-1386375
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

3601 PLAINS BOULEVARD, AMARILLO, TEXAS 79102
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (806) 351-2300

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value per share
(Title of Class) Nasdaq National Market
(Name of Exchange on which registered)

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding twelve months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

As of July 31, 2002, which was the last business day of the registrant's most
recently completed second fiscal quarter, the aggregate market value of the
voting stock held by non-affiliates of the registrant was approximately
$34,446,865 based upon the closing market price of $5.71 per share of Common
Stock on the Nasdaq National Market on that date. (For the purposes of
determination of the above-stated amounts, only the directors, executive
officers and 5% or greater shareholders of the registrant have been deemed
affiliates; however, this does not represent a conclusion by the registrant that
any or all of such persons are affiliates of the registrant.)

Number of shares of $.01 par value Common Stock outstanding as of April 1, 2003:
11,336,473

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the proxy statement for the annual meeting of shareholders of the
registrant to be held during 2003 are incorporated by reference into Parts II
and III of this Form 10-K.

HASTINGS ENTERTAINMENT, INC.
FORM 10-K ANNUAL REPORT
FOR THE FISCAL YEAR ENDED JANUARY 31, 2003

INDEX

PART I

Forward-looking Statements

Certain written and oral statements set forth below or made by Hastings or with
the approval of an authorized executive officer of the company 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 which
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, effects of the adoption of Statement of
Financial Accounting Standards No. 146 and EITF Issue 02-16, the impact on our
financial statements of any adjustment to fair value of interest rate swaps,
inflation, effect of critical accounting policies including lower of cost or
market for inventory adjustments, the returns process, rental video amortization
and our store closing reserve, sufficiency of cash flow from operations and
borrowings under our revolving credit facility and statements expressing general
optimism about future operating results are forward-looking statements. Such
statements are based upon company 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, 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 effects of or changes in economic conditions in the U.S., including the
impact of the war with Iraq, and or the markets in which we operate our
superstores, our success in forecasting customer demand for products, and legal
proceedings (see discussion of Legal Proceedings in Part I, Item 3 of this Form
10-K for the fiscal year ended January 31, 2003 and subsequent SEC filings) 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.

ITEM 1. BUSINESS

General

Hastings Entertainment, Inc. is a leading multimedia entertainment retailer that
combines the sale of books, music, software, periodicals, videocassettes, video
games, DVDs, used products including CDs, DVDs and video games, video game
consoles and DVD players with the rental of videocassettes, video games, DVDs,
video game consoles and DVD players in a superstore format. As of April 1, 2003,
we operated 146 superstores in small- to medium-sized markets located in 21
states, primarily in the Western and Midwestern United States. We also operate a
multimedia entertainment e-commerce Web site offering a broad selection of
books, music, software, videocassettes, video games and DVDs. See note 14 to the
consolidated financial statements for more information regarding our operating
segments, retail stores and Internet operations. We operate three wholly owned
subsidiaries; Hastings Properties, Inc., Hastings Internet, Inc. and Hastings
College Stores, Inc. References herein to fiscal years are to the twelve-month
periods, which end in January of each following calendar year. For example, the
twelve-month period ended January 31, 2003 is referred to as fiscal 2002.

Industry Overview

Music. According to the Recording Industry Association of America ("RIAA"),
total music shipments by manufacturers to retailers decreased 8.2% to $12.6
billion in 2002 compared to $13.7 billion in 2001. The majority of this decrease
can be found in a decline of almost 9% in shipments for the industry mainstay,
the full-length CD, to $12.0 billion in 2002 compared to $12.9 billion in 2001.
RIAA attributed this decline in large part to online and physical piracy and the
nationwide economic downturn. RIAA is taking steps to combat piracy activities
and, according to Hilary Rosen, Chairman and CEO of RIAA, they have increased
seizures of counterfeit and pirate CDRs by 89.5% in 2002. In addition, RIAA has
implemented several programs designed to educate consumers and

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legislators on the effects of piracy. Additionally, RIAA has joined forces with
the Business Software Alliance and the Computer Systems Policy Project to work
together to address piracy issues and enforce existing and suggest new
legislation. Industry shipments of cassettes declined sharply during 2002 to
$210 million, down 42.3% from 2001, as the format continued to lose favor with
music consumers.

Books. The Association of American Publishers estimates total net sales for the
book industry will increase approximately 5.5% to $26.9 billion for 2002, up
from $25.4 billion in 2001. Trade sales, which include adult and juvenile
hardback and paperback categories, exhibited the largest gains on an increase of
approximately 8.8% to $6.9 billion, up from $6.4 billion a year earlier. Sales
in the professional category, which includes educational and rack-sized
paperback books, trailed trade sales closely with an increase of approximately
8.5% to $5.1 billion for 2002, up from $4.7 billion for 2001. Sales of religious
books declined 5.8% to approximately $0.9 billion for 2002 compared to $1.0
billion for 2001.

Rental Video. According to Paul Kagan Associates ("Kagan"), consumer spending on
rental video increased 2.3% to approximately $8.7 billion in 2002, up from
approximately $8.4 billion in 2001. DVD continued its accelerated acceptance
rate as DVD households as a percentage of U.S. television households increased
to 36.8% for 2002, up from 24% in 2001. Kagan projects that DVD households will
increase to almost 70% of U.S. television households by 2006 and the percentage
of multi-DVD homes will triple over that same time frame. By comparison, VHS
households as a percent of U.S. television households increased to 91.1% for
2002 compared to 88.7% for 2001. Based partially on this data, we believe there
remains a viable VHS market despite projections of declining VHS rental and sale
revenues.

Although by Kagan estimates, the sale of video increased during 2002, industry
rental transactions exceeded sale transactions in excess of 3 to 1, with rentals
representing approximately 76% of combined transactions and sales representing
approximately 24% of combined transactions. We believe that the DVD format, with
its superior picture and sound quality and extra features such as outtakes,
director commentary and scene selection, will drive continued growth in the
industry. We also believe rental video will continue to be a favored
entertainment medium for millions of consumers due to its relatively inexpensive
price point, broad selection of new release and catalog (older) movies and
ability for "viewer control" of the experience, i.e., start, stop, fast-forward,
pause and rewind.

Business Strategy

Our goal is to enhance our position as a leading multimedia entertainment
retailer in small- to medium-sized communities by expanding and remodeling
existing superstores, opening new superstores in selected markets and offering
our products through the Internet. Each element of our business strategy is
designed to build consumer awareness of the Hastings concept and achieve high
levels of customer loyalty and repeat business. We believe the key elements of
this strategy are the following:

Superior Multimedia Concept. Our superstores present a wide variety of products
tailored to local preferences in a dynamic and comfortable store atmosphere with
exceptional service. Our superstores average approximately 20,000 square feet,
with our new superstores generally ranging in size from 10,000 to 25,000 square
feet. Our superstores offer customers an extensive product assortment ranging,
depending on the specific store, approximately 17,000 to 60,000 book, 9,000 to
30,000 music, 1,000 to 2,000 software, 2,000 to 3,000 periodical, 4,000 to
13,000 video, and 1,000 to 4,000 complementary and accessory titles for sale. We
also offer approximately 3,000 to 12,000 used CD, videocassette, DVD and video
game titles for sale. In addition, customers can select from 5,000 to 10,000 DVD
titles for sale and rent and 12,000 to 20,000 videocassette, DVD and video game
selections for rent. Although our superstores' core product assortment tends to
be similar, the merchandise mix of each of our superstores is tailored to
accommodate the particular demographic profile of the local market in which the
superstore operates through the utilization of our proprietary purchasing and
inventory management systems. We believe that our multimedia format reduces our
reliance on and exposure to any particular entertainment segment and enables us
to promptly add exciting new entertainment categories to our product line.

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Small to Medium-Sized Market Superstore Focus. We target small- to medium-sized
markets with populations of generally less than 50,000 where our extensive
product selection, low pricing strategy, efficient operations and superior
customer service enable us to become the market's destination entertainment
store. We believe that the small- to medium-sized markets where we operate the
majority of our superstores present an opportunity to profitably operate and
expand our unique entertainment superstore format. In our opinion, these markets
typically are underserved by existing book, music or video stores, and our
competition generally is locally owned or national-chain specialty stores and
general merchandise retailers. We base our merchandising strategy for our
superstores on an in-depth understanding of our customers and our individual
markets. We strive to optimize each superstore's merchandise selection by using
our proprietary information systems to analyze the sales history, anticipated
demand and demographics of each superstore's market. In addition, we utilize
flexible layouts that enable each superstore to arrange our products according
to local interests and to customize the layout in response to new customer
preferences and product lines.

Customer-Oriented Superstore Format. We design our superstores to provide an
easy-to-shop, open store atmosphere by offering major product categories in a
"store-within-a-store" format. Most of our superstores utilize
product-affinities positioned together around a wide racetrack aisle or
three-across departments (books, music and video) that are designed to allow
customers to view the entire superstore. This store configuration produces
significant cross-marketing opportunities among the various entertainment
departments, which we believe results in higher transaction volumes and impulse
purchases. To encourage browsing and the perception of Hastings as a community
gathering place, we have incorporated amenities in many superstores, such as
chairs for reading, a broad selection of gourmet coffee and tea, soft drinks and
snacks, music auditioning stations, interactive information kiosks, telephones
for free local calls, children's play areas and in-store promotional events.

Low Pricing. Our pricing strategy at our superstores is to offer value to our
customers by maintaining prices that are generally competitive with or lower
than the prices charged by other retailers in the market. We determine our
prices on a market-by-market basis, depending on the level of competition and
other market-specific considerations. We believe that our low pricing structure
results in part from (i) our ability to purchase directly from publishers,
studios and manufacturers as opposed to purchasing from distributors, (ii) our
proprietary information systems, improvements to which will enable management to
make more precise and targeted purchases and pricing for each superstore, and
(iii) our consistent focus on maintaining low occupancy and operating costs.

Used Products. Since 1994, we have bought or traded for customer's CDs to sell
as used product and leverage the value of our CD offering. With additional
used-purchasing options, this business now accounts for approximately 10% of our
total music business, generally represents higher margins than new front-line
CDs and drives customer loyalty. During fiscal 2001, revenue generated from the
sale of used DVDs began to accelerate as the DVD medium became more popular with
the consumer. The same process of purchasing used CDs is being applied to used
DVDs and we are excited about the prospect for continued growth in this and
other used product business, including video games. We believe our multimedia
superstore concept will enhance our offering of used products allowing the
customer to choose between a new or a less expensive used copy of the same
title.

Internet. In May 1999, we launched our new e-commerce Internet Web site,
www.gohastings.com. Our site enables customers to electronically access more
than 800,000 new and used entertainment products and unique, contemporary gifts
and toys. The site features exceptional product and pricing offers, search and
auditioning capabilities, and digital downloading of music selections. The Web
site is designed to fully integrate into a store kiosk to leverage both the
physical and digital shopping experience. The site also features a newly
designed investor relations section including links to company press releases,
SEC filings and a useful list of frequently asked questions.

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Expansion Strategy

We plan to open five superstores during fiscal 2003 while continuing our ongoing
store expansion and remodeling programs for our existing superstores. We closed
one superstore in February 2003. We have identified numerous potential locations
for future superstores in under-served, small- to medium-sized markets that meet
our new-market criteria. We believe that with our current information systems
and distribution capabilities, our infrastructure can support our anticipated
rate of expansion and growth for at least the next several years.

Merchandising Strategy

We are a leading multimedia entertainment retailer that combines the sale of
books, music, software, periodicals, videocassettes, video games, DVDs, used
products including CDs, DVDs and video games, video game consoles and DVD
players with the rental of videocassettes, video games, DVDs, video game
consoles and DVD players in a superstore format. By offering a broad array of
products within several distinct but complementary categories, we strive to
appeal to a wide range of customers and position our superstores as destination
entertainment stores in our targeted small- to medium-sized markets.

Superstore Product Selection. Although all Hastings superstores carry a similar
core product assortment, the merchandise mix of book, music, software,
videocassette and video game selections of each superstore is tailored
continually to accommodate the particular demographic profile and demand of the
local market in which the superstore operates. We accomplish this customization
through our proprietary purchasing, inventory, selection and pricing management
systems. The purchasing system analyzes historic consumer purchasing patterns at
each individual superstore to forecast customer demand for new releases and
anticipate seasonal changes in demand. In addition, our inventory management
process continually monitors product sales and videocassette rentals to identify
slow-moving books, music, software and sale videocassettes, DVD and video games
for return to vendors and rental videocassettes, DVD and video games for sale to
customers as previously viewed items or transfer to other superstores. Our
pricing management system allows us to identify slow moving products and
initiate an automated-progressive markdown program to enhance sell-through while
maximizing margin at each subsequent price reduction. It also automatically
implements the price change by printing new tags at the store.

Our superstores offer customers an extensive product assortment ranging,
depending on the specific store, approximately 17,000 to 60,000 book, 9,000 to
30,000 music, 1,000 to 2,000 software, 2,000 to 3,000 periodical, 4,000 to
13,000 video, and 1,000 to 4,000 complementary and accessory titles for sale. We
also offer approximately 3,000 to 12,000 used CD, videocassette, DVD and video
game titles for sale. In addition, customers can select from 5,000 to 10,000 DVD
titles for sale and 12,000 to 20,000 videocassette, DVD and video game
selections for rent. New releases and special offerings in each entertainment
product category are prominently displayed and arranged by product category.

In addition to our primary product lines, we continually add new product
offerings to better serve our customers. Products for sale in these categories
include promotional t-shirts, licensed plush toys, portable electronics,
consumer electronics including DVD players and video game consoles, musical
instruments, sheet music, greeting cards, audio books and consumables, including
soft drinks, coffee, popcorn and candy. Accessory items for sale include blank
videocassettes and CDs, video cleaning equipment and audiocassette and CD
carrying cases. Many of these products generate impulse purchases and produce
higher margins. The rental of videocassette, video game and DVD players is
provided as a service to Hastings customers.

Information System

Our information system is built upon a multi-tiered, distributed processing
architecture and was designed using client/server technology. All locations are
connected using a wide-area network that allows interchange of current
information. The primary components of the information system are as follows:

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New Release Allocation. Our buyers use the new release allocation system to
purchase new release products for the superstores and have the ability within
the system to utilize multiple methods of forecasting demand. By using
store-specific sales history, factoring in specific market traits, applying
sales curves for similar titles or groups of products and minimizing
subjectivity and human emotion for a transaction, the system customizes
purchases for each individual superstore to satisfy customer demand. The process
provides the flexibility to allow store management to anticipate customer needs,
including tracking missed sales and factoring in regional influences. We believe
that the new release allocation system enables us to increase revenues by having
the optimum levels and selection of products available in each superstore at the
appropriate time to satisfy customers' entertainment needs.

Rental Video Asset Purchasing System. Our rental video asset purchasing system
uses store-specific performance on individual rental videocassette titles to
anticipate customer demand for new release rental videocassettes. The system
analyzes the first eight weeks' performance of a similar title and factors in
the effect of such influences as seasonal trends, box office draw and prominence
of the movie's cast to customize an optimum inventory for each individual
superstore. The system also allows for the customized purchasing of other
catalog rental video assets on an individual store basis, additional copy depth
requirements under revenue-sharing agreements and timely sell-off of previously
viewed tapes. We believe that our rental video asset purchasing system allows us
to efficiently plan and stock each superstore's rental video asset inventory,
thereby improving performance and reducing exposure from excess inventory.

Store Replenishment. Store replenishment covers three main areas for controlling
a superstore's inventory.

Selection Management. Selection management constantly analyzes
store-specific sales, traits and seasonal trends to determine title
selection and inventory levels for each individual superstore. By
forecasting annual sales of products and consolidating recommendations from
store management, the system enables us to identify overstocked or
understocked items and to prompt required store actions and optimize
inventory levels. The system tailors each store's individual inventory to
the market, utilizing over 2,000 product categories, configurations and
product status.

Model Stock Calculation/Ordering. Model stock calculation uses
store-specific sales, seasonal trends and sophisticated-sales curve fitting
to forecast orders. It also accounts for turnaround time from a vendor or
our distribution center and tracks historical missed sales to adjust orders
to adequately fulfill sales potential. Orders are currently calculated on a
weekly basis and transmitted by all superstores to the corporate office to
establish a source vendor for the product.

Inventory Management. Inventory management systems interface with other
store systems and accommodate electronic receiving and returns to maintain
perpetual inventory information. Cycle counting procedures allow us to
perform all physical inventory functions, including the counting of each
superstore's inventory up to four times per year. The system provides
feedback to assist in researching variance.

Store Systems. Each superstore has a dedicated server within the store for
processing information connected through a wide area network. This connectivity
provides consolidation of individual transactions and allows store management
and corporate office associates easy access to the information needed to make
informed decisions. Transactions at the store are summarized and used to assist
in staff scheduling, loss prevention and inventory control. All point of sale
transactions utilize scanning technology allowing for maximum customer
efficiency at checkout. We also utilize an automated system for scheduling store
management and sales associates. This system was developed to assist in
controlling personnel costs while maintaining desired levels of customer service
by preventing over-scheduling or under-scheduling sales, stocking and customer
service associates.

Accounting. Our financial accounting software has a flexible, open-systems
architecture. We prepare a variety of daily management reports covering store
and corporate performance. Detailed financial information for each superstore,
as well as for the distribution center and the corporate office, are generated
on a monthly basis. Our payroll, accounts payable, cash control, financial
planning and certain state and local tax functions are performed in-house.

5

Warehouse Management. Our warehouse management systems provide support for
high-volume retail transactions, including shipments, receipts and returns to
vendors. Software to perform these functions was customized through a joint
effort of our purchasing, distribution and information systems departments. The
warehouse system, using "real-time" inputs for total process coordination,
incorporates exact cube sizes of product containers, utilizing flow-through
racks and technologically advanced conveyor systems.

Distribution and Suppliers

Our distribution center is located in a 146,000 square foot facility adjacent to
our corporate headquarters in Amarillo, Texas. This central location and the
local labor pool enable us to realize relatively low transportation and labor
costs. The distribution center is utilized primarily for receiving, storing and
distributing approximately 21,000 products offered in substantially every
superstore. The distribution center also is used in distributing large
purchases, including forward buys, closeouts and other bulk purchases. In
addition, the distribution facility is used to receive, recycle, process and
ship items to be returned to manufacturers and distributors, as well as to
transfer and redistribute videocassettes among our superstores. This facility
currently provides inventory to all Hastings superstores and is designed to
support our anticipated rate of expansion and growth for at least the next
several years. We ship products weekly to each Hastings superstore, facilitating
quick and responsive inventory replenishment. Approximately 24% of our total
product, based on store receipts, is distributed through the distribution
center. Approximately 76% of our total product is shipped directly from the
vendors to the superstores. We outsource all product transportation from our
distribution center to various freight companies.

Our information systems and corporate infrastructure facilitate our ability to
purchase products directly from manufacturers, which contributes to our low
pricing structure. In fiscal 2002, we purchased the majority of our products
directly from manufacturers, rather than through distributors. Our top three
suppliers accounted for approximately 21% of total products purchased during
fiscal 2002. While selections from a particular artist or author generally are
produced by a single manufacturer, we strive to maintain supplier relationships
that can provide alternate sources of supply. Products we purchase are generally
returnable to the supplying vendor. Refer to "Item 7. Management's Discussion
and Analysis of Financial Condition and Results of Operation - General" for a
description of our returns process.

Store Operations

Most of our superstores employ one store manager and one or more assistant store
managers. Store managers and assistant store managers are responsible for the
execution of all operational, merchandising and marketing strategies for the
superstore in which they work. Superstores also generally have department
managers, who are individually responsible for their respective book, music,
software, video, customer service and stocking departments within each
superstore. Hastings superstores are generally open daily from 10:00 a.m. to
11:00 p.m. However, several superstores are open 9:00 a.m. to 11:00 p.m. or
10:00 a.m. to 10:00 p.m. The only days our superstores are closed are
Thanksgiving and Christmas.

Competition

The entertainment retail industry is highly competitive. We compete with a wide
variety of book retailers, music retailers, software retailers, Internet
retailers and retailers that rent or sell videocassettes, including independent
single store operations, local multi-store operators, regional and national
chains, as well as supermarkets, pharmacies, convenience stores, bookstores,
mass merchants, mail order operations, warehouse clubs, record clubs, other
retailers and various non-commercial sources such as libraries. With regard to
our videocassette sales and rental video products in particular, we compete with
cable, satellite and pay-per-view cable television systems. In addition,
continuing technological advances that enhance the ability of consumers to shop
at home or access, produce and print written works or record music digitally by
home computer through the Internet or telephonic transmission could provide more
serious competition to us in the future.

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We compete in most of our markets with either national entertainment retailers
or significant retailers of general merchandise or both. We compete in our sale
of books with retailers such as Barnes & Noble, Inc., Books-A-Million, Inc.,
Borders Group, Inc., Walden Books and B. Dalton Bookseller. We compete in our
sale of music with music retailers, such as Transworld Entertainment and
consumer electronics stores, including Best Buy and Circuit City. Our principal
competitors in the sale and rental of videocassettes are Blockbuster, Inc.,
Hollywood Entertainment Corp. and Movie Gallery, Inc. In addition, we compete in
the sale of books, music and videocassettes and the rental of videocassettes and
video games with local entertainment retailers and significant retailers of
general merchandise, such as Wal-Mart. Retailers such as Amazon.com, Inc. and
Barnes & Noble, Inc., continue to increase their retail sales of entertainment
products, such as books and music, via the Internet. We compete with other
entertainment retailers on the basis of title selection, the number of copies of
popular selections available, store location, visibility and pricing.

Trademarks and Servicemarks

We believe our trademarks and servicemarks, including the servicemarks "Hastings
Books Music Video," and "Hastings, Your Entertainment Superstore" have
significant value and are important to our marketing efforts. We have registered
"Hastings Books Music Video" as a servicemark with the United States Patent and
Trademark Office and are in the process of registering "Hastings, Your
Entertainment Superstore" and "HardBack Cafe." We maintain a policy of pursuing
registration of our principal marks and opposing any infringement of our marks.

Associates

We refer to our employees as associates because of the critical role they play
in the success of each Hastings superstore and the Company as a whole. As of
January 31, 2003, we employed approximately 6,829 associates; of which 2,378 are
full-time and 4,451 are part-time associates. Of this number, approximately
6,171 were employed at retail superstores, 369 were employed at our distribution
center and 289 were employed at our corporate offices. None of our associates
are represented by a labor union or are subject to a collective bargaining
agreement. We believe that our relations with our associates are good.

Executive Officers of the Company

The following is certain information concerning the executive officers of
Hastings Entertainment, Inc.

All executive officers are chosen by the Board of Directors and serve at the
Board's discretion. Set forth below is information concerning the business
experience of our executive officers.

JOHN H. MARMADUKE, age 55, has served as President and Chief Executive Officer
of the Company since July 1976 and as Chairman of the Board since October 1993.
Mr. Marmaduke served as President of the Company's former parent company,
Western Merchandisers, Inc. ("Western"), from 1982 through June 1994, including
the years 1991 through 1994 when Western was a division of Wal-Mart. Mr.
Marmaduke also serves on the board of directors of the Video Software Dealers
Association (VSDA). Mr. Marmaduke has been active in the entertainment retailing
industry with the Company and its predecessor company for over 30 years.

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DAN CROW, age 56, has served as Vice President of Finance and Chief Financial
Officer of the Company since October 2000. From July of 2000 to October 2000,
Mr. Crow served as Vice President of Finance. Mr. Crow is a member of the
American Institute of Certified Public Accountants and the Financial Executives
International and has served as Chief Financial Officer of various retail
companies including Discount Auto Parts, Inc., Scotty's, Inc. and Lil' Things,
Inc. since 1984.

ROBERT A. BERMAN, age 53, has served as Vice President of Store Operations of
the Company since January 1997. From June 1995 to January 1997, Mr. Berman was
self-employed in the financial services industry. From January 1989 to June
1995, Mr. Berman served as Vice President and Senior Vice President of Store
Operations for Builders Square, Inc., a chain of 185 building material
superstores. At Builders Square, Inc., Mr. Berman was responsible for store
operations, store planning and design, purchasing and construction.

JAMES S. HICKS, age 46, has served as Vice President of Product of the Company
since August of 2002. From August 1999 to August of 2002, Mr. Hicks served as
Vice President of Purchasing. From August 1997 to August 1999, Mr. Hicks served
as the Senior Director of Purchasing and from April 1994 to August 1997, was the
Director of Purchasing. He was a District Leader for the Company from July of
1984 to April 1994. From October 1982 to July 1984, Mr. Hicks served as a
company troubleshooter and from April 1982 to October 1982 was a store manager.
Mr. Hicks began his career with Hastings in August 1981 as a manager trainee.
Prior to joining the Company, Mr. Hicks was the Regional Credit Manager for
Liquid Carbonics Corporation, a gas distributor and manufacturer headquartered
in Houston.

ALAN VAN ONGEVALLE, age 35, has served as Vice President of Information Systems
and Distribution since February 2003. From August 2002 to February 2003, Mr. Van
Ongevalle served as Vice President of Marketing and Distribution. From May 2000
to August 2002, Mr. Van Ongevalle served as Vice President of Marketing. From
August 1999 to May 2000, Mr. Van Ongevalle served as the Senior Director of
Marketing and as Director of Advertising from September 1998 to August 1999. Mr.
Van Ongevalle joined Hastings in November 1992 and held various store operation
management positions including Store Manager, Director of New Stores and the
Southern Kansas area through September 1998.

Available Information

We file annual, quarterly and current reports, information statements and other
information with the Securities and Exchange. The public may read and copy any
materials we file with the SEC at the SEC's public Reference Room at 450 Fifth
Street, N.W., Washington, D.C. 20549. The public may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The
SEC also maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC. The address of that site is http://www.sec.gov.

The address of our Internet website is www.gohastings.com and through the links
on the Investor Relations portion of our website, we make available free of
charge our annual report on Form 10-K, quarterly reports on Form 10-Q and
current reports on Form 8-K, and any amendments to those reports, filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Act of 1934. Such
material is made available through our website as soon as reasonably practicable
after we electronically file or furnish the material with the SEC. In addition,
links to officer certifications of financial information and a code of ethics
for financial and other executive officers are posted in the Investor Relations
section.

8

ITEM 2. PROPERTIES

As of January 31, 2003, we operated 146 superstores in 21 states located as
indicated in the following table:

Currently, we lease sites for all of our superstores. These sites typically are
located in pre-existing, stand-alone buildings or strip shopping centers. Our
primary market areas are small- and medium-sized communities with populations
generally less than 50,000. We have developed a systematic approach using our
site selection criteria to evaluate and identify potential sites for new
superstores. Key demographic criteria for superstores include community
population, community and regional retail sales, personal and household
disposable income levels, education levels, median age, and proximity of
colleges or universities. Other site selection factors include current
competition in the community, visibility, available parking, ease of access and
other neighbor tenants. To maintain low occupancy costs, we typically
concentrate on leasing existing locations that have been operated previously by
other retailers.

We actively manage our existing superstores and from time to time close
under-performing stores. During fiscal 2002 we closed three superstores and
during fiscal 2001 we closed five superstores.

The terms of our superstore leases vary considerably. We strive to maintain
maximum location flexibility by entering into leases with long initial terms and
multiple short-term extension options, but always with the ability to relocate
the store to a more favorable location if desired. We have been able to enter
into leases with these terms in part because we generally bear a substantial
portion of the cost of preparing the space for a superstore.

9

The following table sets forth as of January 31, 2003 the number of superstores
that have current lease terms that will expire during each of the following
fiscal years and the associated number of superstores for which we have options
to extend the lease term:

We have not experienced any significant difficulty renewing or extending leases
on a satisfactory basis.

Our headquarters and distribution center are located in Amarillo, Texas in a
leased facility consisting of approximately 44,500 square feet for office space
and 146,000 square feet for the distribution center. The leases for this
property terminate in September 2003, and we have the option to renew these
leases through March 2015.

ITEM 3. LEGAL PROCEEDINGS

In 2000, we restated our consolidated financial statements for the first three
quarters of fiscal 1999 and the prior four fiscal years. Following our initial
announcement in March 2000 of the requirement for such restatements, nine
purported class action lawsuits were filed in the United States District Court
for the Northern District of Texas against the Company and certain of our
current and former directors and officers asserting various claims under
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Although four
of the lawsuits were originally filed in the Dallas Division of the Northern
District of Texas, all of the five pending actions were transferred to the
Amarillo Division of the Northern District and were consolidated. One of the
Section 10(b) and 20(a) lawsuits filed in the Dallas Division was voluntarily
dismissed. On May 15, 2000, a lawsuit was filed in the United States District
Court for the Northern District of Texas against the Company, our current and
former directors and officers at the time of our June 1998 initial public
offering and three underwriters, Salomon Smith Barney, A.G. Edwards & Sons, Inc.
and Furman Selz, LLC asserting various claims under Sections 11, 12(2) and 15 of
the Securities Act of 1933. Motions to dismiss these actions were filed by the
Company and, on September 25, 2001, were denied by the Court.

On September 12, 2002, we announced that an agreement in principle to settle the
actions described above had been reached. The settlement received final approval
by the Court on March 10, 2003. The settlement required a payment of $5.75
million on behalf of the defendants in the lawsuits ($3.15 million of which was
funded from amounts remaining under our director and officer insurance policy
after the payment of litigation expenses) and the assignment to the plaintiff
settlement class of any claims the Company may have had against KPMG Peat
Marwick, LLP, our outside auditors at the time of the March 7, 2000
announcement. The settlement resolves all claims against the Company, our
current and former defendant officers and directors and the defendant
underwriters. Based on the foregoing, we recorded a loss contingency of $2.6
million, or $0.22 per share, during fiscal 2002 and all amounts required by the
settlement agreement were funded by January 31, 2003. The plaintiff settlement
class separately settled all claims against KPMG.

We are also involved in various other claims and legal actions arising in the
ordinary course of business. In the opinion of management, the ultimate
disposition of these matters will not have a material adverse effect on our
financial position, results of operations and cash flows.

10

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of the security holders during the fourth
quarter of fiscal 2002.

11

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The shares of Hastings Entertainment, Inc. common stock are listed and traded on
The Nasdaq National Market (Nasdaq) under the symbol "HAST". Our common stock
began trading on June 12, 1998, following our initial public offering. The
following table contains, for the periods indicated, the high and low sales
prices per share of our common stock as reported on the Nasdaq:

As of March 28, 2003, there were approximately 417 holders of record of our
Common Stock.

The payment of dividends is within the discretion of the Board of Directors and
will depend on our earnings, capital requirements, and the operating and
financial condition, among other factors. Our current revolving credit facility
restricts the payment of dividends. In view of such restrictions, it is unlikely
that we will pay a dividend in the foreseeable future.

The information required by this item regarding disclosure of equity
compensation plan information will be set forth in our Proxy Statement for our
2003 Annual Meeting of Shareholders, to be filed within 120 days after the end
of fiscal 2002, under the heading "Compensation Plans," which information is
incorporated herein by reference.

12

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial and operating data set forth below should be
read in conjunction with "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and our consolidated financial statements
and the notes thereto that appear elsewhere in this report.

13

(1) We adopted a new, accelerated method of amortizing our rental video
assets in the fourth quarter of fiscal 1998. The adoption of the new
amortization method was accounted for as a change in accounting
estimate effected by a change in accounting principle and, accordingly,
we recorded a non-cash, non-recurring, pre-tax charge of $18.5 million
in rental video cost of revenues in the fourth quarter of fiscal 1998,
increasing net loss and diluted loss per share for fiscal 1998 by $11.5
million and $1.10 per share, respectively.

(2) We recorded pre-tax charges of $2.6 million in fiscal 2002 related to
the settlement of the shareholder class action lawsuits as described in
Note 13. These charges reduced net income by $2.6 million or
approximately $0.22 per diluted share.

(3) We recorded pre-tax charges of approximately $2.4 million, $1.5 million
and $6.5 million in fiscal years 2002, 2001 and 2000, respectively,
related to the cost associated with closing superstores. See Note 5 to
the consolidated financial statements for further discussion. As a
result of these charges, fiscal years 2002, 2001 and 2000 net losses
were increased by $2.4 million, $1.5 million and $6.5 million and
$0.20, $0.13 and $0.56 per diluted share, respectively.

(4) In fiscal 2000, we recorded $2.7 million in accounting and legal fees
associated with the restatement of the first three quarters of fiscal
1999 and the prior four fiscal years. As a result of these fees, fiscal
year 2000 net losses were increased by $2.7 million and $0.23 per
diluted share.

(5) We recorded interest income of approximately $1.3 million in the second
quarter of fiscal 2002 as a result of interest earned on income tax
refunds for amended returns filed for fiscal years 1995 through 1998.
As a result, net income was increased by approximately $0.11 per
diluted share.

(6) In fiscal 1996, we established a reserve of $2.5 million ($1.6 million
after-tax charge) to cover potential losses related to certain mall
store leases that were sold prior to fiscal 1995 to Camelot Music,
Inc., which filed for bankruptcy protection in August 1996. In fiscal
1997, the reserve was reduced to $0.5 million, and $1.7 million was
included in Gain on sale of mall stores. In fiscal 1998, we were
released from any contingent liability on the remaining leases by order
of a bankruptcy court. Accordingly, the Company reduced the remaining
$0.5 million reserve to zero as of January 31, 1999, thereby decreasing
net loss and diluted loss per share for fiscal 1998 by $0.3 million and
$.03 per share, respectively.

(7) Includes amounts associated with our rental video cost amortization.

(8) Includes procurement of rental video assets.

(9) Stores included in the comparable-store revenues calculation are those
stores that have been open for a minimum of 60 weeks. Also included are
stores that are remodeled or relocated. Sales via the internet are not
included and closed stores are removed from each comparable period for
the purpose of calculating comparable-store revenues.

(10) Working capital is calculated as total current assets less total
current liabilities.

14

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion should be read in conjunction with our consolidated
financial statements and the related notes thereto and "Item 6. Selected
Financial Data" appearing elsewhere in this Annual Report.

General

Hastings Entertainment is a leading multimedia entertainment retailer that
combines the sale of books, music, software, periodicals, videocassettes, video
games, DVDs, used products including CDs, DVDs and video games, video game
consoles and DVD players with the rental of videocassettes, video games, DVDs,
video game consoles and DVD players in a superstore and Internet Web site
format. As of January 31, 2003, we operated 146 superstores averaging
approximately 20,000 square feet in small- to medium-sized markets located in 21
states, primarily in the Western and Midwestern United States. Each of the
superstores is wholly owned by the Company and operates under the name of
Hastings.

Our operating strategy is to enhance our position as a multimedia entertainment
retailer by expanding and remodeling existing superstores, opening new
superstores in selected markets, and offering our products through our Internet
Web site. References herein to fiscal years are to the twelve-month periods that
end in January of the following calendar year. For example, the twelve-month
period ended January 31, 2003 is referred to as fiscal 2002.

Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles
generally accepted in the United States, which require management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements, the disclosure of
contingent assets and liabilities 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 policies affect 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 basis.

Lower of Cost or Market for Merchandise Inventory. Our merchandise inventories
are recorded at the lower of cost 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
lower of cost or market ("LCM") 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 fair value of merchandise inventory by product
category and record any adjustment if estimated market value is below cost.
Through merchandising and an automated-progressive markdown program, we quickly
take the steps necessary to increase the sell-off of slower moving merchandise
to eliminate or lessen the effect of any LCM adjustments.

Returns Process. Merchandise inventory owned by us is generally returnable based
upon return agreements with our merchandise vendors. We continually return
merchandise to vendors based on, among other factors, current and projected
sales trends, overstock situations, authorized return timelines or change in
product offerings. At the end of any reporting period cost accruals are required
for inventory that has been returned to vendors, or is in the process of being
returned to vendors, or has been identified to be returned to vendors. These
costs can include freight, valuation and quantity differences, and other fees
charged by a vendor. In order to appropriately match the costs associated with
the return of merchandise with the process of returning such merchandise, we
utilize an allowance for cost of inventory returns (the "Allowance"). To accrue
for such costs and estimate the Allowance, we utilize historical experience
adjusted for significant estimated or contractual modifications. Certain
adjustments to the Allowance can have a material effect on the financial results
of an annual or interim period.

15

Rental Video Cost Amortization. We have a series of direct revenue-sharing
agreements with major studios and we anticipate that our future involvement in
revenue-sharing agreements will be similar to that of fiscal year 2002. Revenue
sharing allows us to acquire rental video assets at a lower up-front capital
cost than traditional buying arrangements. We then share with studios a
percentage of the actual net rental revenues generated over a contractually
determined period of time. The increased access to additional copies of new
releases under revenue-sharing agreements allows customer demand for new
releases to be satisfied over a shorter period of time at a time when the new
releases are most popular. Under the terms of the specific contracts with
supplying studios, we expense revenue-sharing payments through rental video cost
of revenue, as revenues are recognized. The capitalized cost of all rental video
assets acquired for a fixed price is being amortized on an accelerated basis
over six months to a salvage value of $4 per unit, except for rental video
assets purchased for the initial stock of a new superstore, which are being
amortized on a straight line basis over 36 months to a salvage value of $4.

Certain events, including a downturn in the rental video industry as a whole or
in the markets within which we operate our superstores, further consolidation of
rental video retailers, substantial change in customer demand and change in the
mix of rental video revenues, could affect the salvage value we have assigned to
our rental video assets. The effect could result in a material reduction of the
carrying value of our rental video assets and have a material impact on the
financial results of an annual or interim period. In particular, the growth of
the DVD market and the shift of consumer purchases from VHS (videocassettes) to
DVD could result in a decrease in the salvage value of rental videos. At some
point during the rental cycle, a VHS item, as with DVD and games, is available
for purchase by a customer as a previously viewed tape ("PVT"). Our current
experience is that the amount received for the PVT is higher than our salvage
value of that item in our rental inventory. Based in part on this factor and
sales of PVTs, we believe our estimate of salvage value is appropriate.

Store Closing Reserve. On a quarterly basis, and in the normal course of
business, we evaluate our store base to determine if a need to close or relocate
a store(s) is present. Management will evaluate, among other factors, current
and future profitability, market trends, age of store and lease status. The
primary expense items associated with the closure of a store relate to the net
present value of minimum lease payments (the present value of remaining lease
payments under an active lease) and the write-off of leasehold improvements and
other assets not remaining in our possession at the time the location is closed
or relocated. The amount recorded can fluctuate based on the age of the closing
location, term and remaining years of the lease and the number of stores being
closed or relocated. These charges can have a material effect on the financial
results of an annual or interim period. We actively pursue sublease tenants on
all closed or relocated locations and the impact of any sublease income is
estimated in the determination of the incurred store closing reserve liability.

Revenue Recognition. The Company's revenue is primarily from retail sales and
rental of our products. Merchandise and rental revenues are recognized at the
point of sale or rental or at the time merchandise is shipped to the customer.
Revenues are presented net of estimated returns and exclude all taxes. Customers
may return certain merchandise for exchange or refund within the Company's
policies, and an allowance has been established to provide for projected
returns. There are no provisions for uncollectible amounts since payment is
received at the time of sale. The Company, as with most retailers, also offers
gift cards for sale. Deferred revenue, a current liability, is recognized at the
time a gift card is sold with the costs of designing, printing and distributing
the cards recorded as an expense as incurred. The deferred revenue liability is
relieved and revenue is recognized upon the redemption of the gift cards. From
time to time the Company will offer sales incentives, in the form of customer
rebates, to its customers. Revenue is reduced by the amount of estimated
redemptions, based on experience of similar types of rebate offers, and a
deferred revenue liability is established. The deferred revenue liability is
relieved when the customer has completed all criteria necessary to file a valid
rebate claim. Any remaining portion of deferred revenue is recorded as revenue
following the termination of the extended redemption period and following
completion of all outstanding rebate claims.

Comparable-Store Revenue. Stores included in the comparable-store revenues
calculation are those stores that have been open for a minimum of 60 weeks. Also
included are stores that are remodeled or relocated. Sales via the internet are
not included and closed stores are removed from each comparable period for the
purpose of calculating comparable-store revenues.

16

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 period
for the three most recent fiscal years.

17

Fiscal 2002 Compared to Fiscal 2001

Revenues. Total revenues for the fiscal year ending January 31, 2003 were $495.4
million, up $23.7 million, or 5.0%, from $471.7 million for the fiscal year
ending January 31, 2002 primarily due to an increase in total comparable-store
revenue ("Comps") of 5.0% for the year. Elements of total Comps are as follows:

Merchandise Comps 4.8%
Rental video Comps 5.9%
Total Comps 5.0%

Total merchandise revenues increased $16.2 million, or 4.3% for fiscal 2002 to
$395.5 million from $379.3 million for fiscal 2001. The increase in merchandise
Comps was driven primarily by year over year increases of approximately 52% and
102% in total sales of DVDs and video games, respectively. Comp increases were
partially offset by a decline in music Comps of (6.3%) due primarily to the
current malaise of the music industry, which overall experienced a decline of
(8.7%) in total shipments of new release compact discs for 2002. Book Comps for
the year increased 3.6% as a result of our focus during fiscal 2002 to improve
our book department performance. Total rental video revenues for fiscal 2002
increased $7.5 million, or 8.1% to $99.8 million compared to $92.3 million for
the prior year primarily due to an increase in rentals of DVD titles of
approximately 90% year over year. The increase in DVD rentals was partially
offset by a 21% decline in VHS rentals. The acceptance of DVD by the consumer is
the primary reason for the decline in VHS rental revenue, but part of the
decline resulted from studios increasing the percentage of rental titles
released simultaneously for sale at a lower price-point, which entices the
consumer to purchase a title instead of renting.

Gross Profit. For fiscal 2002, total gross profit increased 7.2% to $160.9
million, or 32.5% of total revenues, from $150.1, or 31.8% of total revenues for
fiscal 2001.

Merchandise gross profit for fiscal 2002, as a percent of merchandise revenue,
decreased slightly to 26.0% compared to 26.2% for fiscal 2001 due primarily to
reduced margins in music and sale video which resulted from lower sales prices
in order to meet competitor pricing. Partially offsetting these declines was an
increase in book gross profit due primarily to a planned move toward higher
margin products in this category.

Merchandise gross profit dollars for fiscal 2002 increased approximately $3.4
million to $102.7 million from $99.3 million for fiscal 2001. Significant
components of this increase in gross profit dollars were:

(i) higher revenues generating a higher gross profit contribution
of approximately $4.0 million, despite a slight increase in
our product cost from 67.1% of merchandise revenue for fiscal
2001 to 67.5% for fiscal 2002;

(ii) a decline in inventory markdowns of approximately $2.6 million
compared to last fiscal year due primarily to our
automated-progressive markdown programs, which improve our
sell-through on slower moving merchandise;

(iii) a decrease in merchandise shrinkage of approximately $0.5
million; and

(iv) an increase of approximately $0.4 million from an increase in
certain trade and purchase discounts primarily resulting from
volume rebates related to merchandise inventory purchases.

Partially offsetting these increases in merchandise gross profit were:

(i) an increase of approximately $3.6 million in the costs
associated with returning merchandise inventory primarily
related to an increase of approximately $23.2 million, or
35.7%, in the volume of product returned to vendors during
fiscal 2002 compared to fiscal 2001. The higher level of
returns was mainly attributable to a planned reduction in
inventory levels; and

18

(ii) an increase in net freight expense of approximately $1.2
million, which was primarily caused by increases in shipments
from our distribution and returns facilities of approximately
15% for fiscal year 2002 compared to fiscal 2001 and higher
freight costs.

Rental video gross profit for fiscal 2002 increased $7.4 million, or 14.5%, to
$58.2 million up from $50.8 million for fiscal 2001. As a percent of rental
video revenue, rental video gross profit increased to 58.3% compared to 55.0%
for fiscal 2001. These increases were primarily the result of an increase in
rental video gross profit resulting from increases in the rentals of non-revenue
sharing titles, which generally reflect higher margins, representing a higher
percentage of total rental revenues and improved margins on videos acquired
under revenue sharing agreements.

Selling, General and Administrative Expenses. Selling, general and
administrative expenses ("SG&A"), including store and corporate labor and other
overhead costs, for fiscal 2002 increased 9.7% to $158.0 million, or 31.9% of
total revenues, from $144.1 million, or 30.5% of total revenues last year. The
increase was primarily the result of:

(i) charges totaling $2.6 million for the settlement of
shareholder class action lawsuits;

(ii) an increase in store variable human resource expenses,
excluding group healthcare costs, of approximately $3.8
million. Store human resource productivity decreased slightly
to 12.3% of total revenues for fiscal year 2002 compared to
12.1% for fiscal 2001;

(iii) a planned increase of approximately $3.3 million in
advertising expenditures designed to drive Comp revenues and
customer traffic;

(iv) an increase in occupancy related costs of approximately $1.8
million due to the operation of a higher number of superstores
during fiscal year 2002 when compared to fiscal year 2001;

(v) an increase of approximately $1.7 million related primarily to
increases in depreciation and consulting fees in connection
with the implementation of new financial software and upgrades
in our human resource systems; and

(vi) an unplanned increase of approximately $0.8 million in the
costs associated with our group healthcare plan, the majority
of which was the result of two large medical claims incurred
at the end of July 2002.

(vii) an increase of approximately $0.6 million in the costs
associated with expanding or relocating seven superstores and
the write-off of fixed assets related to the closing of one
superstore; and

(viii) an increase of approximately $0.8 million in other
miscellaneous SG&A expenses.

Partially offsetting these increases in SG&A were decreases of approximately
$1.7 million in net expense associated with the closing of certain superstores
and improved sublease activity.

Pre-opening Expenses. Pre-opening expenses were $0.5 million for fiscal 2002, as
we opened seven superstores during the year. For fiscal 2001, pre-opening
expenses totaled $0.2 million with the opening of five new superstores.
Pre-opening expenses include human resource costs, travel, rent, advertising,
supplies and certain other costs incurred prior to a superstore's opening.

Interest Expense. For fiscal 2002, when compared to fiscal 2001, interest
expense remained constant at 0.4% of total revenues. A higher average loan
balance outstanding offset lower interest rates year over year.

Interest Income. During the second quarter, we recorded interest income of
approximately $1.3 million as a result of interest earned on income tax refunds
for amended returns filed for fiscal years 1995 through 1998. The Company was
notified in July 2002 that the payment of the refunds, which totaled
approximately $5.4 million, would be processed in

19

August 2002 and would be accompanied by interest payments. All refunds,
including interest, were received during fiscal 2002.

Income Taxes. We did not record any income tax expense for fiscal years 2002 and
2001 due to the reduction in the valuation allowance related to the net deferred
tax asset.

Net Income (Loss). We recorded net income of $1.9 million, or $0.16 per diluted
share for fiscal year 2002 compared to net income of $4.0 million or $0.34 per
diluted share reported for fiscal year 2001.

Fiscal 2001 Compared to Fiscal 2000

Revenues. Total revenues for the fiscal year ending January 31, 2002 were $471.8
million, up $13.6 million, or 3.0%, from $458.2 million for the fiscal year
ending January 31, 2001 primarily due to an increase in total comparable-store
revenue ("Comps") of 4.7% for the year. Elements of total Comps are as follows:

Merchandise Comps 4.3%
Rental video Comps 6.4%
Total Comps 4.7%

The Comp increases in merchandise and rental were partially offset by the
operation of three fewer superstores throughout fiscal 2001 compared to fiscal
2000. Total merchandise revenues increased $8.8 million, or 2.4% for fiscal 2001
to $379.3 million from $370.5 million for fiscal 2000. The increase in
merchandise Comps was driven primarily by year over year increases of 73% and
114% in total sales of DVDs and video games, respectively. Comp increases were
partially offset by a decline in music Comps of (3.5%) due primarily to the
current malaise of the music industry, which overall experienced a decline of
(4.1%) in total music shipments for 2001. Book Comps for fiscal 2001 increased
slightly at 0.3%. Total rental video revenues for fiscal 2001 increased $4.6
million, or 5.2% to $92.3 million compared to $87.7 million for the prior year
primarily due to an increase in rentals of DVD titles of 140% year over year.

Gross Profit. For fiscal 2001, total gross profit increased 7.4% to $150.0
million, or 31.8% of total revenues, from $139.7, or 30.5% of total revenues for
fiscal 2000.

Merchandise gross profit for fiscal 2001, as a percent of merchandise revenue,
increased to 26.2% compared to 24.3% for fiscal 2000 due primarily to:

(i) a reduction in the costs associated with the return of product of
approximately $5.9 million for fiscal 2001 which is attributable to
improvements made in the product return process during fiscal 2001 that
lowered the cost per dollar of return; and

(ii) lower product costs of approximately $1.5 million as a result of a
movement in our inventory selection toward higher margin products
particularly related to books.

Partially offsetting these increases in merchandise gross profit was an increase
of approximately $1.6 million in the costs of operating our distribution center.
During fiscal 2001, we implemented a strategy to increase the flow of certain
higher turning inventory items through our distribution center. This program
enables us to have a better in-stock position for our customers. For the year,
the volume of shipments from our distribution center to our superstores
increased approximately 42% in fiscal 2001 when compared to fiscal 2000, which
resulted in significantly higher operating costs.

Rental video gross profit for fiscal 2001, as a percent of rental video revenue,
decreased to 55.0% compared to 56.6% for fiscal 2000 due primarily to:

20

(i) an increase of approximately $1.6 million in depreciation expenses as
we procured a higher level of video games and DVD to meet increasing
demand. A large portion of these purchases were for catalog rental
product which exhibit slower turns than a new release title; and

(ii) an increase of approximately $0.8 million in costs associated with the
distribution of rental videos primarily due to increased overhead costs
as we processed a greater number of rental assets through our
distribution center.

Partially offsetting these decreases in rental video gross profit was an
increase in margin of approximately $0.7 million on the rental of revenue
sharing titles due to improved terms on agreements with studios. Additionally, a
higher percentage of non-revenue sharing titles, which generally reflect higher
margins, helped to offset the decreases listed above.

Selling, General and Administrative Expenses. Selling, general and
administrative expenses ("SG&A"), including store and corporate labor and other
overhead costs, for fiscal 2001 decreased 3.3% to $144.1 million, or 30.6% of
total revenues, from $149.0 million, or 32.5% of total revenues last year. This
substantial decrease was primarily the result of a higher level of expenses
recorded during fiscal 2000 including:

(i) $2.7 million in accounting and legal fees associated with the
restatement of the first three quarters of fiscal 1999 and the prior
four fiscal years. These fees did not recur during fiscal 2001;

(ii) asset impairment charges of $1.4 million comprised of $1.0 million in
writedowns of leasehold improvements included in three underperforming
superstores and $.4 million in writedowns of certain assets of the
Company's Internet segment were recorded during fiscal 2000. This
compares to a $0.7 million writedown of leasehold improvements for two
underperforming superstores in fiscal 2001. Although these superstores
continued to operate, such charges were recorded as projected cash
flows from these operations were not sufficient to realize the book
value of the specific assets; and

(iii) we recorded net expenses of $6.5 million in fiscal 2000 associated with
the closure of two superstores during the fourth quarter of fiscal 2000
and an additional four superstores approved for closure prior to year
end of fiscal 2000. This compared to net expenses of $1.5 million
related to two underperforming superstores which were approved for
closure during fiscal 2001, one of which was closed during the fourth
quarter of fiscal 2001 and the other closed in February 2002. Such
expenses are comprised of accruals for the net present value of future
minimum lease payments, the write-off of leasehold improvements, and
other related costs.

Partially offsetting the decreases in SG&A expense listed above was an increase
in net advertising costs of approximately $1.8 million year over year. The
higher expense was the result of a planned increase in targeted advertising
expenditures during fiscal 2001 to increase customer traffic.

Pre-opening Expenses. Pre-opening expenses were $0.2 million for fiscal 2001, as
we opened five superstores during the year. For fiscal 2000, pre-opening
expenses totaled $33,000 with the opening of one new superstore. Pre-opening
expenses include human resource costs, travel, rent, advertising, supplies and
certain other costs incurred prior to a superstore's opening.

Interest Expense. During fiscal 2001, interest expense decreased 40.0% to $2.1
million, or 0.4% of total revenues, from $3.5 million, or 0.8% of total revenues
for fiscal 2000. This reduction was primarily due to lower interest rates as
well as a lower average outstanding borrowing during the current year compared
to last year.

Income Taxes. Income tax expense for the fiscal years 2001 and 2000 was zero and
$2.0 million, respectively. No income tax expense was recorded related to income
for fiscal 2001 due to the reversal of a portion of the valuation allowance
related to the net deferred tax asset established in the fourth quarter of
fiscal 2000.

Net Income (Loss). We recorded net income of $4.0 million, or $0.34 per diluted
share for fiscal year 2001 compared to a net loss of ($14.6) million or ($1.25)
per share reported for fiscal year 2000.

21

Liquidity and Capital Resources

We generate cash from operations exclusively from the sale of merchandise and
the rental of video products and we have substantial operating cash flow because
most of our revenue is received in cash and cash equivalents. Other than our
principal capital requirements arising from the purchase, warehousing and
merchandising of inventory and rental videos, opening new superstores and
expanding existing superstores and updating existing and implementing new
information systems technology, we have no anticipated material capital
commitments. Our primary sources of working capital are cash flow from operating
activities, trade credit from vendors and borrowings under our revolving credit
facility (the "Facility"). Based on our current internal projections, we believe
our cash flow from operations and borrowings under the Facility will be
sufficient to fund our ongoing operations, new superstores and superstore
expansions through fiscal 2005.

Consolidated Cash Flows

Operating Activities. Net cash flows from operating activities increased
$6.4 million, or 14.1% to $51.7 million in fiscal 2002 from $45.3 million
in fiscal 2001. In addition to a reduction in net income of approximately
$2.1 million in fiscal 2002 compared to fiscal 2001, we recorded a decline
in trade accounts payable and accrued expenses of approximately $5.0
million in fiscal 2002 compared to an increase of approximately $11.8
million in fiscal 2001. This variance was primarily the result of increased
merchandise returns to vendors and the recording of subsequent reductions
of amounts owed to those vendors. Offsetting these declines in cash
provided by operations was an increase primarily resulting from a planned
decline in merchandise inventory during fiscal 2002 of approximately $5.8
million compared to an increase of approximately $13.9 million during
fiscal 2001. In addition, we recorded a greater decrease in income taxes
receivable in fiscal 2002 compared to fiscal 2001 of approximately $2.8
million primarily relating to a net increase in the amount of income tax
refunds received during fiscal 2002 compared to fiscal 2001.

Investing Activities. Net cash used in investing activities increased $18.2
million, or 39.1%, from $46.5 million in fiscal 2001 to $64.7 million in
fiscal 2002. This increase was due primarily to the increased purchase of
rental video assets during fiscal 2002 due to new and expanded superstore
activity, increased purchases of DVD and video games to meet customer
demand and a higher percentage of our total rental video procurement
expended for non-revenue sharing titles, which generally have a higher
purchase price than titles purchased under revenue sharing agreements.
Additionally, the increase related to expenditures associated with the
opening of seven new superstores and the expansion or remodel of nine
superstores during fiscal 2002 compared to the opening of five new
superstores and the expansion or remodel of seven superstores during fiscal
2001 and an increase in information systems expenditures to install new and
upgraded hardware and software systems. Our capital expenditures include
store equipment and fixtures, expanding and remodeling existing
superstores, upgrading and implementation of information systems technology
and the purchase of rental video assets.

Financing Activities. Cash provided by or used in financing activities is
primarily associated with borrowings and payments made under our revolving
credit facility (defined below under "Capital Structure"). Cash provided by
financing activities increased $11.8 million to $13.1 million in fiscal
2002 compared to $1.2 million in fiscal 2001. This increase was primarily
the result of higher net borrowings of approximately $9.4 million under our
revolving credit facility for fiscal 2002 compared to fiscal 2001 and lower
stock repurchase activity of approximately $2.5 million for fiscal 2002
compared to fiscal 2001.

On September 18, 2001 we announced a stock repurchase program of up to $5.0
million of our common stock. As of January 31, 2003, a total of
approximately 723,000 shares had been purchased at a cost of approximately
$3.5 million, for an average cost of $4.89 per share.

22

Capital Structure. On August 23, 2002, we executed an amendment to our
syndicated secured Loan and Security Agreement with Fleet Retail Finance, Inc.
and The CIT Group/Business Credit, Inc, (the "Facility"). The amount outstanding
under the Facility is limited by a borrowing base predicated on eligible
inventory, as defined, and certain rental video assets, net of accumulated
depreciation less specifically defined reserves and is limited to a ceiling of
$80 million, less a $10 million availability reserve. The Facility's interest
rate is based on the prevailing prime rate or LIBOR plus a margin percentage, at
our option. The borrowing base under the Facility is limited to an advance rate
of 65% of eligible inventory and certain rental video assets net of accumulated
amortization less specifically defined reserves, which can be adjusted to reduce
availability under the Facility. The Facility contains no financial covenants,
restricts the payment of dividends and includes certain other debt and
acquisition limitations, allows for the repurchase of up to $7.5 million of our
common stock and requires a minimum availability of $10 million at all times.
The Facility is secured by substantially all of the assets of the Company and
our subsidiaries and is guaranteed by each of our three consolidated
subsidiaries. The Facility matures on August 20, 2005. At January 31, 2003, we
had $16.4 million in excess availability, after the $10 million availability
reserve, under the Facility. At January 31, 2003 and January 31, 2002,
respectively, we had borrowings outstanding of $45.7 million and $32.2 million
under the Facility. The average rate of interest being charged under the
Facility was 4.1% and 6.1% at January 31, 2003 and January 31, 2002,
respectively.

From time to time, we enter into interest rate swap agreements in order to
obtain a fixed interest rate on a portion of our outstanding floating rate debt
thereby reducing our exposure to interest rate volatility. On October 4, 2002,
we cancelled, at no cost, two swap agreements entered into in November and
December of 2001 with an aggregate notional amount of $20 million and replaced
those agreements with one interest rate swap agreement with a financial
institution. The notional amount of the swap is $20 million with a fixed
interest rate of 2.45% for two years. We have designated the interest rate swap
as a hedging instrument. At January 31, 2003, the fair value of the interest
rate swap was not significant.

At January 31, 2003, our minimum operating lease commitments for fiscal 2003
were approximately $19.0 million. The present value of total existing minimum
operating lease commitments for fiscal years 2004 through 2030 discounted at
9.0% was approximately $57.8 million as of January 31, 2003.

Seasonality and Inflation

As is the case with many retailers, a significant portion of our revenues, and
an even greater portion of our operating profit, is generated in the fourth
fiscal quarter, which includes the Christmas selling season. As a result, a
substantial portion of our annual earnings has been, and will continue to be,
dependent on the results of this quarter. We experience reduced rentals of video
activity in the spring because customers spend more time outdoors. Major world
or sporting events, such as the war in Iraq, the Super Bowl, the Olympic Games
or 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 superstore openings, the number and popularity of new book,
music and videocassette titles, the cost of the 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.

We do not believe that inflation has materially impacted net income during the
past three years. Substantial increases in costs and expenses could have a
significant impact on our operating results to the extent such increases are not
passed along to customers.

Recent Accounting Pronouncements

In June 2002, the FASB issued Statement No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS No. 146"). This statement
requires that the fair value of a liability associated with an exit or disposal
activity be recognized when the liability is incurred. Prior to the adoption of
SFAS No. 146, certain exit costs were recognized when we committed to a
restructuring plan, which may have been before the liability was incurred. The
provisions of this statement were effective for exit or disposal activities
initiated subsequent to December 31, 2002. The adoption of SFAS No. 146 did not
have a material impact on our financial position or results of operations.

23

In January, 2003, the Emerging Issues Task Force ("EITF") reached a consensus on
Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor." The issue provides guidelines for
specific treatment and classification of certain amounts received by a customer
from a vendor in connection with product purchased from the vendor. EITF 02-16
is effective prospectively for new arrangements entered into after December 31,
2002. The provisions of EITF 02-16 did not have a significant impact on our
financial position or results of operations as of, and for the year ended,
January 31, 2003. We are analyzing the provisions of EITF 02-16 for arrangements
entered into for fiscal 2003 but have not yet determined the impact on our
financial position and results of operations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the ordinary course of our business, we are exposed to certain market risks,
primarily changes in interest rates. Our exposure to interest rate risk consists
of variable rate debt based on the lenders base rate or LIBOR plus a specified
percentage at our option. The annual impact on our results of operations of a
100 basis point interest rate change on the January 31, 2003 outstanding balance
of the variable rate debt would be approximately $0.5 million, including the
effect of our interest rate swap. After an assessment of these risks to our
operations, we believe that the primary market risk exposures (within the
meaning of Regulation S-K Item 305) are not material and are not expected to
have any material adverse impact on our financial position, results of
operations or cash flows for the next fiscal year. In addition, we do not
believe changes in the fair value of our interest rate swap entered into in
October of 2002 with a notional amount of $20 million will be material.

24

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

HASTINGS ENTERTAINMENT, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULE

25

REPORT OF INDEPENDENT AUDITORS

The Board of Directors
Hastings Entertainment, Inc.

We have audited the accompanying consolidated balance sheets of Hastings
Entertainment, Inc. and subsidiaries as of January 31, 2003 and 2002, and the
related consolidated statements of operations, shareholders' equity, and cash
flows for each of the three years in the period ended January 31, 2003. Our
audits also included the financial statement schedule listed in the Index at
Item 15(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Hastings
Entertainment, Inc. and subsidiaries at January 31, 2003 and 2002, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended January 31, 2003 in conformity with accounting
principles generally accepted in the United States. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.

/s/ Ernst & Young LLP

Fort Worth, Texas
March 14, 2003

26

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
January 31, 2003 and 2002
(In thousands, except share data)

See accompanying notes to consolidated financial statements.

27

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
Years Ended January 31, 2003, 2002 and 2001
(In thousands, except per share data)

See accompanying notes to consolidated financial statements.

28

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Years ended January 31, 2003, 2002 and 2001
(In thousands, except share data)