UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended July 31, 2004

For the transition period from __________________ to __________________

Commission File Number 000-24381

HASTINGS ENTERTAINMENT, INC.

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

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 12 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 )

Number of shares outstanding of the registrant’s common stock, as of August 31, 2004:

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Form 10-Q
For the Quarterly Period Ended July 31, 2004

INDEX

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PART 1

ITEM 1 - FINANCIAL STATEMENTS

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

See accompanying notes to unaudited consolidated financial statements.

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HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

See accompanying notes to unaudited consolidated financial statements.

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HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

See accompanying notes to unaudited consolidated financial statements.

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Hastings Entertainment, Inc. and Subsidiaries

1. Basis of Presentation

The accompanying unaudited consolidated financial statements of Hastings Entertainment, Inc. and its subsidiaries (the “Company,” “We,” “Our,” “Us”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with instructions in Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such principles and regulations of the Securities and Exchange Commission. All adjustments, consisting only of normal recurring adjustments, have been made which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods. The results of operations for such interim periods are not necessarily indicative of the results that may be expected for a full year because of, among other things, seasonality factors in the retail business. The unaudited consolidated financial statements contained herein should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for fiscal year 2003.

Certain prior year amounts have been reclassified to conform with the fiscal 2004 presentation.

Our fiscal year ends on January 31 and is identified as the fiscal year for the immediately preceding calendar year. For example, the fiscal year that will end on January 31, 2005 is referred to as fiscal year 2004.

2. Stock Option Plans

We account for our stock option plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations. Compensation expense is recorded on the date of grant only if the market price of the underlying stock exceeds the exercise price. Under Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (“SFAS 123”), we may elect to recognize expense for stock-based compensation based on the fair value of the awards, or continue to account for stock-based compensation under APB 25 and disclose in the financial statements the effects of SFAS 123 as if the recognition provisions were adopted. We have elected to continue to apply the provisions of APB 25 and provide the pro forma disclosure provisions of SFAS 123. The following schedule reflects the impact on net income (loss) and income (loss) per share if we had applied the fair value recognition provisions of SFAS 123 to stock based compensation.

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Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2004 and 2003
(Tabular amounts in thousands, except per share data or unless otherwise noted)

3. Store Closing Reserve

From time to time and in the normal course of business, we evaluate our store base to determine if the need to close a store(s) exists. Such evaluations include, among other factors, current and future profitability, market trends, age of store and lease status.

Amounts in accrued expenses and other liabilities at July 31, 2004 include accruals for the net present value of future minimum lease payments and other costs attributable to closed or relocated stores, net of estimated sublease income. Expenses related to store closings are included in selling, general and administrative expenses in our consolidated statements of operations.

The following tables provide a rollforward of reserves that were established for these charges for the six months ended July 31, 2004 and 2003.

As of July 31, 2004, the reserve balance, which is net of estimated sublease income, is expected to be paid over the next five years. Other costs are charged against the reserve as incurred.

4. Income Taxes

We recognized a provision for income taxes of approximately $0.2 million and $1.4 million for the three and six months ended July 31, 2004, respectively, compared to zero for the three and six months ended July 31, 2003. No income tax benefit was recorded during the three and six months ended July 31, 2003 due to adjustments in the valuation allowance related to the net deferred tax asset.

Based on our past three fiscal years of profitability and our belief that existing and projected levels of pre-tax income are sufficient to generate the minimum amount of future taxable income necessary to realize the deferred tax asset, the realization of our deferred tax asset was considered more likely than not and a valuation allowance was no longer required as of January 31, 2004.

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Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2004 and 2003
(Tabular amounts in thousands, except per share data or unless otherwise noted)

5. Income (loss) per Share

    The computations for basic and diluted income (loss) per share are as follows:

The following options to purchase shares of common stock were not included in the computation of diluted income (loss) per share because their inclusion would have been antidilutive:

6. Litigation and Contingencies

During the current fiscal year, we were named as defendants in complaints alleging that our extended viewing fees for movie and game rentals are illegal under the Uniform Commercial Code. While we intend to vigorously defend these matters and anticipate favorable results, the ultimate outcome of these matters cannot be estimated at this time. In the event an adverse judgment was rendered, the impact on the consolidated financial statements could be material.

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.

7. Segment Disclosures

We have two operating segments, retail stores and Internet operations. Our chief operating decision maker, as that term is defined in the relevant accounting standard, regularly reviews financial information about each of the above operating segments for assessing performance and allocating resources. Revenue for retail stores is derived from the sale of merchandise and rental of videocassettes, video games and DVDs. Revenue for Internet operations is derived solely from the sale of merchandise. Segment information regarding our retail stores and Internet operations for the three and six months ended July 31, 2004 and 2003 is presented below.

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Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
July 31, 2004 and 2003
(Tabular amounts in thousands, except per share data or unless otherwise noted)

8. Change in Accounting Principle

In January 2003, the Emerging Issues Task Force reached a consensus on Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”). 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 was effective prospectively for new arrangements entered into after December 31, 2002. Accordingly, a portion of our vendor advertising allowances have been recorded as a reduction of merchandise inventory and the cost of rental assets and will be recognized in cost of revenues as inventory is sold and as rental assets are rented. Certain amounts that we receive from vendors, such as cooperative advertising payments, are considered reimbursement for specific, identifiable costs and therefore continue to be recorded as a reduction of SG&A. For the three months ended July 31, 2003, net income was decreased approximately $0.2 million and for the six months ended July 31, 2003, net loss was increased by approximately $0.7 million as a result of this change in accounting principle.

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ITEM 2. 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 convey the uncertainty of future events and 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, the impact on our financial statements of inflation, effect of lower of cost or market inventory adjustments, the accrual for product returns, rental asset depreciation, our store closing reserve, revenue recognition, sufficiency of cash flow from operations and borrowings under our amended revolving credit facility and statements expressing general optimism 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:

	-		whether our assumptions turn out to be correct;
	-		our ability to attain such estimates and expectations;
	-		a downturn in market conditions in any industry, including the economic state of retailing, relating to the products we inventory, sell or rent;
	-		the effects of, or changes in, economic and political conditions in the U.S. and the markets in which we operate our superstores, including the effects of inflation, deflation, recession, war, terrorism, changes in interest and tax rates, the availability of consumer credit and any other matters that influence customer confidence;
	-		our ability to forecast and meet customer demand for products;
	-		our ability to access suitable merchandise on acceptable terms from merchandise vendors;
	-		our ability to attract quality employees and control our labor costs; and
	-		our ability to find new sites to lease for our superstores upon acceptable terms.

Any of the foregoing factors and uncertainties, as well as others, 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 the report.

General

Hastings Entertainment, Inc. is a leading multimedia entertainment retailer. We operate entertainment superstores that sell and rent various home entertainment products, including books, music, software, periodicals, new and used CDs, DVDs, video games and videocassettes, video game consoles and DVD players. As of July 31, 2004, we operated 151 superstores averaging approximately 20,000 square feet in small to medium-sized markets located in 20 states, primarily in the Western and Midwestern United States. Each of our superstores is company-operated under the name of Hastings. Our operating strategy is to enhance our position as a multimedia entertainment retailer by expanding existing superstores, opening new superstores in selected markets and expanding our offering of 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 ending January 31, 2005 is referred to as fiscal year 2004.

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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 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 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 an 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 these 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 changes in product offerings. At the end of any reporting period, cost accruals are required for inventory that has been returned to vendors, 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. To accrue for such costs and estimate this 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.

Rental Asset Depreciation. 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 2003. Revenue sharing allows us to acquire rental 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 the shorter period of 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 cost of revenue, as revenues are recognized. The capitalized cost of all rental assets acquired for a fixed price is being depreciated on an accelerated basis over six months to a salvage value of $4 per unit, except for rental 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. Rental assets purchased for less than $4 are not amortized.

We monitor closely the recovery value of our rental assets. Our current experience is that the recovery value of our rental assets is higher than our estimated salvage value of that item in our rental inventory. Based in part on this factor and sales of previously viewed tapes, we believe our estimate of salvage value is appropriate. However, if future demand or market conditions are less favorable than management projections, inventory adjustments, including possible changes to rental asset cost amortization methods or salvage values, may be required.

Store Closing Reserve. On a quarterly basis, and in the normal course of business, we evaluate our store base to determine if we need to close or relocate a store(s). 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. We recognize such expense items 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. We actively pursue sublease tenants on all closed or relocated locations and, as part of the final estimation of store closing liability, the impact of any sublease income is estimated. The net of the described

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charges and sublease income estimates can have a material effect on the financial results of an annual or interim period.

Revenue Recognition. We generate revenue 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 our 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. We, as with most retailers, also offer 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, we will offer sales incentives to customers in the form of rebates. 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 during the comparable period. Sales via the Internet are not included and closed stores are removed from each comparable period for the purpose of calculating comparable-store revenues.

Vendor Allowances. In 2002, the Emerging Issues Task Force (“EITF”) discussed issue no. 02-16 (“EITF 02-16”), which addresses the accounting for cash consideration received from a vendor by a reseller for various vendor-funded allowances, including cooperative advertising support. The EITF determined that cash consideration received from a vendor should be presumed to be a reduction of the prices of vendor’s products and, therefore, should be shown as a reduction in the cost of goods sold when recognized in the reseller’s income statements. The only exception to this rule is if the reimbursement is for specific, incremental identifiable costs. If the amount of cash consideration received exceeds the cost being reimbursed, that excess amount should be characterized as a reduction of cost of goods sold when recognized in the reseller’s income statements. In January 2003, the EITF issued transition guidance concluding that this interpretation should be applied to all new or modified arrangements entered into after December 31, 2002. Accordingly, a portion of our vendor advertising allowances have been recorded as a reduction of merchandise inventory and the cost of rental assets and will be recognized in cost of revenues as inventory is sold and as rental assets are rented. Certain amounts that we receive from vendors, such as cooperative advertising payments, are considered reimbursement for specific, identifiable costs and therefore continue to be recorded as a reduction of SG&A.

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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.

Summary of Superstore Activity

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Three months ended July 31, 2004 compared to three months ended July 31, 2003

Revenues

Total revenues for the second quarter increased $7.0 million, or 6.1%, to $122.4 million compared to $115.4 million for the second quarter of fiscal 2003, resulting principally from an increase of 4.0% in comparable-store revenues (“Comps”). The following is a summary of our revenue results (dollars in thousands):

Comparable-store revenues:

Merchandise revenue. The higher merchandise Comps were primarily the result of Comp increases in our video for sale, video game and music categories. Below is a summary of the Comp results for those categories:

Increases in video for sale were driven by total revenue increases of approximately 58.3% from the sale of DVD items, which were partially offset by a decline of approximately 42.7% from the sale of VHS items, as a result of a continued shift in consumer preference from VHS to DVD. With the simultaneous availability of retail and rental product, we believe that DVD sales will continue to show increases for the remainder of fiscal year 2004, with comparable decreases reflected in VHS over the same period. Revenue increases in video games were primarily due to higher sales of previously rented titles and hot title releases in the Xbox platform. Our music Comps benefited from improved inventory management and system enhancements and stronger title releases during the second quarter of fiscal year 2004, compared to the same period last year. These improvements, initiated during fiscal year 2003, increased our selection of popular titles and augmented product depth, which generated higher sales.

As predicted in the Management’s Discussion and Analysis of Financial Condition in our quarterly report on Form 10-Q for the first quarter of fiscal 2004, our book Comps decreased 1.2% during the current quarter primarily due to last year’s release of the fifth Harry Potter book.

Rental revenue. Rental Comps declined 5.5% for the three months ended July 31, 2004 as compared to the same period in fiscal 2003, reflecting general rental weakness industry-wide. During the current quarter, DVD rentals increased approximately 24.7% from the same quarter in the prior year. This increase was offset by a decline in VHS of approximately 46.4% from the comparable period.

As the rental industry continues to feel the pressure of competitive retail price points on retail DVD and to the extent that the titles released entice the customer to purchase units in lieu of renting, we expect, and have projected, that our rental Comps will be in the negative-low single digits for the remainder of fiscal year 2004. We believe, however, that the rental market will stabilize during 2005.

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Gross Profit

For the second quarter, total gross profit dollars increased approximately $3.2 million, or 8.1%, to $43.7 million from $40.5 million for the same period last year. As a percentage of total revenues, gross profit increased to 35.7% for the quarter compared to 35.1% for the same quarter in the prior year. The following is a summary of our gross profit results:

Merchandise Gross Profit. The increase in merchandise gross profit is primarily the result of higher revenues and margin rates, particularly in our book, music and video for sale categories. The higher margin rates are primarily attributable to better inventory and title selection management resulting in improved sales of higher margin products and reduced cost of merchandise inventory returns. Also contributing to higher margins in our book category was a favorable quarter-to-quarter comparison resulting from lower margins in the prior year as a result of competitive pricing on the release of the fifth Harry Potter book during the second quarter of fiscal 2003. Partially offsetting these increases in gross profit were higher costs of approximately $0.4 million associated with the distribution and return of merchandise inventory primarily relating to the implementation of a new warehouse management system. The new system will increase product picking and shipping efficiencies, reduce dock congestion and provide for faster processing of orders to move product to our stores sooner, resulting in improved inventory in-stock rates and, in the future, lower distribution costs. During the conversion period, we incurred approximately $0.5 million in incremental distribution costs, primarily labor. These incremental costs were necessary in order to catch up on store shipments that were delayed during the conversion.

Rental Gross Profit. The decline in rental gross profit was primarily the result of higher purchases of non-revenue sharing rental assets during the first and second quarters of the current year compared to the same periods of the prior year which resulted in higher depreciation expense. Partially offsetting this increase were improved gross profit rates on videos acquired under revenue-sharing agreements.

Selling, General and Administrative Expenses. SG&A expenses increased approximately $2.6 million to $42.4 million for the current quarter compared to $39.8 million for the same quarter in the prior year. As a percentage of total revenues, SG&A increased slightly to 34.7% for the current quarter compared to 34.5% for the same quarter in the prior year. The increase in SG&A is due primarily to:

	i)		higher human resource and occupancy costs of approximately $2.1 million associated with the operation of a greater number of new, expanded and relocated superstores; and
	ii)		an unplanned increase of approximately $0.6 million in the cost associated with our group healthcare plan, the majority of which was the result of four large claims incurred in June 2004.

Interest Expense. Interest expense declined to $0.4 million, or 0.4% of total revenues, for the second quarter of fiscal 2004 compared to $0.5 million, or 0.5% of total revenues, for the second quarter of fiscal 2003 primarily related to lower average debt balances during the current period than in the comparable period.

Income Taxes. We recognized a provision for income taxes of approximately $0.2 million for the second quarter of fiscal 2004 compared to zero for the second quarter of fiscal 2003. No income tax benefit was recorded during the second quarter of fiscal 2003 due to adjustments in the valuation allowance related to the net deferred tax asset.

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Six months ended July 31, 2004 compared to six months ended July 31, 2003

Revenues

Total revenues for the first six months of fiscal 2004 increased $17.1 million, or 7.4%, to $249.3 million compared to $232.2 million for the same period in the prior year, resulting principally from an increase of 6.0% in comparable-store revenues (“Comps”). The following is a summary of our revenue results (dollars in thousands):

Comparable-store revenues:

Merchandise revenue. The higher merchandise Comps were primarily the result of Comp increases in our video for sale, video game, music and book categories. Below is a summary of the Comp results for those categories:

Increases in video for sale were driven by total revenue increases of approximately 53.3% from the sale of DVD items, which were partially offset by a decline of approximately 35.3% from the sale of VHS items. Music and book revenues benefited from better title selection and inventory management while the sale of previously rented video games boosted revenues in our video game category.

Rental revenue. Rental Comps declined 2.9% for the six months ended July 31, 2004 as compared to the same period in fiscal 2003, reflecting general rental weakness industry-wide. During the six-month period, DVD rentals increased approximately 30.9% from the same six-month period in the prior year. This increase was offset by a decline in VHS of approximately 43.7% from the comparable period.

Gross Profit

For the current six months, total gross profit dollars increased approximately $9.3 million, or 11.8%, to $88.3 million from $79.0 million for the same period last year. As a percentage of total revenues, gross profit increased to 35.4% for the six months ended July 31, 2004 compared to 34.0% for the same period in the prior year. The following is a summary of our gross profit results:

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Merchandise Gross Profit. The increase in merchandise gross profit is primarily the result of higher revenues and margin rates, particularly in our book, music and video for sale categories. The higher margin rates are primarily attributable to better inventory and title selection management resulting in improved sales of higher margin products and reduced cost of merchandise inventory returns. Also contributing to higher margins in our book category was a favorable quarter-to-quarter comparison resulting from lower margins in the prior year as a result of competitive pricing on the release of the fifth Harry Potter book during the second quarter of fiscal 2003. Partially offsetting these increases in gross profit were higher costs of approximately $0.4 million associated with the distribution and return of merchandise inventory primarily relating to the implementation of a new warehouse management system. During the conversion period, we incurred approximately $0.5 million in incremental distribution costs, primarily labor. These incremental costs were necessary in order to catch up on store shipments that were delayed during the conversion.

Rental Gross Profit. The decline in rental gross profit was primarily the result of higher purchases of non-revenue sharing rental assets during the first and second quarter of the current year compared to the same period of the prior year which resulted in higher depreciation expense. Partially offsetting this increase were improved gross profit rates on videos acquired under revenue-sharing agreements.

Selling, General and Administrative Expenses. SG&A increased approximately $4.8 million to $83.6 million for the current six-month period compared to $78.8 million for the same period in the prior year. As a percentage of total revenues, SG&A decreased to 33.5% for the six months ended July 31, 2004 compared to 33.9% for the six months ended July 31, 2003. The increase in SG&A dollars is primarily due to:

	i)		higher human resource and occupancy costs of approximately $4.4 million associated with the operation of a greater number of new, expanded and relocated superstores; and
	ii)		an unplanned increase of approximately $0.6 million in the cost associated with our group healthcare plan, the majority of which was the result of four large claims incurred in June 2004.

Interest Expense. Interest expense declined to $0.8 million, or 0.3% of total revenues, for the first six months of fiscal 2004 compared to $1.0 million, or 0.4% of total revenues, for the first six months of fiscal 2003 primarily related to lower average debt balances during the current period than in the comparable period.

Income Taxes. We recognized a provision for income taxes of approximately $1.4 million for the first six months of fiscal 2004 compared to zero for the first six months of fiscal 2003. No income tax benefit was recorded during the first six months of fiscal 2003 due to adjustments in the valuation allowance related to the net deferred tax asset.

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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 assets, 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 amended revolving credit facility. We believe our cash flow from operations and borrowings under our amended revolving credit facility will be sufficient to fund our ongoing operations, new superstores and superstore expansions through fiscal 2005.

Historically, we have experienced an increase in our debt level during the third quarter of our fiscal year as we build merchandise inventories for the holiday selling season. For the third quarter of fiscal 2004, we are projecting our debt level to increase to approximately $55.0 million. However, we expect this balance to reduce to approximately $25.0 million to $30.0 million due to a higher level of repayments during the fourth quarter following the holiday selling season.

Consolidated Cash Flows

Operating Activities. Net cash provided by operating activities decreased approximately $14.3 million, from $21.7 million for the six months ended July 31, 2003 to $7.4 million for the six months ended July 31, 2004, primarily resulting from an approximate $10.8 million decrease in merchandise inventory balances during the first half of fiscal 2003, which was the result of planned initiatives to lower inventory levels, compared to an increase in inventory levels of approximately $7.8 million during the first half of fiscal 2004. The higher inventory levels at July 31, 2004 were the result of slower shipping from our distribution center during the conversion to a new warehouse management system. Partially offsetting this change in merchandise inventory was an increase in net income for the first six months of fiscal year 2004 of approximately $3.2 million.

Investing Activities. Net cash used in investing activities increased $2.4 million to $27.3 million for the six months ended July 31, 2004 from $24.9 million for the six months ended July 31, 2003. This increase was primarily the result of increased purchases of non-revenue sharing rental assets, which generally cost more per unit than titles purchased under revenue sharing agreements.

Financing Activities. Cash provided by or used in financing activities is primarily associated with borrowings and payments made under debt agreements. For the six months ended July 31, 2004, net borrowings under debt agreements were $18.6 million compared to $2.6 million for the three months ended July 31, 2003. Increased borrowings were primarily the result of higher inventory levels as discussed above.

Capital Structure. On December 9, 2003, we executed an amendment to our syndicated secured Loan and Security Agreement with certain commercial lenders (the “Facility”). The amount outstanding under the Facility is limited by a borrowing base predicated on eligible inventory, as defined, and certain rental 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 permits borrowings at various interest-rate options based on the prime rate or London Interbank Offering Rate (LIBOR) plus applicable margin depending upon the level of our minimum availability. The borrowing base under the Facility is limited to an advance rate of 65% of eligible inventory and certain rental assets, net of accumulated amortization, less specifically defined reserves, which can be adjusted to reduce availability under the Facility. Lenders may increase specifically defined reserves to reduce availability in the event of adverse changes in our industry that are projected to impact the value of our assets pledged as collateral. 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 the assets of the company and our subsidiaries and is guaranteed by each of our three consolidated subsidiaries. The Facility matures on August 29, 2007. At July 31, 2004, we had $15.3 million in excess availability, after the $10 million availability reserve, under the Facility. However, excess availability may be reduced in the future as changes in the borrowing base occur or the lenders increase availability reserves. At July 31, 2004 and January 31, 2004, respectively, we had borrowings outstanding of $47.8 million and $29.0 million under the Facility. The average rate of interest being charged under the Facility for the six months ended July 31, 2004 and the fiscal year ended January 31, 2004 was 3.2% and 3.8%, respectively.

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We utilize standby letters of credit to support certain insurance policies. The aggregate amount of the letters of credit at July 31, 2004 was approximately $1.3 million, which reduces the excess availability under the Facility.

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. We have one interest rate swap agreement with a financial institution that expires October 1, 2004. The notional amount of the swap is $20 million with a fixed interest rate of 2.45%. We have designated the interest rate swap as a hedging instrument. At July 31, 2004, the fair value of the interest rate swap was not significant.

At July 31, 2004, our minimum operating lease commitments for the remainder of fiscal 2004 were approximately $12.0 million. The present value of total existing minimum operating lease commitments for fiscal years 2005 through 2024 discounted at 9.0% was approximately $96.5 million as of July 31, 2004.

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, capital and operating leases and certain revenue-sharing arrangements. As of July 31, 2004, other than operating leases and standby letters of credit, we had not entered into any off-balance sheet arrangements or third-party guarantees, nor is it our business to do so. At July 31, 2004, there have been no material changes in our contractual obligations or off-balance sheet arrangements from those reported in our Form 10-K for the year ended January 31, 2004.

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 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 store 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 retailers in general and Hastings in particular.

We do not believe that inflation has materially impacted operating results 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.

ITEM 3. 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 lender’s 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 July 31, 2004 outstanding balance of the variable rate debt would be approximately $0.3 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 that changes in the fair value of our interest rate swap entered into in October 2003 with a notional amount of $20 million will be material.

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ITEM 4. CONTROLS AND PROCEDURES

As required by Exchange Act Rules 13a-15 and 15d-15, an evaluation was conducted under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of July 31, 2004, and based on this evaluation our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of such date to ensure that information required to be disclosed by us in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

There has not been any change in our internal control over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1. LEGAL PROCEEDINGS

During the current fiscal year, we were named as defendants in complaints alleging that our extended viewing fees for movie and game rentals are illegal under the Uniform Commercial Code. While we intend to vigorously defend these matters and anticipate favorable results, the ultimate outcome of these matters cannot be estimated at this time. In the event an adverse judgment was rendered, the impact on the consolidated financial statements could be material.

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.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

A summary of our purchases of shares of our common stock for the three months ended July 31, 2004 is as follows:

ISSUER PURCHASES OF EQUITY SECURITIES

(1)		All share purchases were open-market purchases made under a repurchase plan publicly announced in a press release dated September 28, 2001. Our board of directors authorized the purchase of up to $5.0 million of our common stock. The purchases satisfied the conditions of the safe harbor of Rule 10b-18 under the Securities Exchange Act of 1934.
(2)		A total of 860,423 shares have been purchased under the repurchase plan at a total cost of approximately $4.225 million, or approximately $4.91 per share.

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

We held our Annual Meeting of Shareholders on June 9, 2004. The sole item submitted by management to a vote of the shareholders was the election of Ann S. Lieff as a Director of the Company for a term expiring in 2007. Proxies for the meeting were solicited pursuant to Regulation 14 under the Exchange Act, there was no solicitation in opposition to the Director nominee and the Director nominee was elected. The vote tabulation with respect the nominee Director was as follows:

The total number of abstentions and broker non-votes was 119,045 out of a total of 11,361,506 shares entitled to vote on the matter.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a. Listing of exhibits

b.

On May 26, 2004 the Company filed a current report on Form 8-K reporting, under “Item 12. Results of Operations and Financial Condition,” that the Company had announced, among other things, its financial results for the quarterly period ended April 30, 2004.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:

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INDEX TO EXHIBITS

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