Oct. 16 (Bloomberg) -- Movie Gallery Inc., the second- largest U.S. video-rental chain, sought bankruptcy protection from creditors, promising to cut debt by $400 million and to leave shareholders with 2 percent of the company.

Movie Gallery listed assets of $892 million and debt of $1.4 billion in its Chapter 11 petition filed early this morning in the U.S. Bankruptcy Court in Richmond, Virginia.

The company said it filed for bankruptcy because of two years of losses and increased competition from Blockbuster Inc. and Netflix Inc. In that time, the video-rental industry was forced to respond to on-demand products delivered over broadband networks.

``I don't think bankruptcy will save them,'' said Stacey Widlitz, an analyst at Pali Capital, who follows the industry. ``They have no edge versus the competition. I think store closings will only accelerate.''

Chief Executive Officer Joe Malugen said on Sept. 25 that the Dothan, Alabama-based company was closing about 520 unprofitable locations, allowing it to focus on 4,000 stores that have ``stronger operating performance and prospects for future growth.''

``Movie Gallery's timing was terrible,'' said Michael Pachter, an analyst at Wedbush Morgan Securities in Los Angeles. ``They misjudged how irrationally both Netflix and Blockbuster would behave in their zeal to escalate the online war. That irrational behavior served to grow the online audience, largely at the expense of Movie Gallery.''

Cash Flow

The proposed reorganization would improve cash flow by cutting Movie Gallery's interest payments, the company said in its statement.

Movie Gallery said it has an agreement for Sopris Capital Advisors LLC to sponsor a plan calling for converting $325 million in 11 percent senior notes and $72 million in second-lien debt into new stock. Sopris will backstop a $50 million rights offering to eligible noteholders.

Goldman Sachs Credit Partners LP arranged $150 million in financing for the reorganization, Movie Gallery said in court filings.

U.S. Bankruptcy Judge Douglas O. Tice Jr. today approved the company's request to access as much as $140 million of that financing to pay vendors and employees, the company said in a second statement.

Some of those funds will enable Movie Gallery to continue paying employee wages and health benefits at pre-bankruptcy levels, according to the statement.

Continuing Operations

``This approval will allow our stores to continue to operate so that we can continue to serve our customers while implementing strategies to enhance our financial performance,'' Malugen said in the statement.

The company also filed papers requesting court approval to reject 212 unexpired leases on vacant stores that cost Movie Gallery about $15.4 million per year. The lease payments for the stores range from $14,400 to $235,000 per year.

Such costs ``constitute an unnecessary drain on the debtors' resources,'' the company said in court papers. The agreements include 194 leases and 18 subleases.

Standard & Poor's Ratings Services analyst Gerald A. Hirschberg lowered the ratings on the company's first-lien and senior unsecured debt to 'D' from 'CC' today following the Chapter 11 filing, S&P said in a statement.

The company plans to auction the leases for 508 of the 520 store locations it plans to close. The auction is subject to court approval. The company requested a Nov. 15 auction date and a Nov. 29 sale hearing, according to court papers. The company said the lease auctions would save about $69.4 million a year.

Cost Structure

``Movie Gallery needs to re-align its cost structure due to the ongoing changes in our industry,'' Malugen said in the statement announcing the bankruptcy filing.

Movie Gallery had a net loss of $25.7 million last year on sales of $2.54 billion. Movie Gallery's has almost $725 million of first-lien debt and $175 million in second-lien debt.

The company defaulted on the debt on July 2, telling credit-line administrator Goldman Sachs that it didn't meet the requirement for the loan in the second quarter.

The company was ``very slow to cut costs, very slow and that's what killed them,'' said Pachter, who has a ``hold'' rating on the shares.

The company said in August that it may not have enough cash to continue operations and that it tapped its entire credit line.

Sopris Plan

The plan with Sopris calls for the first-lien debt to remain in place on revised terms that are being negotiated. The remainder of the second-lien debt will remain in place, also on renegotiated rates and terms.

The plan includes a $50 million equity rights offering to eligible noteholders. Sopris has agreed to purchase any of the equity not bought by other noteholders, subject to the plan to let existing stockholders have about 2 percent of the equity.

``The Sopris proposal provides a full recovery to the first-and the second-lien lenders ,'' Peter Wolfson, a New York attorney who represents Sopris, said in a phone interview.

Movie Gallery said in a July statement that lenders agreed not to press claims on the company's $725 million loan until Aug. 14. Movie Gallery operates under the names Movie Gallery, Hollywood Video and Game Crazy. Its Canadian affiliates aren't included in the bankruptcy filing.

Movie Gallery's shares fell 7 cents to 21 cents, or 25 percent, in Nasdaq Stock Market trading, after reaching a one- year low of 19 cents earlier in the day. The stock, which traded at more than $33 in June 2005, fell from a one-year high of $6.75 in August 2006.

The case is In re Movie Gallery Inc., 07-33849, U.S. Bankruptcy Court, Eastern District Virginia (Richmond).

To contact the reporters on this story: Dawn McCarty in Wilmington, Delaware, at dmccarty@bloomberg.net; Josh Fineman in New York at jfineman@bloomberg.net.

Last Updated: October 16, 2007 19:15 EDT