Thursday, April 21, 2005

Block-Busted

Dallas based Blockbuster (BBI), with over 5,500 retail outlets, is the largest video retailer in the United States. A long-time global leader in the home entertainment industry, the company is facing an onslaught of strategic and competitive problems. Smelling blood, corporate raider Carl Icahn acquired a large stake in the firm, arguing in a letter to the SEC for the sale of the firm. Blockbuster Chairman and Chief Executive John Antioco responded to Icahn’s letter by highlighting the growth strategy that has been devised to elevate the firm from a bricks-and-mortar video rental retailer to a purveyor of total home entertainment, complete with a massive online presence.

The demise of the rental store is attributable to a number of substitute products and services now available to savvy and fickle consumers. First, people can purchase DVD's and video games cheaply at Wal-Mart and other super stores. These firms use DVDs as loss-leaders to generate traffic into their outlets. In 2004, DVD sales came in at $16B, while the movie rentals generated only $8.8B in fees, down from $9.8B in 2003. Second, the once futuristic concept of video-on-demand is now a tangible reality. Finally, and most worrisome, the rental website Netflix has made massive headway onto Blockbuster's turf. The site's three million subscribers can choose from over 40,000 titles for a low monthly fee of $17.99 a month. Without Blockbuster's physical overhead, Netflix can pass along savings to consumers, a great number of whom are willing to sacrifice immediacy for price and selection.

The firm's response to these changes has been to attempt expansion, cut prices, and move in a new strategic direction. In 2004, Viacom divested its interest in the firm, as advertising made a long awaited recovery and the firm no longer needed Blockbuster’s cash life-support. As a stand alone, Blockbuster recognized the benefits of retail scale, so it made a bid for its nearest rival, Hollywood Video. The deal fell apart due to anti-trust concerns. Movie Gallery, the third biggest retailer, successfully bid for the chain, putting a squeeze on Blockbuster.

To combat Netflix, the firm introduced online and in-store monthly rental programs. Take-up has been solid, with about 750,000 in-store Movie Pass subscribers, and over 2 million online members. But the firm moved to slash prices this year, lowering from $24.99 to $14.99 the monthly fee. It also eliminated late-fees, with a $50 million marketing push for “No More Late Fees.” That program has been a disaster: Analysts predict it costing $250 - $300M a year, and states attorneys general lined up to sue, as the program did not actually eliminate late fees.

The very public debate with Icahn, and the many criticisms from market analysts, center around a central question: should Blockbuster continue to invest to broaden its scope, or is its business in such a state of disrepair that Blockbuster needs to get out before it is too late?

Icahn currently holds 9.7% Class A shares and 7.3% Class B shares of BBI. In an attempt to assert control, he has nominated himself and two others for Blockbuster’s board. Icahn argues that the firm’s time has come; it is wasting shareholder value by spending heavily on its new initiatives, at a time when those investments are unlikely to generate future profits. And he blasted Antioco’s lavish $51 million 2004 pay package. Instead, he would like to see cash withdrawn from the business in the form of large dividends for shareholders. Down the road, he envisions a sale to a strategic buyer.

Wall Street has mixed feelings. According to Marla Backer, an analyst with Soleil-Research Associates, Blockbuster should not payout the dividends in order to appease the proxy fight created by Icahn, but she does feel that his criticism is not far fetched. Lehman Brothers expresses concern over the revenues lost from late fees and the unproven investment initiatives.

In our opinion, Blockbuster’s management is trying to increase the company’s growth through unsustainable tactics which diverge from its core competencies. The Blockbuster brand is built around offering comprehensive video and video game rental selection at convenient, well-located retail outlets. It can leverage this brand online, but not at a low price point. Nor can it compete on price against the likes of Wal-Mart for sales. And we have serious concerns about its ability to compete in video-on-demand with the cable industry, especially now that it can no longer lean on Viacom for strength. These attempts will cost Blockbuster both in decreased revenue and increased costs, and will muddle its brand - likely the most valuable asset the company currently owns.

Antioco argues that eliminating late fees and lower the price of the online service will increase membership. Netflix has a solid customer base in large part due to antipathy to Blockbuster’s former dominance, and new online subscriptions to its own site are likely migrations from existing in-store memberships. So given the maturity of the market, we strongly feel that an increase in membership will not be enough to offset the price reductions, and hence increase revenues.

Although we feel that Icahn’s criticism may be more inline with his desire to make a quick dollar, we do agree with his concerns and criticisms of Blockbuster management. Considering the current entertainment landscape and Blockbuster’s position in it, we feel that the company should continue to focus on its retail video rental niche rather than spread itself too thin, both in terms of product offerings and capital expenditures. A strategic buyer is hard to envision, especially one outside the retail universe, but for the intermediate term, Blockbuster should fulfill Icahn’s demands for a cash harvest.

By: Suzanne Davidkhanian

Keith Guerrini

Yvette Nicholas

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