Wednesday, April 20, 2005

Blockbuster or Just Block-Bust?

Recently, financier and corporate raider Carl Icahn, who owns approximately 9.8% of Blockbuster Inc.’s Class A common stock and the company’s embattled Chief Executive Officer, John Antioco, have publicly exchanged volleys over Blockbuster’s strategy. Over the past several months, Blockbuster has made multiple strategic decisions, including entering the mail-order DVD business, changing its late fees policy on rentals, and attempting to acquire brick-and-mortar competitor Hollywood Entertainment. In addition to other charges regarding “unconscionable pay packages” and the bungled attempt at acquiring Hollywood, Icahn has stated in a recent letter to Antioco that management has been on a “spending spree” with shareholders’ money, and has urged the board to consider returning capital to shareholders via a dividend. Most recently, Icahn went as far as saying that the company should be sold. Icahn has nominated himself and two others for board of director positions; if successful in securing these board seats, Icahn could foreseeably gain control of the board as early as 2006 when two more of the seven board seats will come up for voting. Antioco, in his own letter, rebutted Icahn’s claims, saying that Icahn’s assertions are “inaccurate and potentially misleading to our shareholders.” Antioco defended management’s strategies to diversify its revenue streams in light of the challenges that the brick-and-mortar movie rental industry faces. In addition to Antioco’s well-paying job, the future of Blockbuster’s strategy, and perhaps even the viability of the company itself, lies in the balance.
Icahn’s frustration is arguably warranted given management’s recent track record. Last month, Blockbuster had to abandon its approximately $1.0 billion bid for Hollywood Video as the Federal Trade Commission had raised concerns about the potential anticompetitive consequences of the proposed deal with Hollywood. In addition, management agreed to pay approximately $630,000 to settle claims from forty-seven states that the company intentionally deceived consumers with its “No Late Fees” advertising campaign. Finally, Antioco’s compensation package has raised eyebrows, as he made $56.8 million in 2004, a year in which the company lost $1.25 billion and the company’s stock dropped 47%.
In response to competitive pressures from Netflix and Wal-Mart in the mail order DVD business, as well as looming threats from increased delivery of video and movie content directly into consumers’ homes, management has embraced the following strategies to bolster sales and profitability. First, the company shifted its strategy dramatically by launching its “No Late Fees” campaign in 2004. This was an attempt to make the company’s rental offerings more attractive to consumers who have multiple options, including purchasing movies, online rentals and video-on-demand, all of which do not have late fee penalties attached to them. The impact of this shift is a $250-$300 million loss in operating profit that otherwise would have been generated in late fees. Management believes, however, that its previous late fees policy helped cause negative same store sales comparisons over the last few years, and that by ending late fees this trend would reverse and consumers’ view of Blockbuster would improve, which in turn would help drive incremental in-store sales. The second strategy, separate and distinct from the “No Late Fees” strategy, is the creation of the “Movie Pass.” The intention behind Movie Pass is to charge a monthly fee for high usage customers to rent an unlimited number of movies for one price each month. In addition to the convenience of being able to rent multiple titles for one price, there are generally no extended viewing fees associated with Movie Pass. Furthermore, Movie Pass can be purchased for both in-store rentals and online rentals (via Blockbuster Online), the latter being very similar to Netflix’s offering. Blockbuster has been reasonably successful thus far in that it has signed up 750,000 subscribers with a short term goal of achieving 2.0 million subscribers by the beginning of 2006. However, this does not come without a cost: Blockbuster spent $50.0 million in 2004 in subscriber acquisition costs and plans to accelerate this amount to $120.0 million in 2005. Moreover, Blockbuster has shown a willingness to compete aggressively against Netflix and other competitors for these customers as Blockbuster has launched a pricing war against its rivals. As mentioned above, the fourth component of Blockbuster’s strategy, the acquisition of Hollywood Entertainment, failed as a result of FTC concerns over the combined entity’s pricing power.
All of these strategies are an attempt by Blockbuster to turn around its lackluster performance over the past few years. Carl Icahn, however, has been critical of Antioco’s growth strategy, with its cornerstone online effort being dependent on aggressive capex and subscriber acquisition investment. Interestingly, Icahn did not publicly criticize Antioco until after Blockbuster’s bid for Hollywood fell through; in addition to his stake in Blockbuster, Icahn also owns 10.8% of Hollywood Entertainment.
In our view, Blockbuster’s growth strategy is sound; however, we are underwhelmed by management’s lack of vision. Management has repeatedly shown that it is reactive to competitor’s strategies and lacks the ability to predict the direction of the industry. For example, when Netflix launched its subscription service in September of 1999, Blockbuster management wrote Netflix off as a niche player. It took management another five years to realize how significant a threat Netflix was to its business and to launch a competing service. That said, it appears that Blockbuster’s investment has begun to pay off as the company has already gained 750,000 subscribers, or approximately 25% of what Netflix has been able to achieve in five years. Eventually, like most analysts, we believe that there will be another shift in the industry away from subscription service to a more comprehensive video-on-demand model; however, in the meantime it is essential that Blockbuster dominate the subscription model if it is to survive. We do not agree with Mr. Icahn that Blockbuster should pay an additional $330 million in dividends to shareholders as the company tries to adapt its business model to changing technologies. However, we do agree that Mr. Antioco’s pay package is egregious, and that he should be terminated by the board of directors given his lack of foresight and the company’s poor performance over the past several years. Seeing that Mr. Antioco is chairman of the board of directors, we think that this scenario will only play out if Mr. Icahn can indeed gain control over the board.



Patrick Goff, Nate Kieffer, John Morrison

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