Thursday, April 28, 2005

Will this Blockbuster Have a Happy Ending?

When deciding to have a quiet evening at home, in the past people drove to their local Blockbuster to rent the newest movie release or curled up in front of the television to watch a classic. Now consumers have many more choices in how they can access their home entertainment content: join an online DVD rental service like Netflix, pick up the remote control and program a cable box to play a movie, purchase a DVD at the local Wal-Mart, download the content from the Web, or continue to drive to their local video retailer. With these new competitive threats and an eroding market, Blockbuster must find a new strategy in order to survive in this evolving and technological fast-changing home entertainment industry.

Blockbuster is the world’s largest video rental chain, with about 9,100 retail stores in 25 countries. The company rents videos, DVDs, and video games at its conveniently located brick-and-mortar video stores. Remaining loyal to its video retail roots, Blockbuster tried to expand its retail presence in 2004 when the company launched a $700 million takeover bid for rival Hollywood Entertainment. The goal of acquiring the #2 US video chain was clearly to gain more market share and increase the already large number of retail outlets by enveloping Hollywood Video’s 2000 stores into its retail family. Blockbuster eventually dropped the Hollywood bid[1] because of an unfavorable antitrust review by the FTC and shareholders’ reactions.

While Blockbuster was distracted with the Hollywood Video bid, the company ignored the creeping threat of online rental company Netflix. Once thought of as a niche player, Netflix has now signed up more than 3 million subscribers including many former Blockbuster customers and made the online DVD market so attractive that Wal-Mart and Amazon.com have entered. Blockbuster initially ignored the Netflix threat because Mr. Antioco, Blockbuster’s CEO, “didn’t think that consumers would want to think days ahead about what movies they [would] want to order.”[2] Mr. Antioco was wrong and Blockbuster missed the first mover advantage and the opportunity to combat Netflix.

With a change of heart, Blockbuster decided to embrace the mail-order DVD service by investing more than $120 million in it. The company has even aggressively lowered monthly subscription prices to undercut Netflix. Consequently, Blockbuster Online has signed up 750,000 customers and claims that it can integrate its operations with the rest of the brick-and-mortar business to get to profit faster than Netflix. Blockbuster has little chance to tempt Netflix subscribers to Blockbuster Online because of relatively high switching costs such as movie order queues, automatic credit card billing, and customized movie suggestions. However, at least Blockbuster is finally reacting to the Netflix threat, responding to customer demands, and diversifying in order to avoid obsolesce.

Blockbuster reacted so strongly to impeding threats that it even abolished lucrative late fees[3]. Customers will be given a one-week grace period to return the product. After that grace period, the customer will automatically be billed for the price of the product minus the rental fee. Blockbuster management claims that the new “no-late-fees” policy resulted in an increase in rental transactions and retail sales in test markets.

Unfortunately, while customers responded well to this new initiative, analysts and shareholders have been less than enthusiastic. Late fees contribute to some $250 to $300 million in operating income and Blockbuster expects to spend $50 million in advertising. The most vocal critic of Blockbuster’s initiatives is Carl Icahn, who amassed 8.6% of the voting stake in Blockbuster last year (and quite a bit of Hollywood Video stock). Icahn claims that the company’s management is on an irresponsible spending spree. He demanded that Blockbuster stop the extravagant capital expenditures and instead pay shareholders $300 million of its cash flow in dividends. Even our fellow Competitive Strategy peers agreed that Blockbuster’s management was trying to increase the company’s growth through unsustainable tactics and diverging from its core competencies. They further supported Icahn’s demands for a cash harvest[4].

We disagree with both our Competitive Strategy classmates as well as Carl Icahn. Exhibit 1 shows one of Blockbuster’s competitive strengths: A bargaining power over suppliers. Blockbusters’ cash inflow and outflow seem significantly mismatched. Blockbuster’s inventory remains on hand for about 70 days. After Inventory is sold, 11 days elapse before cash is collected from customers. Yet suppliers are not paid until 195 days after inventory is purchased, meaning that Blockbuster has huge bargaining power over its suppliers. The bargaining power over suppliers allows Blockbuster to generate 114 days of “Free Money.” This vendor driven financial system enabled Blockbuster to invest in business without paying cost of capital. However, this vendor driven finance system has a pitfall: Blockbuster must keep cash at hand so that it can pay back suppliers. Therefore, Blockbuster should not pay a big dividend to shareholders. Instead, it can maximize shareholder value by using cash to reinforce its competitive advantages and further invest in future growth strategies; for example, using cash for buying-back shares and use this treasury stock for future potential M&A.

In addition to high bargaining power over suppliers, Blockbuster’s competitive advantages include convenient store locations, variety in entertainment selection, and a strong brand name. Thus far Blockbuster’s strategies of eliminating late fees and an online DVD rental service reinforce its competitive advantages. These initiatives help combat the immediate threat of Netflix and counter the erosion of the video rental retail market. Unfortunately, these solutions are not necessarily sustainable for growth as most industry experts believe that the online DVD rental is a passing fad soon to hit extinction when cable’s on-demand solution and downloading content from the Internet become more popular.

Blockbuster should take advantage of the evolving technology and the new fragmented Internet and on-demand markets. Learning from the Netflix mistake, Blockbuster can be the first mover in this market and create high switching costs to consumers to produce entry barriers against competitors. By investing in technology, the company can provide downloadable entertainment content to consumers. Similar to Apple’s iTunes, Blockbuster.com can serve movies, games, and other entertainment to consumers over the Internet. Consumers can have the opportunity to rent content (by placing a time stamp on the content and setting expiration dates) or purchase content at a discounted price compared to retail since packaging and promotional costs are reduced. Blockbuster’s high bargaining power over suppliers will help the company convince entertainment companies to provide content to consumers over the Internet. Its strong brand name and a reputation for variety and convenience will convince consumers that Blockbuster.com is another great place to get their home entertainment. Downloading content over the Internet is even more appealing than cable on-demand because it has more variety and convenience to consumers.

Blockbuster’s recent strategic initiatives coupled with an investment in emerging technology should help the company remain a dominant player in the home entertainment industry, utilize its competitive advantages, and ease shareholders’ concerns over reckless spending. While it may not guarantee a happy ending, this plan certainly avoids complete extinction.

Abigail Akzin
Naomi Nakagawa
Natalie Yu
[1] “Blockbuster Drops Hollywood Bid,” Joe Flint, The Wall Street Journal, March 28, 2005.
[2] “At Blockbuster, New Strategies Raise Tensions Over Board Seats,” Martin Peers, The Wall Street Journal, April 18, 2005.
[3] “Blockbuster Drops Late Fees,” CNNMoney.com, December 14, 2004.
[4] “Block-Busted,” Suzanne Davidkhanian, Keith Guerrini, Yvette Nicholas, April 21, 2005

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