Blockbusted

September 28, 2006
By

A friend of mine, having heard me rant several times about the impending doom of Blockbuster(BBI), sent me an article from everyone’s favorite source of fake news, The Onion. The article, entitled “Struggling Blockbuster Eliminates Rental Fees,” contemplates a desperate attempt by Blockbuster to retain customers by eliminating all charges and even paying customers for renting videos. It concludes:

Miami resident Scott Patterson, however, was only one of many consumers who said they were unimpressed with Blockbuster’s new offers, including “Two-Dollar Tuesdays,” in which customers are handed $2 cash for every new release they rent. “I don’t know,” Patterson said. “Something about that place just rubs me the wrong way.”

The problem in a nutshell. The service Blockbuster offers is quickly becoming so unattractive that customers might not come even if they were paid to do so.

The video rental market has faced steep declines in the face of mail-based subscriptions and pay-per-view. The emergence of internet-based delivery will accelerate this trend. Netflix(NFLX) already has over 5 million subscribers who pay a monthly fee to rent DVDs by mail. Netflix’ turnaround is quick and its selection dwarfs that of your local Blockbuster store. The only disadvantages: you won’t always get your top choice of movie and some amount of planning ahead is required. That’s okay though, because your local cable company has vastly expanded the number of movies available for you to watch immediately without leaving your couch.

Blockbuster’s only advantage here is the exclusive window studios continue to give to DVD sales and rentals before they make their films available on Pay-Per-View. However there have been signs that this is eroding and it is inevitable that Pay-Per-View and Internet will soon have movies available as soon as they are released to DVD.

Making matters worse for Blockbuster is that those consumers who have opted to sign up for a subscription service tend to be high-volume movie watchers. Casual renters have no need for such a subscription service.

Blockbuster has responded with its own subscription service which has garnered 1.4 million customers, but will have difficulty competing given the twin albatrosses of $1 billion of debt and a $2 billion liability for store leases. Besides that, the mail-based subscription business will come under pressure from the “instant gratification” formats of cable and internet delivery.
Blockbuster has attempted placing more emphasis on DVD sales, but has difficulty competing with behemoths such as WalMart(WMT), Best Buy(BBY), Amazon(AMZN) and Costco(COST).

As valiantly as it may try, Blockbuster cannot cut costs fast enough to regain sustained profitability. There is no new product or service they can leverage their retail footprint to sell. A failed 2002 experiment with another doomed retailer, Radio Shack(RSH), is instructive in this regard.

Carl Icahn has taken a stake in the company and agitated for change, but I’m unclear as to what value he hopes to unlock. One need only look at Movie Gallery(MOVI) to see where Blockbuster will end up. It is the rare company that can successfully transition when its core business becomes obsolete. Blockbuster looks to be of the more common variety of company that can’t make the transition.
Disclosure: I own none of the companies mentioned in this article

This entry was posted on September 28, 2006 at 12:18 am and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed.

  • Lee

    Blockbusters service is better and getting better than NFLX as we speak. Blockbusters profitability has only to do with one thing, movie releases. The quarterly earnings easily prove that out, you just have to compare. The box office downturn is whats behind its and MOVI’s malaise. You talk about all the movies on cable, not very many people I know like to spend $60 on digital cable just to rent on demand movies. Online digital download is a joke and will be for a very long time. There is nothing more flexible, more economical than stopping by your Blockbuster store that you drive by every night or is next door to your grocery store. People love to sound the trumpets about the demise of a 5 billion dollar business, lover to call for the fading of a way of life. If you were a knowledgable investor and did your due diligence you wouldnt be so quick to pucker up on that trumpet.

    Lee

  • investor

    Lee-
    Let me address your points one by one.

    1. “Blockbusters service is better and getting better than NFLX as we speak”
    I presume you’re speaking of the by-mail service as that is the reasonable comparison to NFLX. I do not have personal experience as a customer of both services, so I’ll take your word for it. Blockbuster’s service does have some niceties like integration with its store network. What I do know is that NFLX has more subscribers, faster subscriber growth, and a far cleaner balance sheet.
    2. “The box office downturn is whats behind its and MOVI’s malaise”
    I disagree, but you’ll probably respond again that I’m not a “knowledgable investor” or that I haven’t done my “due diligence.” NFLX’s business has been improving. CMCSA has been selling increasing numbers of on-demand movies. Where is their “box office downturn”? Viewing patterns are fundamentally changing. People are less interested in going to movie theaters. Perhaps not many people you know are signing up for digital cable, but subscriber numbers from the cable companies tell an entirely different story. And why does it make the outlook any better if this is only caused by a “box office downturn?” Why should we expect there to be a “box office upturn?”
    3. “Online digital download is a joke and will be for a very long time”
    Online digital download is not a new idea. It has been slow to catch on. But I think you grossly underestimate the impact it will have in the next two years. Apple sold 125,000 Disney movies in its first week after launch. Amazon’s intial offering has been poorly received but improvements are coming. Go to any college campus, and students are already watching movies they’re downloading over the internet- they’re just not paying for them. We’re on the cusp of a paradigm shift here, similar to the Napster-iTunes inflection point in music downloads. Or is Online digital download of music also a joke to you? How is your local record store doing?

    This is one trumpet I’m happy to pucker up on. Video rental stores are terminally ill. Blockbuster needs a hospice. And investors need to sell it.

  • Larry Paquette

    You hit the nail on the head, and then some. Like many companies in the past who confused their own PR as sources of fact, Blockbuster became a victim of its initial success. After buying out or closing all of its “Mom and Pop” store competition, it believed it was a growing concern. Then came the incessent customer abuse times, where a movie returned 5 minutes late garnered a late fee larger than the rental fee. And who besides some obsure Blockbuster back-office accountant knew that the return cutoff was noon? How many customers were expected to be fooled by exhortations to keep the movie for 5 days, all at $1.99 per day? Blockbuster long believed they had a lock on video rental, and too late, if ever, realized that there were and would continue to be innovations and alternatives to driving to and from a store in the hopes of finding your desired movie in stock. I’ve been with NetFlix for almost 2 years, and couldn’t conceive of ever returning to Blockbuster.

  • ourneon

    While it is healthy to have these discussions, I’m sure you’ll soon see that you are incorrect. While Netflix has gotten a massive headstart in the online business, Blockbuster offers a much better service and free in-store rentals. When you’re sick of Netflix’s “throttling” program delaying your picks, you can simply switch to Blockbuster, print a coupon, and pick up that new release in-store that Netflix has been holding hostage for weeks. Secondly, movies-on-demand and via internet will simply not do for any movie purist. If you don’t mind poor quality, lack of bonus features, progressive scan playback, and all of the benefits inherent with the physical DVD then, sure, watch them on cable or your PC. But if you want widescreen format, 5.1 surround, and the plethora of extras that today’s consumers demand then you’ll steer clear of these inferior formats and drive to your local Blockbuster. Lastly, anyone who has actually tried Netflix & Blockbuster Online side by side know that theres is a far better product. So much so, that Netflix filed a frivalous suit to try to knock Blockbuster Online out of the picture. Heck, even the judge knew that they weren’t going anywhere with this one when he refused to dismiss Blockbuster’s suit. Consumers like to touch the physical movie and browse the store…the online experience just doesn’t compare.

    So, pucker up…your trumpet won’t be the only thing you’re puckering for.

  • Win Mur

    The issues BB deals with are probably no diffrent than most retailers, no customer is 100% satisfied with the retail expereince. Having said that, whenever I go into my local BB store on a weekend night, it is always packed with people. I think it is to early to throw in the towel on BB yet, and as others have mentioned, the BB Online service does kick Netflix’s backside. I prefer the retail store and online combo that only BB offers right now. Plus BB has a great in-store selection of games, a fast growing entertainment option that many people prefer to movies. I don’t care who wins, but to say BB is dead is to day retail is dead and I just don’t see it.

  • Don Bergenty

    I have been both a BBI and Netflix subscriber and I do not see much difference. I don’t see a service advantage from one to the other. I never used the free coupons because I never wanted to drive to the Blockbuster and find a movie. For families with kids the coupons make sense, but not all of us are in that category.

    Is Blockbuster dead – no. Are they dying – maybe. To assume that all consumers want to watch DVD extras as Ourneon says is a little rich. I can count on my one hand the number of times I watched the extras that come with a DVD and forget disc # 2; that never makes it into the player. The movie purist is a small percentage of the movie buying/watching audience.

    With services like Comcast and the speed which Verizon’s fiber optics will deliver movies it will be one more thing that takes revenue away from Blockbuster. The average price for new DVDs continues to drop which also hurts rental revenue. You cannot have a company has no top line growth for 2 – 3 years and expect them to be around forever.

    Retail is not dead, concepts and shopping habits change. Technology changes what people buy and at what prices. Who thought Tower Records might die 10 years ago?

  • cubfitz

    I’ve tried video on demand from Time Warner and am not convinced that it is as big of a threat as everyone seems to think. First of all I had to wait two hours to have access to the movie I wanted and was told by customer service that “on Saturday nights a lot of people are requesting movies, so you’ll have to wait an hour or so”. That doesn’t quite seem to be the next logical step in the industry to me. Not to mention that after I eventually did get the movie it skipped like a dvd that had been put through a blender.

  • http://www.davisfreeberg.com davis freeberg

    This is a very good article that focuses on the real issues with Blockbuster’s business plan. It’s not that you can’t make money running a retail business, but with the amount of alternative competition the company faces it will get increasingly difficult for Blockbuster to continue to make their debt and lease payments. I think that a lot of it is because Blockbuster has a fixed cost structure vs. Netflix’s variable structure. If Blockbuster has consistently run on 10% gross margins and 15% of their customer base moves online, it’s a big problem because their stores start running at losses. If Netflix were to see a reduction of 15% to their customer base, it would still hurt, but because the variable mailing costs would go down too, they wouldn’t necessarily experiences losses over this sort of transition. This makes them nimble and it makes Blockbuster desperate. This also means though that Netflix’s upside is capped because more subscribers doesn’t necessarily translate into higher profit margins. In the heyday, Blockbuster benefited from having fixed costs, but now that they are facing DVD by mail as a threat and VOD as a threat, it’s becoming increasingly difficult to continue paying those fixed costs. Thanks for the great article.

  • christo

    Blockbuster and Netflix offer the exact same online service to customers. The difference between the two is that Netflix ads are all over the internet, and I can’t remember the last time I saw an ad for Blockbuster. So, for now, Netflix is adding a lot more new customers than Blockbuster. I think that will all turn around when and if Blockbuster lets people know about their online rentals.

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  • ourneon

    Read some of the articles about the new movie download services…they’re slow, barely cheaper than buying, and years away from being a real threat. With the HDTV penetration rising at breakneck pace, I think that saying the number of “purists” is small (as Don says) is simply ignorant. Anyone with half a brain would know that 1080 lines of resolution always beats 480…even on my big screen the video-on-demand from Time Warner is a crappy imitation with blocky picture & 2 channel audio. I’ve worked for cable, telcom, and the movie biz…based on my fairly educated guess, DVDs are here to stay. True – many consumers are cheap & lazy, and will love the alternates to the video store. But those who enjoy the shopping & viewing experiences will continue to rent their movies. But, we’ve all got our opinions…

  • http://cheapstockhunter.blogspot.com/ cheapstochunter

    My aversion to Netflix lies in this one paragraph of their most recent 10-K. When you change your depreciation assumptions so that now you depreciate assets over 3 years, which you have historically depreciated over 1 year, is a MAJOR red flag. Lower depreciation expense = higher bogus margins = higher bogus EPS. The companies earnings are drastically overstated, the company does not have this level of earning power! This will come back to haunt investors, mark my words.

    From 10-K

    The Company amortizes its DVD library, less estimated salvage value, on a “sum-of-the-months” accelerated basis over its estimated useful life. The useful life of the new-release DVDs and back-catalogue DVDs is estimated to be 1 year and 3 years, respectively. In estimating the useful life of the DVD library, the Company takes into account library utilization as well as an estimate for lost or damaged DVDs. Volume purchase discounts received from studios on the purchase of titles are recorded as a reduction of DVD library inventory when earned.

    Prior to July 1, 2004, the Company amortized the cost of its entire DVD library, including the capitalized portion of the initial fixed license fee, on a “sum-of-the-months” accelerated basis over one year. However, based on a periodic evaluation of both new release and back-catalogue utilization for amortization purposes, the Company determined that back-catalogue titles have a significantly longer life than previously estimated. As a result, the Company revised the estimate of useful life for the back-catalogue DVD library from a “sum of the months” accelerated method using a one year life to the same accelerated method of amortization using a three-year life. The purpose of this change was to more accurately reflect the productive life of these assets.

  • Phil

    A side by side comparison of Netflix’s online service and Blockbuster’s instore and online combination will show where the best value is for the consumer.



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