March 6, 2008: 1:44 PM EST
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Don't count Blockbuster out

Whenever shifts in technology and consumer behavior seem to threaten its core business, the longtime king of movie rentals still manages to stay afloat. Here's how.

By John Simons, writer

NEW YORK (Fortune) -- Blockbuster Inc. is like a slasher-flick villain that just won't die. In spite of what appear to be deep and devastating blows to its business - the rise of Netflix and mail-order movie rentals, in-home use of DVRs and video-on-demand via cable, and Apple's recent introduction of online film rentals - Blockbuster adapts and lumbers onward.

Part of that adaptation was evident this morning, when Blockbuster (BBI, Fortune 500) announced that its fourth quarter profit grew nearly 360 percent, thanks to aggressive cost cutting and the repositioning of some of its subscription offerings. The movie rental and retail company's quarterly earnings grew from $8.3 million (or 4 cents per share) in the last three months of its 2006 fiscal year to $38.1 million (or 18 cents per share) in the quarter just ended. The company said revenue increased 4 percent compared to the same period a year ago, to $1.44 billion.

Blockbuster shares were up as much as 3.4 percent in morning trading. But by noon, shares had settled about 1.3 percent below this morning's $3.25 opening price.

The Dallas, Texas-based movie rental and retail company operates over 6,000 stores in the United States and around the world. In recent years, the business has undergone a transformation, expanding its offerings beyond in-store VHS, DVD, and video game rentals. The company now operates a combination mail-order and online movie rental business, which has been further enhanced by the company's acquisition of Movielink last August.

By some measures, the movie-at-home business has been thriving. According to Digital Entertainment Group, Americans spent $1.4 billion renting DVDs in 2001; that grew to $7.5 billion in 2006. Yet Blockbuster - despite being one of the largest players in the business - has been conspicuously incapable of capitalizing on that growth. Between 2001 and 2005, Blockbuster posted five consecutive years of net income losses. In 2006, Blockbuster eked out a tiny net income of $54.5 million on revenues of $5.46 billion.

Then growth flattened in 2007, in part because of the rise of online downloads and video-on-demand services offered by cable providers. In the last year, Blockbuster's shares have plummeted by more than half to its current per share price of around $3.00. The S&P 500 has dropped just 3 percent over the same period.

Even so, a handful of observers believe Blockbuster has a chance to do well - if only in the next few years. The company's new Movielink subsidiary is key. The online movie download service was created in 2002 by a group of major movie studios including MGM Studios, Paramount Pictures, Sony Pictures, Universal Studios, and Warner Bros (which, like this Web site, is owned by Time Warner). Those studios poured a reported $100 million into creating the service's infrastructure while spending very little to promote it.

In the midst of poor uptake from consumers, Blockbuster stepped in and purchased the operation for $6.6 million in cash, according to the company's SEC filings. The purchase was a major coup for Blockbuster's new CEO Jim Keyes, who succeeded longtime chief executive John Antioco last July. Although Movielink cannot yet be called a success, it does give Blockbuster the digital rights to some 6,000 films, and provides an infrastructure for digital downloads that it can use as part of its pre-existing Total Access service.

In the midst of slashing costs, closing stores, and cutting jobs to remain competitive, Blockbuster is also experimenting with store redesigns. Keyes is looking to establish a strong brand presence in brick and mortar, online, and mail-order movie rentals and sales. For all its efforts in the online realm, Michael Pachter, an analyst with Wedbush Morgan Securities in Los Angeles, sees a large opportunity for growth in Blockbuster's brick and mortar stores this year due to competitor Movie Gallery's Chapter 11 struggles and its recent decision to close more than 900 stores throughout the United States.

"Blockbuster should benefit from Movie Gallery customer defections, lasting through the end of 2008. The 'tailwind' from Movie Gallery store closings should bolster same store sales at Blockbuster, and the pace of store closings should accelerate in the spring," Pachter wrote in a note to investors Wednesday morning.

Last week, JP Morgan analyst Barton Crockett upgraded his Blockbuster rating from "neutral" to "overweight" arguing that the company's fourth quarter 2007 should be in line with consensus expectations or better, and that the company's 2008 guidance will top consensus views as well, thanks to the company's "cost cutting and reasonable solid demand for video rental," Crockett told investors in a February 28 communication.

Crockett, however, warned that his call "is short term, because we are concerned long-term about competitive threats from Netflix (NFLX), kiosks and new home video technologies. We do not know if new store formats, expected to be widely deployed in the second half of 2008 or 2009, will work."

Tony Wible, an analyst with CitiGroup Investment Research, is less cautious about Blockbuster's long-term outlook. This morning, he told investors that "relative to the competition, we continue to believe Blockbuster possesses an unmatched competitive advantage through its five-point distribution plan that will soon offer content... in-store, by mail, online download, DVD kiosks, and through flash [memory] cards."

While some questions remain about Blockbuster's long-term viability, no one can deny that the company has a history of defying doubters. To top of page

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