By Matthew Boyle

(FORTUNE Magazine) – RIVAL SUITORS! CUTTHROAT BATTLES! Lawsuits! You can catch all this action at Blockbuster but not on the store shelves. No, this Oscar-worthy drama is being played out inside the executive suite of the $6 billion movie-rental chain. Blockbuster is mired in a merger battle with Movie Gallery for control of Hollywood Entertainment and waging a savage price war with online upstart Netflix. And its much-ballyhooed end-to-late-fees marketing gambit has gotten mixed reviews from customers. (Instead of a late fee, you're charged for buying the movie, and in late February, New Jersey's attorney general slapped Blockbuster with a lawsuit, claiming ads for the new policy are misleading and fraudulent. Blockbuster says the policy is "massively popular" with customers.)

Amid this tumult lies a theme familiar to movie buffs--an identity crisis. Blockbuster, long known simply as a place to rent movies, now wants to morph into a home-entertainment bazaar where customers can buy, rent, or trade movies or videogames, in the store or online. "We intend to reinvent the way people rent home entertainment," says CEO John Antioco. In 2004, the same year Blockbuster was spun off from Viacom, Antioco spent $120 million (and a good deal of his Street cred) on programs like movie trading, all-you-can-eat rentals, online DVD rentals, and beefed-up game centers.

The reason? Blockbuster's core movie-rental business has flopped worse than a Ben Affleck flick. From a peak of $10 billion in 2001, that market shrank to $7.7 billion last year. The company has sacrificed another $300 million a year by ending late fees. The changes are also being hastened by dirt-cheap DVDs and video-on-demand (VOD), which has the potential to make renting videos obsolete. (While Netflix and TiVo have already paired up for a movies-on-demand online service, Blockbuster has yet to disclose its VOD plans.)

The transformation is well underway in the stores, many of which now feature gaming centers, enticements to trade in movies and games, and more shelf space for selling new and used DVDs (not to mention 25% more junk food, which makes sense, given that Antioco used to run a chain of convenience stores). Whereas once about 80% of an average store was dedicated to rentals, now it's closer to 65%. But customers haven't yet warmed to Blockbuster's new act, and some parts of the new plan make more sense than others.

Take movie trading, available now in 2,700 U.S. stores and due to be rolled out to just about all stores by the end of this year. It works like this: Blockbuster will give you between $5 and $10 in store credit for your unwanted DVDs, then resell them for between $10 and $15. Analysts say it's a promising market, with profit margins that trump those of new-movie sales (but come nowhere near rental's 70% margins). What's more, trading is an area that discount behemoths like Wal-Mart, Target, and Best Buy--who command most of the booming $15.4 billion DVD retail market--don't play in. Yet this is still a new concept for Blockbuster's customers, only 2% of whom traded a DVD last year.

Then there are videogames, which generated 15% of company revenues in the first nine months of 2004, up from 12.5% in the same period in 2003. (The company was due to report full-year results March 9, after FORTUNE went to press.) That share should increase further as Blockbuster plans to double the number of its Game Rush stores-within-a-store by the end of 2005. (Blockbuster also operates freestanding game stores in the U.S. and Britain.) Blockbuster desperately needs to cater to this market. But while game sales are up, its U.S. same-store game-rental revenues declined 2% in the first nine months of 2004, due in part--ironically--to increased game trading, which cannibalizes rentals. To boost business, the company is hiring staffers with gaming expertise to handle peak traffic periods during the day.

Antioco admits that "our transformation will not be easy." The company has posted $4.3 billion in losses since 1999, and its new businesses will go head-to-head with fierce players, from Wal-Mart to eBay to Comcast. Given that lineup, one thing's for sure: Blockbuster has forever lost its status as the biggest kid on the block. -- Matthew Boyle