Blockbuster, Inc. Q3 2008 Earnings Call Transcript

Nov.20.08 | About: Blockbuster Inc. (BBI)

Blockbuster, Inc. (BBI) Q3 2008 Earnings Call November 6, 2008 4:45 PM ET

Executives

Angelika Torres – Director of Investor Relations

James W. Keyes – Chairman of the Board & Chief Executive Officer

Thomas M. Casey – Chief Financial Officer & Executive Vice President

Analysts

Arvind Bhatia – Sterne Agee

Carla Casella – JP Morgan

Stacey Widlitz – Pali Capital

Karru Martinson – Deutsche Bank

[Randy Raisman] – Durham Asset Management

[Dominique Neal – Kenyon Capital]

[Rosemary Sisson – Knight Lubertos]

[Walt Sinowski – SRC Capital Management]

Operator

My name is Heather and I will be your conference operator today. At this time I would like to welcome everybody to the Blockbuster third quarter 2008 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question and answer session. (Operator Instructions) I would now like to turn the conference over to Ms. Angelika Torres.

Angelika Torres

Welcome to Blockbuster’s third quarter earnings call. Today’s earnings call may include forward-looking statements relating to our operations and business outlook, financial and operational strategies and goals and other matters that do not strictly relate to historical or current facts. Actual results may differ materially from those projected in the forward-looking statements.

For additional information regarding the forward-looking statements and factors that could cause actual results to differ materially, please refer to the cautionary statements in today’s earnings release and in our public SEC filings including our upcoming Form 10Q. Today’s earnings call may also include discussions of certain non-GAAP financial measures. Please refer to today’s earnings release for the required reconciliations to the most directly comparable GAAP financial measures and other related disclosures.

Our earnings release is available on our website at www.Blockbuster.com under the link for investor relations. With that, I will now turn the call over to Jim.

James W. Keyes

Thank you for joining us for the call. On last quarter’s call if you remember we referenced some of the headwinds that we’d be facing in the third quarter and namely an extraordinarily weak slate of movie titles and strong interest in the Olympics. Still, we were cautiously optimistic that improved in stock availability and our increased focus on retail would help us to weather that storm.

I’m very pleased to report today that we did just that, we weathered the third quarter storm that in hindsight proved to be maybe even a little more challenging than we anticipated given the strong interest in the presidential campaign and the events that were taking place certainly in the macroeconomic environment.

Against this backdrop even with box office comparables down 53% in the month of August, we were still able to increase our domestic same store sales by 5.1% and our domestic same store rental revenue by .8%. This was our third consecutive quarter of positive same store sales which we think is a significant accomplishment for any retailer in today’s market conditions. We believe that this is also an example of the importance of movie in stock availability and the resiliency of the DVD business.

Also significant was our continued improvement in profitability with a narrowing of our net loss by more than 48% and an adjusted EBTIDA of $40.2 million. So, overall we’re pleased with the third quarter results and feel like we have some momentum going in to the fourth quarter, a fact that becomes clearer when you look at the domestic results on a year-to-date business and to give you a little confidence to share our confidence in the fourth quarter we wanted to share some of the key metrics that we use to measure the domestic business all of which are showing positive improvements for the first nine months of the year.

For example, paying actives per store up 1.4%, revenue per visit up 15.4%, net paid rental rate up 17%, net total revenue per square foot up 7.6%, gross profit per square foot up 2.4%, same store rental revenues up 11 percentage points, total store revenues improved 16 percentage points. I think you get the idea. Given this momentum we thought that it was very important to stay the course with our initiatives in the third quarter and we are continuing to stay the course with higher inventory rates, higher in stock percentages, etc.

Even though we faced a tough box office in the third quarter we knew that there would be some impact on margin, we stayed the course but on balance we’re able to enjoy higher levels of both EBTIDA and profitability. Fourth quarter, looking forward to the holiday season, we think our business is very well positioned. The great entertainment value of DVDs and video games along with the convenience of renting, particularly the flexibility that our stores offering in conjunction with our by mail service makes for an inexpensive and a very easy way for consumers to escape the pressures of everyday life, these days especially.

The slate of new movie titles coming in the fourth quarter is very strong with movies such as Get Smart that we released this week, Kung Fu Panda will be releasing on Saturday night, Tropical Thunder coming up, Wall-E, Hellboy 2, Hancock and of course the biggest movie of the year, the Dark Knight. Finally, we’re offering a greatly enhanced assortment of holiday gift items from board games to small electronics to stocking stuffers perfect for the value conscious holiday traffic that will be visiting our stores.

As a result we remain confident that we can achieve our full year adjusted EBTIDA target and we believe we are well positioned for the near term and the long term. I’ll give you a few highlights on the strategic initiatives before turning it over to Tom to get in to the details of the financials. On the rental side we believe our results certainly indicate that being in stock on hot new releases is key to driving revenues, regaining customer loyalty and rebuilding the rental business.

We made strong progress in this area now averaging close to 60% on the first week in stock availability for key movie titles versus only about 25% in stock a year ago and we’re averaging around 100% in stock for titles in their second week. Customers are clearly responding to this improvement and we feel it’s very important for us to stay the course with this strategy. In support of our in stock strategy we also continue to work with studios to find innovative ways to improve our in stock availability in ways that are designed to grow their revenues and ours.

We’ve also completed installation of the Blu-Ray display kiosks in virtually all US and Canadian stores and we believe these fixtures are responsible for the growth in Blu-Ray now accounting for more than 2% of our domestic movie rentals. The kiosks have also played an important role in increasing our sale of PS3 hardware units as well. With improved availability and improved assortment we have much greater flexibility to increase price and to capture greater value and offer greater value at the same time to our customers.

So, we’ve made significant progress on this front increasing our average net rental rate from $2.98 last year to $3.43 approximately this year. Additionally, we’ve continued testing various rental pricing and terms combinations. Our learnings from the test so far are pretty straight forward, customers have responded favorably to two things: five day terms; and the lower price point available with daily rates.

So, we’re currently testing a combination of the best of both offerings. We’re letting customers choice their terms so they can rent by the day, by the week or by the month with prices ranging from $0.99 for older library titles to $4.99 for the hottest new releases or for a monthly subscription price. So, going forward while individual store prices will differ we’re working towards a market-by-market deployment of some variation of the daily, weekly and monthly approach between now and the first quarter of next year.

Quite frankly, we believe the timing couldn’t be better for our new pricing terms approach, in these difficult times consumers are looking for the ability to control their monthly expenditures. For our customers who want the value and control of a daily rate we’ll have an offering for them. On the other hand on the other end of the spectrum for the heaviest users who don’t mind committing to a monthly subscription we’ll have an offering for them in store and by mail as well.

Speaking of our by mail rental business, it continues to positively contribute to our EBITDA. We’ve intentionally not been aggressive about growing our buy mail subscriber base until we refine the business model and further enhanced our back office infrastructure. We’ve made significant progress in both areas and also continue to enhance the website with a great new look, easier navigation, thousands of trailers now available on the website and movies to download through Blockbuster.com.

It’s now all about movies for rental and retail, new and used physical and digital. We continue to see by mail rental is one more way we can position Blockbuster as a multiplatform provider of entertainment. We don’t see it as a dominate growth engine but we do consider it an important part of our overall entertainment portfolio of consumer offerings.

On the retail side of the business we’ve continued to ramp up the presence of video games in our stores to take advantage of the broadening appeal of this category to non-traditional gamers specifically our customers who squarely fit in to that Blockbuster demographic and our efforts are paying off. While our share of the game market is still relatively small it is growing substantially faster than the industry as a whole this year.

We’re working with game manufacturers both hardware and software to help that accelerate that growth. For example, as a result of our summer games promotion we were able to increase our allocation of Nintendo Wii hardware about three times our normal allocation amount. We’re currently installing Rock Band II demonstration kiosks in 500 stores with the support of EA and MTV, MTV Games.

On the rental side we’ve increased game units that we’re bringing in store. To revenue sharing we’ve increased our revenue sharing deals by about 100% year-over-year which means improved margin for Blockbuster and for our gaming partners and better availability for our customers. In addition to games we’ve broadened the overall retail selection throughout the store just in time for the holidays.

We’ve got a great assortment now of everything from batteries, media storage devices, income, gaming cards, impulse items, stocking stuffers, entertainment license product, etc. to give our customers a wide variety of gift and impulse buys during the holiday season when we have the most advantage of traffic.

We’ve also added DVD players and Blu-Ray hardware to all of our stores and in select locations we’re offering a slightly more expanded line of consumer electronics. The CE offering is designed for 100% sell through during the holidays and in addition to driving revenues in the fourth quarter will also serve as a way for us to gage our customer’s interest in a broader range of consumer electronics.

Finally, we continue to experience rental and retail success in our remodeled concept stores where we’re able to display a greater assortment of merchandise. We’ve remodeled close to 300 stores in the past year and by the end of this month we’ll have our first fully remodeled market with 12 stores in Reno Nevada where we’ll be able to do some media advertising to support those remodels.

We should also have four rock the block concept stores completed in New York City over the next couple of months and obviously we’ll be inviting you to visit those stores very soon. So, very methodically we’re transforming our stores from movie rental only locations in to complete entertainment destinations.

On the digital side, the third leg of our strategic platform, we’re working on a number of opportunities that we’re very excited about. However, I want to put this side of the business in to perspective, right now the entire digital download market which is dominated by cable video and demand is estimated to be only about $1.4 billion in side today and growing to about $2.5 billion by the end of 2011. So, while we’re very interested in the long term development of this market, right now we’re mostly interested in understanding consumer response and keeping pace with the emerging technologies that are available.

As the market slowly takes shape and begins to emerge you can rest assured that we will look to play a larger role. The strength of the Blockbuster brand around the world combined with our global business gives us a unique advantage when partnering with some of the device and consumer electronics makers. We think portability will be an important factor in the digital market and we’re working with a number of solutions first being the digital kiosk initiative that we recently announced with NCR designed to download content on to disc or flash memory.

We have two stores now in pilot testing primarily again to gage consumer response. Second, we continue to explore the development of at home or living room solutions and in time for the holiday season we will be launching a set-top box that will be able to deliver Blockbuster VOD movie offerings powered by our movie link service. Our primary objective again in this arena is to measure consumer response to this offering.

Another example is the recently announced collaboration with Intel which will include a Blockbuster TV widget on their consumer electronic chip set. This chip which will be in selected IP enabled television sets beginning next year will allow customers easy access to Blockbuster movies. Further, our international presence allows for collaboration and learnings around the globe.

Blockbuster Australia recently announced that in conjunction with hybrid television services, they’ll be launching a Blockbuster VOD movie service on TV. Finally, we’ve made enhancements to our Blockbuster.com movie link offering which now allows customers to load content also on to portable devices. Conversion of movie link to Blockbuster.com has contributed to increased traffic and downloaded movies, a modest beginnings to our anticipated growth in digital content sales.

We encourage you to give the site a try and believe you’ll be favorably impressed with the quality of the site and most importantly the availability of hot new releases. While we’re pleased with this three pillar strategy and the repositioning of Blockbuster in to a multichannel platform and while we’re optimistic about our momentum and that this momentum will continue, we also recognize that the deteriorating nature of the economic environment and the impact of this macroeconomic environment on the near term financing plans causes us to step back from the business and make sure that we have a plan b in place.

While the doubling in our trailing 12 month adjusted EBITDA over the last year puts us in a much, much stronger financial position, we still have nine months to pursue new financing options but we have to have a back up capital plan that if needed would allow us to self fund this business without the use of any additional outside capital.

So, call it a plan b if you will, we are as I said, pleased about the momentum, we’re committed to staying the course with our strategic plan however, we also have a plan b in place if we find that we do have challenges in refinancing our bank debt going forward. Tom Casey now will give you a little bit more detail on those plans and the flexibility that we have.

Thomas M. Casey

Let me start with capital management plan and then I’ll get in to our usual discussion about the quarterly results. As investors are aware, our $28 million term loan A and our revolving credit facility come due in August of 2009. While we plan to but another bank credit facility next year, the current state of the banking and overall credit environment certainly muddies the outlook for that a bit.

Fortunately, with our strong financial results we are in a position to implement a capital management plan, if necessary, to self fund our business through 2009. This contingent self financing plan would temporarily reduce our spending and maximize our cash flow. Of course, we hope that won’t be necessary but in order to prepare for that possibility we need to start making some decisions as early as January as it relates to retail inventory levels, store remodels and store operations.

If necessary we’d look to put parts of our strategy on hold for a few months and run the business to maximize cash flow. For example, under this contingent self funding plan we would temporarily pull back on our movie and game retail initiative by simply adjusting our retail inventory levels. Additionally, while pleased with the results we’re seeing with our rock the block and other store remodels, we could postpone additional remodels and temporarily defer certain non-critical capital projects.

So, let’s talk about the third quarter highlights. As Jim said, not withstanding a very challenging environment we’re pleased with the overall results for the quarter and the way the business is performing in a difficult macro environment. I’ll give a little more color around our same store sales and then focus briefly on our gross profit, SG&A reduction, some balance sheet highlights and our guidance.

Our domestic same store sales increased 5.1% with rental comps up .8%. Strong top line results considering seasonality and the environment we’re in. While August was challenging due to the weak title slate and high viewership of the Olympics, July and September tracked as expected. We think our in stock initiative coupled with price adjustments we’ve took over the past year help drive our third quarter domestic rental comp.

The increase in retail same store sales was mostly driven by roll out of games to all domestic stores that were completed last quarter. On domestic gross profit we had a decline of about $17 million or about 4%. This was primarily the result of lower rental revenue from subscription as well as higher in stock levels in our stores. While we knew we’d face some traffic and rental headwinds in the quarter, we thought it important to stay the course on our in stock initiative.

Jim discussed the importance of this initiative to our core strategy and the correlation between rental comps and availability. With title flows returning back to a more normalized pattern, we’re seeing a correlating impact to the business. On a per store basis, domestic rental gross profit was only slightly down. We believe the in store rental business will continue to benefit from greater copy depth and new rental and pricing terms.

Domestic retail gross profit declined slightly which has more to do with the overall retail environment than any fundamental changes in this business. As Jim already discussed we continue to reposition Blockbuster around both the best rental and retail entertainment products with video games being the biggest driver of retail. On the international side, Blockbuster’s international business delivered good results for the quarter with merchandise revenues decreasing slightly in this environment and merchandise gross profit improving.

Particularly impressive as we cycled double digit merchandise comps from last year with some new game platforms that had come out then. Per store retail gross profit increased 3.8% as we continue to shift towards higher margin used game sales and per store rental gross profit declined 4.7% principally because of the weak results in UK and Canada that were the same as we experienced in the US.

SG&A, our total operating expenses declined by $29 million which was primarily the result of a $28 million reduction in G&A. Through the first three quarters even with inflationary pressures, we’ve reduced our domestic above store G&A by about $60 million and are on track to hit our $100 million annual target that we have previously discussed. On a percentage of sales basis, operating expenses decreased 90 basis points to 53.6% of sales from 54.5% of sales last year.

As far as balance sheet and cash flow, we ended the quarter with cash of $95 million, merchandise inventories of $471 million and total debt of $854 million. That debt level corresponds to a strong debt to EBITDA ratio of under 2.8 times. Our merchandise inventory levels increased about $24 million sequentially as we’ve started building inventory for the holiday season. Most of the increase was driven by the addition of Blu-Ray and DVDS.

We did not grow our video game business during the quarter. We had an additional $40 million in net borrowings on our revolver which is consistent with our seasonal borrowing pattern. As part of our liquidity discussion let me take a moment to touch on the reduction in the Viacom LC. As you may have seen from our press release last Thursday, we reduced our letter of credit commitment to Viacom to $75 million from $150 million.

This letter of credit relates to store lease obligations from the spinoff from Viacom in 2004. Given the changes to our real estate portfolio over the past few years we were able to reduce the face amount of that letter of credit. So, that frees up $75 million of liquidity under our revolver but, more importantly reduces the size of any future credit facility we may look to put in place as the parts of the current facility come due.

Finally, on guidance we reaffirm our 2008 adjusted EBITDA guidance. That represents a more than 70% increase over 2007 adjusted EBITDA. As a reminder, every company is required to do an annual goodwill impairment test and this annual test will perform in the fourth quarter, could result in an adjustment to the carrying value of certain assets and a related non-cash charge. Of course, our adjusted EBITDA guidance excludes any such potential charge.

That concludes our prepared remarks. Both Jim and I would be happy to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Arvind Bhatia – Sterne Agee.

Arvind Bhatia – Sterne Agee

Just a couple of questions, first of all I guess I wanted to understand from your standpoint the Blu-Ray penetration you said is increasing, I guess I think you said 2% now. I just wondered just as you look at the Blu-Ray kiosks that you have in the store and just the overall impact of that on your business, how much of that do you think is a benefit to you guys the last couple of quarters that might not recur as we look for comps for next year?

James W. Keyes

We think the Blu-Ray growth is really in its early, early stages, still only representing – while 2% is good it’s all incremental or arguably it is very incremental to our business, 2% is still a very small amount. So, the kiosk is going to help. Now, where we really think the benefit will come will be to further penetrate households with Blu-Ray players. That’s why it’s one of the motivations that we have in stocking a Blu-Ray player now in all stores.

You’ll see us coming out with a little broader assortment and some extremely competitive price points on Blu-Ray players. We have been working with a couple of consumer electronics manufacturers so that we’ll have a retail offering on Blu-Ray players that’s as competitive as anybody in the market and still the ability to make a small margin on it. Now, we’re doing that because the more Blu-Ray players, of course the more people will come back to rent or buy Blu-Ray discs so we think we’ll be able to show favorable comps from Blu-Ray for really well in to next year or maybe even the next two or three years as this segment continues to grow.

Arvind Bhatia – Sterne Agee

My second quick one is what percentage of your game rentals are on revenue share right now?

James W. Keyes

Let’s see, we had 100% improvement, I would say about 20%. We’re trying to be accurate but let’s say a ballpark of 20% and it is a challenge. The game business is a two tiered challenge because you’ve got the license fee required by the manufacturer, Nintendo, Microsoft, Sony for example and then you have a second tier of fee structure required by the game company whether it’s Activision, EA, etc.

So, as a result even with rev share the minimum guarantee price to lay inventory of games in to our store is extremely high. That of course limits availability to there’s a constant trade off that we face between working capital, cost for inventory availability and having games in stock. So, we’re managing that balance, you saw our inventory grow in the last quarter. We’re trying to position ourselves, particularly through the holiday season with a good solid inventory for both rental and retail on the game side.

But, the ultimate key to success here both with games and movies is our continued discussion with the suppliers to be able to find a win/win. Candidly I’ve got to get this industry, both the game industry and the movie industry to see the opportunity cost of retailers being out of stock on their product and there are better ways to be able to manage this inventory balance upstream. We’ll continue to work on that.

Arvind Bhatia – Sterne Agee

My last question, on your EBITDA guidance for the year, the adjusted EBITDA guidance, you’re reaffirming that. As I look at the fourth quarter comparisons and as I back out what you’ve done so far in the year, it looks like the Q4 guidance would again imply something like 5% to 10% decline versus Q4. Is there any reason for this? Your trends have been pretty good so far in the year. Is that just a little bit of conservatism given the environment or is there anything else that we should be keeping in mind when modeling Q4?

Thomas M. Casey

That really just relates to the 53rd week that occurred in 2007 which was about a $13 million benefit on an annual basis to the EBITDA of 2007 that we wouldn’t have in 2008. So, when you back that out Arvind we actually expect an increase in EBITDA in the fourth quarter.

Operator

Our next question comes from Carla Casella – JP Morgan.

Carla Casella – JP Morgan

You talked a bit about the new facility you’re looking to refinance, you have you decided whether you’re going to look just to refinance the term loan A and the revolver that come do or are you also considering the B?

Thomas M. Casey

Carla, obviously we’re in the worst financial market I think any of us have ever seen. Our current plans are to go to the market as it recovers but the whole point of our self funding plan is to be prepared, plan for the worst and hope for better. It’s conceivable I guess that if the market came back even stronger that that would make sense but you know, it’s all about what’s the lowest cost of capital for us.

I think just given where the market is today we’d be happy if the bank market came back to provide just the simple and relatively modest needs that we need on our new revolver.

Carla Casella – JP Morgan

Then can you talk a little bit more about the performance of the stores that you’ve remodeled to various degrees from the white tornado to some of the more major rock the block remodels?

James W. Keyes

Well, we’ve been getting on balance I guess we have been saying double digit sales improvements inception to date of the remodeled stores. Now, within that the ranges are huge. We have some stores that are in the low 20s, we have some stores in the high single digits. It really has depended on what elements of the remodels we put in. I’ll give you a little color on that, of the various components consumer electronics, beverages, games, etc., one of the strongest contributors to improved returns has been the beverage section.

It surprised me frankly because I didn’t think that would be quite so popular so we are continuing to fine tune that beverage offering, working on smaller, hopefully less costly or less capital intensive beverage bar offerings that would allow us to deploy this in even more stores going forward. I think the key though will be to test Reno.

This is why we’re excited about Reno. It will be the first deployment in a market where we can tell anyone because the very favorable returns that we’ve enjoyed so far have been with virtually zero advertising. These are just random stores selected in several different markets with no consumer communication whatsoever, just purely word of mouth and foot traffic. So, we’re excited about the opportunity to get Reno finished up here in the next month or so and to get some media advertising and to see how the consumer really reacts when we truly tell them about a new blockbuster.

Carla Casella – JP Morgan

What we heard from a lot of retailers today was that October deteriorated significantly from September. Anything you can tell us anecdotally about what you’re seeing out there?

James W. Keyes

Well, without speaking specifically to October I can tell you that we think that we’re somewhat resistant to these trends because the nature of our business, movie rentals in particularly, represent a great entertainment value and entertainment itself is a good escape for customers during these times. So, going back historically we’ve found some resistance to these markets and the ability to continue to have good solid comps.

October presented a bit of a unique challenge in that the slate of movie titles was particularly weak. It was of this entire year the only month that was weaker was the month of August. I think box office in August I referenced was down about 50%, box office in the month of October was down close to 30%. Now, our comps were substantially better than box office as they were in August so it’s hard for us to say how much of the month of October was influenced by a very weak movie slate and how much by the economy.

We are though still optimistic given what we enjoyed in the third quarter even with the month of August having it’s challenges, we still posted favorable rental comps for the quarter and that’s what we’re still anticipating for the month of December. I’ll remind you as well that we have some terrific titles coming up in November and our strongest traffic month is certainly December where we have the strongest slate of titles.

Operator

Our next question comes from the line of Stacey Widlitz – Pali Capital.

Stacey Widlitz – Pali Capital

Could you just clarify when you talked a little bit about the pricing, you said a daily, weekly and a monthly rate. Will that be uniform nationwide by Q1 so all stores will be the same and just have sort of three offerings? I guess that’s the first thing.

James W. Keyes

First of all, all stores will never be the same. We have a combination of franchise and corporate stores and market-by-market we have different market conditions that will cause us to put different offerings in place. So, you’ll never see one universal price platform throughout the country. On the other hand, as you know, we are trying to find that right balance between price and terms that makes sense for the majority of the stores.

As we tested all of these various things and part of the reason that we were not quite so quick to roll out this national platform is that we were getting mixed signals from our customers. Some of them really like a daily rate, particularly in these tough economic times. You can actually offer a lower price point if customers are willing to bring the movies back more quickly. Other customers like the flexibility of being able to keep it out for a week. They use us on a weekly basis.

It just makes it more convenient for them. So, we were getting these mixed signals and we decided to put the test in place in Orlando recently that offered the three pronged platform. We’ve actually backed it up with some advertising, you recall the old Journey song, any way you want it, we’ve got that in place in radio in Orlando telling the customers about the flexibility of this pricing platform, any way you want, they can have it by day, by week, by month.

We will begin rolling more, and more markets. Now, whether we roll this nationwide or not really depends on the continued reaction of our customers to this and how they respond over time. But, directionally his is where we’re heading. We believe that the flexibility, particularly in these economic times is something that our customers will reward us for.

Stacey Widlitz – Pali Capital

Then if you could just comment on your plan B for self funding, by January will we see notable changes in a pull back in the merchandise in stores or is that something that will be evolving maybe starting in January?

James W. Keyes

Let me give you a little bit of flavoring for the kinds of things that we are looking at. When we say a self funding plan, there are various levels of aggressiveness in self funding. The first priority that we have it so increase our revenues, continue to increasing our revenues and our gross profit. Through the new pricing and terms, through the opportunity to capture more value with the consumer, that’s the first opportunity in our self funded plan.

On the expense side of our self funded plan we’ve certainly got further G&A opportunities, further outsourcing opportunities as we’ve referenced. We have real estate expenses that we will be very aggressively looking at. We can be a bit more aggressive with closing stores. As you know, I’ve been extremely conservative with our store closing plans because we really want to give our stores a chance to improve the business model before we prematurely close store models. Yet, we do have flexibility there. That helps us in the short term.

We have a lot of distribution cost savings. With all the savings we’ve addressed so far we haven’t even really drilled in to some of the inefficiencies in the way we go to market with DVDs and products. So, distribution costs will be a big focus. On the cash side of that first priority in self funding, we’ll be looking at our cap ex.

We’ve been pretty aggressive this year in rock the block remodels, those rock the block remodels, since they are not scalable at this point we haven’t done a wide roll out, are higher than the costs we expect going forward. So, we can dial back some of the cap ex needs for a period of time and that’s primarily for the first half of the year and to push our more aggressive roll out plans in to the back half after our self funding needs are met.

Then further, you saw the LC reduction that we’ve achieved already. There are lots of other things that we can do to try and bring down our LC requirements and to just reduce our cash needs. Those are the kinds of things that we’re talking about. The more aggressive opportunity that we have but the lever we are probably not going to pull unless we really needed to would be to pull back inventory on the stores, to pull back store labor, to pull back aggressively on advertising.

These are the things that we’d like to keep in place because they will help to continue to drive top line growth. You’ll see those are opportunities if we needed to go to them to max cash, to be in a self funded mode but we think we have a plan that we can put in place that will allow us to generate a significant improvement in cash flow without resorting to aggressive measures to pull back inventory or store labor.

Operator

Our next question comes from Karru Martinson – Deutsche Bank.

Karru Martinson – Deutsche Bank

How much do you feel the Olympics and the political connections really depressed sales? Is there a percentage kind of that the comps were down from?

James W. Keyes

As you know, I’m a rookie to this business and I’m still after a year and a half try to understand the drivers and I would attribute the impact of both August and October to box office more than I would the external environment. When box office is down 50% it doesn’t matter what’s going on in the outside world we just don’t have as much to sell or rent in terms of content. So, I think that’s the single biggest driver.

Yes, Olympic viewership had an impact but it’s hard to separate how much of that was just people watching the Olympics versus our inability to have much of a compelling movie slate to offer folks during the month. Our primary objective here is to both deseasonalize this business, as you know the second and third quarters have historically been less profitable.

We think we can deseasonalize the business, things like including beverage bars in some of our remodels are small but important steps in taking away the traditional seasonality factor. We can also decrease our reliance on both title strength and external environment factors like the Olympics or the presidential elections by improving or diversifying the content mix in our stores, having product like we have now with the discovery channel and other initiatives to bring new and different content in to the stores.

Some of the television shows, etc. that we have available that customers didn’t otherwise find in our stores will help us to offset what could be lower box office or a less favorable slate of movies.

Karru Martinson – Deutsche Bank

You historically have been out of your revolver by year-end, is that still the plan here?

James W. Keyes

I can’t give you specific guidance on that Karru but you would expect our working capital to follow normal seasonal patterns. But, you need to factor in the one-time step ups we’ve had with gains and Blu-Ray that occurred in the second and third quarter. But for that, it’s the normal seasonal pattern.

Karru Martinson – Deutsche Bank

Then when we look at advertising, advertising was up a bit more this quarter, is that kind of the level that we’re looking at going forward?

James W. Keyes

Directionally, yes.

Karru Martinson – Deutsche Bank

Then could you update us on where we stand with the NCR kiosks, how those are rolling out. Well the NCR kiosk, I would characterize it as a roll out at this stage.

James W. Keyes

Or test phase.

James W. Keyes

There are really two kinds of kiosks that we’ve discussed with NCR. One is the pilot of a vending kiosk that’s really very similar to what you see in the market today with Redbox and others. The second is a pilot of a digital download kiosk. Now, eventually we’ll be able to bring these together and have one kiosk offering that does both vending and digital download. We do have only about two stores with a digital download kiosk and it really is more for consumer reaction.

We’re trying to get a read on how customers will respond to the availability of this content on a machine, their willingness to buy the portable device and to use the machine to reload their portable device. So, I wouldn’t expect much in terms of our ability to monetize this product or to have a roll out for on the digital side at least the next 12 months as we continue to learn.

Karru Martinson – Deutsche Bank

Just lastly, the digital library that you have, what’s available there today versus your competitors?

James W. Keyes

This has been a real challenge to communicate what we believe is among the best of the digital libraries available anywhere in the market place. I’ll split that market in to two pieces for you, there is the ala carte market which is Apple, Amazon and Blockbuster. Then there is currently the subscription market which is Netflix and a couple of others and then actually there’s the third which would be the free advertising sponsored [Hoolu] kind of market.

Free obviously generates a lot of traffic. It’s pretty hard to monetize though so we haven’t yet gone down that path but we at some point will have the ability for our customers to have free content and we’re looking at advertising sponsored content at some point. But, if you just look at the ala carte versus prescription, it comes down to what kind of content is there. We think what we’re able to offer through movie link is high quality hot new releases which is what our customers predominately have demonstrated a desire for.

Some 80% of sales in store are new releases. It’s a little broader, a little less focus on new releases for the by mail customers but still our by mail customers, the vast majority are looking for new releases. Our digital offering today on an ala cart basis let’s customers get access to the hottest of new releases and we think we have among the best of the libraries out there as I mentioned.

On the subscription side, we have entertained various opportunities to build the subscription library but we have not yet gone down that path because first we want to have improved delivery mechanisms. Let’s face it, not a lot of people are downloading movies on their PC today and until we have a commercially viable set-top box which we think is some distance down the road, we’re not sure how many months or years it will take to have a commercially viable solution for the at home offering.

Until we have that we want to be somewhat prudent in our acquisition of subscription content because by nature it is much longer tail content. You can provide an all you can eat buffet to your customers but it is by nature a somewhat older titles and we believe it’s a little less consistent with what our traditional demographic has been looking for.

Operator

Our next question comes from the line of [Randy Raisman] – Durham Asset Management.

[Randy Raisman] – Durham Asset Management

Just a few additional follow ups around the self funding plan. I mean, can you give us a little bit of color as to how many leases you could get out of relatively quickly? On top of that I just wanted to know kind of sort of what the lower level of cap ex that you think is the right level that you could run the business on?

Then lastly, just with regards to the comments made about the business being resistant to the economic headwinds which one of the questions I have is just can you give us a little bit of insight then to maybe how the stores are performing in a market like a Detroit or in the inland empire in California just so we can get a little more flavor as to kind of how you’re holding up in these really challenged parts of the country right now.

Thomas M. Casey

I’ll address cap ex and leases first, as you may know our domestic leases average lease term is about 2.5 years. It’s nearly $450 million of rent expense associated with those leases so given that set of facts and the environment we’re in and the number of leases that we’re in the process of renegotiating, you can imagine there’s opportunity in this real estate environment to look for some important opportunities there.

Cap ex, you can think of our cap ex as roughly half maintenance and have growth oriented so if need be we could cut back nearly 50% from the $130 million that we’ve been talking about. As far as weak economic markets, the recession states are actually performing slightly better than the other markets. I wouldn’t be too definitive on that though because we have taken a look at the markets you mentioned vis-à-vis others but there are a lot of other factors that would affect differences between markets.

But, generally speaking we think there may be a slight benefit to the weakness in the economy to our business.

[Randy Raisman] – Durham Asset Management

Then one last one on the merchandise inventories line of $471 million, can you give us a sense as to how much of that is actually movies versus some of the other inventory items like gum and candy and popcorn and things? And maybe if you could just put them in broad categories for me?

James W. Keyes

Most of the increase in our inventory build as been related to DVDs, Blu-Rays and game software. As I noted earlier we didn’t increase our game inventory very much this quarter but just to breakdown the parts of our – the biggest by far our domestic inventory is DVDs, it’s more than double our game software. I guess we don’t break out the specifics here but maybe that gives you a flavor for it.

Operator

Our next question comes from [Dominique Neal – Kenyon Capital].

[Dominique Neal – Kenyon Capital]

A question about working capital which in the quarter I’m guessing the change was about a -$50 million or even -$60 million. I’m just wondering if you can give us more detail on what it’s going to be for year-end and maybe the way to do that is to quantify the step up you were referring to in terms of gains and Blu-Rays? Or, if you have any other way to sort of guide us towards that number, that change year-over-year?

Thomas M. Casey

As I said before, we have normal fourth quarter seasonality in merchandise inventory so there would be a significant positive working capital number in the fourth quarter. That is our strong cash generating quarter typically. I can’t guide you to a specific number there other than to say it would be significantly more positive in the fourth quarter than last year let’s say.

[Dominique Neal – Kenyon Capital]

I think last year fourth quarter was in the $65 million positive inflow in the fourth quarter?

Thomas M. Casey

Approximately, yes.

[Dominique Neal – Kenyon Capital]

Should we expect a much bigger number or how do we - ?

Thomas M. Casey

Significantly bigger. I don’t want to be more specific than that. But, yes.

[Dominique Neal – Kenyon Capital]

Then for the year can you help us thinking about whether working capital is going to be a source or use of cash?

Thomas M. Casey

It will be a use of cash in this year to be consistent with our strategy in gains and other inventory in store including Blu-Ray and other products. So, working capital would be a net user of cash in 2008. I would overlay that net increase with normal seasonal patterns and it’s mostly the investment in games actually. The biggest single chunk of that is the investment in games in the second quarter which was about $50 million.

Operator

Our next question comes from the line of [Rosemary Sisson – Knight Lubertos].

[Rosemary Sisson – Knight Lubertos]

A couple of quick questions, most of mine have been answered by now but I was just curious in terms of your core customer I’d imagine you would divide your customer base up and look at kind of their habits in terms of renting and what not. Have those changed significantly in the last few months?

James W. Keyes

Not yet. Rosemary we haven’t seen much change in our core customer. What we really expected and seems to be coming to pass is that most of the near term improvement is going to be our core customer increasing their transactions. We were pleased that we’ve had some small lift in active customers in the quarter and I reference the active customer count for the year. So, those have been positive.

But, we’re really not doing a lot of aggressive advertising telling people about this new Blockbuster so it really is mostly the core customer being happy with our in stock position, coming more frequently perhaps and buying more or renting more when they come.

Over time you’ll see that shift. I’d say for the first year or two we’re going to relay very heavily on driving our growth through our core customer and increasing transaction size then as we get more effective advertising and we have more to say frankly once we’ve got more stores remodeled and once we have a more consistent inventory both movies and games to offer, you’ll see us do more external communications and then we should see a shift in our demographic and that core customer actually change and hopefully grow.

[Rosemary Sisson – Knight Lubertos]

What is the current window between the time the movie studios allow you to have the movie versus the box office?

James W. Keyes

30 to 45 days approximately?

[Rosemary Sisson – Knight Lubertos]

Has that changed recently or do you anticipate it changing?

James W. Keyes

No, we don’t anticipate a change.

Operator

Our next question comes from [Walt Sinowski – SRC Capital Management].

[Walt Sinowski – SRC Capital Management]

Given the continued disconnect between the A shares and the B shares, what are you current thoughts about collapsing the two classes?

Thomas M. Casey

I can’t be any more specific other than to say that two classes of stock were put in place in 2004 in connection with the split off from Viacom. The B shares as you know trade at a substantial discount to the As and it would be fair to look at that situation and wonder what benefit we derive from having to classes but we’ve obviously been focused on the new strategy at Blockbuster and implementing that but it’s certainly one of the things we will evaluate going forward.

Operator

That was our final question for today. Are there any closing comments?

James W. Keyes

We hope you all share our enthusiasm for the continued improvements in results and the continued transformation of Blockbuster. Stay tuned, we’re excited about the fourth quarter. Some really good things coming in the quarter and I look forward to sharing those results with you. Thank you everybody.

Operator

This concludes today’s Blockbuster third quarter 2008 earnings conference call. You may now all disconnect.

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