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Blockbuster (BBI)

Q2 2006 Earnings Conference Call

July 27 2006, 10:00 am ET

Executives

Angelika Torres - Director, IR

Larry Zine - EVP, CFO, CAO

John Antioco - Chairman & CEO

Analysts

Walter Wible - Citigroup

Ted Irvin – Bear Stearns

Michael Pachter - Wedbush Morgan

Robert Blasi – JP Morgan

Arvind Bhatia - Sterne Agee

Carla Casella - JP Morgan

Grant Jordan – Wachovia

Presentation

Operator

Good morning and welcome to the Blockbuster, Inc. second quarter 2006 conference call. At this time, all participants have been placed on a listen-only mode and the floor will be open for questions following the presentation. It is now my pleasure to turn the floor over to your host, Ms. Angelika Torres. You may begin.

Angelika Torres

Thank you and good morning, everyone. Thank you for participating in Blockbuster's second quarter 2006 earnings conference call.

Today's earnings call may include forward-looking statements relating to our plans, objectives and initiatives, our outlook for the industry and our performance relative to the industry, projected trends for financial items, anticipated liquidity, goals for online subscriber growth and profitability, cost reduction expectations, divestitures, store closures 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 these forward-looking statements and factors that could cause actual results to differ materially, please refer to the cautionary statements in today's earnings release in our public Securities and Exchange Commission filings including our 2005 Form 10-K and our upcoming Form 10-Q.

Today's earnings call may include a discussion 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 www.Blockbuster.com under the link Investor Relations. With that, I will turn the call over to Larry Zine, our Chief Financial Officer.

Larry Zine

Thank you, Angelika and good morning, everyone. We delivered another quarter of solid performance and I am pleased to report the second quarter of 2006 represented another strong step forward in the execution of our plan.

Our profitability and cash flow has improved significantly year-over-year resulting in a healthier balance sheet. Since the beginning of the year, we've paid down approximately $150 million in debt, which includes fully repaying the outstanding balance on our revolver.

Our domestic same-store rental revenues were positive, led by a 3.8% increase in domestic same-store movie rental revenues following a similar increase in the first quarter.

Operating expenses declined by $32.5 million sequentially and $64.9 million year-over-year. We are gaining momentum in our online business, as you will hear from John later on the call.

Now, let's talk about the most significant aspects of our second quarter performance in more detail. For the quarter, total revenues decreased 5% to $1.32 billion, mainly due to the reduction in our company-operated worldwide store base. Since the beginning of this year, our domestic company-owned store count decreased by 164 stores including 48 non-Blockbuster branded stores. Our international company-owned store base declined by 112 stores this year, mostly due to our exit from Spain, which accounted for about 95 store closures.

Additionally, revenues for the quarter were affected by a shift away from high revenue, low margin merchandise sales, lower overall advertising and promotional activities coupled with continued pressure on the in-store rental industry, particularly in international markets; and, a year-over-year decline in Movie Pass subscribers. Currently we're at about 800,000 subscribers versus 1.9 million for the same time last year.

Our domestic same-store rental revenues increased 1.6%. Despite a significant impact from higher Movie Pass revenues and higher levels of promotional activities in the second quarter of last year, we are able to drive a 3.8% increase in our domestic same-store movie rental revenues.

The improvement in domestic same-store movie rental revenues was somewhat offset by 15.1% decline in domestic same-store game rental revenues, mostly attributed to a lack of new game titles as compared to last year and a low installed base for next generation platforms.

Worldwide same-store rental revenues were flat as compared to last year, reflecting a strong performance domestically which was partially offset by 4.8% decline in international same-store rental revenues.

Worldwide same-store retail revenues declined 9.2% during the quarter, mainly due to the continued reduction of domestic retail movie inventory, and was partially offset by strong performance in international same-store retail sales driven by Game Station.

Our gross profit declined $28.2 billion, mostly due to a decline in the company-operated store base. Additionally, rental gross margin decreased 150 basis points to 64.8%, mostly due to increased product purchases to support our combined in-store and online offering; and, increased promotional activities around previously-rented product.

Despite merchandise sales being down over $40 million year-over-year, retail gross profit increased 10.1% during the quarter. Merchandise gross margin increased 520 basis points to 26.2%, due to a shift in retail revenues away from lower margin new product, towards higher margin traded product, particularly games, as well as other general merchandise.

Furthermore, we have improved profitability on sales of new movies and games. Operating loss for the quarter was $6.4 billion, an improvement of $49.6 million from an operating loss of $56 million last year. The year-over-year improvement was driven by a $64.9 million decline in SG&A as compared to the second quarter of last year, driven by more efficient management of store labor, the reduction in the company-owned store base and lower corporate overhead and advertising expenses. The SG&A improvement was partially offset by $9.1 million in costs incurred for store closures.

During the second quarter, we completed our exit from Spain and these results were accounted for as discontinued operations.

Income from continuing operations for the quarter were $60.7 million or $0.28 per diluted common share, reflecting the favorable settlement of income tax audits in the amount of approximately $105 million, which resulted in a cash receipt of about $21 million and approximately an $84 million reduction in accrued liabilities. I would like to point out that this tax settlement affected our income from continuing as well as discontinued operations.

Adjusted net loss for the quarter was $21.4 million or $0.13 cents per common share, a significant improvement over an adjusted net loss of $44.6 million or $0.24 per common share for the same period last year.

I would like to address one major difference between our reported EPS and the First Call consensus. As I mentioned last quarter, because of our tax position, we are currently not recognizing income tax benefit associated with the current period results. Most of the analysts surveyed by First Call are using a normalized pro forma tax rate of 38% in their models, which gave us a tax benefit in their estimates on average of $0.04 per common share. Going forward, our tax expense will be approximately $4 million a quarter in each of the remaining two quarters of the year.

In summary, as we enter the second half of 2006, our financial position has improved significantly while we continue to go through a transition as a Company and as an industry. Now, I'll turn the call over to John.

John Antioco

Thanks, Larry. We feel good about the second quarter results, especially in light of the fact that they mark the third consecutive quarter of solid performance and delivery against our business plan. A plan which calls for us to grow our share of the overall movie rental business, in-store and online, to control costs, to maximize asset portfolio and to improve our profitability and cash flow, much of which was accomplished this quarter. As a result, we believe better positions Blockbuster to deal with the transitioning video rental industry and to take advantage of the opportunities the industry has to offer.

Looking first at our domestic store business, we have been working to increase our efficiency, revenue and profitability on a by-store basis. Not only has this is good business short-term, but by taking aggressive actions now, we believe we are getting our store base situated so that as consolidation occurs in the future we are best prepared to draw the revenues from industry-wide store closings to Blockbuster and Blockbuster Online; and as a result, gain market share.

To this end, during the first half of the year, in our domestic stores we lowered our labor year-over-year; lowered our advertising; cut distribution costs and significantly reduced overhead in the field and corporate office. We also have closed less profitable stores at an accelerated pace.

We are approaching these store closures prudently and are generating strong revenue and profitability transfers to our other stores as well as maintaining our presence in competitive markets.

As a result of our efforts, we have significantly decreased the number of stores we have that are not cash positive and improved our market level profitability. But even as we have taken costs out of the stores and out of the business, our overall customer satisfaction levels have remained consistently high among our core customers. So we feel we are headed in the right direction with our domestic store business.

As a result, based on our market data, we believe we have increased our share of the domestic store-based rental industry during the first half of 2006, even with the accelerated number of stores we have closed.

As for the international side of our business, we continue to explore alternatives for these assets, including selling or franchising some markets. Simultaneously, we are working to improve our international financial performance. As we did with our domestic business, we are looking at ways of cutting overhead and closing underperforming stores.

We have mentioned store closings a couple of times today. I want to make it clear while the industry is overcrowded and some stores need to close, we believe there will still be a strong need for a store-based industry for many, many years to come.

The fact is that most customers still like to rent exclusively at stores. A smaller group of customers now like to rent only online. An increasing number, and we believe this is with our greatest opportunity lies, want to do both. Blockbuster is the only company offering both.

Based on total revenue increases we have seen from our in-store customers who have also begun using our online service, we believe these dual-use customers are good for our business. So beginning the last week of May, we stepped up our efforts to use our store assets as a marketing platform for our online service. Our employees have responded well to this and have really gotten behind it and their enthusiasm grows every day.

It's at this point that our assets really picked up traction and we ended the quarter with 1.4 million subscribers, including approximately 100,000 who were on the service at the end of the quarter and subsequently converted to paying subscribers.

The goals of our ongoing in-store program are to:

  1. Drive awareness of our online service;
  2. Acquire subscribers by encouraging trial;
  3. Prevent our customers from leaving Blockbuster or from sharing their rental dollars with a competitor.

We still remain confident about hitting our goal of 2 million subscribers by year-end, largely through the efforts of our in-store sales force. Other benefits of using our store assets to recruit online subs are low subscriber acquisition costs. Our stores are the least expensive recruitment channel we have. Those store-based customers who try our service but don't convert to being a paid subscriber have at least experienced our service, are aware of the benefits, and if they decide online renting is right for them in the future, we believe they will use Blockbuster Online. Meanwhile, they continue to use our stores.

All of that to say we feel good about where we are with our online service. Based on the improvements we have seen with all of our key service metrics since the first of the year, we believe Blockbuster Online customer experience is on par with that of our largest competitor. Over the near and long-term, we believe our online capabilities, combined with our store network will give us a significant advantage in the battle for a video rental share.

In summary, I hope we've made it clear that Blockbuster's future isn't just about closing stores or cutting costs. Certainly we've taken those steps because we believe that it puts Blockbuster in the best position to take advantage of the industry consolidation which we think is inevitable.

But our future is really about building something. Down the road, we think there may be increasing opportunity for digital distribution of rented movies and electronic sell-through. However, for the foreseeable future, the overwhelming opportunity is the store-based and online movie rental business. That’s where our efforts are focused.

Whatever direction the future of home entertainment takes, we have the assets that we believe will enable Blockbuster to bridge the future. We have the brand that stands for rented movies. We have a relationship with tens of millions of customers. We have good relationships with Hollywood studios and other content providers. We have entertainment marketing know-how. We have the largest in-store presence of any company in the movie rental business. We have a growing online presence. We have the capability -- currently the only capability in the marketplace -- to integrate bricks and mortar and online. We have an improving balance sheet and a business plan that we have shown we have the ability and the discipline to execute against.

In short, I believe we have the ability to meet consumer's home entertainment needs today, tomorrow and long into the future. We are now ready to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from Walter Wible - Citigroup.

Walter Wible – Citigroup

Hi, John. I want to spend a second to focus on the rental gross margins. With it being down, is that a function of just seeing a temporary decline in the turns per disk or are we seeing more utilization on the online? Can you talk through what is driving that trend? Is it a seasonal pattern or is it a secular pattern? Especially in light of the stores that you are closing, I would assume that since you are closing the less productive stores that we could see that improve.

Larry Zine

Tony, it's Larry. Let me at least start to answer the question. If John wants to add on, I'm sure he will. In terms of the margin, I would say that one of the bigger drivers was actually the sale of the used products during the quarter, which actually flows against that margin as well. It's a little bit lower margin than our rental and as a result would reduce the amount of the gross margin.

So if you have seen our stores, we've run a lot of promotions on that product during the last couple of quarters.

Walter Wible – Citigroup

The $5 liquidation?

Larry Zine

Well, we've been running four for $20. I wouldn't call it a liquidation. It's basically taking product that has been in the stores for a while and moving it along. We've done very, very well at it. Year-over-year we've seen very nice improvement in that.

Additionally, we've bought a little extra product to support the online and in-store promotional activities going on around again online and usage in the store.

Walter Wible – Citigroup

With the stores that you just closed, how long does it typically take you to get the recaptured revenues on a closed store? Would you anticipate seeing that in advance of closing or after you close?

Larry Zine

Tony, we pretty much start seeing revenue transfers almost immediately. So a person comes to a store that's closed, they see that it's closed and just go on to the next closer Blockbuster store. We've seen revenue transfers on average in excess of 25% when we close stores. So it makes sense to us to close stores on an accelerated basis in certain markets, where we're very confident of the store revenue transfer. In competitive situations, we obviously would spend a lot more time looking at the economics around whether we should close the store, stay open longer, and test the waters in the marketplace a little bit longer, because of competitive issues.

So on an overall basis, we feel very confident with the revenue transfers we get. We continue to look at accelerating store closures where we get significant paybacks from it. As John mentioned earlier, we'll continue that process that we've been using in the domestic markets into our international markets now, to see if there is significant opportunities like we found in the U.S. to close stores.

Walter Wible – Citigroup

Last question is, can you guys provide any commentary about the trends to date in this quarter? Are you seeing the same trends you saw in the second quarter persisting? Has there been any change in the trend?

Larry Zine

As you know, we never really give any forward-looking commentary. Certainly, in August the box office was better. It's not as good later in the quarter. But, that's just as always store activity is what's most important to measure our results by. We're certainly happy with the results we've seen in our same-store rental movies through the first half of the year. The quarter will develop out over the next couple of more months and hopefully will continue the trends that we've seen in the past.

Walter Wible – Citigroup

Thank you, guys.

Operator

Thank you. Our next question is coming from Glen Reid - Bear Stearns. Please go ahead.

Ted Irvin – Bear Stearns

This is Ted Irvin in for Glen Reid. In the quarter, there was significant in free cash flow, rental and purchases contributing on the positive side off of that working capital. Do you expect a continued contribution from rental purchases? What do you expect on the free cash flow side for the full year?

Larry Zine

Again, we don't give guidance as to full year numbers as it relates to cash flow. You will continually see fluctuations in rental library purchases versus products that come out in rev shares. There are always going to be month-to-month and quarter-to-quarter fluctuations there. So depending on the release schedule and where we have rev share deals versus product purchases, you'll see fluctuations in that.

We had some swings in working capital during the quarter that were driven primarily by tax, essentially the favorable settlement of the income tax audit relieved a liability of about $85 million, which reduced our accrued liabilities. That had a significant impact on liabilities for the quarter.

But additionally, I'd add if you looked at our overall balance sheet position for the quarter, we had reductions in accounts payable and year-to-date a significant reduction as well as a quarter reduction in our outstanding balance. Obviously on revolver, that’s fully paid off. $150 million in total debt reduction the first half of the year.

Ted Irvin – Bear Stearns

Also, regarding the divestitures, you mentioned you continue to evaluate the market for international asset sales. I'm wondering if you can comment on what you're currently seeing in that market?

Larry Zine

We are currently seeing, as we've said previously, we're in the process and as John mentioned, we're implementing plans that we believe will significantly improve our international operations. That obviously is good for us from a financial picture and it's taking actions that if we chose to ultimately sell the it would obviously help the valuation of those markets because of the actions taken.

Ted Irvin – Bear Stearns

Great. Thanks.

John Antioco

A little bit more color on the international operations. We have very strong operations in Ireland, Italy and Denmark are good operations for us. We have definitely had challenges in our biggest international market, in the U.K. that we are addressing. We have a very valuable and growing business in Game Station, so all of which we are focusing on in analyzing and attempting to make the right shareholder decisions, so to speak, going forward in terms of selling, operating. All of that is going to be contingent on getting right price for the right asset at the right time. But we are actively engaged in all of that.

Ted Irvin – Bear Stearns

Thank you.

Operator

Thank you. Our next question is coming from Michael Pachter - Wedbush Morgan.

Michael Pachter - Wedbush Morgan

Hi gentlemen, and lady. Can you tell me if you have seen seasonality in your business similar to what NetFlix described a couple of days ago with the higher customer losses in colder climate cities as we had an onset of warmer weather? Specifically, did you see higher online churn or lower pay as you go sales in those colder cities as compared to cities in the sun belt?

Larry Zine

We have briefly looked at that since NetFlix made those comments. We haven't been able to see any pattern in-store or online in those markets that is any different than, quite frankly, how our markets are performing broadly. So I would say not in our numbers.

Michael Pachter - Wedbush Morgan

I particularly wanted to address whether you saw any kind of a change in the pay as you go. They said they had pretty high customer churn in cities like Chicago and Minneapolis. I was wondering if you saw your pay as you go sales and in-store rentals decline in those cities.

John Antioco

Nothing worth mentioning, Michael. I can tell you that it's obvious that I can see a correlation between increased churn, significant increases in-store, you know, a little bit of a mixed bag. But on balance, it performs about like the rest of our market.

Michael Pachter - Wedbush Morgan

All right. My last question: NetFlix characterized you guys as convinced of the inevitability of online dominance and they called you courageous; their analogy was Southwest Airlines advertising Greyhound Bus Lines based on your in-store advertising of Blockbuster Online.

Is that an accurate characterization? Not the courageous part, but the ‘convinced of the inevitability’ part.

John Antioco

I didn't know Southwest Airlines owned Greyhound.

Michael Pachter - Wedbush Morgan

I don't believe they do.

John Antioco

Well, we are convinced of the fact that the online business will grow. We are not at all convinced that it will dominate. In fact, we're convinced it won't. We see the market growing. I'm not going to look out into 2012. I'm just not that much of a visionary to do that.

But clearly, you could see a point where the online rental business will represent 20% to 30% of the overall rental business. I think stretching it beyond that is probably not something that we can see, nor do we believe will happen.

We are very encouraged by the growing number of customers that like the convenience of online combined with the spontaneity and convenience in-store and the way we are combining it today.

We also intend to, let's say step up our integration of in-store and online beyond what we are doing today in a bigger way before the end of the year, giving our online customers even greater in-store access to movies. We'll talk about that more fully at our next quarterly call.

That is a big and growing market that we think gives people the best of both worlds: convenience, selection, value of online with all of the in-store benefits. And, as I mentioned earlier, the ability to go out and get today the hottest new release you want or whatever other movie you want at a Blockbuster store.

Operator

Our next question is from Barton Crockett - JP Morgan.

Robert Blasi – JP Morgan

Good morning, everyone. This is actually Robert Blasi for Barton. I had a follow-up question on the online business. Just trying to figure out your 2 million sub goal, you still believe in that. I'm just trying to figure out how you plan on getting there. Should we still be expecting an increase in actual marketing expense in the back half of the year? Or do you believe that really just the in-store promotion is enough to get you there?

Secondly, if you could talk just a little bit more about the 100,000 subs in the trial. I mean is that pretty consistent for you, that you have that large a number of non-paying subs? Or is that pretty new?

Larry Zine

As far as the hitting the 2 million goal and increase in marketing and in-store activity, the answer is both. We see our in-store activity picking up traction based on, quite frankly, us learning how to do it better. What we have to do and how much we can say at the store level, what we give the customer to take home and how we follow that up with email communication to convert that customer to a trial and hopefully eventually to a paid member. So we expect that will definitely pick up momentum.

Additionally, we've always planned to step up our marketing activities in the back half of the year. We will be doing a little of that, also. So between those two things we feel good about the 2 million subscriber goal.

John Antioco

Let me try to answer it. As it relates to the 1.4 million subscribers, we actually had more members on the service, but we conservatively gave out the numbers basically as those subscribers that have been on the service and converted to the service at the end of June. So it's a conservative number of the overall people subscribing to the service today.

We said earlier we started promotional activities of this really in late May. As a result, we had a significant number of free subscribers on the service in June. We basically wanted to give out a conservative subscriber number that would reflect not only those people that were free subscribers but those that were actually free that became paid subscribers. So that's essentially where the 100,000 subscriber growth came from.

Larry Zine

The way it looks to us and you can do your own analysis of this, but we picked up about 100,000 net subscriber adds. NetFlix looks like it picked up about 300,000. That was slightly ahead of our market share in the business so we feel good about that, in terms of the overall growth of paid subs.

We don't give out specific subscriber acquisition costs. What we have said in the past is that our subscriber acquisition costs are about or slightly below that of our number one competitor. I would tell you at this point that gap has grown significantly. We are somewhere around half the average subscriber costs of our number one competitor now.

So we think we're adding subs at the appropriate manner, picking up momentum and doing it in a way that we feel is financially prudent by leveraging the assets that we have.

Robert Blasi – JP Morgan

Great. If I could ask a quick follow-up question on the merchandise gross margins. I understand they are increasing due to the mix out of new movie sales. I know that's something that has been going on for at least the third quarter, but we haven't seen anywhere near this level.

Additionally, my understanding is that second quarter merchandise gross margins are typically seasonally weak so the impact would seem even greater in this quarter. I'm wondering if that 25%, 26% plus level is sustainable. Thank you.

Larry Zine

Based on our current mix of product, it would be probably sustainable. Again, you're going to see fluctuations in that always just because of the makeup. We are seeing a much greater influence from general merchandise sales of candy, confection and items like that which are a higher margin than movie retail sales were that were a significantly greater part of the number in the prior year.

It would also relate to a significant amount of game sales that would happen base on release of whether it was software or hardware of games. You'll see fluctuations. Obviously if we sold more games, hardware in any particular quarter, especially towards the end of the year when new platforms are released, those are lower margin but higher sales revenue so they would affect the margin.

Just really briefly answer the question, you are going to see continued fluctuations in it. In a steady-state quarter, this kind of a margin level is probably about right.

Robert Blasi – JP Morgan

Great. Thank you very much.

Operator

Thank you. Our next question is coming from Arvind Bhatia - Sterne Agee.

Arvind Bhatia - Sterne Agee

Good morning. A couple of questions. First on the status of your game business in the U.S. and in Europe. I am wondering if you can comment on how you are preparing for the next cycle? Are you doing anything special this time around? Also particularly curious about the used business and how that is trending for you.

John Antioco

Also in games, Arvind?

Arvind Bhatia - Sterne Agee

Yes.

John Antioco

Well, yes. Like all other game retailers, we are certainly preparing for it. We are expecting to build momentum as the platforms get further penetration. As I mentioned earlier, our Game Station business, we think it's the best games concept in the U.K. One way other another, will be converted to value for Blockbuster going forward.

Last year, the fourth quarter was a tough – if you will remember -- financial quarter for us where a lot of our financial constraints on our inventory and tighter credit terms from suppliers caused us some stress and strain, especially in the game area in Europe. We'll obviously not have those pressures this year. So we feel very good about gaining momentum in the game business, both internationally and domestically.

Arvind Bhatia - Sterne Agee

How about the used game business? How has that been trending for you?

John Antioco

I don't have that number right in front of me in terms of games. Maybe before the end of the call, I'll take the next question and then Arvind, I'll come back to you on that.

Arvind Bhatia - Sterne Agee

Also John, just wanted to see if you can remind us of your goals for profitability in the online business. Is that still some point next year? Are your store employees, do they have any incentives to send customers online? Is it just mainly in the training that you are providing them to send customers online? Or is there some added incentive for them to do that?

John Antioco

There is some added incentive in this sense, Arvind. A store’s overall compensation structure is based on the profitability of the store. The store is given some credit, an internal transfer if you will, for the acquisition of the sub. So all of the employees who are participants in the store pay plan get some benefit associated with the sale of an online subscriber.

Also, our people have been hearing and now believe that it is a very good conversion for them for a number of reasons. One, the customer stays with Blockbuster. Second, the customer stays in their store, they continue to see that customer through the in-store benefits we get for them. Third, the alternative of not converting that customer to a Blockbuster Online customer is to run the potential to lose him to a competitor.

So between what's in it for them, what's in it for the company, and what's in it for the store, they are a highly motivated to see Blockbuster Online be successful.

Arvind Bhatia - Sterne Agee

I don't know if you mentioned what trends you are seeing in terms of conversion or what percentage are you transferring online?

John Antioco

I'm sorry. Could you repeat that question?

Arvind Bhatia - Sterne Agee

Meaning, what's the trend on being able to convert somebody who comes in the store? How do you monitor people who are going online and were a customer at the store before, but now are doing both in this case? But what are the trends in that regard? How many people have decided to do both?

John Antioco

Well, we're not going to get into that level of disclosure on it, so to speak. But let's say that hopefully all of our customers are exposed to the fact that we are in the online business when they are in the store. A significant amount of those customers want to know more and give us their email address to give them more information, go on our site and with their email address and with a promotional code they get, they qualify for a one-month free trial.

Many of them are taking advantage of that and they are converting to paid at approximately the same rate as a convert to pay free trial we get from other sources.

Their churn, after they go with the Blockbuster Online is actually better than subs we get from other sources. Their in-store purchase activity is better than non-store solicited customers.

So overall, it's a very good thing to do. I'm not going to represent we're getting the majority of our new subscribers from store, but it is a growing number coming through that vehicle.

Arvind Bhatia - Sterne Agee

And then the timing of profitability for online?

Larry Zine

Well, at 2 million subscribers, we could clearly run Blockbuster Online profitably. At this point, we're not changing any of our guidance with respect to that.

Arvind Bhatia - Sterne Agee

One last question for you, John is the industry trends you are seeing on store closings at this point, I know you mentioned a target, or you thought a certain percentage of the industry needed to close doors. Could you refresh us on what your thoughts are there?

John Antioco

I still continue to believe that we will see it. As you know, some of our competitors are going through extensive portfolio analysis looking at subleasing, downsizing, closing. It's the rational thing to do. The store-based rental industry has shrunk by about 15% over the last several years. The number of stores has remained relatively constant and now is beginning to decline.

Assuming that there is still some continued pressure and erosion of the store-based business going online and other alternatives, it still continues to make sense to me that the stores will close.

I believe that over the next two years, the rate of store closures will exceed the rate of decline in the market and that will have a positive impact on industry comps.

Arvind Bhatia - Sterne Agee

Last question for Larry. CapEx guidance was $90 million at the start of the year. I think you've done about $23 million so far. Should we still be looking for the same number?

Larry Zine

Arvind, we're obviously running well low of that on a trend basis. At this point, it's hard to say. Normally the second half of the year we spend a little bit more than we do in the first half of the year. We're trying to manage CapEx as tightly as we can. So it would not surprise us if that number came in lower than the $90 million that we previously said.

Arvind, as a follow-up to your used game question, I would just say that year-over-year used product sales for games have been relatively consistent both in revenues and in margins.

Arvind Bhatia - Sterne Agee

Thanks, guys.

Operator

Our next question is coming from Carla Casella - JP Morgan.

Carla Casella - JP Morgan

You mentioned your payables had come down during the quarter. I'm wondering if you have seen any changes in vendor terms?

Larry Zine

If there had been any changes in vendor terms it would actually be more positive than they have been in the last 18 months or so. As we said even last year, we've basically had pretty consistent terms with all of our vendors throughout the year. It continues that way.

Obviously, by having paid down our revolver we have significant financial flexibility. This year we're making the product purchases that we want and we're getting the vendor support that we want and deserve.

Carla Casella - JP Morgan

Great. And then on the advertising, is this a good run rate to use going forward? Will you need to up advertising to get to that subscriber number that you are looking for year end, the $2 million?

Larry Zine

As we said previously, advertising was going to be down about $50 million year-over-year. That would imply a larger spending in the back half of the year. What we actually do and what we actually advertise and promote on during the back half of the year is yet to be determined.

I think we're not saying anything different than what we've said previously about our advertising.

Carla Casella - JP Morgan

Your rental library is lower than it was a year ago. Even if you do it adjusting for the smaller store base, is it just a timing issue? Or is it a sign that you are less optimistic about the early part of the third quarter?

John Antioco

No. I think it's much more a reflection of a little lower store base and more revenue-share product this year versus last year.

Carla Casella - JP Morgan

That’s all I have. Thank you.

John Antioco

Thank you, Carla.

Operator

Our last question is coming from Grant Jordan - Wachovia. Please go ahead.

Grant Jordan – Wachovia

Thanks. I think most of my questions have been answered. One follow-up on the rental library purchases, the beta between the book and the cash purchases. You said that it's mainly due to timing. So should we expect those to even out over time? Are you going to be spending less on cash purchases as the store base continues to contract?

John Antioco

Let me try to clarify a little bit. A lot of it is the mix between rev share and purchased product. So if we buy the product and own it, we obviously have a higher cost up-front that goes to our rental library purchases. If it's more rev share, it's a significantly lower up-front cost because the cost of that product is spread over the rental life as we make payments on this revenue share.

So overall if you look at units in the store, we're actually probably up year-over-year in terms of units. But because the mix this year is greater per rev share product versus purchase product, the rental library purchases are lower.

Grant Jordan – Wachovia

Based on your conversations at the studios, do you feel like rev share agreements are going to increase? Or it will just stay about the same depending on which studios have better movies at the time?

John Antioco

It always is going to fluctuate. We have, as I said, more rev share this year than we have in prior years. But it's always going to be a combination of some degree of rev share, some degree of copy depth program from other studios and some degree of just purchased product from others. It really depends on the release schedule and what we and the studios want to do with particular movies as they come out.

Grant Jordan – Wachovia

Thank you.

Operator

Thank you. Ms. Torres, do you have any final remarks?

Angelika Torres

I would like to think everybody for participating and please feel free to give us a call if you have any follow-up questions. Thank you.

Operator

Thank you. This does conclude today's teleconference. Please disconnect your lines at this time and have a wonderful day.

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Source: Blockbuster Q2 2006 Earnings Conference Call Transcript (BBI)
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