Blockbuster and Movie Gallery Pay the Ultimate Late Fee

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 |  Includes: AAPL, BBI, MCD, MVGRQ, NFLX, OUTR, PEP
by: Alex Morris

When FORD (NYSE:F) produced the first Model T in 1908, transportation as a whole changed instantly. While the horse drawn buggy had its time to adjust to the change, it was quite clear from that day forward that its future was limited. When Redbox and Netflix (NASDAQ:NFLX) came onto the scene, brick-and-mortar movie rental chains shared a similar fate: they had time to make changes, but needed to adapt as soon as possible if they wanted to stay in the game.

Movie Gallery (OTC:MVGRQ), the owner of the rental chain Hollywood Video, decided to stick with their business model at a time when they should have been looking for the exit. They instead decided to continue expanding, one store after another. In 2005, the company acquired Hollywood Entertainment, and continued opening roughly 100 stores a year, two moves that put them under a substantial amount of debt.

This acquisition happened a year after Redbox, which was started by McDonald's Corp. (NYSE:MCD), had already been introduced in 140 McDonald's (Redbox is now completely owned Coinstar (CSTR), which bought out McDonald's remaining 47% stake for $175 million in February 2009) . The technology was out there. They could look around and see the potential changes that were coming, the low cost alternatives that could bring them to their knees. But instead of addressing the new business environment, Movie Gallery went all in, betting that their “horse drawn buggy” could outperform the Model T.

In September 2007, the company began having its first of a long line of financial troubles, and was forced to close 520 stores. Less than a month later, the company was forced to file for Chapter 11. After emerging from bankruptcy in May 2008, the company continued its struggles for less than two years, before being forced to file for Chapter 11 bankruptcy protection yet again on February 3, 2010. As of February 2010, the company still operated 2415 outlets in the U.S., and had plans to close more than half of them. This past Friday, the story came to an end, as people familiar with the matter informed reporters that the remaining stores will be closed over the coming months.

Movie Gallery made a critical mistake that ended up costing them everything. When Redbox hit the scene, Movie Gallery should have sat down and considered the possible outcomes of their competitor’s success. Is this a real threat to our way of doing business? At first, Redbox was very likely not cost effective. But with a powerhouse like McDonald's backing the venture, Movie Gallery and Blockbuster (BBI) should have both realized that this could potentially be a game changer, and done anything necessary to protect the moat they had, the dominant position that they held from already handling thousands of DVDs every single day.

Netflix, another game changer, was started in 1997, and had its IPO on May 29, 2002. From 670,000 subscribers in 2002, the company increased their count to an astonishing 5.6 million subscribers in 2006. In 2004, two years after Netflix had their IPO and five years after they had first launched their monthly subscription concept, Blockbuster finally came onto the scene, introducing an online DVD rental service. After sitting around and watching Netflix steal the business that they had built an economic moat around, Blockbuster was now the one left standing outside the castle’s walls. Today, Blockbuster has failed to make any significant stabs at either Netflix or Redbox, and has warned that they could soon be forced to seek bankruptcy protection.

Companies around the world should take note of what has happened in the movie rental business. Blockbuster is currently sitting on over $800 million in debt, and has lost nearly $1 billion combined over the past three years. For anybody who bought BBI stock at the start of 2000, a $10,000 investment is now worth a laughable $266 dollars. Looking back on what now appears to have been a golden opportunity, Blockbuster turned down the chance to buy Netflix for $50 million in 2000. And I don’t blame Blockbuster for turning down the offer; ten years ago, the future was much cloudier, and they could have found plenty of reasons to pass. But this doesn’t give them the leeway to close their eyes and blindly stick to their business model. They should have kept their eye on Netflix, and with any sign of potential success, jumped at the opportunity to either buy the business for a larger sum, or create their own way to use their competitive advantage to take a stranglehold on the market. But they looked the future dead in the eyes, and decided that they would rather fight it than attempt to adapt from their set business model; this decision ended up costing them everything they had.

This same idea can be applied to companies all across the world. For Apple (NASDAQ:AAPL), for example, failure to innovate would quickly mean the end of everything that took years to develop and implement. If they sat down today and called the iPad the pinnacle of technological development, they would quickly find out that they had made a gross miscalculation. The same holds true for companies well outside the view of Silicon Valley. PepsiCo (NYSE:PEP), for example, spends millions annually to complete new research and development and to stay ahead of the pack. One challenge they face is to reduce the amount of salt in their snacks, while still delivering the same taste that consumers have grown accustomed to. Without these developments, PepsiCo would undoubtedly lose sales in the future to companies that cater to the needs of health-conscious consumers, a growing portion of the population.

Failure to innovate and adapt to consumer desires is a pitfall of countless businesses, a majority of whom find themselves with no other options once they finally realize that they can’t survive without adapting. Movie Gallery realized this too late, and is paying the price today. Blockbuster has fought off the apparently inevitable up to this point, and unless they can quickly implement an improved business model, will soon follow the route of the horse drawn buggy.

Disclosure: Long PEP