To look at what the future of Blockbuster (OTC:BLOAQ) should be, let’s look at two lists. The first list is a list of what Blockbuster has to offer potential buyers. The second list is a list of potential buyers. Let’s have a look at what each potential suitor would get in a purchase of the dying retail chain. Let’s also remember that the international blockbuster chains are separate legal entities, so only the US business is evaluated here.
What you get with Blockbuster
Blockbuster has a lot of stores. They had 3,231 retail locations in the United States at the time of filing and they continue to shutter doors aggressively as the shift to DVD delivery via mail or kiosk has effectively rendered the retail DVD rental business model obsolete. This is the albatross that is causing the bankruptcy and any suitor must find a way to gracefully exit this business over the next couple years. As of the last quarterly filing for Q3’10, Blockbuster had $450M worth of inventory and rental library and $200M worth or property and equipment. This has gone down substantially as they have already closed the doors on the weakest retail locations already.
Blockbuster has an online presence. Blockbuster Online had 1.2M subscribers as of the end of Q3, 2010. With the online presence comes a business that is viable, but has not reached the scale required to be highly profitable. They must obtain subscribers at all costs to increase scales of economy.
Blockbuster has lots of debt. They have about $1B worth of debt. They also had about $120M of cash and equivalents, but that hardly helps when you are bleeding nearly $50M in operating cash flows as they did in Q3 of last year.
Netflix (NASDAQ:NFLX) – There is really only one main reason I can see for Netflix to purchase Blockbuster. They would be playing keep away from other competitors and basically buying whatever customers Blockbuster Online has. By inheriting a large portion of their online customers after some amount of churn, they could close down the majority of Blockbuster’s distribution warehouses and add the revenue to their bottom line. They would effectively be using the purchase as an extremely expensive marketing expense while getting some efficiency in their overhead.
Netflix had 20 million subscribers and approximately a $12B market cap. That would put the value of each subscriber at $600. That would value Blockbuster's 1.2 million subscribers at $720M. Considering that taking over Blockbuster would mean taking on that enormous debt load, a bunch of cash, and a bunch of headaches, Netflix would indeed be paying a huge premium (2x?) to squash the competition. This is an even more expensive proposition when you factor in their subscriber acquisition cost of approximate $20.
NCR – NCR has licensed Blockbuster’s name for their kiosks and they are trying to catch up to Redbox. Blockbuster Online is desperately trying to reach a size where they can take advantage of scale. There may be some synergy in terms of combining the distribution for both, but I believe that to be minimal. However, when you combine the second place finisher in both mail and kiosk DVD delivery, and both are playing catch up, you can get pretty innovative with sales and marketing. How about offering three free kiosk exchanges per month to simulate Blockbuster’s current Total Access program? How about combining a 2 week trial of Blockbuster Online with 2 free kiosk rental codes? For anybody who rents at the kiosk, you could send them your 2 week free trial to Blockbuster Online for a bit of cross marketing.
Netflix has proven that distribution of entertainment can be very beneficial when you combine multiple methods of delivery. Blockbuster Online already has online streaming technology, albeit without the content. They could create a Kiosk/Online/Streaming combination in a matter of a couple years to become very competitive with anybody out there.
Coinstar (CSTR) – What do you get when you put Redbox Kiosks together with Blockbuster Retail and Blockbuster Online? It’s the same as above without the name. For that reason, I think NCR makes a bit more sense than Coinstar.
Amazon (NASDAQ:AMZN) – This makes no sense whatsoever. Amazon wants streaming solutions to the customer. Retail delivery of items vs DVDs seems very divergent to me, although they could probably drive some efficiency. I just don’t think Amazon wants to get into the physical DVD business at all.
Creditors/Hedge Fund – There also is the possibility of recapitalization of the business by creditors. You’d need to have those retail exit plans in place AND a strategy to start stealing away customers from Netflix without going bankrupt again. This is possible, but you wouldn’t find me investing in it.
And the winner should be…
NCR seems to be aggressive in expanding their expansion, as they now have as many as 10,000 kiosks in the United States. They will be here to stay. I firmly believe that adding Blockbuster Online will help both businesses expand even faster with subscription packages that Netflix can’t offer and additional cross marketing opportunities. This, in addition to a large scale marketing program on the scale of Netflix, would juice subscriber counts and kiosk usage.
I can see them spinning off the entertainment portion of their business into a subsidiary named Blockbuster and then going public with that subsidiary in a matter of three years to five years. During that time, they must rid themselves completely of all retail Blockbuster stores, increase both their kiosk and subscription count, AND implement an online streaming solution. It’s a tall order, but they are already heading in the right direction for all of those tasks and the path forward is quite clear.
NCR currently has a market cap under $4B. Netflix has a market cap of nearly $12B. That certainly gives them something to shoot for if they cared to dive full on into the entertainment delivery industry. This may not be their company charter, but there is potentially a lot of money to be made, even if the company remains in second place. If they can accomplish those tasks above, I can see them garnering at least 20% of domestic market in 3 years.
Today, there are 22M subscribers to the DVD mail delivery business. With a conservative 20% growth rate over three years, that would equate to 20% of a 38M subscriber market, or 7.6M subscribers. That would be about 1/3 the size of Netflix or $4B; lower that number by a factor due to the lower growth rate assumption, and the BB Online portion of the business may be worth $3B in three years. You would also have to factor in better growth of their kiosk business and this would be a huge growth driver for NCR.
But what about Netflix?
No matter what happens upon resolution of the Blockbuster sale, Netflix stock WILL GO DOWN. Netflix has reaped GREAT benefits by having their only competitor in the DVD mail delivery business be on life support. Customers have flocked to Netflix because of the uncertainty of the Blockbuster business. No matter how many assurances Blockbuster gives in press releases, customers aren't comfortable giving their business to a company that may not be around in three years.
If Netflix actually buys Blockbuster (highly doubtful), their stock would immediately go into the tank for a number of reasons. They would be paying too much. They would have to deal with retail stores. They would have to deal with regulators. They would have to divert their attention away from streaming and towards integration. Netflix management is smart and they don't want to deal with any of this.
On the other hand, any acquirer, whether it be NCR, Coinstar, Amazon, or hedge funds, plans would immediately be put into place that would involve a LOT of marketing dollars, a LOT of clean up, and possible price wars over subscription prices and the cost of online content. Blockbuster has been in conservation mode for a long time as they have been feeding the retail business. This will not happen any more and they will 'sunset' the retail business, using any remaining funds to feed the mail/online delivery of entertainment.
I predict that in three years, Netflix will have 30M subscribers domestically, some amount of international business that will be lower margin (10M customers?), and a market cap that is somewhere in the neighborhood of $15B. Today's market cap is $12B based on a high growth rate. The $15B estimate is based on doubling the $12B since we doubled the subscriber count ($24B), reducing that figure by $3B due to the low margin nature of 1/4 of the business ($21B), and then reducing growth assumptions due to market saturation and competition.
If Netflix actually does buy Blockbuster Online, they'll suffer more in the short term due to the excessive price, but the elimination of a major competitor will produce way more than just a 25% return in three years as described in the scenario above. In this business, subscriber count and scales of economy (neither of which Blockbuster has) is king.
Disclosure: I am short NFLX. I own Netflix puts in 2012 and 2013. I own these LEAPS primarily due to the fact that I believe Netflix margins from their first mover advantage in the streaming space will erode, and current valuations don't discount the stock enough for this scenario.