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Blockbuster, Inc. (BBI)

Q1 2007 Earnings Call

May 2, 2007 10:00 am ET

Executives

Angelika Torres - Director of IR

Larry Zine - CFO

John Antioco - CEO

Analysts

Tony Wible - Citigroup

Carla Casella – JP Morgan

Barton Crockett – JP Morgan

Arvind Bhatia - Sterne Agee

Presentation

Operator

Good morning and welcome to the Blockbuster, Inc. first quarter 2007 earnings release conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Ms. Angelika Torres, Blockbuster's Director of Investor Relations. Ms.Torres, you may begin.

Angelika Torres

Good morning and welcome to Blockbuster's first quarter earnings call. Today's call may include forward-looking statements relating to our plans, objectives, and initiatives, such as: Blockbuster Total Access, our goals for online subscriber growth and profitability, and our expectations with respect to investments in our business, our expectations with respect to anticipated revenue, customer, and market share growth; our outlook for the industry and our performance relative to the industry; our expectations regarding our cost structure and other financial items; industry consolidation, divestitures, and store closures; anticipated liquidity and financial flexibility and other matters that do not strictly relate to historical or current facts. Actual results may differ materially from those projected in 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 and in our Public Securities and Exchange Commission filings, including our upcoming Form 10-Q.

Today's earnings call may also include discussion of certain non-GAAP financial measures. Please refer to today's earnings release for the required reconciliation to the most directly comparable GAAP financial measures and other related disclosures. Our earnings release is available on our website at Blockbuster.com under the link for Investor Relations.

With that I will now turn the call over to Larry Zine, our Chief Financial Officer.

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Larry Zine

Thank you, Angelika and good morning, everyone. Our results for the quarter reflect investment in our business and demonstrate ongoing and significant progress toward our often-repeated objective of aggressive Total Access subscriber growth and divestiture and monetization of our non-core assets. We believe that growing our Total Access subscriber base will allow us to increase our combined in-store and online market share. As such, we have said that we will work to grow that part of our business as quickly as possible within the parameters of our economic model.

I will first walk you through our results, and John will then talk about our strategic outlook and address the trends we are seeing in the business.

Starting with revenues, our total revenues for the quarter increased 5.4% to $1.47 billion, reflecting about a $65 million increase in merchandise sales led by strong sales of games in some of our international markets, and approximately $20 million in revenues associated with the termination of Blockbuster's Brazilian franchise agreement. Our rental revenues for the period remained essentially flat at $1.05 billion reflecting growth in revenues from Blockbuster Total Access which offset a larger than expected decline in the in-store rental industry and a smaller company-operated store base.

Worldwide same-store rental revenues increased 1.3%, reflecting a 3.2% increase in domestic same-store rental revenues, offset by a 5% decline in international same-store rental revenues. Growth in domestic same-store rental revenues was led once again by 4.3% increase in our domestic movie rental comp, reflecting the significant and growing contribution from Total Access.

As we reported this morning, we met our aggressive online subscriber growth objective for the quarter and have added approximately 800,000 Blockbuster Total Access subscribers; our highest subscriber growth quarter thus far bringing the total subscriber count to about 3 million subscribers and the paying subscriber count to approximately 2.8 million.

Our domestic same-store game rental revenues declined 6.9% which had a negative impact of a little over 100 basis points on our domestic same-store rental revenues. Worldwide same-store retail revenues increased 14.3% during the quarter, reflecting a 31.7% increase in international retail comps. Demand for next-generation game platforms and new and traded games in many of our international markets in Europe and South America continued to drive strong retail sales for the second consecutive quarter.

Gross profit for the quarter was down about $28 million, reflecting a 5.4 percentage point decline in rental margin from the same period last year. We have previously said that we expected rental margin to decline this year mainly as a result of the additional investment in rental product in order to support in-store exchanges resulting from additional traffic generated by the significant growth of Total Access.

Additionally, the in-store rental industry remained under pressure during the quarter, resulting in a higher than expected decline in our in-store rental revenues and putting further pressure on our rental gross margin. Our G&A expenses were down $13 million as compared to the prior year. Advertising costs increased by approximately $37.4 million as compared to the same quarter of 2006, largely due to the incremental $35 million we spent on our Total Access media campaign.

The operating loss for the first quarter totaled $18.4 million as compared to operating income of $32.1 million during the first quarter of 2006. The net loss for the quarter was $46.4 million, or $0.26 per common share, as compared with a net loss of $1.9 million, or $0.03 per common share for the same period during 2006, primarily reflecting the changes discussed earlier.

Moving on to our balance sheet, in keeping with our ongoing efforts to reduce debt, we have made payments of approximately $60 million on the term portions of our credit facilities during the first quarter of 2007, primarily due to excess cash flow generated during 2006.

We recently completed an amendment to our credit agreement providing for additional divestitures and this morning announced the sale of Game Station, our freestanding game store chain in the U.K. to the game group PLC. A large portion of the proceeds which totaled approximately $150 million in cash subject to working capital adjustments will be used to reduce our debt level and further strengthen our balance sheet.

Just to put it all in perspective, if you add the improved cash flow from the business, proceeds from the sale of Game Station, and proceeds from our November 2005 convertible preferred offering, we will have effectively reduced our debt levels by approximately $500 million since November 2005, while simultaneously making significant investments in our online rental business. I believe we are well positioned now to obtain greater operating flexibility and intend to take advantage of our improved balance sheet and leverage by putting in place a new credit facility that is expected to launch sometime this quarter.

Before concluding my remarks about our first quarter performance, I would like to comment on cash flow. During the quarter, it was negative $144 million, down from a positive $41 million in 2006. Several factors contributed to the decline in cash from operating activities, including increased product purchases and a reduction in accounts payable and accrued expenses.

As I told you on our 1Q06 call, we did not have a build in inventory and accounts payable at year end 2005, causing the Q1 2006 comparison to be higher than usual. This is now skewing the year-over-year results this quarter, as we have returned to our normalized working capital cycle.

In summary, we believe we are taking the right steps to better position the company for long-term success, and we are absolutely convinced that it's the opportune time to aggressively invest in and grow our online rental business and preserve the momentum created by the introduction of our Total Access program. Now I will turn the call over to John.

John Antioco

Thanks, Larry. The company's first quarter performance was in keeping with our plan to aggressively grow our Total Access subscriber base. Clearly our results were impacted by our investment in the growth of this offering and by an extremely tough in-store rental market which we estimate was down 10% industry wide for the first three months of the year. However, I'm extremely pleased with our accomplishments in the first quarter.

In keeping with our previously stated objectives, we captured share of the overall rental market, continued to contain operating expenses and we believe significantly outperformed our competition, both in store and online. In fact, during the first quarter, we captured more than 60% of the subscriber growth in the online space and since the end of the year, grew our subscriber base by 35%.

Our year-over-year comparison, our online revenues increased 116%, and we picked up 10 percentage points in market share going from approximately 20% of the online market to 30%. During the first quarter, we also improved our total unaided awareness of Blockbuster Online from 40% to almost 60%, exactly what we set out to do. In the five months since launching Total Access, we nearly doubled our online base to 3 million subscribers. We now have the fastest growing online rental service in the marketplace and intend to keep it that way.

Additionally, as a result of the huge consumer appeal of our integrated in-store/online offering, we added more net subs during the first three months of the year than anyone in the online movie space has ever been able to add in a single quarter. To achieve these results, we invested approximately $70 million in the first quarter, which includes the additional store product to support the traffic generated by Total Access and also an incremental introductory $35 million in advertising we told you we would be spending to jump-start the year. We intend to continue investing in Total Access in 2007, spending another approximately $100 million on the offering over the remaining three-quarters of the year.

As a result of this investment, by the end of the year we plan to:

Double our year-over-year subscriber base to well in excess of 4 million subs.

To grow our total domestic revenues and customers for the first time in several years and continue to grow our share of the overall video rental market.

Additionally, based on our online competitors downward revision of their subscriber expectations, we now believe we may capture all of the total net growth in the online market during the second quarter and close to 70% for the year, up from the 20% we were capturing the first three-quarters of last year before the launch of Total Access.

Our outlook for the year is based on what we're seeing in our business thanks to Total Access. First, we are retaining and reattracting customers both online and in-store, who prior to Total Access would have left us for a competitor.

On the store side, despite the store-based industry's first quarter decline, our customer visits and new membership sign-ups were both at the highest levels we've experienced in two years. Research we completed just last month showed that customers who split their business between us and Hollywood Video had substantially increased their share of business with us. Again we believe due in large part to Blockbuster Total Access.

In support of this point are Hollywood Video's rental comps which for the full year and the fourth quarter of 2006, their most recently reported results, were almost 6 and 7 percentage points respectively below our domestic store-based rental comps for the same period. Just to be clear, that comparison excludes our online rental revenues. So it's apples to apples.

We're also attracting customers from outside the video rental category, customers who have been getting their movies from other sources, like satellite or cable pay per view services. Simply put, consumers are discovering or rediscovering Blockbuster in increasing numbers because of the flexibility, the convenience, and the value Total Access offers. As a result, we believe we will continue to pick up share in the overall rental market by attracting business from both our traditional and non-traditional competitors.

We also believe it will be very difficult for our major online competition to impact our growth since we don't think they have an answer to what we believe is a superior integrated service. Our competition has said they will simply wait us out until we change our proposition. They may have a long wait. We have no intention of making any changes to our Blockbuster Total Access proposition any time soon, unless we feel these changes will fuel our growth even faster or improve our cost efficiencies and service metrics.

Changes like a la carte rentals for our store customers, additional enhancements to our web experience, and the introduction of an online-only rental option for customers who may not want to or can't take advantage of our in-store exchanges. We believe that with the online rental business in strong growth mode projected to increase 43% this year by Adams Media Research, and with the store-based industry continuing to struggle and as a result, poised for consolidation, this is time for investment.

If we decided to slow the growth of our subscriber base, our online service could be profitable now. But we believe the subscribers we acquire today are setting the stage for future profitability. We are already managing our online business to improve profitability by reducing churn, increasing the duration of our subscribers, managing product costs and mix, and increasing our scale.

We believe the present value of Total Access subscribers is worth significantly more than we are spending to acquire them. The market is currently valuing the online subscribers of our competition at around $200 per sub. If our subscribers are valued in the same way, we will have created shareholder value well in excess of the investment we are making this year.

Plus, as a result of Total Access and our growing number of subs, we will have increasing opportunities to sell additional products and services online. We're currently in the early stages of selling previously-viewed movies through Blockbuster.com, and we will be stepping up our retailing efforts behind both used and new movies later this year. In the future, we believe we can further monetize our website traffic through the sales of online advertising and the sales of other entertainment products like VOD.

Additionally, we are continuing to work at monetizing the increased traffic Total Access is driving to our stores. Our Total Access customers are spending incremental dollars with us in-store in addition to their monthly subscription fees. We are focused on increasing that spend further through specially created promotional offerings and by training our employees to take advantage of additional sales opportunities. We are also focused on offering a superior in-store rental experience through better in-stock availability and faster, better customer service.

Our online offering has increased the value and consumer relevance of our stores. The reason our online service is the fastest growing one in the marketplace is because of our stores. We have also shown that our stores are valuable sales and fulfillment stations, which we can put to use in the future to sell other entertainment products and services.

We also are investing in Total Access because we believe it's our gateway to digital delivery. We want to establish an online relationship with customers today through online movie rentals and sales, so that when it comes to renting and selling downloadable movies, Blockbuster is the first brand they turn to. We continue to move closer to the day when Blockbuster is a triple play. Movies through the stores, movies through the mail, and movies through a download; the only brand offering all three ways to access movies.

For all of these reasons, we continue to love our Total Access offering and plan to aggressively leverage it to drive as much share of the total rental market as possible while positioning ourselves for digital delivery. Looking beyond this year, we clearly believe we will be able to operate on line profitably and still have growth in subs.

As you know, I plan to depart Blockbuster by year end. Based on the years I have invested in the Blockbuster brand, the relationships I have formed here, the responsibility I feel to our employees, our franchisees, and our shareholders -- not to mention my equity position -- I have a strong and vested interest in leaving the company in great shape to grow and compete in the future. To this end, we are strengthening our balance sheet and since November of 2005 will have paid down approximately $500 million of debt, including the proceeds from the sale of Game Station. As Larry has already said, we plan to put a new credit facility in place during the second quarter.

We are implementing a plan, a plan our entire Board fully supports, that will ensure strategy continuity and that we believe will enable us to end 2007 with more than 50% and perhaps as much as 70% of the total 2007 online subscriber growth; growth in our total domestic revenue and customers for the first time in several years and continued growth in our share of the overall rental market.

We are investing upwards of $170 million in Total Access this year. We are adding new customers to online and to our stores and finding new ways to get incremental revenue from these customers. We clearly believe we can operate our online business profitably next year and still achieve very respectable subscriber growth.

As for the in store business, we continue to believe it is poised for store closings and inevitable consolidation and that Blockbuster, both as a result of the trends we are seeing in the industry and because of our superior integrated offering and no late fees program, can be the beneficiaries of this consolidation. To be prepared to take advantage of this opportunity we are reducing store expenses and continuing to look for downsizing opportunities, as well as continuing to close any of our overlapping stores. We want Blockbuster to walk into 2008 firmly positioned for growth in revenues and profitability.

Now we'll open for questions.

Question-and-Answer Session

Operator

Your first question comes from the line of Tony Wible - Citigroup.

Tony Wible - Citigroup

I was hoping you could share with us a little bit color about the mix shift for where the Total Access subs are coming. Last quarter I think you indicated a certain ratio that were coming within the store walls versus outside. Can you comment on what that was in the quarter and how it was trending in particular towards the end of the quarter?

John Antioco

Clearly the mix is shifting. Obviously we began our external media essentially at the beginning of the year, and at this point, the mix of call it in-store sign-ups and sign-ups we get from other sources is somewhere around 50/50.

Tony Wible - Citigroup

There was no change in that over the course of the quarter one way or the other?

John Antioco

Not really. It fluctuates a little bit from week to week but stays relatively consistent.

Tony Wible - Citigroup

When you indicated that you didn't foresee any changes in the online program other than potentially an online-only option, could you provide a little more color? Are we talking about the online being a discount to where we're currently pricing Total Access? Is that what we should read into in it?

John Antioco

I don't think you should read anything into it at this point, Tony, other than we believe that option ought to be available to customers. Obviously we would try to do it in a way that would create some competitive differentiation. We think we have other ways to do that beyond price. So stay tuned for further details.

Tony Wible - Citigroup

With the merchandise same-store sales, the domestic front being down this quarter, and you indicated you're seeing a nice cross-sell, does that mean that we're seeing more a la carte rentals on Total Access customers to make up for that cross sell, or are we seeing more restocking fees? Where are you seeing the incremental dollars?

John Antioco

Primarily in the purchase of movies, new and used, and some a la carte rentals, yes.

Larry Zine

Tony, just keep in mind when we are selling the previously viewed movies, they are coming through the rental line.

Tony Wible - Citigroup

Any thoughts on the VOD same-day release at DVD? I guess some of the cable MSOs talked about it a lot the last couple of days. Anything you're seeing incrementally one way or the other?

John Antioco

Yes. We are seeing a small impact from the test. I think ultimately Tony what will be the deciding issue of that is what impact is it having on primarily retail and secondarily rental which we continue to believe will be a decision that will produce diminishing returns for the studios if they decide to implement the day in day pay per view.

Operator

Your next question comes from the line of Carla Casella - JP Morgan.

Carla Casella - JP Morgan

The $20 million Brazilian revenue, is that included in other or merchandise sales?

Larry Zine

It's in other.

Carla Casella - JP Morgan

If we look at gross margin, you talked in the press release about the pressure of being associated with buying additional product to supply the in-store exchanges. Does that mean that it would be unusually weak gross profit this quarter and you'll regain some of that in the back for the next three quarters or should we expect this kind of gross margin to hold through the rest of the year?

Larry Zine

I think in keeping with John's comments about investing $100 million through the rest of the year you're going to see most of the impact of that in margin. The activity of the Total Access subscriber is very good in store. There's significant exchanges in store. As a result that has an overall margin effect. So that's primarily where you see it, and it will continue as we're continuing this rapid growth in Total Access.

Carla Casella - JP Morgan

So that $100 million was not the advertising spend?

Larry Zine

No.

Carla Casella - JP Morgan

Then what were rental library purchases?

Larry Zine

You mean what's the dollar amount?

Carla Casella - JP Morgan

Yes. You mentioned they were up. I'm just curious the magnitude of it.

Larry Zine

It wasn't necessarily that material. It was more just fluctuations and a mix between rev share and actual purchases.

Carla Casella - JP Morgan

You mentioned you're going to come to the bank market in second quarter. Do you know off the top of your head the amount of bank that you are permitted to take on under your bond indenture? I know the basket has probably been reduced by all of your asset sales and pay downs. Do you have the total amount you could do?

Larry Zine

Basically that had a covenant that restricted borrowings but far in excess of where we are today. It basically was an incurrence-based test that was based on EBITDA, which is, given where our trailing EBITDA is and given the significant debt reductions we have quite a bit of room to incur significant indebtedness if we chose to do. Obviously, we've been going down a quite different path with the significant pay downs we've had over the last 15 months or so.

Carla Casella - JP Morgan

So we should assume more refinancing of a similar amount, or slightly different, or any major changes?

Larry Zine

Well, we haven't gone to market yet, so I would just say that we would expect that we would have significantly more flexibility inside a facility, and we're currently not looking to increase the size of any facility. We're looking for what we believed is a well-earned reduction in rate and significant change in the overall makeup of the credit agreement that reflects the type of credit we are today versus the struggles we had in 2005. So a very different company, very different capital structure, very different leverage picture and we think it's time for the rewards of that.

Carla Casella - JP Morgan

The U.S. merchandise sales were down considerably. Is that an exit of any certain businesses? I think I missed what that was related to.

Larry Zine

I think it relates more to our deemphasizing retail sales in the domestic stores of movie product. We've been continually on that path for the last year-and-a-half or so as we've reduced inventories fairly dramatically.

Carla Casella - JP Morgan

So that should continue?

Larry Zine

Well, it should pretty well level out at this point. We're just talking about the domestic business. As a matter of looking forward, obviously with the sale of the Game Station business you will not see the same kind of revenue increases on retail sales that 217 stores were generating, but we think that the proceeds of the deal and the partnership that we created with Game was the right thing to do for us as we focus on our core business and the growth in Total Access.

Operator

Your next question comes from the line of Barton Crockett – JP Morgan.

Barton Crockett - JP Morgan

I wanted to ask a question about the asset sale there, Game Station. Can you give us some sense of the EBITDA and revenue give-up that will be associated with selling that asset, and then also update us on the extent to which there are other things that you're still looking to sell, like Extravision and if there's anything else meaningful that we should think about to be sold, particularly internationally?

You talked about the $70 million spend here in the quarter for the in-store product that you stocked for Total Access, and in the last quarter you talked about a $2 per sub per month net impact net and a number of things including that and other items. I was wondering if could you just walk us through the reconciliation of those two. How do we get from the $70 million to the $2, and so we can just try and understand it a little better? Thank you.

John Antioco

Well, let's start with the asset sale. We haven't been in the business of disclosing profitability of subs like that. That was basically a contributor of less than 5% of our EBITDA. I think if you actually read The Game Group PLC press release you'd come to a multiple of slightly better than ten times that we sold the business for. If you look at that business overall, it's obviously an important business. It's a growth business, but it requires significant investment. The investment that we would have made in that business to continue to grow it would have probably exceeded its earnings this year.

So we made a strategic decision, as we've been saying all along to focus on the core North American business, and as a result we felt that the right time to take advantage of what we thought was a superior multiple of its trading earnings and monetize that asset.

As far as further asset sales, as we've said all along, we're going to continue to look at other markets where opportunities may present themselves. We're not looking to do any kind of fire sale. We're looking to maximize either proceeds or profitability in every market that we operate in, and we think we still have some great assets as is Extravision that you mentioned.

In terms of the reconciliation of the $70 million and the $2; first of all, subtract the $35 million in incremental advertising, because that was basically launch costs. What we said is, over the course of the year, we expect to have an average impact per subscriber of about $2. It's obviously a little higher in the first quarter as we're ramping up the program, and we're working on ways of monetizing that consumer spending within the store, and so the cost of that will be less later in the year, but given the growth and the way we see the growth continuing in the online business, we expect, on average throughout the year, that it will amount to about $2 per sub to satisfy the exchanges in the store offset by incremental revenue that we will receive from that subscriber.

So I hope that gives that a little more clarity. Just in simple terms, it will cost a little bit more at that time beginning of the year per sub than it will at the end of the year as we further refine our offer to the subscriber.

Barton Crockett - JP Morgan

To be clear, is that $2 cost net of improvement in churn as well?

John Antioco

Yes. Again, over the course of the year, that's what we expect that we would have.

Barton Crockett - JP Morgan

In terms of the 10X multiple, any sense of the revenue that you're giving up with the Game Station sale?

Angelika Torres

We haven't disclosed that.

John Antioco

I think based on your knowledge of the games industry, I think you can come up with a proxy.

Operator

Your next question comes from Arvind Bhatia - Sterne Agee.

Arvind Bhatia - Sterne Agee

John, you talked about special order rentals in the last quarter, you talked about how those things could help reduce your in-store catalog and ultimately perhaps the footprint could be reduced to about 3,000 square feet. Wondering where you are with that?

Then also we notice that there's a promotion at the store, I guess a snack deal which you are promoting to the Total Access subscribers. Wonder what the acceptance rate of that has been, because that certainly could be one way you could enhance the value of the proposition.

Larry, what do you expect the free cash flow to be for the year, and also the debt level at the end of the year also?

John Antioco

Arvind, on the downsizing question, we are testing a couple of prototypes right now to determine what's the right size, configuration, and mix of catalog and new releases. Obviously we haven't started the a la carte rentals yet, so it's a little bit of modeling and prototyping. We have analyzed all of our stores in the Blockbuster system and have identified some significant number of potential down sized stores that will work through over the next couple of years to determine which ones we can efficiently downsize, make economic sense to do that, or we want to relocate to a smaller footprint in the immediate area, and all of those options are available to us. We think we'll get 200 or so downsizes done in 2007. Obviously as we get more proficient at it, that number will increase going forward. We are in negotiations for many more.

As far as the candy promotion, it's been in effect two weeks. We like the early signs that we're seeing, but too early to call, but a minor example of some of the stuff we're going to be continually doing to monetize the additional customer traffic that we're generating through Total Access.

Larry Zine

Arvind, as you know we don't give guidance, so I won't comment on the debt level or free cash flow for the year.

Arvind Bhatia - Sterne Agee

If I could ask another question, as far as the box office is concerned and the DVD schedule for the second quarter, can you give us some feel for that, the way you're looking at it?

Larry Zine

Well, I would say the second quarter will continue to be tough, and the third quarter, from a product standpoint, is looking much better.

Operator

This concludes the Q&A portion of today's conference call. Ms. Torres, are there any closing remarks?

Angelika Torres

We'd like to thank everybody for participating. Give us a call if you have any follow-up questions. Thank you.

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