Blockbuster Poised for a Turnaround

Jul.16.07 | About: Blockbuster Inc. (BBI)

I was originally planning on featuring two merger arbitrage opportunities and adding Blockbuster (BBI) to my watchlist, but then noticed an announcement about a change in management at Blockbuster last week. This catalyst, along with an experience during my recent vacation, lead me to make a last minute change and feature Blockbuster instead.

As most of you are aware, the rise of the DVD rental by mail model that Netflix (NASDAQ:NFLX) perfected has had a dramatic negative effect on the bottom line of both Blockbuster and Movie Gallery (MOVI), the parent of Hollywood Video, and Game Crazy. While Movie Gallery has headed into penny stock territory and is considering selling itself, Blockbuster has attempted to fight back by closing underperforming stores, and launching its own rival DVD rental by mail service called "Blockbuster By Mail."

Blockbuster also went one step further and launched a service called "Blockbuster Total Access," that allows subscribers to receive rentals by mail, and send them back by mail, or exchange it for a new rental at a neighborhood store. Despite having a Netflix membership, I would sometimes rent movies from a DVDPlay kiosk at Safeway (NYSE:SWY) because my Netflix movies were "in transit" when I wanted to watch something. I have been reluctant to switch from Netflix to Blockbuster even though the Blockbuster service is cheaper and the in-store rental exchange option is very appealing to me.

The primary reason for my reluctance to switch has been the breath of Netflix's DVD catalog. While talking to some friends who currently use the Blockbuster service, I was surprised to learn that they found most of the movies they wanted to watch through Blockbuster's online rental service. I decided to do a comparison to see if I could find the 64 movies in my Netflix queue on Blockbuster and was surprised to find that Blockbuster had all but 4 of those titles. The expansion of Blockbuster's catalog to 70,000 titles might explain why I was able to find an Indian movie released in 1974 as well as a British television series released in 1977. Netflix currently has 80,000 titles.

Given this improvement in Blockbuster's online service, the involvement of activist investor Carl Icahn (who was recently featured in a Fortune magazine story called The hottest investor in America) and the appointment of former 7-Eleven Chief Executive James Keyes as its chairman and CEO, Blockbuster is beginning to look like a story that might have a happy ending while providing all the thrills of a turnaround stock.

The parallels between Blockbuster, and another turnaround story Wild Oats (OATS) are striking. Both companies have activist investors (Ron Burkle in the case of OATS), both companies embarked upon a strategy of closing underperforming stores and both of them also have similar total debt/equity ratios. I used to consult for the natural food industry and seriously considered investing in Wild Oats at about $8 in early 2005 but missed the turnaround and the subsequent 100% appreciation in its stock price.

Revenues at Blockbuster have been slowly rising over the last four quarters but the company remains unprofitable and faces many risks. While Blockbuster now has a game plan to compete against Netflix using the Blockbuster Total Access service, Netflix has already moved on to offering free movie downloads to its subscribers. Netflix now has about 2,000 titles for online download and another competitor Vongo.com has a similar number of titles available for online downloads at a low price of just $9.99 per month. I personally prefer DVDs to online downloads, and I am sure a majority of current movie watchers have the same preference.

But movie downloads are the future, and Blockbuster has no choice but to move in that direction by acquiring a company like Vongo.com or building its own download service. If Blockbuster decides to build its own download service, this unprofitable company will have to spend even more money on its money losing online division. The company happens to have almost a billion dollars of debt on its balance sheet and capital to acquire other companies would be hard to come by.

However with the new CEO, I expect improved retail focus and I am encouraged by the subscriber growth at Blockbuster in the face of failed attempts by companies like Wal-Mart, and even Amazon to capture the online DVD rental market. Blockbuster happens to be selling for 16 cents per dollar of sales (a Price/Sales ratio of 0.16) and if there is even a hint of the company becoming profitable again, the stock, which has fallen from $26 in 2002 to the current $4.59, is likely to see significant gains.

Did I mention that turnaround situations are risky (just ask investors of Gateway (GTW) or Imax (NYSE:IMAX) who are still waiting for a turnaround) and the company may just as easily go bankrupt. Blockbuster may be best suited for investors who have an healthy appetite for contrarian bets and/or have a diversified portfolio that is anchored by core holdings like Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG).

Competitors:

Blockbuster faces stiff competition from a plethora of competitors including Movie Gallery (MOVI), Netflix (NFLX), online download services like Vongo.com, Cinemanow.com and Amazon.com's (NASDAQ:AMZN) Unbox as well as DVD kiosk companies like DVDPlay and Redbox. Redbox is a division of Coinstar (NASDAQ:CSTR), a company I wrote about in the blog post titled The Short Case on Coinstar.

The Numbers:

BBX numbers