Blockbuster Poised for a Turnaround

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 (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 (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 (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 (JNJ) and Procter & Gamble (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 (AMZN) Unbox as well as DVD kiosk companies like DVDPlay and Redbox. Redbox is a division of Coinstar (CSTR), a company I wrote about in the blog post titled The Short Case on Coinstar.

The Numbers:

Comments

[Davis Freeberg:]

This is a very well written overview on some of the issues facing Blockbuster, but I'm not sure that I see the logic for a "turnaround" here. A lot of what you mentioned in the piece, has been out there for sometime and I wonder what is different about right now, than six months ago?

I also don't know that it's fair to compare the company to Wild Oats. Wild Oats was forced to close underperforming stores, but Wild Oat's didn't face the obsolence of their business model. Blockbuster on the other hand, faces an industry that will see even more competition over the next 5 years, than they've faced from Netflix for the last 5.

2007 Jul 16 02:33 PM

[Asif Suria:]

Davis, there was a section in the newsletter that preceded this write-up of Blockbuster that discussed the effects of management change at a company in trouble. If you are interested, you can read the entire newsletter here,

www.sinletter.com/arch...

There are three factors that may result in a turnaround at Blockbuster. Activist investors, new management and an increasing number of subscibers from a product that may be more appealing than Netflix to some movie lovers (no throttling of active users as Netflix does). The catalyst at this point that did not exist six months ago is the former 7-Eleven Chief Executive James Keyes as the new CEO of Blockbuster.

2007 Jul 16 03:59 PM

[Davis Freeberg:]

Thanks for the link Asif - The argument makes a little more sense with the additional commentary and I would agree that Keyes has been important improvement over their current management, however, I would still question how much of an impact he will have on the company. It was one thing to turn 7-11 around, but their problems were very different than BBI. 7-11 got caught in a credit squeeze, BBI is seeing their core business die. How you react to both threats is very different. While it makes sense for BBI to hire a retail oriented CEO, given that the future appears to be digitization, I don't see Keyes being all that different than Antioco, in the skills that he brings.

As far as activist shareholders go, it's hard for me to understand why you think Icahn would be a catalyst. People talk a lot about Icahn's BBI holdings, but he's had his shares for two years already and still isn't profitable. While he was integral in getting rid of Antioco, I don't know that there is a lot more he can do, in order to turn Blockbuster around. While, I'm all for seeing investors come in and clean out bad management, Antioco was actually a pretty good retail CEO, he just didn't react to the changing video store environment fast enough. In the long run though, he's done more to help, than hurt BBI. His biggest downside was that he made too much money and while Icahn was able to put a stop to that, it wasn't without a pretty nice golden parachute that BBI has to pay. While the new management will bring in a breath of fresh air for investors, I still don't see what Keyes can do, in order to solve the problems that Antioco couldn't deal with.

As far as the online growth, I'm not sure that BBI investors should be getting excited about that. They've clearly priced the service aggressively and while it's been good for consumers, it's been terrible for BBI shareholders. As the service gets bigger, the losses will intensify. At some point something will have to give. It would be one thing, if the growth of TA was adding to the bottom line, when I see that BBI is asking for another break on the covenants, it makes me think that things get worse, before they improve.

A lot has been made about the success of the online program, but what has been the cost. Even at 3 million customers, it's chicken feed compared to the number of customers Blockbuster serves at their retail stores. While I don't have the numbers in front of me, I'm fairly certain that BBI has lost a lot more retail customers than they've gained online customers, since launching their own online program. BBI management has said that approximately 50% of their subscribers are coming from in-store channels. While seeing subscriber growth for their online program is important, if you are giving up higher profitable fixed margin customers to do it, than I'm not sure that I see the logic in the move. It's great to start to see some life out of them, but how many millions of retail customers did they lose, before they could get to the 3 million online subs?

Blockbuster has to do something to compete, but when I look at the future of the video store, I see it continuing to move online and towards digital. While BBI's fixed cost structure gives them great leverage when they are profitable, it also makes things hurt even more when they start to see lose money. Considering that online rentals and downloads are likely to be a variable cost business, I question what happens to that leverage, as they move away from their retail business.

It may be that BBI is a screaming buy and could even go high as one times sales, but until the company can figure out a solution to their struggles, that actually makes them money, I can't help, but be a little pessimistic about a turnaround happening.

2007 Jul 16 04:50 PM

[Asif Suria:]

Thanks for engaging in an healthy discussion Davis.

I encourage you to be as pessimistic as possible and by no means is Blockbuster a screaming buy because of all the challenges it faces. I have stated this clearly in the article.

However I feel that a lot of that pessimism is already priced into the stock. Assuming that the company will only lose more money as the number of subscribers grow would be ignoring a few facts. The fact that all users are not likely to be heavy users and could actually help the bottom line. The fact that an internet model is best suited for economies of scale and the fact that regular "fixed margin" customers who are being converted to their online service may actually bring in more revenue over a period of time.

2007 Jul 16 08:39 PM