E Video Stores: Cut!

Hollywood Entertainment's stock flops after its Net foray

He was the toast of Portland, Ore. Starting with a single downtown store in 1988, Mark Wattles built Hollywood Entertainment Corp. into a video-rental powerhouse second only to industry leader Blockbuster Inc. With employees decked out in usher-style vests and bow ties, his Hollywood Video stores popped up on more than 1,000 street corners within a decade. By 1998, the chain's stock had grown fourfold, to 27, giving Hollywood a market value of $1.2 billion. With a 25.2% stake, Wattles, then 38, was worth $312 million. That same year, he discovered the Internet. It has been downhill ever since.

Hollywood is now struggling to right itself from its $160 million plunge into the Net. Since Wattles paid $96.9 million for video and DVD retailing site Reel.com in July 1998, shares in Hollywood have fallen below the $7.50 level of its 1993 initial public offering, even as the primary business of renting videos at its 1,710 stores has grown impressively.

The slide prompted Hollywood on Apr. 19 to hire investment bankers Donaldson, Lufkin & Jenrette Inc. to "explore strategic opportunities" in an attempt to heal its sickly stock price. "Would I do it all over again?" asks Wattles. "It would be tough to do the deal all over again, only because the pain has been so great."

Hollywood's problems come despite Reel.com's standing as a major player in the emerging online market for video and DVD sales. But huge marketing expenses and price discounting helped Reel.com rack up a $98.5 million loss last year. That's nearly five times what it lost the year before, even as revenues nearly tripled, to $42 million. As a result of the losses at Reel.com, Hollywood lost $51.3 million on sales of $1.1 billion. Reel.com has since raised its DVD prices, but still faces hefty marketing costs to compete with Blockbuster's new site, which recently signed a marketing deal with America Online.

Although DLJ could yet find a buyer with an offer Wattles couldn't refuse, the chairman says his company isn't for sale. Instead, he would prefer to take Reel.com off Hollywood's balance sheet by lining up outside partners to make the Internet business an "unrestricted" unit not dependent on the parent for funding. DLJ is currently lining up candidates, which may include a technology partner that can help Reel.com develop its downloading capability. Wattles says grocery-store billionaire Ronald W. Burkle's Los Angeles investment fund, Yucaipa Cos., has already agreed to inject $20 million for a 10% stake. Wattles expects to attract at least one other outsider, but figures Hollywood will maintain about an 80% share.

Meanwhile, Wattles still must shore up Hollywood's sagging reputation on Wall Street. To do it, he's curtailing expansion plans, opening only 200 to 250 new stores this year, vs. 355 in 1999. And he's downsizing the stores to 5,000 square feet from 7,500 square feet, which should help trim store-opening costs by about $100,000, to just under $400,000. By spending less on opening new stores, says Wattles, the company will buy down some of the debt it amassed during more than a decade of expansion.

The moves have started to win favor among some on Wall Street. "This is a company that still has a strong core business, but it is being penalized by one acquisition," says Jennifer Jordan, an analyst with Portland (Ore.)-based Black & Co. That's another sale for the one-time whiz kid, who still needs to make several more.

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