Blockbuster Finally Gets It Right

But its IPO raises a question: Why unload a turnaround?

Will Viacom Chairman Sumner M. Redstone finally--to borrow Blockbuster Video's latest catchy slogan--Go Home Happy? For most of the 4 1/2 years since Viacom Inc. bought Blockbuster Inc. for $8.4 billion, the giant video-rental chain has been a drag on everything from Viacom's earnings to Redstone's standing as a media grandee. Now, Blockbuster's financial performance is suddenly living up to its name. "A year ago, that chain was a C-minus operation," says Robert C. Alexander of New York-based entertainment-industry consultant Alexander & Associates Inc. "Now, it's really quite a powerhouse."

A powerhouse for sale, that is. Within the next few weeks, Viacom is expected to file for an initial public offering of as much as 20% of Blockbuster, which would value the company at close to $6 billion, analysts say. That will likely be followed by a spin-off of the rest of the company later this year, when it will be legal for Viacom to do so tax-free. But despite its improved performance, selling Blockbuster to investors may not be as easy as renting the latest Leonardo DiCaprio flick to teenage girls.

After all, if Blockbuster is such a roaring success, why unload it? Will shareholders buy the argument, made by Viacom execs, that the company's value as a retailer will never be realized within a content business like Viacom? And in an era when billions have been spent on systems to deliver video signals directly to the home via cable, satellite, and, ultimately, the Internet, how long will consumers be willing to lug little plastic boxes to and from video stores? "The clouds on the horizon are two to three years from affecting cash flow," says Larry Haverty, senior vice-president of Viacom shareholder State Street Research. "So, you get rid of this thing before then."

COST CUTS. Certainly Blockbuster is in a better position to face skeptics now than it has been in years. After a series of CEOs and failed strategies, current boss John F. Antioco appears to have gotten it right. After taking charge in July, 1997, the former Taco Bell chief dramatically lowered costs and increased volume at Blockbuster's 6,000 outlets.

Traditionally, Blockbuster bought new video releases for $65 to $80 apiece and hoped it would rent them out enough times to make a profit. Now, it pays only between $3 and $8 per tape but gives an average of 40% from every rental back to the major film studios under revenue-sharing deals, say industry sources. This has allowed Blockbuster not only to stock far more copies of new releases but also to guarantee to customers that the tape they want will be in stock--or it's free.

As a result, analyst Frederick W. Moran of ING Baring Furman Selz expected cash flow for 1998 to increase 18%, to $607 million--even though Alexander & Associates says consumers rented 2.6% fewer videos nationwide in 1998 than the previous year. SG Cowen Securities Corp. analyst Edward T. Hatch expects Blockbuster's same-store sales to be up 14% for 1998, compared with a 2% drop in 1997. "The revenue-sharing agreements have completely revitalized this company," says Hatch.

STOCK HOP. As far as shareholders are concerned, it's about time. Selling Blockbuster represents the last in a slew of debt-slashing sell-offs by Viacom (table). Aside from the Blockbuster turnaround, Viacom's improving results have been led by its Paramount TV and film studios and hot cable-TV networks MTV and Nickelodeon. After languishing for years, Viacom stock is up more than 90% in the past year, to 85 5/8 on Feb. 22.

Blockbuster may also be hoping to catch investor enthusiasm from its closest competitor, Hollywood Entertainment Corp., based in Wilsonville, Ore. Hollywood, which has about 8% of the $11 billion U.S. market, vs. Blockbuster's 30%, has seen its stock jump more than 200% in the past year on the strength of its revenue-sharing moves. Unlike Blockbuster, though, Hollywood also is making a strong Web push; both chains sell videos over the Net, but Hollywood recently paid $90 million for Inc., a site that operates a film-related search engine. Hollywood CEO Mark J. Wattles hopes Reel will eventually serve as a platform for sending videos digitally over the Web.

Viacom execs, who declined to be interviewed for this article, have shrugged at the potential impact of such video-on-demand services, and point out that some 13 million VCRs are still sold each year. Although some analysts expect pay-per-view to crimp Blockbuster's growth in the next two to three years, others argue there is still plenty of share for Blockbuster to grab. In the meantime, Blockbuster must also contend with the charges of smaller chains and independents that its revenue-sharing strategy gives it an unfair pricing advantage.

Such criticism will likely not get in the way of the upbeat story Redstone & Co. aim to sell the Street in the weeks ahead. And among Viacom investors, Blockbuster is already discussed in the past tense. Says Mario J. Gabelli, chairman of Gabelli Funds Inc., which owns about 9.4% of Viacom: "What we need to figure out now is where Sumner takes the company strategically over the next three years." You can bet that no matter how good its results, it won't be the video-rental business.

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