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Why It's Hardly Boffo at Blockbuster

DVDs are the problem. As buying them gets cheaper and cheaper, where will that leave the movie-rental giant?

Why It's Hardly Boffo at Blockbuster

DVDs are the problem. As buying them gets cheaper and cheaper, where will that leave the movie-rental giant?

By Amy Tsao

Since buying his first DVD player two years ago, computer programmer Dan McCarthy of Sewall, N.J., says he has bought 30 to 35 DVDs. Next, he plans to gradually replace his existing collection of movies in VHS format with digital versions. Because renting movies often ends up costing him $15 -- including the rental fee and late charges -- he figures that buying DVDs for a few bucks more makes sense. "If the movie stinks, so be it," he shrugs. He hasn't rented a movie in more than a year, but expects to buy one to two DVDs a month in 2003.

McCarthy and others like him are Blockbuster's (BBI ) worst nightmare. Since it warned on Dec. 18 that its fourth-quarter revenues would be lower than expected because of weakening rental income, the stock of the world's top video-rental chain has fallen 36%, to around $12.34 as of Dec. 27. Sales for the period will be up less than 10%, and its gross-profits gain will be in the low-single digits, Blockbuster said. As a result, 2002 earnings per share could come in as much as 21% below the $1.31 it had earlier forecast -- between $1.03 and $1.10, vs. the $1.01 Blockbuster earned in 2001.

FLAT RATE.

  In its pre-Christmas announcement, the Dallas company, which is a majority-owned, publicly traded subsidiary of media giant Viacom (VIA ), blamed the shortfall on DVD discounting by mass merchandisers, plus this year's quicker interval between Thanksgiving and Christmas, which presumably left customers less time to watch movies.

Seasonal factors notwithstanding, the big worry at Blockbuster is that a change could be occurring in consumers' video-viewing habits. A growing number of them seem to be looking at the falling prices of DVD movies -- which often cost less than $20 -- and asking themselves, "Why rent?" Thus, DVDs may increasingly hurt the rental market.

At $10.3 billion, DVD and VHS rentals were about flat in 2002, according to entertainment industry research and consulting firm Adams Media Research. DVD sales, meanwhile, rose about 50%, to around $8 billion, and Adams expects them to increase a further 30%, to $10.4 billion, in 2003. Rental sales should inch up much more modestly, to $10.6 billion.

A HARD LOOK.

  That explains the cloud over Blockbuster's short-term prospects. "We'll be in a better position to evaluate this when more normal conditions return during the first quarter of next year," said John Antioco, Blockbuster's chairman and CEO, on Dec. 18. However, the first quarter could also be difficult, since people who received DVDs as gifts will have plenty to watch, says Alan Weichselbaum, an analyst with Fulcrum Global Partners in New York.

"The stock won't move until [Blockbuster] has one or two quarters of decent earnings and shows that deterioration in its business has stopped," he adds. Weichselbaum, whose firm does no investment banking with Blockbuster, rates the stock neutral and says it could fall further.

Indeed, the profit warning has many analysts taking a hard look at the business model. What if Blockbuster, which reported $5.2 billion in 2001 revenue and owns 8,200 corporate and franchise stores worldwide, is wrong in assuming that the low prices offered by Wal-Mart (WMT ) and Best Buy (BBY ) during the holidays won't persist -- or even fall further.

PERMANENT ROTATION.

  "With the precipitous drop in their rental business in an allegedly short period of time, we will be cautious and defensive" says analyst Jeffrey Logsdon of Gerard Klauer Mattison in Boston. He recently lowered his rating on the stock to underperform from market perform. "Even a 5% to 10% change in renting patterns is a big deal," says Logsdon, whose firm has no investment-banking ties with Blockbuster.

It isn't as if Blockbuster didn't see the changes coming. In November, it announced plans to devote more store space to selling DVDs. However, the margins on movies it sells are a fraction of those on rentals, Weichselbaum notes. Assume, for instance, that Blockbuster pays $15 for a DVD. Renting it 10 times yields a profit of $35 to $40, whereas selling a new DVD, for say, $18, yields a gross profit of only $3.

DVD sales are outpacing rentals for several reasons. Every parent who owns Baby Mozart, a learning title based on classical music, knows that a child will watch the video ad nauseam. In the case of older, classic titles such as Star Wars or Ben Hur, analysts say, many viewers plan to watch them multiple times, which makes buying worthwhile.

REVENGE OF THE STUDIOS.

  There's also convenience to consider. "On a rainy night, you can go to your own library," says Weichselbaum. Though DVDs may be usurped by another home-video technology -- perhaps by video on demand -- they're now the highest-quality product on the market because of their sharper picture and the additional material they contain, such as commentary by directors.

A change in the way Blockbuster and movie studios share revenues is also contributing to the DVD boom. Blockbuster sends a percentage of its VHS rental income to the studios. But thanks to a different deal it insisted on for DVDs, Blockbuster buys the disks outright from studios and keeps all the rental income.

Studios have responded by selling DVD versions of films at the same time that they make them available for rent -- and pricing them more aggressively than they did when it was in their best interest to get consumers to rent, not buy. Stir into the mix a few huge retailers that are willing to use the disks as loss leaders for products such as DVD players, and suddenly the average movie buff sees a reason to switch, says Weichselbaum.

"MASSIVE RESTRUCTURING"?

  At the moment, no end is in sight to the fierce competition in the DVD marketplace, which may continue to drive down prices. For instance, Walmart.com, the discounting giant's online division, says it's willing to sell top movie releases at a loss to attract customers who might buy something else.

That raises the question: What will happen to the movie-rental market when DVDs start going for as little as $10? Weichselbaum figures that as many as two-thirds of the 52 million card-carrying Blockbuster customers might never rent again. If that happens, he adds, the outfit might find itself owning twice as many stores as it needs -- and be "headed for a massive restructuring."

Blockbuster insists that lower rental income is a temporary problem. "We know retail sales will continue to grow at a fast rate," says spokeswoman Karen Raskopf. "But people will continue to rent." She argues that during this holiday season, cutthroat competition among retailers for customers created "hyperexaggerated" discounting that won't last into the new year.

SHRINKING MARGINS.

  Of course, the rental business, which accounts for more than 80% of Blockbuster's revenues, isn't going to disappear overnight. For instance, the price differential between buying a $60 or $70 video game and renting one for $5 still works in Blockbuster's favor.

Moreover, David Joyce, an analyst with Guzman & Co. in Miami who recently cut his rating on the stock to market perform from outperform, is optimistic that the rental business still has a future. (Joyce doesn't own the stock, and his firm has no investment-banking relationship with the company.) He expects ultralow DVD prices to be a temporary phenomenon and thinks rental revenues will continue to grow, by around 4% annually. "All of the viewing public across the world will not switch to buying movies," he says.

Yet even Joyce concedes that gross profit margins on rentals, which stood at 60% in 2001, are falling. They declined to about 57.5% in 2002, Joyce believes, and "could lose a little more ground in 2003."

While that doesn't sound so bad, the mere fact that a profit machine such as Blockbuster is encountering unforeseen problems has come as a shock to the market. For years, no one has questioned the idea that the high-margin rental business would continue to flourish. Yet even true believers are having to come to grips with Blockbuster's anticipated earnings per share growth of no more than 10% in 2002, down from 20% in prior years. Blockbuster might devise a strategy that combines DVD sales and rentals, but its days of minting money could still be in peril.

Tsao covers the markets for BusinessWeek Online in New York