A Blockbuster Offer With Little Star Power

As Viacom's (VIA ) CBS News flounders in humiliation over its report on President Bush's National Guard service, the damage to this prized asset might be a shareholder's top worry. Yet investors face a more pressing issue: Should they swap their Viacom stock for shares in Blockbuster (BBI ), its chain of movie- and game-rental outlets? Viacom's offer expires on Oct. 5, and it has investors such as Jerome Donovan, of New Hartford, N.Y., asking if Viacom "is dumping a declining business" or simply refocusing on its main television, radio, and film operations.

That's no simple question, as the hundreds of pages filled with figures and legalese that Viacom dropped on its stockholders make plain. Much of the gobbledygook is designed to keep the deal tax-free, but it all boils down to this: Viacom, which bought Blockbuster in 1994, took it public in 1999 but kept a majority stake. Now it's telling Viacom investors that, for each Viacom share handed in, they'll get 5.15 shares in Blockbuster. If the deal goes as hoped, Viacom will wind up handing its entire stake in Blockbuster to the public while cutting its own shares outstanding by 1.6% -- a neat way to lift its future earnings per share.

THE SIMPLEST THING to do is nothing. But the relative values of the two stocks make Blockbuster seem enticing. A share of Viacom, recently worth $33.11, would bring 5.15 shares of Blockbuster worth $37.90 -- a 14.5% premium. Yet that spread has already narrowed since the deal's terms were disclosed. It may narrow more as the actual exchange nears. You probably wouldn't buy stock in Blockbuster for its current results, which are being hurt by the decline in the movie-rental business as consumers choose to buy more and more titles on DVD. In the first half, revenues rose a tad, to $2.9 billion. But with heavy investment in such new initiatives as Blockbuster Online, which is aimed at competing with Internet DVD rental service Netflix (NFLX ), cash flow after capital spending dried up. Free cash flow in the first half came to a negative $9.6 million. A year ago there was $88 million in cash left after capital projects. The company has not forecast free cash flow for the full year, but it expects net income to fall 30% or more, to perhaps $1.03 a share. When I asked CEO John Antioco if this year's financial results will prove to be a nadir, he was careful not to go that far. He did say, however, that Blockbuster will end most of its spending on new projects -- creating stores-within-stores for video gamers, a DVD trading-and-resale initiative, plus the online service -- in 2005. After that he sees Blockbuster as able to create $200 million to $300 million in free cash flow a year.

If Antioco turns out to be right, then Blockbuster's current stock market value of $1.3 billion would be only six or so times free cash flow in 2006 -- dirt cheap. And Viacom? With $27.7 billion in revenue over the past four quarters, it boasts a much larger stock market value of $58 billion. Last year free cash flow came to $3 billion, and as Viacom's sales of TV advertising rebound this year, it's growing smartly, up nearly 24%, to $1.8 billion, in the first half. At that rate, Viacom is trading near 16 times this year's free cash flow -- squarely between such major rivals as Walt Disney (DIS ) and Time Warner (TWX ).

So Blockbuster is a much riskier bet, and the market is pricing it as such. To give up stock in Viacom, with its variety of revenue sources and greater certainty of returns, you would have to believe that Blockbuster will be able to fend off not just Netflix but also sales of DVDs by the likes of Wal-Mart Stores (WMT ) -- while also competing with the onrush of technologies such as as video on demand. It may. Yet after weighing the odds, most shareholders will likely do with Viacom's offer what Jerome Donovan did: toss it in the trash.

By Robert Barker

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