Blockbuster proposes 'exclusive' content, devices in Circuit City bid

With the format war over, the half-life of disc-based video in the US may already have been expended. So the survival of Blockbuster as a brand may depend on a device that helps move its storefront directly into the household. Enter Circuit City.

In his public letter to the CEO of Circuit City requesting that negotiations commence on a merger deal, Blockbuster CEO Jim Keyes suggested that the combined retailers would not only be able to secure exclusivity deals for content -- as Blockbuster has already been known to do for its 7,800+ rental outlets in the US -- but might also have the ability to market and sell an undefined, exclusive content delivery device.

"The combination of Blockbuster and Circuit City will result in an $18 billion retail enterprise uniquely positioned for the convergence of media content and electronic devices," wrote Blockbuster's Keyes this morning. "We would seek to differentiate products in both Blockbuster and Circuit City stores by offering exclusive content and content-enabled devices. Both companies would benefit from complementary products, marketing, management strengths, technology and distribution and the resulting synergies would significantly improve consolidated financial performance."

Last week, Blockbuster said it would proceed with a full rollout of Blu-ray content across all its US stores, after having tested Blu-ray in 1,700+ outlets beginning last summer. Though it's been playing catch-up with Netflix in the online and rent-by-mail departments, its primary business remains renting discs from its storefronts -- a business which more analysts lately have been condemning to the annals of history, at least within five years' time, some saying as soon as three years.

With Netflix looking ahead toward the video-on-demand era, and seeking to stake an early claim in the field of electronic delivery, Blockbuster may be realizing it needs a branded alternative. That alternative may include some type of console, and it may need a guaranteed outlet to sell that console.

"Our vision for the 'new' Blockbuster is to be the most convenient source for media entertainment," wrote Keyes. "We have undertaken a series of strategic initiatives including enhancement of our core rental business; a transition from solely rental to a concentration on consumer retail; and development of the fast- growing digital download market. We are pleased that these strategic initiatives have begun to improve our financial results and anticipate further improvement going forward."

While both Circuit City and Blockbuster may hope to be able to forget 2007, their fourth quarters weren't all that bad in retrospect. Circuit City posted an 11% annual sales increase during its holiday quarter; meanwhile, Blockbuster's total revenues for Q4 2007 were $55.1 million higher than the same quarter a year ago, and its combined revenues from same-store and by-mail rentals increased 7.4% over the year-ago quarter.

But un-combine those figures, and concentrate on just the disc rental business in the United States, and you'll see a 0.9% annual revenue drop. The core of Blockbuster is still rotting, and it knows it needs a new infrastructure.

Keyes wrote that Blockbuster may be prepared to pay as much as an $8-per-share premium for Circuit City stock. That's enormous -- some might say even ridiculous, considering Circuit City shares were trading way up as much as one-third at $5.18 by 11:30 am on the New York Stock Exchange.

In his letter, the Blockbuster CEO noted that his company had tried to commence merger negotiations with Circuit City on February 17, but implied that the retailer rebuffed its advances by failing to do due diligence on the offer -- to provide the necessary information and guarantees about itself so that its new prospective corporate parent can trust it.

But in an official response later this morning, Circuit City said it was Blockbuster that had failed to provide the due diligence on itself, by failing to prove it was capable of financing the deal.

"Circuit City and its advisors have a number of other fundamental questions regarding the structure, sources and uses of funds and consents required with respect to the proposed transaction," reads a statement this morning. "Among those questions are whether the proposed acquisition would require a refinancing of the existing Blockbuster debt." The electronics retailer added that it believes Blockbuster may be over-estimating the value of what it's capable of offering, noting that the dynamics of its "rights offering" is predicated mainly on the notion that credit can somehow be converted into cash.

Indeed, Blockbuster's Keyes did make that very point this morning, writing: "Given current debt market conditions, we believe most of the cash necessary would be generated through the issuance of additional Blockbuster equity, most probably in a rights offering to our existing shareholders. We believe they, and the market, will recognize the merits of this transaction and we are confident that we can raise the required equity. The borrowing capacity of the combined business would provide the remaining cash proceeds."

In other words, Blockbuster could offer more equity (stock) in itself, driving up its own price and hopefully thereby generating enough equity that the credit the beefed-up company would be granted could result in cash that could satisfy Circuit City's shareholders' requirements.

Until Blockbuster can fully explain such matters as how the Securities and Exchange Commission could possibly sign off on such a deal, Circuit City responded this morning, it will continue to refrain from providing its own due diligence on the deal. If this were a poker game and Blockbuster were bluffing, that bluff may have just been called.

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