Blu-ray could be Blockbuster's bailout

It takes a lot of discs to stock the more than 7,800 Blockbuster Video stores in North America, and the company is a prolific purchaser of disc-based media, both movies and games. So when the company's substantive value derives directly from the discs it buys, any big changes to its structure could impact the disc production industry, and all the other businesses that rely upon it.

Blockbuster's future has been uncertain since well before it attempted to purchase the now-defunct Circuit City, a move which CEO Jim Keyes said at the time was not in the best interest of Blockbuster's shareholders.

While that potential crisis was avoided, shareholders last week faced an even bigger one: The news was made public that Blockbuster has hired Kirkland and Ellis LLP for "refinancing and capital-raising initiatives." One of the company's specialties is bankruptcy, and it has dealt with several high-profile airline industry bankruptcy cases in the past. Because of the looming potential of bankruptcy the legal firm represents, Blockbuster's stock plummeted 80% in value on Wednesday.


In response to the hysterics, Blockbuster released some of its fourth quarter figures, highlighting that same-store sales had increased by 4.4% and that its earnings had actually exceeded projections by around $15 million.

The mitigating effect of this statement was nominal.

CEO and Chairman Jim Keyes said, "With respect to our financing initiatives, we continue to work diligently to resolve the August 2009 debt maturities, aggressively reduce costs and maximize the company's strong cash flow generation. We look forward to sharing our progress."

The debt maturities Keyes mentioned will amount to more than $380 million in August, and the preliminary numbers Blockbuster released could look quite different by March 19, when the company hosts its quarterly earnings call. Stocks did regain some lost value, but only around 10%.

Blockbuster Case Study

In 2006, Blockbuster's inventory was worth an excess of $800 million. The company's combined physical assets (i.e., stores, offices, warehouses, and everything contained within them) only totaled $508 million in value. Over 60% of the company's value was its discs. This sort of larger-scale title acquisition began in the company's era of "guaranteed availability," which caused upset among the rental industry.

This is because that $800 million dollars worth of discs Blockbuster has is not just a stockpile of old films, it's a constantly refreshing and circulating inventory that's intentionally heavy on the new releases. Blockbuster buys so many movies, that in the late '90s, distributors had to come up with "depth-of-copy" schemes to give smaller retailers bonus copies of a film just to stay competitive with Blockbuster's massive inventories. Blockbuster could buy as many as 4 million copies of a single film at a time.

The original cost to purchase a movie for rent at Blockbuster is around $65, but through its 40% revenue-sharing deal with Hollywood studios, it ends up paying around $6 each. This revenue sharing deal affected 81.8% of inventory. [Source: Cambridge Business Review, 2008, 9(2) 68-75]

But Hollywood gets more money when discs are sold, and the strength of video rental stores has crumbled since the VHS era. At the turn of the millennium, rental revenue took a sharp drop. Adams Media Research predicted that until 2013, the sale of discs would increase while rentals level off. While the economy has taken a 23% bite out of DVD and Blu-ray sales in 2008's fourth quarter, rentals have actually remained quite true to analysts' predictions. Of the $8.16 billion in rental revenue across the category, about $1.93 billion went to Hollywood.

While the transition to discs took out many of Blockbuster's competitors, it also allowed for viable alternative methods of distribution where cassettes did not. Two renters capitalized on this, and severely damaged Blockbuster's preeminence in the process: Netflix and Redbox.

Netflix pioneered the no-late-fee, by-mail rental model, and made an early and highly successful move into the streaming model. The CoinStar-owned Redbox has installed over 10,000 of its $1 rental kiosks, including the pivotal Wal-Mart and McDonald's locations.

Blockbuster pledged increased support for all of those models. In addition to the company's pay-per-view set top box for digital delivery, its Total Access by-mail program has expanded to include 700 Blu-ray titles and video games. Likewise, the company has worked with NCR on creating branded rental kiosks for physical movie sales without the costly real estate. Unfortunately, the company has thus far failed to gain the dominance it has in physical video shops.

With all of these factors in line, Blockbuster looks poised to close corporate stores and use their valuable stock in the by-mail and automated rental trade, gradually falling back onto a business model similar to Netflix, while leaving the fate of Blockbuster franchises up to the franchisees (similar to when a franchisor files for Chapter 7 Bankruptcy.)

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