Description

Blockbuster Arbitrage

Blockbuster has been written up three times -- first at $10/share, then 3.55 and then 0.47. Notice a trend? It's been a classic value trap, cheap on all the metrics if only the business would stop declining. But the decline is terminal.

Video on demand is the long-term killer. VOD is more economical and convenient for all parties, from producer to consumer. The timeline is unclear -- consumers change behavior slowly and studios always tiptoe into digital distribution -- but eventually chaufferring shiny silver discs to and from to the video store will exist only in our memories alongside digging for change to feed pay phones and the unique melodies of modem dialtones.

If VOD were the only threat Blockbuster might be a good cigar butt, milking cash flow as the business declined. But the Netflix subscription-by-mail model and RedBox's "Blockbuster-in-a-box" vending machines ruined that. Neither competitor completely matches everything Blockbuster offers, but with vastly lower fixed and variable costs they don't need to. New competitors taking big chunks of a business that's doomed anyway -- talk about a disaster movie!

BBI revenues decline 5-10% per year, falling from 6b+ in 2004 to below 4b (forecast) in 2010. They have a billion of gross debt:

675 - Secured notes due 10/2014, 14% effective yield
300 - 9% Sub notes due 8/2012
 30 - Cap leases

Against this BBI has about 200m cash and hopes to free up another 100m from the restricted pile and further asset sales. They'll need that cash for the 90m+ annual debt amortization because 280m of hoped-for EBITDA minus 100m maintenance capex, 115m interest and 20m cash taxes does not cut it. The runway ends in May 2012 -- BBI must refinance the sub notes by then or the secureds become puttable. I recommend the following posiiton:

Short 1 BBI @ 0.81
Long 1 BBI-B @ 0.40

The B shares came about as part of the Viacom divestiture. The two classes have equal economics but BBI-B shares get two votes. They should trade at a small premium but due to illiquidity they historically trade at a 5-10% discount. This discount widened dramatically as BBI fell into penny stock territory last year. There is no reason for the dual class structure to exist any more, but Blockbuster management has more important fish to fry these days and is understandably unwilling to invest resource in this type of housekeeping.

If BBI goes to zero within two years as expected you net 41 cents. If BBI dodges the reaper and quickly returns to profitability the shares will most likely return to their historic trading range (e.g. $4ish with 5-10% spread) and you'll break even until management collapses the share structure (as CMG recently decided to do). The equity offering envisioned circa 2011 to refi the sub notes would present a good opportunity for management to take care of the share structure housekeeping issue, again delivering 41 cent profit in a two year time frame. Finally, it's possible for the spread to narrow while the dual-share structure remains in place, giving you 25-35 cents of profit in a shorter time frame. I'm personally in the "go to zero" camp, but there are multiple ways to win.

BBI is a moderately difficult borrow with a 6% negative rebate, not pleasant but not a deal breaker considering the expected two year horizon.

Catalyst

-Continued deterioration in reported results and cash position.

-End of runway becoming visible in mid-2011.