Description

SUMMARY

I have been following Blockbuster (“BBI”) for some time now, and I think now is finally the right time to buy, as the market, misunderstanding the goals/strategy of the new management team, has given up on the story.  Ever since BBI’s Q3 earnings, and a follow-up analyst meeting with the new management team, investors have rapidly sold-down BBI’s shares, driving their price down to levels approaching the stock’s all-time low of $3.38 (shares are trading near $3.55 on December 3^rd).  Expectations are now incredibly low, and it won’t take much to surpass the low bar that the market has set for the company (and maybe that’s exactly what the new management team wanted).

Bottom line: BBI could realistically double over the next six months, and I believe downside is relatively limited given that the stock is trading near its all-time low.  I recommend building a position, targeting a reevaluation/exit date by Q4 2008 earnings (the end of February), and taking profits opportunistically in the interim, as BBI shares can jump very quickly over short periods of time.  By February 2008 the company will 1) further clarify its strategic plan and begin to execute and 2) announce formal earnings guidance, both of which should appropriately set expectations and reduce investor confusion.  When the stock hit $7.19 earlier this year, I think the stock got a little ahead of itself as new management came in, and as Netflix and Blockbuster saw strong growth in the online movie rental segment.  Since then, I don’t think the picture has changed for the worst – arguably, there are more tailwinds now than there were six months ago, U.S. economy notwithstanding.  What has changed, though, is management and their strategic plan, and the market fears this change after it was just starting to get comfortable with BBI’s shift toward the online market. 

CAPITALIZATION/ESTIMATES

The company currently trades at approximately 6x consensus “run-rate” EBITDA (2008 and 2009), which seems very conservative given the company’s minimum LTM EBITDA covenants pursuant to its secured debt, re-negotiated in July 2007.  The company must generate $250 mm of EBITDA for FY2008 to remain in compliance.  Depending on the source (Thomson One or Bloomberg), consensus estimates are approximately in-line at ~$250 mm.  Because of the issues that prior management had in complying with certain financial covenants in the past, I find it highly doubtful that the company would negotiate an aggressive minimum EBITDA threshold going forward. 

Admittedly, given the new management team and the new strategies they plan to implement, it is difficult to get a strong handle on profitability over the next few quarters.  But given low expectations, management need only show modest financial progress in the near-term, and if management provides any sort of positive comments regarding outlook, we could see a virtuous cycle of earnings beats and multiple expansion. 

INVESTMENT CONSIDERATIONS

Positives

• New CEO is a turn-around specialist, has a track record of success at Seven-Eleven, and brings a fresh management team and set of ideas to the table
• Management bullish: plans to take EBITDA back to historical levels of $600-700 mm from $150-250 mm today
• Retail turnaround story – the new CEO is a retailer by trade; he plans to change the pure rental model to a more balanced rental/retail model
• Near-term catalysts include: 1) Reduced G&A and advertising expenses 2) Strong movie line-up/writer’s strike, 3) Movie Gallery store shut-downs, 4) Total Access profitability, 5) Blu-Ray/HD format cycle
• Seemingly limited near-term earnings/valuation downside given low expectations
• Price maker in the rental-by-mail business segment
• Icahn owns a large stake, and increased his stake after the recent share price downturn

Concerns

• Secular decline of the in-store movie rental business
• Levered company
• Potential cost of certain new strategies (i.e., new store formats, kiosks)
• Some risk that movie studios collapse the 45-day rental window
• Potential overhang from 7.5% Preferred, struck at $5.15
• Longer-term concerns regarding Video On Demand, Apple, and any other player that seeks to bring content directly to consumers

PAST PROBLEMS, NEW STRATEGIES

The new management team, lead by Jim Keyes, looks to return BBI to EBITDA of $600-700 mm, levels the company hasn’t seen since before it eliminated late fees in 2004.  Jim Keyes is a turnaround specialist, and was most recently the CEO of Seven-Eleven.  A retailer by trade, he guided the Seven-Eleven to 36 consecutive quarters of same store sales growth.  On a recent conference call, Jim described BBI’s mistakes over the past few years, and discussed generally what he plans to change going forward. 

“Managed Dissatisfaction”

BBI transitioned poorly into the 21^st century, as evidenced by blunders on the execution side coupled with questionable strategic moves.  After changes in movie studio agreements that came about in the shift from VHS tapes to DVDs, BBI was forced to purchase inventory from movie studios.  In the past, BBI had entered into revenue sharing/leasing agreements.  As a result of this shift, BBI began to purchase fewer movies in order to limit wasteful overstocking that can come about during a movie’s rental cycle (i.e., movies are heavily rented for the first few weeks after they come out, and then rarely rented).   Inevitably, customers found Blockbuster stores to be out-of-stock of new releases.  Old management originally believed this to be favorable, as they noted a customer would, after having not found the new release he was looking for, instead rent an older, higher margin product.  This strategy was known as “managed dissatisfaction”.  Obviously this situation proved untenable, and eventually resulted in significant same store sales declines. 

No More Late Fees!

In 2004, after extensively surveying its customers, BBI found that one of customers’ main complaints related to Blockbuster’s late fees.  Management believed that eliminating late fees would improve customer satisfaction and drive rental volumes.  While this undoubtedly helped volume, customers were confused by the “no late fee” structure, and improved volumes were of little help in the face of a massive revenue drop due to the lack of late fees.  In addition, average price per rental dropped from $3.60 in 2004 to $2.79 in 2007, and the average time DVDs were checked out increased from 3.6 days to 5 days, further exacerbating inventory issues.

In response to Netflix’s online DVD rental by-mail program, BBI implemented and heavily promoted its own online plan, effectively spending millions of dollars to convert 65%+ gross margin in-store customers to 30-35% gross margin online customers.  In addition, with BBI’s Total Access program, BBI mail customers can exchange DVDs rented by mail for DVDs in Blockbuster stores.  Heavy usage from certain Total Access customers further depleted store inventory.    

However, in spite of all these missteps, industry competition from Netflix, secular challenges, and investor perceptions to the contrary, BBI has maintained and even slightly grown its market share from 31.5% to 33%.  Video On Demand has captured some market share, but has only grown from 10% in 2004 to 12% today – hardly the massive growth many predicted. 

In order to correct these fundamental problems, management intends to implement a two-pronged approach by “fixing” its rental business, and by shifting its business model from one that is almost wholly rental to a more balanced model that gains a substantial portion of its revenue from retail sales. 

Coming from a retail background, Jim Keyes noted that he was appalled to learn that Blockbuster customers consistently were unable to find popular new movies because they were out-of-stock.  In order to improve store inventory without simply spending more money on DVDs, management is experimenting with new pricing strategies for its in-store customers (in order to encourage customers to return movies more quickly) and its Total Access subscribers (increasing pricing; limiting the number of free exchanges in order to encourage attrition of heavy users). 

Management also plans to be more flexible with its retail offerings.  For example, when the latest Harry Potter movie came out, certain Blockbuster store managers preemptively purchased Harry Potter books to sell alongside their movie offerings, and had great success doing so.  In addition to more innovative strategies like this, management hopes to improve sales by performing more basic retail strategies by, for example, placing popular, recently released children’s movies for sale next to rental stands (e.g., placing a Shrek sales display next to a rental display).  Management hopes to compete for these retail sales on the basis of convenience rather than price (i.e., Wal-Mart).  Some investors argue, with merit, that BBI has tried to invigorate retail stores in the past.  What’s different this time?  As with so many other issues in BBI history, execution, not strategy, has been the real problem.  Before abandoning management’s reassertion of strategies that it has tried in the past (i.e., retail), I think it’s worth seeing what a new team can do.  

The most speculative ideas that management has relate to new store formats, Movielink and its movie download service, sales kiosks, and partnerships to get content from PCs to TV.  I don’t find these last strategies as interesting or as easy to implement as some of the aforementioned opportunities, but they are important in that they lay the groundwork for wherever media entertainment goes over the next several years.   However, it will be important to monitor management’s ability to target high return, easy-to-implement strategies, and to quickly identify and discard low return plans. 

CATALYSTS

In addition to the newer strategies mentioned above, management has announced plans to reduce G&A by $45 mm on an annualized basis and to reign in advertising expenses from over 3% of sales today to under 2%, in-line with most retailers, representing another $55 mm+ of savings.  The new management team appears committed to being more “Street Friendly”, and will provide 2008 guidance as well as new metric detail for investors to follow on its Q4 earnings call in February 2008. 

While Blockbuster undoubtedly has some level of recession-risk, like any company, this concern is trumped by the quality (or lack thereof) of its near-term movie line-up.  Over the next quarter or two, the movie lineup for all rental companies is considered to be strong.  And depending on how long it lasts, a writer’s strike may well play into Blockbuster’s hands, as customers may rent movies rather than watch re-runs of television shows. 

Another significant catalyst is the announced shutdown of over 500 Hollywood Video stores (with more likely on the way) during the Movie Gallery bankruptcy.  Many of these stores have “overlap” with Blockbuster stores (upwards of 30%).  As the in-store rental business has very high fixed costs, Blockbuster could experience significant increases in store utilization in overlapping areas, driving improvements to profitability.   While BBI originally traded up on this news, the market no longer appears to be giving credit to this extremely positive event. 

Over the past quarter, management has proven to be fairly nimble with Total Access pricing and promotions.  Recently, management cut Total Access advertising and changed pricing in order to better understand customer demand elasticity.  While this curtailed customer uptake of the Total Access program, in concert with in-store exchange limitations, the company purged some of its least profitable customers.  In addition, Blockbuster has proven that it can, when necessary, take market share directly away from Netflix through Blockbuster’s Total Access program.  Customers perceive BBI’s Total Access plan to have a greater value than Netflix’s online-only offering.  In fact one of the main reasons Netflix shares have traded up recently is because Blockbuster has decreased its marketing spend for Total Access, allowing Netflix to expand its customer base.  While there has been some speculation that the market for rental by mail is now relatively saturated, and may experience slower growth in the near-term, it is clear that Blockbuster, not Netflix, will dictate how the rental by mail segment will be priced. 

Finally, as Blu-Ray and HD formats gain momentum, renting may once again become a more compelling value proposition relative to simply buying a movie.  These formats are more expensive to buy at the retail level, and thus customers may shift some of their entertainment dollars toward more affordable movie rentals. 

Catalyst