Description

“This report of my death was an exaggeration.”
--Mark Twain

• Blockbuster (BBI) is valued at 4.9x net income plus depreciation minus capital expenditures, 4.7x cash flow from operations minus capital expenditures and 5.6x net income (each after Viacom split-off adjustments), implying yields of 18-22%.
• CEO John Antioco will receive 4.2-5.0 million options, with 1/3 priced at each of the fifth, thirteenth and sixtieth trading days. He will also receive 1.0-2.6 million restricted stock units.
• Blockbuster is a retailer with very special economics. Blockbuster has maintained gross margins of 58-60% while retail bell-wether Bed Bath & Beyond’s gross margins have been 41-42%. How does Blockbuster do it? It typically gets a DVD for $2, rents it 10 times for $4 each and then sells it for $10.50.
• These economics are not in imminent danger. Why? Because video rental is the single largest source of revenue for U.S. film studios. Blockbuster alone contributes to the studios almost as much as the entire U.S. motion picture exhibitor industry (Blockbuster contributes approximately 20% of U.S. studio revenues). The studios control the profitability of each distribution channel, and it is not in their interest to benefit other channels at Blockbuster’s expense. I will examine the technological and competitive risks in detail below.
• Leonard Green’s acquisition of Hollywood Video in March implies a valuation for Blockbuster of approximately $19.50-$22.50 per share (before the special dividend), almost 40% above the current price.

Split-Off Mechanics
While a spin-off and a split-off both result in the “orphaned” equity becoming completely independent from the parent entity, the mechanics differ materially. In a spin-off, the parent company simply distributes a predetermined number of shares of the orphan for every share of the parent held. This results in every holder of the parent owning some of the orphan, even though none have made an affirmative decision to adopt the orphan. As most VIC readers fully understand, this creates an opportunity, as holders of the orphan sell because they either can not or do not want to own the orphan and the orphan may trade at a discount to its valuation.

Viacom has chosen to separate Blockbuster through a split-off. Viacom will set an exchange ratio that allows shareholders of Viacom to exchange their Viacom shares for the shares of Blockbuster held by Viacom. From Viacom’s perspective, the result is a share buyback using Blockbuster as the currency. The key is to set the ratio so that Viacom shareholders will exchange enough shares to take all of the Blockbuster shares. If too few Viacom owners tender their shares, Viacom will spin off the remaining Blockbuster shares as in a traditional spin-off. In order to make the exchange attractive to Viacom holders, the exchange ratio will be set at a discount to Blockbuster’s market price.

In a spin-off, it is typically better to wait until after the transaction, when selling pressure typically forces the orphan’s stock down. The dynamic is unlikely to be the same for Blockbuster. Blockbuster shares will only be given to shareholders who make an affirmative decision to exchange their shares, so there will not be the same selling pressure. Additionally, Blockbuster will pay a special dividend of $5 per share (taxed as return of capital) immediately prior to the transaction, meaning Viacom holders that exchange their shares for Blockbuster shares will not receive the payout.

You can buy Blockbuster now, buy Viacom and exchange your shares for Blockbuster’s, or buy Blockbuster after the split-off. Blockbuster today promises, in my opinion, safety of principal and an adequate return. How you navigate the tactics of purchasing, I leave up to you.

Video Rental Economics
The studios maximize their revenues by controlling the distribution “window,” the time period during which each distributor class (e.g., theaters, video rental stores, mass merchants, cable and satellite systems, etc.) can release a movie. Video rental and retail sale have an exclusive window that begins six months after release. That exclusive window is maintained for approximately two months, at which time pay-per-view and video-on-demand are allowed to distribute.

• The marginal cost of manufacturing, packaging and shipping a DVD is less than $3.00, as it was for videocassettes.
• Blockbuster obtains videos under two models: purchase and revenue sharing. In a purchase, Blockbuster buys the DVD from the studio for $15-18 ($16.50 average). In a revenue sharing deal, Blockbuster pays the studio $0-4 ($2 average) and the studio receives 30% of the rental revenue for the first six months. Blockbuster currently has revenue sharing deals for approximately 65% of its DVDs. In 2000, when movies were released on videocassette, approximately 90% of movies were obtained under revenue sharing deals (as an aside, Blockbuster exploited its large size by negotiating revenue sharing deals directly with the studios; independent video stores had to negotiate through an intermediary and Blockbuster’s advantage was one of the key factors in its success relative to the independents).
• The typical DVD is rented 10 times for approximately $4 and then sold for $10-11.
• When the studios sell to Wal-Mart, they make the same $16.50 that they make in a sale to Blockbuster.
• When the studios distribute through cable and satellite providers, the providers charge $3-5 per viewing. The studios have been offered as much as 80% of these revenues, but typically receive 50%.
• The summary economics of the marginal DVD are as follows:

Purchase Revenue Sharing
Revenues $50.50 (10 x $4 + $10.50) $50.50 10 x $4 + $10.50)
Cost (16.50)(same as Wal-Mart) (14.00)($2+10x$4x30%)
Profit 34.00 36.50
Gross margin 67.3% 72.3%
Studio revenues $16.50 $14.00

Financial Summary
Pro forma for the split-off from Viacom, Blockbuster will have the following capital structure and valuation:

(all amounts in millions)
Basic shares out (A&B): 181.1
Restricted stock units 2.6 (maximum Antioco can receive)
Options 0.6 (treasury method for new options)
Fully diluted shares 184.2

Price per share $15.00
Minus special dividend (5.00)
Pro forma price per share $10.00
Market capitalization $1,842

Cash $173 (incl. $35.6 million of excess proceeds)
Term loan and other 159 (6.2%-8% interest)
Term loan A and B 950 (swap half for 6.9% rate; rest L + 3.1%)
Net debt $936 (pf net interest approx. $56.2 million)
Total enterprise value $2,738

LTM Revenues $5,897 (0.5x)
LTM EBITDA 736 (3.8x)
LTM EBITDA-CapEx 533 (5.2x)
LTM Net income + D&A – Capex 486 (3.8x) ($379 and 4.9x w/cash taxes)
LTM CFO-CapEx 392 (4.7x)
LTM Net income (excl. impairment) 436 (4.2x) ($328 and 5.6x w/cash taxes)
Please note that the LTM financials include management’s estimate of $16 million of incremental stand alone operating expenses and pro forma interest expense. Additionally, I replaced Blockbuster’s rental amortization with cash spent on purchasing rentals, effectively excluding any impact of rental inventory amortization games and making it comparable to other retailers.

The store base is as follows:
Company owned stores 7,112 (the historical and future focus)
Franchised units 1,779 (no longer a major focus)
Total units 8,891 (to open 400 new stores this year)

Interestingly, 65% of Americans live within a 10 minute drive of a Blockbuster store. Customers are extremely loyal to a store, with 70% never visiting another store to find a video they want to rent.

Competitive threats

1) Subscription model risk

Subscription model risk refers, of course, to NetFlix (NFLX). Netflix allows its 1.9 million customers, for $21.99 per month to choose up to 3 DVDs online, and these DVDs are then sent to the customer via U.S. mail. The customer faces no due date or late fees and simply returns the DVDs via US mail (aside: approximately 9% of Blockbuster’s revenues are from late fees). While some believe NFLX’s model represents a significant competitive threat to Blockbuster, I believe that it fails to account for one of the fundamental attributes of video rental: approximately 84% of video rental purchases are decided on that day and nearly half are made on the “spur of the moment.” It takes two to five business days to get a DVD via first class mail.

NFLX has no advantage over Blockbuster (it does have more titles, but when approximately 25% of revenues come from the top 20 titles and 80% of revenues come from new releases, how important is having 15,000 titles?), and it could be argued that BBI will have several advantages over NFLX when it launches its own subscription model. To meet the desire of certain customers to avoid late fees and due dates, Blockbuster recently introduced an unlimited rental/flat fee in-store program called “Movie Pass,” which now comprises 7% of its customer base.

Blockbuster will expand this service to include US mail delivery, giving it a subscription model virtually identical to NFLX, in mid-2005 priced at $24.99 per month for 2 movie rentals at one time. NFLX will not enjoy any advantage in terms of distribution set-up or delivery time. Blockbuster has almost 9,000 stores that will be able to act as distribution centers and these stores will fill orders before 5 PM, at which time the USPS closes, when they are typically underutilized. Additionally, customers will have the ability to return DVDs via mail or a store (approximately two-thirds of Americans live within 10 minutes of a Blockbuster). The cost of introducing this service to Blockbuster will be relatively low given that Blockbuster does not have to obtain additional DVDs; orders will be met from its current inventory. Management anticipates spending $70-90 million in incremental operating expenses and $100 million in incremental capital expenditures relating to new distribution facilities this year. The capital expenditures will be non-recurring and a portion of the increased operational expense will be non-recurring, although management will not break out start-up costs.

2) Video-on-Demand (VOD) and other digital distribution risk

Let’s start with the answer: Studios control the product and have no incentive to allow a shift from rentals to VOD.

From the consumer’s perspective, VOD seems like an attractive alternative to visiting a Blockbuster, and depending on whose projections you believe, VOD has potential. However, the consumer’s preference is moot relative to the studios’ perspective and economics (if, for some reason, you place any faith in such forecasts, Forrester Research believes the rental market will grow from $10.6 billion in 2003 to $11.1 billion in 2007). Generally speaking, when a film hits the rental market (and retail market simultaneously for DVDs), there is a 45-60 day window before studios release the film to the VOD/PPV market, during which time Blockbuster generates the bulk of its revenue. The pivotal question becomes, “Do studios have an incentive to shrink this window?”
• A studio can either sell new releases to rental stores and retailers (Wal-Mart) for $15-$18, or it can allow a cable operator to offer the same movie through VOD. Cable operators charge between $3-$5 for a VOD movie and split the revenue with studios. Blockbuster management told me that the cable operators have been offered as much as 80% of the economics, but that the average is probably closer to 50%. Fifty percent of $4 is $2.
• If the world consisted only of Blockbuster and cable operators, there might be an incentive to close the window. The average Blockbuster customer rents 1.5 DVDs per month at $4 each. If the title was obtained through revenue sharing, the marginal customer would generate $1.80 for the studios. VOD customers, on average, watch approximately 2.5 movies per month. At $2 per viewing, the VOD subscriber generates studio revenues of $5 per month versus $1.80 for the Blockbuster customer.
• The world does not consist only of Blockbuster and cable operators; it also includes Wal-Mart. Wal-Mart generates $16.50 of revenues and $13.50 of profit for the studios on every DVD sale. The studios received $11.9 billion in 2003 from DVD sales (Warner alone received $2.6 billion). Luckily for Blockbuster, it occupies the same window as Wal-Mart and other mass merchants and consumer electronics stores and about $10 billion of related marginal studio profits.

3) Retail “sell-through” risk

This is Blockbuster’s most significant threat and has already hurt its performance. The good news is that it is not new.

DVDs are sold at the same time and at the same price for the same profit to Blockbuster and Wal-Mart. Every sale represents at least one less rental (every time you watch the DVD you just bought, you could be using the time to watch a rental). It is not surprising to learn, therefore, that as DVD sales have captured market share at the expense of rentals, the average number of rentals per month has declined from approximately 1.8 to 1.5.

Common sense suggests that consumers are not divided between purchasers and renters. That is to say, consumers do not choose purchase over rental for all of their titles; the price difference between purchase at $19.99 and rental at $3.99 is too great. Rather, they may choose to purchase a few favorite titles that they plan to view multiple times and rent (or watch on PPV or VOD) the rest. This bifurcation is what allows Blockbuster to continue to generate substantial free cash flow.

The question becomes: will the studios price their DVDs at $8.65 rather than $16.50 so that Wal-Mart can sell them for $9.99 rather than $18.99? You would have to do some work on price elasticity to be sure, but it is hard to see why the studios would really push pricing that far, ruining the business that provides them with 20% of their revenues and leave themselves at Wal-Mart’s mercy. The risks seem more obvious than the benefits, but it is, nevertheless, a threat.

Other risks
The latest craze for video rental companies is adding retail video game shops within their stores. Hollywood Entertainment has its “Game Crazy” (GC) concept, and Blockbuster has its US branded “Game Rush” (GR) concept and its UK branded “Game Station” (GS) concept. Currently, Blockbuster has 150 GRs and 150 GSs with plans to open another 250 GRs this year. (Blockbuster also recently purchased a small stand-alone game retailer, Rhino Video Games). The logic for creating video game retail store-in-stores is four fold:
• Importantly, 80% Blockbuster’s revenues come from new releases on the outer walls of the store, leaving a relatively underutilized floor area for older rentals.
• Blockbuster has been renting video games for years and is familiar with the space.
• It is a hedge against growing retail video sell-through competition.
• Blockbuster management can easily monitor the success or failure of Game Rush on a store-by-store basis and adjust its growth accordingly.

The required investment for a Game Rush is minimal on Blockbuster’s part. While Hollywood Entertainment spends $200K on a GC unit by hiring additional staff and a separate outside entrance, Blockbuster only spends $75K for a GR. Blockbuster’s concept is more of a gaming store-in-store light concept because additional staff is only used for peak hours and customers use the same registers as rental customers. Blockbuster won’t specifically disclose any profitability figures (HLYW does break out GC statistics), but it claims that each unit is profitable after 1 year and will break even in 3 years. Note that none of a rental store’s overhead is allocated to the retail concept.

As with any mature business facing technological substitution, there are those who would encourage Blockbuster to invest in new initiatives and others, including presumably most VIC readers, who would urge management to use free cash flow for share repurchases. Larry Zine stated that Blockbuster would have repurchased significant amounts of stock over the last several years had it not been controlled by Viacom. A “slow motion liquidation” (perhaps what we are seeing at Kmart) in which shares are repurchased at less than 4 times free cash flow would be a very rewarding experience for shareholders. Having said that, this board is not controlled by deep value hedge funds and managements typically find it too difficult to run a business that acknowledges it is slowly liquidating. I raised the issue with Blockbuster management and was told they would quickly squash any initiative that does not generate acceptable returns. Time will tell. Capital misallocation is a risk, mitigated in part by the incentives in Antioco’s options package.

Background
Some background on threats to Blockbuster’s business model may provide some perspective:
• Cable companies began offering pay-per-view in the late 1970s (I can remember, in 1979, calling a cable company and asking the operator to “turn on” a pay-per-view movie).
• Wayne Huizenga sold Blockbuster to Viacom in 1994 (for $8.4 billion, 3 times today’s total enterprise value when revenues were 38% of their current level). He told shareholders: “While it would be years, maybe decades, before new technologies would take a toll on Blockbuster’s mainstay video rental business, the threat would create a constant cloud over the company and depress the stock.” He was right. I would be hard pressed to find as succinct an explanation as to why value investors should consider buying the shares.
• DIRECTV and DISH were launched in 1994 and 1996, respectively. During the last five years, subscribers have increased from approximately 8 million to 20 million. One in five television households now subscribes to direct broadcast satellite. Blockbuster perceived satellite television to be a very significant threat by 2000, when penetration approached 10%. Management responded by leveraging their brand and “control” of the movie customer and striking a joint marketing deal with DIRECTV. Blockbuster began selling DIRECTV for a commission and a share of pay-per-view revenue. Blockbuster’s economics were such that its customers became more profitable to it if it sold them DIRECTV (although it would lose some “control” over that customer since store visits could decline by half). Blockbuster’s relationship with DIRECTV continues, although it has been de-emphasized as net subscriber growth has slowed.
• Kozmo.com introduced a service in 1997 that allowed customers to order videos online and take delivery the same day from a bicycle-riding courier. Despite having video inventory comparable to Blockbuster’s, Kozmo ceased operations in April 2001.
• Circuit City introduced an alternative to DVD in 1998 called DIVX that provided enhanced piracy protection. Several studios released films in DIVX format to much fanfare. The technology was abandoned in 1999.
• Tivo and other digital video recorders were widely available by 2001-2002. When combined with pay-per-view, Tivo could be used to create a home library of movies.
• Disney introduced a product in 2003 called EZ-D, which was a chemically treated DVD that was designed to become unreadable after 48 hours.

Disclaimer
I am currently long BBI shares. That could change at any time, and I will not disclose additional transactions in this security. Do not rely on this analysis. Do your own work; it is what you get paid for.

Catalyst

CEO Antioco's options are priced soon after the split-off.
Shares will provide a cash-on-cash yield of approximately 20%.
It is not a part of my investment thesis, but I would not be surprised to see a respected value investor like Eddie Lampert take a significant position.