At 47 cents per share, the Blockbuster Class B’s are currently priced for bankruptcy despite clear evidence that 1) a companywide operational turnaround is well underway; and 2) the overall business can hold its own, if not prosper a little more, from the dramatic economic downturn we are currently experiencing (i.e. the business may be considered slightly counter-cyclical).

 

An investment in the B shares couples significant financial leverage with tremendous operating leverage.  Current levels value the enterprise at less than 3.7 times 2008 EBITDA, and Blockbuster’s equity market cap at less than one times 2009 free cash flow.  The leverage on these shares is illustrated by the fact that no operational improvements and a tweaking of the company’s valuation up to a modest 5.0 times trailing EBITDA gives us a share price of $2.50 per share – a 400% return from the current price.

 

Moreover, we believe the current management team has the experience and vision to take advantage of Blockbuster’s vast, underutilized bricks and mortar presence to grow its top-line while at the same time continue to slice down the company’s relatively high cost structure.  Management has communicated that the company has earnings power in excess of $500mm in EBITDA as 1) it moves towards a media convenience store model to take advantage of selling merchandise to regular traffic and 2) identified cost-reduction initiatives are implemented.

 

With $60mm in term loan amortizations and a $135mm revolver maturing in August 2009, bankruptcy is indeed a possibility.  However, the company’s operating cash flow and other sources of cash should prove more than ample if their bank group proves unwilling to extend.  While there is some possibility of a donut here, it is small enough to offer a very attractive risk/reward relationship given the tremendous upside from the market price.  Management has communicated to investors a fairly detailed “Plan B” that they anticipate implementing if lending conditions maintain their frozen state.  Inventory reductions, minimalist capex, and lease renegotiations offer sources from which the company can harvest over $200mm in excess cash to accommodate these near-term obligations.

 

Interestingly, there is also a dramatic Class A/Class B arbitrage available in this name.  The Blockbuster Class A shares currently trade at over twice the price of the Class Bs. Both classes offer the same economic rights, but the Class Bs have superior voting rights, at two votes per share versus only one vote per A share.  The As are somewhat more liquid - well over 1mm A shares trade on a typical day, while the B shares see volumes ranging from 50k to 500k on most days.  We have not looked into the borrowability of the A shares as we are not in this for the arbitrage but rather for the multi-bagger potential on the B shares as a long-only investment.  There has been talk between management and some of the larger Class B shareholders about “collapsing” the A and B shares, creating a single class of common stock.  On the most recent conference call the CFO responded to a question about this by saying, in effect, that he doesn’t see how the company benefits from the dual class structure.  While we don’t sense that collapsing the shares is a current priority, we do think it will occur eventually.  Obviously, the huge price discrepancy between the two classes offers a “bonus” potential catalyst as a decision to collapse the classes would likely cause the B shares to trade more in line with the A shares and converge to the higher A share price as implementation approaches.

Blockbuster Inc., headquartered in Dallas, Texas, is a leading global provider of in-home rental and retail movie and game entertainment. The company operates almost 4,000 stores in the United States and 2,000 stores abroad. It also has about 1,500 stores operated by franchisees.

 

Founded in 1985 by David Cook, the company was bought by Wayne Huizenga in 1987 when it was a chain of just 20 stores.  Mr. Huizenga expanded the enterprise to 3,600 locations and $2bb in revenues before selling it to Viacom in 1994. Viacom IPO’d Blockbuster in 1999, and fully divested its ownership in 2004 by allowing its shareholders to exchange each Viacom share for 5.15 Blockbuster shares (thus giving rise to the Class B shares that are the subject of this writeup).   After several years of increasing customer dissatisfaction, operating losses and destruction of brand value, Carl Icahn accumulated 10% of the company’s shares and launched an activist campaign to oust John Antioco, the company’s egregiously compensated CEO.  Jim Keyes, who brought in his own team in July 2007, replaced Antioco with Icahn’s support.  Notably, when Mr. Keyes was hired he was granted 7.8mm stock options with strike prices ranging from $4.50 per share to $6.80 per share.  He was also required to buy $3mm worth of stock in the open market, for which he paid approximately $4.50 per share at the end of July 2007.

The bear case on Blockbuster reasonably considers a broken brand name and an industry steadily whittled away by technologically superior distribution methods.  A long investor must therefore believe in management’s ability to execute on the top and bottom line in the near-term, and transition the business in the long­-­term. A look at Jim Keyes’ background gives us comfort that we have the right captain at the helm.

 

From May 2000 through November 2005, Mr. Keyes served as President and CEO of 7-Eleven, Inc., which operates or franchises almost 6,000 stores in the United States and Canada, and licenses almost 23,000 stores worldwide.  During 2004, 7-Eleven stores worldwide generated total sales of approximately $41 billion.

 

Mr. Keyes is credited with an impressive turnaround at 7-Eleven.  His merchandising strategy involved analyzing point-of-sale data to understand and cater to customer trends within each market.  He also focused on partnering with suppliers to bring new or enhanced products into his distribution system.  Under his stewardship, 7-Eleven maintained remarkably consistent same-store sales growth throughout its footprint.  At the end of 2000 when Mr. Keyes was appointed CEO, 7-Eleven’s equity traded at approximately $8 per share.  In November 2005, a Japanese franchisee tendered for the entire company at $37.50 per share.

 

Mr. Keyes brought Tom Casey, his banker from his 7-Eleven days, to Blockbuster as his CFO. Mr. Casey is a graduate of the Harvard Business School, and had been a Managing Director at Deutsche Bank.

 

Management’s strategy involves significant top-line initiatives as well as taking advantage of opportunities to reduce the company’s significant fixed-cost base without compromising the customer experience.  Top-line initiatives include 1) revitalizing the brand with significantly improved new release stocking and appealing store format upgrades, 2) offering a broader and more fulfilling consumer experience through alternative delivery methods, including digital vending kiosks and in-home download applications, as well as through their existing mail-subscription and bricks and mortar channels, and 3) broadening the merchandise available to its prodigious store traffic, including CDs, magazines, games and game consoles, as well as convenience store snacks and beverages.  Results are encouraging so far. The 3^rd quarter of 2008 represented Blockbuster’s sixth consecutive quarter of improved same-store sales and its third consecutive quarter of video rental revenue growth.  Domestic same-store revenues increased 5.1% during the quarter as a result of a 30.7% increase in same-store merchandise revenue and a 0.8% gain in same-store rental revenue.

 

Management is taking advantage of a range of opportunities on the cost front as well.  In addition to closing underperforming stores, significant savings can be realized from lease renegotiations and optimizing its Total Access online/in-store product.  The company has closed 326 stores since the 3^rd quarter of 2007 – resulting in not only improved EBITDA but also improved liquidity, as the letters of credit securing those leases were freed up.  Blockbuster is in a strong negotiating position in reducing its lease expense.  As the anchor tenant on many of its properties and with an average 2.5-year lease across its network, management believes that a number of landlords would be willing to lower their lease charges by well over 10 percent.  Finally, management believes that their Total Access program is costing the company $80mm annually by requiring excess inventory.  They believe this can be managed down significantly through pricing and program adjustments.

 

Current Debt:

There are 125.4mm Class A shares and 72mm Class B Shares outstanding.


Valuation

The latest balance sheet is arguably a very conservative view of the company as 1) the third quarter is seasonally high in working capital cash drain, and 2) significant additional DVD and other merchandise stocking investments have just been made. 

 

Using $1BB in net senior claims and 200mm shares priced at the Class B price of 47 cents, we have a total enterprise value of $1.1BB.  It now seems very likely that 2008 EBITDA will comfortably exceed $300mm, and management believes they have many levers to drive EBITDA toward $500mm over time.  Through the Class B shares, the enterprise is therefore trading below 3.7 times a conservative, growing EBITDA estimate.

 

Using a 2009 EBITDA estimate of $315mm and defining free cash flow as EBITDA less interest, preferred dividends, cash taxes, and maintenance capex, we get a forward free cash flow estimate of $315mm less $70mm less $11.5mm less $28.5mm less $75mm, or $130mm. With the B shares trading at 47 cents, the company’s equity market cap of $94mm is valued at significantly less than one times next year’s free cash flow.

 

 

1.      Business falls off a cliff with other retailers, the expected positive cash flow in the 4^th quarter doesn’t materialize, and the banks refuse to refinance next August.

 

2.      Alternative delivery technologies are adopted faster than expected, and management doesn’t have enough time to complete transition plan.

 

3.  The company’s “Plan B” strategy is either insufficient to cover the cash drain on the business or impacts the consumer experience to the point of doing long-term damage to the brand.