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Less than a decade ago, the video-rental business was a hot-growth industry. On Main Street USA, the video store quickly became as ubiquitous as the neighborhood diner and dry-cleaner. But then the Internet arrived and started to threaten the video-rental industry.
That was bad news for Blockbuster Inc. (
BBI) and even worse news for its shareholders. The hardest hit was Viacom Inc. (
VIA), which owns 80% of Blockbuster's shares. Today, Blockbuster's stock price is languishing at $10.94, which gives it a market capitalization of only $1.9 billion. Pretty darn low for a company that made $4.5 billion in sales last year.
Investors appear to think it deserves such a valuation because the company's core business -- renting videos -- faces eventual extinction as broadband Net access starts becoming a reality across the land. Soon consumers will be able to download the movie of their choice over their cable modems and watch it whenever they want. That eliminates the drive to the video store and the need to return the movie.
PAY-PER-VIEW PLAYER. The good news is that Blockbuster has finally identified the threat and seems to be -- for the first time -- adjusting its ways in response. "They haven't just turned the corner," says PaineWebber analyst Aram Rubinson, who has a buy rating on the company. "They've built themselves a new corner."
The centerpiece of Blockbuster's strategy is to establish its brand name in the pay-per-view field. This business, expected to be worth $10 billion a year next year, according to CEO John Antioco, is growing rapidly as cable and satellite subscribers get used to ordering movies over their TVs. But more important, the move gets Blockbuster a foot in the door for the next generation of pay-per-view, which will use the Net to deliver the Holy Grail of at-home-entertainment: movies on demand. If Blockbuster can somehow be a part of this new technology early on, it'll open up all kinds of revenue opportunities.
To establish the Blockbuster brand in pay-per-view, the company has entered into strategic partnerships with several major players in the industry. By far the most significant agreement is with DirecTV, the satellite-TV company. In return for branding the pay-per-view channels with the Blockbuster logo and sharing some of the pay-per-view expenses and revenue, Blockbuster will sell DirecTV equipment in its stores.
ONE BIG HOLE. In addition, a possibly far-reaching deal was recently reached with Enron Broadband Services, which will allow Blockbuster to supply videos on demand via the Net to Enron customers. Enron (
ENE), which owns one of the largest fiber-optic networks in the world, will be one of the first communications companies to launch a widespread video-on-demand service. Blockbuster can score big if the program is a success. A smattering of other deals, including a partnership with America Online (
AOL), could add to Blockbuster's momentum into the online world.
Still, the strategy has one huge hole: cable TV. Blockbuster has yet to make an agreement with AT&T (
T) or any of the other major cable players to provide it with access to cable lines, which could become the dominant means for consumers to get broadband access. If Blockbuster continues to be shut out of the cable business, its plans for interactive TV could get stymied. But the company does always have its video revenue to fall back upon.
Rather than tumbling, as many expected with the emergence of the Internet, video sales have continued to climb, albeit slowly, the past few years. Since 1997, Blockbuster's revenue has grown about 15% each year, almost all of that coming from video rentals and sales. The company surprised investors with its second-quarter earnings report, released on Aug. 1, when it announced a gain of 8 cents per share. Analysts who follow the company expected it to earn only 6 cents per share. Even more exciting than the better-than-expected earnings was the increase in same-store sales. Compared to the second quarter of 1999, Blockbuster's existing stores increased sales 11% in the same period this year.
GLOBAL BUILDUP. Leading the charge was a dramatic jump in DVD sales and rentals, which now account for 7% of overall revenues. "The numbers are excellent," says analyst Maureen McGrath of ING Barings. "There is good momentum in the core video business, and DVD is building at a greater rate than the industry expected."
The greatest challenge facing management now will be to consistently deliver profits, quarter after quarter. The recent quarter was only the second one in the past three years that hasn't produced a loss. The good news is that previous losses were usually due to heavy capital spending on new stores. Blockbuster continues to expand aggressively internationally -- it built 127 outlets in the second quarter, many of them in Latin America -- but it was able to make a profit anyway. In fact, its biggest money-losing unit was the new interactive division. If you exclude that subsidiary's costs on Blockbuster's earnings report, the company would have produced 24 cents per share in profits.
With such a stable revenue stream and a relatively bright online future, it's surprising that Blockbuster still sells for a price-to-2001 earnings ratio of 13. The company's stock has recovered 20% from its June low of $8.88. But it could still be a slow, steady climb before it starts to fulfill its potential. For one thing, CEO Antioco has already warned that the third quarter could be a rough one, thanks to a scarcity of big movie titles coming out on video the next three months.
Blockbuster will also have plenty of potholes to steer clear of as it merges onto the information highway. That's why PaineWebber's Rubinson has his optimistic sights set low. His price target on the stock is $15. "I think this one needs to walk before it runs," he says. But for a company that once appeared destined for the cutting-room floor, the outlook is far from gloomy.
Jaffe writes about the markets for Business Week Online
What are your thoughts on Blockbuster's future? Join in the discussion at our Ask Sam Jaffe Forum Edited by Beth Belton
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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