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Get Four
|  | DECEMBER 9, 2004
By Ronald Grover Hollywood Video's Hot Sequel Despite recent setbacks, potential acquirers like Blockbuster are lining up. But even a merged video chain faces big challenges Never count out second acts in Tinseltown. An attempt by Hollywood Entertainment (HLYW ) founder and CEO Mark J. Wattles and investment bank Leonard Green Partners to take the company private foundered amid increasingly gloomy growth prospects. But only months later, the company and its Hollywood Video chain are suddenly generating as much interest as a hot new DVD. Since Wattles and his private-equity partners cut their bid from $1 billion to about $700 million on Oct. 14, Hollywood rivals Blockbuster (BBI ), the largest retail video chain, and No. 3-ranked Movie Gallery (MOVI ) have both tendered offers for the outfit. The Wattles-Leonard Green group is still pitching. And even Carl Icahn, the veteran '80s dealmaker, has expressed interest. In a Nov. 16 Securities & Exchange Commission filing, he said he had bought an 8.4% stake and might consider buying more. A special panel of the Hollywood Entertainment board was expected to ask for final bids on Dec. 8, with a decision due in a few days. Wattles would not speculate on the timetable. "TIME TO REGROUP." Why all the interest in a retail segment that's rapidly losing share to the likes of Wal-Mart (WMT ), Best Buy (BBY ), and Target (TGT )? For Blockbuster and Movie Gallery, the move is clearly defensive. Both chains are betting that linking up with Hollywood Entertainment would help them stave off the competition, not just from big-box retailers but such new players as online video service Netflix (NFLX ), too. "It gives them time to regroup," says Wedbush Morgan Securities analyst Michael Pachter. And Icahn? He isn't saying, but if history is any guide, the wily investor may want to get hold of a company that's still generating an estimated $15 million of free cash flow per month. Make no mistake: Stand-alone video chains have plenty of problems. Over the past six years or so, Wal-Mart, Best Buy, and Target together have grabbed 29.8% of the $24.7 billion market for video sales and rentals, according to Video Store Magazine. They've done it as they have in so many other niches -- by undercutting the competition on price. MORE BUYING POWER. They've also proved that movie fans often are more interested in buying DVDs than renting them -- a shift that most video chains were late to exploit. At the same time, Netflix has shown that demand is strong for rental movies online, another place where the original players have lagged. But would putting together two ailing video chains add up to a company better equipped to compete? Clearly, there are potential benefits -- chief among them cost savings. A Blockbuster-Hollywood Video merger would give the combined stores as much as 60% of the rental market, while cutting $57.5 million in overhead, figures Bear Stearns (BSC ) analyst James Hurley. A Hollywood Video-Movie Galley combo would have 20% of the rental market and unspecified other savings, he says. The increased heft would also give the resulting combination more buying power. That would allow it to better compete on price with Wal-Mart and others in the home-video business, which is expected to grow to $55 billion a year by 2008, up from $37 billion today, according to Veronis Suhler Stevenson. And as Blockbuster builds an online service to catch up with Netflix, which now has 2.5 million subscribers, it could use Hollywood Video's customers to beef up its six-month-old online offering. Even without Hollywood, that service is closing in on 1 million subscribers, Blockbuster has said. REAL LIFE VS. MOVIES. Hollywood Video's juicy cash flow could come in handy, too, providing an acquirer with the financial wherewithal to move into promising new segments. Both Blockbuster and Hollywood Entertainment have small but growing sections that buy and trade video games, for example. Already, that business accounts for an estimated 30% of Blockbuster's revenues. Analysts figure it could see 9% average annual growth over the next five years. Still, to take on Wal-Mart, Best Buy, and others, a newly merged video chain would need to execute perfectly. And no matter how well it did so, it would still need to figure out how to deal with an array of new video-delivery systems, ranging from the video-on-demand already offered by cable operators to broadband movie downloads. It's the typical Hollywood story. The down-and-out hero comes back to battle the rival. In real life, however, sometimes the rival wins.  Grover is BusinessWeek's Los Angeles bureau chief
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