John Palys William Hetfield Ariana Schuster April 20, 2005

Blockbuster Inc.

Table of Contents

Executive Summary ...... 3

Company History ...... 4

Competitive Analysis ...... 7

Industry...... 7

Entry ...... 8

Substitutes and Complements...... 8

Buyer and Supplier Power...... 9

Financial Analysis ...... 11

Key Issues and Solutions...... 14

Conclusion ...... 17

References ...... 18

SageGroup, LLP 2 Blockbuster Inc.

Executive Summary Blockbuster Inc. thrived throughout the 1990’s as the video rental industry grew, with VHS tapes the dominant format and VCR’s in the majority of American households. The introduction and spread of new technologies, however, has in recent years caused the rental industry to stagnate and even recently contract. The DVD format has seen relatively far more sales than rentals compared to VHS tapes, and pay-per-view, video-on-demand, and the ever-expanding number of choices on cable television have hurt the traditional rental model. These problems, combined with costly introduction of new initiatives aimed at changing that rental model, have led to large financial losses for the company in the last two years. Early this year, the company failed in its bid to acquire Hollywood Video, Blockbuster’s closest rival in in-store rentals. All these issues have raised questions regarding Blockbuster’s viability as a major entity in the broader home entertainment industry. Despite the expectations of a continued decline in Blockbuster’s traditional operations, we believe the company can return to enjoying sustained growth by shifting its brand image towards attracting internet users and technologically savvy consumers of home entertainment. Furthermore, we believe an expanded and better integrated trading model for used titles can allow Blockbuster to take advantage of the growing secondary market in DVD and video game sales.

SageGroup, LLP 3 Blockbuster Inc.

Company History Blockbuster’s history can be traced earliest to the formation of Cook Data Services by David Cook in 1982. Founded in Dallas, Tex., to perform data services locally for the oil and gas industries, Cook Data Services struggled as those industries became increasingly irrelevant in Dallas. By 1985 Cook sold his software business, and in October of that year opened the first Blockbuster Video store, which had an inventory of nearly ten times its nearest competitor. Cook used barcode technology, combined with his software expertise, to create a state-of-the- art inventory system that made transactions much faster for customers than was typical of contemporary video stores and reduced inventory tracking costs. By 1986, Cook had expanded to four locations in the Dallas area and officially named his company Blockbuster Entertainment Corporation. In 1987, Wayne Huizenga headed an investment group which injected over $18 million into Blockbuster, which had actually suffered losses of over $3 million in 1986. By the end of 1987, Huizenga’s group had managing control of the company and Cook was no longer associated. Huizenga’s vision for the company involved majority company ownership of rental stores, whereas Cook had foreseen operations as primarily franchised. With Cook out of the picture, Huizenga began buying back some franchises, aiming for 60 percent company ownership, and also began a major expansion undertaking in which it purchased several existing video rental chains. Blockbuster increased sales nearly sixfold between 1986 and 1987 with this expansion. Huizenga also oversaw the move of corporate headquarters from Texas to Ft. Lauderdale, Fla. In 1988, Blockbuster continued expanding by buying more and increasingly large video rental chains. Some it operated, while others, such as those resulting from a deal with United Cable Television Corporation, were franchised. By the end of the year, Blockbuster had 415 stores and was easily the largest video rental chain in the country. Expansion within the U.S. continued rapidly in 1989 and 1990; by the middle of 1990, Blockbuster was expanding at the rate of one new store per day, and it had a total of well over 1,000 stores. Blockbuster’s last major acquisition, and the largest in its U.S. history, was of Erol’s, a rental chain of over 200 stores. In the early 1990’s, Blockbuster’s major undertaking was foreign expansion. In addition to opening stores in countries as diverse as Japan, Chile, Spain and New SageGroup, LLP 4 Blockbuster Inc.

Zealand, Blockbuster undertook a major expansion effort in Britain, seeking to become the largest video rental retailer there. That goal was accomplished in 1992 after the purchase of 875-store Cityvision, the country’s largest such chain at that time. In December of 1992 Blockbuster began a major domestic undertaking by buying music retailers Sound Warehouse and Music Plus, and thereafter creating Blockbuster Music stores. This diversification effort was coupled with further expansions into video game, software, and virtual reality. These efforts, as well as Blockbuster Music, were not particularly long-lived. Another major acquisition was of rights to Republic Pictures and Spelling Entertainment features, which included libraries of classic films and television programs. An unsuccessful period for Blockbuster began at least as early as Viacom’s 1994 takeover. With the merger, Huizenga stepped down and was replaced by Steven Berrard, who presided over unsuccessful attempts to further expand geographically. By the time Berrard was replaced in 1996 by Bill Fields, Blockbuster’s stock was at half its 1993 price, and Viacom’s had also slipped significantly. Fields’ tenure as CEO was hardly more successful. His major undertaking was an attempt to revise Blockbuster’s image to fit that of a “family entertainment center” with video rental as just one part. The company also closed several stores and downsized about two-thirds of total staff, while moving corporate headquarters back to Dallas. In 1997, Fields stepped down and was replaced by John Antioco, who scaled back many of Fields’ efforts and focused on video rental as the centerpiece of Blockbuster. He oversaw updates to the inventory tracking system and helped further streamline the distribution center in Dallas. His major achievement, however, was a revenue-sharing agreement with the major Hollywood studios, by which Blockbuster could purchase videos at a fraction of what it was previously paying. The studios would then be entitled to a percentage of Blockbuster’s rental revenue. Additionally, Antioco oversaw the sale of Blockbuster Music in 1998, returning Blockbuster primarily to a video rental business as he had intended. In 1999, Viacom, having announced intentions to divest itself of Blockbuster, made an initial public offering at $15 per share and raised $465 million. 1999 also saw the first of three partnerships. First, it teamed with AOL, which invested $30 million into Blockbuster with the purpose of developing online broadband content.

SageGroup, LLP 5 Blockbuster Inc.

In 2000, a partnership with food.com was forged to attempt to create a joint food- movie home delivery service. That year Blockbuster also allied with DirecTV to begin joint branding of the latter’s pay-per-view home movies and programs. Later, in 2002, Blockbuster would team up with Coca-Cola to advertise and sell its products in Blockbuster stores. By late 1999, Blockbuster was moving decisively towards DVD’s as the dominant rental medium rather than VHS cassettes. This continued with the introduction of Nigel Travis as president and COO, who also pushed the company further into DVD sales in addition to rentals. It found out fairly quickly, however, that these efforts were undermined most directly by broader retailers such as Best Buy, Wal-Mart, etc., which have had a significant cost advantage over Blockbuster in retail. By the end of 2004, however, Blockbuster had eliminated VHS sales from its stores in order to focus its retail operations on DVD’s. Also in 2004, Viacom finally sold its controlling stake in Blockbuster. At the end of the year, the company announced the elimination of late fees in most markets would take effect in 2005, to be replaced by a ten-day grace period, after which the customer is charged for the entire price of the tape or DVD. With the introduction of this program and loss of late-fee revenue, major operating losses are expected in 2005 as was the case in 2004. The company hopes that eventually, however, customers will rent more titles and more frequently with the new policy.

SageGroup, LLP 6 Blockbuster Inc.

Competitive Analysis

Industry Blockbuster is by far the leader in market share for home entertainment rentals, with total revenues at more than triple those of its nearest competitor, Hollywood Video. There are a few main firms in the in-store rental market, particularly Blockbuster, Hollywood, Movie Gallery, and Video City. In addition to these, however, there exist many independent rental stores, as well as local and regional chains, to provide significant competition. Complicating the analysis is the expected merger between Blockbuster’s two biggest competitors, Hollywood and Movie Gallery. Blockbuster had responded to Movie Gallery’s initial merger proposal by attempting a hostile takeover of Hollywood, but a Blockbuster- Hollywood combination would result in a market share over 50 percent, a likely obstacle in gaining Federal Trade Commission approval. Blockbuster thus dropped its bid. A more important development with respect to the in-store rental market is its overall decline over the last several years, including an 11 percent drop from 2003 to 2004 alone. (Adams, 2005; Blockbuster’s estimate is closer to five percent) With the new Movie Gallery-Hollywood combination expected to be entrenched in in-store rental operations for the foreseeable future, they may attempt to more aggressively take market share from Blockbuster, especially as the latter is focused on expanding its online subscription rental services. This could result in increased price competition, or, more importantly, expansion into new stores by Movie Gallery/Hollywood. The latter strategy would be of particular importance to the market because of Blockbuster’s current geographical predominance, with about 8,000 domestic stores. If new Movie Gallery/Hollywood stores are opened up in areas previously dominated by Blockbuster’s presence, switching costs would greatly decrease for consumers. In addition to in-store rentals, Blockbuster has created an online subscription rental service in the model developed by Netflix, which still controls 85 percent of the online rental market, with Blockbuster second at 11 percent. Wal-Mart offers a similar program which is price competitive but holds very little market share. With almost purely identical products between Netflix and Blockbuster, (although

SageGroup, LLP 7 Blockbuster Inc.

Blockbuster has now begun tying some in-store privileges into their service) – with each allowing three titles to be held by renters at once – price competition would be expected, and Blockbuster now charges $14.99 per month, compared to $17.99 for Netflix. Internet giant Amazon has also indicated that it add video rentals to its operations, adding another major competitor.

Entry There are significant barriers to entry into the in-store rental market. The first factor creates economies of scale in adding to and maintaining a library of video titles. Specifically, the computing technology of video inventory tracking used by large firms like Blockbuster and Hollywood makes it easier to maintain supplies of popular titles and keep track of how popular particular titles are. Second, the major film studios have entered into profit-sharing agreements with Blockbuster, Hollywood, and Movie Gallery that allow them to purchase new releases in large quantities, which has allowed longer rental periods for those titles. With respect to the online rental market, the main barrier to entry is the cost of purchasing a vast library of titles and copies. When Netflix invented the online rental model in 1997, it rented exclusively DVD’s which at the time were still relatively novel. They have been able to build a large library (although one reputed to have fewer copies of new releases on hand than Blockbuster) by growing steadily since then. For new entrants like Blockbuster and potentially Amazon, their initial positions as video rental giant and online retail giant, respectively, facilitate entry.

Substitutes and Complements The increasing number and decreasing price of substitutes to rented video content is the biggest problem facing Blockbuster and other rental firms today and for the foreseeable future. First, the purchase price of DVD’s is cheaper than ever, especially with discount retailers such as Wal-Mart and Amazon offering many new titles for less than $15. A rapidly increasing trading and resale market for DVD’s has also had a negative effect on demand for rentals. This refers to consumers’ selling DVD’s that they had previously purchased to rental stores, used video retailers, or directly to other consumers, which has been made increasingly easy by internet auctions and resale sites.

SageGroup, LLP 8 Blockbuster Inc.

Other channels for home entertainment are also being created, enhanced, and more competitively priced as technological advances are made. The cost of pay-per-view movies on cable and satellite television systems is lower than ever, and since most of these can be purchased with a remote control, searching costs are virtually zero. In addition to pay-per-view, the expansion of cable and premium television to include a wider variety of specialty channels and, more importantly for rental firms, more movie channels, have decreased the demand for rented media. The availability of digital recorders like TiVo has allowed many consumers to record what they watch on television, allowing for an even closer substitute for a rented video. Video-on-demand is another new innovation which is likely to pose a threat to demand for rented content in the near future. Consumers can directly download content via the internet or their cable or satellite system with VOD, but its use remains very limited at this point. Netflix, however, has announced intentions to begin offering VOD over the internet at some point in 2005. The benefits to the rental market of decreases to prices of complements – specifically DVD players – appear to have stagnated somewhat, if not been eliminated by cheaper DVD sales and the increase in DVD trading. The rapid growth of households buying DVD players has slowed, and many households, perhaps attracted by the increases in special features and extra content on DVD’s, are choosing to build their own libraries of collected DVD’s rather than rent and return them.

Supplier and Buyer Power Supplier Power The major film studios have considerable supplier power in the rental market. As copyright owners of the rental market’s product, the studios are able to extract considerable profit from the rental industry. Specifically, the profit-sharing arrangement that began in 2000 gives 60 percent of the profits from the new- release period to the studios, and half of the profits from used tape and DVD sales. The exclusivity of this arrangement has also been a major obstacle for small chains and independent stores to enter the market. In fact, some class-action and anti- trust suits against the studios are still pending. For online rentals, the paradigm seems to be somewhat different. Netflix in particular engages in a sort of hybrid system of purchasing and profit-sharing in SageGroup, LLP 9 Blockbuster Inc. which it buys discounted “rental-only” DVD’s which cannot be resold and shares a smaller percentage of end profits with the Hollywood studios. Blockbuster may be able to benefit from their previous arrangement, since it still need not purchase titles at the outset. Buyer Power Because of the tiny portion of revenues that each individual consumer comprises in the video rental market, there is virtually no buyer power for consumers. One possible exception to this is consumers’ ability to respond to false or misleading advertising through class-action lawsuits. Specifically, Blockbuster’s failure to make completely clear the details of its new “no late fees” policy, in which a renter must pay the full purchase price of the item if it is not returned within a week, recently led to a settlement with aggrieved consumers.

SageGroup, LLP 10 Blockbuster Inc.

Financial Analysis Blockbuster has sustained operating losses of over $2 billion in the last year, and is expected to again sustain losses for 2005. This is due to two main factors. First, the company’s new “No Late Fees” policy has entailed a significant advertising campaign and major costs of switching to the new system, while also projecting rental revenue decreases of $250 million for 2005 from lost late fees. The company expects to offset this in the long run as customers rent more titles and more often. Second, the entertainment rental market has been shifting away from Blockbuster’s main operations – in store video, DVD, and video game rentals – towards pay-per- view, Video On-Demand, and internet-based DVD and game rentals. In 2004, Blockbuster began offering an internet rental service similar to Netflix, in which customers select titles online, receive them through the mail and return them at their leisure. Recently, Blockbuster attempted to acquire Hollywood Video, Blockbuster’s current runner-up in in-store rental revenues. Initially, Movie Gallery, currently third in the in-store rental market, bid $13.25 per share of Hollywood stock, to which Blockbuster responded with an offer of $14.50. This attempted takeover was opposed by Hollywood’s board of directors, and, feeling it unlikely that the FTC, which may well have determined that the potential domination of the in-store rental market the takeover would have created would not be sufficiently offset by competition from independent stores and online rental services such as Netflix, Blockbuster dropped its bid. In addition, some analysts are simply wary of an expansion of participation in a market – that for in-store video, DVD, and game rentals – that appears to be on the decline. The uncertainty over both the future Hollywood/Movie Gallery combination and the rental market overall complicate the value analysis. In the model used, growth estimates used as assumptions are fairly conservative, are and based to some degree on projections already made by Blockbuster. The company has said it expects revenues to decline by $250-300 million for 2005 due to lost late fees, a result of the new “no late fees” policy. This is reflected in a -5% growth rate from 2004 revenues. As customers become used to the policy, however, more overall rentals are expected; additionally, the company’s online rental program, a la Netflix, is expected to grow. We resultantly

SageGroup, LLP 11 Blockbuster Inc. assume 6% revenue growth from 2005 revenues, and 4% from 2006. The long- term revenue growth rate for Blockbuster is projected at 3%. With an expensive advertising campaign for the “no late fees” policy, as well as significant switching costs to the new system, expenses are projected to be abnormally high for 2005. Structural switching costs are included in the 8% growth of “Selling, General and Administrative” expenses, while costs of adjusting to the new system for employees are in “Costs of Revenue,” which are projected to return to normal by 2007. Also included is a “non-recurring” expense of $1 billion. This is in following of a company trend that has seen goodwill decline by at least that amount in each of the last three years. Overall, we see that Blockbuster’s value is dependent on at least a moderately successful increase in revenue growth resulting from the “no late fees” program, as well as a sustained overall rental market. If this does not occur, Blockbuster is unlikely to be able to maintain revenue growth through sales, as it already faces difficult price competition in this market from large retailers.

SageGroup, LLP 12 Blockbuster Inc.

Comps:

SageGroup, LLP 13 Blockbuster Inc.

Key Issues and Solutions

Despite continued increases in overall consumer spending for home movie viewing, the video rental industry is in a state of decline. Rental industry revenues declined from $8.2 billion in 2003 to $8 billion in 2004, and are projected to continue to decrease. Kagan Research projects these revenues at $6.3 billion for 2009. To this point, the main driver in this trend has been the increasing affordability of DVD’s for purchase, a shift from the VHS period, in which most videos had a very high initial rental price, and would only at a later date be priced for retail. Today, movie studios engage in “sell-through” pricing of DVD’s, and as a result more consumers are buying rather than renting movies once their exclusivity to theaters has ended. Other formats for home video entertainment (e.g. pay-per-view, video-on- demand), while still a small portion of industry revenues ($1.1 billion of $25.1 billion total sales), are also expected to grow, particularly as existing technology spreads and improves and new technology is developed. Video-on-demand (VOD) may be the most important of these technologies, as it currently remains in limited use but is capable of most of the features DVD’s provide. Digital recorders (e.g. TiVo) must also be considered as their use becomes more widespread, since digital recordings of movies on cable television are such close substitutes to rentals. These trends point to a continuing decline of the home entertainment rental industry, and this is the primary problem facing Blockbuster at this time, particularly since traditional in-store rentals are still its core business. In part resulting from a declining rental market but primarily due to investment in new programs and initiatives, Blockbuster sustained large losses for 2004. Combined with a failed bid to acquire its closest in-store competitor, Hollywood Video, this gave some a pessimistic view of the company. Leading shareholder Carl Icahn has publicly demanded that corporate management curb advertising and implementation spending on new initiatives and instead allot those cash flows to shareholders’ dividends. He has also implied he may attempt to take over the company in the foreseeable future. Although some outsiders have suggested possible exit from traditional in-store rental operations and Blockbuster stores are typically located in desirable strip mall-style shopping centers, the company primarily leases those properties on a five to ten-year term, making such exit SageGroup, LLP 14 Blockbuster Inc. unfeasible in the short run. And with new initiatives as well as a sizable remaining core of home entertainment renters, Blockbuster stores can remain a significant and even primary source of company revenues. Among Blockbuster’s recent initiatives is its “No Late Fees” program, in which traditional late fees were replaced by a system in which titles seven days late would be automatically billed at the full purchase price (or pay a restocking fee upon return), was introduced in part to reduce the effectiveness of competitors’ advertisements highlighting their own lack of late fees. The new program imposes de facto late fees, however, and the company has been forced to settle with aggrieved customers who were unaware they would, after the seven-day grace period, be forced to pay at minimum a restocking fee. Moreover, despite a national advertising campaign for the program, not all stores are participating, particularly franchisees (approximately one-sixth of Blockbuster stores are franchised) who do not wish to forgo the revenues generated by the traditional late fees. Reflecting these problems, as well as shareholder concerns over excessive spending, it is our recommendation that costly advertisement of the “No Late Fees” program be eliminated. We believe that a more general transition from Blockbuster’s image (described more fully below) as a video-rental store to a more comprehensive video entertainment network can encompass the change in rental policy. Moreover, loud claims regarding the “end of late fees” are likely to do more harm than good to brand image if seen as disingenuous. The larger problem facing Blockbuster is the overall decline in the rental industry. We recommend a three-tiered approach to this problem. First, continue to aggressively compete with Netflix, the current leader in internet-based rental subscriptions. Blockbuster entered this market in 2004 and has quickly built a customer base of over 750,000 and expects this to reach 2 million by the end of 2005. This recommendation reflects the growth of online subscription services both overall and as a share of the rental market. It is also through the internet that emerging technologies, particularly internet-based VOD, can be best offered to customers. Netflix has already announced plans to add VOD to its offerings, and we recommend that Blockbuster do the same. Second, begin to phase out franchised stores, particularly those that have been unwilling to participate in the company’s updates to pricing and viewing policies. This recommendation reflects the company’s transition into what it has

SageGroup, LLP 15 Blockbuster Inc. openly called the “new” Blockbuster, in which traditional in-store video rentals are only a part. Besides just the “No Late Fees” problem posed by nonparticipating franchises, we believe new initiatives will require universal store participation for the shift in brand image to take hold. For example, Blockbuster offers two in-store rental coupons for online subscribers. It is important that these coupons be redeemable at all locations to maintain brand image. To further this, we finally recommend that Blockbuster expand its “trading model” beyond what it has publicly announced. Besides offering store credit for used DVD’s (as well as video games), we recommend moving towards a trading network model, in which customers could create a list of titles they wish to rent or buy used, while at the same time offering titles they own and wish to sell. Blockbuster, meanwhile, could act as an EBay-style intermediary for internet based transactions, while offering store credit and internet-based purchasing or renting credit for sales of used titles made in-store. Involvement of all stores would be particularly important for the brand to become associated with this network-based approach.

SageGroup, LLP 16 Blockbuster Inc.

Conclusion The decline in the traditional video rental market is just one aspect of the significant shift seen in the home entertainment industry in recent years. More important for the future of Blockbuster are the burgeoning parts of this market. Specifically, DVD sales, the emergence and expansion of new technology, and a shift within the rental market towards internet-based subscription services, are the most important factors affecting Blockbuster in the near future. We believe the company’s move towards establishing itself as the “new Blockbuster,” combining a brand image makeover with expanded internet-based operations, a more active “trading model” for used titles, and is a positive step in adapting to these changes. We recommend furthering this change by continuing to aggressively compete with Netflix on both price and content (including adding internet VOD to offerings within the year), taking over or phasing out franchised stores that do not wish to participate in the alterations to the business model, and expand and integrate the trading model to combine stores with internet operations and generally move towards a more comprehensive trading network for used titles. In summary, Blockbuster is capable to regaining the stature it once held in the home entertainment industry, but this will not occur through the same operations that drove its remarkable growth in the 1990’s. Instead, adapting to a marketplace in which consumers are increasingly demanding ease and simplicity through internet transactions and associating the brand name with innovative technology and business methods can allow Blockbuster to re-establish a leading presence in a home entertainment industry that seems likely to continue growth in the foreseeable future.

SageGroup, LLP 17 Blockbuster Inc.

References Adams Media Research, “The Future of Video Rental: A Strategic Analysis.”

2005, cited in Sporich, Brett, “2004 Home Video Wrap.” Available:

www.thehollywoodreporter.com, 2005

Blockbuster Inc. Annual Company Report. U.S. Securities and Exchange

Commission: 2005

The Wall Street Journal. Various articles: New York, 2005

Yahoo! Finance. Available: finance.yahoo.com

SageGroup, LLP 18