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Is Blockbuster doomed?
Video rental chains are cash cows today. But thanks to developments in technology and marketing, they could become dinosaurs more quickly than many investors believe.
By Michael Brush
Fast-forward five years, and you may not have to slog to the neighborhood video store to catch your favorite movie. As home-viewing technology improves -- and gets cheaper -- huge numbers of film aficionados will be picking up flicks in new ways. Among them:
- Regularly downloading movies over the Internet to watch on wide-screen TVs at home
- Paying $20 monthly fees to rent "unlimited" movies that arrive and return by mail
- Selecting from large film menus offered by cable companies in viewing formats that are just as convenient as DVDs and VHS tapes
- Buying DVD movie discs that "self-destruct" 48 hours after they're opened
All of these cutting-edge delivery systems are a lot easier than schlepping back and forth to the video store. They also forever eliminate one of the biggest headaches in renting movies: annoying late fees. Its a dirty little secret of the movie rental business that video stores make a huge piece of their profits from those late fees. Overdue movies cost renters more than $1 billion a year.
It's never clear how fast a new consumer technology will become mainstream. But there's no doubt this revolution is coming, and the momentum could turn fairly quickly. Once the technology and marketing bugs get worked out, alternative home-viewing methods will pose some serious, and possibly devastating, challenges to the home-movie majors: Blockbuster (BBI, news, msgs), Hollywood Entertainment (HLYW, news, msgs) and Movie Gallery (MOVI, news, msgs).
All of this raises a simple question: Why in the world would anyone own shares of these brick-and-mortar video chains right now? The answer: Because these threatened companies are still cash cows at the moment. Theyre perfectly appropriate for nimble traders and money managers who are looking for short- or intermediate-term profits. But for the rest of us -- the everyday investors who are looking to put their money in companies with solid long-term outlooks -- Blockbuster stock is just about as attractive as its video late fees.
Says Rod Wright, a portfolio manager at Pioneer Investments, which owns shares of the company in its Pioneer Mid-Cap Value fund (PCGRX): We are not holding Blockbuster with a 10-year time horizon.
Heres why the challenges to Blockbuster and other video stores may come even sooner than many analysts think.
Downloading movies
With a relatively new computer and a broadband link, movie buffs can download flicks from sites such as Movielink or CinemaNow for $2-$5, and watch them on their computers. Movielink offers about 400 movies, which take a half hour to 90 minutes to download, but you have the option of starting the movie about 10 minutes into the download. Otherwise, the file self-destructs 24 hours after you start watching the movie. Quality is somewhere between that of a VHS and a DVD.
The downside to this format: A lot of people dont like watching movies on computers. But its great for travelers who want to put a movie on their laptop or people who use PCs as their entertainment centers, like college students, says Alan Citron, who handles marketing for Movielink.
As technology advances over the next few years, though, it will become a lot easier to run a movie from your PC to your television. That will make this format a direct threat to home-video chains. Movielink, based in Santa Monica, Calif., has a subscriber base in the low five digits, but it's growing steadily. People seem to like the product, and generally what people want is more, says Citron.
If downloading movies ever really takes off, video rental chains could hop on board the trend and offer a similar service. But theyll have serious problems competing on price since their sprawling brick-and-mortar operations will keep costs high, compared to their slimmer, online competitors.
Movies through the mail
A few years ago, Netflix (NFLX, news, msgs) CEO Reed Hastings returned a video to find he had an enormous, $40 late fee. It ticked him off, to say the least. I didnt want to tell my wife about it, he says. It just sat with me and bugged me. Hastings went a step further than most of us and resolved to do something to make sure it wouldn't happen again. He founded a movie rental business that never charges a late fee.
The result: Netflix, now a company with an $862 million market cap. Netflix customers pay $20 a month for up to four movies ordered online and delivered by mail. Customers can rent more, once they return discs in pre-paid mailers from Netflix. But even if they wait weeks to return movies, they dont pay any late fees.
Netflix offers a deep selection of 15,000 titles, and it has more than 1.1 million subscribers. Our goal is to get to 5 million subscribers by 2007-2009, says Hastings. Since Netflix already has 5% of some markets -- like those in the San Francisco Bay area -- that goal doesnt seem too far-fetched.
With 5% of the nationwide video rental market, Netflix would have its 5 million subscribers. It would also command about $1 billion worth of what is now a $10 billion home-video rental market. (Netflix, based in Los Gatos, Calif., has about $200 million in annual revenue.)
Given that serious movie buffs and high-volume movie renters (essentially the industry's best customers) flock to Netflix, that kind of growth looks like a serious threat to the likes of Blockbuster.
Why couldnt the brick-and-mortar chains simply adopt the Netflix model? Well, theyre doing just that. But there are two huge problems with this copy-cat tactic. First, Netflix won patent protection for its business model of taking orders online and mailing DVDs to customers. To date, imitators such as Blockbuster and Wal-Mart Stores (WMT, news, msgs) havent stolen enough business to make it worthwhile for Netflix to spend the money in legal fees to enforce the patent and shut the copycats down, says Hastings. So we dont really know if the patent will hold up in court. But even if the big video chains successfully challenged the patent and ran a big online-based mail-order business, theyd still have a tough time competing because of their brick-and-mortar overhead.
Video on demand
For years, video on demand (VOD) from cable companies has been the Holy Grail of movie viewers. And for just as long, analysts have been predicting VOD would bring the demise of video rental chains.
Generally, cable subscribers pay $5 to $10 dollars on top of their normal cable bills to get digital capability allowing them to use VOD. Then people might pay $3.95 for recent releases, and $2-$3 for older films. Despite competitive pricing like this, lousy marketing by cable companies (many people dont even know they have VOD), a cumbersome navigation system, and limited offerings have kept VOD from being a real threat -- so far.
Now, though, much of the equipment that cable companies need to deliver a rich offering of movies with VOD is in place. And improvements in storage and file-compression technology around the corner suggest that movie selection will go up, even as the costs of delivering movies in this format come down. Thatll be a big problem for Blockbuster and its rivals.
Right now, for example, the best cable systems offer about 100 movies at a time by VOD. But Sergei Kuharsky, senior vice president for marketing at In Demand, a joint venture managing VOD content for several of the biggest cable companies, predicts that number will grow to several thousand over the next few years. Mike Antonovich, senior vice president for global sales and marketing at PanAmSat (SPOT, news, msgs), offers a similar outlook. "I think you are going to see a tremendous explosion in the amount of content that is out there," says Antonovich. Panamsat collaborates with cable companies by beaming content to cable storage facilities.
Granted these two marketers have a built-in bias, as allies of the cable industry. But since video chains get so much of their revenue from the top 100 or so titles, it wont take much of an increase in the VOD menu size for this format to be a big threat. If you compare what the most regularly rented movies are in video stores to what is available in VOD right now, you find that nearly all of it is available from cable operators, says Josh Bernoff, an analyst with Forrester Research in Cambridge, Mass.
Skeptics claim the real obstacle is that movie studios get so much of their revenue (about 59%) from their cut of the business done by video rental chains. For that reason, they'll be reluctant to double-cross these players, which get exclusive distribution rights for movies fresh off the cinema circuit, typically for around 40 days. But the truth is, the movie studios are going to follow the consumer. And if consumers start watching more movies via VOD, you can bet the studios will support those channels.
We want to get our product into the hands of consumers any way we can, as long as it makes economic sense. So it will be consumer driven, says Blake Thomas, executive vice president of worldwide marketing for MGM. All the studios are pursuing VOD and other alternatives relatively aggressively. They are not stupid. I expect that VOD and other delivery systems will become a significant part of our overall home viewing revenue stream.
One constraint: the limited number of people getting digital cable, the format needed for VOD. Right now, only 20 million out of the 72 million cable households subscribe to digital cable, according to the National Cable & Telecommunications Association. But cable companies have spent $65 billion putting in new equipment in the past five years, says Kuharsky. So 85 million households are now reached by digital cable connections, the kind that allows them to have VOD. Within two years, virtually every household will be reachable by cable connections with digital capability.
Self-destructing discs
Pick up a movie on one of these discs and you have 48 hours before a chemical reaction renders the disc useless; the destruction countdown begins when you open the package. The obvious result: no need to return it. Buena Vista Home Entertainment, a Walt Disney (DIS, news, msgs) division, began test marketing these discs earlier this summer, with technical help from Flexplay Technologies, at a suggested retail price of $6.99.
Brett Sporich, who covers the home video market for Hollywood Reporter, thinks there are still some bugs to work out -- such as making packaging secure enough that it wont be inadvertently opened. And the test market price is too high. But if they can reduce the cost, this could be a threat to the rental industry, he says.
The fight will continue
Your local video store isn't likely to close its doors in the next couple of years. Fact is, most chains are working hard -- and, so far, successfully -- to stay alive and relevant. Most offer video games, for instance, though those, too, could be delivered digitally to the masses.
Perhaps the best hope for Blockbuster and its cohorts is an alternative technology solution, much like the Disney discs. In a few years, you might be downloading movies at your video store from a giant server onto disposable discs youll never have to return. Now, whether you, the customer, will view that as easier, cheaper and otherwise more desirable than instant digital delivery via cable, the Internet or some other method is questionable.
Sure, some people love the thrill of the hunt for rentable movies, much like they groove on cruising brick-and-mortar bookstores for books. Says Saul Berman, an entertainment industry expert with the business consulting services division of IBM (IBM, news, msgs): There is a social element to going to a Blockbuster store that people like.
But then again, there's also a "social element" to spending more time at home with family and friends -- and less at stores like Blockbuster.
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