Don’t Touch Blockbuster

Early this month, in the space of a week, two things happened at Blockbuster (NYSE: BBI). First, on August 8 it announced acquiring Movielink for a price that later came to light to be a measly $6.6 million. 10 days later on August 17, COO Nicholas Shepherd and outgoing CFO Larry Zine both unloaded a little over 40% of their holdings in the company.

The stock rose 10% in the last week despite Nicholas’ and Larry’s selling, but that has more to do with JP Morgan increasing its rating on Blockbuster shares to “overweight” from “neutral.”

Movielink’s addition to Blockbuster’s arsenal is promising because its digital movie downloading service plugs a hole for sure. Significantly, the market hailed the move back in March this year scoring a 52-week high for BBI when speculations first emerged about the acquisition.

The advantage with Movielink is that it has license agreements with its five founding studios plus more than 30 other studios, distributors, foreign and independent content providers. The real value is perhaps that Movielink doesn’t introduce another set-top box in the already cluttered mix (although, it is not clear to me that the function of downloading moving can be achieved without adding new storage hardware), yet it provides Blockbuster access to one of the largest libraries of downloadable movies. Personally, I am not bullish about Blockbuster’s prospects in offering downloadable movies. The DNA mismatch is significant, and if they truly want to be in this business, they need a compelling partner who knows how to operate a new-age video-on-demand channel, even if that channel is branded Blockbuster. Movielink, clearly, has not been successful in becoming so. The absence of the set-top box, in my assessment, may be detrimental, rather than beneficial.

Blockbuster’s biggest competitor Netflix (NASDAQ: NFLX) has seen a decrease in new subscribers by as much as 55,000 in the last quarter (Q2-07) (as against an increase of 481,000 in the previous quarter, Q1-07) presumably due to Blockbuster’s Total Access program. Blockbuster, though, is handicapped by a smaller inventory of 40,000 titles as of this year compared to NFLX’s stock of 70,000 movies. There are reports that some of its customers are unhappy with limited movie selection most of which cater to new releases at the expense of more specialized genres such as classics and special interest.

Clearly, there is much catching up for BBI to come near NFLX. However in sharp contrast with NFLX, BBI’s financials do not inspire confidence. Q2-07 total revenue stands at a lackluster $1,263.2 million while total liabilities tower at $1,906.1 million. No wonder the net income is a negative $35.3 million translating to a disappointing –28.20% return on average equity.

BBI has 67,300 employees compared to NFLX’s just 1,300, which means its gross revenue per employee in Q2-07 is a dismal $0.02 million compared to NFLX’s $0.23 million, which is 13 times BBI’s. On the other hand, Blockbuster is a brick-and-mortar business, and a lot of mainstream customers still prefer to go to stores to fetch their movies.

This, however, will change as Generation Y becomes a bigger mix of the consumer base, giving Netflix its clear advantage.

I analyzed Netflix yesterday, and my conclusion is that whichever way you look at it, this video/DVD rental business is a bad business. Low margins, price cutting and consequent erosion makes it virtually a commodity. Against that backdrop, I suggested that Netflix ought to rethink its strategy.

It is evident that Blockbuster has a lot of debris to be cleared. However, I am not sure if the strategy I suggested for Netflix is necessarily the strategy for Blockbuster. For one thing, I have zero confidence in Blockbuster’s ability to execute on a compelling online Web 3.0 strategy. That requires a completely different DNA.

Unfortunately, my guess is that Blockbuster’s woes will continue since they are inherent in their business model, and I would not touch this stock with a ten-foot pole.