Blockbuster Charts Course to Digital Age

By DAVID KOENIG
AP Business Writer
November 17, 2007

DALLAS -- In his corner office 32 floors above downtown, Blockbuster CEO James Keyes pulls out his phone and starts up last year's Oscar winner, "Crash," to demonstrate his vision of the movie-rental giant's future.

Customers, he said, will someday soon go to kiosks in Blockbuster stores to burn movies on to a disk or download them directly to phones or other devices.

Technology is usually seen as Blockbuster Inc.'s enemy. Why would anyone drive to a store when they can order online and have movies mailed to their home or transmitted straight to their television set by video on demand?

Keyes said store rentals will be an important part of the business for at least five more years. And if Blockbuster can remain the world's biggest movie-rental company during that time, it will be in stronger position to lead when viewers routinely download films, he said.

"This is an industry in transition and a company that hasn't been able to keep up with that change," said Keyes, named CEO in July. "But Blockbuster is one of the best-known brands in the world. We've just got to find ways to use technology to make the company more relevant."

With nearly 8,000 stores, Blockbuster is synonymous with renting movies. But it lost more than $4 billion from 2002 through 2005. The Dallas-based company eked out a $54 million profit in 2006, but it lost money amid further sales declines in the first nine months of this year.

In an Associated Press interview, Keyes outlined steps the company will take by early next year as part of a plan to shore up its rental business and increase retail sales:

* In the next few months, Blockbuster will test new store layouts with kids' areas and beverage bars. It will also test "various forms of price increase," including incentives to return DVDs sooner -- although Keyes was careful not to call them late fees.

* Some stores will get kiosks that eventually could be used to download movies, although their functions will be more limited at first.

* Using a movie-download company that it just bought, Blockbuster will begin transmitting movies to customers' PCs.

* The chain will test new sales of small electronic devices, soundtrack CDs and books to reduce its dependence on the stagnant movie-rental business.

Allen Klose, a former Blockbuster marketing executive, said the company has had mixed success with previous efforts to sell products, going back to the mid-1990s. He said the company hasn't changed consumers' expectation that Blockbuster is just a place to rent movies.

Keyes, a former 7-Eleven Inc. CEO, will also have to steer the $5.5 billion company around immediate dangers, including financial losses, junk-status debt, and a setback in its mail-delivery rental business.

Last week, Keyes got his first chance to explain his vision of Blockbuster to investors at a meeting in New York.

It did not go well, judging from the stock market reaction.

Blockbuster shares dropped 17 percent in three days, to around $4 -- about the price of a 2-day movie rental.

Analysts said Keyes did a poor job of explaining how the company will overcome short-term challenges.

It's hard to think of a major U.S. corporation whose demise has been predicted more often than Blockbuster. Since peaking in 2004, Blockbuster's sales have slipped each year, and same-store rentals eroded.

Executives often blamed a weak lineup of movies released on DVD, but that didn't explain how Netflix Inc. grew into a 7-million subscriber competitor by taking rental orders on the Internet for mail delivery.

Blockbuster built its own mail-delivery service. But the heavy investment sapped profits and led to an unusual public fight between then-CEO John Antioco and the company's largest shareholder, Carl Icahn.

Antioco left, and other recent departures include the chief financial officer, chief operating officer, general counsel and the manager of the online business.

Keyes said some of Blockbuster's problems were self-inflicted, especially its decision nearly three years ago to eliminate most late fees. The fees once accounted for nearly one-fifth of Blockbuster's revenue, but customers hated them.

Without the onerous late fees, however, customers held on to movies longer -- 5 days on average now, up from 3.6 days. That means Blockbuster can't re-rent popular titles as often, and store shelves are stripped bare of new releases.

Another misstep, Keyes said, was trying too hard to catch up to Netflix. Blockbuster launched a similar service called Total Access, then let subscribers get an unlimited number of free rentals simply by taking their movies back to a store instead of returning them by mail.

Blockbuster figures the freebies cost it $29 million in the third quarter. So many Total Access customers took advantage of the all-you-can-watch feature that the chain's average payment per rental fell to $2.79, nearly a dollar less than in 2004.

One of Keyes' first actions as CEO was to limit the free in-store exchanges unless customers paid an extra $7 per month. Blockbuster lost 500,000 online subscribers over the summer, leaving it with 3.1 million.

Keyes also closed a deal that Antioco had started by acquiring video-downloading service Movielink from a group of Hollywood studios. Movielink lost $10 million on revenue of just $2 million in the first six months of this year, but Keyes said Blockbuster gained digital rights to 6,000 movie and TV show titles.

Arvind Bhatia, an analyst for Sterne, Agee & Leach, said the movie studios tried to sell Movielink for more than $50 million, but Blockbuster ended up buying it for $7.7 million.

"That begs the question where is the (movie-downloading) market today, and how well do the studios see it developing?" Bhatia said. "The answer is, probably not much."

Michael Pachter, an analyst for Wedbush Morgan Securities and bullish on Blockbuster, said DVD rentals will be Blockbuster's backbone for much longer than expected -- maybe 10 to 15 years -- because movie studios will resist downloads, which are less profitable for them than selling and renting DVDs.

Pachter believes Keyes and Chief Financial Officer Thomas M. Casey need to focus more on Blockbuster's short-term issues and do a better job explaining their strategy to Wall Street.

"They need to say 'Rental is here to stay, and we're going to be profitable next quarter,'" the analyst said. "These guys just aren't particularly practiced at articulating a near-term strategy. That makes people sell the stock and ask questions later."