Davis Freeberg’s Digital Connection

I never thought that Movie Gallery would actually pull it off, but the company may have just saved themselves from bankruptcy for another five years by agreeing to restructure their senior credit facility in a deal with Goldman Sachs. The exact terms of the deal weren’t disclosed, but the transaction is expected to close sometime in the first quater. Like their existing debt, there will be covenants that the company must meet to maintain the debt, but the restrictions on the new debt are likely to be much less restrictive then their current arrangement.

The restructuring comes at a desperate time for Movie Gallery. After borrowing heavily to make an ill advised acquisition of Hollywood Video in 2005, the company soon found themselves in serious trouble as the bottom of the video store market began to fallout. With bondholders getting nervous and the fundamentals of their industry rapidly deteriorating, in early 2006, Movie Gallery was forced to convince debt owners to renegotiate the covenant terms on their debt. The move bought Movie Gallery an extra year to help figure out how to turn their firm around, but as 2006 dragged on, liquidity concerns continued to intensify for the company.

In November of last year, things got even worse. Movie Gallery was forced to delay their quarterly earnings filing for almost three months over questions on how to value their store leases. When they did release their quarterly results in late January of this year, the numbers weren’t pretty. Losses continued to accumulate, cash was dwindling down and come April 1st, Movie Gallery was going to have to either file chapter 11 or pay off $780 million to bond holders.

In the filing, Movie Gallery told investors that between cash and access to their line of credit, they were only left with $50 million in liquidity as of Oct 1st, 2006. Because of the increasing likelihood that they would miss their covenant tests in 2007, Movie Gallery was also forced to reclassify their senior credit debt from long term debt to current debt in the same filing. This move prompted analysts to warn that Movie Gallery was facing a cash crunch and could slip into bankruptcy if they couldn’t figure out a way to get a refinancing done. At the time of the filing, Movie Gallery had said that they were researching a sale/lease back transaction with bondholders or possibly a massive equity underwriting to pay off the debt.

Without knowing the terms of the restructured debt, it’s too early to say if this financial engineering will actually turn out to be a home run for Movie Gallery, but undoubtably it will be welcome relief for shareholders who had been faced with the prospect of losing their equity through a bankruptcy filing or losing most of their equity in a massive dillutive underwriting. Even after the restructuring, Movie Gallery will still have many challenges to overcome, but with the new credit facility in place, it will give Movie Gallery five more years to focus on cutting costs and closing unprofitable stores, as the company fights to get back on track.

While shareholders are celebrating the move by Movie Gallery to restructure their debt, not everyone will be quite as pleased with this development. Over the last few years, Netflix has been cleaning house with their DVD by mail program and the success of the program has put a lot of pressure on Movie Gallery to close more stores. Each store that closes only drives more people online. If this move by Movie Gallery is able to slow down the decline of the video store, it won’t necessarily have a negative impact on Netflix’s business, but it could impact their growth rate if video stores hang around longer then people expect.

Perhaps even more importantly though, is the effect that this restructuring will have on Blockbuster’s core business. Because of the economics of the video store business, Blockbuster and Movie Gallery operate with heavy fixed costs, but relatively low variable costs. This means that if a store is profitable and you can increase revenue at all, the increase contributes almost entirely to the bottom line. It also means though, that if you see revenue move away from your store, it becomes increasingly difficult to keep stores profitable and to meet those high fixed costs. Over the last few years, Blockbuster has faced an incredibly tough market for video stores and with Movie Gallery’s business on the ropes, many investors had jumped into Blockbuster’s stock, in anticipation of the profit increases that they would see, if Movie Gallery had to move aggressively to close stores.

With Blockbuster and Movie Gallery competing head to head in many of the same markets, the strengthening of Movie Gallery’s business will likely mean that Blockbuster will be forced to continue their operations on razor thin margins, as they struggle to adjust to this rapidly changing industry. In the past, Blockbuster management has indicated that if a Movie Gallery store near them closes, they could see an increase in revenue in excess of 25% at nearby competing stores. Because of the high amount of leverage used for video stores, this 25% can be almost pure profit for those stores and with Movie Gallery’s financial situation having gotten pretty bleak, many investors made aggressive bets on Blockbuster Video, in the belief that the lionshare Movie Gallery’s revenue would go straight to Blockbuster’s brick and mortar stores instead. With Movie Gallery having reinvigorated their balance sheet with their Goldman Sachs deal, Blockbuster now faces a much stronger opponent in these markets where they are forced to compete head to head.

While many investors have been focused on the recent success of Blockbuster’s total access program in their war with Netflix, this is really the wrong battle for Blockbuster investors to focus on. Blockbuster may have had no choice but to get rid of late fees and to offer their own online program, but they made this move as a defensive step to help save customers from leaving their stores, not as revenue or profit driver. For every customer that Blockbuster signs up for the program, they move a high gross margin transaction oriented customer into a lower gross margin monthly renter. While the move was important for Blockbuster to make to protect their business, ironically, the more successful the program is, the greater pressure it puts on Blockbuster’s highly leveraged fixed costs.

Blockbuster’s battle with Movie Gallery however could have had a much more direct effect on the profitability of their business. If Movie Gallery would have been forced into chapter 11, it would have put Blockbuster in a position to directly capitalize on aggressive store closings or by buying out Movie Gallery stores in a fire sale. Because Movie Gallery is a direct competitor to Blockbuster, any store closing would transfer high gross transaction customers straight back to Blockbuster. Now that Movie Gallery won’t be forced to liquidate the business though, Blockbuster will continue to have to compete not just for lower gross margin online renters with Netflix, but will also continue to face a very tough market for transactional customers as well.

It’s too early to say how Blockbuster or Netflix will react to this renewed competitive threat, but it is clear that Movie Gallery has gotten a new lease on life from their deal with Goldman Sachs. While the fundamentals of the video store market continue to be challenging, with this deal in place, it buys the company at least five more years, before we’ll know how this movie ends.

Posted on February 6th, 2007 by Davis
Filed under: DVDs, Disclosure - I own stock in co. mentioned, Netflix