New Paradigm

Over the last few years, I’ve followed the DVD rental industry pretty closely. During that time, I’ve been one of Blockbuster’s biggest critics and have frequently blasted the company for failing to adapt to the digital age. With their core rental business experiencing massive deterioration, I’ve had very few positive things to say about the company.

Their hyper-focus on competing with Netflix, has cost the company dearly and was a huge blunder by Blockbuster’s previous management. In order to try and counteract Netflix’s momentum, Blockbuster ended late fees, started a price war against a well funded innovator with little debt, and they massively cannibalized their higher margin in-store business. All in a desperate attempt, to differentiate their online service. Meanwhile, their executives took home pay packages that were unconscionable, especially when you consider Blockbuster’s dwindling resources and their dismal financial performance.

At the end of the day, their fight against Netflix has cost them at least a half a billion dollars and they still only have 3,000,000 subscribers.

Six months ago, I would have told you that there was nothing that Blockbuster could do to save itself. I had seen Antioco and Co. make too many poor decisions, to believe that they could figure out how to turn the company around. Instead of increasing prices, they were lowering them by offering unlimited total access rentals. While the program proved to be popular with consumers and the Mad Money crowd, it wasn’t an acceptable long term solution for the challenges that Blockbuster faces.

Of all the decisions that I’ve seen the company make, squeezing out Antioco may have been their best one. Ironically, the one move that I think was good for shareholders, turned Mad Money against them and started the spiral towards a new 52 week low today.

With so much going wrong for the company, I had low expectations when they brought in Jim Keyes to takeover at the helm. With the future of rentals being digital, I didn’t immediately appreciate the importance of bringing in a retail specialist.

Over the past few months, I’ve watched as Keyes has taken over and while it will take him time to steer Blockbuster back on course, his immediate move to cut advertising and unlimited rentals was one that made economic sense.

What a lot of people interpreted as Blockbuster refusing to face reality, I saw as an admission that they had lost their focus on their most profitable customers. In the short term, this is a good thing because it helps to stem the losses from the Total Access program, but it’s not a long term solution.

Following Blockbuster’s 3rd quarter earning’s call, I could understand why their shareholders might be nervous, but after listening to Keyes unveil his turnaround strategy at their analyst event, I was shocked to see such a negative market reaction to his ideas. Analysts slammed the event as being big on dreams and light on details and since the event, Blockbuster’s market cap has taken a 20% haircut.

What other’s may have interpreted as bad news, I saw as a stroke of genius. Keyes’ prescription for saving Blockbuster is the exact remedy that they need, in order to remain relevant in a digital age. There is little doubt that there will come a time where we see the end of the DVD rental, but for the first time, Blockbuster is willing to admit this and they laid out a compelling plan for how they will adjust to this transition.

Keyes discussed several initiatives, but at the heart of the strategy was a plan to evolve from a rentailer to a retailer. While the differences may be subtle, the details have tremendous implications on the viability of Blockbuster’s business model.

Dedicate More Square Footage To Retail

While Blockbuster has seen their brutal selloff, shares of Gamestop have caught on fire. The market clearly has no faith in the future of DVD rentals, yet they are still willing to invest in profitable retailers. The rental industry is a tough business and as that stream dries up, Blockbuster needs to be able to replace this with higher profit opportunities.

In order to accomplish this goal, Keyes has worked out an agreement with Sony to provide 2000 PS3 kiosks, in their stores during the holidays. I view this as an an early test for the viability of Blockbuster’s retail approach. I believe that the consoles will sell well among Blockbuster’s customer base and will lead towards more high end consumer electronics.

By focusing on selling higher ticket items, Blockbuster stands a better chance of covering their fixed costs. People are already going to Blockbuster to rent their movies, but if they can start to buy things like computers, cellular phones, HDTV’s and Blu-Ray players, it will give Blockbuster an opportunity to capture some of the money that retailers like Best Buy are able to take in.

If Blockbuster is successful with this transition, they could even get to a point where they could use rentals as a loss leader to drive higher revenue transactions. If you can sell enough HDTV’s, the decline in rental revenues becomes less of an issue. What some might see as the abandonment of the rental market is really Blockbuster pursuing better market opportunities.

Invest In Kiosk Technology

It’s no secret that I believe that burn on demand could save the DVD rental industry. As a tech savvy consumer, I have lots of options for streaming digital content to my television, but most people still prefer the good old fashioned DVD. Even after the digital revolution gains critical mass, there will still be a need for movie rentals. While it’s easy to believe that everyone has a computer and internet access, there is still a large part of the market that VOD and Netflix, can’t get at.

The problem with Blockbuster’s retail initiatives, is that this will eat into the selection and inventory. If half the store is dedicated to selling consumer electronics, it becomes challenging to offer as many choices. Burn on demand can solve this issue for Blockbuster. By taking care of the heavy lifting, Blockbuster can make it easy for consumers to watch an even wider range of content.

Keyes plan to invest in burn on demand technology shows that he understands the savings and impact, that this technology can have. My only reservation about his approach, is his intention to introduce the kiosks at the store level. Kiosks can provide a lot of efficiencies, but they don’t do well with volume. I can see the potential in letting franchisees use the technology in non-video store locations, but believe that Blockbuster needs a different solution at the store level.

Everybody knows how to work a printer at the supermarket, but there is a reason why people still go to Kinkos. They can handle volume like nobody’s business.

Burn on demand kiosks will be good for expanding into supermarkets, coffee shops and fast food restaurants, but Blockbuster will need dedicated servers and lots of burners at the store level, if they want to provide a superior experience at their retail locations. By handling the heavy lifting for consumers, they could bypass a significant technological hurdle in the adoption of burn on demand DVD.

Shifting To More Revenue Sharing Arrangements

One of the biggest weaknesses in Blockbuster’s business model are the high fixed costs that they have to deal with. Blockbuster can’t get rid of the lease payments or all of the employee costs, but they can reduce their leverage by approaching their stuido partners. Whether rental will eventually die or not, the studios want to protect the DVD stream and have an incentive to work with Blockbuster towards ensuring their survival. In order to get less up front costs, Blockbuster will be forced to give up their gross margins, but it will allow them to keep top movies in stock and to offer a burn on demand experience.

Raising Prices and Reinstating Late Fees

Over the past few years, we’ve seen the price of a lot of products go up. Whether it’s higher gas prices or postal rate increases, the cost of living has been increasing. When it comes to rental though, we’ve seen price deteriorate. The DVD price war has taken it’s toll and there is more than enough justification for Netflix and Blockbuster to increase prices. This strategy is probably the most risky, because if Netflix didn’t follow through with their own price increase, there could be a severe reaction against Blockbuster.

One of the things that has always impressed me about Netflix, has been their commitment to testing ideas before implementation. When Blockbuster ended late fees, they took a shotgun approach and hoped that it would pay off. It obviously didn’t.

When Netflix lowered prices it was after they understood the elasticity of the demand curve. By taking their time to react to competitive threats, Netflix was able to make more intelligent decisions in combating Blockbuster. While I’m sure that Blockbuster shareholders would welcome an imediate price increase, I have to admire the fact that Keyes isn’t willing to dive in head first on this one.

As far as the late fees goes, this is clearly a problem. By allowing customers to keep rentals, it’s prevented other people from having access to the inventory. I think it’s fair for Blockbuster to consider this move, but after such a massive no late fee campaign, there could be a strong backlash. One of the problems that I think most people had with Blockbuster’s late charges was the punitive nature of the fees. Instead of having to pay for one more day, you often had to pay for another three day rental.

During the analyst presentation, Keyes expressed admiration for Redbox’s pricing model and pointed out that a $1 a day wasn’t really cheaper then Blockbuster. If Blockbuster had $3 rentals for three days and then a $1 per day afterwards, consumers might accept the return of late fees. Still, after such a massive promotion (and lawsuit settlements), it would be gutsy to try and re-introduce them.

There is no way to know for sure, if any of these initiatives can save Blockbuster, but I do believe that Keyes is making the right moves towards securing the long term future of the company. While I may have written off the video store, I’m not ready to call the end of retail and I’m impressed by Keyes focus on improving revenue per square footage, instead of being distracted by the internet. It’s the right move for Blockbuster to make and one that marks the divergence of the Netflix vs. Blockbuster paradigm. With rental revenues set to eventually expire, Blockbuster is smart in positioning themselves to take on other retailers, where they have an advantage. By making these changes, it shifts the battle to Blockbuster vs. Circuit City, Best Buy and Game Stop and this is a business model that should make more sense to Blockbuster’s investors.