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This Week's Score: David 1, Goliath 0

10 Feb, 2004 By: Holly J. Wagner

Netflix CEO Reed Hastings is far too gracious to gloat in public, but I'm betting he's sleeping with a smile on his face these days.

It must be satisfying to know a little upstart can pressure major chains like Wal-Mart and Blockbuster Video to conform to a model it created. Kind of like giving birth to a genius in a world in which most kids are just average, at best.

Netflix is in the catbird seat today, positioned to watch Blockbuster and Hollywood Video buckle under the weight of their bricks and mortar as they struggle to jettison the unprofitable (read: rental) parts of their business and stop the bleeding by launching subscription rentals.

Big Blue has never broken out its previously viewed numbers, but Tuesday's financial report stresses executives see it as a growth area, along with games and subscriptions. But changes in a business model cost money.

In a January stump to investor analysts, Blockbuster CEO John Antioco cited internal and Kagan Media figures showing “anticipated 50 percent-plus growth in movie and video game rentals and sales through 2007 in the United States.”

Notice that growth lumps rental and sellthrough together. Kagan showed total U.S. rentals dropping from $8.2 billion in 2003 to $7.4 billion, including subscriptions, in 2007. But gross figures leave out the impact of converting $50- and $60-a-month customers to $25- or $30-a-month subscription customers, as well as the presumable loss of late fees, which analysts say account for an average of 15 percent of Blockbuster's bottom line each year.

By Tuesday, Antioco was singing a different tune.

“The first quarter of 2004 will be difficult due to a weak box office and a tough year-over-year comparison,” he said. “Our full-year results will be impacted by an incremental $70 million to $90 million in operating expenses we will be investing in our business to support key growth initiatives,” he said.

It may sound like the worst is over, or at least out in the open, but analysts at Fulcrum Global Partners don't seem to think so. A Feb. 6 Fulcrum report on Blockbuster is not so optimistic.

“The search for new comp growth drivers highlights just how fragile the core rental business really is,” the analysts wrote. “In addition, we think the search for growth may lead to earnings missteps this year. Finally, the online model could cost the company as much as $200 million in capital expenditures, according to our estimates, damaging the cash flow story.”

That means the $70 million to $90 million Blockbuster plans to sink into all of its stated growth areas this year will fall far short of what analysts believe it will cost just to do what Netflix is already doing.

Happy Father's Day, Reed.

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