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Analyst Calls Rental Woes 'Air Pocket'

12 Dec, 2005 By: Holly J. Wagner

An analyst firm has cast a ray of light on otherwise dim projections for the future of traditional rental.

JP Morgan analyst Barton Crockett, initiating coverage on Blockbuster Inc. and Movie Gallery, called the weak rental year an “air pocket” owing to a weak release slate. He suggested that “very real” fears for the industry and potential bankruptcy for its biggest players are “overdone.”

An industry recovery will need better movies, and the big chains may have to sell off non-core businesses to stay afloat, Crockett wrote in notes aimed at investors.

The good news for the chains may not be good for others, however. Movie Gallery will gain market share by gobbling up more indies, and Blockbuster's success will rest on execution of its online strategy, Crockett wrote.

“We believe Movie Gallery will continue to roll up smaller mom-and-pop operations over the near term, albeit at a lower rate as it continues to digest Hollywood Entertainment,” he wrote. Net store growth will stop in 2007 “as Movie switches to relocating and replacing unprofitable stores.”

Blockbuster's online comps could be up 6.7 percent next year by doubling subscription fees, against 1 percent for the chain's store-based business and the industry overall.

The end of late fees was the start of trouble for the chain, Crockett wrote, reducing gross margins from 74 percent to 62 percent and lifetime profit per disc from $52 to $30.

“We estimate Blockbuster would have to grow sales by 39 percent to make up for the gross shortfall,” he wrote. As a mitigating factor, Crockett said Blockbuster appears to be increasing pricing.

Selling off assets and subleasing floorspace could keep both chains out of bankruptcy, the report said. Crockett estimated the value of Blockbuster subsidiaries Video King and Mr. Movies at $266 million. Proceeds from that sale, combined with pulling out of foreign markets, could total $538 million — about half of Blockbuster's debt.

Movie Gallery's comps should stabilize next year, he wrote, but will lag behind Blockbuster and Netflix because of the chain's refusal, so far, to wade into online rentals. The prognosis calls for a 0.5 percent increase in comps next year, but a 15 percent hike in operating income as the chain realizes cost savings from the merger.

The Hollywood acquisition, coming as the release slate hit the skids, increased exposure to losses that could force Movie Gallery to renegotiate its debts or face bankruptcy in the second half of 2006, he wrote. Gallery's secret weapon is its fledgling kiosk program, which it could use to reduce labor costs and extend store hours, the report said.

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