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Does Wall Street Hate Video Rental?

3 May, 2004 By: Erik Gruenwedel

Executives at Blockbuster Video and Hollywood Video would appear to have good reason lately to scan the financial obituaries in search of their companies' tickers, if you believe some analysts.

As a microcosm of the video rental market, the top two publicly traded chains have long been subjected to Wall Street's fickle eye, even as they have delivered steady earnings growth, emerging as whipping boys to some analysts who consider the industry increasingly irrelevant in the dissemination of entertainment into the home.

The result is that both chains are taking radical measures that have been spurred by Wall Street.

Media giant Viacom, parent to Blockbuster, said it plans to spin off the video chain — despite its ongoing positive impact on corporate cash flow — as a separate business by this fall, after unsuccessful attempts to sell its 82 percent stake in Blockbuster.

Last month, rival Hollywood Video, weary of consecutive quarters of flat-line growth and a shrinking rental market, threw in the towel to investor scrutiny when management declared intentions to take the company private in a deal with investors worth $890 million.

Both strategic actions have been met with myriad shareholder lawsuits.

To add insult to the circling of wagons, stock trader Jim Chanos, renowned for successfully short-selling companies like Enron, Tyco, Bally and Capital One, added Blockbuster to his hit list. Short sellers buy stock with borrowed funds, betting that it will go down, and they can pocket the difference.

As reported in Barron's, Chanos said Blockbuster “faces the fate of all intermediaries who become redundant,” which in Blockbuster's case, Chanos said, includes being caught in the crosshairs of loss-leader DVD sales at Wal-Mart and increased digital downloading of films in the home.

“It's getting easier and easier to get entertainment into the home with the explosion of digital capacity,” said Tom R. Wolzien, analyst with Sanford C. Bernstein in New York. “Initially that was thought to benefit the [video-on-demand (VOD)] providers over [video] retailers; now as storage gets cheaper and transport costs are low, it benefits those who want to start new businesses on the Web.”

“There's no question that the home video rental business has matured,” said analyst Dennis McAlpine with McAlpine Associates in New York. “It is not a growth area anymore, which is why you are seeing Hollywood Video and Blockbuster moving into other things.”

Industry experts say Wall Street's pessimistic outlook toward video rental is rooted in the belief that the industry is an aging cash cow whose players operate in a state of denial that their business model will ultimately face technological obsolescence.

Industry experts contend video rental will soon be comprised of diehard veterans content in the knowledge that the future is going to look a lot like the past.

“No doubt [Wall Street] hate[s] them,” said Michael Pachter, analyst with Wedbush Morgan Securities in Los Angeles. “There is a misperception that technology [VOD, Netflix] is going to eliminate the need to rent videos.”

Analysts also say that as mass merchants, notably Wal-Mart, continue to slash DVD sellthrough prices, the rental option becomes secondary.

Regardless of innovation and technology, Jon Peddie, president of Peddie Research, Tiburon, Calif., said the majority of video consumers are not savvy enough or have the patience to download movies from the Internet or alternative sources.

While Wall Street has turned its back on traditional video rental, it has all but embraced Los Gatos, Calif.-based Netflix, whose online subscription rental model is being hailed for its growth potential and improved operational efficiencies.

Both Hollywood and Blockbuster have said they will launch similar subscription services this year. Wal-Mart, which supplanted Blockbuster last year as the top video retailer in the country, according to Video Store Magazine Market Research, has invested in an Internet-based video rental service, and Amazon.com is expected to announce plans of its own.

“Netflix is being treated as an Internet play,” said Josh Bernoff, analyst with Forrester Research in Boston. “Netflix has a highly developed Web relationship with its customers.”

With about 2 million subscribers, Netflix has fewer than 2 percent of the domestic rental market. CEO Reed Hastings has said the service's goal is to reach 10 percent market penetration in the San Francisco Bay Area this year as a blueprint for the rest of the country.

“If we get to 20 percent, there won't be a Blockbuster open in the Bay Area,” Hastings told investors in February.

Not all agree.

Some question Netflix's ability to compete online against similar services launched by Blockbuster and Hollywood.

Analyst Pachter goes so far as to say that Netflix exists because Blockbuster failed to counter in a timely manner with an identical product.

He said that with a “brick-and-click” setup, Blockbuster's online rental service would cater to Netflix users, and more than 5,000 physical store locations would appeal to the majority of renters, who, according to Pachter, rent films on impulse. “People like to touch the video case and read the back panel,” he said.

“The question is whether they bloody themselves in the process because it will cost them money both on the implementation and potentially on the lost revenue from existing customers,” he said.

Among delivery formats most likely to supplant video rental, VOD generates the greatest buzz, despite being a much-hyped threat to home video for almost 20 years.

Forrester's Bernoff said, “VOD will continue to impact home video over the next five years. We're looking at a long, slow, steady decline in rentals and some decline in sales.”

Analyst McAlpine doubts the studios will replace one delivery channel with another.

“Historically, I don't think you can find an example of a delivery system in Hollywood that has been eliminated,” McAlpine said. “Usually, they create a window before or after the existing window.”

Pachter said the studios would be “stupid” to turn their backs on video rental and DVD sales.

“VOD is going to put rental stores out of business just like WebVan was going to put supermarkets out of business,” Pachter said.

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