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Lehman Bros. Analyst Downgrades Estimates for Blockbuster, Movie Gallery

8 Jul, 2005 By: Holly J. Wagner

The video rental chains got more bad news as Lehman Brothers analyst Anthony DiClemente downgraded estimates for Movie Gallery and Blockbuster based on a weak release slate for the next two quarters and increasing competition.

Blockbuster will be hard-pressed to make up lost late-fee revenue, DiClemente wrote, because base rental revenue without late fees “must grow in the high-mid teens” in the second half of the year for Blockbuster to meet its own estimates for the year.

When the chain announced its “no late fees” campaign, Blockbuster CEO John Antioco said the chain would lose $250 million to $300 million in operating income but would offset that loss with increased store traffic. DiClemente said that is not playing out.

“Blockbuster effectively lost 13 percent of its rental revenue in the form of late fees and experienced a 5.5 percent year-on-year decline in rental revenues … meaning that Blockbuster only partially offset losses on late fees, despite having spent $50 million of launch costs related to the advertising and marketing” for the program in the first quarter. Nonsubscription in-store customers will have to rent five movies per customer over the annual average of 46 rentals to make up the no-late-fee losses this year, he wrote. He also suggested a price hike for online subscriptions, “a strategic move that would be a clear positive for competitor Netflix,” won't be long in coming.

Blockbuster declined comment on DiClemente's remarks.

The move appears unlikely, as Movie Gallery had already scaled back its guidance based on a weak release schedule for the second half. Shortly after DiClemente's notes for rental, sellthrough chain Trans World also reduced its guidance.

“Our sales softened in June, and we expect the softness to continue through the end of the second quarter, reflecting delays in a number of key music releases and lower-than-expected sales of DVD new releases,” said Trans World CEO Robert J. Higgins. "We were particularly disappointed with sales in the music and DVD categories for the Father's Day holiday. However, we continue to see positive trends in video game and accessory sales.”

Consumers are buying fewer DVDs, but that does not necessarily translate to renting more, DiClemente said.

And while subscription programs expose Blockbuster to the danger of migrating high-end customers to the low end, he believes subscriptions also are hurting Gallery since the Hollywood acquisition because Hollywood stores compete more directly with Blockbuster than Gallery's rural sites.

“We believe Hollywood stores are more likely to offer their in-store subscription program in competitive response to Blockbuster's offering, given in-store subscribers are precluded from paying any late fees at all,” DiClemente wrote.

He revised his target share prices from $32 to $27 for Gallery and from $11 to $8 for Blockbuster.

“As overall industry revenue continues to shrink, irrational competitive offerings designed to protect revenues at the expense of profitability may exacerbate the impact on industry profits,” he wrote.

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