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Rental Biz Takes More Punches From Wall Street

30 Sep, 2005 By: Holly J. Wagner

The next year and a half will reveal whether Blockbuster Inc. CEO John Antioco stays or leaves and whether Movie Gallery is a rock or a dinosaur, according to analysts at Bear Stearns.

Analysts R. Glen Reid and Joseph Holland relaunched Bear Stearns' coverage of Blockbuster Video and Movie Gallery Sept. 26 with dire predictions for brick-and-mortar rentals, especially mom-and-pops. But they praised online rental pioneer Netflix for its forward thinking.

Movie Gallery, which pulled its third-quarter dividend last week, fielded the toughest criticism.

“Movie Gallery is charting a course based upon a premise that industry weakness is chiefly product-related. Our view is otherwise,” the analysts wrote. “What is more, we believe that consensus estimates on operational efficiencies [from the merger with Hollywood Entertainment Corp.] are overly aggressive.”

Gallery has the added pressure of having to compete with Blockbuster head to head through the acquired Hollywood stores, the report stated.

Blockbuster has its own challenges to overcome, the analysts wrote. The worst is probably over for the chain, they said, with the abatement of launch costs for Blockbuster Online rental and public image damage from the “End of Late Fees” campaign. Still, execs must make the new initiatives work. Serving online rentals from 30 distribution centers and 4,000 stores is “a challenge of heroic proportions” and the most “imposing” risk to making the new initiatives work, the analysts believe. Blockbuster has the unique issue of getting its franchisees on board and avoiding a “muddled message” for the consumer.

“Overall, we view the execution challenges as significant, and believe that upon their outcome hangs the fate of CEO John Antioco,” they wrote.

Only Netflix is insulated from the defections from store-based rentals, the analysts believe. The top online rental service stands to gain precisely because it has no stores, even though Blockbuster Online's free in-store rentals each month make it an attractive proposition, the analysts wrote.

All of this adds up to trouble for smaller independents, the analysts believe, as chain and online rentals gobble up ever more market share. In turn, more stores closing could drive more renters online as they can't find an outlet close by.

“Until now, we have based our assumptions for the market size of online DVD rentals chiefly on a forecast of consumer interest in the service. Our assumptions now include a strong emphasis on the viability of video rental stores themselves,” they wrote. If the industry as a whole continues to contract over the next several years, “it may become that online DVD rentals becomes the only game in certain towns,” said the analysts.

Reid and Holland increased the estimated size of the online market, from a potential of 10 million to 12 million customers, to a potential market of 15 million customers. Netflix already has a third of that amount sewed up, and Antioco has said Blockbuster should reach 2 million subscribers by the first quarter of 2006. Blockbuster does not break out in-store vs. online subscriptions.

The analysts rated Netflix “outperform” and set a $30 price target on Netflix shares. That compared to an “underperform” rating and $7 target for Movie Gallery and a “peer perform” rating and $4.50 target for Blockbuster.

The Movie Gallery rating drove its stock price down as much as 15 percent, from $12.82 at close Sept. 26, before it settled at to $11.04, down $1.78, at close Sept. 27. The slide abated somewhat by Sept. 28, but the price slipped another 2.5 percent after Southwest Securities downgraded the company from a “strong buy” to a “neutral” rating.

Gallery announced after Sept. 26's market close that it would not pay a dividend for the third quarter this year. That came on the heels of an announcement a few days before that Movie Gallery was taking on more debt to buy out former Hollywood Video CEO Mark Wattles under a clause in the contract to buy the rest of the chain. Under the terms of the Hollywood Video chain acquisition, Wattles had the right to require that Movie Gallery buy the 20 stores he personally owns and operates.

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