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UPDATE: Cannibals Chase Hollywood Entertaintment Into DVD Rev-Share Camp; Q2 Earnings Uptick Boosts Second-Half Forecast

8 Aug, 2001 By: Joan Villa

VHS rentals drop an average 70% to 75% following a customer’s purchase of a DVD player, Hollywood Video chairman, c.e.o. and president Mark Wattles told investors in what may be the first concrete number placed on DVD’s “cannibalization” of VHS in a major chain’s earnings call. A 30% increase in overall rental activity more than offsets the decline, he added.

“DVD is driving traffic into stores, clearly, which is helping overall rentals,” he concluded.

The positive overall impact of the new format may explain why the nation’s No. 2 rental chain admittedly “changed its tune” on DVD revenue-sharing and announced last week that it has entered its first-ever such deal with a major studio: MGM Home Entertainment.

While Hollywood reported a 2% increase in same-store sales for the first half 2001 and 1% for the second quarter ended June 30, VHS taken alone would have declined 8% in the quarter, Wattles said.“VHS rental comps were negative and will be from now until the day VHS goes away, which is probably five or six years from now,” he predicted. Hollywood tracked its more than 20 million rental households before and after their first DVD rental activity to calculate the cannibalization numbers, he added.

Although Wattles declined to give terms of the MGM pact, such deals are in Hollywood’s best interests so long as the DVD revenue-sharing terms maintain the same margins as VHS, he said. “As a result of entering agreements, we would not be looking at benefiting from the shift from VHS to DVD,” Wattles explained. “All I want to do is fix my margins.”

Further, Hollywood will seek out more combined DVD-and-VHS revenue-sharing deals from other studios to boost copy depth and breadth, according to Wattles. “There are a number of DVD titles that we bring in under VHS rev share but do not under DVD because the title would not generate enough revenue to justify the expenditure even under a sellthrough price,” he explained.

According to Hollywood analyst Jennifer Jordan, of Wells Fargo van Kasper, the deal also assumes that as DVD player penetration rises, DVD prices will slowly go up, so the 1,815-store chain is in effect locking in today’s DVD pricing.

Wattles “didn’t want to experience the slow adjustment of pricing up, he wanted to maximize the volume of DVDs and keep the margins the same — those were his goals,” Jordan says.

Although the agreement may mean that Hollywood is paying more for DVD through revenue-sharing than it would under a flat purchase under sellthrough pricing, it also enables the 1,800-store chain to lower its initial cash outflow, although revenue-sharing payments may be required down the road as the discs generate rental turns.“You get a slight benefit in terms of cash management,” she concludes.

In a decidedly upbeat earnings call, Hollywood reported a 5% increase in consolidated revenue to $325.1 million for the second quarter versus the same period last year, excluding losses from Reel.com. Adjusted net income was $4.1 million, without the benefits of operating losses carried forward from last year that reduced the company’s tax obligation. Diluted earnings per share were $.13 compared to a year-ago loss of $1.37 per share.

In addition, the chain raised its guidance through the end of the year, predicting same-store sales increases of 4% to 5% through the 4th quarter, with 3% to 4% boosts in same-store sales through 2002. Pro forma earnings for full-year 2001, without the benefit of tax loss carryovers from 2000, will be between $.45 and $.49 cents per share, climbing to $.95 to $1.10 per share in 2002, Wattles said.

He noted that DVD revenues, which currently capture 16% of the chain’s rental revenue — up from 9% earlier in the year — could reach 30% by year-end.

In games, he expects two new systems due out in the 4th quarter to lift software rentals 50% in the coming years. “The game industry will grow faster over the next two years than it ever has,” he added.

Chainwide, Hollywood benefited from operational controls and careful rental product management, implementing “meaningful changes in the allocation of new releases from store to store based upon the unique demographic characteristics and demands of that store,” he said.

For the first time in seven quarters, movie rental numbers per store increased, along with higher individual transactions and more movies rented per transaction, according to Wattles.

In addition, the company has seen “no impact in any region of the United States of our stores as a result of any video-on-demand trials,” he noted.

“We’re feeling a lot more confident about our company’s future and our ability to grow earnings significantly,” Wattles said. “A lot of financial discipline has been introduced to the company over the past year which I think you can see in our earnings results.”

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