Wall Street Favors Video Stocks14 Mar, 2002 By: Joan Villa
Video stocks are fast becoming the new darlings of Wall Street, as analysts take a favorable view of companies that show consistent revenue growth and cash flow.
Both Hollywood Entertainment Corp. and Blockbuster Inc. were given a boost last week when Robertson Stephens initiated coverage with a “buy” rating. The brokerage set a 12-month price target of $32 for Blockbuster, assuming a 31 percent upside in the stock, and a $21 per share target for Hollywood's stock, which currently trades near $16.
“In consumer electronics the things that work best are digital technologies and the gaming cycle, so as we look out over the next couple years, what we expect to perform and drive the industry are those things plus broadband,” explained Robertson Stephens analyst Sarah Gragg. “If you believe the sector overall has strength, you have to believe that [Blockbuster and Hollywood] have a significant amount of opportunity ahead of them.”
Blockbuster's valuation is based on its “dominant positioning” among studios and consumers, totaling 40 percent U.S. market share, she said. The company is also “rapidly aggregating share of the highly fragmented international market,” Gragg noted. She also cited “impressive” cash-flow generation capabilities coupled with favorable industry dynamics, mostly ongoing growth in DVD and games.
Hollywood, on the other hand, recently revamped its management team, boosted store productivity and improved its financial position “at a time that will enable them to take advantage of the strength of the sector and to resume their store opening program,” she said. Hollywood's 1,801 stores comprise 10 percent of the home video market, followed by Movie Gallery at 3 percent, according to her research.
“Our thesis on that is that the stars have all aligned for Hollywood,” she added. “Everything's happened at the right time for them to take advantage of what are very, very compelling industry trends.”
In addition to the high-margin opportunities of DVD and games available to all three top chains, Blockbuster in particular is able to generate incremental revenue from DirecTV and pay-per-view, Gragg added.
She also emphasized that the threat of video-on-demand “isn't as close as we think it is.” She doubted studios that earn an estimated 55 percent of revenue from home video would “suffocate the channel that is bringing in a significant portion of [their] revenues in favor of a technology that, so far, has not really received widespread consumer adoption and really has not proved it has the ability to do that.” Besides, she added, “There's no reason the two can't peacefully coexist as they do now.”
Robertson Stephens' evaluation comes on the heels of a recent upgrade by SWS Securities raising Blockbuster to “buy” from “accumulate.” Last June, after Hollywood restructured its $255 million debt and gained control of its cash flow, Goldman Sachs upgraded the stock to “market outperform” from “market perform.”
Robert DeLean at Morgan Keegan — so far the only analyst following Movie Gallery — has had a long-time buy rating on the stock based on the chain's fundamentals and demonstrated growth. He is not surprised at Wall Street's sudden interest in the segment.
“The entire theme of the last 15 to 18 months, as the technology [sector] has blown up, is people have migrated back to those stocks that have real value, with real earnings and a business that they can understand,” he said.
What the past six- to nine-month surge in video retail shares indicates is the “old economy is not dead,” DeLean added. “I don't expect in the next five years Blockbuster's going to go away, and the stock's move has told you that investors feel the same way.”
While investors are disenchanted with slowing sectors such as consumer electronics, chip makers and telecommunications, research director Greg Durkin at Alexander & Associates also believes video's fundamentals are strong. Consumer video spending is at an all-time high, while the chains are paying lower wholesale costs for both DVD and VHS.
“Overall the price they pay is 30 to 50 percent lower than what it was four years back, so the cost of goods sold is drastically reduced, and that makes the model look better,” he said.