120 Million Dollar Baby

Blockbuster Inc. spent the better part of the past year re-inventing itself. In August, it launched Blockbuster Online, its answer to NetFlix Inc., pioneer of online DVD movie rentals. Since then, it`s cut prices for online subscriptions, rolled out subscriptions for online and store rentals and eliminated late fees. And it ventured into new areas--video game rentals and movie and game trading.

But some say NetFlix is only one of Blockbuster`s concerns. Wal-Mart Stores Inc.`s entrance into online DVD rental is equally worrisome, says Patti Freeman Evans, analyst at Jupiter Research. "When somebody as big as Wal-Mart gets into any business, you can`t ignore them," she says.

Indeed, Wal-Mart`s low-price strategy could drop the bottom out of the online DVD rental market, some anlaysts say. "If Wal-Mart starts selling DVDs for $4, who`s going to rent one?" says Michael Pachter, analyst with Wedbush Morgan Securities Inc. "That`s not going to happen anytime soon, but it`s a threat."

And another potential entrant into online video rental in the U.S. looms large: Amazon.com Inc. Amazon began offering online rental of DVDs and videos in the United Kingdom last year, a move many see as a dress rehearsal for the U.S. market.

A store boost

But while Blockbuster is besieged on all fronts by a rapidly changing market, it has adopted a nimble online strategy that seems to be paying off. Blockbuster.com, launched as an e-commerce site in August, is helping Blockbuster regain lost ground in the $40 billion home video market, analysts say. And it`s giving Blockbuster stores a boost, the company reports.

Blockbuster executives credit coupons that give online customers two free movies per month with increasing traffic to the company`s stores. 50% of online customers hadn`t shopped at a Blockbuster store in at least six months or were new customers, says Shane Evangelist, senior vice president and general manager of Blockbuster.com.

"Those customers are now taking those coupons into our stores and seeing that we have an expanded retail offer, that we have an expanded games offer, that you can do movies and games trading," he says. "From a strategic perspective, we are getting customers who haven`t shopped with us in a while, and now they`re back in our stores seeing a whole bunch of new offerings that we have."

Blockbuster offers online subscribers coupons for two in-store movie rentals per month. The lowest online rate is $14.99 for unlimited rentals with one movie out at a time. New subscribers get a one-month introductory rate of $9.99. Online subscribers have access to more than 25,000 DVDs and games. Titles are delivered to customers within three business days and there are no due dates.

Blockbuster, which lost $1.26 billion last year on revenues of $6.05 billion, compared with a loss of $983.9 million on revenue of $5.91 billion in 2003, has signed up 750,000 subscribers since the August launch. 40 million customers a year visit Blockbuster stores.

10,000 new a day

Blockbuster started the online service because of customer demand, not because of the threat posed by NetFlix, Blockbuster maintains. "Consumers were asking for an online offering that also had some sort of store benefit," Evangelist says. "Obviously, we want to play in markets that are growing, but more importantly we want to service customers that have needs that we aren`t currently servicing." Blockbuster has been adding subscribers at a rate of about 10,000 per day.

"You can`t segment a customer base into people who rent or buy, which is why we sell movies, why we rent movies and why we trade movies and games," Evangelist says. "An online customer in general skews a little bit higher in income but other than that it`s a very similar customer to offline."

Blockbuster fulfills online orders through 23 distribution centers near high density populations, but plans to ship products directly out of its stores by year-end, Evangelist says. "It will allow us to send an order to a local store, and have that store deliver it to that customer in the local area," he says. "It allows subscribers to get almost next day delivery everywhere in the country."

Adding its 6,000 retail stores to the distribution network also allows Blockbuster to leverage the inventory in its stores and cut costs, Evangelist says. "We`ve got `Top Gun` in every store across the country but it doesn`t rent every day," he says. "If someone online wants to rent `Top Gun,` instead of us having to buy it and put it in a distribution center, we can send the product we already purchased for our stores to the online customer."

Blockbuster stores typically carry 5,000 to 6,000 titles while the distribution centers have more than 30,000, he says. Blockbuster expects 50% to 60% of customers` needs will be served from the stores.

The next test

The next step for Blockbuster Online will be to combine its in-store movie pass with the online subscription service. Under Block-buster`s existing movie pass, consumers can get unlimited movie rentals for $24.99, with three movies allowed out at a time. With the combined pass, "you could get three videos online one day," Evangelist says, "and maybe in the future, get two online and one in the store."

Blockbuster will test the combined-offer program this year, Evangelist says. "Today, we`re satisfying the in-store and online demand through our in-store coupons," he says. "That might be enough for consumers to be happy with. But we`re going to test to see if consumers want a subscription in both channels."

In a move to integrate its in-store and online operations, Blockbuster last month began offering its in-store customers the ability to rent as many movies as they want for the same $14.99 monthly fee that online subscribers pay. New subscribers to either the in-store or online programs will pay an introductory rate of $9.99 for the first month.

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Customers who buy the in-store Blockbuster Movie Pass at the special price will be able to rent unlimited movies one at a time. Those customers who choose the online option can rent three movies at a time, and receive the coupon for two free in-store rentals good each month for movies or games.

"We wanted to give people another option, another way to rent movies for those people who weren`t ready to jump onboard and sign up for $24.99 Movie Pass in-store," a spokesperson says. "You can do it online, you can do it in-store, but if you`re not ready to commit to a full $24.99, this gives you an option."

Same for games

In addition, Blockbuster is offering its in-store Game Pass at an introductory price of $14.99 for the first month and $19.99 per month afterwards through April 11. The Game Pass gives customers unlimited games rentals, one at a time, with no due dates or late fees.

Blockbuster also has made arrangements that allow its online subscribers to access and manage their accounts through AOL and MSN. "You`ll be able to do the same thing you do at Blockbuster.com," including ordering movies, Evangelist says.

While some believe Blockbuster waited too long to enter the online market, Evangelist says the company was just being cautious. "Fortunately, we`ve got a very powerful brand, we`ve got over 20 years of rental experience," he says. "We have the luxury to watch markets develop. Once we feel there`s a true market there, that consumers are truly demanding that service, then we can move very quickly."

For its part, NetFlix isn`t ready to cede the online video/DVD rental market to Blockbuster. NetFlix added 517,000 net subscribers in the two quarters since Blockbuster Online`s launch, the company notes, and ended 2004 with more than 2.6 million subscribers, up 76% from 2003. "Blockbuster has thrown everything but the kitchen sink at us, and yet we have continued to grow and retain our customers at a record rate," chairman and CEO Reed Hastings told analysts during NetFlix`s fourth-quarter conference call earlier this year.

There`s also a question of whether Blockbuster will be able to sustain the heavy investment in its online operation, Barry McCarthy, NetFlix`s chief financial officer, said during the fourth-quarter earnings call. "We estimate that Blockbuster has invested about $100 million in the last six months," including setting up the 23 distribution centers and revenue lost due to the deep price cuts for online renters.

Blockbuster reported in March that it spent $50 million in 2004 on Bockbuster.com and that it expects to spend an additional $70 million this year to accelerate the growth of the subscriber base. "While this will increase our online costs in the short term, we believe the additional investment will dramatically ramp up our subscriber base, with our goal to have in excess of 2 million subscribers by the end of the first quarter of 2006," John Antioco, CEO, told investors and analysts.

Multi-channel strategy

"At the $15 price point, based on our modeling, we expect their online business to lose money on every subscriber indefinitely, unless they slash their marketing spending," NetFlix`s McCarthy said. "The more aggressively they compete with us for market share, and the lower they price their service, the faster they drain their stores of customers and the more money they lose online."

But Jupiter Research`s Freeman Evans says that it`s better for Blockbuster to have a $15 a month fee on a two-year average contract, than to leave itself open to the vagaries of consumers` video or DVD habits. "It`s not bad to have a consistent amount of money flowing in," she says. "You can count on that rather than the haphazard sort of rentals that are harder to predict."

Blockbuster`s elimination of late fees is potentially a bigger issue in the competitive foray because it is a major draw for consumers, Freeman Evans says.

Wedbush`s Pachter says the fact that Blockbuster has both an online and store presence gives it an edge over NetFlix. "There are many brick-and-mortar retailers that have successful Internet presences as a complement to their businesses," he says.

No more sitting back

In fact, the retail industry`s broader move to multi-channel shopping is not likely to bypass the movie-rental business, Freeman Evans says. "Consumers use multiple channels when they`re shopping for anything, and the renting of movies, and the purchase of movies particularly, will be no exception," she says.

Blockbuster`s move online also leaves NetFlix vulnerable, Pachter says. "The NetFlix model is a great model and it`s a commodity, you know what you`re getting," Pachter says. "When Blockbuster offers exactly the same product, the same way at a lower price, I don`t see how NetFlix survives."

Even an easy-to-use interface won`t be enough, he says. "NetFlix will tell you that its customers love its interface, and there`s an argument for that," Pachter adds. But that may not be enough to keep NetFlix afloat, he says. "Apple Computer exists because people like the Apple Macintosh operating system," he says. "But Apple had 15% market share in the mid 1980s and it has 4% share now. NetFlix is a great product but Block-buster`s going to kick their butt."

Wachter believes that Blockbuster learned from its delay in getting into the online market. "They sat back complacently watching NetFlix take their business away," he says. "They`re now making sure that NetFlix takes no more customers away. I think they`ll succeed at that."

linda@verticalwebmedia.com