Monday, February 8, 2010

Internet Killed the Video Store

The Internet has been a major disruptive force in business ever since Al Gore invented it a couple of decades ago (Al just can’t seem to remember exactly when it was).

Of course, of the assumptions we all made about it back then, many didn’t pan out, but others did, not necessarily in the immediate, cataclysmic fashion expected, but gradually and in some cases definitively.

In any case, battles between the “new” (Internet-based) and “old” (Bricks and mortar) abound and are ongoing, some having lasted for well over a decade now.

Today on the History Channel: The war between Intenet-based mail-order movies for home viewing and the video store. Netflix vs. Blockbuster.

This one, in particular has been raging for over a decade.

Essentially the war is over. Netflix won. In their latest quarter, the company reported excellent results and has accumulated over 12 millions subscribers. Netflix put together two things that worked relatively well: the Internet and the postal service, and with low overhead, provided a model that was hard to beat. More info HERE.
Check out the stock performance:

On the other hand, Blockbuster has had to deal with a model, which is outdated, but still has its followers. They operate over 7,000 stores in 25 countries. It used to be over 9.000 but reality has forced a round of closings and more are expected. They tried to beat Netflix at its own game with a mail-based system, but faltered and apparently are now losing subscribers. The estimates out there have them at between 1 and 2 million, far behind Netflix. And they have had to contend with a second battle front, from automated “kiosks” which rent out recent release DVDs for $1 per night. (Operated by Coinstar CSTR). To fight that, Blockbuster has set up some kiosks of its own (Blockbuster Express), but it’s a $1/day rental vs. a $4.99 2-day rental (what Blockbuster offers on new releases at the store), so that’s not going to be good for margins in the short run.
Here’s an interview with the CEO. Prepared to be unimpressed. LINK.

Don’t be sad, everyone dies sometime. With Blockbuster, it’s not a matter of “if”, but “when”. A competitor, Movie Gallery, operator of over 2.000 stores under the “Hollywood Video” brand, filed for bankruptcy last week, for the SECOND time in two years. LINK.

This was supposed to be good news for Blockbuster. I’d call it mixed at best, but most likely ominous.

With all that said, here come the investment ideas, starting with the winner: Netflix.

Idea # 1: Netflix bonds. In November, Netflix issued $200 million of 8.5% unsecured bonds due in 2017 (8 years). When you can find them, they trade somewhere around 102-104%, to yield around 8% to maturity. They are callable at par in 2015. This trade looks easy. Nice yield. S&P rates the issue at BB-, which is “junk” but only “a little junky”.
One concern perhaps is that the trend towards direct downloads could grow, overtake and overwhelm Netflix. Probably. But when? These things take time. Habits do not change overnight. The horse and buggy did not disappear once the car was invented. AOL STILL has dial-up Internet subscribers, people still buy magazines and so on. The bonds look safe to me for the next 5-7 years (which is all it will take). Netflix as a business, probably hasn’t peaked yet, so let’s not worry about its demise. YET.

Idea #2 Netflix puts. Instead of the straight equity play (buying Netflix stock), I prefer a more conservative approach. The stock has traded up a bit recently and the market isn’t looking so great. So the idea is to SELL Netflix puts 6 or more months away and at strike price lower than the current price (out of the money) The stock is at 61 right now, but you can get $2 or more for a Jun 50 put or $3.50 for a Sep 50 or $5 if you want to take it to Jan 2011. What this means (I know not everyone is an expert), is that if the stock goes below $50, which is 20% less than today, you will be assigned the stock (i.e. you must buy it at $50). If the stock doesn’t go under $50, you get to keep the premium. Sure, this is not an idea with a great upside and if NFLX goes to $100, you’ll still only get your $2-$5 in premium. So be it, I’m not greedy.

Now, lets go check out the unburied corpse (Blockbuster). Without getting too “numbery”, lets point out that the company last October issued $675 mm in new SECURED 2014 bonds to pay down its credit lines. At the end of the year, the company was said to have $247 million in cash. Leading us to…

Idea #3 Blockbuster secured bonds. Now trading around 71%, those secured bonds with a 11.75% coupon, yield over 27% to maturity…IF they pay. That of course, is the question. If and “how much?” or “how long?”. These bonds have an additional advantage, if you will, that they are a “sinking fund”, paying 3.33% back in principal each quarter.

If Blockbuster manages to stay out of trouble, you would have your 71 cents back in about three years counting interest and principal. Any payments after that, be it the result of normal operation, restructuring, reorganization or bankruptcy would be profit. There would still be 60 cents worth of principal outstanding on the bonds at that point.

Before you say, “they won’t last that long”, just look how long they HAVE lasted. And there are options for companies in these downward spirals: asset sales, cost-cutting, etc. I’m often amazed how long they can go on. Sometimes they even manage to “reinvent” themselves. Heck, Businessweek pronounced Apple dead over a decade ago. LINK.

There is a lot at stake, namely the CEO pulls in over a cool million a year and the top execs all over half a mill. I wouldn’t personally give that up without a good fight.

Bringing us to…

Idea #4 for the greedy and the optimistic. No, not Blockbuster stock. That’s for the foolhardy. This one is Blockbuster UNSECURED 9% 2012 Bonds (Maturity 09/01/2012), currently trading around 22% of par for a YTM of 93%. I guess it’s obvious that the market doesn’t expect these bonds to be paid in full and on time. Being unsecured, they are behind the secured bonds in a reorg or a bankruptcy and could come out of such an event with nothing.

But then again, 22% is pretty close to nothing already. There are many possibilities, not excluding the company tendering for these bonds (say at Ford did early last year) or some sort of discounted swap. If Blockbuster can buy back or somehow write off part of its obligations at a deep discount, it can make the remaining debt more payable.
These kinds of maneuvers are what make investing in distressed assets interesting, and this is distressed for sure. Expect it to be interesting, in the Confucian sense (apparently he never said that…).

Ok, so there it is. I blogged a long blog this time. For those who didn’t bail halfway through: a thought. Think about these wars and those like them. The winners, the losers and the implications. Keep it in mind next time someone offers you some commercial real estate, a bookstore or a bank or gives you a DVD for Christmas.

Here’s a classic clip from “The Holy Grail”. Quite Appropriate.


  1. Another great article, but two quick comments. First, Blockbuster's cash is probably closer to $195 million right now because their figures didn't take into account their principal and interest payment that hit on the 1st of the year, but was technically pushed back four days because of the Jan. 1 holiday. 2nd, you can't ignore the size of their losses right now and even more importantly how quickly revenue has started to drop. At their current burn rate they run out of cash by July 4th of this year and while you're right that a lot can happen, things can get worse too. If vendors demand secured payments, they violate debt covenants requiring the acceleration of payments or landlords refuse to let them out of long term leases, things could get ugly quick. I'm not saying that those bonds might not end up being worth 22% from some financial engineering, but they're really are no assets to back them up.

  2. Thanks Davis for your insight. I think we need to see the 10-K for Blockbuster (December quarter) to have a better idea. In any case, I do believe you may be underestimating the amount of working capital that BBI can free up with its store closings. Less inventory, etc. Also those DVDs get amortized very quickly and there is likely to be more residual value than meets the eye (not that that helps the unsecured in a bankrupcty).
    S&P and Fitch seem to believe that BBI has enough cash to last the year, and although I don't always agree with them, they may have a point.
    It will be interesting to see how this plays out. I wouldn't be surprised to see someone swoop in to try and buy some of the parts which may have some value (like those 1-2 million mail order subscribers).
    Buying into that mess via either the secured or unsecured, is certain to be "interesting". That, I think we can agree upon.

  3. Blockbuster had started it's decline with the Enron's affair. They both have had a great idea of streamig movies much earlier than everyone else, but the things went bad then, and never revived.

  4. Interesting indeed! It looks like it won't take long to see how it plays out. If Blockbuster can convert their Jr. bonds into equity, it'd certainly be helpful to the company. I'm not sure how the bond holders would feel about it, but it would remove the cash squeeze.

    NCR is also saying that they'd pay $100 million+ for Blockbuster's by mail and kiosk operations, but I think that would undervalue the assets and wouldn't solve their debt problem. If they could get $300 million+ for both units, it might make the jr. bonds more attractive, but any less than that I still say that there is no collateral to back them up.

    Earnings will be out later today, so we should have a better sense of what the working capital is like, but for now I'm sticking with my estimate that unless they complete a restructuring, they'll run out of cash around the 4th of July.