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We are initiating a 700-share position in
. The stock was recently trading at $4.33, and we believe this Inflection Point play -- a stock of a company that is in the process of a turnaround -- can potentially double from current levels.
Our bullish position on Blockbuster is a reversal from our bearish stance in March. There's no question that Blockbuster has been in dire straits. As we said in a
story March 23, the company has suffered over the past two years from declining revenue and a secular slowdown in the movie-rental industry. But we now have new information on the company's store closings and online business that suggests there are some strategies Blockbuster can implement to right its business. As with all potential turnaround stories, that's a gamble.
Several Wall Street analysts are re-examining the Blockbuster story, and are viewing the company's chances favorably. Citigroup and Bear Stearns recently upgraded Blockbuster, and if the company's efforts show results -- particularly as it closes stores and delivers positive operating income and EBITDA (earnings before interest, taxes, depreciation and amortization) during 2006 -- we believe that others also will change their negative view of Blockbuster's prospects.
Blockbuster shares, along with the shares of its closest competitor,
, have been under pressure over the past year. Rising adoption of video-on-demand services from cable companies and poor box-office results have led to a slowdown in revenue for the company.
A quick review of Blockbuster's financial results reveals evidence of an industry under pressure from new means of video distribution, such as the Internet and discounted used-movie sales at Amazon.com. Blockbuster's rental revenue was essentially flat at $4.2 million in 2004 and 2005, although gross margins declined to 55% in 2005 from nearly 59.7% in 2004. Meanwhile, cash flow from operations declined to $701 million in 2005 from $1.2 billion in 2004, due in part to an increase in working capital.
In addition, Blockbuster hasn't done itself any favors during this period, first promising to have 2 million subscribers in its online-rental segment by the end of the first quarter this year only to revise that deadline to the end of 2006. Despite these pressures and Blockbuster's currently bleak financial picture, we don't believe the company will be forced to file for bankruptcy. We believe Blockbuster has a handful of strategic options it can implement to deliver solid EBITDA results this year.
Lastly, Blockbuster recently announced it is changing the way it accounts for purchases of movies for its rental library. The company had been classifying this cost as an investing expense on its cash flow statement. Blockbuster will now classify this cost as an operating expense, which will reduce cash flow from operations. Even so, the accounting change will have no impact on the company's total liquidity position or the company's ability to meet creditor liquidity and leverage covenants.
Making a Right Turn
As part of its turnaround strategy, first, the company has said that it will close some of its stores. Blockbuster had a total of 6,984 stores at the end of 2005, which is the highest number of stores owned by any rental video chain in the world. An undisclosed number of these stores are losing money or underperforming, and closing money-losing stores will have an immediate positive impact on operating income.
Also, we believe that closing stores will have a positive impact on the sales and margins of neighboring Blockbuster stores. An average Blockbuster store generates $800,000 in revenue per year. Blockbuster would incur limited operating expenditure expansion at existing stores as sales increase due to the closure of neighboring stores. It is reasonable to estimate that 25% of the sales from stores it closes will be picked up by other nearby Blockbuster stores. If the company sees as little as $200,000 in sales from these closed stores moving to a nearby Blockbuster, the company could see a boost in margins.
In addition, Blockbuster could benefit from the closure of competing Movie Gallery rental stores, which appears likely in the near future. As we have chronicled on
, Movie Gallery has suffered worse comparable-store sales than Blockbuster during the current industry slide, and we believe Movie Gallery, for company-specific reasons, will need to close a significant number of stores. Movie Gallery stores each average $400,000 per year in revenue, and a percentage of these sales could flow to nearby Blockbuster stores.
Turning to Blockbuster's online division -- which enables consumers to pay a monthly fee of $17.95 for unlimited rentals delivered through the mail -- it too has the potential to contribute meaningful operating income in the coming years if Blockbuster can deliver on its revised subscriber goal. If the company achieves its goal of reaching 2 million online subscribers by year-end, or about 35% of the subscribers competitor
has, Blockbuster estimates that its online business will be at break-even.
Blockbuster has said that its gross margins are around 50%. Using that basis and assuming some operating-expense acceleration as the business ramps, the online segment would contribute about $100 million in operating income at the 5 million-subscriber mark. While this is a ways down the road, we believe Blockbuster could achieve this result by the end of 2008, based on the online business' recent growth and the fact the company has a well-established brand name that can compete against Netflix.
Blockbuster has been an aggressive cost-cutter, which should help it maintain EBITDA levels that are acceptable to creditors for the foreseeable future. Also, the company has assets, namely its video-game chain, Gamestation, which it can use to raise capital, pay down debt and meet its $100 million annual interest-expense burden. While the company's overall revenue will decline as a result of store closures and asset sales, key profitability measures such as EBITDA will improve.
As we explained in our earlier story, based on a recent amendment to the company's credit agreement, Blockbuster must maintain minimum EBITDA levels. For 2006, the company must deliver EBITDA of $210 million on a trailing 12-month basis.
Trailing 12-month EBITDA for the first half of 2007 must be better than $235 million. In the third quarter of 2007, the minimum EBITDA requirement jumps to $240 million.
And in the fourth quarter of 2007, Blockbuster must generate more than $250 million in EBITDA on a trailing 12-month basis. Failure to hit these critical levels could result in default on its nearly $1.2 billion in debt and force the company into bankruptcy.
Even so, we believe that if Blockbuster successfully implements the steps outlined above, it can yield significantly higher cash flow results. So even though turnaround stories are dicey, and this one is no exception, we believe the potential risk-reward makes this one worth betting on. We will continue to monitor the situation and report updates to subscribers as warranted.
William Gabrielski is a research analyst at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabrielski welcomes your feedback;
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