Blockbuster Weathers Netflix Battle

The company records subscriber gains even as a price war bangs up its bottom line.
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Updated from 3:59 p.m. EDT

Blockbuster

(BBI) - Get Report

fired another shot in its price war with

Netflix

(NFLX) - Get Report

Thursday, after showing Wall Street the spoils of battle -- and also the costs.

The movie-rental giant announced another raft of changes to its subscription offerings, after reporting that it added 600,000 net new subscribers to its rental service in the second quarter, bringing its total to 3.6 million subscribers.

The report came after Netflix on Monday posted a quarterly decline in subscribers for the first time since it pioneered the online DVD-by-mail subscription service. It ended the quarter with 6.7 million subscribers.

Wall Street clobbered Netflix for its performance and its admission that Blockbuster's pricing strategy, along with the added value it can offer through its huge chain of stores, is a greater threat to Netflix's profitability than the company anticipated. That said, Netflix maintains that Blockbuster's strategy to win subscribers requires it to bleed red ink at a rate that is unsustainable, and Blockbuster acknowledged as much on Thursday.

Blockbuster reported a second-quarter loss, after paying dividends on preferred shares of $38.1 million, or 20 cents a share, for the three months ended July 1. That compares with a year-earlier profit of $65.6 million, or 31 cents a share.

The latest results included a one-time gain of $77.7 million, or 41 cents a share, related to the sale of 217 Gamestation stores in the U.K. Results from the year-ago quarter included a favorable tax audit settlement of $91.2 million, or 42 cents a share.

Excluding one-time items, Blockbuster reported a loss of 53 cents a share, missing Wall Street's expectations for a loss of 33 cents a share, according to Thomson First Call.

"The costs associated with

Blockbuster's Total Access subscription affected our profitability," said the company's new chairman and CEO, Jim Keyes.

Blockbuster's second-quarter revenue slipped 2.8% to $1.26 billion, due to store closures and a lack of big DVD releases. The top line narrowly beat Wall Street's forecast.

For years, Netflix stole customers from Blockbuster's chain of stores with its online subscription service. Now, Blockbuster has embraced the Internet, and it's winning back customers with an aggressive pricing strategy that combines an online subscription service of its own with the instant gratification that is available in its stores.

In essence, Blockbuster is allowing the hard-core movie renters that were once its most profitable customers to pay much less for a monthly subscription that allows them to rent the same amount of movies.

"The high-profit customer is basically gone," says Wedbush Morgan Securities analyst Michael Pachter. "But there are more customers now, and Netflix has less customers. That bodes well for Blockbuster's future."

Pachter says Blockbuster's second-quarter subscriber growth was more dramatic than he expected, and he says the price war will be a long-term win for Blockbuster (he does not own the stock, and his firm has no banking relationship with the company).

Arvind Bhatia, analyst with Stern, Agee & Leach, said in a research note that "strong subscriber growth

at Blockbuster should overshadow weak earnings."

Netflix responded to its subscriber loss by cutting its subscription prices and slashing its outlook for subscribers and profits. For its part, Blockbuster said it's undergoing a "comprehensive review" in order to "revitalize the company, enhance the organizational structure and improve profitability."

As part of that effort, the company announced several changes in its offerings, one of which limits subscribers of its most popular Total Access plan, priced at $16.99, to a maximum of five in-store DVD exchanges every month. Beyond that, subscribers will have to pay the discounted price of $1.99 for each in-store rental.

That will allow Blockbuster to recoup some profits on its heavy-use customers. Those customers that want unlimited in-store and by-mail rentals, with a maximum of three DVDs out at a time, can subscribe to its new Total Access Premium DVD rental plan, priced at $24.99 per month.

For its cheapest Blockbuster By Mail service, priced at $4.99, the company said it will give customers the option to exchange their online rentals at some stores for $1.99 apiece. Previously, subscribers to its Blockbuster By Mail offerings had no access to in-store rentals.

Brian Bolan, analyst with Jackson Securities, says the changes announced by Blockbuster signaled that the company is trying to squeeze more revenue from its subscriber base. He attributed a gain in shares of Netflix during a broader market selloff on Thursday to hopes that such efforts will bring frustrated DVD renters back to Netflix.

Shares of Netflix jumped $1.14, or 6.8%, to $17.84 on the day.

Blockbuster also said it will review its store models.

"Traditionally, we needed 5,000 to 6,000 square feet to meet the catalog and new-release demands of our customers," said Keyes. "Today, that business model is under significant pressure."

Blockbuster shares closed up 10 cents, or 2.4%, to $4.27.

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