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Updated from 7 a.m.

Monday morning wasn't kind to

Blockbuster

(BBI) - Get Free Report

, but some fans say recent setbacks won't derail the big entertainment-rental outfit.

Shares in the Dallas-based company fell 5% after the company withdrew its bid for a rival. The stock has been stuck in the high-single digits ever since last summer, when Blockbuster split from longtime parent

Viacom

(VIA) - Get Free Report

and paid out a hefty one-time dividend.

The news certainly didn't improve last week. If anything, it took a turn for the worse, as the company finally dropped its hostile takeover bid for smaller rival

Hollywood Entertainment

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. Blockbuster dropped the nearly $1 billion bid Friday,

citing likely opposition from antitrust regulators, and leaving Hollywood in the hands of No. 3 operator

Movie Gallery

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.

Even factoring in the loss of Hollywood, though, some industry watchers think Blockbuster's looking more robust than investors seem to appreciate.

"Blockbuster has significant opportunities for development," says Marla Backer, an analyst with Soleil-Research Associates who rates the stock hold and whose firm doesn't do any underwriting. "I don't think that's fully reflected in its stock in the long term."

CEO John Antioco has made changes across the board. Over the last year, the company has launched an online rental service, introduced in-store promotions and tightened its focus on the emerging game-and-movie-trading businesses.

While Antioco has put Blockbuster Online on the front burner, analysts expect it to take at least a couple years for the gains Blockbuster makes in cyberspace to start showing up on the bottom line.

"It's a must that Blockbuster get a piece of the online rental business," says Tom Adams, president of California-based Adams Media Research, which doesn't do any underwriting. "We see online rental as being one-third of the rental market five to six years out."

Blockbuster launched its online service in August last year in an effort to take on rival

Netflix

(NFLX) - Get Free Report

, which has more than 2.5 million subscribers. A price war ensued, with Blockbuster twice slashing its monthly subscription price. The company now charges $14.99, $3 less than Netflix.

The move paid off in expanding user rolls. Blockbuster gained 750,000 subscribers, and now hopes to reach the 2 million mark by the end of the first quarter of 2006.

All agree, however, that Blockbuster eventually will have to raise its prices. "It's sustainable till Netflix ceases to exist," says Michael Pachter, an analyst at Wedbush Morgan Securities, who has a buy rating on BBI and whose firm hasn't underwritten for Blockbuster. "Netflix started it, and Blockbuster is going to finish it."

To increase in-store sales, the chain has launched a slew of promotions, including eliminating late fees and offering all-you-can-watch monthly pricing. Few observers think Blockbuster can make up for the $250 million to $300 million in annual revenue it lost by banishing the late fees, but some say it was a necessary step.

"They didn't have any choice," says Dennis McAlpine of McAlpine Associates, who has a hold rating on the stock and whose firm has no investment-banking arm. "They were correct that the major thing going against video stores" was late fees.

The company hopes to make up for it by cutting spending, probably including a round of employee layoffs. "That's one source of cost-saving," says Pachter of Wedbush Morgan. "Rationalizing and closing underperforming stores can improve their order."

The company says it will strive to cut costs but won't specify any targets right now. "We will be reducing unnecessary expenses like discretionary spending, and

eliminating positions where necessary," says Blockbuster spokesman Randy Hargrove.

In the last year, Blockbuster has also pushed forward its games business, which contributed one-sixth of the company's $6 billion in revenue for 2004. At the end of 2004, it had more than 700 game locations and "plans to refine its games business and continue its growth in 2006 and beyond."

Blockbuster also hopes to cash in on sales of new and used DVDs and games, through movie and game trading offered in 3,500 of its 8,500 stores worldwide. According to the Video Software Dealers Association, sales of DVDs amounted to over $15 billion last year.

The fate of the $8 billion video rental market has been in question lately amid a rise in online rentals, pay-per-view offerings and video-on-demand. While these newer services have gained some ground, the most popular way for consumers is still video rentals. "Store rentals are going to decline, but they are not going to go away," says Adams.

In fact, some people say there may be a slight turnaround in the market at some point next year. "We expect a slight pickup in the rental market," says Backer. "The rising DVD penetration should result in a slowdown of sell-through, increasing the demand for rentals."