Not every stock priced below $10 a share will be a profitable investment. Some of the companies trading at these prices are doing so because their operations are in disarray or their business segments in severe decline. One great example of this is Blockbuster ( BBI), the giant video retailer. Indeed, the entire video-rental market is ailing, mainly due to negative same-store sales results, competition from video-on-demand (VOD), overleveraged balance sheets and plans by movie makers to release their titles through VOD and in cinemas at the same time. Given all these headwinds, Blockbuster is a stock that is best avoided. At the end of 2005, Blockbuster operated 7,158 company-owned movie-rental stores and 1,884 franchised stores, and generated revenue from its newest initiative, online movie rentals, where it competes with the likes of Netflix ( NFLX) The company also generates approximately one-third of its revenue through selling merchandise in its stores, though this business carries significantly lower gross margins, about 22% vs. almost 70% for video rentals. From a fundamental standpoint, Blockbuster's financials are dismal, at best. The company has delivered negative same-store sales for the past three years, been forced to amend its credit agreement with JPMorgan three times, and completed a recent $150 million convertible preferred offering that showed signs of financial desperation, as it was done to meet creditor leverage demands. Blockbuster reported its fourth-quarter and full-year earnings results in early March. For the quarter, revenue declined by 11% from the same quarter a year ago, to $1.53 billion, and the company delivered a profit of 17 cents a share. For the full year, sales declined 3.1% to $5.86 billion, and the company lost $70 million in operating income vs. an operating profit of $170 million in 2004. Despite the decline in revenue, the company's cost of goods sold increased, which compressed gross margins enough to weigh on operating results.
Blockbuster's problems, as stated before, stem from an industry in decline. The advent of VOD in the cable industry has made it possible for customers to avoid the hassle of going to the video store; they simply remain on their couches and press a few buttons on their remote controls. With VOD, customers do not have to pay late fees. Last year, Blockbuster scrapped late fees in favor of billing the entire retail value, less the cost of the rental, for videos kept out longer than the 30-day "good will" period. The video retailer is also facing pressure from other retailers, including those online. Many consumers are using Amazon.com ( MSFT) to purchase videos outright. Amazon offers used DVDs at prices that are often no more than two or three times a rental fee, eliminating the legwork of going to the video store. In addition, just last week The Wall Street Journal reported that Amazon is planning to offer movie downloads on its Web site. Given the increasing presence of home-entertainment centers connected to the Internet, consumers may soon be able to download movies using Amazon's service. Amazon is reportedly in talks with major film studios, and the Journal said the studios are considering simultaneous Amazon/DVD releases. Hollywood is responding to the change in preferred methods of content delivery. For instance, the time between a movie's release in the theater and its release on DVD has fallen by about 35% over the past decade. And Fox is pondering the idea of simultaneous theater/DVD releases. However, we suspect Fox also will eventually offer new releases through VOD, which will have a catastrophic impact on video-rental data. Blockbuster has responded to the crisis by doing what most scared retailers do: cutting prices and offering membership perks. In February, Blockbuster announced that it will offer the 1.2 million subscribers to its online service one free rental a week, which is an increase from its previous handout of one free rental every other week.
However, these price-cutting initiatives should be viewed as customer and subscriber acquisition costs, which means the cost of doing business is headed higher. Blockbuster had to give up its lucrative late fees, which represented almost 10% of its total rental revenue, in order to keep people coming to its stores. Also, its online business, which has cost hundreds of millions of dollars to ramp up and has yet to turn a profit, has failed to live up to expectations. Blockbuster management recently said that it will miss its target of 2 million subscribers by the first quarter of 2006, a target it set in 2005. The company now expects its online business to deliver a profit in 2007, though this seems farfetched, given that Blockbuster's previous forecasts surrounding this business have proved too aggressive. Blockbuster's poor operating results have led to three amendments of its credit agreement with JPMorgan. The most recent amendment in November led Blockbuster to sell $150 million in convertible preferred securities and use a portion of the proceeds to pay down existing bank debt. In other words, the banks would only forgive Blockbuster for breaching its minimum earnings before interest, taxes, depreciation and amortization (EBITDA) covenants if it shifted a portion of its debt liability to other lenders in the public market. It is worth noting that the convertible deal is priced at $100 a share and is already trading lower to about $84. In addition, Blockbuster was granted easier operating restrictions. Under the terms of the new agreement with creditors, Blockbuster will have to maintain minimum trailing 12-month EBITDA figures of $210 million in 2006, $235 million in the first half of 2007, $240 million in the third quarter of 2007, and $250 million in the fourth quarter of 2007. Under the company's second credit amendment in August, the base level of trailing 12-month EBITDA it was permitted to deliver was $250 million for the first two quarters of 2005.
Blockbuster has trailing 12-month EBITDA of about $250 million based on our calculation, but maintaining this level will be increasingly difficult. For its part, Blockbuster plans to trim about $100 million from its selling, general and administrative (SG&A) costs in 2006. However, this may be difficult, as the costs of advertising its online business will likely rise. But even assuming Blockbuster does manage to improve it overall SG&A expense through store closures and other cutbacks, declining revenue will make it difficult for the company to show meaningful operating income growth. Looking ahead, threats are emerging that could weigh on Blockbuster's ability to show positive same-store sales. Most notably, competing formats for next-generation high-definition DVDs could cause mass consumer confusion and raise the company's inventory costs, as it will have to consider carrying multiple formats of the same movie. But Blockbuster isn't dead. Board member Carl Icahn, an activist investor, is pressing the company to show operating improvements after disagreeing with management's decision to end late fees. The company finished 2005 with $276.2 million in cash and plans to rein in capital expenditures to $90 million in 2006, which is about $28 million less than Blockbuster spent in the fourth quarter of 2004 alone. And the company may be able to close less-profitable stores or sell its international store base to raise funds. However, Icahn can do little to change the habits of consumers and has been less effective of late in instituting change, as evidenced by his failed attempt to gain control of Time Warner's board of directors. Blockbuster's cash balance is only about 20% of its total obligations at the end of 2005, by our calculation. And closing less-profitable stores and making asset sales that will see proceeds go directly to creditors is only a short-term fix that will have zero long-term impact on equity holders. Barring a shift higher in box-office results, which would lead to a surge in demand for video rentals, I would be surprised if Blockbuster doesn't wind up back at the drawing board with creditors for a fourth time in the next 12 to 24 months. With little left over for equity holders in the event creditors decide to stop giving Blockbuster handouts, investors should stay on the sidelines with this name.