Bankruptcy Is Blockbuster's Only Hope

(Blockbuster bankruptcy article updated with S&P rating and commentary from the company.)

NEW YORK ( TheStreet) -- Blockbuster's ( BBI) warning that bankruptcy might be looming is a scare for investors who fear for the value of their stock -- but could ultimately be a smart move for the company.

Blockbuster

The video rental store declared in a Securities and Exchange Commission filing on Tuesday that it might be forced to file Chapter 11 if cash flows don't improve and it is unable to restructure its debt. Blockbuster's reportedly has about $1 billion in debt. "These factors raise substantial doubt about our ability to continue as a going concern," Blockbuster said in the filing.

As a result, Blockbuster's shares plunged 30% to close at 28 cents on Wednesday. While the move could ultimately be beneficial for the company, investors fear a bankruptcy filing would leave common shares practically worthless. Shares rallied a bit Thursday in after-hours trading following positive comments from CEO James Keyes, gaining 3.3% to 29 cents.

Still, a voluntary bankruptcy, while painful, may be its only way out, Needham analyst Charles Wolf says.

The news prompted Fitch ratings to cut Blockbuster's rating to C from CCC and downgraded its $675 million in senior secured notes to CC/RR3 from B/RR2. Fitch also affirmed $300 million in senior subordinated notes at C/RR6, which it said reflects poor recovery prospects in a distressed case.

The ratings agency said Blockbuster needs to restructure a large portion of its debt and expects its credit situation to continue to weaken in 2010. Similarly, Standard & Poors also downgraded Blockbuster's corporate credit rating to a "most speculative" grade of CC from CCC. "The CC rating indicates that, in our opinion, Blockbuster is highly vulnerable to default," said S&P in a statement.

Blockbuster has provided little confidence that it will be able to recover on its own and it's debt load isn't its only issue. Last month, the video rental company reported a fourth-quarter loss of $434.9 million, or $2.24 a share, as same-store sales fell almost 16%. This dour result came as a majority of the retail industry began to recover.

Bearing these numbers in mind, it should hardly come as a shock that Blockbuster is mulling filing Chapter 11. Yet, just two weeks ago Keyes told CNBC that the company has a "bright future," which sent the stock surging.

Keyes reiterated this optimistic sentiment on Thursday, telling the Dallas Business Journal that despite the SEC filing Blockbuster's situation hasn't changed dramatically over the past year. He called the filing "routine" and similar to other ones the company has had in the past.

No one can say Blockbuster isn't trying. Over the past several years, the company has shuttered underperforming stores, cut costs and rolled out kiosks in an effort to compete with Netflix ( NFLX) and Coinstar's ( CSTR) Redbox.

"There's a role for physical stores to play in video distribution," Wolf says. "And Blockbuster's plan to close underperforming stores is spot on."

Earlier this week Blockbuster also announced that it's in talks to divest its European unit.

The company has also said that it will reduce its costs by $200 million this year.

Still, no matter what the company does, there is always the looming shadow of debt and interest burden, which was caused by the special dividend Blockbuster was forced to pay when it was spun out of Viacom ( VIA) in 2004.

"A voluntary Chapter 11 would enable Blockbuster to reduce its debt burden and interest payments to manageable levels and allow it to implement its strategy for closing underperforming stores and building a digital distribution business," Wolf says. "I can see why management is contemplating it."

Edward Neiger, bankruptcy attorney and founder of Neiger LLP, says the probability of Blockbuster filing for bankruptcy is about 75%. He expects the company is currently in frantic talks with their debt holders and if they don't agree on a resolution Blockbuster won't have any other choice. And even if the two parties do renegotiate the term of its debt agreement, there is still a chance Blockbuster could file Chapter 11.

Neiger expects a bankruptcy filing to come in the second or third quarter.

Blockbuster will likely use the filing as a platform to renegotiate terms with its existing senior debt holders, reject or renegotiate terms with a large number of its store landlords and liquidate non-core assets," says Kenneth Latz, director at Conway MacKenzie, a financial and operational consulting firm. "I would imagine that the holders of the existing subordinated notes will ultimately end up owning the majority of the business."

So if bankruptcy is imminent, what then will become of Blockbuster? Well, that all depends on the terms of the bankruptcy.

Latz does not think a pre-packaged bankruptcy is likely or there is any possiblity of settling outside of court. "It would be unwise for Blockbuster to just deal with the debt holders and not address the vast store overhead or their operational issues," he says.

If they were to do this, it is likely Blockbuster will be staring at Chapter 22 down the road, Latz says, which often means liquidation.

-- Reported by Jeanine Poggi in New York.

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