Blockbuster struggles while the DVD thrives

May 05, 2010  

The demise of Movie Gallery may breathe new life into Blockbuster, but probably not for long.

 Frank Grange JohnsonBy Frank Grange Johnson

When I was in business school back in 1992, one of my professors, who was a successful media entrepreneur, predicted that video rental stores in general and Blockbuster in particular would soon be put out of business by an early Time Warner Cable version of video on demand. Time Warner’s first effort consisted of a warehouse full of video home system (VHS) players and employees popping video cassettes into the machines while they roller-skated from machine to machine.

My professor’s statement was a bit premature, as here we are in 2010 and the video store still exists. Nevertheless, conventional wisdom maintains that the DVD is dead and soon everyone will be downloading movies to play on their computers and TVs. Indeed, 2010 is the year when Blockbuster is likely to disappear. Movie Gallery, the second-largest movie rental chain, announced today that it was closing down after entering bankruptcy in February and attempting to restructure. Its demise may breathe new life into Blockbuster, but probably not for long.

The force that will kill the big-box movie rental chains is not, ironically, super-fast internet age downloads, but rather a low-tech kiosk run by Chicago-based Redbox. In fact, Redbox’s kiosk is so disruptive that it may actually retard the growth and acceptance of video on demand, further extending the life of the DVD.

The DVD business is not all that different from the VHS business in that there is a sale and a rental market. The new kid on the block is digital downloads. The one crucial difference between VHS and DVD formats is that the studios, led by Time Warner, shifted from selling high-priced copies of its movies to rental stores to embracing a more discounted sale price and revenue-sharing model. This change was highly profitable as millions of Americans bought disks to build their own video library and to give as holiday gifts. Video on demand and low cost kiosks threaten to disrupt this ecosystem.

The physical DVD market has three segments, each served by a different form of distribution. The purchase market is for people who want/need to own the content for repeat viewing or for gift-giving. This market is still largely served by big-box retailers like Walmart who often use the disks as loss leaders to drive traffic. The studios love this business as the cost of producing a disk is close to zero and there is significantly less piracy than in the music industry. This part of the business is shrinking. People prefer to rent.

The other two segments are DVD rentals, which are of two types. One group of customers likes to watch the thousands of movies and TV shows that have been produced over the years. They are serviced by Netflix, which can efficiently mail DVDs to America’s more than 100 million families from a few large distribution centers. While Netflix does have the newest releases, they buy relatively few copies and don’t highlight the hottest DVDs on their website. Also, by definition, it takes a few days for the latest titles to reach your mailbox.

The second group of renters wants the latest hits. For this second group there was the rental store, long dominated by Blockbuster and, to a lesser extent, Movie Gallery/Hollywood Video (now going through a second chapter 11 reorganization in 3 years). These stores have traditionally made their money by carrying hundreds of copies of the hot new releases and little depth of anything else. If you wanted to see My Dinner With Andre, you had to either wait for PBS to show it or rent it from Netflix. Blockbuster was the best way to rent Batman, so you could avoid spending $20 to buy a copy or waiting for it to be shown on HBO.

It is in this final mass rental category where the big change is happening. About five years ago, Redbox was created with the model of replacing a 4,000 square foot Blockbuster store with a 12 square foot box that can carry 600 to 1,000 rentable DVDs. Unlike the special trip that Blockbuster requires, these kiosks are in supermarkets, convenience and drug stores, where customers are going anyway. The brilliance of Redbox is not just its convenience, but also its pricing: $1 a night. Simple, cheap and convenient, it is the perfect Great Recession product. In fact, some studios hate Redbox’s value pricing model so much that they refuse to sell DVDs to the company directly, forcing Redbox to go and buy physical DVDs from Walmart and Best Buy.

It is this combination of convenience and pricing (entertain the whole family for $1 a night) that will enable Redbox to stave off video on demand. It is worth noting that Blockbuster has also entered the kiosk business via a joint venture with NCR, a producer of automated teller machines and cash registers. This venture is subscale with only a couple of thousand kiosks cobbled together through various acquisitions of incongruous machines versus the 30,000 kiosks that Redbox will have by yearend that boast a vastly superior user interface and software. Listening to Jim Keyes, Blockbuster’s CEO, talk about the kiosk business at one investor conference made me realize how little Blockbuster is doing other than lending its name to the venture. He even talks about NCR as if it were a competitor to Blockbuster, which it is in many ways. Blockbuster has effectively supported a business that, if successful, would cannibalize its core revenue stream.

The supposed upstart, video on demand, is not nearly as cheap for the consumer. At $4 to $5 a night for a limited selection, it compares unfavorably to $1 for a larger selection at Redbox or $9 to $20 a month for an unlimited selection at Netflix. Additionally, video on demand has never perfected its user interface. There is no uniform standard, and you must watch your video on demand selection within 24 hours or it disappears.

The peak year for consumer DVD sales was 2004. Annual movie rental per TV was probably at its highest in the late 90’s when VHS copies were plentiful and there were fewer entertainment options. Over the past decade, DVD rentals replaced VHS but never achieved quite the same high levels. Since 2005, movie rentals per household have stabilized at just under 25 per year with cable video on demand and online digital rentals taking a slightly higher, but still minimal, share. Why this "Back to the Future" outcome? Price. One dollar a night for Redbox is so low that good old fashioned cheap has proved to be more disruptive than new technology.

Not that Redbox’s DVD kiosk is as low-tech as it would appear. It is as much a software company as it is a hardware company. The key to making money at $1 a night is rapid turnover of inventory. From its central headquarters, the company runs complex algorithms to determine what people want to watch at its almost 30,000 locations. These preferences are then sent out to the various distribution centers and the inventory mix is maximized by kiosk (Greenwich, Conn. has different viewing habits than Dallas, TX). Since the machines are networked, you can return a disk rented at a kiosk in Los Angeles to a kiosk located in Manhattan. There is also an iPhone app that, in three touches, enables you to reserve new releases on your credit card at your preferred local Redbox.

The result of all this technology and infrastructure is a system with as much, if not more, choice than a typical cable video on demand offering. The chairman of a movie studio once told me that, for most Americans, video on demand is Tuesday at Wal-mart when the new releases come out and are sold at or below cost. For many people, the various on demand services that cable companies sell are just too expensive. Redbox is a solution that is cheaper and as convenient. Unless the price of video on demand is lowered dramatically (something the cable companies and studios show no sign of doing), Redbox will expand to its projected 60,000 kiosks and the DVD will live on.

Frank Grange Johnson is the founder of LaGrange Capital Partners, an event-driven hedge fund based in New York. He holds a long position in Coinstar, the parent of Redbox.

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