Blockbuster's Online Focus is Killing its Competitive Advantage

“Invite your enemy onto the roof, then remove the ladder." One of the ancient Chinese 36 Strategems of war aptly describes Netflix's (NFLX) (perhaps accidental) strategy in the movie rental battle with Blockbuster (BBI).

Enticing the giant, store laden Blockbuster into a battle for online customers ('the roof') is an excellent way to use Blockbuster's current strength (retail stores) against itself.

BBI has tried to compete with NFLX with its Total Access [TA] service which, so far, has gained a lot of customers and cost a lot of money (not least the $2 BBI spends every time a TA customer enters a BBI store).

BBI is currently seeing a massive revenue and margin shortfall for its TA customers versus its traditional in-store (offline) customers, but is busy turning offline customers ('the ladder') into TA subscribers at the rate of ~1M per quarter.

With no strategy in sight to improve the profitability of its TA subscribers, it is clear that BBI's stores currently stand as a competitive disadvantage if BBI continue to chase the online rental market (whether by mail of by video on demand).

To illustrate why, take a 10,000ft view of the two businesses:

Take BBI movies without the online component (60% of BBI business).

- It's got 2006 rental revenues of 2.8B and and almost 65% gross margins...throwing off about 1.8BN in cash before the fixed costs kick in:

- There are 8,000 worldwide stores (6,500 domestic, mostly company leased) with an average size of 6,000sqft. That's around $1bn/ year just in property leasing costs.

- Each store employs 5-10 people, which adds at least another $1.5bn in fixed costs.

- Each store has $300-600k in annual revenue - that's about 10M company wide active customers going to the store and buying one $5 movie per week ($200-250 per year). The total number of BBI subscribers is a lot higher than 10M, but a small percentage of these are probably active.

- Revenues are declining 2-3% year on year and are expected to keep declining.

- Previously rented product revenue, new DVD sales and other in store merchandise are a small and also declining part of the business with about 25% gross margin. What market is BBI chasing with Blockbuster online?

- Acquisition cost of ~$30-$50 per subscriber (BBI is predicting net add of 800,000 subs in Q107 at the cost of 17MM in advertising and 20MM in investments in extra DVD stock)

- Revenue/ subscriber / year of ~$100-$150 (considering FY06 numbers)

- Subscriber growth of 3-4MM per year, to reach 50% of the market in 2010 with a revenue of $1bn

- Margins best case of 40% (NFLX, with 1,300 staff), and this is without the $3bn 35,000 staff millstone which is BBI stores. Why is BBI trying to replace its current high margin (65% GM) business with this low margin one (40%)?

- BBI has to stop losing its customer base to NFLX. The online rental market is projected to be 20MM by 2010 (source: Netflix). With current NFLX membership of 8M, and revenues of $1bn, BBI is projecting more market share impact from NFLX and is trying to move accordingly. It is also trying to gain market share from other domestic competitors by locking customers into the BBI stores with the TA features of free movies and in store swaps.

- BBI believes its stores are a competitive advantage over NFLC. How can $3bn in fixed costs be a competitive advantage? Well, BBI believe two things:

a) The in store coupons and free movie swaps will entice online customers away from NFLX

b) BBI can make up the revenue shortfall for online customers vs existing customers by selling more in store merchandise to the visiting TA customers.

Here's what's happening:

- 70% of TA customers are visiting BBI store 3 times a month, costing BBI on average $2 per visit (source: BBI). With average monthly revenue of $12, this means BBI is currently only pulling in $6 per month for a customer who is probably viewing 5-10 of BBI's stock every month. This compares very unfavorably to BBI's regular business, where a customer pays $5 just for one movie. When we include BBI's investment in extra inventory and marketing costs to support TA, it is clear that BBI is currently 'investing' a lot of cash into TA, to the benefit of the happy TA customer.

- BBI would have to sell at least $8 in store merchandise (with margins of 25%) to each TA customer who visits a store to break even on the $2 each TA member visit costs BBI. This is not happening, at least if the merchandise at my local BBI store is anything to go by. There are signs from the company that they recognize that TA margins are a killer so far

- BBI is trimming their store count and trying to reduce outlet size from 6,000 sqft to 3,000sqft by moving seldom watched inventory to online access only.

- In a 'bait and switch' move, BBI is considering price increases for the TA service so that the next 8M customers don't cost the company as much as the current 2M. These are (source: company surveys):

- Restricting TA online access to new releases and 'satisfying more of their new released needs through our stores.'

- Increasing fees for TA by $4-$5 per month and replacing the current service with 'Blockbuster by mail' which allows no in-store privileges

- Or charging $50c per in store exchanges for TA, with a limit of 6 monthly exchanges.

What BBI can do:

- BBI needs to roughly half the cost of their stores from $3bn to $1.5bn to match the decline in store based rental traffic and the lower margins from the TA business. This is just a starting point

- BBI needs to gain $10 in store revenue per TA subscriber per month in order to turn the stores from a competitive disadvantage into a competitive advantage. If BBI is not selling merchandise to incoming customers, then the 3,000 sqft and 2-5 staff are useless to the business. A vending machine in the local supermarket would be just as useful for picking up and dropping off movies.

How could BBI monetize the store base? Here's a random selection of ideas BBI could take further:

a) Add free wireless in all stores. This is for free - BBI is currently paying dearly for single laptops hooked up to the web via a cellular modem in all its stores for potential new TA subs. Replace this with a DSL line and a wireless router and buy a few sofas. Offer free wireless to all members, where they can check their mail or maintain their TA online queue. This will increase the store traffic and drive ancillary sales of DVDs and beverages.

b) Offer 'download and burn' kiosks in stores, for in-store purchase of movies.

c) Offer HD-DVD equipment rental for those who want to check out the HD-DVD experience but don't wanHere's what's happening

Disclosure: author has a long position in BBI

Comments

[alexbakertech]

I think you present a very interesting analysis. However, I think that it must be noted that Blockbuster's brick and cement disadvantage is not going away. If they sold every store today they would be left with a lot of cash but not a strong enough customer base to follow them into the internet world. Blockbuster NEEDS to use its stores to offer an alternative to the, already well-crafted, structure of Netflix.

Also, your suggestion about wireless in Blockbusters cracks me up. Do you really see Blockbuster being the place to hang out and check your e-mail?? Starbucks...okay. Airports....okay. But who is goign to bring their laptop into a blockbuster?? Or, furthermore, who carries their laptop around and finds themselves in a blockbuster?


If blockbuster can deliver their promised doubling of online customers by the end of the year we may see a difference in the Netflix dominated online retailers. I think Blockbuster is losing focus of what really seperates itself from Netflix——VIDEO GAMES. Obviously a smaller market, the Nintendo Wii focuses on small easy games that really lose their excitment after a week. Blockbuster could make a killing on the new systems if they offered games online, which Netflix does not and Blockbuster is slowly realizing they need to do.