Blockbuster

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Business Case Study Blockbuster, Inc.

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Draft Table of Contents Title Page .......................................................................................................................... i Draft Table of Contents ......................................................................................................ii LIST OF FIGURES......................................................................................................................III 1.0 1.1. 1.2. 2.0

INTRODUCTION ...........................................................................................................1 Origin and Financial Overview...........................................................................................1 Mission Statement and Corporate Goals ..............................................................................4 BOUNDARIES OF THE FIRM .......................................................................................5

2.1. Origin and Financial Overview...........................................................................................5 Vertical Integration through Strategic Alliance ...........................................................................5 A Classic Example of Holdup ....................................................................................................6 2.2 Diversification ...................................................................................................................8 Aquisition ...............................................................................................................................8 Internal Growth .......................................................................................................................8 3.0

BOUNDARIES OF THE FIRM .....................................................................................10

3.1. Industry Overview...........................................................................................................10 Industry Structure ..................................................................................................................12 3.2. Competition ...................................................................................................................13 Analysis of Competitive Dynamics ...........................................................................................14 Examination of Competitive Strategies .....................................................................................15 3.3. Current Status ................................................................................................................15 Porter’s Five Forces in the Video Rental Industry ......................................................................15 4.0

STRATEGIC ANALYSIS..............................................................................................18

4.1. Overview and Introduction to Strategy...............................................................................19 Basis of Strategy Selection ......................................................................................................19 Trends and Recent Activity......................................................................................................19 4.2. Retail Strategy................................................................................................................20 Reducing the Number of Retail Locations .................................................................................21 Leasing Out Space .................................................................................................................22 Partnering With Other Retailers ..............................................................................................22 4.3. Technology Strategy........................................................................................................23 4.4. Marketing Strategy..........................................................................................................24 In-Store Promotion.................................................................................................................25 Advertising............................................................................................................................25 4.5. Conclusions and Summarization of Recommendations .........................................................26 5.0

REFERENCES..............................................................................................................26 ii

LIST OF FIGURES Figure 1: Blockbuster Inc. Timeline

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1.0

INTRODUCTION Blockbuster, Inc.’s (Blockbuster) origins date back to 1985, when David Cook sought

to fill a niche market for customers wanting to rent a variety of VHS titles. The enterprise was highly successful, and over the next two decades Blockbuster transformed itself into a worldclass operation with thousands of locations and billions of dollars in revenues. Throughout this paper, the story of Blockbuster will be chronicled — from its early financial performance, to how the company performed as a unit of Viacom, to how it has performed since going public again in 1999. A timeline showing this sequence of events can be seen in Table 1. 1.1.

Origin and Financial Overview

Cook, a computer services entrepreneur from Dallas, Texas opened a local computerized video rental store in 1985. A year later, he called the store Blockbuster Entertainment. Cook funded the first store by selling off his existing oil and gas software business. This first location stocked an unprecedented 8,000 tapes. At an average $70 per tape, inventory costs alone amounted to $560,000. The investment proved worthy as the store was a huge success. This prompted the addition of three more locations by mid-1986. By September of 1986, the need to raise capital to fund further expansion led to an IPO. However, on the day prior to the offering, a damaging news article delayed the stock offering. Blockbuster ran into liquidity problems, and ended the year with a $3.2 million loss. In February of 1987, the need for additional capital lead Cook to sell a one-third stake in the company to a group of investors lead by Wayne Huizenga. In exchange, this infused Blockbuster with $18.6 million to fund Cook’s vision. In return, Cook was forced to turn over future control of the company, and he left the company altogether by April. With Huizenga now in control, Blockbuster set out on a rapid expansion program, with a goal to maintain a 60/40 mix in favor of corporate versus franchised owned locations. Additionally, Blockbuster’s headquarters was moved to Fort Lauderdale, Florida. Between 1987 and 1993, Huizenga catapulted the company into an enormous success. He added Errol’s Video Inc., the third largest video chain in the U.S. and Major Video, a 1751

store chain, opened the 3,000th Blockbuster location in New York City and also added Super Club Entertainment Corp., a top music and video retailer. In 1993, he bought additional rival chains and opened stores around the globe at the rate of one every 24 hours. In late 1993, Blockbuster became an acquisition target for Viacom. The $4.7 billion deal ran into difficulties when talks stalled as Viacom was positioning itself to purchase Paramount Communications. While the merger eventually took place, stocks in both companies dropped as investors lost confidence. This in part led to Huizenga turning over control of Blockbuster to pursue other opportunities. After Huizenga’s departure, Blockbuster suffered a great deal under the leadership of Steven Berrard and later Bill Fields. Although the business suffered, one positive initiative during this time was the launch of a corporate website in 1995. In addition, an arrangement with Sony Electronics, Inc. to create in-store promotions introducing the DVD was made in 1996. Even with these positive initiatives, the turmoil left Blockbuster worth $4.6 billion, which was half of its 1993 market cap. In 1997, John Antioco became chairperson and CEO. Blockbuster’s headquarters moved back to Dallas.

From there, Blockbuster then headed in a positive direction.

Antioco forced the movie studios into an agreement that changed the way movie rentals were transacted —revenue sharing reduced costs and enabled Blockbuster to offer more copies for less money. In 1998, horizontal integration occurred with the creation of Blockbuster Music. Under Antioco’s reign, additional acquisitions of competitors such as Video Flicks stores in Australia were made and incentive programs such as Blockbuster Favorites were initiated. In August of 1999, Viacom made a decision to take Blockbuster public again with an IPO of 18% of its stock. This time Blockbuster would be trading under the BBI symbol, whereas BV had been used prior to 1994. The offering raised only $465 million. Nonetheless, things were looking up in 1999.

Blockbuster served its first official

sponsorship for the Sundance Film Festival, was named number one franchiser in the

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Video/Video Games Stores category by Entrepreneur’s magazine, and ranked number 13 in Brandweek’s magazine of the top 2,000 brands in America. Keeping up with technology and arrangements made with Sony, Blockbuster added the higher margin DVDs to stores worldwide by the end of 1999. Two years later, DVDs had replaced 25% of the VHS and video game inventories. Despite higher revenues, Blockbuster continued to post losses during this time. Alas, one of the biggest hits to the bottom line occurred in 2002, when a change in accounting rules forced Blockbuster to write-off excess goodwill for the first time. Even with these setbacks, Blockbuster continued to buy out competitors. In 2003 — Movie Trading Company, a used DVD retailer was purchased to study the used DVD business. Overall, 2003 was an interesting year. While revenues were up 6.2% from 2002 ($5.91 billion), the company posted a net loss of $845.2 million. The loss stemmed from an accounting charge of $1.3 billion due to the write-off of goodwill per FAS standards. These standards eliminated the practice of amortizing goodwill and instead compare book value against fair value, with a mark down resulting when fair value is lower. Excluding this charge, Blockbuster actually posted an increase in net income of 41.4% from 2002 to $267.8 million. Other highlights of 2003 include: an addition of 224 company operated stores, a 200 basis point increase in total gross margins leading to $3.52 billion in gross profits, an increase in the rental portion of gross profits of 390 basis points to $3.17 billion, driven by the higher margins on DVD rentals, and an overall decrease in interest expense, partially driven by lower rates. These positives were offset by a worldwide downturn in same store revenues of 2.2% and an increase in other operating expenses. For the first quarter of 2004, total revenues decreased 1% from the same quarter in 2003 to $1.5 billion, with net income of $75.5 million after excluding the recognition of a one-time tax benefit of $37.1 million. Worldwide same store revenues were down 7%, and total rental revenues were down 3.7% to $1.1 billion. However, rental gross margins were up 390 basis points and total margins were up 300 basis points bringing in $76.1 million in 3

retail gross profits. Interestingly, total margins were lower than rental margins as retails sales increased as a percentage of total revenue. Ever since going public with Blockbuster in 1999, Viacom has been seeking to divest itself of the remaining 81% stake it holds. It recently announced plans for a stock swap at a to be determined ratio that will complete the spin-off by late 2004. Although Blockbuster has been contributing to Viacom’s cash flow, concerns over Blockbuster’s growth prospects prompted Viacom to sell its remaining stake. From humble beginnings in 1985 to over 8,900 stores today, Blockbuster continues to grow. In nineteen years the company has grown into a $900 million company, however new technologies and clever competitors will keep the blockbuster of video games, movies, and other entertainment media on their toes. 1.2.

Mission Statement and Corporate Goals

Blockbuster’s mission is to help people transform ordinary nights into “Blockbuster Nights” by providing a complete source for movies and video games. The core values of the firm include an increased focus on retail, introducing innovative programs and expanding the in-store selection of movies and gaming equipment, including hardware, software and accessories. Blockbuster implements its strategy through a network of over 8,900 companyoperated and franchised stores throughout the United States, its territories and 25 additional countries. As, Nick Shepperd, Executive Vice-President and Chief Concept officer said to The Dallas Star on May 13, 2002, “Blockbuster’s goal is to become the leading one-stop location for gamers who want to buy or rent their games (Blockbuster Inc., 2003-2004).” Blockbuster is also committed to strengthening the communities it serves. Sponsors outreach programs and partnerships with the Boys & Girls Clubs of America, the Children’s Miracle Network and local schools, providing complimentary movies and game rentals to children, grades one through eight, who maintain A and B grade point averages. 4

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BOUNDARIES OF THE FIRM In this section we look at the changes that have occurred in Blockbuster through

vertical integration and diversification. Further, we will examine the possible explanation for the level of vertical integration and diversification management has elected and the economic cause and effect of such decisions.

In essence, we will look at how

Blockbuster’s management decided to confront such issues as: what should the firm do, how large should it be, and what business should it be in? 2.1.

Origin and Financial Overview

According to Besanko, an effective strategy for determining the appropriate level of vertical integration involves a calculated balancing of costs and benefits. The levels of processing and handling and professional support activities are integral components of this decision process. This delicate balance is commonly referred to as the make versus buy decision. Blockbuster’s effective growth strategy has led to upstream vertical integration. When Viacom purchased Blockbuster, they had expected substantial synergy with Viacom’s other holdings, MTV and Paramount. In 1997, after an apparently unsuccessful attempt at synergy, Viacom’s CEO brought in John Antioco to turn things around. Although discussion regarding the acquisition of Blockbuster may be better suited for the diversification portion of this paper, the actions of Mr. Antioco revolutionized the way Blockbuster did business, and led to vertical integration through an extremely successful strategic alliance with the movie industry. Vertical Integration through Strategic Alliance Traditionally, retailers like Blockbuster bought recently released videotapes through a distributor for about $70 a copy and would keep all of the revenue from the subsequent rentals. Due to the high cost of such purchases, Blockbuster could not afford to stock 5

enough copies of popular titles. Antioco referred to this as the “Customer Dissatisfaction Model”. His belief was that customers should not come to rent a video and expect not to find it in stock. In Antioco’s words, “The dynamic of going to a video store expecting not to get what I wanted was finally enough for me to stop making the trip…What other business treats you like that?” Because of this, customers would frequently substitute less popular titles, or even worse, leave the store without renting anything at all. According to a Time Warner survey, 20% of customers were unable to rent their preferred video on a typical trip to the video store. The studios were initially hesitant, but Antioco successfully integrated upstream by forming a strategic alliance with the movie studios. Through contracting, videos are now purchased at a much lower rate and the total revenue is shared. According to one source, Blockbuster keeps 45% of the revenue, the movie studio gets 45%, and the remaining 10% goes to Rentrak, Blockbuster' s distributor. An enormous gamble that quickly paid off for both Blockbuster and the studios, this action restored Blockbuster’s profits (in both level and growth rate) and increased market share. Revenue sharing has allowed Blockbuster to increase its inventories of recent releases seven fold. This allowed Blockbuster to launch a successful "Go Home Happy" marketing campaign, in which customers are guaranteed that a select list of videos will be in stock. In this example, Antioco’s move shows how strategic alliances bound by a clear expectations of tasks in the form of contracts, play a useful role in vertical integration, and how revenue sharing, combined with a low input price, aligns the incentives along the vertical chain. A Classic Example of Holdup The leverage Antioco utilized to make this deal with the movie studios had a lot to do with Viacom’s’ continued Blockbuster expansion from late 1993 to August 1999. In fact, the sheer size of Blockbuster and its 20% share of the U.S. video-rental market led to 6

Blockbuster negotiating a revolutionary revenue sharing agreement with the studios in 1997. This is a classic example of how Blockbuster was able to “hold up” the movie studios and negotiate more favorable terms on tape purchases. Hold up prior to 1997 was relatively easy because as Blockbuster purchased video rental chains, they also rid themselves of potential competitors, essentially creating a video rental monopoly. Movie studios relied on Blockbuster to reach consumers and if the studios did not agree with negotiated prices, Blockbuster had the leverage to get what they demanded. “Viacom can wheel out Blockbuster to keep vendors in line,” said author of Information Week, Ida Picker shortly after the acquisition. And, “We never would have been able to do that without Blockbuster,” said Frank Biondi, former Viacom CEO. From the movie studios perspective, the biggest investments in producing a video tape rest in creating a tape master, setting up the duplication process, designing cover artwork, distribution and advertising. After taking into account the large fixed cost investment, the variable cost associated with one additional unit is minimal. Leading up to 1997, the studios had ramped production capability to fill the large number of tapes needed for Blockbuster’s inventory. This essentially put Blockbuster in the position of being able to coerce the studios into the revenue sharing agreement, as the studio’s ability to produce a large number of tapes was in effect a relationship specific asset dependent upon Blockbuster’s purchase of the tapes for rental inventory. With a huge investment in the fixed cost associated with tape production, the studios could not risk losing Blockbuster’s business. As long as the studios were able to cover the variable cost of a tape, they would still be better off selling to Blockbuster for a lower price as they could offset the fixed costs investment. Knowing this, Blockbuster was able to negotiate a lower price for tapes, and in return share a percentage of the rental income with Hollywood. This additionally shifted some of the risk that a title would not rent well to the studios.

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A potential side effect of this strategy was distrust and a compromised relationship between the movie industry and Blockbuster. Based on the success of the agreement, the relationship between Blockbuster and the movie industry appears to have remained intact. 2.2

Diversification

Firms can diversify, or produce goods and services, for numerous markets and in many ways. Internal growth, strategic alliances, joint ventures, and mergers or acquisitions are the most common modes. The primary pathways for diversification at Blockbuster identified are internal growth and acquisition. Although Viacom is not the primary subject of discussion, it is relevant to briefly discuss the thought process that led to their acquisition of Blockbuster in 1994. The internal growth strategies will be discussed in somewhat greater detail. Aquisition Although Blockbuster has acquired many competitors in its quest to gain market share, Viacom’s acquisition of Blockbuster represents diversification in that Viacom purchased Blockbuster in an attempt at synergy between movie making, video sales and cable television operations. Regardless, the result reinforces the skepticism in the ability of diversification strategies to add value. Internal Growth The second front on which Blockbuster expanded while it was a unit of Viacom was through horizontal integration. Horizontal integration took place on several fronts; most notably in music, video games, and DVDs. Why did Blockbuster diversify its product lines into these areas? Let us first examine Blockbuster’s foray into the video game and DVD arena. A large chunk of Blockbuster’s operating expenses comes from maintaining its thousands of retail outlets around the globe. The cost of these retail stores is a largely fixed 8

expense, which is recouped mainly via rental revenues. As the nineties wore on, Blockbuster was experiencing a downward trend in VHS rentals. In order to make up the revenue from fewer VHS rentals, Blockbuster would have to raise prices, or find some other way to generate revenue from its stores. Given the exploding video game market in the 90’s, it made sense for Blockbuster to horizontally integrate video game rentals into its stores. This would allow them to leverage the economies of scale and scope within the existing infrastructure and spread the fixed store expense across games as well as VHS titles. Likewise, as DVDs grew in popularity during the period, the addition of DVD rentals to the product line continued to spread costs over more products, while simultaneously expanding the revenue base. Plus, there was a natural correlation between VHS, video game, and DVD rentals as all three were relatively expensive items that had enough demand for short-term low price rentals. The expansion into music, on the other hand, did not take full advantage of Blockbuster’s existing retail store locations. Instead, Blockbuster Music locations were often separate outlets. So why would they pursue this course of action? We believe that Blockbuster sought to use its brand power to attract customers to its music stores. Not only would Blockbuster be able to diversify its revenue stream by capturing music sales, but it could also cross promote its video products. Given its eventual divestiture of Blockbuster Music, this plan was obviously not 100% successful. Perhaps Blockbuster was overly confident in its ability to expand into music. While it relates to movies and games, which proved to be highly successful, music was not. The segregation of music from the movie/game store was a likely hindrance. The name Blockbuster was not synonymous with music. Best Buy, Circuit City and clubs such as BMG and Columbia House hold greater presence in the market. Also, the growth of consumers who began illegally downloading music put all outlets of music retail at a great disadvantage.

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Finally, and most recently, Blockbuster has diversified from being primarily a rental outlet to one that also produces a substantial amount of retail sales. The move to horizontally integrate sales is driven by several factors. First, Blockbuster recognizes a purchasing advantage due to its size, and can offer products that are very competitively priced. Second, it is able to bundle products to effectively increase revenues across the board. Examples of this include promotions such as receiving 10 free rentals when buying a hit DVD. Third, by offering previously viewed DVDs or previously played video games for sale, Blockbuster reduces the operating costs associated with the disposal of old inventory while at the same time drawing more price conscious consumers into its stores. When combined, the increased emphasis on retail sales increases overall revenue, and once again spreads the fixed cost of operating a store over yet another product line. This is quite an effective strategy, and has been a key driver in Blockbuster’s recent comeback in the marketplace. According to The Digital Entertainment Group, selling previously viewed tapes has become extremely profitable and collectively will likely surpass one billion dollars this year. 3.0

BOUNDARIES OF THE FIRM In this portion of the paper we will define and characterize the structure of the

video rental industry. We will discuss the nature of the competition and the competitive dynamics of the video rental industry using microeconomic principals and industry analysis. In addition, we will identify the innovations Blockbuster has created and implemented in relation their competitive strategies. 3.1.

Industry Overview

When the VCR first appeared on the market in the 1970s, Hollywood resisted the revolution and had no idea how large a role it would play in its future. Today, the video rental industry is big business.

According to V.G. Narayanan and Lisa Brem of the 10

Harvard Business School, consumers spent $21 billion in 2001 on video rentals and sales and $10.5 billion of that was in rentals. When you compare this to the fact that $7.9 billion was spent on movie theatre tickets, it is not difficult to see how important video rentals and sales are to the industry. The technology driver behind this revolution was the VCR. The first video recording media sold to consumers was the Sony Betamax in the mid seventies, but it was soon replaced by the VHS-VCR which was created by a division of JVC and sold and marketed by RCA. The Betamax device touted a hefty price tag and could only hold about an hour of recorded material. Although VHS tape quality was less than that of its Betamax competitor, it could hold up to two hours of video and the market power of JVC and RCA helped to push out Betamax by making the VHS-VCR readily available, providing a longer recording time, and a lower cost to consumers. The sole purpose of these units at the time was to allow consumers to tape shows that they would normally miss and allow them to watch later2. Hollywood (and Universal Studios in particular) felt threatened by the possibility of duplication and sued for copyright infringement. The lengthy case was lost and the stage was set for the video industry. Shortly after the VCR was introduced, Twentieth Century Fox predicted the trend and began to license copies of pre-recorded movies. These titles were limited to older material, and were sold through magazine ads and other limited retail methods. Others, including Universal soon followed suit. Companies didn’t believe that people would rent videos at first, but as rental advocates appeared, this quickly changed. Proponents felt that unlike music, you would not want to purchase and watch a video over and over. A few times was enough, and the idea of renting videos started catching on. The earliest video rental stores were small independently owned and located in large cities.

Successful businesses tended to be clean-cut, provide flexible hours, and had

extensive selections. The rental prices started out high and began to drop as more and more consumers purchased VCRs and began renting movies. In turn, more and more players entered the market, setting the foundation for the industry. Thus, the 1970’s and 11

80’s were considered the formative years for the video rental industry. The video rental industry surged in the 1980s and 1990s, even though it was predicted that substitutes like cable and satellite would lead to its demise. 2000 Industry Structure The industry structure consists of the content creators who create movies and shows. These content creators then distribute the content to schedules/packagers (generally television and cable venues) and pipelines (movie theaters, video rental stores, and retail outlets) (Harvard Business School, 2002). Each of these links in the value chain is an integral part of and defines the structure of the video rental industry. Within eighteen months after the release of a movie by a studio, the product has generally been through home video, pay-per view, and pay cable distribution channels before making final transition to basic cable and television networks. The trend to vertically and horizontally integrate within the entertainment industry has combined all three links in some cases. Regardless of ownership, content travels from the creators to the distribution channels and we will discuss the role of each. Creation of content (especially movies) usually entails large capital investments and a good deal of risk. This may explain why six large entertainment companies (including Viacom) generated over 75% of box office revenues in 1999 and 2000 (Harvard Business School, 2002). Content creators traditionally had the leverage to control and maximize revenues through the distribution channels (schedulers/packagers and pipelines).

As

previously described, Blockbuster’s entrepreneurial innovation to negotiate with the content creators under the direction of Antioco led to a power shift in the industry. In the scheduler/packager distribution channel, networks or stations air content produced in-house or material licensed from others. Companies such as Viacom’s CBS Television Network, AOL Time Warner’s Turner Broadcasting, and Disney’s ABC Television and the Disney Channel are examples of such distribution channels. Pipelines deliver movies and other content to consumers and traditionally include 12

movie theaters, home video stores, and retail outlets. Blockbuster falls into this category. The emergence of new technologies that can provide product to the consumers digitally includes pay-per-view and video on demand. This has caused more traditional pipelines to redefine themselves in order to compete within the industry. 3.2.

Competition

As more and more consumers rented videos, the small independent stores or small regional chains dominated the industry until the 1990s when the large rental chains developed under the flagship for the movement (Blockbuster).

As stated previously,

Blockbuster grew from 1,500 stores in 1990 to over 5,500 stores in 2001. Hollywood Video followed in Blockbuster’s footsteps and gained a significant share of the market (1,800 stores) during the same time period. When it comes to rental and sales revenue in 2003, Blockbuster holds first place with $5,815.1 million. Amazon.com, Inc. (Amazon) runs second with $5,263.7 million, however this figure reflect revues for all products sold on Amazon. Hollywood Entertainment is third with $1,682.5 million. Movie Gallery Inc. (Movie Gallery) is fourth at $692.4 million and Netflix is fifth with rental revenues of $272.2 million. Hollywood Video is Blockbuster’s primary physical competitor though the video rental and sales store channel. The company is from Oregon and owned by Hollywood Entertainment Corp. (Hollywood Entertainment). Blockbuster and Hollywood Entertainment held meetings in 2001 to discuss, in essence, ways to keep the online companies out by merging but the Federal Trade Commission raised antitrust concerns. Due to the inability of the merger, Hollywood Entertainment partnered with Amazon. Because Hollywood Entertainment owns one of the Internet' s most popular film sites, Reel.com, beginning in 2002, consumers are linked to the Amazon.com website when they visit Reel.com. This partnership and innovative strategy led to sales of $1.5 billion in 2002 for Hollywood Entertainment. Movie Gallery ranks third in the video rental business. Their niche is to focus on 13

small cities and rural areas. There are 2,200 stores. Movie Gallery acquired Video Update, Inc. in 2001 which helped to secure its place in the top five list. Virtual sales and rental competitors include Amazon and Netflix. Both companies are Internet based and take advantage of web-based distribution. Amazon sells mainly books, videos, and music. However, this competitors product line is quite broad; they even sell clothing. A relatively innovative concept was implemented by Netflix. Customers can pay around twenty dollars a month for three video rentals via the Internet, eliminating the need to travel to rent the video. Netfilx has twenty distribution centers across the country in major U.S. cities. The niche of Netflix is the provision of access to anyone with an Internet connection, the elimination of travel time and overdue rental fees. The Netflix channel model allows consumers to rent three movies at a time or more for a higher price. The main draw back is the wait time in processing and shipment. The real competitor, as defined by some industry analysts, will be VoD (Video on Demand) due to the fact that the technology allows customers to access their preferred video almost instantly. The competition dynamic in the video rental industry had matured from many independent rental stores to several large firms. Many of these firms, through acquisition, integrated vertically to take advantage of being able to deliver content directly through the pipeline. There has been mixed success with this strategy. Emerging trends seem to focus on technology as a means to provide rental products to the costumer when and where they want to do business.

Analysis of Competitive Dynamics Blockbuster’s competitive advantage is sheer size and name recognition. The company is clearly an effective value chain. Blockbuster can keep costs down though economies of scale and costs to consumers inflated due to brand loyalty and benefit 14

leadership. This achievement has been accomplished primarily through excellent marketing and branding strategies. The loyalty of consumers as well as reputation is a direct result of these efforts. Geographically, frequency of locations makes Blockbuster widely available compared to competitors. Up to a few years ago, Blockbuster was able to eliminate competition by acquisition. The dynamics have changed, and alternate channel strategies have evolved. Examination of Competitive Strategies Blockbuster has more competitors now than ever. The Internet has created an entirely new avenue for the distribution of movies and games into the hands of consumers. Blockbuster has been a latecomer to the Internet with respect to Netflix and Amazon. One possible reason for this is the high profit of previously viewed movies, which has increased Blockbuster’s same-store rental revenue by 29.7 percent in 2002. Another is the enormous investment already made in the current channel model. While previously viewed movie sales have increased Blockbuster’s revenues, the delay of going online with a model such as Netflix seems to be a critical issue for Blockbuster. It may be important to consider that the home video didn’t eliminate the movie industry, and that pay-per-view didn’t eliminate rentals. 3.3.

Current Status

Previously in this section, we have identified the industry and touched on the economics of competition. In order to ensure that key concepts have not been overlooked, an industry analysis was conducted. This provided a structure that enabled the team to systematically break down the economic issues and competitive dynamics associated with this industry.

In addition, such an analysis can be used to assess and provide

recommendations for business strategies. Porter’s Five Forces in the Video Rental Industry 15

Although the five forces framework has limitations, it is a useful tool to asses the current status of the video industry.

The impact of each of Porter’s forces will be

examined, and the extent to which the industry is impacted by that force will be reviewed. Firm Rivalry/Internal Rivalry Rivalry refers to the jockeying for market share by firms. In the video rental industry, there are two main types of players: traditional renters, such as Blockbuster, who operate physical store locations, and mail-order renters such as Netflix. For the traditional renter, competition for market share is fierce. As a traditional renter, Blockbuster has positioned itself with a heavy fixed cost infrastructure investment in retail store locations. Due to this high fixed cost, the only way Blockbuster can lower its average cost per item (be it a VHS, DVD or game rental) is to spread the fixed cost over many rentals/sales. As competition takes market share away from Blockbuster, it is possible that average cost for Blockbuster would begin to increase. This would occur if Blockbuster was no longer able to achieve the minimum efficiency of scale required to spread fixed costs to a point where average cost was declining. If this were to happen, Blockbuster would find itself competitively disadvantaged. Therefore, Blockbuster fiercely competes to maintain its market share. This can be witnessed via several recent Blockbuster promotions, most of which were aimed at the competition from Netflix. Plans such as the Blockbuster Game or Movie Passes (unlimited game or movie rentals for a flat per month fee) were designed to stem the loss of market share. While these passes clearly do not generate as much revenue as per rental fees, it does regain some market share for Blockbuster, which is critical in order for it to remain cost competitive overall. In contrast to the traditional renter, mail order firms such as Netflix have a different cost structure. Netflix’s fixed costs are primarily its distribution centers, inventory, and website maintenance. These fixed costs in sum are far lower than the fixed costs a chain such as Blockbuster incurs. As such, the fixed cost per rental component for Netflix is lower, and Netflix can reach a competitive average cost at much lower rental volume. This 16

allows them to offer flat fee rentals, while maintaining a profitable margin. Netflix may not need market share as desperately as Blockbuster in order to avoid increasing average costs. However, Netflix does recognize that if it can steal enough market share away from Blockbuster that it will place Blockbuster at a price disadvantage. Thus, this leads to intense competition and firm rivalry as well. Other factors influencing firm rivalry in the video rental industry include the fact that the industry itself is stagnant. Since the size of the market is not expanding, the only real alternative for growth is to increase market share. This obviously intensifies competition. Further, movie/game rentals are a highly undifferentiated product. A rental from Blockbuster is the exact same as a rental from Hollywood Video or Netflix. There is little or no switching costs for consumers to move between firms. This intensifies price competition to gain market share. Finally, there are strong exit barriers for firms such as Blockbuster. As a result, Blockbuster will continue to match prices with Netflix or others as it struggles to survive, intensifying the competition even more.

Entry Prior to the explosive growth of the Internet in the late 1990’s, a strong argument could be made that there were high entry barriers in the video rental industry which limited competition. This would include the relatively large economies of scale required to operate retail locations which did not operate at a cost disadvantage relative to Blockbuster. Another entry barrier was the high brand loyalty enjoyed by Blockbuster, which was the de facto place to go for movie rentals. Lastly, new firms would also face Entry barriers in the form of needing to generate sufficient volume in order to gain access to revenue sharing agreements with the studios similar to those which Blockbuster had in place. All of this changed however with the evolution of the Internet. As the technology allowed companies such as Netflix to reach a nationwide (or even worldwide if it so desired) audience without a physical presence, the retail location entry barrier disappeared. 17

The brand loyalty barrier was overcome mostly via chance: Blockbuster had alienated many of its customers by not keeping enough copies of popular movies in stock, among other aforementioned reasons. The barrier of needing to have high enough volume to negotiate revenue sharing agreements with studios simply became moot. DVDs had replaced VHS, and DVDs were priced for retail sale (less than $25, unlike VHS which was rental priced in the $70-$90 range). This meant Netflix did not have to negotiate revenue sharing like Blockbuster did in the VHS days (although any agreement reached on DVDs would serve to lower costs even more). As a result, there are now few entry barriers in the video rental industry, which has served to increase competition further. Substitutes, Supplier Power, and Buyer Power Substitute products to video rentals are plentiful. This includes items such as payper-view, video-on-demand, and streaming on-line video. As these are all viable alternatives, delivering a nearly identical product, the threat of substitutes plays the role of yet another intensifier. As for supplier and buyer power, suppliers in the video rental industry yield little power. The price of inputs (games and DVDs) is nearly identical for all suppliers. There is virtually no ability to price discriminate, and there is the widely available presence of substitutes, as mentioned above. These factors erode the supplier power, while at the same time strengthening the position of buyers. When all five forces are combined, it is readily apparent that for firms desiring to compete on price within the video rental industry, intense competition with falling prices will be the dominant trend in the future. 4.0

STRATEGIC ANALYSIS In this portion of the paper we will present our recommendations for future strategic

moves. The team will explain the rational used to make these decisions using sound economic reasoning and the essential truth: Customers will buy more if you meet them where they want to do business. Otherwise they will buy less. Blockbuster has been winning in its market for some time. As the market gets more and more competitive 18

however, it is going to have to also make sure that it maintains competitive advantage. 4.1.

Overview and Introduction to Strategy

As Blockbuster has seen, firms that fail to assess customer behavior and channel preferences put themselves at incredible risk. As a result, most companies seem to put as much into how they go to market as what they bring to market. This trend is evident in Blockbuster, as seen with the recent addition of a website and partnering with technology innovators. With the advent of alternative methods for video procurement (namely though technology advancement), Blockbuster has realized that they will have to provide flexible options to meet their customers’ needs. Potential and existing customers have channel preferences as well as historical purchasing patterns. These define which channels could work. Basis of Strategy Selection As the text suggests, the market and the firm’s position in that market jointly determine a firm’s profitability. The team believes that a broad coverage strategy and the right channel mix the can help Blockbuster to create and maintain competitive advantage. Although Blockbuster appears to see the need to provide alternative methods of delivery for its products, it already has a large network of retail chains throughout the country. Blockbuster will not likely depart from this method to pursue emerging technology channels wholeheartedly. We anticipate that a mixture of the two will occur, along with some additional tweaking to provide maximum benefit advantage. The goal then becomes to provide the right channel mix by optimizing the retail channel and to select the most attractive technology based channels. The ideal end result would be to then make people aware of these channels through effective marketing and to achieve profitability and to maintain dominance in the industry. Trends and Recent Activity Throughout its history, Blockbuster has faced a number of competitive 19

challenges. While the company has previously been successful in managing through these obstacles, the number of competing technologies and rival firms has never before posed the level of threat that it does today. Video on Demand (VoD), Pay-Per-View (PPV), and Disposable Rentals (EZ-D DVD) are worthy challengers to the traditional rental, but Antioco clearly views Netflix as the most potent threat (Source: USA Today June 22, 2004). To ward off this foe, Blockbuster has a two part plan. It is introducing its own online rental service, and is increasing the number of stores selling used, inexpensive DVDs in an attempt to draw more customers to retail locations. The merits of competing online will be discussed later. As for increasing previously viewed DVD sales, it is our opinion that this move in and of itself is insufficient. If Blockbuster is to be successful with its Brick & Mortar (B&M) locations, then it needs to reassess its fixed cost infrastructure. We have performed such an analysis, and our recommendations are presented below. 4.2.

Retail Strategy

Blockbuster is currently saddled with the high cost of its retail stores. As Netflix erodes Blockbuster’s market share, there is the very real threat that volume will drop below Blockbuster’s minimum efficiency of scale (as noted in section 3.3). It is our opinion that Blockbuster can mitigate this risk by reducing the cost of B&M operations. Specifically, if Blockbuster can lower the fixed cost portion of operations, then the average cost curve will shift down and to the left. This would allow Blockbuster to reach the original AC (MES) with lower volume, as illustrated in figure 4-1. Of course, Blockbuster would not be operating at the MES of the new cost curve, but AC would remain comparable to the level it was at with higher volume, before the fixed cost reduction. While this volume level is not optimal on the new curve, if market price is only slightly above the original AC (MES), Blockbuster would still be able to operate without a loss at lower volume under this new cost structure. Alternatively, they would be losing money at the lower sales level with the higher

fixed

cost

20

structure.

Impact of lower FC on AC Curve (Figure 4-1)

AC

Q Avg Cost (Orig Fixed Cost)

Avg Cost (Reduced Fixed Cost)

Avg Cost (MES)

So, how does Blockbuster reduce its fixed costs? Several options were considered including: reducing the number of retail locations, leasing out space, and partnering with other retailers. Each will be discussed below. Reducing the Number of Retail Locations The first available option is for Blockbuster to close some of its B&M locations. This action would constitute a move unprecedented in Blockbuster’s history. However, we believe that opportunities to close stores without impacting revenue may exist under the following scenario: Through personal observations in several major metropolitan areas, it has been noted that there are often three or more Blockbuster stores located within a ten minute drive of each other. This level of overlapping coverage may be unnecessary. A study could be done to determine how willing consumers in affected areas would be to drive an extra few minutes to the next closest store. If the survey showed closing one of the stores would have no material impact on customer behavior, then B&M outlets in this situation could be closed, with the revenue redistributed to the nearby Blockbuster locations which customers would be using instead. The overall affect on Blockbuster would be similar revenues with reduced operations expense – specifically, 21

fixed store costs will be down. Leasing Out Space Another method Blockbuster can use to reduce fixed expense is to lease out space within its existing stores. Similar to the recent trend at many gasoline stations, Blockbuster could rent out space to restaurants Subway or Quizno’s or potentially coffee shops. These eateries take up a minimal footprint in the store, and the rent generated from leasing the space has the potential to offset a significant portion of fixed store expense. In addition, the presence of a restaurant or coffee shop inside a Blockbuster may actually increase foot traffic, and ultimately sales, as the convenience factor of the collocated firms draws incremental customers inside. Partnering With Other Retailers Our final recommendation to reduce fixed costs is for Blockbuster to investigate moving locations inside other existing retailers. Specifically, we believe there is an opportunity for Blockbuster to partner with upscale grocery chains. Through several regional alliances (i.e., Publix in Florida, Ukrop’s in the mid-Atlantic), Blockbuster could acquire a substantial presence inside grocery stores. The fixed cost associated with leasing space from a grocery store is much less than that of a stand alone store; resulting in the desired down-left shift of the AC curve. Blockbuster would also benefit by gaining access to the grocer’s customers, opening up cross-promoting opportunities which could drive additional revenues. If this concept is successful, traditional Blockbuster locations within proximity of a partner grocery chain could be relocated en mass. The savings associated with this move would be quite substantial. Unless provisions were made for alternative access, there is a potential downside that Blockbuster store hours would be limited to that of the host grocery store. Additional research would be needed to determine the potential implications. Nonetheless, this concept warrants serious consideration. Combined with the previously mentioned suggestions, we believe Blockbuster has the potential to seriously 22

lower its fixed cost structure. 4.3.

Technology Strategy

The field of home entertainment has changed dramatically since the presence of the Internet and VoD. After many years of dominance using a retail sales channel, now Blockbuster is facing new competitors and new ways to compete. The Internet has proven itself as a premium channel for the sale of services. Netflix with its hybrid rental model (Internet based check-out combined with mail distribution) has eroded Blockbuster’s customer base. But Netflix more than anything has built upon Blockbuster’s weaknesses like customer’s dissatisfaction on selection, late rental fees and lack of access to B&M locations (rural areas). Blockbuster is now working to catch up with Netflix’s cost and benefit advantages. This new online service affords a cost advantage in price ($2 off of Netflix monthly subscription) and also benefit advantage in return time, since you can return rentals to any Blockbuster store besides using the U.S. Postal Service. To compete, Blockbuster offers traditional incentives such as free rentals to increase store traffic and is beginning to take advantage of other technology based sales channels. The first lesson and challenge that Blockbuster is facing is its own bureaucracy. Their retail model has been extremely successful but it is now time to move into the uncharted waters of the Internet and VoD. Internet Rental Netflix has proven that the Internet is the preferred channel for many customers. Blockbuster can take advantage of Netflix’s investment in the learning curve for Internet distribution. To increase its chances of success in this new venture, Blockbuster has entered in a partnership with MSN Movies for online rentals and for VoD with CinemaNow, which offers 2,000 titles at a cost of $3.99 for a 24-hour download. Blockbuster also has an agreement with AOL to establish portals (links to their website) with intent to move into account management 23

in the future. This move is not new (Netflix has their own portals), but it will help to increase brand recognition in this new channel. Netflix may remain a fierce competitor in this market due to branding and well established partnerships and VoD ventures like TiVo.

Netflix’s success has grown of

Blockbuster’s customer dissatisfaction and the loyalty of its customer base is still emerging. Video on Demand Whereas a successful model exists for renting videos online, VoD is considered bleeding edge technology. Blockbuster is currently in the process of establishing relationships with VoD’s providers because they understand that they cannot afford to ignore this technology. In just a few years, industry leaders predict that customers will be able to easily download a wide selection of titles from home computers or kiosks. The DVD will not likely disappear completely (look at the CD industry), but for many customers this will be the only way they will allow Blockbusters to be part of their life. The advantages in the creation of value through niches and customization with VoD are endless including the possibility of advertising to help offset technology costs. The real key remains in understanding the concept of entertainment and how marketing looks to create opinion through entertainment. Under clever customization, the Internet has proven a great way to create powerful messages for its users. 4.4.

Marketing Strategy

If the customer isn’t aware that a specific channel exists, then there is virtually no chance they will use it. Although the idea of low cost mass infection through so-called “idea-virus methodology” (such as that utilized by Hotmail and others) is incredibly attractive, it is likely that more traditional methods of marketing will be necessary to achieve maximum effectiveness. Through marketing, there are multiple ideas Blockbuster could implement to maintain market share and to enhance brand awareness. Ideas for in-store include a loyalty program and a time limit buy program. A focused online niche and a powerful advertising message 24

stressing the convenience factor of B&M rentals is recommended. A carefully planned mix will be necessary to achieve maximum effectiveness. In-Store Promotion The company has had marked success with loyalty programs and another incentive programs could be designed to target those customers who choose to frequent the store more readily than via the Internet. A point system could be introduced where each time a customer rents or buys a movie from the physical location double point(s) are earned. Singled points could be offered online. Once a pre-determined amount of points are reached, the B&M customer will receive a free movie rental and if an ending to such an incentive program is needed, the customer who receives the most points wins an all expenses paid trip to the Oscars or other movie awards ceremony. A time-limit buy would be a managerial duty. If a manager looks at the sales figures from the previous year for a given day and determines sales are down for the current year of the same day, frequent customers could be called or more likely, sent an email, offering up to 3 movies half-off from 5 – 7 P.M. for that day only. The recipient would need to print out the offer with special code, etc. and bring it in. The idea would be to make this a random act. This will likely boost sales when they would otherwise be stagnant, creating incremental revenue. This could also work for the virtual store model. Advertising Another option is for the online Blockbuster to solely target a niche audience. The target of such an audience would include people who favor foreign films and other hard-to-find movies. People who enjoy these types of movies are more likely to be technologically inclined as well as follow a Netflix-like model. For the B&M Blockbuster locations to compete against Netflix and similar model types, an integrated media campaign involving print, television, radio, and Internet, should stress the message of immediacy in retrieving a Blockbuster movie. The fact that days pass 25

before a person receives a movie due to the vulnerable process of Netflix shows the power of Blockbuster in which a person has basically no wait time for a movie. If Blockbuster were to go with a niche such as foreign film movie seekers as previously mentioned, we do not think this should be advertised as heavily as the B&M campaign if at all. The shoe company Converse has not advertised in years until recently. Their target audience was anti-commercialism. Perhaps their target is changing and is this why they are beginning to advertise more. However, we think this may back fire as would be the possibility if Blockbuster were to advertise their ‘underground’ website for foreign and other hard-to-find films under the name Blockbuster. 4.5.

Conclusions and Summarization of Recommendations

Reputation and buyer uncertainty have seemed to plug the dyke thus far. As more and more people become accustomed to the alternative methods of video purchase and rental Blockbuster will need to meet the customers where they want to do business. The road ahead is not an easy one. The power struggle between the studios, distributors and retailers will continue. Blockbuster currently has leverage due to purchasing (supplier) power and prestige: Consumers already think of Blockbuster as a repository of films and only a minority shop for studios. A film is a film, an experience to be shared and for customers what prevails is the access to choices and convenience. Blockbuster has a potent marketing tool: a database of viewing habits of its 50 million customers. If this tool was exploited properly, consumer behaviors such as channel preference could be leveraged to maximize revenue per customer. An effective marketing and channel mix based on the aforementioned recommendations would help to ensure and maintain a competitive edge in the industry. 5.0

REFERENCES

Blockbuster Inc; Investor Relations – Various Press Releases; 2003-2004 http://www.blockbuster.com

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Brem, Lisa and Narayanan, V.G.; That’s a Wrap: The Dynamics of the Video Rental Industry; Harvard Business School Case 9-102-051; May 20, 2002. Hoovers Online; Blockbuster Inc – History; Date Unknown http://premium.hoovers.com/subscribe/co/history.xhtml?COID=10218 Lieberman, David. “Blockbuster jabs back at rivals”. USA Today – June 22, 2004. Reuters Via Hollywood Reporter.com; Viacom posts $1.3 billion loss, will spin off Blockbuster ; Feb 11, 2004 http://www.hollywoodreporter.com/thr/article_display.jsp?vnu_content_id=2087266 Sweeting, Paul. “Private practice: a debt-free, high-margin cash machine likeBlockbuster is something equity firms drool over.” Video Business. (2003):12. Gale-group. U of Florida Business Lib., Gainesville, 20 July 2004 http://galenet.galegroup.com/servlet/BCRC. Thomson Gale; International Directory of Company Histories, Vol. 31. St. James Press; 2000 http://galenet.galegroup.com Thomson Research; Blockbuster, Inc - Various releases; Dates Unknown http://research.thomsonib.com Yahoo Finance; Various Press releases; 2004 http://finance.yahoo.com/q?s=bbi _______. “Videotape Rental.” Encyclopedia of American Industries (2004). U of Florida Business Lib., Gainesville, 20 July 2004 http://www.galenet.galegroup.com/servlet/BCRC. _______. “Video Tape Rental and Retail.” Encyclopedia of Global Industries (2004). U of Florida Business Lib., Gainesville, 20 July 2004 http://galenet.galegroup.com/servlet/BCRC. Wagner, Holly J. “2003: a breakout year for previously viewed: top previously viewed retailers.” Business & Company Resource Center (2004). U of Florida Business Lib., Gainesville, 20 July 2004

http://galenet.galegroup.com/servlet/BCRC.

Table 1. Timeline 1985 David Cook opens first video store in Dallas, Texas 1986 Blockbuster becomes official company name 27

1987 Wayne Huizenga acquires Blockbuster Inc. / corporate headquarters move to Ft. Lauderdale, Florida 1990 Blockbuster acquires Errol’s Video Inc. and Major Video 1992 Blockbuster opens 3,000th retail store in New York City 1993 Super Club Entertainment added to the Blockbuster company (New locations average one every 24 hours) 1994 Viacom buys Blockbuster/ Huizenga leaves Blockbuster/ Profitability drops due to lack of leadership 1995 Blockbuster website established 1996

Introduction of DVDs through in-store promotions/ Complications lead BBI to sink to half 1993 retained earnings

1997

John Antioco becomes chairperson and CEO/ Headquarters moved back to Dallas/ Revenue-sharing with movie studios considered/ Various charitable activities

1998

Integration of Blockbuster Music/ Video Flick stores of Australia acquired

1999

BBI publicly traded/ DVDs offered at stores worldwide

2000

Partnership with NAACP for charitable cause

2001

Over one million dollars raised for Children’s Miracle Network/ Despite greater revenues in 2001-2004, BBI continues to post losses

2002

Over 8,000 Blockbuster stores worldwide/ Changes in accounting standards force BBI to write-off excess goodwill for the first time

2003 Movie Trading Corporation acquired, a used DVD trading retailer in order to study the used DVD business 2004 Twenty-four stores scheduled to close in Hong Kong within 18 months due to the high cost of rental property/ Viacom intends to sell-off BBI due to concerns with growth of the company

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