Good Luck, Blockbluster

You have to think that Blockbuster (NYSE: BBI  ) knew it would come to this. The video rental giant has lent out enough copies of Thelma & Louise and Scarface to know that living large usually ends in either a speeding car plunging toward certain death or Tony Montana's bullet-riddled demise.

This week's abysmal quarterly report was a lot like that. The company had taken some bold chances with a dirt-cheap mail-delivery service to compete against Netflix (Nasdaq: NFLX  ) and had launched an aggressive yet subtly deceptive marketing campaign that eradicated conventional late fees. It was Blockbuster living dangerously with little left to lose. It was the last fraternity toga-party kegger before Dean Wormer would order Delta House thrown off the Faber College campus.

Going over Blockbuster's June quarter, you begin to see the binge's clumpy carnage of a hangover. Losing $57.2 million on a 2% decline in revenue isn't going to make the company very popular with investors. Posting negative free cash flow of $119 million is going to really test the mettle of antsy creditors.

The company is owning up to some of its mistakes. It's raising the monthly rate for its online rental service. New and recent subscribers will now be paying $17.99 a month for the standard plan that allows for unlimited rentals as long as the member has no more than three DVDs out at a time. That $3-a-month hike matches the company's pricing with what Netflix is charging these days. That's great news for Netflix in the near term but may prove troublesome if it whets the appetite of Amazon.com (Nasdaq: AMZN  ) . The leading online retailer appeared to be gearing up for a similar offering before the price war between Netflix and Blockbuster squashed the notion of the service's feasibility as a profitable venture.

The lunacy of $14.99
Charging so little for its online service has to go down as one of the dumbest business moves in recent memory. Blockbuster included coupons for a pair of free in-store rentals to its virtual renters. The logic may have seemed sound. Get the couch potatoes to the store. Expose them to impulse items and pre-viewed clearance sales. However, at that ridiculous price point, it belittled the value of its flagship business. For the price of roughly three in-store rentals, someone can go the $14.99 route and have a pair of in-store rentals and an unlimited supply of discs by mail.

The company also launched an unlimited rental in-store service that was more expensive than the similar service online. It was discounting the more convenient option. What did it think would happen?

Yes, comps fell by 5% in the June quarter. Blockbuster doesn't consider this a complete failure. Backing out last year's take on late fees, quarter-over-quarter rental revenue rose by 9%. There's a catch there, though. The company is including its online rentals in that number, so it's not a true same-store sales comparison.

Fixing Blockbuster
It's not too late for the struggling video rental chain. It is starting to fulfill orders from its sea of stores. If that is effective and doesn't disrupt the bricks-and-mortar inventory levels, it can't hurt. Unfortunately, Netflix has already canvassed the country with distribution centers assuring overnight delivery for most subscribers.

But now that Blockbuster has priced its service in line with Netflix, it needs to go that extra step and venture into areas where Netflix won't. Back in February, I had four suggestions for Blockbuster to matter.

One already took care of itself when Movie Gallery (Nasdaq: MOVI  ) was able to acquire Hollywood Entertainment. I had argued that Blockbuster had no reason to keep bidding for the Hollywood Video chain when its own physical stores were struggling and its online strategy was threatening the physical format.

Another suggestion called for a cap on the "unlimited" rentals. It's the way Amazon is doing business in the United Kingdom. Some of the recent Netflix plan additions limit the number of rentals to assure that Netflix will turn a profit on every new subscriber. That's just what Blockbuster needs to keep its shareholders and debtholders upbeat. Right now, Blockbuster has a million subscribers, and it expects to double that count by the end of March. It is sticking to that target despite the fact that the next million will be recruited at a 20% price hike. I just don't see that panning out. Blockbuster needs to realize that the investing community would rather see the company make money on 1 million subs than lose money on 2 million subs.

I also suggested that Blockbuster should beat Netflix to the video game punch. The chain has already been renting games out of its stores for years. Netflix has been hesitant to offer its customers a similar online service. It's a mixed bag. Games cost more than flicks and, in many cases, depreciate in value more rapidly. However, the fact that the end user will hold on to games longer than to movies is significant, especially when Blockbuster is footing postage both ways.

My final suggestion was for Blockbuster to team up with Amazon. The timing couldn't be any better. Amazon may be sniffing around now, anyway. Teaming up with the biggest name in online retail would give Blockbuster credibility -- and a partner to lean on when the time comes to blur the value proposition of its online storefront with its offline storefront. Companies like Wal-Mart (NYSE: WMT  ) came and went in the online DVD rental market because they lacked the allure of the wired literati. Amazon would help Blockbuster in a major way. It would also help appease investors, knowing that a proven dot-com driver has been handed the keys.

A little humility wouldn't hurt, either. Blockbuster expects to incur $40 million this year in stock-based compensation. This is coming from the same company that just blew estimates, is bleeding money, and has sworn off providing guidance because of its bleak outlook on the rental industry. I'm sorry. You don't reward that kind of malaise with stock incentives. It's proved to be a flimsy -- and highly ineffective -- carrot at Blockbuster. I'm not saying that these folks shouldn't get paid. In fact, general and administrative costs inched higher despite the revenue dip, so it's clear that they're not hurting when it comes to salaries. Let that be enough. Until the creditors and shareholders are smiling again, no cookie for you.

So good luck, Blockbuster. You know what you have to do. Tell Thelma & Louise to hit the brakes. And as for Tony Montana, when he shouts, "Say hello to my little friend," let that jolly green dwarf be profitability.

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Longtime Fool contributor Rick Munarriz lives in South Florida, the original nesting ground for Blockbuster. He also owns shares in Netflix.The Fool has a disclosure policy. He is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.


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