Blockbuster takes a profit plunge

Viacom blames industry-wide conditions on video rentals

NEW YORK — Viacom Inc.’s troubled Blockbuster video chain will report an alarming 76% plunge in operating profit to as low as $40 million for the second quarter, Viacom warned Tuesday, signaling that Blockbuster’s problems are getting dramatically worse.

And Viacom apparently doesn’t see any short-term end to the earnings free fall, warning that if current trends continue the video unit will report 48% lower operating profit of as low as $400 million for the full year.

The earnings plunge, which Viacom blamed on industrywide conditions in video rentals and operational changes instituted by former Blockbuster CEO Bill Fields, highlights the enormity of the turnaround task now facing Blockbuster’s new CEO, John Antioco, and almost certainly ends Viacom’s chances of spinning off Blockbuster in a stock offering early next year as it announced in April.

In addition to the operating profit decline, Viacom said Blockbuster would take a one-time charge of $300 million in the second quarter to write off the cost of confections and retail tapes now on its balance sheet and to cover the cost of closing “underperforming Blockbuster stores in certain international markets.” The second-quarter profit will be reported later this month or in early August, a Viacom spokesman said.

Combining the one-time charge with the operational earnings decline, Blockbuster’s contribution will send Viacom heavily into the red for the quarter, analysts estimate. Blockbuster in the past has accounted for about one-third of Viacom’s total earnings.

Viacom stock dropped on the news, but recovered through the day and closed up 31¢ to $30.31. The stock had fallen 17% in the past two weeks as word spread throughout Wall Street that video industry revenues had fallen in the second quarter, and analysts said Blockbuster’s problems were now well-known by investors.

Still, the severity of the earnings decline took Wall Street by surprise. “The depth of the problems were shocking and much worse than I expected,” Lehman Bros. analyst Larry Petrella said.

“It’s astonishing how quickly the cash flow eroded,” Cowen & Co. analyst Harold Vogel said.

What puzzled Wall Street analysts was that the profit decline was much worse than the drop-off in revenue. Viacom said it expected Blockbuster’s earnings before interest, taxes, depreciation and amortization to be between $40 million and $50 million in the second quarter, compared with $168 million a year earlier, on 8% lower revenue of $880 million to $900 million. On a “same-store” basis (adjusting for new stores opening), revenue fell about 5%, Viacom said.

These numbers translate to a Blockbuster profit margin of 4.5% in the second quarter. That’s down from 16.4% in the first quarter, which was slightly down from full-year 1996 margins but well down on the 25% margin earned by Blockbuster in 1995.

What puzzled analysts is that Viacom’s explanation for the problems pointed to few new factors. The company blamed industrywide “softness in the domestic video rental market,” which has been a major issue for the past couple of years, as well as disruptions caused by Blockbuster’s relocation of its headquarters to Dallas and distribution shuffle, which were cited in the first quarter.

Both the headquarters switch and distribution change were undertaken by Blockbuster’s former CEO Bill Fields, who quit in April. Fields’ decision to switch to internal distribution appears to have been the biggest blunder. Blockbuster is at least six months from completing construction of its new distribution center in Dallas and has been forced to rely on a makeshift arrangement with temporary workers, which is believed to be causing chaos with distribution.

Additional factors hurting earnings were “cost pressures stemming from new store development and the depth of buying videotapes and other product,” Viacom said. New store development is nothing new for Blockbuster, however, and analysts questioned why the second quarter showed such a drop.

“I can’t figure it out,” Media Group Research video analyst Curt Alexander said. A Viacom spokesman declined to elaborate.

Schroder & Co. analyst David Londoner suggested that Viacom may have understated the depth of Blockbuster’s earnings dip in the first quarter. “I am guessing, but they could have had gross margin assumptions in the first quarter that turned out to be too high. They have made up for that in the low margins in the second quarter which are difficult to explain in any other way,” Londoner said. A Viacom spokesman scoffed at this explanation however.

Londoner estimated Blockbuster’s earnings drop, including the one-time charge, will push Viacom to a loss of $306 million in the second quarter, compared with his previous estimate of a loss of $3.5 million.

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