Blockbuster move

Rentailer may buy No. 2. Hollywood Video

WASHINGTON, D.C. — Blockbuster, the nation’s biggest video rental store chain, has taken steps toward the possible $1 billion purchase of No. 2 vid rentailer Hollywood Video, which would give Blockbuster control of well over 50% of the $8 billion-plus vid rental market.

The surprise move comes as Hollywood is attempting to finalize a management-led buyout backed by investment firm Leonard Green & Partners. In an announcement last month, however, Hollywood said its revised merger agreement with LG&P allowed the company to solicit bids from “other interested acquires,” giving Blockbuster the opening it needed.

In a statement, Blockbuster said it has contacted Hollywood’s investment bankers, as well as the company itself, to express interest in acquiring Hollywood for $11.50 per share, a 12% premium over Hollywood’s current $10.25 per share agreement with LG&P.

Proposed deal values Hollywood at about $700 million, but the total value of the transaction would be about $1 billion including the assumption of $300 million in Hollywood debt, the company said.

“Blockbuster’s expression of interest has been communicated to Hollywood Entertainment but has not yet resulted in a substantive discussion regarding the terms of a potential transaction,” the statement said.

All-cash deal likely

The statement did not say how an offer for Hollywood would be structured but it would likely be an all-cash deal. Although Blockbuster recently took on just over $1 billion in debt to finance a special dividend related to its split off from Viacom, its balance sheet is still relatively unleveraged relative to cash flow.

Despite a recent slump in earnings, moreover, Hollywood remains cash-flow positive, which would help service any new debt Blockbuster took on to finance the transaction.

If a deal were to happen, it would create a giant chain of nearly 7,000 U.S. stores. Blockbuster represents 40%-45% of the video rental market, with Hollywood a distant second at 8%-10%. The rental market matured several years ago and has seen a sharp decline in the core over-the-counter rentals. Revenue from fast-growing online subscription services such as Netflix has increased from 2% of the overall rental market in 2003 to about 7%-9% this year, according to Rentrak’s Home Video Essentials.

The overall rental market has been relatively flat and slipping slightly in recent years. Through October, video rental revenue stood at $6.81 billion, down about 0.9% from the same period last year.

Deal would come at a time when video rental stores are facing significant competitive threats from the sale of low-priced DVDs through mass merchant channels, online services and the rollout of advanced video-on-demand technologies. Whereas rentals once dominated the overall video market, purchases now represent almost two-thirds of consumer spending on videos. Last year consumers spent more than $14 billion buying videos, according to Daily Variety sister publication DVD Exclusive, and that figure is projected to be much higher this year.

“We believe this proposed transaction better positions Blockbuster to compete in the rapidly changing home entertainment marketplace, while simultaneously benefiting consumers as well as Blockbuster and Hollywood Entertainment shareholders,” said Blockbuster chairman and CEO John Antioco. “In addition to providing Hollywood shareholders with a substantial premium for their shares, the proposed transaction would give us more ways to serve more customers by taking advantage of both companies’ combined store distribution capabilities and brand portfolios.”

Shares soaring

News of Blockbuster’s interest sent shares of Hollywood up nearly 11% in early morning trading Thursday.

Blockbuster shares were also up sharply, suggesting Wall Street would greet a deal between the companies warmly.

Some analysts were skeptical of the proposal, however.

“I’m not sure what they’d be buying,” said McAlpine Associates principal Dennis McAlpine. “The video rental business is pretty much a store-by-store business. Whether you have 5,000 stores or 6,000 stores you don’t get a lot of economies of scale in terms of operations.”

McAlpine also noted that about 25% of Hollywood’s 1,900 stores are located adjacent to Blockbuster locations, which could complicate any integration plans.

“I don’t know what you would do with those stores,” he said. “I think we can assume their landlords aren’t going to let them out of those leases, so do you convert them to Blockbuster locations and then have a Blockbuster next to another Blockbuster? Or do you continue to operate under two brand names?”

Operating under two distinct brand names, however, could allow Blockbuster to expand the number of titles it offers by shifting Hollywood’s inventory mix away from its current emphasis on new releases, particularly in those stores located next to Blockbuster outlets.

Bigger inventory a boon

An expanded retail inventory would also benefit Blockbuster’s recently launched online subscription service once that service is fully integrated with the store-based inventory.

In a third-quarter earnings conference call, Antioco noted that about 40% of online orders are for titles not typically stocked in Blockbuster or Hollywood stores.

The Hollywood stores would also give Blockbuster another 1,900 distribution points for its online service.

The biggest boost that a deal would give to Blockbuster’s diversification plans, however, would be in games.

Although Blockbuster has recently rolled out its Game Rush store-in-store concept to about 450 stores, it trails well behind Hollywood’s Game Crazy, which the chain started four years ago and has rolled out to nearly 700 locations.

Combining the two would make Blockbuster far more competitive with the leading game specialty chains, Electronics Boutique and GameStop.

In its most recent quarterly report, Game Crazy accounted for about 15% of Hollywood’s revenue.

(Paul Sweeting is a reporter for Variety sister publication DVD Exclusive.)

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