Icahn prevails in Blockbuster battle

The DVD rental wars have also eliminated one of video renters' major pet peeves — the "late fees" charged if they didn't watch their selection and return it on time. Dropping those late fees cost Blockbuster some $145 million last year and contributed to the company’s $1.2 billion loss for 2004. The “no late fee” program also cost the company some $630,000 to settle claims by 47 states on behalf of consumers who didn’t read the fine print — and were charged the purchase price of the DVD if they kept it more than a week. (The policy remains in place.)

Blockbuster’s management says the heavy investment in its new strategy is paying off. The company expects to double its subscription base to 2 million by early next year. But the plan remains costly: analysts expect Blockbuster to spend another $170 million this year and lose another $500 million in late fees. The company also plans to continue opening new stores.

That aggressive — and costly — expansion plan is at the center of the battle for control of the company. Simply put, Icahn and his supporters want the company to spend less and let more of its revenues flow to the bottom line -- and to shareholders.

“If you’re spending $350,000 per new store — if you stop building those new stores, you’re going to generate a lot of cash out of the existing stores,” said media analyst Dennis McAlpine.

Blockbuster's management has said it needs to continue investing in new stores and online subscribers and that its strategy is working.

Another eToys?
Meanwhile, Netflix CEO Hastings has said his company is continuing to open up its lead, and that Blockbuster’s strategy isn’t working.

“When you look at Blockbuster’s spending, they'll have spent close to $400 million to be able to get to break-even 2 million subscribers,”  Hashings told CNBC last month . “It’s actually a very large investment to get in this market and be successful. And despite their very heavy spending, we're continuing to grow very rapidly.”

But it’s much too early to count Blockbuster out, say analysts. Some believe that the company’s multiple channels of distribution (both online and instore), along with multiple offerings that include video games and DVDs for sale, gives the home entertainment giant the staying power to outlast its smaller rival.

‘I’m convinced that Netflix is doomed. They’re toast.’ — Michael Pachter Wedbush Morgan Securities

“I’m convinced that Netflix is doomed. They’re toast,” said Pachter. “This is really like eToys... It doesn’t matter if the product is better, if your competition is that formidable.”

Waiting in the wings for both competitors is the threat of an entirely new way of watching movies -– video on demand. Delivering movies via cable television systems holds the promise of an even faster, cheaper form of distribution.  But that day may be years away, for several reasons.

For starters, the technology is not in place yet for cable companies to duplicate the huge backlist of some 40,000 titles that the rental companies can provide. McAlpine estimates that some 70 percent of Netflix business comes from people renting older movies.

Bu technology aside, the economics of renting and selling DVDs is extremely profitable for Hollywood studios, say analysts. Pachter estimates that that the movie industry makes roughly two-thirds of its profits from DVDs.

“If you could get everything on video-on-demand, you wouldn’t necessarily buy a DVD player,” he said. “And if you don’t have a DVD player, you’re not buying any DVDs -– which is where the studios profits are coming from. So video on demand hurts them.”

DVD sales are growing much more quickly than rentals, generating some $15 billion in sales last year, up from just $2.8 billion in 2000, according to J.P. Morgan. During that period, rental revenues grew to $5.8 billion from $640 million.

And the coming switch to high definition television gives Hollywood another compelling reason to keep DVDs alive, says Pachter.

“As we migrate to HD, they’re counting on you throwing away your entire library of DVDs and buying all new (HD) DVDs,” he said. “And they can’t wait to sell them to you.”

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