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Conserving Cash is Blockbuster's "Winning" Initiative

Speaking to analysts during a second-quarter financial call on August 13, Blockbuster chief executive Jim Keyes said the video rental chain had drafted new revenue-sharing agreements with studios -- "win-win" initiatives designed to increase the number of rentals at Blockbuster and improve profits for the studios on the backend.

To the contrary, given the company's existing debt-service obligations on its levered capital structure, I remain skeptical that the motivation behind the new purchase arrangements was not for growth, but an attempt by Blockbuster to continue managing the business for cash conservation, as additional credit restrictions were forced on the company by its suppliers, according to its 10-Q regulatory filing:

Given our liquidity limitations and uncertainty surrounding our ability to finance our obligations, we are currently in discussions with several of the large studios regarding the credit terms for our inventory purchases. Several of the studios have tightened their credit terms and one studio has eliminated its provision of credit to us, meaning that we must purchase product from this particular studio with cash in advance.

Purchases under revenue sharing arrangements already make up 85 percent of total domestic movie rental fees. Although details are confidential, it is likely that the newly negotiated deals provide for lower initial payments by Blockbuster to acquire the inventories. A read of past regulatory filings suggest that in exchange for lower up-front cash payments, these purchase contracts likely include minimum purchase requirements based upon box office results of the titles. In addition, Blockbuster has historically paid an agreed upon percentage of rental income earned from supplied product(s) to the studio/game vendor for a limited period of time (usually 30 - 45 days).

In addition, a majority of its revenue-sharing agreements have historically required video product to be destroyed at the conclusion of the initial rental cycle. As studios move more aggressively to preserve their pricing control over new DVD releases, this shortening of the rental life cycle will likely adversely affect 'previously rented product' (PRP) going forward. In the second-quarter ended July 5, PRP sales declined 15.8% year-on-year.

Same-store rental revenue tumbled 13.3 percent, driven by lower store traffic and lower copy depth (as management tried to conserve cash and get a handle on upcoming debt maturities). Keyes said Blockbuster was making a "concerted effort to improve unit availability," inferring on the earnings call that increased unit availability would at least partially offset anticipated lower same-store comparables in the second half of the year. The rift in his logic, in my opinion, is that even an increase in favorable title releases (g ames and movies) will do little to reverse changing consumer preferences as to how they access entertainment, demonstrated by customer defections to rivals like rental-by-mail provider Netflix and DVD-rental kiosk operator Redbox.

The combination of tight expense controls and working capital management resulted in a significant turnaround in net cash from operations in the second-quarter: $114 million as compared to a $63 million use of cash in the same period last year. In the context of uncertain market dynamics (including consumer spending behavior), $729 million in interest payments and debt maturing over the next three years, and the company's desire to replace existing credit facilities (interest rate of 13.5 percent) with less-costly options, cash management still remains the priority in the months ahead at Blockbuster.

Contrary to CEO Keyes' optimism, there is no real "win" for Blockbuster stockholders resulting from the new video distribution deals. If anything, the goal remains the same as six-months ago-avoiding bankruptcy.

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