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Circuit Buster - April 14, 2008

Wall Street didn't exactly exult in Blockbuster's $1.3 billion bid for ailing consumer electronics retailer Circuit City Monday, sending shares of the video rental chain down more than 10% on the news. "Tying two bricks together won't make them float," and all that. Aaron Task of TechTicker was particularly brutal, calling the proposed acquisition "one of the more ill-conceived deals in recent history." His tag-team partner, Henry Blodgett, called the bid "ludicrous" and "crazy" in a post on Silicon Alley Insider. The big winner in the proposal, according to Blodgett, will be Netflix, which will now have 18-24 months to consolidate its lead in the DVD-by-mail business and develop its digital delivery business while its leading competitor is distracting by a pointless acquisition.

Few commentators put much stock in Blockbuster CEO Jim Keyes' rationale spelled out in his letter to the Circuit City board;

Our vision for the "new" Blockbuster is to be the most convenient source for media entertainment. We have undertaken a series of strategic initiatives including enhancement of our core rental business; a transition from solely rental to a concentration on consumer retail; and development of the fast- growing digital download market. We are pleased that these strategic initiatives have begun to improve our financial results and anticipate further improvement going forward.

The combination of Blockbuster and Circuit City will result in an $18 billion retail enterprise uniquely positioned for the convergence of media content and electronic devices. We would seek to differentiate products in both Blockbuster and Circuit City stores by offering exclusive content and content-enabled devices. Both companies would benefit from complementary products, marketing, management strengths, technology and distribution and the resulting synergies would significantly improve consolidated financial performance.

The deal may or may not make sense financially. That's not really Media Wonk's metier. By I can see at least a couple ways in which Keyes isn't completely out of his mind.

Closing the gap with Netflix in the DVD-by-mail business is never going to get Keyes a valuation at Blockbuster. It would mean a major marketing spend, resumption of the price war between the two and in the end only convert some high volume in-store renters into lower margin online subscribers. That's basically what happened under his predecessor, John Antioco. As first-mover, Netflix owns that business. The battle has been fought and lost. Blockbuster can play in that market--and probably needs to to prevent further defections to Netflix--but it can't own it and shouldn't invest to try.

As for pursuing digital distribution as a replacement for the declining DVD rental business, that's a pipedream for retailers within any reasonable time-frame. Unless and until online retailers can offer consumers the same kind of comprehensive aggregation of movie and TV titles as they can with DVDs, digital distribution will remain a niche market--eating away at the DVD business but never fully replacing it.

What are the chances of that aggregation happening? Not very good in the near term. Securing all of the rights from all of the content owners that would be needed to truly have a Blockbuster store online is simply not possible today and won't be anytime soon. It would and will take years to sort out all of the rights and clearances and to unwind existing contractual arrangements that give exclusive access to certain movies during certain windows to other service providers. It short it would require the effective elimination of all post-theatrical exclusive windows and the studios just aren't there yet.

Enormous technical challenges also remain to be overcome. Broadband penetration isn't anywhere near that of DVD players and probably never will be. Delivering broadband content to the television is in its infancy and is already Balkanizing into proprietary formats and technologies that won't scale.

I could go on. But the point is, betting the future of the company on the development of the digital distribution business is not a realistic play for any third-party retailer that must license rights from the studios, and that includes Netflix. Yes they need to be in that business but they need to treat it as incremental to their core business.

Whether, for Blockbuster, that adds up to buying Circuit City I don't know. But it doesn't strike me as crazy for Keyes to conclude that Blockbuster's future will necessarily involve a significant brick-and-mortar component. In the immediate term, the acquisition of Circuit City will make Blockbuster a bigger buyer of DVDs, which will help it with the studios, particularly since CC is a sell-through account.

The added retail footprint would also give Blockbuster more options for experimenting with download kiosks, manufacturing on demand and other forms of download-to-device distribution, which is likely to be at least as important in the near- to medium-term as digital delivery to consumers. The Circuit City connection would give Blockbuster entree with the device makers, who will play in critical role in the development of that market.

More to come, I'm sure.

LATE UPDATE: The Circuit City board issued a statement today questioning whether Blockbuster would be able to fund its offer, according to TWICE.

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