[The Impact of the Internet on the Video Rental Industry.docx

[The Impact of the Internet on the Video Rental
Industry: Blockbuster vs. Netflix]
2
Table of Contents
INTRODUCTION 3
VIDEO RENTAL INDUSTRY ANALYSIS 5
BLOCKBUSTER BUSINESS DESCRIPTION 7
BLOCKBUSTER BUSINESS MODEL 7
BLOCKBUSTER HISTORY 8
BLOCKBUSTER SWOT ANALYSIS 10
NETFLIX BUSINESS DESCRIPTION 14
NETFLIX BUSINESS MODEL 14
NETFLIX HISTORY 15

COMPETING ONLINE SERVICES 16
FINANCIAL ANALYSIS 18
THE FUTURE OF THE VIDEO RENTAL INDUSTRY 24
CONCLUSION 25
REFERENCES 26
3
The Impact of the Internet on Video
Rentals: Blockbuster vs. Netflix
Could Brick and Mortar Video Rental Stores be a thing of the
past? The Internet has
challenged the way movies are rented in the United States.

Blockbuster, one of the
biggest video rental companies, has completely restructured its
operations to meet the
market demands due to the emergence of the Internet and
companies like Netflix. The
first impact the online video rental industry made on
Blockbuster was making late fees
obsolete. Blockbuster enacted a “no late fees” policy in 2004 to
remain competitive in the
industry. The company gave up about $450 million in late fee
revenue and $250 million
to $300 million in operating income the first year the policy was
enacted (Halkias). This
is not counting the increased number of new releases the
company needed to purchase to
meet customer demand due to the policy. Under the "no late
fees" program, a customer
was charged the purchase price for a movie if it was kept longer
than 14 days. The charge
was dropped if it was returned within 30 days, and the customer
was then charged a $1.25
restocking fee (Halkias). Blockbuster then created Blockbuster
Total Access in attempts
to compete in the online video rental market. With Blockbuster

Total Access, customers
would pay a subscription fee of $24.99 a month and rent up to 2
movies online at a time.
4
Netflix, the online DVD rental pioneer, sold a similar service
for $21.99 a month.
Company CEO, John Antioco, said the overall online subscriber
market is about 3
million to 5 million households, and he believes Blockbuster
can attract a 30 percent
market share (Halkias). Blockbuster spent between 70 and 90
million dollars on the Total
Access program in hopes of reinventing itself. Program costs
and continued decline in
rentals caused the company’s 2004 earnings to fall about 10
percent below the $1.48 a
share earned in 2003 (Halkias). The company will have to
continue developing in this $8
billion dollar a year industry as it continues to change. Within
another four years,
customers are expected to spend about $1.7 billion getting
movies from cable to watch at

their convenience (Cohen). The video rental industry is also
moving to legal downloading
sites such as CinemaNow Inc. Founded in 1999, the service lets
people download movies
as a rental with a viewing window, or buy the film outright and
burn it on a disc (Cohen).
Blockbuster hoped to leverage its infrastructure of brick and
mortar locations to compete
with Netflix and Video on Demand operations. In 2006 it gave
its customers the ability to
return online rental movies to stores to receive a free in store
rental in exchange. Antioco
says of the effort, "It puts the online customer in the store. It
creates traffic and
incremental revenues” (Mohl). In the first quarter of 2007
Blockbuster added 800,000
online subscribers to its Total Access program in the first
quarter to end with 3 million
subscribers, beating Netflix's 481,000 new customers in the
same period (Halkias).
Despite the increase in online customers, stores were
performing lower than expected and
online costs were high, leading to a stock price drop of 81 cents
after the first quarter of

2007 to close at $5.40 a share (Halkias).In 2008 Blockbuster’s
main competitor Netflix
stepped up the competition with online movie download
services and plans to expand
5
into TV downloads. "Internet to the TV is a huge opportunity,"
said Netflix Founder,
Chairman and CEO Reed Hastings (PR Newswire). The sale and
rental of movies over
the Internet will grow dramatically over the coming years and
could reach nearly 60
million (59.4 million) units by 2010, with revenues
skyrocketing to over a half billion
dollars ($534 million) (Business Wire).
Video Rental Industry
Porter’s 5 Forces Analysis:
Threats of New Entrants:
When the home movie/video game rental industry commenced,
the threat of new entrants

was very high because video rental stores were mainly small
local businesses. Operating
costs and capital requirements were low because customers
demanded less selection.
Currently, customer demands are high and there are no
switching costs. Barriers to entry
are higher now because huge capital requirements are needed to
provide variety to
customers. With the emergence of the digital video realm, it is
easy for big name Internet
retailers to offer movie downloads and rentals. The increase of
piracy sites that provide
free movie downloads are emerging, making it harder to be
competitive in the industry.
Nevertheless, copyright policy changes may hinder many new
entrants from entering the
industry (Xie & Lin).
Bargaining Power of Suppliers:
Bargaining power of suppliers is very high since there are only
a few of them in the video
rental industry. Revenue sharing agreements with movie
production companies allow
major players like Blockbuster and Netflix to somewhat

minimize supplier bargaining.
6
Threats of substitutes:
Substitutes include movie theaters, satellite TV, and cable TV.
The threat of substitutes is
high as customers can choose to go to a movie theatre for a
different movie experience
and see movies before they come out on video. Movies on “pay-
per-view” service from
cable companies are also attractive to the customer they are a
very easy and convenient
option. Video on demand (VOD) allows users to select and
watch video and clip content
through a network in an interactive television system (Xie &
Lin). The main advantages
of video on demand and pay-per-view over movie rentals are
that customers do not have
to leave their homes to go to a store and they do not have to
worry about movie returns.
Rivalry among industry competitors:

The video rental industry is a highly competitive industry.
Competitors range from
retailers such as Wal-Mart to Internet entertainment providers
such as iTunes. Retailers,
like Wal-Mart and Best Buy sell movies in their stores and are
now looking to sell online
movies as well. There are also video game and movie rental
stores like Hollywood Video,
Blockbuster and Movie Gallery which provide brick and mortar
locations. Netflix has
also become a major competitor with its online and mail
delivery service. Publix and
McDonalds have also become competitors, as they have movie
rental machines offering
movie rentals for one dollar a day. iTunes and many other
Internet entertainment
providers are also entering the industry as competitors with
movie downloads.
7
Bargaining power of buyers:

Because customers have so many alternatives in the industry
and switching costs are
almost nonexistent, their bargaining power is high. It is
therefore important for businesses
in this industry to provide the variety of movie selection
customers expect and the new
technology to ease transactions. Buyer bargaining power can be
proven by the change in
customer preferences from VHS to DVD technology and with
the recent introduction of
Blue Ray disks.
Blockbuster
Business Description:
Blockbuster Inc. is a global company in the industry of rental
and retail sale of
entertainment movies and video games. By 2008, the company
had over 7,800 stores in
the United States, its territories, and 21 other countries
(Reuters). In Ireland it operates
under the Xtra-Vision brand and in Canada, Italy, and Mexico

under the Game Rush
brand. Its stores offer movies and games for sale and rental. In
2008 they added to their
product line Blu-Ray DVDs. The company’s expansion and
innovation has included
8
offering monthly memberships, removal of late fees, movie
home delivery, and now
online downloading.
Business Model:
The key elements of Blockbuster’s business model are to:
movie titles
ally advertise and market the Blockbuster brand name
distribution
History:

The Beginning: 1980s
Technological development has always been a part of
Blockbuster’s business
model. In the 1980s, the video rental industry was very
fragmented and was run mostly
by mom and pop shops. These small video rental shops had
movies behind the desk to
discourage theft and movie selection was very limited. David
Cook, former computer
software company owner, decided to streamline the video rental
process through a
computerized system for inventory control and check out. In
1985, he opened the first
Blockbuster store in Dallas, Texas (Hoovers). The company
was an instant success and
was taken over by investor Wayne Huizenga in 1987 (Hoovers).
Huizenga invested 18
million dollars into Blockbuster. This was the start of the
Blockbuster expansion.
The Expansion: 1990s
Acquisitions allowed blockbuster to have 1, 500 stores by 1990,
just 5 years after its

opening (Hoovers). The company then started to expand
internationally and opened
9
stores in Australia, Chile, Mexico, Spain and Venezuela in
1991(Datamonitor). It also
became the largest video renter in the UK in 1992 by purchasing
Cityvision (Hoovers).
Possibilities seemed endless until Viacom acquired Blockbuster
in 1994 for 8.4 billion
dollars (Hoovers). Huizenga left Blockbuster immediately after
the takeover and Steven
Berrand (Blockbuster’s CEO after the takeover) left only 2
years later. Bill Fields took
over the CEO position and restructured Blockbuster to not only
be a rental store but to
also sell movies, books, CDs, gift items, and music. He
resigned a year later and was
replaced by John Antioco. Antioco’s vision for Blockbuster was
different and he started
undoing some of Fields’ efforts. In 1997 he forced the movie
studios in a revenue sharing
agreement that replaced the standard practice of buying rental
copies for as much as $120

each (Hoovers). It allowed Blockbuster to increase its movie
variety and save more
money. The company winded up returning to its rental roots by
selling Blockbuster
Music in 1998. By 1999 Viacom spun off a minority stake in
Blockbuster (Hoovers).
Conflict of New Technology and Competitors: The New
Millenium
In 2001 Blockbuster adapted to new technology by reducing its
VHS and video game
inventory by 25% to make room for DVDs. To emerge itself in
the new technology it
acquired Movie Trading Co., a used DVD trading retailer, in
2003. Blockbuster in 2004
eliminated late fees on all of its in-store rentals at locations in
the US and Canada
(Hoovers). This was an action Blockbuster took to stay
competitive in the market and
therefore spent 60 million dollars in marketing. They also ended
up losing more than
$500 million in late fee revenues. This caused many
Blockbuster franchisors to drop the
promotion and continue charging late fees. In 2006 the
company, due to competitor

pressure, introduced Blockbuster Total Access, a movie rental
program that gave online
10
customers the option of returning their DVDs through the mail
or exchanging them at
more than 5,000 participating Blockbuster stores for free in-
store movie rentals
(Datamonitor). In July 2007, there was another CEO change in
the company as James
Keyes replaced John Antioco. In 2007 Blockbuster decided to
roll out with Blue-ray
disks for rental to 1,700 corporate-owned stores (Datamonitor).
Due to even more
competitor pressure, Blockbuster acquired Movielink to provide
movie download
services in the US in August 2007 (Datamonitor). The
acquisition gave Blockbuster
access to one of the largest libraries of downloadable movies
and a large array of
television content. Currently, Blockbuster and 2Wire are
introducing the “2Wire
MediaPoint” digital media player, an easy-to-use, on-demand

video solution, which
offers instant access through their television sets to Blockbuster
(Datamonitor).
SWOT Analysis
Strengths:
1. Brick and Mortar Locations
Having many store locations provides convenience to
customers. It also allows
customers to communicate any problems or concerns face to
face with the staff,
an advantage over online services.
2. Geographic Coverage
Blockbuster is a global company and has stores in the US and
22 other counties
(Xie & Lin).
3. Diversified Offerings
Blockbuster delivers its products through in-store products, by-
mail and by
downloads. Blockbuster’s diversified services portfolio helps in
attracting and

11
retaining customers by providing them the convenience of
renting movies online
or in-store, and enables Blockbuster to reach customers where
the company does
not have convenient store locations (Datamonitor).
4. Strong Distribution Capabilities
Blockbuster has 35 distribution centers and a distribution
headquarter in
McKinney, Texas, which allows for fast delivery (Xie & Lin).
5. Cost Reduction Mechanisms
It has revenue sharing agreements with suppliers to help cut
down costs of
operations. The company also closes unprofitable stores to
control costs. It closed
84 outlets in Spain and shut down 150 stores in the US in 2006
(Xie & Lin).
6. Strong Brand Name
Blockbuster has been in operations since 1985 creating its well-
known brand
name and reputation.
7. Game Concept

Game concept is a unique offer from Blockbuster that most of
its competitors and
substitutes don't provide. Blockbuster had 480 store-in-store
game locations in
2004 and continually grows in game market (Xie & Lin).
Weaknesses:
1. Weak Operating Performance
The company’s operating profits recorded a year-on-year
decline of 47% in 2008
to reach a value of $39.1 million (Datamonitor). The operating
margin also
declined from 1.3% in FY2006 to 0.7% in FY2008
(Datamonitor). The cash from
operations has also decreased as well limiting the company’s
ability to fund its
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debt
2. Weak Interest Coverage Ratio
In 2008, Blockbuster’s interest coverage ratio was 0.44, it has
declined from 0.72

in 2006 (Datamonitor). This indicates the company is having
trouble paying
interest on its outstanding debt.
3. Debt
As of 2006, Blockbuster has total debt of $984.2 million (Form
10-k, 2006). The
debt could be attributed to Blockbuster’s cash flow problem that
originated with the
elimination of late fees.
4. Lack of Mature Web Technology
Customers sometimes have difficulty finding information they
need because the
website does not have a search engine (Xie & Lin).
5. Shipping Problems
Customer complaints include delivery time, product availability
and reliability.
Customers have also complained that desired movies are not
available, that
reserved movies stay in the order queue too long, shipping takes
too long, or that
DVDs arrived with quality problems
(www.forums.slickdeals.net).

Opportunities:
1. Movie Download Service
Blockbuster’s acquisition of Movielink will allow Blockbuster
to offer unlimited
access to download movies. Business in the content
downloading industry will
reach $1 billion by 2010 according to John Antioco's estimation
(Xie & Lin).
2. DVD Vending Kiosks
13
Blockbuster has started an initiative with NCR to launch DVD
vending kiosks.
The company had a goal of 50 Blockbuster branded kiosks by
the 3
rd
quarter of
2009 (Datamonitor). These kiosks will offer DVD rentals but, in
the future, could
offer downloads and sales. DVD vending kiosks are expected to
grow more than
60% in the next three years (Datamonitor).

3. Booming Video Game Market
According to industry trends, the worldwide gaming market is
expected to grow
at a CAGR of 11.4% during 2007-10 to reach $46.5 billion in
2010
(Datamonitor). This could be beneficial for Blockbuster because
of their
significant investment in gaming.
Threats:
1. New Technologies
The new video format video-on-demand, pay-per-view, and
Internet downloading
method made new released movies immediately available from
the studios before
they reach the video retailers (Xie & Lin). Online offerings are
also taking
customers from in store rentals. The internet video downloading
business requires
less capital requirements and therefore is appealing to more
entrants.
2. Stiff Competition
Blockbuster is facing fierce competition from low priced DVDs
sold by retailers

such as Wal-Mart and Target video-on-demand from cable
companies, and on-
line DVD rentals by Netflix and iTunes (Xie & Lin).
3. Movie Piracy
Movie piracy is on the rise in both the US and international
markets. Piracy has
14
increased because of technological advances that allow for the
conversion of
programming into digital formats to display over the Internet.
Netflix
Business Description:
Netflix is one of the world's largest online movie rental services
that provide more
than eight million subscribers (Datamonitor). The online
service includes over 100,000
DVD titles and over 12,000 of those are available for online
viewing (Datamonitor).
Their online service includes movie ratings and
recommendations. They have followed

Blockbuster’s footsteps in establishing revenue sharing
relationships with studios and
distributors to save money. The company ships and receives
DVDs through the post
office with postage paid return envelopes. Netflix can now also
stream movies instantly
to members’ TVs through Netflix Player by Roku and PCs
(Datamonitor).
Business Model:
The key elements to their business model are:
of internet delivery
15
History:
Reed Hastings founded Netflix in 1997 and opened the world’s
first internet store

to offer DVD rentals in 1998 (Datamonitor). That same year
Amazon.com and Netflix
entered into a marketing relationship, where they would direct
their customers to the
other. In 1999 Group Arnault invested $30 million dollars in
Netflix, which allowed the
company to launch its subscription service (Datamonitor). To
maintain an edge in this
highly competitive industry Netflix entered an agreement with
TiVo in 2004 to develop a
technology for digital distribution. In order to improve their
customer service to
customers they developed the feature “profiles” in 2005. This
allows individual family
members to have their own movie queue in a single account.
ForeSee Results twice
independently ranked Netflix number one in customer
satisfaction across all of e-
commerce in 2005 and 2006 (Datamonitor). In further efforts to
continue as number 1 in
customer service they introduced a new feature “Previews” in
2006 on their website that
allows members to watch movie trailers that have been
personalized for them based on

their movie tastes.
16
Competing Online Services:
17
18
Financial Analysis
The Internet and the Netflix model, based on its use for

connecting with the customers
and coordinating the distribution of different media, have
affected Blockbuster in many
ways. One of the easiest ways to analyze the effect of the
Internet in Blockbuster’s
operations is to examine its financial statements before and
after the “boom” of the new
model and compare them with the ones of Netflix and the
market trends.
Stock Price
The stock price reflects the present value of the future cash flow
of a company, thus it is a
valid indicator to compare how the market forecasts the
performance of each company.
The following graph presents a comparison between the
historical stock prices of both
companies:
Figure 1 –Blockbuster and Netflix stock prices from August
1999 to December 2008
19

Although Blockbuster’s stock has been traded before Netflix’s,
it only took the new
competitor around one year to surpass its price. In addition,
Netflix’s stock has reached
levels as high as $73, which Blockbuster’s stock has never
achieved. Also, it is clearly
distinguishable that at the same time that Netflix’s price has
risen, Blockbuster’s stock
behaves contrary, decreasing its value. Currently Blockbuster
stock is trading at around
$0.80, while Netflix’s value is around $46. Since the first time
Netflix outdid
Blockbuster, the old market leader has never been able to
recover its superiority, so a
visible trend can be defined to describe which business model
and company the market is
favoring.
Holding Period Return
An element closely related to the price of a stock is the return
obtained for investing on it.
This case is another clear example of how the Internet model
affected Blockbuster. In
2002, before Netflix’s stocks were traded, Blockbuster offered,

on average, around a 3%
return, but since the new competitor appeared, that amount has
decreased considerably. A
person who held Blockbuster stock since 1999, would receive,
on average a negative
2.3% rate of return, which incidentally is the rate of return
offered by Netflix, with a
positive sign, of course.
20
Figure 2 –Blockbuster and Netflix average expected return
comparison before and after June 2002
Sales
Sales are a key factor for the success of any business. Although
by 2006 Blockbuster’s
sales were considerably higher than those of Netflix and still
remained as an important
contender, an inflexion point was created in 2004 where it is
clearly divisible how the
Internet model starts an increasing trend, taking sales revenues
from Blockbuster. As you

can see in the following graph, a forecast can be made
predicting that at some point both
sales will converge:
Figure 3 –Blockbuster and Netflix Sales from 1998 to 2006
21
Net income
Taking into consideration the wide difference between the sales
of each company, it
could be expected that the incomes would follow a similar
pattern, but the reality is
different. Unlike Netflix that has generally had positive net
income (it only had negative
net income from 2000 to 2002), Blockbuster has always had
high levels of different types
of expenses that decrease their revenues, reducing their income.
In addition, it is only
recently that Blockbuster has been able to achieve a similar
level of income to Netflix,
proving that a fast growing company, with a business model
based on the Internet can
manage their expenses very efficiently.

Figure 4 –Blockbuster and Netflix Net Incomes from 1998 to
2006
Current Ratio
The current ratio is an indicator of the ability of any company
to pay back its short-term
liabilities with its short-term assets like cash or inventory. As
we can see in the following
graph the appearance of Netflix did not influence the liquidity
capacity of Blockbuster:
22
Figure 5 –Blockbuster and Netflix Current ratio from 1998 to
2006
But it is also very clear that the model based on the Internet
gives higher liquidity
capabilities to Netflix, which in turn reduces its necessity to
incur debt, pay interests and
finance operations. Also, the current ratio indicates that Netflix
has a much more efficient
operating cycle, turning its operations into cash faster.

Profit Margin
Although the profit margin ratio it is not a good indicator for
comparing different
companies because different types of organizations are bound to
different levels of
expenditures, we can observe in the following graph that the
internal margin of
Blockbuster decreased from an average of -4% to -13.4% in the
following years after the
appearance of Netflix. This indicates that Blockbuster would
have to assume higher risk
if sales decline, erasing the possible profits.
23
Figure 6 –Blockbuster and Netflix average profit margin
comparison before and after 2000
Asset turnover
Even though Blockbuster has been able to increase the asset
turnover ratio, it has never
achieved in its history such high level as Netflix in its
comparable shorter life. This fact

demonstrates that the Internet based business model can be
considered more efficient at
using assets to generate revenues.
Figure 7 –Blockbuster and Netflix asset turnover ratio
comparison from 1998 to 2006
24
The Future of the Video Rental Industry
1. Regularly downloading movies over the Internet to watch on
wide-screen
TVs at home:
Movie buffs can download flicks from sites such as Movielink
or CinemaNow for
$2-$5, and watch them on their computers. Movielink offers
about 400 movies,
which take a half hour to 90 minutes to download, but you have
the option of
starting the movie about 10 minutes into the download (Brush).
iTunes also
offers movies for download for about the same price that
customers can put on

their iPhones and iPods. The file lasts 24 hours but makes the
movie rental
portable. Blockbuster customers can now also download rental
movies on their
site.
2. Paying $20 monthly fees to rent "unlimited" movies that
arrive and return
by mail:
Netflix customers pay $20 a month for up to four movies
ordered online and
delivered by mail. Customers can rent more, once they return
discs in pre-paid
mailers from Netflix. Blockbuster now offers a similar service
that allows
customers to return movies both my mail and in the store. If
movies are returned
in stores, customers can also check out replacement movies for
free.
3. Selecting from large film menus offered by cable companies
in viewing
formats that are just as convenient as DVDs and VHS tapes:
Cable subscribers pay $5 to $10 dollars on top of their normal
cable bills to get

VOD and then pay $3.95 for recent releases, and $2-$3 for older
films (Brush).
VOD is not yet a real threat because of little marketing
initiatives and limited
25
offerings. But current improvements in storage and file-
compression technology
could prove favorable for VOD and a big problem for
Blockbuster.
4. Buying DVD movie discs that "self-destruct" 48 hours after
they're opened:
Buena Vista Home Entertainment, a Walt Disney division,
began test marketing
these discs earlier this summer, with technical help from
Flexplay Technologies,
at a suggested retail price of $6.99 (Brush). There are still some
problems with
this technology, but once kinks are figured out returning movies
could become a
thing of the past.
Conclusion

The Internet based business model used by Netflix has
undoubtedly affected the
leadership position of Blockbuster. The use of the Internet,
combined with other key
elements, naturally generates more efficiency in the operations
of any company,
specifically the video rental market. The strength and the
success of the new competitors
have completely changed the way the industry is approached.
Blockbuster realizes this
evolution, which is the reason why the old leader has been
striving to integrate their old
business model with the new technological trends to adapt to
the force of the Internet and
its advantages. Netflix has been facing different challenges, but
technology is once again
their main issue of concern. Netflix keeps looking for alliances
to integrate with other
players to keep current with the latest industry trends.
Nevertheless, only time will tell if,
in modern times, the media rental business can survive the
challenges of technology and
whether the brick and mortar model will remain alive.

26
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