Videos on the Net

The struggle continues for video rental company Blockbuster Inc. (NASDAQ/BBI) as it battles declining sales at its stores and a rising trend in online rentals and video-on-demand. The company had misjudged the growing importance of the online DVD rental market, which has been on a strong positive trend. Online DVD leader Netflix Inc. (NASDAQ/NFLX) recognized the growing significance of online DVD rentals and is currently the market leader.

 The reality is the trend of online video rentals and video-on- demand is on the rise while rentals at brick and mortal outlets are on the decline. According to research by Screen Digest, estimates call for the online DVD rental market in the U.S. to rise to 25% of all video rentals by 2009.

 Blockbuster tried to increase rentals at its 8,500 stores by adapting a strategy of eliminating late fees. The strategy worked, but it also translated into lower revenues from late fees that Blockbuster was collecting. Now, finally accepting the fact that it had failed in its initial strategy, Blockbuster has been successfully beefing up its online rental business.

 At the end of the second quarter ended June 30, Blockbuster saw an increase in revenues from its online business as the number of subscribers stood at about 1.4 million, well below the 5.17 million subscribers at Netflix.

 And while the competition may be daunting, Blockbuster is showing progress in trying to gain more subscribers. But it will not be easy to wrestle market share from Netflix. Netflix has a very strong balance sheet and financial strength with no debt, in addition to $342 million in cash. This will allow Netflix to continue the expensive process of attracting customers even in the event of a price war with Blockbuster, in which I believe Netflix could be successful as the online rental market is price sensitive.

 For Blockbuster, it will be difficult to fight a potential price war as the company’s balance sheet is weak with about $1 billion in debt and a mere $125 million in cash. The company is in no state to battle with Netflix on a price war and this could prove to be a problem for Blockbuster.

 Blockbuster is facing a tough uphill battle to reverse its fortunes and this will not be easy. The company did manage to return to profitability in the 2005Q4 and 2006Q1 but then lost money in the 2006Q2. Watch the next several quarters to see how things play out for Blockbuster.