Blockbuster (BBI)
Q4 2005 Earnings Conference Call
March 9th 2006, 10:00 AM EST

Executives

Mary Bell - SVP IR
Larry Zine - EVP, CFO and CAO
John Antioco - Chairman and CEO

Analysts
Barton Crockett - JP Morgan
Tony Wible - Citigroup
Glen Reid - Bear Stearns
Stacey Widlitz - Pali Capital
Jeff Logsdon - Harris Nesbitt
Marla Backer - Soleil Asset Management
Arvind Bhatia -Sterne Agee

Presentation

Operator

Good morning and welcome to the Blockbuster, Inc., fourth quarter 2005 earnings release conference call. At this time, all participants have been placed on a listen-only mode, and the floor will be open for questions following the presentation. It is now my pleasure to turn the floor over to your host, Ms. Mary Bell, Blockbuster’s Senior Vice President of Investor Relations. Ms. Bell, you may begin.

Mary Bell

Thank you and good morning, everyone. Today’s earnings call may include forward-looking statements relating to our plans, objectives, and initiatives; our outlook for the industry, and our performance relative to the industry; projected trends for financial items; anticipated liquidity; goals for online subscriber growth and profitability; cost reduction expectations; divestitures, and other matters that do not relate strictly to historical or current facts. Actual results may differ materially from those projected in the forward-looking statements. For additional information regarding these forward-looking statements and factors that could cause actual results to differ materially, please refer to the cautionary statements in today’s earnings release and in our public SEC filings, including our 2004 Form 10-K, our subsequent Form 10-Qs, and our upcoming 2005 Form 10-K.

Today’s earnings call may also include a discussion of certain non-GAAP financial measures. Please refer to today’s earnings release for the required reconciliations to the most directly comparable GAAP financial measures and other related disclosures. Our earnings release is available on our website at Blockbuster.com under the link for investor relations. I will now turn the call over to Larry Zine, our Chief Financial Officer.

Larry Zine

Thank you, Mary, and good morning, everyone. This morning we reported our fourth quarter and full year results, highlighted by a significantly lower cost structure and notable sequential quarterly improvement in overall profitability and cash flow.

Adjusted net income, which excludes stock-based compensation and certain other items, for the quarter was $34.2 million or $0.17 per diluted share, a significant improvement over $16 million or $0.09 per diluted share for the same period last year. Adjusted net loss for the full year was $52.6 million as compared to adjusted net income of $147.1 million last year, reflecting the launch of No Late Fees and growth in Blockbuster Online.

Before I walk you through our results for the quarter in more detail, I would like to start by pointing out that the launch of No Late Fees and accelerated growth in online during the first half of the year, coupled with depressed rental market conditions beginning in the middle of the year, put pressure on our cash going into the fourth quarter. These factors led to availability constraints of certain product. Therefore, we focused our activity in the fourth quarter on uses of cash that best supported an improvement in profitability.

In many ways, this quarter turned out to be very much a transitional quarter for us from a revenues and margin standpoint. While facing continued pressure on the rental industry, we cycled against the contribution from late fees and strong in-store Pass performance in the fourth quarter of 2004, with some of the offset coming from the year-over-year growth in lower margin revenues from online.

In addition, we took several important steps to improve liquidity and better position ourselves financially and operationally. In November, we put in place an amendment to our credit agreement, which allows for greater flexibility over the original term of the agreement. In conjunction with that, we raised $150 million in gross proceeds from the convertible preferred stock offering, of which $75 million was used to reduce our revolver balance and the remainder was used to alleviate the pressure on working capital. We reduced our SG&A expenses by $186.5 million as compared with the fourth quarter of last year. Our operating margin improved by 220 basis points as compared with the fourth quarter of last year.

The continued focus on profitability and cash flow in the fourth quarter of 2005 and the first quarter of 2006 allowed us to reduce our revolver balance by an additional $70 million in December and $75 million since the beginning of this year.

We further reduced our accounts payable balance. As a result, our liquidity position improved significantly and as of February 28, 2006 our available borrowing capacity under the revolving credit facility increased to approximately $240 million compared with a low of $36 million in November of 2005.

Now let’s get into more detail. Total revenues decreased 11% to $1.53 billion for the quarter, and decreased 3.1% to $5.86 billion for the full year. Our worldwide same-store revenues for the quarter were down 10.1%, and for the year were down 4.9%. Worldwide same-store rental revenues decreased 7.9% due to the elimination of extended viewing fees, which were about 13.2% of our rental revenues in the fourth quarter of 2004, and a decline in the overall rental industry.

These decreases were partially offset by increased revenues from Blockbuster Online, which positively impacted our comps. The year-over-year comparison was further impacted by aggressive advertising and promotional activity during the same period last year, which resulted in a higher revenue contribution from Blockbuster Movie Pass during the fourth quarter of 2004. We had over 2 million Movie Pass subscribers in the fourth quarter of 2004, one of our highest Pass penetration quarters, and around 1 million at the end of 2005.

Worldwide same-store retail revenues declined 14.5% for the quarter, reflecting our ongoing efforts to reduce the number of stores selling deep catalog movies as well as product availability constraints in the third and fourth quarters. Our other revenues decreased by $8 million, mostly as a result of lower partnership marketing activities and a decline in royalty payments from our franchisees.

Despite the decline in total revenues, operating income for the quarter was $54.5 million, up significantly from $24.9 million last year. The improvement in operating income was driven by a 21.5% decline in SG&A due to a leaner overall cost structure both above and at store level, and lower advertising expenses. As a percentage of total revenues, SG&A expenses decreased to 44.5% for the fourth quarter of 2005 from 50.5% for the same period last year. Lower SG&A costs were partially offset by a 17% decline in gross profit, largely due to the decline in total revenues.

Gross margin for the quarter was 51.8% as compared to 55.6% in the same quarter of last year, largely as a result of the growth in revenues from Blockbuster Online, which has a lower gross margin; as well as increased product purchases to improve product availability in our stores. Operating margin was 3.6% as compared to 1.4% in the fourth quarter of last year, reflecting a lower overall cost structure. Adjusted operating income, which excludes share-based compensation, a reserve for a franchise note, and severance increased to $70.7 million for the quarter from $44.8 million last year.

For the full year, the adjusted operating loss was $2.5 million compared with an adjusted operating income of $271.1 million for 2004, reflecting the elimination of late fees, weak industry conditions, and the impact on profitability from the growth in the Online business. The year-over-year decline in free cash flow for the quarter is primarily a result of changes in working capital discussed earlier, which were driven primarily by lower retail inventory purchases resulting in lower accounts payable year-over-year.

Historically, during the fourth quarter the increase in working capital has been a source of cash flow for us, largely because we have built retail inventory and accounts payable. This created a significant use in the first quarter of cash in prior years that we haven’t experienced this year because of the lower payables balance at year end.

Before I close and turn the call over to John, I do want to call your attention to the 8-K we filed this morning regarding the accounting treatment of our rental library in both our balance sheet and statement of cash flows. Historically, our rental library has been included as a long-term asset on the balance sheet; and the purchase of rental library product has been included as an investing activity on the statement of cash flows. Based on the discussions with the SEC, we have determined that we will reflect the rental library as a current asset on the balance sheet and rental library purchases in operating activities on the statement of cash flows.

To make this change, we will restate our historical balance sheet and statement of cash flows in our 10-K that will be filed next week. We have included a summary presentation of the financial effect of the planned restatements in the 8-K filing. It is important to note that these changes do not affect our net income, total assets, total cash flow, cash balance, or debt covenants.

In summary, 2005 was a challenging year for Blockbuster and the industry. We started the year with the No Late Fees program, an acceleration of growth in Blockbuster Online, and cost reductions. As the rental market changed, we took actions that by the fourth quarter began to improve both our profitability and cash flow.

We have entered 2006 in a much stronger position and will continue to focus on improving the profitability of our business, growing market share, and reducing SG&A costs by approximately $100 million. Additionally, our capital expenditures will be approximately $90 million in 2006, a decline from approximately $140 million in 2005, primarily due to fewer new store openings. Now I will turn the call over to John.

John Antioco

Thanks, Larry, and good morning. We are very pleased with the fact that we were able to produce a significant improvement in profitability for the fourth quarter, especially in light of the fact that 2005 was a challenging year for Blockbuster and for the entire video rental industry.

During the first two quarters of the year, we were on track with our plan to position Blockbuster for the future, which included building our subscriber base for Blockbuster Online and seeing strong improvements in our active member trends as a result of eliminating extended viewing fees. Then along came the dog days of summer and some of the worst — if not the worst — months the video rental industry has ever experienced.

While our initiatives helped us outperform the competition in the third quarter, the unanticipated and unprecedented decline in the industry as a whole put pressure on our capital structure and our liquidity, and prompted us to take decisive actions that suppressed revenues from lower margin transactions including:

1. The elimination of promotional pricing for Movie Pass, our in-store subscription program.
2. Significantly lowering our inventory of deep catalog retail movies from a large number of stores.
3. Greatly reducing our marketing spending behind both in-store and online.

As a result, we gave up some revenues in Q4 and we were unable to grow our online subscriber base in accordance with our plan. However, the actions we took positively impacted our profitability and will continue to do so. Now, with the elimination of extended viewing fees and the launch of Blockbuster Online behind us, we have entered 2006 a leaner, more focused organization with greater financial flexibility, determined to profitably grow our market share of in-store and online rental.

So let me summarize our business model going forward, a model that focuses on delivering more to our customers, but also delivering more to Blockbuster in the form of profits.

First, Blockbuster is no longer just a chain of video stores. We are an in-store, online retailer, becoming more integrated every day. In 2005, we grew our online subscriber base from 400,000 subs at the start of the year to around 1.2 million by year-end, a 190% increase, even though we virtually shut down our online marketing efforts in the second half of last year.

We now have marketing cranked up to a more normal level and are building momentum again around subscriber acquisition. Based on what we were seeing, we believe our goal of 2 million subscribers by the end of 2006 is attainable. In support of this, we continue to promote and sell Blockbuster Online in our stores, making our online service accessible and available to our in-store customers. Our goal isn’t simply to keep customers renting from our stores. Our goal is to keep them renting from Blockbuster, in-store and online.

Going forward, we intend to continue utilizing our store base to keep our subscription acquisition costs low, while still nearly doubling the size of our online business this year. We also plan to continue to expand our online fulfillment capabilities beyond the 1,000 stores we are using now.

We will continue to look for additional ways to leverage our integrated capabilities to drive savings for us and to differentiate Blockbuster as the one brand movie rental customers can access in-store or online. We will have significantly lower operating losses associated with Blockbuster Online in 2006; and our goal is to have our service operating profitably in 2007.

In addition to operating more and more as an integrated Company, Blockbuster’s business model in the U.S. no longer includes extended viewing fees. We don’t charge late fees online, and we don’t charge them in-store. Our customers have responded positively. Since launching No Late Fees, our active member numbers and pure rental revenue — in other words, our domestic rental revenues excluding extended viewing fees from ‘04 and ‘05 — have continued to track better than our franchisees who are not participating in the program.

We feel very confident based on our results to date that we will outperform the industry in 2006. From a bottom-line perspective, we believe Blockbuster will perform better in 2006 and even better in 2007 than we would have if we were still charging extended viewing fees.

Additionally, we have been able to greatly reduce promotional discounting from the way we do business, because we are using the elimination of EVF to drive traffic to our stores and better satisfy customers.

We will also continue to offer Movie Pass, our in-store subscription program; and Rewards, our paid loyalty program. These two offerings, which appeal to different customer segments, are designed to encourage members to visit our stores more often.

As for product availability, it’s better this year than it was in 2005 because we have more movies coming to our stores through revenue-sharing agreements and because we have lowered our Movie Pass penetration to a lower and more profitable level. We also have significantly lowered our inventory of deep catalog retail product from a large number of stores, only carrying an extended mix at locations where we can justify the investment in labor, product, shrink, distribution, and inventory carrying costs.

However, we will continue to sell hot new titles and high-value promotional movies at all our stores. Customers want to be able to buy hit movies from us, and they are willing to pay a convenience premium. We will also continue to sell previously viewed movies at all of our stores to give customers a good selection of titles and great value.

As for marketing our store-based business, overall spending will be less in 2005 than it was last year. However, we will be stepping up our activity over what it was during the last half of 2005. You won’t see us doing as much mass marketing as we have in the past. Rather, we will be putting emphasis on one-to-one communications with direct mail and e-mail, which costs us less and, we believe, allows us to be more effective in tailoring offerings to customers.

What you’re hearing me say with all of this is that Blockbuster is focused on delivering more to customers, more ways to access movies and games through our stores, through online, through a la carte rental transactions, subscriptions, rental, retail, new and used product, and more value with the elimination of EVF, our Rewards and Pass programs. But we are also focused on delivering all of this at optimal level of profitability.

In support of our profitability goals, we’re building on the G&A cuts we made during the second quarter of 2005. This past month we began eliminating additional G&A above the store level. We want to be a lower-cost operator and we will continue to work to drive costs out of our system at every level.

As for store closures, they will be in line with what they have been over the past few years. However, if we can strike the right financial terms, we may close some additional locations. We expect our competitors to be closing stores as well. Our goal is to drive revenues from these closed stores, both our own and our competitors’, to other Blockbuster stores and to Blockbuster Online. This transfer of revenue is wonderful for flow through profitability. We will also continue to look at options for our non-Blockbuster branded assets, as well as exploring the potential divestiture of some of our international assets.

In summary, 2005 was a challenging year. but we dealt with everything that was thrust upon us and we have used it to get our house in order for 2006 and beyond. We advanced two huge initiatives, No Late Fees and Blockbuster Online, which should help us adapt better into the future. We greatly improved our financial flexibility. We have permanently lowered our cost of doing business, and we will continue to work on taking that even lower.

In other words, although the store-based rental industry will continue to be challenging, based on the changes we have made last year and the trends we are seeing in our business thus far, we are optimistic about this year and believe we will outperform the domestic rental industry and grow Blockbuster Online in 2006. Thank you and we are ready to open up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Barton Crockett with JP Morgan.

Barton Crockett - JP Morgan

Thank you very much. I was wondering if you could get a little bit more granular on why the same-store sales, particularly the rental sales, year-over-year worsened so much in the fourth quarter versus the third quarter? I was wondering if you could tell us sequentially what changed there in a little bit more detail? The Movie Pass comps might would be helpful in terms of the revenue differential there year-over-year, the sub differential there.

Additionally I was wondering if you could talk a little bit about, just looking at your capital structure and the asset sales that you’re talking about. With all of the fears now surrounding this industry, I think one could ask whether it would be plausible for you guys to think about pursuing asset sales at a level that might be sufficient to meaningfully pay down your bank debt? To get that risk at the back of people’s minds rather than at the forefront, where it has been at times. I don’t know if that is something you think is plausible or desirable. I was just wondering if you could address it.

Larry Zine

Thank you for your questions, Barton. Let’s start with the same-store sales, and hopefully I can add a little more granularity to it. What we have said, and I will try to make a little more clear if it wasn’t, is that we had a lot of promotional activity in the fourth quarter of last year, 2004. We promoted heavily our Pass program. We did it by discounting prices; we did it by heavy promotion, et cetera. That drove our in-store Pass membership to about 2 million consumers at the end of the year.

In the fourth quarter of this year, we obviously ratcheted back our promotional activity significantly. Over the course of 2005, we gradually raised the price of our Pass program to make it more profitable than it had previously been. As a result, year-over-year we had about 1 million fewer in-store Pass members. The result of that obviously had a significant impact on year-over-year Pass revenues. To quantify it, it’s a little bit difficult. If I just looked at the Pass revenues, they would be down probably between 6% and 7%. However, it’s a little difficult to say how much incremental rent that we may have picked up from somebody switching out of the Pass program and just becoming kind of the, as John referred to them, as an a la carte renter.

So that would have been the biggest single driver of the year-over-year difference in comps. Now that obviously, coupled with what we said previously about EVF and the elimination of late fees, exacerbated by tough industry conditions that we faced over the second half of the year.

As to asset sales and what it might mean to the capital structure, we are continuing to work on asset sales. We’re very focused on that. We think we have some assets that are very desirable both in the movie rental business and in the games business. What those assets might absolutely be worth and what a buyer might be willing to pay is yet to be determined. But we are focused on either maximizing the profitability out of those assets for ourselves, or maximizing the cash that we could receive in a potential sale.

All of which would obviously help the capital structure even more. But if you look our capital structure from really the beginning of the fourth quarter on, it has improved significantly, largely as a result of improved profitability in the fourth quarter and as a result of significant efforts that we have made over the course of 2005 to improve it, including substantial reductions of our merchandise inventory for sale.

If you look at that year-over-year, our merchandise inventories dropped by about $200 million. Obviously, that may have had some effect on revenues; but on the overall grand scheme of things, fully loaded with working capital costs for carrying it, labor to try to sell it, we think it was the appropriate move to take inventory out of a significant number of stores and focus on the retail inventory that sells best for us.

In addition to that, if you look at our accounts payable balances year-over-year, there was a substantial drop in that, which also obviously improves our overall liquidity. So I think we are focused on it as best we can. We continue to look for opportunities that may arise for creating more working capital for us, and we will continue to do that.

John Antioco

Barton, to build on Larry’s answer on the rental comps, although there are no perfect numbers for the industry, if you look at the Rentrak public numbers, make an adjustment for online versus in-store, it looks like the industry for the fourth quarter was down about 6.5%.

So if we look at the impact of EVF and the impact of Pass that Larry alluded to, we can kind of come up with an understanding of why our comps were what they were in the fourth quarter. I think more importantly, as I said in my script, going forward we do expect to exceed the industry in 2006, from this point forward.

Barton Crockett - JP Morgan

Okay, that’s helpful. I think I will leave it there for now and let others ask questions. Thank you very much.

Operator

Thank you. Our next question comes from Tony Wible with Citigroup.

Tony Wible - Citigroup

Good morning. I was hoping we could start off with the cost-cutting guidance of $100 million. How many store closures are implied in that number? Where I’m heading with this question is, if we just take the 4Q level of G&A and annualized it, I would calculate you got about $160 million of production on just sustaining this level. It would seem like if you have any incremental closures that you would see even further reduction in that. Could you tell me where I am missing something?

John Antioco

Tony, you are not really missing anything. The guidance around the $100 million was really intended to be costs that we were taking out, as best we could, excluding store closing costs. So they were really G&A reductions, labor reductions, that we were taking out of the business. We were not trying to take credit for store closures and rent reductions that we would have as a result of that. Hence that is part of the difference.

Tony Wible - Citigroup

So I guess I don’t have to read into that, that marketing is going to increase based on, John, your comments. You had indicated that you don’t intend to do much mass marketing in the future. Should we anticipate then that the TV ads that we have seen will start to die down now?

John Antioco

What I said was our expectation is overall 2006 marketing spend will be less than what our overall 2005 marketing spend was. So you got that part of it right. The second part will be, we do expect to do less broadcast advertising in favor of direct communication, which we think is cheaper and more effective. Lastly, the only broadcast advertising we have done this year was around Blockbuster Online, which proved to be extremely effective marketing for us in 2005, worthy of repeating in 2006. But you should not read into that that you’re going to continue to see a barrage of television advertising from Blockbuster.

Tony Wible - Citigroup

Great, that’s helpful. I will ask one last question and I will jump off to allow others. I was hoping that on the adjustments, I noticed when I was running through it, there were not any tax adjustments to get to the adjusted net income number. Are all these items not taxable, or am I missing something there?

Larry Zine

Tony, right now, because of the large number of operating loss carry-forwards that we have, we’re not really recognizing a provision for these things. So it is basically 100%.

Tony Wible - Citigroup

Great, thanks. I will jump off now. Thank you.

Operator

Thank you. Our next question comes from Glen Reid with Bear Stearns.

Glen Reid - Bear Stearns

Good morning. Just a few questions. Could you comment on what you’re seeing in your markets in terms of overall store closures? Obviously aside from what you guys are doing with your own stores. Secondly, could you comment on what you’re seeing as the response consumer-wise, to the new one free rental in-store per week with the online subscription?

Then lastly, sorry to sort of beat the cost thing to death, but on the marketing side, you spent $50 million marketing the No Late Fees last year. Is that essentially what you would expect the reduction to be in ‘06? Or should we expect something in addition to that? Thanks.

John Antioco

The question regarding competitive store closures, we are beginning to see some competitors closing stores at a more rapid rate than we have ...