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HOLLYWOOD ENDING?

Landlords prepare for some potential upheaval in the video rental market

By Dakota Smith

Uncertainties about the future of the video rental business have some landlords pondering a scary ending.

Retail leasing executives have long expected a shake-up among video rental chains. But when Movie Gallery bought Hollywood Video for $1.2 billion earlier this year, the spotlight on the sector intensified, with the real estate industry pondering the new 4,710-store behemoth’s growth strategies.

Facing a slowdown in sales on the one hand and new competition from such online retailers as Netflix on the other, the video rental business has been in flux for some time. “Developers are very wary,” said Numa Jerome, vice president of retail leasing at Columbia, S.C.-based development firm Edens & Avant. “They want to understand if there is going to be long-term survival of these stores.”

The prognosis is not overly optimistic. Rental revenues continue to drop, according to Portland, Ore.-based Rentrak Corp., which provides analysis and intelligence to the entertainment industry. The nearly $4 billion Americans spent on DVD rentals during the first half of this year is down 2.3 percent from the year-ago period (taking into account both online and brick-and-mortar rentals).

Adding to the rental slowdown is the rise of outright sales of DVDs, which are increasingly cheap and easy to find. Indeed, retailers from Wal-Mart to the local gas station hawk DVDs these days.

For the three major chains focusing on brick-and-mortar rentals — Blockbuster, Movie Gallery and Hollywood Video (now a subsidiary of Movie Gallery) — heat is coming also from Netflix, with its 3 million online subscribers. Additionally, Amazon.com’s foray into the online rental market in the U.K. last winter was widely seen as a warm-up to its U.S. launch.

Echoing an industrywide sentiment, Jerome voiced concerns about the sustainability of the sector, noting that a dent will come, though he is not sure when or how. Technological advances and further consolidation will play pivotal roles, he says. “It’s premature to think that all these stores are going out of business right away,” he said. “But change is going to happen in the industry.”

Cutting back on store openings will be crucial to the ability of the big rental chains to weather the coming storm. In May Movie Gallery announced that it would cut the number of stores it planned to open this year to 300 from 400. The Dothan, Ala.-based company reported a 5.5 percent drop in same-store sales for the second quarter. For June, same-store sales fell 12 percent. Joe Malugen, Movie Gallery’s chairman, president and CEO, said in a press release that he anticipates an equally tough third quarter.

Blockbuster says it will continue to open stores, despite having lost $1.2 billion last year. The company, which currently has 9,000 stores worldwide, opened 129 last year, double the number it opened the year before. Blockbuster says it plans to spend about $150 million this year on new stores, barely more than half the $289.1 million it spent last year. The Dallas-based company lost $57.5 million in the first quarter, on revenue of some $1.55 billion, though same-store sales grew 17.2 percent for the period.

In terms of new markets, Edens & Avant’s Jerome says he believes that Movie Gallery retains an edge because the rural market, in which Movie Gallery has found the most success, still has room for video stores. By contrast, Blockbuster, which dominates in the cities and suburbs, is finding its market to be saturated.

“Blockbuster is not like Starbucks, where they can just enter a market and instantly create a demand,” said Jerome. But Blockbuster’s saturation does give it an opportunity to steal Hollywood Video’s customers, particularly with the “no late fee” promotion it launched this year, according to Lehman Bros. analyst Anthony DiClemente, who points out that 25 percent of Blockbuster’s stores operate within 2 miles of a Hollywood store. (Things may not be that simple, though; Blockbuster’s no-late-fees program is being called misleading in a lawsuit filed by 48 states and the District of Columbia. In reality, customers are charged the price of the movie if the item is not returned within a certain time.)

Video rental stores are getting smaller, says George Demuth, COO of Santa Monica, Calif.-based Centro Watt, a manager and leaser of shopping centers, as the chains are able to better utilize space by stocking DVDs rather than the larger VHS tapes.

“The [video chains] are asking our guys for less and less space,” said Demuth, who notes that stores in his centers now measure about 5,000 square feet, whereas they used to range up to 7,000 square feet five years ago.

Blake Lugash, a Blockbuster spokesman, contends that the company has always had stores of 5,000 square feet. What has changed is the way the space is used, he says. Game Rush stations, 900-square-foot spaces where video games are displayed, are being added. To date, Blockbuster has these stations in 450 of its stores.

Landlords say they like the gaming component because it brings in the parents, though whether the concept has legs remains to be seen. Through its purchase of Hollywood Entertainment, Movie Gallery inherited 600 Game Crazy stores, which sell electronic games. But shortly after the sale, the company announced that it would shut 51 underperforming Game Crazy stores.

Netflix has exhibited strong consumer appeal, but analysts are not entirely sold on the company, pointing out that the seven-year-old Internet rental service has yet to post consistent profits. The Los Gatos, Calif.-based company says its subscriber base grew 56 percent to 3.02 million during the first quarter versus a year ago. But it posted a loss of $8.8 million on total revenue of $154.1 million for the period. Additionally, its recent partnership with Wal-Mart, in which the world’s largest retailer would market Netflix on its Web site, drew mixed reviews from analysts.

Still, the Netflix model has succeeded in forcing Blockbuster and Movie Gallery to retool their own offerings. In the summer of 2004, Blockbuster launched its own online video rental program. That business now has 750,000 subscribers, compared with Blockbuster’s 40 million walk-in customers, says Lugash, who estimates that 20 percent to 30 percent of Blockbuster’s rental business will eventually be done online.

Blockbuster also cross-brands its online and brick-and-mortar sales, offering coupons to online customers for use at physical stores. In May Blockbuster even launched a program to entice Netflix members with two months of free service and a free DVD.

Movie Gallery’s purchase this year of VHQ Entertainment, a Canadian-based online movie rental company, was seen as a way to bolster its online presence. But analyst Dennis McAlpine, head of McAlpine Associates, a Scarsdale, N.Y.-based media research firm, does not believe that Movie Gallery has shown much interest in the online rental business. “Their position,” he said, “has basically been, ‘Why should I bother to rush into doing online?’ ” Perhaps Movie Gallery is looking at the setbacks Netflix is facing, he says.

Despite the transition in the marketplace, Jerome cautions that naysayers have been predicting the death of video rental stores for a decade. “Everyone thought video-on-demand would take out the video stores 10 years ago,” he said. “And that hasn’t happened.”

But most landlords do believe that competition from technology, whether video-on-demand, self-destructing DVDs, or Web sites that offer downloadable movies, will eventually have the most influence on the marketplace.

Additionally, Jerome points out, though it is too soon to know how big a dent new technology will inflict on the industry, the biggest impact will be felt within about 10 years. “We are a ways away from bankruptcy,” he said. “It’s a minimum of five years away.”

In the meantime, a cautious approach seems to be the standard for leasing to video chains. Centro Watt’s Demuth says his company will rent to a video rental chain but that building a new space for a Blockbuster or a Hollywood Video store seems unlikely at this point. “I just don’t see us building a new store for them,” he said.

While insisting that “it’s not over for the movie rental business in any way,” Mary Lou Fiala, president of Jacksonville, Fla.-based Regency Centers Corp., says her company will no longer offer tenant improvement allowances to video chains.

“If video stores don’t feel confident to spend their own money on the stores, why should we?” she said. As it happens, Regency provides very little on tenant improvement funding in general, the company says, because it enjoys a high occupancy rate across its portfolio — 96.1 percent — and tenants are eager to renew their leases.

If a chain store were to go out of business, it is unlikely that its 5,000-square-foot space could be leased as is, says Fiala. Instead the space would probably be divided into two restaurant spaces, for the likes of, say, a Starbucks and a Cold Stone Creamery. The video rental industry shakeout is “part of the normal business cycle,” said Fiala. “I think this is what happens in every sector.”

Adding to landlord comfort levels is the fact that Blockbuster tends to have prime locations that can easily be snapped up by other retailers, says Doron Valero, COO of North Miami Beach, Fla.-based Equity One, which owns close to 200 mostly supermarket-anchored shopping centers.

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