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Hollywood's New ZombieThe last days of Blockbuster.

By Edward Jay Epstein
Posted Monday, Jan. 9, 2006, at 1:03 PM ET
An endangered species Click image to expand.

In 1998, at the dawn of the age of the DVD, Blockbuster made a decision that would change the future of Hollywood. Warren Lieberfarb, who then headed the home-video division of Warner Bros., offered Blockbuster CEO John Antioco a deal that would have made the DVD the same kind of rental business as that of the VHS tape, which, at the time, provided the studios with $10 billion in revenue. Lieberfarb proposed that Warner Bros. (which, along with Sony, was launching the DVD) create a rental window for DVDs during which sell-through DVDs would not be available for new movies.

With this window, Blockbuster, which then accounted for nearly half of the studios' rental income from new movies, would have had the opportunity to rent out DVD releases before they went on sale to the general public. In return, the studios would receive 40 percent of the rental revenues that Blockbuster earned from DVDs, which was exactly the same percentage they received for VHS rentals. In fact, it was Sumner Redstone, whose Viacom conglomerate then owned Blockbuster, who personally pioneered the revenue-sharing arrangement for video. Only a few years earlier, Redstone had told Lieberfarb, "The studios can't live without a video rental business—we [Blockbuster] are your profit." Yet, even though Lieberfarb was only asking that the same deal be extended to DVD, Blockbuster, perhaps not realizing the speed with which the digital revolution would spread, turned him down.

Nevertheless, Lieberfarb, determined to make the DVD a success, went to Plan B: pricing the DVD low enough so that it could be sold to the public in direct competition with video rentals. Wal-Mart, seizing the opportunity for an enormous traffic-builder for its stores, began selling DVDs like hot cakes. By 2003, the studios were taking in three times as much money from DVDs as they were from VHS videos (click here for the actual numbers). In this reversal of fortune, Wal-Mart replaced Blockbuster as the studios' single largest source of revenue. Other mass retailers followed suit, often pricing newly released movies on DVD below their own wholesale price to draw in customers who might buy products with higher profit margins, such as plasma TVs. Blockbuster, with no other products to sell, became a casualty of this cutthroat competition for traffic. Not able to match these low prices, its rental business was decimated.

The other shoe dropped with the emergence of Netflix as a major online competitor for what remained of the rental market. (Blockbuster turned down the opportunity to buy Netflix for a mere $50 million, instead entering a disastrous home-delivery deal with Enron.) Netflix signed up over 3 million subscribers by 2005 by offering DVDs that could be kept as long as renters liked for a monthly fee. To compete, Blockbuster had to do away with its single biggest profit-earner: charging late fees to customers who kept videos past the due date. It also had to invest millions of dollars in a copycat online plan.

Meanwhile, even after many Blockbuster store closings, the company was paying the rent on over 4,000 brick-and-mortar locations in the United States. Initially, opening new stores every week had provided Blockbuster with outlets for the excess inventory of used videos from old stores. The resulting proliferation of stores also provided a competitive advantage when most people rented videos and needed a nearby location to return them. But as people switched to buying DVDs or getting them by mail from Netflix, this plethora of stores proved a liability, leaving Blockbuster hemorrhaging red ink: $1.62 billion in 2002, $978.7 million in 2003, and $1.24 billion in 2004. Still losing money in 2005, Blockbuster had to renegotiate its loan covenants to avoid being forced into bankruptcy. By 2006, the company Redstone had bought in 1994 for $8.4 billion had a market value of under $700 million.

Blockbuster can "reinvent" its store business, adding new products, such as popcorn, candy, and video games, and clone a Netflix-like subscription business, but it still has the albatross of the huge monthly rent payments from its stores weighing it down. Even if it could manage to slip out of these leases, it would still have to contend with Hollywood's move to deliver its movies into homes and iPods via video-on-demand. Offering movies that could be downloaded directly by couch potatoes, as I previously pointed out, is the Holy Grail for Hollywood, since it both cuts out middlemen like Blockbuster and leaves studios in control over their own products.

As far the studios are concerned, other than collecting the money that Blockbuster owes them for past movies, the video chain has little relevance to their future. Viacom perspicuously divorced itself from Blockbuster by spinning it off to its shareholders, and, as one Viacom executive told me, "Blockbuster will certainly not survive and it will not be missed." It is another zombie in Hollywood.

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Edward Jay Epstein is the author of The Big Picture: The New Logic of Money and Power in Hollywood. (To read the first chapter, click here.)
Photograph of Blockbuster store by David Friedman/Getty Images.
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