STYBEL PEABODY /
BOARDOPTIONS
The
Turning Point
What options do companies have when their industries are dying?
Kris Frieswick, CFO Magazine
April 01, 2005
Blockbuster Corp. has looked at life from both sides now. When it
leaped
out of the gate in 1985, it quickly swallowed its mom-and-pop competitors
to become the dominant player in the fast-growing video-store industry.
Today, it faces the grimmer side of the corporate life cycle as emerging
technologies and delivery systems threaten the demise of video stores
altogether.
Industries have been dying at least since the Middle Ages, and often
because a new technology (cars, in the case of buggy whips) or product
(petroleum, in the case of whaling) made the old industry obsolete.
For Blockbuster, it is video on demand and digital downloading that
threaten to make its business proposition obsolete. PCs put Smith Corona on
the critical list. Electronic banking may spell the end of check
printer Deluxe Corp., based in St. Paul, Minnesota.
As different as these
companies are, each is facing or has faced the same
conundrum: in a mature
industry, should a company aggressively pursue
transforming technologies or simply ride out its current business model?
The choice is far from clear-cut. History shows, for example, that it is
easy to get entrenched in existing technology—even when change is bearing
down. "A lot of times, the train doesn't look like it's coming at you
that
fast, and sometimes that's because you're looking at it head-on," says
Bert Ely, a banking industry consultant with Ely &Co., in Alexandria,
Virginia.
Human nature is also a hindrance, since "people in a legacy
business want
to hang in there,"
adds Ely. Moreover, the cost to move to an
industry-changing technology can be prohibitive to the company—and to its
shareholders. As Deluxe CFO Doug Treff points out, sometimes
"shareholder
value is the ultimate driver of decisions—more important than survival of
the company."
Blockbuster has every intention of surviving. Yet, while chief
competitor
Netflix is investing aggressively in pay video-on-demand (VOD) delivery,
Dallas-based Blockbuster is mostly focusing on extracting every cent from
the home DVD-rental market—seeking acquisitions, boosting its online
DVD-rental services, launching a subscription program similar to Netflix,
and creating a DVD trade-in program. And why shouldn't it? In its most
recent quarter, the world's largest video-rental chain posted more than a
6 percent increase in revenue over the previous year. Sure, there have
been rough spots: Blockbuster's
planned acquisition of Hollywood Video was
still under intense scrutiny by the Federal Trade Commission at press time,
for example, and it is being sued by the state of New Jersey over
its new "no late
fees" policy. But publicly, executives say critics are just trying to
throw cold water on a profitable business proposition.
"We've been hearing about the ultimate demise of Blockbuster for
years,"
says Blockbuster CFO Larry Zine. "All we've heard about is the threat
of
video on demand and how that is going to put us out of business. What
happened in the interim is something that gives us a lot of comfort in the
future." What happened in late 1999 was Blockbuster's introduction of
DVDs, which were cheaper to store, ship, and save than VHS tapes. More
important, says Zine, people still love the "experience of the
Blockbuster
store," a habit that he says will keep Blockbuster's DVD-rental model
viable for some time.
It's
Just Not Happening
As Zine's comments illustrate, finance executives in challenged industries
are in a precarious position. Publicly, they must tout their companies'
commitment to innovation and long-term goals. Yet instead of investing in
new technology, they can become enamored of their current business
model—especially if it is
successful. And their unrelenting focus on
shareholder value can blind them to the fact that they may be facing a
Waterloo moment.
That's partly what happened to Smith Corona. The
company had been making typewriters for more than a century as it sank into
the sunset—kicking the
whole way. Despite tough times in the early 1980s due to overseas
competition, Smith Corona was soaring late in the decade after it was
acquired by Hanson Trust Plc, posting its best year in 1989. That same
year, though, Hanson (apparently recognizing what Smith Corona's
executives would not) spun off the typewriter division as a separate
entity. Shortly thereafter, the company was run over by the
personal-computer revolution.
It wasn't that Smith Corona didn't see the PC coming. In 1991, the
company
actually partnered with Acer, a Taiwanese manufacturer, to make what was
lauded as one of the most user-friendly PCs yet built. But the market was
already filled with Johnny-come-latelies when Smith Corona got in. The
venture faced severe price competition, and most telling—the Smith Corona
board killed it after a year because the product line wasn't growing fast
enough. In November 1992, the company's CEO, G. Lee Thompson, told the
Wall Street Transcript, "Many people believe that the typewriter and
word-processor business is a buggy-whip industry, which is far from true.
There is still a strong market for our products in the United States and
the world." When asked what new products and services the company
planned
to introduce, he replied, "Nothing right now. They're still in the
formative stages."
Smith Corona grossly misjudged the public's preference for PCs,
contends
one former company executive. "It was a decision made without a lot of
vision as to what the computer was going to be," says Mike Chernago,
former vice president of operations, who believes the Acer machine could
have saved the company. "People screamed like crazy when they killed
that
deal. But at the time, the executives thought that Smith Corona was never
going to be put out of business. It was hard to imagine that the
typewriter would be annihilated in just 10 years."
In contrast, Remington Rand acted on the next big thing. The company,
which produced the first commercially available typewriter in 1873, also
made the first business computer, the 409 (sold as the Univac), in 1949.
After merging with Sperry Corp. to form Sperry Rand in 1955, the company
sold off the Remington Rand typewriter division in 1975, years before the
PC was a threat. It was a fortuitous move: Remington Rand Corp. went
bankrupt in 1981. Meanwhile, Sperry Rand thrives in its latest
incarnation—as computer-services giant Unisys.
A Checkered Approach
Smith Corona illustrates that insight into a changing industry is useless
unless it is followed by preemptive, definitive action—even if
shareholders seem unimpressed.
Like typewriters, the paper-check industry has been under fire for
decades, as consumers turn to electronic banking. But only in recent years
have the biggest players begun to react. In fact, industry leader Deluxe
made 90 percent of its revenues from checks up until fiscal-year 2003, and
continues to unveil paper-check-related services.
In the mid-1990s, the company made a Smith Corona-like stab at
acquiring
companies in the electronic-payments field. But Deluxe CFO Doug Treff, who
was not with the company at the time, says that shareholders were not
enamored of the strategy. "Our shareholders are value-oriented, and the
electronic companies were more growth-oriented," says Treff. Lack of
sell-side coverage made it hard to get the word out that the acquisitions
were part of a long-term strategy, he adds. So, instead of tolerating
short-term stock pressure in order to diversify, the company consolidated
the acquisitions and spun some of them off as a tax-free distribution to
shareholders (called eFunds).
"Check printing was such a large contributor to profitability
and cash
flow," says Treff, that the company was ultimately unwilling to
contribute
to the demise of the sector by embracing electronic-fund technology. But,
he admits, "the spin offs left us with a company focused on the paper
check." In other words, back at square one with no long-term
diversification plan.
Deluxe then made the traditional moves to boost earnings per share:
it cut
costs, closed manufacturing facilities, and bought back shares. Finally,
in June 2004, Deluxe purchased New England Business Service (NEBS), a
forms, office-supply, and stationery manufacturer. As a result, in the
third and fourth quarters of 2004, print-check revenues accounted for 75
percent of total 2004 revenues, and the firm posted an 18.8 percent
increase in its fourth-quarter profits.
Still, 75 percent amounts to a dangerously high portion of revenue
dependent upon a vanishing consumer activity. In 2003, according to the
Federal Reserve Board, Americans for the first time conducted more
transactions using debit cards, credit cards, and E-billing than they did
using paper checks. Although NEBS may prove a sound acquisition from a
shareholder-value standpoint, it might not ultimately guarantee Deluxe as
a going concern.
Treff, it seems, is OK with that. Yet, while he may hold shareholder
value
in the highest regard, the CFO, who joined Deluxe in late 2000, maintains
that it "has to be looked at in the long term." And, he adds,
"We do make
investments that don't pay off right away." Meanwhile, eFunds is
trading
at 23, double its opening share price.
In comparison, Deluxe's main competitor, Atlanta-based John H.
Harland
Co., has spent the past few years acquiring electronic-funds and
data-processing, testing, and software companies, and reinventing itself
as a software and services provider. Its shareholders have supported the
acquisitions, which led to reduced earnings in 2004. Harland's stock has
jumped 30 percent in the past three years, compared with Deluxe's, which
dropped about 15 percent over the same period.
Ultimately, a Crapshoot
In the immediacy of the moment, no one can tell which choices are
sound
and which fatal. In the DVD-rental market, this uncertainty is compounded
by the fact that the two category leaders, Blockbuster and Netflix, are
betting on what a feeder industry—in this case, the movie studios—will
do.
Currently, those studios make 50 percent of their gross profits on DVD
sales and $2.5 billion annually from DVD rentals, a revenue stream
guaranteed by well-guarded distribution channels. Once a movie has ended
theatrical release, for example, it is sold or rented via Wal-Mart,
Blockbuster, Netflix, or similar outlets for between 30 and 60 days or
more. Only after that does the film go to pay-per-view and pay VOD. The
film moves into the cable film channels and free VOD after that channel
has gone cold, and finally ends up on regular TV. "The studios are very
good at adding distribution channels," says Dennis McAlpine, an
entertainment-industry analyst. "They don't eliminate channels when
something new comes along."
Blockbuster is staking its future on traditional DVD rentals in
stores and
online. To CFO Zine, the threat posed by VOD will be thwarted in several
ways. (Blockbuster, which was spun off from Viacom Inc. last October, has
not yet generated annual earnings as a company, due to write-downs,
accounting changes, and other noncash adjustments.) He argues that
Blockbuster receives new releases before VOD services, it has a bigger
library of titles than VOD, and its DVD technology offers higher
production values than VOD movies. Most important, movie studios don't
think VOD is a big revenue generator. "The studios would have to hope
for
a fivefold increase in VOD rentals before VOD would really become a viable
channel for them," says Zine.
That may be more likely than Zine predicts. According to Derek Baine,
an
analyst with Kagan Research, several studios have begun to make some films
available on pay VOD simultaneously with home DVD rental. "They want to
see what happens to their DVD sales when they move up the window for pay
VOD," says Baine. If DVD sales aren't affected, the home DVD-rental
business could face far more of a threat than it does at present.
Of course, DVD-rental companies could always counter this threat by
getting into VOD themselves. Netflix has already pounced. The company,
which just hit 2.5 million subscribers and posted earnings of $4.8 million
on revenues of $144 million for 2004, announced an alliance with TiVo, the
digital video recording service with 2.3 million subscribers, to create a
"digital entertainment product." Although Netflix won't say much
more than
that, the service will reportedly allow customers to order a movie online
at Netflix.com, which will then be loaded onto their TiVo sets, providing
DVD-quality movies on demand. The combination of delivery channel,
quality, and selection could dramatically change the business proposition
for Blockbuster.
There's no guarantee Netflix will succeed, either. Licensing hurdles
could
be a deal-breaker. But standing still equals failure, eventually. And
Netflix seems willing to put long-term survival ahead of short-term
shareholder concerns: its stock was trading at $10 in early March, down
precipitously from its all-time high of 38 in April 2004. Despite the
hits, Netflix CFO Barry McCarthy is currently investing 1 to 2 percent of
revenues into digital-downloading technologies, which, coupled with a
recent subscription price cut, should lead to a loss for 2005. "But
it's
potentially important for our future," says McCarthy. "The only
way to
have a seat at the table is to test the proposition with consumers, figure
out the best model, then rapidly innovate as you learn more about the
consumer proposition."
McCarthy is unsure how long it will be before digital downloading and
VOD
become a "meaningful component of our revenue stream. It will come
slower
than people think." He says this is partly due to the difficulty of
licensing digital content from studios loathe to mess with their precious
DVD sales and rental revenue, and partly to the challenges of the
technology required to download high-quality movies. Also at play is the
price point for the "boxes" that would store the downloaded
movies. Still the TiVo alliance goes a long way toward painting a picture of
how home
movie rental may soon
look.
In contrast, Zine says that Blockbuster takes a more cautious
approach to
new technologies, often buying smaller companies that are engaged in that
technology, and
"learning lessons" from them that they eventually
incorporate into their own business model. For instance, two years before
getting into online rentals, it bought a small online company, Film Caddy,
and studied its operations. Only then did it unveil Blockbuster Online.
Blockbuster also purchased a
small company specializing in movie trading
before introducing trading to
its stores. And it launched VOD tests in the
United Kingdom and the United States before announcing during its annual
conference call in March that it plans to launch its own VOD service on
Blockbuster Online in 2006—although it had no details about how it would
work, or what delivery mechanism would be used.
The company, which is now appearing to embrace VOD as a potential new
business line, was far from enthusiastic about it just two weeks earlier
when Zine said of VOD, "we don't think the economics work well right
now."
Instead, the CFO said, the company was focused on boosting revenue through
its online and in-store subscriptions program (a replica of Netflix's
program), same store rental revenue through elimination of late fees (a
concept also pioneered by Netflix), its DVD trading program, and the
transformation of some of its stores into "gaming" venues, which
allow
customers to rent video games before buying them. It appears that someone
at Blockbuster got the
message that VOD is a space in which, economics or
not, Blockbuster must
be.
Smoke and Mirrors?
In truth, nonchalance about impending technology may conceal
aggressive
behind-the-scenes moves. Whether that is the case with Blockbuster, or if
there is simply a hesitance to embrace the next big thing, remains to be
seen. Without a significant shift in the studios' distribution strategy,
analysts predict, Blockbuster can continue to grow revenue by a couple of
percentage points a year for the foreseeable future. Ironically, analysts
said the same about Smith Corona, predicting that an established base of
typewriter customers would never move to PCs, including a large overseas
market. The company sold
its assets for $6 million in 2000.
Blockbuster does appear to be doing a few things right, says Kathryn
Rudie
Harrigan, Henry R. Kravis Professor of Business Leadership at Columbia
University Graduate School of Business. "You need to love your
laggards,"
she says. Customers who are laggards don't switch over to new technology
right away, she explains. Instead, "make it very convenient for them.
Make
it so they are reluctant to switch to a new product. Eliminating late fees
is a great way to get
people to go to video stores."
But the key to survival in a contracting industry, says Harrigan, is
"to
become diversified and to evolve as your customers evolve. Define yourself
broadly enough to develop other products, some of which may make your
older products obsolete." This means CFOs must put aside some of the
cost-cutting and EPS-boosting tools they use to pull companies through
tough times in more-robust industries. They must make the argument to
shareholders and to Wall Street that long-term investment in emerging
opportunities is more important than short-term stock price.
What
CFOs can't do, she warns, is ignore obvious signs of industry
contraction. Believing in your company is important, but CFOs must be
active participants in learning all they can about the industry-killer
next door. "It's like a lot of things," she adds. "If you let
yourself get
stagnant, if you're not constantly reinventing yourself, you're dead
meat."
