Internet Mini Case #17 Movie Gallery, Inc. J. David Hunger Movie Gallery, Inc., in August 2006 was the second largest North American video rental company with 4,763 stores located in all 50 states plus Canada and Mexico. The company specialized in the rental and sale of DVD and VHS movies and video games under its subsidiaries, Movie Gallery, USA and Hollywood Entertainment. The renting of videos began in the 1980s shortly after motion picture studios began selling videotapes of their movies to play on home videocassette player/recorders (VCRs). Because a typical videotape of a recent motion picture cost at that time around $15 to $25 to purchase, renting a movie for a few days for $5 made economic sense—especially if a person only wanted to view the movie once or twice. This made renting a movie much cheaper than paying about $10 for a couple to view the same film in a movie theater. Video rental stores quickly spread throughout North America as people invited friends and family to join them in eating pizza and watching rented movies in their living rooms. Growth and Success Movie Gallery was founded in 1985 by Joe Malugen and Harrison Parrish in Dothan, Alabama. Through its wholly owned subsidiary, M.G.A., the company’s founders began operating video specialty stores in southern Alabama and the Florida panhandle, and franchising the Movie Gallery concept. By June 1987, the company owned five stores and had a franchise operation of 45 stores. Between 1988 and 1992, management consolidated the franchisees into 37 companyowned stores with annual revenues of $6 million. Using the proceeds from an initial public offering (IPO) in August 1994 to fund an aggressive expansion strategy, Movie Gallery grew to more than 850 stores by 1996 through more than 100 separate acquisitions. It also grew internally by building new retail outlets. During 1999 and 2000, for example, the company built 100 new stores each year. Additional acquisitions, including Blowout Entertainment in 1999 and Video Update in 2003, raised the total number of stores to 2,000. The purchase of Video Update launched the firm’s international presence with 100 retail outlets in Canada.
__________________________________________________________________________________________ This case was prepared by Professor J. David Hunger, Iowa State University and St. John’s University. Copyright © 2006 by J. David Hunger. The copyright holder is solely responsible for case content. Reprint permission is solely granted to the publisher, Prentice-Hall, for the books Strategic Management and Business Policy–11th and 12th Editions (and the International version of this book) and Cases in Strategic Management and Business Policy–11th and 12th Editions, by the copyright holder, J. David Hunger. Any other publication of the case (translation, any form of electronics or other media) or sale (any form of partnership) to another publisher will be in violation of copyright law, unless J. David Hunger has granted an additional written permission. Reprinted by permission. Sources available upon request.
Movie Gallery’s video stores primarily targeted small towns and suburban areas. By focusing on rural and secondary markets, the company was able to compete very effectively against the Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 1
independently owned stores and small regional chains in these areas through its purchasing economies. It was able to deliver first-run movies at cheaper prices to customers in towns with fewer than 20,000 people. The company’s profits increased 57% from 2001 to 2004, resulting in its being listed Number 61 on Business Week’s 2005 list of the fastest-growing small companies. Movie Gallery’s top management made a strategic decision in 2005 to expand out of the company’s target market by purchasing rival Hollywood Video for $1.2 billion. At the time, Hollywood Video’s management had been fighting a hostile takeover bid by industry-leader Blockbuster, Inc. This acquisition raised Movie Gallery’s store total to 4,700 outlets with revenues in excess of $2.5 billion annually. Operating under the Hollywood Video and Game Crazy brands, Hollywood Entertainment primarily targeted urban centers and surrounding suburban neighborhoods and was especially strong on the West Coast where Movie Gallery was weak. It competed head-to-head with Blockbuster through excellent customer service and innovative marketing and merchandising programs. At the time of its purchase, Hollywood Entertainment operated 2,031 video rental stores and 20 free-standing video game stores throughout the United States. Its acquisition propelled Movie Gallery into second-place in the U.S. video rental market behind Blockbuster and made it a major player in large U.S. cities, such as Atlanta and Los Angeles. In June 2005, the company added 61 retail stores to its presence in Western Canada by purchasing VHQ Entertainment. Among VHQ Entertainment’s businesses was VHQ Online, a flat-fee, direct-to-home movie delivery service (http://www.VHQonline.ca). Canadian subscribers were able to choose from 52,000 movie titles, which would then be shipped by first-class mail to the customer’s home for a basic monthly fee. Consequences of Growth The acquisition of Hollywood Entertainment left Movie Gallery heavily in debt. At the same time, the recent rise of online video rental services, such as Netflix, was cutting into retail store revenues and reducing the company’s cash flow. Overall in-store sales for video rental outlets throughout the industry shrank 13% in 2005 to $7.1 billion, according to Adams Media Research, Inc. Online sales, in contrast, more than doubled to $1.4 billion in that same year. Movie Gallery’s sales slid 5% to $2 billion in 2005. By the end of the year, Movie Gallery recorded a $553 million loss. Absent one-time charges, it earned $31 million—a 38% decline from the previous year’s profit. With just $135 million in cash at the end of 2005, Movie Gallery’s management found itself facing possible bankruptcy. Movie Gallery’s stock, worth about $3 on April 24, 2006, had lost more than 90% of its value since April 2005. Investors in mid-2006 had short positions (betting that the stock would decline further) on 18.6 million of the company’s 32 million shares. Competition Movie Gallery was not alone in its financial difficulty. Blockbuster, the largest U.S. competitor in video rental stores, also lost money in 2005—around $450 billion. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 2
In contrast to the situation at Movie Gallery and Blockbuster, Netflix, Inc., earned $41 million in profits on $688 in revenue during 2005. The company’s shares rose 157% in the 12-month period through April 2006. With 5 million subscribers, Netflix management expected revenues to reach $990 million in 2006. CEO Reed Hastings had set the objective of Netflix reaching 20 million subscribers (around 20% of U.S. households) between 2010 and 2012. Netflix had a different business model from that used by Movie Gallery and Blockbuster. Once Netflix subscribers selected a movie from the Web site (http://www.netflix.com), a DVD was mailed to them for $5.99 per movie. A flat rate subscription service was also available. After viewing the movie, subscribers would mail back the DVD in order to rent another movie. Pressure from Netflix, which didn’t charge late fees, forced Blockbuster’s management to drop most late fees, costing it approximately $400 million in 2005. Although 70% of Blockbuster’s rentals were new releases, the reverse was true of Netflix. The company promoted lesser-known movies that often received little distribution in movie theaters. The average customer of Netflix was an over35 woman with family income of $75,000 or less. Netflix was not the only company using the movies-through-the-mail business model. Amazon had successfully copied the Netflix postal model in Britain and Germany and was thinking of launching a postal movie service in the United States. In response, Netflix management was exploring the option of delivering movies online. Apple had pioneered downloading digital music through its iTunes and was likely to expand into video. Microsoft entered the music-download business in 2006 with its Zune digital player. In August 2006, Nokia bought Loudeye, an American digital music distributor, to develop its own service for its music-enabled handsets. Video downloads were already being offered by Movielink.com, which was owned by five large film studios. News Corp’s Web sites, including MySpace.com, were planning to sell films and shows from the group’s Fox network. The main problem with video downloads was the large size of video files, leading to long download times. The increasing availability of broadband cable and DSL should shorten these download times and make video downloads more popular. Broadband-equipped televisions and personal video recorders should also make the process easier. Current Situation In 2006, Movie Gallery’s founders were still very active in the company. Joe Malugen served as Chairman of the Board, President, and Chief Executive Officer of Movie Gallery. Harrison Parrish was Vice Chairman of the Board and Senior Vice President. Both had seats on the corporation’s board of directors. They were very much aware that the industry was changing and that Movie Gallery’s management needed to take action to stem the losses and to position the company for future success. For the first six months of 2006 ending July 2, total revenues were $1.3 billion compared to $1.3 billion for the same period a year earlier (assuming revenues from Hollywood Entertainment had been included in the 2005 totals). Rental revenue was 82.1% of total revenues with the remaining 17.9% coming from product sales. During this six-month period, same-store revenues decreased 5.6% from the same period in 2005. Interestingly, same-store revenues decreased only 1.3% at Movie Gallery branded stores compared to a 7.5% drop at Hollywood Entertainment branded stores. Management felt that the better performance of the Movie Gallery brand was Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 3
caused by the resiliency of its Eastern-focused rural and secondary market presence as well as the success of the company’s efforts to sell previously viewed titles from Hollywood stores at Movie Gallery stores. Although the company reported a net loss of $14.9 million in the second quarter of 2006 (compared to a $12.2 million loss during the same period in 2005), the company’s year-to-date net income was $25.5 million (compared to $6.2 million during the same six-month period in 2005). According to management, the company had sufficient cash to operate the business, satisfy working capital and capital expenditure requirements, and meet the company’s foreseeable liquidity requirements, including financial covenants for its debt service for the remainder of 2006. Although the company’s cash and cash equivalents totaled only $21,151,000 as of July 2, 2006, compared to $51,122,000 on July 3, 2005, accounts payable had dropped from $194,000,000 on July 3, 2005, to $92,156,000 on July 2, 2006. Long-term debt (including current portion) declined slightly to $1,100,943,000 on July 2, 2006, from $1,143,359,000 on July 3, 2005. According to Chairman, President, and CEO Malugen in Movie Gallery’s 2006 Second Quarter Report: Our business continues to be affected by a weak home video release schedule and other industry-wide challenges, but we are making great progress on a number of internal initiatives intended to improve Movie Gallery’s financial and operational performance. We continue to expect a slow late summer, as is typical due to the seasonality of our industry, with gradually improving business conditions beginning in October when the first of several $100 million titles will be released to home video. In the meantime, Movie Gallery is aggressively pursuing opportunities to increase revenues and further improve operating efficiencies. We have engaged Merrill Lynch to advise us on ways to improve our capital structure as well as Alvarez & Marsal, a leading turnaround management, restructuring and corporate advisory firm. Responding to the firm’s financial problems, Movie Gallery’s management twice renegotiated lending agreements with bankers to ease payment terms. Management planned to close 175 underperforming and overlapping stores and lay off 380 of its 1,800 workers by the end of 2006. Hoping to cut at least 20% from its $500 million in annual rental expenses, it was negotiating subleases in almost half of its stores. Most of the financial benefits associated with lease renegotiation were expected to begin in 2007 with the bulk of the financial benefits to be realized in 2008 and beyond. Although the company opened 30 new stores in 2006 (which were already in the pipeline), management planned to curtail new store openings over the next several years in order to maximize free cash flow. Management was also reviewing its asset portfolio to identify any non-core assets it could divest for cash. (Movie Gallery’s annual and quarterly reports and SEC filings are available via the company’s Web site at www.moviegallery.com.) What Next? Movie Gallery’s stock price began to rise after the company’s announcement of its first-quarter results on May 11, 2006, and by August 9, 2006 a share of its stock was selling for $6.47. Even though the financial results for the first six months of 2006 showed an improvement in the company’s financial position compared to 2005, the company’s stock price fell to $2.97 on August Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 4
10, 2006, with the announcement of Movie Gallery’s second-quarter results. Management’s implementation of a turnaround strategy was showing some indications of success. The reduction of costs and expenses was certainly important, but what should management do to increase revenues and profits? How could Movie Gallery be positioned for future success?
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