Circuit City Should Remind Blockbuster Investors of 2005 Bankruptcy Fears

"Just because I don't care doesn't mean I don't understand." ~ Homer Simpson

Circuit City Stores Inc (CC-$4.95) rejected the recent offer by Blockbuster Inc (BBI-$2.79) to acquire the company for between $6.00 and $8.00 per share in cash, questioning how the video rental chain would finance the offering.

Circuit City Board of Directors – Fools or Geniuses

There are a good many fools who call me a friend, and also a good many friends who call me a fool. ~ Essayist G K Chesterton (1874 – 1936)

Activist shareholder Wattles Capital Management, a 6.5 percent holder of the electronic retailer’s shares, in a proxy filing derided management and the Board for "dismissing the legitimate, third-party interest in acquiring the Company."

Mark Wattles faulted the Board, too, for its failure to open its books: "During the due diligence process the ability of Blockbuster to finance the transaction and the ultimate structure of the financing [could be] fully fleshed out by all parties."

Mr. Wattles is best known for selling the video chain he founded, Hollywood Entertainment Group, to Movie Gallery Inc for approximately $1.2 billion in April 2005.

In the view of the 10Q Detective, the Board of Directors did not neglect their fiduciary duties. Their refusal to negotiate further with Blockbuster was in the best interests of shareholders, for after examining the books of the video chain we strongly believe Blockbuster would find it difficult to (i) refinance its existing debt and/or (ii) raise the proceeds sufficient to purchase Circuit City.

How would BBI, which held just $184.6 million of cash on its balance sheet and burned through $56.2 million in cash from its operating activities, as of the fourth quarter ended Jan. 6, 2008, finance (up to) a $1.4 billion acquisition?

Blockbuster CEO Jim Keyes tried to assure Circuit City and investors that billionaire Carl C. Icahn, who beneficially owns 16 percent and 7.7 percent of Blockbuster’s Class A shares and B shares, would provide support for the deal (backstopping a rights offering).

You might as well praise a man for not robbing a bank. ~ American golfer Bobby Jones (1902 – 1971)

Amid foundering growth prospects at Circuit City, in our view, Mark Wattles feigned sympathy for other long-suffering Circuit City shareholders. A savvy investor—not accustomed to being on the losing end of a deal—he now sits on dead money, with purchases of several million shares made in December 2007 at prices between $6.00 - $7.00 per share, according to regulatory filings with the SEC. His comment that they [shareholders] "were immediately and substantially damaged" because of "a lack of cooperation by the Board"rings hollow.

Bait and Switch

Blockbuster was definitively less than a "legitimate third party."

BBI was tapped out. As of January 6, 2008, BBI’s available borrowing capacity totaled $247.3 million—significantly less than the $1.4 billion tender offer.

In addition to aggregate indebtedness of $757.8 million, minimum rental payments under non-cancelable operating leases (commitments for various real and personal property, including office space, and stores) of $542.6 million and $438.4 million come due in fiscal 2008 and fiscal 2009, respectively.

The 10Q Detective opines that BBI’s play for the electronic gadgets retailer was an effort to turn Street attention away from its own business failings—and, a last-ditch effort to revive a moribund brick& mortar business model. "The transaction would allow both companies to benefit from the revenue growth generated by their complementary products," said CEO Keyes. "While the resulting synergies would substantially improve consolidated financial performance, thereby increasing shareholder value.

Does anyone remember the RadioShack - Blockbuster alliance? In June 2001, 130 “RadioShack Cool Things” boutiques opened in Blockbuster outlets--six months later BBI pulled the plug on the 'pilot program.'

"I'm normally not a praying man, but if you're up there, please save me Superman." ~ Homer Simpson.

Increasing competition from other retailers (more favorable studio pricing policies for mass merchants such as Wal-Mart, Best Buy and Target) coupled with a shorter "rental window" (timing and exclusivity of home video retailers versus alternative methods of content delivery, such as video-on-demand) is the video trailer for an accumulated deficit of $4.85 billion at this disaster-in the-making motion picture!

"Kids, you tried your best and you failed miserably. The lesson is, never try." ~ Homer Simpson

Although same-store sales increased 3.4 percent Y/Y, rental and merchandise margins fell 450 basis points and 160 basis points, respectively, to 60.7% and 23.3 percent. Management did not breakout revenue per transaction, but we suspect that much of the same-store comps improvement was due to price hikes.

Is BBI is headed for bankruptcy?

In the early 60's Edward Altman used statistical techniques—combining a set of 5 financial ratios—to predict a company's fiscal fitness—its probability of failure—called the Altman Z-Score. The beauty of Altman’s equation is its ability to pinch the fat and read only the muscle on a balance sheet.

Two of the eight variables used in Altman’s equation are working capital and total assets. As of fiscal year ended January 6, BBI reported Total Assets of $3.14 billion. Back out, merchandise inventories & rental library (zero residual values), pre-paid assets (monies already allocated for future uses), and goodwill—value of Total Assets declines about 60 percent to $1.30 billion. Ergo, working capital falls from $170.3 million to $(852.5) million, and the Ratio of Working Capital/Total Assets at BBI plummets to less than zero from 5.42 percent.

A Z-SCORE less than 1.80 suggests the "Probability of Financial Embarassment is very High." BBI scored a negative 2.90!

"Oh, people can come up with statistics to prove anything, Kent. 14% of people know that."

BBI escaped insolvency in 2005--when liquidity problems threatened its a/c payable(s) with its trade distributors. Unfortunely, Homer, this time around, we believe the statistics do not bode well for the future of Blockbuster Inc.

Editor David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.