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Tickers in this Article: BBI, NFLX, PZZA, AAPL
There's no doubt that Blockbuster (BBI) was caught flat-footed when Netflix (NFLX) launched its online service back in 1999.

But to its credit, the bricks and mortar video retailer has slowly but surely inched its way back into relevance.

In fact, just this past week management reported that the company now has an impressive 2.2 million online subscribers under its belt -- not bad considering it has offered the service for just two years and really only began marketing it in earnest in early 2006.

Still, does the news imply that a full scale comeback is in the cards, or is it merely another false start? That's the $64,000 question and unfortunately there's no clear answer.

On the one hand, if we add the company's cash (according to its September 10-Q) of $254.8 million, its inventories of $295.3 million, its video library of $416 million, and its plant, property, and equipment of $610.8 million, and then subtract out its long term debt of $909 million, there's still about $667 million in value left over.

If we then divide that number by the roughly $187.2 million shares outstanding, the company is worth about $3.57 a share – on an asset basis. That's pretty cheap.

On the other hand, a simple balance sheet analysis neither factors in its ability to generate income going forward, nor the competitive risks it's likely to face.

So delving a bit deeper, here are some potential revenue drivers:

• It has the potential to partner with a number of food vendors or manufacturers to sell complimentary products in its stores in 2007. Companies such as Papa John's (PZZA), (with whom it already has a limited co-promotion agreement) would be a logical fit.

• It could realize substantial cost savings by continuing to convert its massive in-store membership base to online subscribers and then shuttering it's less profitable stores.

• It could hypothetically work in conjunction with a technology company, such as Apple (AAPL) to distribute movies in other non traditional mediums such as iPods.

• Unlike 2006, a number of new high profile movie releases could drive rental revenue in 2007. The upcoming slate sure seems exciting. In the first half of the year, Teenage Mutant Ninja Turtles and Spiderman 3 are expected to debut. In the second half, a new Harry Potter movie and a Simpsons film are due out.

• Blockbuster expects to offer digital movie downloads later this year which down the road could really drive revenue. Although to be fair digital downloads cut both ways because they will probably cannibalize in-store sales to some degree.

With that in mind, here are some risks to the Blockbuster story:

• Netflix is heavily advertising its service. And it has about $368 million in cash (in addition to a host of operational cash flow) that it can use to market its wares, and theoretically steal back share from Blockbuster.

• Blockbuster may be luring online subscribers at a healthy clip, but it will probably need to deliver on the earnings front for several quarters before investors warm to the stock.

• Netflix is expected to offer downloadable movies early this year. Exactly how that plan plays out remains to be seen. But it could have an adverse impact on traditional DVD rentals.

• Blockbuster trades at about 30 times the 2007 consensus estimate of 20 cents a share. If indeed Blockbuster's comeback is for real it will need to show substantial earnings growth in 2008 and beyond in order to garner a higher multiple.

• The highly promotional environment and the need to advertise things like digital downloads could pinch margins at both Netflix and Blockbuster well into 2007 and possibly 2008.

In short, Blockbuster isn't out of the woods by any stretch. While a number of potential catalysts exist that could drive the stock materially higher over the next year an equal number of challenges remain that could just as likely thwart their comeback.

The Bottom Line
Unless Blockbuster makes a big splash with its digital download service, or announces a huge partnership deal, or Netflix falters in some way, I can't in good conscience recommend this stock.

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