Why Blockbuster clings to its DVDs and rentals

Forget about Blockbuster's new "no late fees" policy, which has sparked questions from consumer groups and a lawsuit from the state of New Jersey.

The behemoth is in the middle of a bigger battle to win and hold customers: a $1 billion-plus bid to acquire Hollywood Entertainment, the No. 2 player in the video-rental business. That strategy - now imperiled by antitrust concerns - would help Blockbuster enlarge its already considerable brick-and-mortar presence.

Blockbuster is also taking a hipper approach, mounting a hard charge at Netflix with the launch of its own through-the-mail subscription DVD exchange, which was announced last summer and touted in high-priced Super Bowl ads.

The US video-rental business may be worth a scuffle. It reeled in $8.2 billion in 2003, according to the Video Software Dealers Association (VSDA) in Encino, Calif.

So what makes the attempted grab so bold? Trends in technology and consumer behavior that reject middlemen and signal a rapid evolution away from traditional delivery formats. More buyers want anything, anytime, through digital downloads.

In sticking with discs and tapes, Blockbuster is banking on a revolution delayed.

Already, as wildly popular as rentals remain, the real action is in sales: $14 billion in VHS and DVD combined in 2003, up from about $10 billion just two years earlier, according to the VSDA. Rental revenues slid slightly during that period.

And some experts point to budding threats to the DVD itself, formidable though it is (discs accounted for 85 percent of those 2003 sales). For example, signs point to long-awaited improvements in video on demand (VOD) programming, piped into homes now that high-speed broadband runs into nearly one-third of US households.

The world of audio - while inherently different from video for many reasons - has shown how fast digital media can become a bottle-it-yourself affair. Though compact-disc sales have held on amid a frenzy of downloading, "the new format is no format," one music-industry insider told The Washington Post earlier this month.

DVDs won't vanish tomorrow. Demand for "packaged" - professionally produced - DVDs has soared, especially abroad, says Gerry Kaufhold, an analyst for In-Stat, a market research firm in Scottsdale, Ariz.

He also points out that movie downloading remains too cumbersome for average consumers, most of whom lack the hard-drive space to store full-length movies, particularly in the high-definition formats soon to hit stores. [Editor's note: The original story misstated when it is expected high-definition DVDs will be available for purchase in stores.]

But VOD has already made inroads, Mr. Kaufhold says, and cable, phone, and satellite companies will widen those significantly within the next two years. "They're all going to be trying to push [video] content into your house that gets stored on a disc drive and lets you play it back at your convenience," he adds.

In addition, antipiracy technology being put in place - it uses digital "watermarks" to register video-replicator machines and even their individual operators - will give the movie industry the confidence to allow on-the-spot "pressings" of custom DVDs while you shop.

"In the next five years you'll go to a convenience store, hit the kiosk, and say, 'I want "Pirates of the Caribbean," the director's cut, in French,' " Kaufhold says.

And for residences, he adds, service providers will offer high-capacity set-top boxes into which they will transmit a much broader selection of movies than current pay-per-view services can offer.

The service will probably come loaded with ancillary options. DVD players with Ethernet connections are already on the market, he says. At the end of a video, you might be taken to a website for more material - a direct answer to the special-feature component that DVD backers hail as a major advantage.

Others are more skeptical about VOD seeing sudden acceleration.

"It's been the Next Big Thing for as long as I can remember, says Sean Bersell, the VSDA's vice president of public affairs. "And at some point, when there's enough technology in the home ... VOD will be a player in the movie-delivery marketplace. But there are lots of obstacles. The biggest right now is bandwidth, and the other is just consumer acceptance."

Some VOD suppliers - such as CinemaNow - already hold Internet distribution rights to thousands of films.

But consumers still like the "tangible-product element," Mr. Bersell says. Boxed sets make great gifts, he adds. Stores position them to be grabbed as impulse buys. People loan DVDs to friends.

Still others take a harder line. "The assumption that VOD is coming on strong is mistaken," says Tom Adams, president of Adams Media Research in Carmel, Calif.

Demand for more VOD over DVD will come with consumers raised on virtual goods, says Mr. Adams. "Ultimately there will be a lessening of the basic human need to finger the product," he says. "But that's generational, not the next five or 10 years."

Many video-service providers have already trumped the old pay-per-view model, Adams allows, with its rigid schedule of showings. "[But] real 'video on demand' is actually owning the product," he says. "The more potent threat to Blockbuster and the [other] rental stores is ownership."

Cable operators and others have just not figured out how to provide an enormous selection of movies to consumers for a few dollars each, he says, "and that's something that Blockbuster excels at."

Blockbuster, meanwhile, hasn't ruled out an incursion into VOD.

"If there were a financially viable model, then we would look to see how we might participate," says Randy Hargrove, a spokesman for the Dallas-based firm. At the moment, however, Blockbuster views VOD as an upgrade for pay-per-view, not a replacement for video rental.

Movie studios now make about a $15 profit on the sale of each DVD to a conventional retailer, says Mr. Hargrove. And Blockbuster's research indicates consumers would be willing to pay about $5 for a VOD movie.

"The studios would have to share about 40 to 60 percent of that $5 with the cable provider or whomever else is involved," Hargrove says. "That would reduce their take from a $15 gross profit for a DVD sale to about $3 for a VOD transaction."

Blockbuster, he says, is looking for other ways to extend service, including video game and movie trading, and some video sales.

Small businesses, too, try to maintain their usefulness to customers. Mike Matrullo, who manages Mike's Movies in Boston's South End, says rentals are holding steady, and that his company is on the verge of announcing a partnership with a Florida firm that will provide a computer server that will handle nationwide requests for video rentals, tapping small independent stores like his rather than maintaining its own inventory.

He's happy to participate. But Mr. Matrullo says too many services and products will only confuse customers. Forget pining for video on demand. Not even the step up to high definition is likely to change the habits of Matrullo's regulars. "I still have customers," he says, "who won't give up their VCRs."