Fitch Revises Blockbuster's Outlook to Stable; Affirms IDR at 'CCC'

Business Wire, Nov 17, 2006

CHICAGO -- Fitch Ratings has affirmed the following ratings for Blockbuster Inc.:

--Issuer default rating (IDR) 'CCC';

--Senior secured credit facility 'CCC/RR4';

--Senior subordinated notes of 'CC/RR6'.

Fitch has also revised Blockbuster's Rating Outlook to Stable from Negative. Approximately $1.2 billion of debt is affected by the action.

The ratings continue to reflect ongoing credit concerns which include weak financial performance driven by pricing pressures which continue to limit margin expansion, difficult industry conditions, and intense competition from mass merchants, pay-per-view suppliers, and online retailers. The Stable Outlook reflects Blockbuster's improved financial flexibility, stronger liquidity position, and the company's cost cutting efforts that have enabled Blockbuster to improve Free Cash Flow despite ongoing revenue declines, and the Company's leading position in the rental entertainment industry. Importantly, Blockbuster's improved financial flexibility includes covenant relief over 2006 and 2007, a stronger liquidity position that has been aided by a $150 million preferred stock offering and LTM free cash flow of approximately $165 million. The stable outlook also reflects Fitch's belief that the Company will be able to meet its amended 2006 minimum EBITDA covenant of $210 million.

However, Blockbuster's revenue generation continues to be negatively affected from structural changes in the industry, competitive factors, and the company's strategic decision to eliminate late fees in 2005. Blockbuster's online movie rental business, which is subscription based and was launched in 2004, has not yet grown in size to offset competitive and industry factors. Despite these challenges, Blockbuster's operating margin and operating EBITDA showed some improvement through the first three quarters of 2006 as the company has significantly reduced its advertising budget and overhead spend. For the quarter ending Sept. 30, 2006, Blockbuster's operating margin was 0.1% versus -25.3% for third quarter-2005 (3Q'05). Operating EBITDA of $64 million in the third quarter of 2006 reflected growth of 14% over $56 million in 3Q'05. These positive variances reflect cost containment related to corporate overhead, lower store level compensation, and reduced advertising expenses. Fitch notes that the cost cutting strategy has driven better results however ongoing reduction of expenses like advertising may be disadvantageous in the long run as it does not help grow top line revenue. Nevertheless, Fitch expects margin and operating EBITDA improvement to continue in the historically strong fourth quarter

Overall, Fitch remains concerned about Blockbuster's operational policies, which have included major changes to its business model in response to weakening market conditions. These changes include replacing lost revenue from the elimination of high margin late rental fees in 2005. Fitch views the elimination of late fees as particularly risky and challenging given that Blockbuster is now required to offset this source of operating profit with substantial increases in rental and merchandise revenues. This may continue to be difficult for Blockbuster due to price discounting employed by the company's online division and strong competition in the home video/DVD market from mass merchants. While Fitch recognizes that Blockbuster's online initiative has grown, Fitch notes that these revenues typically carry a lower gross margin, as do other areas such as video sales and game sales. This is important given Blockbuster's large fixed-cost base due to its real estate leases, especially if the online revenues cannibalize existing rental revenues.

Blockbuster generated meaningful discretionary free cash flow over the last twelve months (LTM) Sept. 30, 2006 due to the aforementioned cost cuts as well as lower capital expenditures offset by moderate working capital usage. As such, Blockbuster's free cash flow to total adjusted debt improved to 2.7% for LTM Sept. 30, 2006 from -3.4% for fiscal year 2005. Blockbuster improved its financial flexibility in the last twelve months by securing $150 million in private equity funding and using the proceeds to pay off the balance on its revolving credit facility. Importantly, Blockbuster has had no borrowings on its facility for the last two quarters. Leverage as measured by total adjusted debt to operating EBITDAR strengthened from 7.8 times (x) as of fiscal year 2005 to 6.7x as of LTM Sept. 30, 2006. Total debt to operating EBITDA also improved from 7.0x in fiscal year 2005 to 3.9x in LTM Sept. 30, 2006.

Blockbuster's liquidity is improved and supported by cash balances of $255 million at third quarter end and availability of $293 million on its $500 million secured revolving credit facility (after deducting for Letter's of Credit and Viacom's legacy reserve), which matures 2011. The secured credit facility has a covenant package with amendments related to minimum EBITDA levels, restricted payments, and future fixed charge coverage and leverage tests. Blockbuster has been in compliance with its amended covenants. In addition, Fitch notes that Blockbuster must continue to generate strong operating EBITDA in the coming year in order to meet the fixed charge covenant of 1.35x for any four consecutive fiscal quarters ending after Dec. 31, 2007. Fitch expects Blockbuster to continue reducing its fixed cost base and meet this covenant.