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Seen this Movie Before?

posted by Michelle Harner

For the past several years, we have watched various industries struggle, including the automotive, airline and entertainment industries. Although troubled companies within these industries have their own unique issues, they also share common experiences relating to the recent recession, competition and product/technology obsolescence. Recessions and in turn bankruptcy often are said to facilitate creative destruction, but I actually like a phrase recently used by Chrysler’s CEO, Sergio Marchionne, "creative reconstruction."

U.S. bankruptcy laws—in particular, chapter 11—give companies an opportunity to recreate themselves. In this sense, creative reconstruction might be a more apt phrase for the utility of chapter 11 (see my previous post on that topic here). A company can use the chapter 11 tool not only to reorganize its capital structure but also to streamline or transform its operations (e.g., eliminating outdated product lines or technologies). In those instances, the protection of the automatic stay, the flexibility of the executory contract and lease provisions and the time granted companies to reorganize are critical. It is here that the 2005 amendments to the U.S. Bankruptcy Code arguably weakened the utility of chapter 11 for many companies.

Rather than rehash the issues created by the 2005 amendments, I would like to focus on the potential for creative reconstruction in chapter 11. And I would like to do so by reflecting on the recent experiences of Movie Gallery and Blockbuster. Both companies incurred significant debt as the result of M&A activity during 2004 and 2005 (see, e.g., here for Movie Gallery and here for Blockbuster). Both companies faced increased competition from new technologies and new market entrants (Netflix, Redbox, etc.). And now only one company remains, but it too is on the verge of extinction.

Starting with Movie Gallery, it tried to tackle its financial issues using chapter 11, first in 2007 and then again in 2010. The company focused on its capital structure in the 2007 filing and then was forced to file chapter 11 again in 2010 primarily because of poor performance in a very competitive industry. Shortly after its 2010 filing, Movie Gallery announced that it was closing its remaining stores and liquidating all of its assets. Is this result a potential opportunity for Blockbuster? The answer remains uncertain.

Blockbuster started experiencing financial distress in 2004/2005 after it assumed approximately $1 billion in debt to pay a $5 per share dividend to Viacom as part of a spin-off transaction. Since that time, Blockbuster has been struggling to repay its debt and remain competitive in the industry; Carl Icahn became its largest shareholder, obtained three board seats and then resigned from the board and unloaded most of his holdings (see here); and Blockbuster’s stock price has dropped significantly, currently hovering at about 21 cents per share. Blockbuster has tried vehemently to stay out of bankruptcy, but recent reports suggest that it might finally relent (see here). And its chapter 11 script could have a very different ending than that of Movie Gallery.

Specifically, Blockbuster might be able to avoid some of the collateral damage associated with creative "destruction" (known all too well by its former competitor, Movie Gallery) and use chapter 11 to strengthen its potential opportunities in the industry while eliminating its deadweight. A script we have seen others use—sometimes quite successfully—in chapter 11.

For example, Blockbuster recently negotiated an exclusivity deal on new releases with Warner Brothers, which gives it a significant competitive advantage over Netflix and Redbox. It also has been building its online and kiosk businesses—technologies that at least one investor warned could cause the demise of Blockbuster back in 2005. Blockbuster could use chapter 11 to reconfigure its brick and mortar operations and place new emphasis on its new technology ventures. In other words, Blockbuster could use chapter 11 to design a business model that entices debtholders to support an equity conversion plan or better positions parts of the company for disposition now or in the future.

But would Blockbuster be successful after emergence or end up in a chapter 22 like Movie Gallery? That largely depends on how the company uses chapter 11 and the post-emergence management team. If Blockbuster uses chapter 11 as a bandage simply to address its leverage and liquidity issues, it likely will not survive. If it, however, implements meaningful changes in its business model, reduces its leverage and emerges with a management team that is committed to staying on top of technology and innovation in the industry, it has a chance. Admittedly those are significant challenges, but that is the beauty of chapter 11—it gives companies like Blockbuster the opportunity to overcome such adversity.

So, for those of you who follow troubled companies like others follow the stock market or Supreme Court nominations, Blockbuster may make for an interesting summer. I know that I will be watching, with popcorn and snowcaps in hand of course.


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