Less than two weeks after video rental leader Blockbuster Inc. launched a hostile takeover bid for Hollywood Entertainment Corp., Hollywood surprisingly accepted a $1.2 billion buyout offer from third-ranked Movie Gallery in early January. Hollywood teamed with the smaller buyer rather than tempt the Securities and Exchange Commission's ire by creating a behemoth that could raise antitrust questions.

Blockbuster could come back with another bid. Movie Gallery's offer only values Hollywood at $13.25 per share. And the breakup fee in the deal is a relatively low $27 million. Industry analysts think that Blockbuster may be more than willing to cough up that fee and raise the offer price to $14 or $15 per share.

All of this drama is occurring during a tumultuous time for video stores. The explosion of the DVD-rental-by-mail programs run by Netflix and Wal-Mart has forced big changes. In recent months both Blockbuster and Hollywood launched store rental programs with Netflix-like terms: flat monthly rates with unlimited rentals. And now Amazon.com is making noise about joining the fray.

Blockbuster, in turn, also runs an online service to compete with Netflix and Wal-Mart. The three have engaged in a pricing war, with each firm lowering rental costs in the past six months. Blockbuster is the low-cost king at $14.99 per month (plus two free in-store movie or game rentals). Analysts following the battle are concerned that the pricing war will lead to no real winners as the services, at those prices, are not profitable.

“Netflix management illustrated many times that Blockbuster isn't making money at its price level. … What we find even more interesting is that Netflix, with over 2.6 million subscribers and charging $3 more than Blockbuster, isn't making any money either,” says Alden Mahabir, an analyst with Janney Montgomery Scott LLC. Netflix is expecting a net loss of between $5 million and $15 million in 2005.

Farewell late fees

Blockbuster — with much fanfare — also ended its unpopular late fees in January. (In reading the fine print, however, you learn that by keeping a movie for more than a week, the renter is charged the purchase price of the movie. If the movie is returned within 30 days, though, the renter can get a refund, minus a “restocking” fee.) By dropping late fees, Blockbuster is forfeiting $250 million to $300 million in operating profits, banking that the loss of fees will be offset by increased rentals.

Also a blow to video chains, the use of video-on-demand services is increasing. The threat they pose, however, is limited because of the large gap between the time movies are released on DVD vs. on demand

“Although we acknowledge the benefits of video-on-demand, we do not recognize the service as a real threat until the window between the video rental release date and the VOD release date closes meaningfully,” wrote Arvind Bhatia, a video rental analyst for Southwest Securities. The average lag is 40 to 50 days, according to Bhatia's report.

Rental spending in 2004 totaled $8.1 billion, down about 0.4 percent over 2003.

How will the changes impact brick-and-mortar stores? A merger between Blockbuster and Hollywood would create redundancies in many markets and likely lead to a large number of store closings. But if Movie Gallery's bid stands, there is less cause for concern.

Movie Gallery, though not as well known as Blockbuster or Hollywood, has grown swiftly in the past 10 years.