Buyout Firm to Acquire Video Chain

Los Angeles buyout firm Leonard Green & Partners and the founder of Hollywood Video will team to acquire the rental chain’s parent company under an agreement reached Monday.

The $888-million cash deal comes as Hollywood Entertainment Corp. and its larger rival, Blockbuster Inc., grapple with a video rental market flattened by rising sales of videos and DVDs and new technologies that deliver movies directly to TV sets.

But Leonard Green and some analysts said predictions of the rental market’s decline were exaggerated. Hollywood Entertainment could remain a growing and profitable business, they said, as the pace of video sales slows.

“The worst is over as far as the impact of sales on rentals,” said Tom Adams, president of Adams Media Research in Carmel.

Leonard Green, the largest private-equity investment firm in Southern California, teamed with Hollywood Entertainment Chairman Mark Wattles to offer $14 for each of the company’s shares.

That was a 31% premium to Hollywood Entertainment’s closing price Friday, and the announcement boosted the stock $2.96 a share, or 27.7%, to $13.66 on Monday on Nasdaq. Wattles would continue running the chain after the buyout and would own about half of the new company’s equity.

Based in suburban Portland, Ore., Hollywood Entertainment and its 26,000 employees operate 1,920 Hollywood Video stores in 47 states, including about 200 in Southern California.

The company also has 600 Game Crazy stores -- housed inside Hollywood Video outlets -- that cater to the video game market.

Rival Blockbuster, which is 82% owned by Viacom Inc., has about 8,900 stores worldwide. This year, Viacom said it was interested in selling its stake in Blockbuster.

The proposed purchase is a textbook deal for Leonard Green, which specializes in buying mid-size companies involved in retail and consumer products.

The firm’s other major holdings include ownership stakes in drugstore chain Rite Aid Corp., mapmaker Rand McNally & Co., pet store operator Petco Animal Supplies Inc. and florist FTD Inc.

But in teaming with Wattles -- who started Hollywood Entertainment in 1988 and remains its chief executive -- Leonard Green is poised to enter a video rental market that is past its prime.

The public increasingly is buying new and used videos and DVDs rather than renting, and Hollywood studios are making a wider array of new movies immediately available for sale. Hollywood Entertainment sells videos and DVDs, but discount retailers such as Wal-Mart Stores Inc. and Target Corp. have jumped into the market, capturing sales and pushing prices down.

Competitive pressure also is coming from Internet-based rental services such as Netflix Inc. and cable TV systems offering movies “on demand.”

The result: Total spending on video rentals in the U.S. “has remained fairly flat from 1998 to 2003” at about $9.9 billion a year, Hollywood Entertainment said in its annual report filed two weeks ago with the Securities and Exchange Commission. The figure includes conventional rentals and services such as Netflix but not on-demand services.

Amid those trends, Hollywood Entertainment’s profit has sagged, though sales at stores open at least a year -- a key measure of retail success -- have continued to increase. The company last year earned $82.3 million on revenue of $1.7 billion; two years earlier, the chain earned $100.5 million.

Hollywood Entertainment declined to comment, pending its filing of proxy materials about the deal with the SEC. But John Baumer, a partner at Leonard Green, said “all the turmoil regarding the industry has, in part, created an opportunity for us.” Indeed, at $14 a share the buyout group’s offer is well below the $25-a-share level where Hollywood Entertainment’s stock traded five years ago.

“The pure rental business is very mature, no question,” Baumer said. “But sales of previously viewed titles is a growth business, and [video] game rentals is a growth business. When you blend them together, it’s our judgment the business will perform quite well over the long term.”

Moreover, the growth of DVD sales and on-demand movies eventually will level off, said analyst Michael Pachter of Wedbush Morgan Securities in Los Angeles. The walk-in rental market at that point will be about 85% of its current size, and then rentals will start growing again because the vast majority of consumers will still prefer “going and choosing” their movies, he predicted.

“The market has discounted this [rental] business as if it’s going to zero,” but Leonard Green sees rentals as “a renewable resource,” Pachter said. Also, Hollywood Entertainment’s investment in Game Crazy will spur additional growth, he said.

Also, “the movie studios know that, with the exception of really big-name shows, people won’t buy a movie until they’ve seen it,” Pachter said. “It’s more likely that you’re going to rent it once, then buy it. They know rentals drive sales.”