REWINDING A VIDEO GIANT

As first dates go, this one couldn't have been more awkward. Last month John Antioco, the CEO of Blockbuster, flew to Manhattan to dine with Carl Icahn, the billionaire and former corporate raider. For weeks Icahn, who owns 9 percent of Blockbuster's shares, had publicly railed against Antioco's plans to invest millions to get the lagging movie-rental company growing again. Instead of trying to rejuvenate Blockbuster, Icahn argued, Antioco should just milk the mature business for cash. The two men's clash over the future of the company had recently culminated in a dramatic proxy fight, in which Icahn's side won three seats on Blockbuster's eight-member board. But at the dinner a few nights later, as both men recounted to NEWSWEEK, they called a truce. "I hope we're going to have a good working relationship," Icahn told Antioco, who replied, "Carl, for better or worse, we're in this together."

If that sounds like something less than the start of a beautiful friendship, it's a testament to how challenging times have become at the chain that's provided Americans with Saturday-night entertainment for the past two decades. Blockbuster, with $6 billion in annual revenue, still dominates the movie-rental industry, but lately that business has been shrinking faster than Lindsay Lohan's waistline. As DVDs have replaced VHS tapes, more Americans have shifted to buying movies instead of renting them--and most don't buy them at Blockbuster. In 2003 U.S. movie rentals were an $8.2 billion business, but by 2009 that will shrink to $6.3 billion, according to industry analysts at Kagan Research.

Other threats loom. Netflix, the online DVD-by-mail rental company, is still small and unprofitable, but Blockbuster admits that the upstart has the potential to steal many of its best customers. And each month more cable subscribers gain access to video-on-demand, which allows customers, for a fee, to watch a movie without the hassles of planning ahead or returning a DVD afterward. Blockbuster, says Forrester Research analyst Josh Bernoff, "is getting nibbled away at from all sides."

Now Antioco's team is biting back. After years of trivializing these threats, Blockbuster has launched a series of programs to try to counteract them. Last August the company began promoting an online program similar to Netflix's--but offering lower prices, as well as two coupons each month for free in-store rentals. And for movie buffs who like Netflix's pricing concept (in which customers pay a flat monthly fee for unlimited rentals) but prefer renting from a brick-and-mortar store, Blockbuster now runs a flat-price Movie Pass program. Some stores have also begun letting customers trade in their old DVDs to get credit toward new ones; the trading program should open in most locations by late this year. The chain has also made a big push into videogames, which now account for nearly 20 percent of its business.

In its most controversial move, in January Blockbuster stopped charging customers late fees. Well, sort of. Customers can keep a movie without penalty for more than a week--more than twice the old rental period. But after that, Blockbuster's new system assumes they've decided to buy it and automatically debits their account for the purchase price minus the rental fee. (Customers who balk can still return the DVD within 30 days for full credit, less a $1.25 restocking fee.) Blockbuster insists its customers understand and like the plan--indeed, since its inception, rental transactions are up 20 percent. But several state attorneys general have declared it misleading, forcing the company to spend millions to advertise and clarify the arrangement. Even before the legal spat, the so-called End of Late Fees program was a risky move, since eliminating the charges will cost Blockbuster more than $250 million. It's hoping to make that up in volume as customers who hated being gouged by the late fees rent more.

Whether these strategies work will rest on how customers ultimately decide they want to receive and pay for their entertainment--and that's one reason Blockbuster's problems are not just a tale of a business struggling with technological obsolescence, but a compelling illustration of how more general changes in consumer behavior can affect a business. Consider Blockbuster's tussle with Netflix. How much of the movie-rental business eventually migrates online will depend largely on how many Americans become organized enough to plan ahead for their entertainment needs. Traditionally, most renters pick up movies on impulse a few hours before watching them--say, because the family drove by a Blockbuster store on the way home from the mall or realizes it has nothing to do on Saturday night.