THE QUESTION WASN'T WHETHER Todd W. LeRoy and Michael L. Atkinson were going to launch a business venture together. Late afternoons, when they were both working at Shearson Lehman Brothers Inc., they'd brainstorm over start-up possibilities. Atkinson had already created several restaurant concepts. Maybe their joint venture should have something to do with food. Hmm . . . food . . . dinner . . . dinner and a movie. Gourmet frozen dinners sold in video stores? Messy, but video stores . . . hmm. A video store . . . a convenient video store . . . a chain of drive-through video stores. Of course. That's it. Put them in strip-center parking lots close to commuter routes in suburban locations. Stock them with new releases. People drive up, order some tapes off the menu board, take them home. No hassles: Minimal overhead. Keep it simple. And yeah, franchise them for fast growth and minimal operational headaches.
They got the idea in March 1986, incorporated in May, opened two pilot stores last summer, and sold their first franchise to a Rochester, N.Y., investor group in August. Now, LeRoy, 34, and Atkinson, 33, are betting that the company, called Video's 1st, will become the hottest franchise in the country. In fact, they figure it had better become the hottest, because if it doesn't, someone faster is going to adopt the idea -- there's no way to protect it -- and steal the market out from under them. The greatest challenge they see isn't making the Video's 1st concept work, but using the 12- to 18- month head start they think they have to establish national market strength before a better-heeled competitor can. There were some dozen franchises open, or about to open, at the end of 1987. LeRoy and Atkinson's objective almost boggles the mind: to move from scratch to having sold 100 franchises for the kiosk-type video rental stores by the end of this year and 5,000 by mid-1990.
Here's why they think they'll make it.
Estimates vary, but in 1986 Americans spent at least $3 billion renting movies to watch on their home videocassette recorders. Last year they spent $1 billion more, bringing the video industry's revenues close to if not slightly more than the take at movie-theater box offices. This year, rental revenues will grow again. As the percentage of VCR-equipped homes increases from about half of those with TVs now to a projected 90% by 1995, one of the studies LeRoy and Atkinson like to cite predicts that the videocassette business will reach $15 billion annually.
Already it's hard to find a strip center, a mall, or a downtown retail district where someone hasn't planted a video store. Most rentals take place at these untold thousands of independent mom-and-pop and franchised outlets. But price competition here has put pressure on profit margins, and with a video store on every block, analysts wonder if the market isn't saturated.
In his research binder, Atkinson has filed a trade association survey reporting that the average video store in 1986 covered 2,089 square feet and stocked 3,478 tapes. But those tapes included 2,417 different titles, meaning that, on average, stores carried fewer than 2 copies of each title. And that, in turn, means that if just one or two other people in your neighborhood want to watch the same tape you hanker to see on the same night, you don't see it. Yet the average store rents just 12% of its titles every day. Some 88% of the inventory sits on the shelves. Brian Woods, Video's 1st's executive vice-president for marketing, likens an unrented tape to the proverbial empty airplane seat. Both represent a sale lost forever.
In a effort to boost margins, industry innovators have come up with two responses to retail saturation: the rack jobber and the superstore.
Rack jobbers maintain bare-bones inventories of tapes at convenience stores, gas stations, and other such places where potential customers are likely to be found anyway. Their emphasis is on convenience.
Superstores, on the other hand, are emporiums; they carry gadgets along with every title a videophile could imagine, in quantity.
These two retail formats appear to be the fastest-growing parts of the video-rental industry. They are, industry observers suggest, the direction in which the market is moving.
What's wrong with this picture, LeRoy and Atkinson think, is that conventional video stores pay a lot of overhead to house a lot of tapes that don't get rented very often. Then they also note that nearly 80% of the people who go to a video store to rent a movie go there looking for new releases, one or more of the 30 or so most popular titles that have only recently been released on video.
As for rack jobbers, Atkinson suggests that convenience store and gas station employees aren't attitudinally equipped to perform the two-way transaction that a video rental invoices -- checking the tape out, then checking it back in. Employee turnover rates in these outlets are too high, he says, to permit proper training.
Superstores, he thinks, are a great idea -- but expensive to build. And, he says, nationwide there are probably only 150 or so remaining markets in the country capable of supporting one of these rental monsters.
So, he and LeRoy reasoned, why not a small, inexpensive video store that carries just the current hot titles and in enough depth -- say, 10 to 25 copies each -- to assure almost every customer of getting the hit movie he or she wants? Or if not that hit, certainly another one. But in any case, not a dog. And why not put these 300 to 750 tapes in a Fotomat-type kiosk for which rent and utilities cost practically nothing? And why not expand this concept quickly? After all, LeRoy points out, the cost to erect one of these units is not very high, a lot less than it would be for a full-service, full-size retail rental store.
"We keep asking people to shoot holes in the concept," says Atkinson, "and they can't do it."
By starting out as franchisors with little or no operating experience, Atkinson and LeRoy are, as a practical matter, launching two new businesses. If one fails, so will the other.
First, there's the retail business -- the kiosks -- to be run by the franchisees. If they stumble, the two entrepreneurs have nothing to sell, and their revenue from franchise sales and royalties will dry up quickly.
On the other hand, while the kiosk concept might be a smash, if the franchisor organization is undercapitalized, poorly organized, or badly run, the business still fails -- for lack of support to the retailer.
Here's what they propose to do on the retail side.
At $2.95, Video's 1st's rental price is high compared to the industry average of less than $2. Atkinson and LeRoy say studies show that people will pay more for convenience (double drive-through windows, short waits) and for selection (getting the new releases). Price, the founders insist, is not a critical issue.
If that's true, the Albany-based duo will be more alchemists than entrepreneurs, changing plastic tape to gold. Each kiosk's projected return is nothing short of astounding.
Currently, Video's 1st expects to hand over a turnkey kiosk, complete with training, initial inventory, grand opening, and adequate working capital to a buyer on his or her site for a total cost to the franchisee of $87,727 or less.
The financial pro formas that Atkinson posits promise remarkable margins for franchisees. The figures represent an average month and the annual total, both for the second year of a kiosk's operation, when it is in top gear. According to his figures, if roughly 40% of the minimum 300-tape inventory rents daily at $2.95 per day, a prefabricated 48-square-foot kiosk should earn $33,807, or almost 24% before taxes, on annual revenues of $139,317. With about only 50 tapes, or 17% of the inventory, rented per day, a kiosk still breaks even under Atkinson's assumptions. The figures don't account for taxes or depreciation, and they assume that the franchisee has to service $45,000 in debt used to finance the start-up. They also assume the kiosk will sell its used tapes for $20 each, or about one-third their cost new. With the margins Atkinson's rosy scenario predicts, a franchisee's annual pretax return on assets will reach 40% or more.
Furthermore, a franchisee's risk is minimized, Atkinson and LeRoy argue, by the portability of the kiosk. If the first location turns out to be poor, the franchisee can pick up the box and move it someplace better.
Executing a sound retail idea, however, is just half the battle. The business will either fail to take off or stall out in the climb unless several things work well on the franchisor's side.
The franchisor must be well capitalized. Its franchise documents -- the agreement it makes with franchisees -- must be sound. It has to be able to see franchises, and it has to be able to support what it sells, which means staffing up at headquarters, but not so quickly that overhead outruns cash.
Inadequate capital, franchise veterans say, trips up most would-be franchisors, and there is more than one way to fall here.
Just getting started requires some money. Except for three pilot stores in Albany, the company's home base, Associated Video Hut Inc. (the name given to the corporate umbrella), won't operate kiosks itself. The founders chose not to divide their energies between operations on the one hand and building a franchise organization on the other. But with no operations, there's no revenue. They've only just begun signing franchise contracts, and it will be some months before they can count on regular royalty payments. LeRoy and Atkinson knew they'd need capital to carry them over that gap.
First they raised $465,000 in early 1987 with a private equity placement, giving up just short of 20% of the company's stock. Calling on their Wall Street backgrounds, Atkinson and LeRoy sold the issue themselves, saving the underwriting fee. This money, they figures, would be all they'd need. Franchise sales, which began in August, would generate enough cash to carry the company for some time, they thought, and they priced their franchise product accordingly.
Altogether, Atkinson figured, each franchise sale would bring $18,500 into the company, even before royalties began to flow. Upon signing a contract, a new franchisee hands over a onetime franchise fee of $18,500 (it was $13,500 before January 1, 1988). When the kiosk is actually delivered from the independent manufacturer to the new franchisee, Associated Video Hut realizes another $5,000 in cash from a markup over the kiosk's cost. Total cash in: $23,500.
Out of this revenue, subtract a sales commission of approximately $3,885. That's the only direct cost, as Atkinson calculates it, in selling a new franchise. So, he figures that he has $19,615 left to cover overhead and indirect expenses -- plenty, he and LeRoy thought, until they looked at the payment schedule.
Getting the contract signed probably takes 60 days. They don't get their $18,500 until then. The franchisee has 90 days to find a site and Associated Video Hut has 60 more days to approve it -- both of which must happen before the kiosk gets purchased and the franchisor pockets the other $5,000. So it turns out that getting the whole $23,500 could take as long as nine months from initial contact to final setup. The company could find itself that far behind on cash. "That was our one mistake," Atkinson says, "and we recognized it right away." They are currently selling, again through their own efforts, $1 million in five-year, 12 3/4% debentures to cover the shortfall.
When kiosks come on-stream, franchisees will pay a weekly royalty of 7% of gross revenues -- toward the high side -- plus corporate and national advertising fees that come to another 1%. But Atkinson doesn't expect to begin seeing substantial cash from franchise operations much before the end of this year.
Actual cash flow for the nascent company is as unpredictable in the near term as are the number of franchise sales. One large deal -- such as one recently negotiated with a Burger King franchisor who wants to combine drive-through burgers with drive-through movies -- pushes the numbers around dramatically. But by ensuring that every direct cost of a franchise sale is balanced by an equal or larger payment from the franchisee, Atkinson believes that he'll avoid selling the company poor -- a common error among new franchisors.
As businessmen, LeRoy and Atkinson profess to believe their own projections, but they can't completely shake a personal incredulity. "We keep asking ourselves," says LeRoya, "what are we missing? It's too simple." Atkinson's tendency is to complicate plans -- to make the stores larger, to carry more products. The kiosks will sell microwave popcorn, blank video tapes, and possibly VCR head cleaners. But LeRoy keeps leading them back to the basics to work out the bugs. For weeks they engaged in role-playing. They'd get friends or their wives into the office around a conference table and go through simulated rental procedures over and over again. Could they handle peak-hour Friday and Saturday traffic? Cutting average transaction times to as little as two minutes would help, and so would offering plenty of the hottest titles. "People don't mind waiting in their cars," Atkinson claims, "if they know that at the end of the line they're going to get what they want." Keeping franchisees loyal to the system would be another challenge. To meet it the founders devised a program that would provide ad slicks, movie listings for insertion in local papers, four-color newsletters that franchisees could distribute to patrons, and three new radio spots every quarter.
For every issue the role-playing and questioning raised, the partners found a comfortable answer -- and the concept, they say, still felt right.
Initially, LeRoy and Atkinson thought it would be logical to develop their franchises by geographical regions, beginning with the Northeast, then the Midwest. But they changed their strategy to pursue an immediate national selling campaign when it became clear that there was no advantage -- no economies of scale, for instance -- in growing progressively from one are to the next contiguous one.
In marketing franchises, they're not ignoring the individual who might want to buy a single kiosk, but they want to concentrate on potential buyers interested in 3 or more units. Their first sale was 15 units to an investor group in Rochester. They're also thinking that existing mom-and-pop operators interested in expansion may be good sales targets. After all, LeRoy says, someone who is already in the business can open three or four Video's 1st kiosks for the price of a single new conventional store.
There's nothing in the Video's 1st concept -- as even the two founders admit -- that other people haven't thought of before. LeRoy and Atkinson have lost track of the number of people who have told them they already had the idea for doing drive-through video rentals. "Sure," says Atkinson, "other people think of things. The difference is that Todd and I do them."
* THE COMPANY: Associated Video Hut Inc., d/b/a Video's 1st; Albany, N.Y.
* CONCEPT: To franchise a national chain of drive-through video rental kiosks, specializing in hit movies
* PROJECTIONS: 100 franchises to be contracted by year-end, 5,000 by mid-1990; each franchised kiosk to earn $33,807 on $139,317 annual sales
* CHALLENGES: Sustaining above-market rental price; providing customers with promised convenience in a business with severely bunched peak-hour traffic; providing franchisees enough marketing and operations support to earn their loyalty -- and continued royalty payments
Video's 1st Pro Forma Operating Statement Per Kiosk *
REVENUES Average ( $ ) Total ( $ )
Tape rental fees (116 rentals per day at $ 2.95) $ 10,260 $ 123,117
Used tape sales (55 tapes per month at $ 20) 1,100 13,200
Popcorn 150 1,800
Other 100 1,200
Total revenues 11,610 139,317
COST OF SALES
Prerecorded tapes (55 tapes per month at $ 60) 3,300 39,600
Popcorn 93 1,116
Other 50 600
Total cost of sales 3,443 41,316
GROSS PROFIT 8,167 98,001
Rent 500 6,000
Payroll (12 hours per day, seven days per week) 1,950 23,400
Payroll taxes 234 2,808
General (Insurance, supplies, utilities, 505 6,055
Royalty payment (7% gross receipts) 813 9,752
Local advertising (2% gross receipts) 232 2,786
Corporate advertising (1% gross receipts) 116 1,393
Note payable, principal, and interest 1,000 12,000
($ 45,000 note at 12%, five-year term)
Total operating expenses 5,350 64,194
NET INCOME BEFORE TAXES 2,817 33,807
* Depreciation and amortization not included
Industry average performance Video's 1st
for video retailer performance assumptions
Store size * 2,089 square feet 48 square feet
Tapes stocked * 3,478 300
Individual titles stocked * 2,417 30
Tapes rented daily ** 185 120
Percent of stock rented
daily ** 5.3% 40%
Rental price ** $ 1.80 $ 2.95
Wholesale tape cost
(new releases) ** $ 50 $ 60
Resale price of used tapes ** $ 16 $ 20
Full-time employees * 3 1
Part-time employees * 4 4
* Video Software Dealers Association
** The Fairfield Group Inc.
Todd W. LeRoy, 34
Cofounder; chairman and CEO
Chairman and chief executive officer, Associated Video Hut Inc., since founding in May 1986; full-time since April 1987 . . . vice-president/Hutton portfolio manager/financial consultant, E. F. Hutton & Co., October 1986 to September 1987 . . . vice-president and financial consultant of trust services, Shearson Lehman, February 1981 to October 1986
Michael L. Atkinson, 33
Cofounder; president, COO and CFO
President and chief operating officer, Associated Video Hut Inc., since founding in May 1986; full-time since February 1987 . . . financial consultant, Shearson Lehman, March 1985 to February 1987 . . . co-owner, Pasta Express, Albany, November 1984 to March 1985 . . . owner and operator, Bailywick's Restaurant and Bar, Reno, Nev., August 1980 to November 1983
What the Experts Say
We sent the Video's 1st case study to a variety of industry observers, moneymen, and potential competitors. Here is some of what they told us:
IRA MAYER AND PAUL SWEETING
Analysts; editors of Video Marketing Newsletter, published in Los Angeles
When people ask us about going into video retail, we tell them, I'm afraid, that the time is past. The industry has peaked. There is already a lot of shake-out. Video-rental income will be essentially flat for the next two or three years, and the number of retail video stores has stabilized. There is less and less of an aftermarket for used tapes, which Video's 1st is counting on being able to sell.
Obviously, Video's 1st thinks differently, but if we were advising investors, we'd say no way -- steer real clear. The time is over for this sort of thing.
The idea that customers aren't sensitive to price -- that they care more about convenience and about getting exactly the tape they want -- has always been a nice theory, but history doesn't substantiate it. The pricing of rentals responds to local competition. And it's a cutthroat market. One dollar is not uncommon, compared with Video's 1st's $2.95. It sounds nice that people would pay a premium for convenience or mystique, but people have tried it, and it hasn't worked.
They should give up on the idea of being national. Try to grow market by market instead. Go into a market that isn't oversaturated with existing video retailers and blanket it with kiosks, then concentrate advertising and promotional efforts in that market. Get the most bang for the buck. Don't spread yourself too thin for the sake of national ambition.
Look, it's not just that the concept is flaws. It's also the fact that the market isn't ripe anymore -- it's mature. We think the window has closed for video retailing.
Competitor; executive vice-president of National Video Inc., a Portland, Ore.-based chain of 580 franchised video stores
I think the concept has some validity, but implementation is going to be much more difficult than they think. They haven't discovered something by magic that no one else has seen. it's a strategy we've thought hard about. But there are problems.
One is that they really underestimated their reinvestment in videocassettes each month. They expect to do 116 rentals per day, or 3,480 per month. On a minimum inventory of 300 cassettes, which is what the pro forma assumes, that's an average of 11 1/2 rentals per cassette per month. Now this turn rate is possible. In our experience, the turn on new releases can be pretty high for the first 30 days -- maybe as high as 20 rentals for a particular cassette. But it drops dramatically, to about 8 rentals, over the next 30 days, as the title loses its gleam. And in the third month the turn falls to the norm of 2 or 3 rentals per cassette per month.
Therefore, to average 10 or 11 turns a month over the life of a title, you can't keep it more than 90 days. After that the average drops, and Video's 1st wouldn't meet its revenue needs. So, they have to renew their entire inventory every three months (actually, they'd have to keep inventory fresh by bringing in a third of the total, 100 new tapes, each month while dumping the 100 oldest ones). The problem is those 100 tapes would cost -- studios are increasing their prices, not decreasing them -- anywhere from $65 to $70 wholesale. That means they would have to reinvest $6,500 to $7,000 a month to keep their inventory fresh -- more than twice what they've figured. In fact, it puts them in a negative cash flow. If they really do buy 55 tapes a month, as they say, then they'll have to keep each one for almost six months before the 300-tape inventory is renewed, and that won't work. They wouldn't be carrying the hits, as they claim.
The second problem is that video traffic comes in bunches: 70% of your business takes place on Friday, Saturday, and Sunday, and even that 70% is generally crammed into a few peak hours during each of this days. Now, if you have long lines of cars during these peak periods, you're going to discourage people from even lining up. When I go to a McDonald's, for instance, and see six or seven cars in front of me, I just keep going. And I think that's what's going to happen. In a regular store, you might combat the traffic from that peak rush by opening three or four terminals. Also, inside a store customers can browse until they see the line lessen a little -- there are things for them to do. And they don't see the line until they get into the store in the first place. The difference in Video's 1st's case is that their customers are going to see the line before they ever turn into the parking lot.
Those are the two biggest weaknesses of the concept: the first means that expenses will be much greater than what they're anticipating, and the second means revenues may be less than what they're anticipating because they can't generate enough rentals during Video's 1st's peak periods.
Will they make it? My gut feeling is no.
But I'll certainly watch them, and watch with interest. And if they do make it, then the threat is exactly what they mentioned in the beginning: anybody can reproduce it. I don't think 12 to 18 months lead time is anything. There will be lots of other people jumping in with the same concept.
Financier; partner in The Early Stages Co., a San Francisco venture capital firm specializing in consumer products and retailing
Would this work as a prospective venture capital investment? Absolutely not. There are two reasons: the inexperience of the founders in their field, and the unlikelihood of building value for shareholders. These are low-volume outlets. It takes more than 7 of them to make a million dollars of sales for the system -- nearly 400 of these to make $50 million. That starts to get into lots of problems in terms of controlling that big a network. And of course, even those numbers won't yield much to the franchisor, who gets only a small cut of the system's take.
Also, look at their pricing: it's high end. Their projections show that they can totally wipe out profitability if the retail price drops by a third. They're supposing that convenience and multiple copies of the current movies will cause people to shop there instead of getting the movie through some more difficult process at a lower price -- a risky supposition. They could fall to break-even by a drop in volume or by not being able to maintain their price level, or any combination of those things. Whatever the average price now is -- say $2 or $1.99 -- it isn't stable. It might drop by a dollar. They probably now have, and will continue to have, competitors who are not primarily in the business of renting tapes, and who'll undercut. I'm worried about a concept that depends for all its profitability on a pricing differential. If you said to me that it makes a good profit at a competitive price and a better one at a higher price, so that if they had to be competitive it wouldn't put them out of business, OK. But when it knocks out the total profit margin, that's troubling.
Here's what I'd recommend to them:
1) Invest in providing excellent franchise operating benefits -- tape resale programs, buying programs, signage, marketing tools, kiosk design -- so these stores rise above others in the market and we implement better.
2) Don't defer your own rewards too long; maybe you can make a nice living for a while. Think in terms of getting your rewards in the next two years because the business may not be something you can sell for millions of dollars down the road.
Will you find them in the telephone directory two years from now? I'd say there's a reasonable chance of that. My crystal ball says they'll be around for two and a half years, then I get nervous.
Consultant; cofounder of Wilkofsky Gruen Associates Inc., a New York City firm specializing in the entertainment industry
In a very competitive market, they're proposing to carve out a nice little niche for themselves. I think their prices are fine, because people will pay a reasonable premium for convenience. Their concept makes perfect sense, at least for them as franchisor.
What's not clear, however, is what they're going to do for potential franchisees that an individual entrepreneur, acting on his own, couldn't do for himself. Anyone can put up a kiosk and stock it with tapes, just like anyone can cook a hamburger. But having the McDonald's name on your hamburger stand makes it a more valuable asset. What does Associated Video Hut propose to do to add value to the Video's 1st name -- which is the main thing they can do for franchisees? If they don't build an identification in the public's mind between product and logo, then they've go nothing to sell.
Competitor; president and CEO of Video Library Inc., a chain of 42 company-owned video stores, all in San Diego
I think that in order to do the revenue they need, the lines will be too long. We do 15% of weekly rentals in four hours on Saturday afternoon. Using their numbers,they'd be handling during that peak period about 30 to 35 customers per hour. Can you take care of that much business, through a window, without creating massive lines that will turn your customer off? When I think of how long it will take to do a transaction, and when I think about how customers would have to line up to return the movies, too, I just can't see it. No one can take care of people that fast.
And there sure are reasons to grow from one area into another instead of going national immediately: you've got to handle these things, you've got to take care of them. Franchisees need to be serviced very, very well, or they won't survive -- or, even if they do, they'll stop paying you royalties, because they'll think you don't deserve them.