Blockbuster (BBI) entered into the movie rental business in 1985 and gained momentum when it was acquired by Viacom (VIA) in 1994. VCRs ruled the day, and VHS videotapes of new releases were in high demand. Blockbuster immediately positioned itself against the mom-and-pop video stores that had sprouted up in many neighborhoods, and with its strong financial backing and industry ties to the largest studios in Hollywood, the smaller players had little chance of survival. It offered dozens of new releases and had an inventory that dwarfed any of its competitors. The smaller rental chains fell over time and BBI’s revenues peaked at more than $6 billion in 2004.

But technological advancement sped to a blistering pace and the company started taking on challengers from unsuspecting places. Set-top cable boxes began to offer movies on demand at the touch of a button. Netflix (NFLX) , a by mail DVD rental entity that boasted no late fees and quick delivery, gained steam and exposed huge flaws in Blockbuster’s brick and mortar strategy. Even Coinstar’s (CSTR) Redbox line offered movie rentals at convenient locations like your local 7-Eleven.  This brings us to the present state of this once-proud company…

Revenues are in a free fall; various competitors are eating its lunch; and an overbearing debt load has the share price hovering around $0.25. Delisting concerns are growing, and the potential of filing for bankruptcy has become a very real possibility, according to the company Chapter 11 seems more likely than ever now that the credit agencies have each downgraded portions of the company’s debt. Current grades demonstrate extremely poor prospects for recovery from Blockbuster’s distressed state. A voluntary bankruptcy, though painful in the near term, looks more and more likely to be BBI’s only way out of this jam.

Talks of a debt-for-equity swap began circulating recently, but with BBI’s share price so low, we think such an agreement would be a hard sell to even the most venturesome lenders. And when taking into account current credit landscapes, such a pact may well be wishful thinking by BBI’s most loyal supporters.

What we do know is that bankruptcy will be the only alternative if the overall debt cannot be cut quickly. Viacom spun off BBI in 2004 and a good chunk of the nearly $1 billion in borrowings on the company’s books stems from a mandatory dividend that was paid to VIA shareholders at that time. Blockbuster pays more than $100 million in annual interest expenses, which has been dragging down the bottom line and causing a major distraction at a time when management needs to be more focused on thwarting the ongoing vulturing of its market share by rental rivals.

Further compounding BBI’s woes is that in an effort to turn potential clients away from Netflix and toward its offerings, late fees were done away with a few years back. Many pundits believe this was the straw that broke Blockbuster’s back. The move proved largely unsuccessful in stemming customer attrition to Netflix, and peeled away the roughly $500 million annually that these penalties contributed directly to BBI’s bottom line.

On top of this, the company is saddled with the high cost of operating the large number of stores that it had built out during the years in which operations thrived. To management’s credit it has been quick to order substantial store shutterings and get the number of outlets in line with the reduced demand environment it is currently experiencing. Still, many could argue that while these cuts should be carried out quickly, it is still far too little too late.

One thing that Blockbuster has in its favor is its strong ties to the major studios. For example, Warner Bros. recently struck a deal with the company to provide immediate availability of the studios big-name titles. Such a timeframe provides four weeks of breathing room before Netflix and Redbox get their hands on such offerings. Additional exclusivity deals and revenue-sharing agreements where BBI pays less per title and gives the studios a cut of the sales by each movie are likely in the future.  Such moves are a step in the right direction. BBI, by paying less money up front and sacrificing some profitability should be able to garner more cash on hand. These funds can only aid in the paying down of debt. But again, to soothe the aforementioned financial woes, larger moves than this will needed.

Too, even if the company is able to close the gap with the subscriber-based, home delivery rental players, the landscape continues to change so rapidly that many argue that Blockbuster will not be able to keep pace. The cable companies are beefing up their on-demand schedules to offer catalogs of movies that rival the industry’s largest. In that vein, companies with deep pockets like Wal-Mart (WMT) and Apple (AAPL) are throwing their hats into the in-house movie rental service and offering motion pictures in much higher definition than the majority of the competition. The latter entity is a technology behemoth that has had success in nearly all ventures.  The whispers that it will do to the movie industry what it has done to the music industry cannot be taken with a grain of salt.

Still, physically going to a store to rent a DVD has not yet fully gone the way of the drive-in movie. Older people and those that shun technology remain loyal to BBI. It is worth noting that automated rental kiosks operated under the Blockbuster Express flag have sprouted to varying degrees of success.  But the generation growing up now is all about instant gratification and patience is no longer a virtue, so thinking that demographics are in the company’s favor would be unprofitable.

In summation, it will take a two-pronged approach to get BBI back on its feet. Debt covenants must be renegotiated to ease the immediate financial stress all the while investing in newer, high-tech platforms that will bring its products up to speed with its competitors. The fact that this task is daunting leads many to believe that nobility is not at hand for Blockbuster. The best case scenario seems to be a Chapter 11 filing under which the company continues to operate. There is little doubt that the new BBI would emerge with far less debt constraints, but its viability as a major player in the movie rental business would likely be questionable under bankruptcy protection.