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Blockbuster announced Tuesday it's teaming up with PayPal to offer users another payment method for purchases off its Web site.

Under the arrangement, consumers can use their PayPal account to pay for their online movie rental subscriptions. And later this summer, Blockbuster expects to launch its downloading service for movie rentals and purchases.

Eventually, Blockbuster expects to make PayPal available for use to purchase other things off the Web site, from gift cards to new and used DVDs.

Blockbuster is offering users a $10 cash back to their PayPal account, if they sign up for a new online Blockbuster rental subscription.

A correction was made to this story. See details below.

Here's hoping that Netflix managers have the confidence to carry on with a plan that isn't just necessary for growth, but is essential to the company's survival.

Netflix CEO Reed Hastings is being second guessed by Michael Pachter, an analyst with Wedbush Morgan Securities. According to a story in Portfolio (via Wired.com), Pachter "would prefer that Netflix stick to selling movie-rental subscriptions."

Like many on Wall Street, Pachter can't see past the next quarter. He crunched the numbers and argues that Netflix is spending too much on building a digital-delivery service that enables users to download movies.

Netflix may drop as much as $70 million this year on the digital service. That equals to about 70 cents per share in 2008 profits. The company had to pay Hollywood studios $40 million last year for the rights to offer 10,000 films online. Pachter, who wants Netflix to reveal more details about the online service, said that if Netflix paid $70 million to service 100,000 customers, the company would be paying $700 for each.

"I would say they're crazy; it's not worth it," Portfolio quoted Pachter as saying. He added that he only likes the deal if most of Netflix's customers switch from receiving DVDs through the mail and start getting their flicks via the Web.

But that's not going to happen overnight. What Pachter doesn't seem to get is that the online distribution of movies is coming whether investors like it or not. Hastings said last week that he expects his DVD revenue to peak within five years. Perhaps the best proof that the move-rental business is on the threshold of dramatic change is the set-top box introduced two weeks ago by none other than Netflix.

Pachter should try the Netflix Player by Roku. The $99 device enables Netflix users to watch downloadable movies on their TV sets. Most Netflix subscriptions allow for the viewing of any movie at no extra charge. Netflix streams the films, which means no extended download times. The major flaw is that there isn't enough titles to choose from. That will come in time unless Pachter gets his way and Netflix doesn't shell out for a better film library.

Regardless, the service is cheap. It's easy to hook up. The quality of video is comparable to digital TV.

But will anyone be willing to watch their Netflix movies without fussing with red envelopes or waiting for the mailman? Hastings isn't the only who thinks they might. Heavyweights such as Apple and Amazon have jumped into the Web movie-rental business. Others are sure to follow.

"Netflix is betting that during this time, we can establish ourselves as a leader in the space," said Barry McCarthy, Netflix's chief financial officer, last week at the company's investor day.

To be sure, online video is still in its infancy. It will take time before it goes mainstream. But it's hard to find anyone in entertainment or technology circles that doesn't believe consumers will eventually embrace it.

The big question is whether Netflix can afford to wait to build a digital business and possibly watch its competitors cut its grass. I don't think it can. Putting off a digital strategy is a bet against the Web, and that's the opposite tack Netflix took to build itself into a movie-rental powerhouse with 8 million subscribers.

Blockbuster and Movie Gallery are examples of companies that hesitated to embrace the Web. Now, Blockbuster continues to try to prevent Netflix from taking more of its customers. Movie Gallery went bankrupt last year.

In the opening scene of The Player, Tim Robbins' character is meeting with writers who are pitching movie ideas they hope the Hollywood producer will agree to make. One idea is pitched to him as, "It's Pretty Woman meets Out of Africa, without stars."

(Credit: Blockbuster)

Applying that Hollywood approach, the latest idea from Blockbuster can best be described as "Netflix meets YouTube, without the convenience." That's basically the pitch Blockbuster Chairman and CEO James Keyes made at his first annual shareholders meeting on Wednesday when he unveiled an in-store kiosk he hopes consumers will use to download movies.

The plan, as outlined by The Hollywood Reporter, is for consumers to bring portable devices into Blockbuster stores and download movies, usually in about two minutes. Blockbuster expects to begin testing the kiosks, which were produced by airline-kiosk maker NCR, in about three weeks. Initially, the system will work only with Archos devices, but Blockbuster expects the kiosk to be an "open system" that is compatible with a range of devices. Keyes declined to predict how many titles will be available on the kiosk, noting that Blockbuster was still in negotiations with the major studios for content.

I wasn't at the meeting, but I have to wonder if reporters giggled at this idea:

Keyes acknowledged that the kiosk pilot is likely coming well ahead of broad consumer demand for such services and should therefore only be seen as one additional distribution channel for the company as it tries to offer entertainment content whenever consumers want in whatever form they want.

"Well ahead of broad consumer demand for such services." Huh?

Talk about an innovative idea. Amazon.com, Microsoft's Xbox Live, and Netflix already deliver movies directly to PCs; TiVo, Vudu, and Apple TV, as well as cable and satellite services offer video on demand to TVs; and electronic copies of movies are being sold alongside DVDs. So what makes Keyes think people want to leave their homes to drive to a store with a laptop-size device to download movies from an ATM?

People don't want to make the trip to the video store. Convenience is why Netflix is kicking Blockbuster's butt. Blockbuster seemed to have a road map for getting back on top with its acquisition of movie download service Movielink in 2007, and its idea for a set-top box for streaming video seemed to show promise (Indeed, my colleague Greg Sandoval reports that Netflix sees video streaming eventually overtaking physical DVD rentals). But this is also the company that has been kicking around the idea of buying electronics retailer Circuit City for $1 billion.

I could see these kiosks appealing to airport travelers, but otherwise this strikes me as an expensive remake of a soda machine.

If Circuit City gets sold anytime soon, it probably won't be to its chief suitor, Blockbuster, according to one of the electronics chain's most vocal investors.

In an interview with TWICE magazine Friday, Jim Wattles, owner of Wattles Capital Management, which owns 6.5 percent of Circuit City shares, said a sale could happen in the next two months. Wattles also said that Blockbuster, which bid roughly $1 billion for Circuit, isn't the only interested party, and in fact, the likely future buyer will be a private equity firm.

So, essentially, the company has options. It was revealed Friday morning that it has retained Goldman Sachs to look at other opportunities for acquisition besides Blockbuster. And another famously vocal shareholder, Carl Icahn, let it be known that if Blockbuster can't make good on its bid, he's interested.

Wattles comments to the magazine come a few weeks after Blockbuster's bid became public and he sent a letter to the retailer's chairman encouraging him to allow Blockbuster to at least kick the tires. Circuit City was, at the time, resisting allowing Blockbuster a look at its books, necessary to make a complete acquisition offer.

Not that he's soured on Blockbuster. On the contrary, he praised Blockbuster's hiring practices and employee training.

He's probably the only one. Sure, investors are unhappy, but the combination of two different retail companies with different cultures, products, and business models, is a disaster waiting to happen. In concept, it's great: selling hardware and content together. In execution? It's unclear how this could ever work.

Apple's iPod and iTunes combination is a tantalizing example of the possibilities a tie-up like this could represent. So is Amazon.com, with its Kindle e-book reader and e-books. But the difference, according to consumer electronics and retail analyst Stephen Baker, of the NPD Group, is that both of those occurred organically.

"Amazon and Apple did everything natively. It was an extension of what they were already doing," he said. "This is bolting pieces on."

Blockbuster sure sounds like it wants to buy Circuit City, but is it able to?

The financial advisers to Circuit City told company officials Wednesday that they think Blockbuster, which has offered $1 billion for the consumer electronics retailer, doesn't have the proper financing to make good on its bid, according to a Reuters report.

In a statement, the company said, "Circuit City awaits a viable financing structure that is predictably executable by Blockbuster given its current constraints of size and capital structure before it would be appropriate to allow further due diligence."

Blockbuster's CEO said earlier this week that his company would proceed with its takeover effort only if conditions are right and that it is loath to go through with a hostile bid. Circuit City has essentially stonewalled Blockbuster since the initial bid was made in February, not allowing easy access to its books.

Also Wednesday, a Circuit City investor who owns 6.5 percent of the company's stock sent a letter to Circuit City urging the company to open its books to its suitor and begin negotiations. The retailer responded quickly to Wattles Capital Management, issuing a statement reiterating its position that Blockbuster hasn't answered its questions regarding how it plans to finance a deal.

Blockbuster seemed to have no qualms about offering roughly $1 billion to buy up Circuit City stores, but it may not have the stomach for a protracted acquisition fight.

(Credit: Blockbuster)

James Keyes, the CEO of video-rental giant Blockbuster, told The Wall Street Journal that his company would proceed with its takeover effort only if conditions are right and that it is loath to go through with a hostile bid. The threat of hostilities is looming, apparently, because Circuit City is not allowing easy access to its books.

"The heart of the matter is that we still need further facts," Keyes told the Journal (subscription required). "With those facts, we can choose whether to proceed or get back to our continued success."

Part of what's at issue is how Blockbuster will pay for the billion-dollar deal, and that has Circuit City saying "Not so fast, 'buster.'" One possible maneuver would have Blockbuster making use of Circuit City's own balance sheet to finance the offer, or using its own existing debt facility, possible asset sales, or belt-tightening, the Journal reports in a separate story, citing people familiar with the situation. There's also the Carl Icahn angle to factor in; the billionaire investor has indicated his support for the idea.

Circuit City has been stonewalling on opening up to Blockbuster for a while now. Blockbuster went public with its acquisition effort a week ago, a month after making its initial proposal to the electronics retailer--and that after having had talks about a prospective union dating back to December.

But however much sense the deal might have made early on in the Blockbuster boardroom, by and large it has most people scratching their heads. As CNET News.com's Jim Kerstetter wrote Monday:

Here's what I do know: You'd get a really big company with about $18 billion in combined sales. It would be saddled with a lot of real estate, and it could achieve some cost savings by shutting down some of those stores. But this isn't some roll-up strategy (like Larry Ellison is doing at Oracle) where costs can be quickly squeezed out and a bigger outfit can just roll in the cash. With this, you have two companies struggling to keep up with both more nimble (Netflix, Amazon.com) and much larger competitors (Best Buy, Wal-Mart, Comcast). It's a lousy place to be.

Sun Microsystems CEO Scott McNealy had a colorful assessment of the planned merger between Hewlett-Packard and Compaq: it's like two garbage trucks, he said, backing into each other in slow motion. (Beep, beep, beep...thunk.)

That brings me to Monday's rather stunning news that Blockbuster, the giant video chain that's seen better days, is trying to buy Circuit City, the giant consumer electronics retail chain that's also seen better days. The offer, which was made in February and is just now becoming public, is worth $6 to $8 per share--between $1 billion and $1.3 billion total. It's about a 54 percent premium above Circuit City's value before the news broke.

This hybrid garbage truck unveiled Monday has a brighter future than Blockbuster/Circuit City.

(Credit: Volvo Trucks)

Now you can argue McNealy was way off base on the HP-Compaq merger, but he'd be spot on if he applied the double-garbage-truck metaphor to Blockbuster and Circuit City. As Peter Kafka at Silicon Alley Insider wrote earlier, it seems like they'd "rather be in a low-margin business than none at all."

In fairness, there is some logic to what they're trying to do. By combining a company that sells the entertainment with a company that sells the equipment that entertainment plays on, you have the mass-market equivalent of Apple's retail stores. If Blockbuster really is developing a set-top box that could allow movie downloads from another Blockbuster acquisition, Movielink, the Blockbuster/Circuit City hookup moves from the realm of the insane to the "nice idea if it were operating in a vacuum" category. At least that's the theory.

But here's the reality: Apple has around 200 retail stores and can meticulously control what is sold in them and how they are run. Apple retail employees go to a veritable boot camp before they're allowed to sell in Apple stores. By comparison, the combined Blockbuster and Circuit City would have 9,300 retail stores, with 5,500 in the United States (though I have to think more than a few of them would be shut down). Quality control? They're going to have to bring in a logistics expert from the military for that one.

Wall Street already hates this. Blockbuster was in the middle of a modest turnaround, after several years of suffering at the hands of Netflix's lightweight mail distribution business and various forms of digital distribution such as on-demand television from Comcast. The company's net income for the first quarter, which ended March 31, is expected to be $30 million, compared to a net loss of $49 million a year ago. Not great, but it's a start.

Pundits already worry a Circuit City takeover could distract Blockbuster executives (they're right) and divert money that could be used elsewhere (they're right about that, too). In afternoon trading Monday, Blockbuster shares were down 14 percent to $2.69 per share.

Circuit City shares, of course, jumped more than 30 percent to $5.12 in afternoon trading. Talk about a company suffering from a changing market...and Best Buy. For the full fiscal year, which ended February 29, Circuit City lost $321 million on $11.7 billion on revenue. The fourth fiscal quarter, thanks to $65 million in reduced costs, did show signs of improvement, with a modest $4.5 million profit on $3.65 billion (sales were down 7.7 percent from same quarter a year ago). But this is not exactly a company with a long line of suitors.

So bring this troubled pair together and what do you get? Well, I'm not sure, to be honest. I suspect Circuit City's ownership also has no idea, since the Blockbuster offer has been on the table since February 17.

Here's what I do know: You'd get a really big company with about $18 billion in combined sales. It would be saddled with a lot of real estate, and it could achieve some cost savings by shutting down some of those stores. But this isn't some roll-up strategy (like Larry Ellison is doing at Oracle) where costs can be quickly squeezed out and a bigger outfit can just roll in the cash. With this, you have two companies struggling to keep up with both more nimble (Netflix, Amazon.com) and much larger competitors (Best Buy, Wal-Mart, Comcast). It's a lousy place to be.

This proposed deal may have one thing going for it: Billionaire corporate raider Carl Icahn is reportedly backing the move and is willing to finance it. He owns about 16 percent of Blockbuster's Class A shares, so I have to think he sees real value in acquiring struggling Circuit City. But as my CNET News.com colleague Dawn Kawamoto wrote a few months back, Icahn's interest doesn't always translate to a Midas touch.

Like most other people who learned about this deal Monday morning, I'm baffled. And I smell desperation.

Video rental giant Blockbuster on Monday announced it has offered to purchase Circuit City Stores for $6 to $8 per share, or about $1 billion to $1.3 billion.

Blockbuster initially made the proposal on February 17, but says Circuit City has not provided the due diligence it needs to make a more definitive offer. On Monday, Blockbuster decided to go public. In a letter to Circuit City CEO Philip Schoonover, Blockbuster CEO Jim Keyes notes that the two companies have been discussing proposed tie-ups since December.

(Credit: Blockbuster)

Blockbuster says the offer is intended to "capitalize on the growing convergence of media content and electronic devices."

"Our proposal offers Circuit City a significant premium to its existing stock price and creates a game-changing retail concept with a sustainable competitive advantage. We believe the combination will result in a compelling consumer proposition that will drive significant revenue and margin enhancements as well as cost synergies," Keyes said in a statement.

Circuit City issued its own statement saying it had received the offer, and was still evaluating its options.

A combination of the two companies would add up to an $18 billion business, according to Blockbuster's calculations. Both companies have struggled in the past year--Circuit City posted a $200 million loss near the end of 2008, and Blockbuster has been fending off Netflix's success in online video rentals, as well as the growing threat of digital movie downloads.

Last week news leaked out that Blockbuster had a set-top box under development that would stream video content directly into homes, which was seen by many as a last-ditch effort to adapt its business.

Trips to the video rental store may be a thing of the past sooner than thought.

Netflix and Blockbuster are already offering DVD rental service by mail. Amazon.com, Microsoft's Xbox Live, and Netflix deliver movies directly to the PC. TiVo, Vudu, and Apple TV--not to mention cable and satellite companies--are doing the same for TV sets. Local independent stores notwithstanding, the only major brick-and-mortar options left for renting discs are Hollywood Video/Movie Gallery, which is close to bankruptcy, and Blockbuster.

(Credit: Blockbuster)

But The Hollywood Reporter says Blockbuster may be giving customers more reasons not to visit its stores. The rental chain is said to be making a set-top box that will allow video content to be streamed directly to a television. The announcement should come sometime later this month, according to THR

A Blockbuster spokeswoman said it is "talking to numerous companies" about ways it can provide "access to media content across multiple channels--from our stores, by mail, through kiosks, through downloading, through portable content-enabled devices--so it's not surprising that there are rumors out there."

The service would take advantage of video-on-demand technology from Movielink (which Blockbuster bought last year) that allows movie downloads from Universal Studios, Paramount, Sony Pictures, MGM, and Warner Bros.

There was no mention of price or how such a service would work in the report. But let's think about this: to compete with Apple TV or Vudu, the device would have to cost around $200, and rentals of movies and TV shows should be around $3 to $4 each, which would be slightly cheaper than rentals of new releases from Blockbuster currently. The big advantage Blockbuster would enjoy over Apple TV, Vudu, and TiVo, it seems, would be selection. Considering its longstanding relationships with the studios, it would likely have the largest library of films and TV shows to choose from. See my colleague John Falcone's excellent comparison of set-top rental boxes.

No matter the details of the how the device would work, this represents a new direction for Blockbuster and the video rental market. Money spent on DVD ownership and rentals has been decreasing steadily for the past four years, according to the Digital Entertainment Group, which tracks sales of disc media. And though there's no indication Blockbuster would eliminate its brick-and-mortar stores, a streaming video service would clearly cannibalize some of that business.

Assuming the report is spot-on, and Blockbuster attempts to make this transition to digital content, it's time to wonder how much longer physical media will be a factor for mainstream movie renters.