updated 11/1/2007 6:46:31 PM ET 2007-11-01T22:46:31

Blockbuster Inc.'s third-quarter loss widened as the movie-rental company lost a half million online customers and absorbed costs for layoffs and store closings.

Chief Executive James W. Keyes said Thursday that many of those online subscribers were costing more than they were worth, and Blockbuster was happy to see them go to the competition.

Blockbuster shares fell 32 cents, or 6.1 percent, in trading Thursday to $4.94.

Blockbuster reported a quarterly loss of $37.8 million, or 20 cents per share after preferred dividends, compared with a loss of $27.5 million, or 15 cents per share, a year earlier. The results included $9.6 million, or 5 cents per share, in one-time severance and lease-termination costs.

Analysts surveyed by Thomson Financial predicted a loss of 18 cents per share. Analysts usually exclude one-time costs from their estimates.

Revenue fell 5 percent, to $1.24 billion, below analysts' forecast of $1.28 billion.

Blockbuster has spent heavily in the last couple years to build up its online business and was narrowing the gap in customers with industry pioneer Netflix Inc. But over the summer, the number of Blockbuster online subscribers fell to 3.1 million from 3.6 million.

About 300,000 had been on free trial memberships. And the whole group may have been losing money for Blockbuster, according to Keyes.

Here's how: Blockbuster offered free rentals to online subscribers who returned their movies to a store instead of sending them back through the mail. The idea was to steal customers from Netflix and get people into Blockbuster stores.

But some customers boasted of getting dozens or even hundreds of free rentals at the stores, lowering their average spending per movie. The company figures the giveaways cost $29 million.

Keyes said the freebies also left store shelves bare of new releases, angering other customers. Blockbuster also got into a price war with Netflix.

"Our pursuit of by-mail subscribers was a bit overzealous," Keyes said. "Clearly our spending ... was exceeding our returns ... We attracted some of the most price-sensitive and the heaviest-consumption customers with our offer of free in-store exchanges."

Keyes said Blockbuster is now willing to walk away from those subscribers. But some analysts weren't impressed with the explanation.

"We don't see the loss of nearly 15 percent of (online) members as necessarily a good thing when trying to compete with Netflix," said Jeffrey Logsdon, an analyst for BMO Capital Markets.

Netflix added 286,000 customers in the third quarter and finished September with 7 million subscribers.

JP Morgan analyst Barton Crockett said the numbers suggested that the online movie rental business may be getting saturated.

Future comparisons between Blockbuster and Netflix will be more difficult. Blockbuster said Thursday it would stop breaking out its number of online subscribers.

Blockbuster is also trying to shift more of its business to selling movies, posters, candy and other items instead of relying so heavily on DVD rentals, which have been flat or declining. But the chain won't try to undercut other retailers on prices.

"Yes, customers can always buy a DVD cheaper at Wal-Mart or maybe even Best Buy, but the question is, will they be willing to pay a little more for the convenience of purchasing it when they're already in a Blockbuster store?" Keyes said.

For the holidays, the chain plans to stock more than the usual 10 to 20 retail copies per store of "Shrek III" and will charge a premium price, Keyes said. He said retail sales for such a movie can be four times bigger than rentals in the first few weeks, and that Blockbuster has missed that sales opportunity with other movies.

Keyes was named CEO in July, replacing John F. Antioco, who had come under fire from major shareholder Carl Icahn for aggressive spending on the online business.

Blockbuster aims to cut annual overhead costs by about $45 million.

The Dallas-based company cut 400 jobs in September and closed more than 500 stores in the third quarter — about 7,800 stores remain worldwide. Blockbuster trimmed advertising spending in the third quarter to $27.5 million from $33 million a year ago.

For the first nine months of the year, Blockbuster lost $125 million after preferred stock dividends on $2.44 billion in revenue, compared with a profit of $33.4 million on revenue of $2.51 billion last year.

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