June 27 issue - 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.

This business wasn't so complicated when Blockbuster opened its first store in 1985. Founder David Cook's idea was to offer a well-stocked, uncluttered, porn-free and family-friendly alternative to mom-and-pop video stores. Wayne Huizenga, who'd already made millions founding Waste Management, bought the 20-store company in 1987 and built it up to 3,600 locations and $2 billion in sales before selling out to Viacom in 1994. From there Blockbuster began to lose focus. In one ill-fated move, the company hired a Wal-Mart executive who filled stores with T shirts, movie posters and other merchandise. As profits fell, in 1997 Viacom chief Sumner Redstone hired Antioco, a retailing veteran of 7-Eleven, Pearle Vision and Taco Bell, to fix the mess. As an unhappy Blockbuster customer himself, Antioco immediately recognized the chain's biggest problem. "I'd quit going to Blockbuster on weekends because I could never get the movie I wanted," he says.

To boost inventories, Antioco persuaded movie studios to sell VHS movies to Blockbuster for a fraction of the usual price, in return for a share in the rental revenue. To promote its deeper selection, he launched a Guaranteed In Stock program, in which customers who couldn't find the movie they wanted got a rain check for a free rental. The plan worked, and revenue started rising again.

But as Antioco and his Viacom overseers celebrated, new threats were emerging. By 1999 Reed Hastings, a Silicon Valley veteran, had created Netflix, partly out of anger when Blockbuster charged him $40 in late fees on his overdue rental of "Apollo 13." Its biggest selling point: customers could return movies by mail —whenever they wanted, with no extra charges.

Hollywood presented other challenges. By the late 1990s, studios were buying into the vision of Warner Home Video chief Warren Lieberfarb, the so-called father of the DVD. Since DVDs cost less to manufacture than videotapes, Lieberfarb convinced studios that instead of selling copies mostly to rental chains for $50 or more (as they'd done with VHS), the studios should sell DVDs directly to consumers for $20 or less. His plan caught on. By 2002 Americans were spending more to buy movies than rent them, mostly at places like Wal-Mart and Best Buy. For Blockbuster, which was slow to jump on the DVD bandwagon, the shift has hurt badly. Its stock recently traded below $10, a third off the price of a year ago.

Blockbuster's attempts to fight these trends haven't come cheap. Advertising the End of Late Fees program, for instance, has cost $50 million. To see how this spending is playing out, stroll up to the Blockbuster store in the Detroit suburb of Plymouth, Mich. In one window hangs a yellow banner: welcome to life after late fees. Store manager Matt Penhollow says the program has caused a spike in rentals (as it has at most Blockbuster locations). Inside, to the right of the entrance, is a large, segregated part of the store called Game Rush, its shelves lined with videogames. Blockbuster plans to incorporate it as a subsection of many stores. While the walls of the store are lined with new DVDs, as in every Blockbuster location, a growing section of the interior aisles sells used DVDs. Many of those films were traded in by customers, who get $3 and up for each title. Blockbuster hopes to sell them at double or triple that price.

Along with the online program, that means there are now many different ways to take a movie home from Blockbuster. In a sense, the company is trying to become customers' entertainment concierge, in a strategy similar to how stock brokerages evolved from processing trades into serving as clients' financial advisers. Antioco articulates Blockbuster's strategy as wanting to serve customers regardless of whether they choose to buy, rent or trade movies—and whether to do it online or in a store.

For customers who want to buy new DVDs, though, Blockbuster executives admit they'll have a hard time matching Wal-Mart's prices. Because of that, it appears much of the chain's new strategy rests on their belief that some customers will shift back from buying to renting DVDs. By year-end, Americans will own 3 billion DVDs, the chain says. Consumers really do watch some of them—like "The Matrix"—over and over. But some viewers can't help but wonder whether that $18 investment in "Legally Blonde 2" was really a smart move after all. Over time, Blockbuster suggests, this accumulated buyers' remorse will lead people to realize that renting offers better value. "You'll eventually see a slowdown in the number of DVDs consumers buy," says Antioco, suggesting that will boost rentals.

Outsiders are skeptical. "When you have seven years of [rising DVD sales] data, that suggests a pretty strong trend," says Lieberfarb, the former Warner Home Video chief. He says that for busy families, in which not everyone can watch at the same time, buying DVDs will remain more appealing. For years Lieberfarb has been saying Blockbuster is doomed, and despite all its new marketing initiatives, his opinion hasn't changed.

Bigger issues lie ahead. Video-on-demand provided by cable companies may one day be the home-entertainment industry's killer app. Blockbuster is unfazed. It believes that because studios can earn more from DVDs than video-on-demand, the studios will have a vested interest in supporting the older technology. If video-on-demand really catches on, however, it's hard to see how Blockbuster would compete.

Some investors, including Icahn, see the current challenges as an opportunity. "With a lot of companies, the time to buy is when people don't like them—that's what I've done all my life," Icahn told NEWSWEEK. Just a month ago he was lambasting Blockbuster's management over its failed merger with Hollywood Video and Antioco's $54 million compensation package. (Blockbuster says that figure mostly represents future bonuses that assume big stock increases; his cash compensation last year was $7 million.) But now that Icahn is a director, his views have softened. He even offers measured praise for Antioco's strategies.

And though the company seems like an endangered species, Jennifer Illes, a Harvard Business School researcher who has coauthored case studies on Blockbuster, refers to the classic '80s song "Video Killed the Radio Star." "I still listen to radio all day long," she says. Sometimes even obsolete technologies survive longer than you think.

With Ramin Setoodeh