by Gina Keating
Craft then turned to finding enough movies to satisfy Evangelist’s mandate, spending hours squinting at long inventory lists from DVD wholesalers. He ordered every film title available on DVD, plus oddities like disks featuring wood-burning fires and fish swimming in aquariums, and still came up short, so he hired a couple of guys to sit in front of TV monitors all day and screen the treasure trove of unrated independent films for sex and nudity that ran afoul of Blockbuster’s family-friendly policy.
Evangelist wanted a full complement of cross-promotional deals done with high-profile online affiliates like MSN, AOL, and Yahoo! to drive traffic to the service, starting on launch day.
Before the Accenture engineers wrote too much code, he, Cooper and Bloom met with Yahoo! and Amazon about online rental partnerships that envisioned Blockbuster providing the operations—DVD inventory, fulfillment, and subscription management—in exchange for using Yahoo! or Amazon’s sophisticated Web site as a portal to the business. A partnership with a well-known Internet name could help consumers embrace Blockbuster Online as a cool new brand separate from its conventional parent and equal to hot and hip Netflix, Evangelist thought. But Blockbuster’s legal team proved to be a stumbling block to it—Stead, by walking out of a meeting over terms he considered too steep, seemed to have torpedoed talks with Yahoo!. Deals with other prospective Internet partners faced similar roadblocks from Blockbuster’s lawyers, with contracts returning to the Paramount Building with demands the online marketing team felt were not germane.
To finalize a cross-promotion deal with AOL, which owned online movie information and theater ticket purveyor Moviefone, teams from the two companies spent a week in the Paramount Building on separate floors sending the contract back and forth to keep it out of the hands of Stead’s and AOL’s legal departments. But Internet companies for the most part were wary of Blockbuster Online, because of its parent company’s poor track record in technology, and deals were hard to come by.
Amazon founder Jeff Bezos clearly wanted an online DVD rental offering as a bridge to digital delivery, but his terms proved too onerous for Blockbuster Online, which already faced a steep path to profitability and worried about violating the federal Video Privacy Protection Act by sharing its subscribers’ rental history data with the online retailer.
Evangelist had heard that Bezos was also talking with Netflix. He fervently hoped Amazon would buy Netflix and force the rental operation to take a backseat to the online retailer’s growing and lucrative DVD sales business.
• • •
THE WEB SITE and distribution system were taking shape fairly quickly as Cooper labored over the marketing plan. Rick Ellis, an Accenture consultant acting as operations manager, took over Craft’s initial work on the distribution system and translated it into a network of fully staffed warehouses. Ellis, who had worked in operations for international shipping company DHL, hosted a three-day tour to select warehouses near postal-processing facilities that would operate with no automation and eight to ten workers. That’s how they would fulfill orders until it was clear the business was viable.
He found dealing with the U.S. Postal Service unexpectedly challenging, considering that Netflix had pioneered and perfected a rental-by-mail operation. Rather than revealing Netflix’s procedures, which it deemed confidential, post office officials insisted that Blockbuster had to invent its own.
Ellis tested a fulfillment system in the mini–distribution center at the Paramount Building that he likened to a fast-paced lending library before deciding to use an identical layout in all ten locations, even down to the shelving positions for each title. As the launch neared, he drilled the teams at each site, using dummy data and real DVDs to meet Evangelist’s productivity targets. Ellis started the project in December and had all ten distribution centers functioning smoothly enough by the July 4 deadline to earn a performance bonus.
Although Ellis was curious about how Netflix ran its warehouses, he never thought about spying on his competitor or asking his employees to do so. Evangelist, on the other hand, was not quite so principled. He and Cooper recruited consumers in several cities to become Netflix subscribers for the purpose of dissecting the rival service in regular questionnaires sent by the marketing department.
The Blockbuster Online team located most of Netflix’s distribution centers on the new consumer blog HackingNetflix.com and studied videos of its warehouse operations that they found on YouTube to figure out how the complex system worked. They encouraged friends and family members to visit the facilities posing as confused subscribers asking to drop off DVDs and have a look around
At first Netflix warehouse personnel did not suspect anything, willingly giving informal tours and allowing the visitors to take photos.But when word got out about the rash of “subscribers” showing up at the distribution centers, Tom Dillon stopped the tours and took down signs identifying the warehouses as Netflix facilities. He also took great glee in disguising the provenance of the custom-made sorting machines in the San Jose warehouse by painting an invented logo, “M&J Automation of Dillon, South Carolina,” on them. “M&J” stood for Mutt and Jeff, the nicknames Dillon had given to the two salesmen from NPI, the Dallas company that had sold Netflix the machines.
In coming years, Evangelist and his team would keep a close eye on where and how quickly Netflix expanded its distribution network, knowing that the centers represented new growth frontiers that Blockbuster Online and its parent had to defend.
• • •
IT WAS NO secret to McCarthy and Hastings that Blockbuster was close to launching its online service. In fact, through a chance encounter between a friend of Hastings’s and a loud-talking consultant, they thought they knew exactly what shape that service would take. In October 2003, Hastings’s friend had sat in front of the Blockbuster consultant on an airplane and taken notes on the conversation the consultant had with his seatmate, which he forwarded to Hastings. The consultant had revealed the budget and the number of people working on the project, its launch date, and the fact that subscribers would be able to return their movies at any Blockbuster store.
The consultant had described an integrated in-store/online DVD rental plan that, had it been carried out as described, would have posed a lethal threat to Netflix by giving Blockbuster Online access to the twenty million active customers of Blockbuster’s stores. The convenience of getting a movie in the stores combined with the selection of online rental was something that Netflix could not match. But Hastings was so confident that Blockbuster could not master the complicated technology to integrate the two that he went out of his way to dismiss the service.
“In terms of their online efforts, we expect Blockbuster.com to be approximately as successful against us as Barnes & Noble was against Amazon,” Hastings told investors in early 2004. “Until we are sure, however, we plan to watch them closely.”
After enduring three years of reflected disgrace from the dot-com bust, Internet stocks had rotated back into favor in early 2004, and Netflix was suddenly the darling of the postbust era. Its share price had risen nearly 400 percent, and its steady average revenue growth of more than 100 percent each year was starting to attract attention.
Even though they’d had no real competition since launching the subscription plan, Netflix had nevertheless continued smoothing out kinks in its subscription business and was pushing ahead in all areas: consumer satisfaction was high; cancellations were low; and finally the service was being noticed by regular Americans, who were signing up at a clip of nearly three thousand per day. The potential online rental market was huge, maybe as large as twenty million subscribers, based on the penetration they were seeing in their first market, the San Francisco Bay Area, where more than 5 percent of residents were members, Hastings told investors.
In early 2004, Hastings and McCarthy boasted that Netflix would more than double its revenue in 2006, reaching $1 billion a year earlier t
han they had predicted. They announced plans to expand internationally—to the United Kingdom and Canada—and to present consumers with a movie download service in 2005.
Kilgore added television commercials to their marketing plan for the first time in early 2004, and subscriber sign-ups went through the roof. Netflix announced a month later that a planned quarterly loss would be three times wider than forecast, because a promotion for a free month of service was proving more successful than expected—more people were trying it out than they had predicted
Netflix’s stock price soared past seventy-five dollars from a low of five dollars in 2002, and investors enjoyed a two-for-one split in February 2004. With the wind finally at their back, McCarthy announced that he would leave Netflix at the end of the year to find his own company to run. Hastings had no plans to step down, and McCarthy, now fifty, had no intention of playing second fiddle indefinitely.
McCarthy wanted to put the company on a solid cash footing before he left, and so he championed raising prices for Netflix’s primary plan—the three-out plan—and investing the proceeds in more inventory and an upgrade for the Web site. He believed the resulting increase in customer satisfaction and decline in cancellations would compensate for subscribers who dropped the service because of the higher prices.
At its launch, Blockbuster Online surely would follow Netflix’s lead and price its plans to take advantage of the boost in profit margins, especially since it faced higher costs to acquire subscribers.
“Why would the business with the higher cost structure start a price war?” McCarthy reasoned. It would make no sense.
In April, Netflix raised the price for the three-out plan to $21.99 from $19.99.
The move seemed to Evangelist like a gift Hastings had handed to him personally. He had, in fact, planned to price Blockbuster Online’s subscription plans the same as Netflix’s, and to give an added sweetener of two coupons for free in-store rentals.
Evangelist was elated by his rival’s mistake: Blockbuster Online’s market research showed that customers balked at paying more than twenty dollars per month for online rental, and below twenty dollars was where he planned to stay.
Blockbuster Online’s Web site was not exactly ready when a test version quietly went live on July 15, 2004—the day Netflix announced its second-quarter earnings—but it amused Evangelist to screw with Hastings and McCarthy, whom he felt had been unaccountably condescending and dismissive of his new service.
The Blockbuster Online team issued sign-up codes for the site for each employee and offered a prize for the person who could recruit the most testers. Cooper ended up winning after the e-mail he sent out to friends touting the arrival of his “baby” went viral.
By the time their earnings call ended that afternoon, Netflix executives had discovered the Blockbuster Online beta site and began logging onto it. Cooper and Evangelist laughed when a URL tracing program showed e-mails with Netflix domain names—including [email protected] and [email protected]—signing up for a free test of the service and trickling onto Blockbuster Online for a look around.
CHAPTER SIX
SOME LIKE IT HOT
(2004–2005)
MCCARTHY SAT STEAMING IN NETFLIX’S conference room. The earnings call he had just presided over had ended, and the Netflix team had clicked onto Blockbuster Online’s beta test as soon as it was over.
The site was practically identical to Netflix.com. They had copied it all—the user interface, the back-end functions, even the Queue. McCarthy had to hand it to them—no one at Netflix had perceived Blockbuster Online as a threat. But Netflix was not competing against bloated, slow-moving, technologically inept Blockbuster. Netflix was competing against itself—its own patented business model had been turned against them.
Hastings pointed out that, although Blockbuster had copied the look of the Netflix Web site, they couldn’t see the algorithms underpinning it. Without the ongoing optimization of costs, the matching algorithm, and the market research platforms, Blockbuster Online had only half of the whole picture.
The first thing that happened, as word of the Blockbuster Online beta spread, was that Netflix’s stock price tanked—again. Netflix investors, now enjoying a brief honeymoon, were notoriously wary. In mid-2002, Netflix’s stock dropped to five dollars on the news that Walmart planned to launch an online DVD rental service. When Walmart launched the site in late 2002, and Netflix’s marketing and analytics staff had had a chance to dissect it, they were underwhelmed.
Even before Walmart rolled out its service, at one dollar below Netflix’s subscription price, Netflix had predicted that any entrant into online rental would struggle to replicate the pioneer’s customer experience and functionality.
The tiny graphics, the lack of flow, and the clunkiness of the Walmart site revealed its creator’s failure to grasp the idea that an online store had to be more than an animated catalog—it had to engage customers’ imaginations and spark longings strong enough to compensate for the lack of a tactile shopping experience. The market had apparently reached the same conclusion, and slowly bid Netflix’s stock price back up to past its IPO price, to nearly forty dollars a share by early 2004.
When intelligence reached Netflix’s then chief analyst, Paul Kirincich, that Blockbuster was testing Film Caddy in 2003, he ran market tests to learn whether the little service was affecting Netflix’s adoption rates. The tests detected not even a ripple in the market from Film Caddy, which made it easy to discount Antioco’s announcement in April 2003 that Blockbuster would bring its own service to market in about a year.
“Whenever a competitor says that next year they’ll have a better offering, to me that’s a sign of weakness, because you’re telling competitors what you’re going to do, and you don’t have the service to offer consumers,” Hastings said a few days later.
For all Hastings’s bravado, the market experienced a crisis of faith as soon as analysts took a look at Blockbuster Online’s beta test. A round of selling started the following day that sent Netflix’s share price careening off a cliff and into “sell” status for some analysts for nearly four years. The company lost nearly 60 percent of its market capitalization in a week, as its share price settled back at its IPO level of fifteen dollars.
In ongoing meetings and phone calls with investors and analysts, McCarthy and Deborah Crawford, Netflix’s director of investor relations, explained that the young MBAs from Blockbuster Online faced a seasoned team in McCarthy, Hastings, and Kilgore, and that their new competitor would cause an expensive drain on Blockbuster’s stores’ inventory. It was useless. Most of Wall Street thought they were in denial, or plain stupid. It was exasperating, but a new threat was developing that demanded immediate attention from Netflix’s executive team and its board.
• • •
A COUPLE OF days before Blockbuster Online launched its beta test, Hastings, McCarthy, and others at Netflix heard reports that Amazon had at last taken concrete steps to set up its own DVD rental service. McCarthy heard about it from a hedge fund manager, and chief content officer Ted Sarandos, who liaised with the entertainment industry at Netflix’s Beverly Hills office, learned that studios were in negotiations with the giant e-retailer over inventory purchases for movie rental.
This news alarmed Hastings and McCarthy more than the specter of competing with Blockbuster or any other bricks-and-mortar retailer. Amazon, with thirty-eight million unique visitors flowing through its site each month, had the technological know-how to build a service to equal that of Netflix and the brand might be able to blow them out of the water.
Sarandos said he would try to confirm the somewhat cryptic reports, and for the time being, they decided to watch and wait.
• • •
UNLIKE THE BUSINESS-AS-USUAL attitude that accompanied Netflix’s launch, the debut of Blockbuster Online on August 20, 2004, was an event. Cooper and
Craft organized a movie-themed party in the Granada Theater in Dallas, complete with celebrity impersonators who mingled with guests.
An oversized button sat on a podium on the stage, ready for Antioco and Blockbuster president Nigel Travis to use to officially push the Web site to the Internet. Store personnel mingled with the 180 or so Blockbuster Online employees and Accenture programmers. Cooper, dressed in jeans and a black-and-white T-shirt imprinted with a screen shot of Blockbuster Online’s home page, made sure the program went smoothly.
Throughout the beta test period Antioco and Zine had nervously cautioned Evangelist not to launch the site unless it was relatively bug-free and ready to show to customers. Evangelist assured them everything would be ready—he did not want to miss the start date he had promised Antioco. He did not share some misgivings he had about whether the site would support a huge influx of users.
The lights went down, and Cooper cued up the program. White words appeared on a black background on the theater’s huge screen. A thumping electronic beat accompanied the video.
“‘Blockbuster’s track record in online technology and marketing is less well developed.’—Reed Hastings, CEO, Netflix,” the screen read.
“‘We find it unlikely that Blockbuster will promote their online service effectively.’—Reed Hastings,” a second graphic read.
The crowd booed and made catcalls as the video cut back and forth between famous scenes from macho-themed movies like Rocky, Braveheart, Taxi Driver, and Fight Club. They went crazy as the screen lit up with yet another quote, this one from Antioco: “You have officially awakened a sleeping giant. Now let’s go kick some ass.”
A roar went up, and the video continued, cutting between movies scenes and graphics showing the monumental achievement that Evangelist and his team had put together in six months: six million mailers printed; 750,000 lines of code written; a half million Web pages created; twenty-five thousand titles purchased; fifteen thousand days of labor accumulated; one hundred–plus legal contracts signed, ten distribution centers created.