Netflixed

by Gina Keating

  Blockbuster spokesman Randy Hargrove shot back on Antioco’s behalf, saying that the value of the stock grants and options, which made up most of the package, depended on the CEO remaining at the company and resurrecting the stock price. Antioco publicly called out Icahn for attempting to discredit Blockbuster’s management with investors in order to press his own agenda for a payoff. Antioco warned that threats of a proxy fight would distract the company from the battle it faced to retain customers, potentially throwing away tens of millions already spent on new initiatives.

  “The turmoil and uncertainty you have created threatens to destroy the organization, jeopardize our success and could prove damaging to shareholder value,” Antioco wrote in a letter to Icahn that he filed with the SEC.

  Just one month remained before Blockbuster’s annual meeting in Dallas, and Antioco turned to protecting his company and his job from Icahn and his followers.

  In Los Gatos, McCarthy and Hastings watched with interest. Their hope for a speed bump to derail Blockbuster Online had been answered.

  CHAPTER EIGHT

  KICK ASS

  (2004–2005)

  IT WAS CLUNKY AND PLAGUED with software and inventory problems, but in its first three months of operation, Blockbuster Online captured more than half of all the subscribers who were signing up for online rental for the first time. The two-dollar price difference helped divert traffic from Netflix, but persuading subscribers to stick to Blockbuster’s service beyond the free trial period would prove challenging in the shifting competitive landscape that both companies faced in 2005.

  Netflix felt the squeeze in new sign-ups almost immediately, but Hastings and McCarthy had bigger problems claiming their attention at almost exactly the moment Blockbuster Online launched. The rumors about Amazon entering their marketplace had grown louder over the summer of 2004, and then, in late September, proof surfaced that there was something behind them.

  Jeff Bezos had seen forecasts that DVD sales would erode in a pattern suspiciously similar to the way music sales fell off with the advent of Apple’s iTunes store. Like big-box retailers, Amazon was reaping healthy profits from DVD sales and wanted to protect that business until digital movie delivery became as lucrative as iTunes had become with music. Even though Amazon did not have a distribution system that could match Netflix’s speed, it had all the ingredients it needed to run a DVD-by-mail service until digital delivery became a reality.

  In late September Ted Sarandos, Netflix’s chief of content acquisition, delivered solid proof from his studio contacts that Bezos was just three to six months away from launching a competing service, using his existing distribution centers. Amazon had purchased reader sorters to process the mailers and was close to completing deals to buy inventory from the movie studios, his sources in the industry said.

  In early October 2004, venture capitalist and Netflix investor John Doerr set up a phone call between Hastings and Bezos in the hope that the two CEOs could reach a business arrangement that would keep Amazon out of their market. But the negotiations stalled a week later over Amazon’s demands for steep fees for referring would-be renters to Netflix. “I talked to Bezos,” Hastings told his executive team. “There is no working together that makes sense.”

  McCarthy scheduled a series of marathon board meetings for the following three days to come up with a strategy to either drive off Amazon or find a way to survive its challenge.

  The company’s major investors were incredulous and angry. How did Netflix not know Amazon was coming, some asked. The stock price surely would collapse again, others said. How could you do this to us?

  Netflix’s executive team began working from the supposition that Amazon would come in at a cheaper subscription price to try to spur sign-ups among its six million daily users, so they decided to carry out the most brutal price cut they could afford. Hastings told Kilgore and her team, and Kirincich, who modeled Netflix’s financial forecasts in McCarthy’s office, to figure out how low they could go on the monthly subscription price and still fund their marketing plan. Because Kilgore’s husband worked at Amazon, they spent a weekend at Kirincich’s house running numbers. On Monday they returned with a proposal to cut the three-out subscription plan by 18 percent, to $17.99.

  Less than a week later, on October 14, 2004, Netflix tucked the news of the price cut into the bottom paragraph of a news release detailing its third-quarter financial results. Hastings divulged to investors and the media on a conference call an hour later that the new price, effective November 1, was intended to position Netflix for Amazon’s imminent entry into the U.S. online rental market.

  In a curt nod to Blockbuster Online, he acknowledged that the business environment had become increasingly competitive, but he barely mentioned that newest player in the space. McCarthy announced that he would abandon his plan to leave Netflix at year’s end. He would instead stay on as CFO for at least two more years, and possibly indefinitely, until Netflix had weathered the competitive squall.

  “There are very few challenges as exciting as the one we face, if in fact Amazon enters the marketplace,” McCarthy said. “This is going to be epic, and it will be part of the lore of Silicon Valley.”

  “Besides,” he added later, “you don’t leave your friends in the middle of a knife fight.”

  After spending $10 million to open offices and a distribution center in the United Kingdom, Hastings decided to postpone the international expansion for at least a year, reasoning that he did not want a two-front war with Amazon, which had already launched its UK online rental service.

  The raft of bad news sent the company’s stock price sliding again.

  “Look, everyone, I know the Amazon entry is a bitter and surprising pill for those of you that are long in our stock,” he told investors on the earnings conference call. “This is going to be a very large market, and we’re going to execute very hard to make this back for our shareholders, including ourselves.”

  Then Hastings laid out a scenario at once alarming and exciting: If Blockbuster and Amazon matched or beat Netflix’s new eighteen-dollar price, video stores in America would be vacant within a few years. The $8 billion in U.S. store rentals would pour into online rentals, setting off a grab for subscribers, he said. The ensuing growth of online rentals would cannibalize video stores faster and faster, until they collapsed.

  As video store revenue dropped sharply, Blockbuster would struggle to fund its online operation, he concluded. “The prize is huge, the stakes high, and we intend to win.”

  • • •

  AT THE PARAMOUNT Building, Evangelist listened rapt as Hastings laid out his plans, wondering how Blockbuster Online should respond. The call echoed from speakerphones all over the office. A jeer had gone up when McCarthy made his knife-fight comment, and within minutes, one of the developers had photoshopped a knife-wielding McCarthy facing off against a gun-toting Antioco under a headline that read: “This dumb ass thinks he’s in a knife fight.”

  As soon as the call ended, at around 6:00 P.M. local time, Evangelist was on the phone with Antioco. The Blockbuster CEO agreed to come over before having dinner with Shepherd and his thirteen-year-old son, James, at The Palm, a steak restaurant around the corner from the Paramount Building whose walls were covered with caricatures of its loyal patrons, including Antioco.

  By the time Antioco and Shepherd joined them later that night, Evangelist and Cooper had decided to undercut Netflix by fifty cents—a price differentiation that preserved their ability to grow and turn a profit in the foreseeable future.

  Antioco ridiculed the move as a timid half measure—like kissing your sister, he said. He argued for a deep chop—to $14.99—on the theory that their per-subscriber losses would be relatively small but Netflix would be seriously weakened if it tried to absorb the same losses from 2.2 million subscribers.

  Shepherd didn’t think a couple of bucks
would change consumers’ opinions about the online service, and he was worried about the short-term effect of a price cut on Blockbuster’s financial health. But when he half jokingly asked James to weigh in, the teenager agreed with Antioco that a price drop was a great move.

  “The kid says drop the price,” Antioco said. “What are you going to do?”

  He agreed to announce the smaller cut the next day. In Evangelist and Antioco’s nightly conversations during that time they often entertained the idea of trying to pressure Netflix’s share price low enough for Blockbuster to buy it. Evangelist mused that the price war they were about to set off could be just the catalyst needed for such a takeover.

  The next day, Antioco and Karen Raskopf, vice president of corporate communications, made a series of phone calls to reporters at major financial news outlets, including me. As I spoke with Antioco, I pushed a few headlines announcing the details of Blockbuster’s new pricing plan to Reuters’s financial wires and watched as Netflix’s shares tumbled.

  “We were growing our business at a very nice clip but would not have elected to lower our prices,” Antioco told me, clearly enjoying himself. “Having said that, we are determined that we are not going to be beaten from a price-value perspective.” I hung up the phone and quickly called Netflix to get a reaction to what had turned into a price war. I was connected with Sarandos. After I explained why I was calling, a surprised Sarandos was silent for a moment.

  “Do you have any comment?” I asked him again.

  “We have to digest this a bit before we can make a comment,” he said, sounding shocked.

  McCarthy and Hastings had miscalculated badly, first by ignoring the threat posed by Blockbuster Online, and then by expecting Antioco and Evangelist to enter the online market in a way that made sense to Netflix. Since they also had failed to anticipate the Blockbuster chief’s answer to their price cut, the Netflix team turned to what it understood—numbers—to find a way out of the price war they had set off.

  Blockbuster Online was essentially Netflix in a time warp and would experience the same growth and usage patterns, they reasoned. McCarthy tasked Kirincich with modeling Blockbuster Online’s business and growth trajectory using subscriber metrics they had gathered from Netflix’s operations over the years—data that Evangelist had no way of knowing. Kirincich also created a financial model of Blockbuster’s store operations to test the effects different price and spending scenarios in the online business would have on Blockbuster stores’ balance sheets.

  Since Blockbuster stores would have to fund the online business until it could break even—at about two million subscribers—it was critical to understand how many marketing dollars Antioco could put behind Blockbuster Online before he started to have budget problems. The $1 billion debt that Blockbuster had taken on in the Viacom split-off put a time limit on how long they would have to wait out Blockbuster Online if it continued to spend on marketing and price cuts, he told Hastings and McCarthy.

  Among the advantages Netflix enjoyed were lower costs—they spent less to attract and keep subscribers, as their base aged, and on operations, which improved over time as the novelty of the service wore off and subscribers watched fewer films. Blockbuster would spend more to get its subscribers, who would turn over more quickly, and to service them for the first nine months or so, before their demand for movies flattened out.

  Netflix’s data also showed that an online service had to maintain a minimum level of marketing to attract enough subscribers to replace those who canceled. Cut advertising and public awareness campaigns below that magic number and the base would melt away.

  McCarthy and his team believed that by running different price scenarios they could pinpoint exactly when Blockbuster would have to back off its marketing spending for the online service or risk violating its debt agreements with its lenders.

  Another piece of luck fell into their laps fairly early in the battle that proved crucial to Kirincich’s models. A Netflix investor pointed out to Dillon that Blockbuster Online assigned sequential account numbers to each new subscriber, and those numbers appeared in the bar codes on its mailers. By having Netflix employees and their family members sign up for Blockbuster Online on a regular schedule—say, once a week—and noting down their customer numbers, Kirincich could calculate how effective its spending on marketing was, how quickly its base was growing, and how many movies the service had to ship. All of this data added up to the burn rate—how fast the online business was going through the budget provided to it by the store business. Kirincich believed that at the rate Blockbuster Online was growing, Antioco would be forced to back off, or possibly suspend marketing activities, by the second quarter of 2005.

  The intricacy of their models and the accuracy of McCarthy’s forecasts in the past made Hastings fairly comfortable about sticking to the pricing and spending plan they had announced in October. Their forecasts showed that Netflix’s growth was still moving in the right direction, just a little more slowly with Blockbuster Online in the mix. Since only 20 percent of consumers were able to identify the Netflix logo, the company had plenty of room to grow. Blockbuster’s ads were raising awareness of online rental, so the market would expand faster than they had anticipated.

  They were still on course to finish 2004 with 3 million subscribers, and to add another 1 million in the coming year. Their models showed a base of at least 5.65 million subscribers in 2006—surpassing what market research had once said was the size of the entire online rental market.

  A few days after the price war began, Hastings decided to approach Walmart chief executive John Fleming to see about joining forces to attack Amazon, which had become a Walmart competitor in a growing number of product categories. At an October 27, 2004, meeting he offered to refer subscribers to Walmart for DVD sales, with Walmart reciprocating by recommending Netflix for DVD rental. For all the fanfare of its launch, the Walmart site had managed to attract only about sixty thousand subscribers, and was not growing enough to dent Netflix, even at $4 a month less. Shortly after Blockbuster dropped its rates, Walmart cut its prices below both services, to $17.36 per month.

  Hastings also wanted to gauge whether Fleming was open to a possible offer from Netflix to buy Walmart’s meager subscriber base. The talks that night went nowhere, mainly because Fleming was trying to negotiate a partnership with Yahoo! in hopes of making the subscription business work.

  As luck would have it, a young Netflix executive ran into a female acquaintance who worked for Walmart.com at a San Francisco Bay Area music venue. The two often joked about the rivalry between their two companies. One night the woman told him over drinks that Walmart’s online service had little support from its corporate parent. Armed with this information, Hastings dug in to wait, and kept lines of communication open with Fleming.

  • • •

  AND THEN, ANTIOCO ratcheted up the pressure on Netflix again.

  In late autumn, Cooper brought Antioco a plan to test a Blockbuster Online television spot in a few markets to see what effect it had on sign-ups compared to other advertising channels. They agreed to shoot two different commercials—one that Cooper and Evangelist liked and the other recommended by the ad agency for Blockbuster stores—and decide which explained online rental more clearly.

  When he viewed the ads in the first week of January, Antioco loved the one Cooper had storyboarded so much that he decided to dispense with testing it.

  “Let’s run this on the Super Bowl,” he told a surprised Cooper and Blockbuster’s media buyer from Camelot Communications. “This is great, and we need to do something big. Forget the test market. Let’s go with it.” The spot featured a man who tells his wife he’s going to return a movie and backs his car to the end of the driveway to put a Blockbuster Online envelope inside the mailbox. The spot was a perfect vehicle to rectify something that was still annoying Antioco—the price for the three-out plan. He
wanted it cut to $14.99.

  Following through on Antioco’s directive, they purchased relatively economical ads that ran before the coin toss and after the last play of Super Bowl XXXIX on February 6 between the New England Patriots and the Philadelphia Eagles. Cooper and his wife, Jess, stayed home to watch the game without interruption. Shortly before the kickoff, Cooper’s BlackBerry buzzed with the hourly subscriber report—two hundred sign-ups. At the hour after the first ad ran, the number was up to nine hundred. The Darth Vader ring tone emanated from his BlackBerry seconds later.

  “Are you seeing this?” Evangelist asked. “This is big.”

  Cooper was cautious. “Let’s wait and see what happens next hour,” he said. When his BlackBerry chimed next, Cooper could hardly believe it—two thousand subs. The number kept climbing. Evangelist was ecstatic. That day, Blockbuster Online signed up about nineteen thousand subscribers—nearly four times their daily average. The next day, more than twenty thousand subscribers signed up.

  The ad, which ran for several weeks, bestowed the double benefit of boosting customer awareness of the program and convincing skeptical business development partners that Blockbuster was serious in its bid to catch Netflix.

  Hastings agonized over whether to drop prices further to meet Blockbuster’s $14.99 holiday price cut, but McCarthy steadfastly objected. With Blockbuster losing even more on every subscriber, relief from its advertising juggernaut was even closer at hand. Kirincich checked his models again—and the outcome was the same. Blockbuster would have to raise prices by summertime. Because Netflix was still growing solidly, McCarthy wanted to sit tight and wait until the inevitable happened.