by Gina Keating
When the economy fell off a cliff in late 2008 it took Blockbuster’s fragile store revenues with it. Netflix’s subscriber growth chugged along nearly unchanged, inciting analysts to make unwelcome comments about Blockbuster’s poor performance. Keyes first blamed lower store sales and rentals on a poor slate of DVD releases, and then on a slate of hot theatrical releases that stole business from Blockbuster when consumers spent money at the box office instead. In early 2009, Blockbuster notified the Street that it had hired a law firm and an investment bank to explore restructuring options, including a potential bankruptcy, a source said.
Instead of accepting a second overture from Netflix to sell its subscribers, Blockbuster looked to the past for answers. Keyes raised prices for in-store rentals and reinstituted late fees, which he called “a daily rate. . . . We’re very careful not to call it a late fee,” he told analysts. The one-dollar daily rate started accruing after five days and resulted in consumers purchasing a DVD if they kept it longer than fifteen days.
Keyes launched a rental plan called Direct Access that allowed customers to order back catalog titles from the stores and have them shipped to their homes for a five-day rental, in an unconscious resurrection of Netflix’s first business model from more than a decade earlier. Blockbuster had no money to promote the program, and it sank.
Keyes advocated instituting the “vending rental window” proposed by the movie studios: Kiosks, including those of Redbox and Blockbuster, would not be able to buy and rent new titles for at least a month after their release. He aimed to rely on the studios to enforce the windows against his competitors and loaded up on new Christmas releases; then he waited for consumers to stream into Blockbuster stores.
“Certainly the windows, to the extent that they do stick, they help the stores, because it gives the store yet another reason to be and makes them more relevant for the consumer. Frankly, the consumer’s awareness of movies that are one week old, two weeks old, I challenge most of the people on the call to tell me what movies were released last week,” Keyes said.
But the windows did not stick, and Keyes’s plan to profit from new DVD releases that Netflix and Redbox could not obtain in bulk from the studios or wholesalers backfired. Predictably, Redbox and Netflix flouted the studios’ rules and bought the disks from big-box retailers like Walmart, which discounted them heavily over the holidays.
The outlay of money for the unsold Christmas inventory left Blockbuster with a huge earnings shortfall. “We had every reason to believe that December, especially the holiday season, would provide its historic contribution . . . with newly announced studio windows,” Keyes explained.
Kiosk deployment was far behind schedule, with just two thousand units rolled out compared with nearly twenty thousand for Redbox, whose revenue had shot up to $1.1 billion and was growing at 26 percent per kiosk in 2009—far from the “oversaturated” market Keyes had described.
Movie Gallery filed for bankruptcy protection for the second time in February 2010, less than two years after emerging from its 2007 bankruptcy. This time it would be forced to close its remaining twenty-four hundred Movie Gallery and Hollywood Video stores for good. The company’s chief restructuring officer, Steve Moore, told the bankruptcy court the beleaguered chain could not compete in the changing rental landscape. “One of the most significant industrywide factors affecting the company’s performance since the 2007 bankruptcy cases has been the cannibalization of rentals by DVD-dispensing kiosks operated by Redbox, which offer low-priced rentals and convenience,” Moore said.
The following month, Blockbuster, too, began its descent into bankruptcy. It had $1 billion in debt on its books and reported a half-billion dollars in losses. Icahn sold off his nearly 17 percent stake in Blockbuster and left the board. On a conference call with investors, Keyes pleaded with shareholders, bondholders, and creditors to stay the course as Blockbuster tried to recapitalize again in May 2010.
“Netflix is growing really well in a bad economy—the same economy Blockbuster is facing,” Wedbush Morgan Securities analyst Edward Woo said. “You have to wonder how much more patience investors have.”
When Blockbuster’s stock price fell below one dollar, it faced delisting on the New York Stock Exchange. The once-mighty rental chain now consisted of just thirty-five hundred U.S. stores and four thousand kiosks.
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REDBOX OCCUPIED SIX floors in a sleek glass tower in suburban Chicago. A huge electronic ticker board in the lobby showed the number of rentals that customers made each day—usually in the millions—as well as the number of first-time visitors to the DVD vending machines. An electronic map mounted on the wall below displayed a rash of red dots where Redboxes were springing up at supermarkets, airports, and convenience stores across the country at a rate of one an hour by 2010. Parked near the elevators on each floor stood iterations of Lowe’s beloved kiosks, including the one he designed in 1984 and had a Connecticut robotics company build for fourteen thousand dollars.
Shortly after he left Netflix, Lowe went to work as a consultant for a venture that McDonald’s was testing in-house to drive traffic to its fast-food restaurants: a DVD rental kiosk called Tik Tok DVD Shop and an enormous convenience store–type vending machine called the Tik Tok Easy Shop that sold everything from soup and sandwiches to diapers. The twenty feet by ten feet by ten feet convenience-store machines drew crowds when they appeared in six McDonald’s parking lots in the Washington, D.C., area in 2003, but the fast-food giant quickly pulled the plug on the rather ungainly, glitch-prone machines to concentrate on the DVD kiosks. The DVD machines were bright red, and after fruitlessly hiring a branding company to come up with a name, the Tik Tok team decided to call the business Redbox.
Lowe had been almost certain that consumers’ discomfort with being locked into a subscription would hold Netflix’s growth to no more than two million subscribers. He thought there was more opportunity in challenging store chains, which had not lowered their prices even after their inventory costs dropped from sixty dollars per VHS title to sixteen dollars for DVDs.
Most importantly, however, it irritated Lowe that the people at Netflix said no one would rent movies from a machine, and he planned to prove them wrong.
It made perfect sense: Shrink down the bloated real estate costs that Blockbuster and Movie Gallery were shouldering and concentrate on the big new releases that would attract impulse rentals as consumers walked past the machines on their way home from the grocery store or fast-food restaurant.
Redbox’s first test market for McDonald’s was Denver, and Lowe was shocked to see Blockbuster make the same mistake it made with Netflix. It ignored the kiosks that sprang up in 140 McDonald’s restaurants across the city. That neglect allowed Lowe to tinker with his pricing and product mix completely unchallenged by Blockbuster throughout 2004 and into 2005.
In early 2005, McDonald’s decided to exit the kiosk business, realizing, as one executive told Lowe, that late founder Ray Kroc would roll over in his grave at the revelation that McDonald’s was peddling R-rated movies at its restaurants. Redbox convinced McDonald’s to let it keep the revenue from its eight hundred or so kiosks in a half-dozen markets. Then Lowe and McDonald’s’ strategy executive Gregg Kaplan went to seek $30 million in funding from another big investor. Lowe’s first two stops: Netflix and Blockbuster.
Blockbuster stores had belatedly pushed back against Redbox’s Denver test by offering a ninety-nine-cent one-day rental that turned into a four-dollar rental if customers didn’t return the DVD the next day. So Lowe figured Blockbuster executives considered the kiosks a competitive threat. He called Shepherd at Blockbuster and explained that Redbox wanted to sell half the kiosk company for $30 million. Was Blockbuster interested?
Shepherd turned him down flat.
Lowe tried again: “This is the second time I’ve talked to you guys about an investment,” Lowe said. That
was as far as he got. Shepherd had hung up the phone.
(Shepherd does not recall this conversation with Lowe, but he says he participated in 2006 talks with Redbox over a joint venture that never materialized, because of Redbox’s apparent lack of interest.)
Lowe had kept Hastings apprised of his new business, and he and Kaplan met with the Netflix CEO several times about investing in Redbox. While Hastings seemed increasingly interested—especially after Redbox expanded nationwide—he hinted that McCarthy and Kilgore disliked the idea and preferred to spend their capital on streaming.
When Blockbuster’s Total Access program surfaced a year or so later, the two companies again discussed teaming up on a hybrid Redbox-Netflix offering but could not agree on how it should be structured.
The rejections by both rental companies and the venture capital community in 2005 stung, because Lowe and Kaplan knew there was a waiting market for Redbox. Lowe remembered a guy he had met during his Netflix days who worked at a vending machine company named Coinstar. The Bellevue, Washington–based company, which took its name from the army of coin-counting machines it installed in supermarket lobbies, had since expanded its reach into other types of vending machines. It purchased about half of Redbox for $32 million in 2005 and bought the remaining stake from McDonald’s four years later for around $175 million.
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AT FIRST LOWE and Kaplan assumed Redbox would attract the young affluent males who were Netflix’s early adopters, because customers had to have a credit card to use the kiosks. But the fluke placement of a kiosk at a Smith’s grocery store in a low-income Las Vegas suburb showed them otherwise. The machine unexpectedly rented two or three times the number of disks of any other Redbox kiosk. Lowe stationed staff members in front of the machine, and others in well-to-do areas, to interview customers to find out what was going on.
Those surveys revealed that affluent grocery store customers were nervous about putting their credit cards into the machines and viewed the one dollar price with suspicion—it was too low. But for the poorer patrons the one dollar rental was so compelling that they were less concerned about credit card security.
As a result, Redbox reconfigured its kiosk placement to low-income areas, and as the brand became better known, more prosperous customers came along as well. Redbox fended off challenges from other small vending competitors with the help of Coinstar, whose relationships with grocery store chains opened doors that Lowe and Kaplan had been pounding on without success. Once they had taken out rival kiosk chains, Redbox set its sights on Blockbuster, and by 2007, Redbox kiosks outnumbered Blockbuster stores.
The store chains were not the only companies affected by the rise of rental kiosks. Netflix and Hollywood studios had both started seeing an alarming dent in revenues as a result of Lowe and Kaplan’s creation.
“The long-term effects of ubiquitous one-dollar new release DVD rental are not positive for us or the industry as a whole,” Hastings told investors in 2009.
The studios had been clamoring for a window of twenty-eight days or more to let them sell new DVD releases before rental outlets began offering the titles. In exchange, the studios would not try to block sales of the new titles, and would offer incentives to the rental companies, in the form of lower costs on bulk purchases of new titles.
New releases comprised Redbox’s entire business, and Lowe fought the proposal strongly, but more than 70 percent of Netflix rentals were older titles. Hastings was all for the windowing deal.
“The advantage to taking the windowing deals is cost savings. Warner has given us a huge number of copies up to the twenty-ninth day at a very attractive price, so we are able to fulfill all of the consumer demand, and then we are able to use those savings to pour that into more streaming,” Hastings said in late 2009.
Consumers had embraced instant streaming; within eighteen months of its launch, half of Netflix’s subscribers were using the feature to watch movies and TV shows, and Hulu, YouTube, Amazon, and Apple’s iTunes were quickly filling in gaps in Netflix’s catalog by offering newly released titles for sale and rental as downloadable video files.
The online video services provided “drops of water in an ocean of viewing,” but they were competing for the five hours a day of U.S. householder viewing time alongside cable, satellite, and telecoms, Hastings said. One day Netflix would become one of the studios’ and networks’ largest customers—a fourth option, representing Internet television, he said.
Netflix, Facebook, and YouTube were forerunners of television for the Internet generation, as Hastings saw it. He envisioned personalized and portable applications featuring content shared and promoted through social networks replacing the standard channel grids with the scheduled programming that populated cable, satellite, and telecoms’ video products. Hastings and his team viewed the cable bundle as a sort of latter-day record album that would be torn apart and shopped to consumers as pieces of programming by the video equivalent of iTunes.
While Netflix reached for bigger content deals and a slice of online video profits, Hastings publicly tried to mollify threatened cable and satellite operators and telecoms by linking the rise in online streaming to a corresponding bonanza in higher-margin broadband services. “As we see it, the growth of Internet video is likely to boost overall cable profit,” he said, on a conference call with investors.
Netflix had to work hard, as a new player in the content game, to amass its streaming library, at first picking up shows piecemeal, as it did with Comedy Central’s South Park, and then striking deals for bundles of shows, such as the Disney–ABC Television Group’s prime time hit shows Lost, Grey’s Anatomy, and Desperate Housewives, as well as popular Disney Channel kids’ shows.
Every year the deals got a little better, although Netflix still was not part of the decade-long distribution agreements for home entertainment. Doubts about the long-term growth of online video were so pervasive that Netflix was able to strike a deal with pay-TV channel Starz for streaming rights to its films for two years for a paltry $25 million. The licensing agreement for Starz’s roster of top-tier movie titles gave the instant streaming service legitimacy as a content provider equal to cable but at a fraction of the price. A similar deal with NBC Universal, for a deep selection of hit and classic television shows, including making Saturday Night Live available the day after it aired, came just as cheaply.
Hastings made it known that Netflix had cash to spend for TV shows, movies, and straight-to-video content, but the overtures to studios and other content owners went unnoticed.
The dam finally broke with the signing of an $800 million, five-year licensing agreement for new releases and library titles owned by EPIX, a pay-television service owned by Paramount Pictures, Lionsgate, and Metro-Goldwyn-Mayer. The remarkable price tag—reported as “close to $1 billion” in the trades—had potential licensors flowing into Netflix’s Beverly Hills offices to talk about their online video strategies. Those in the movie industry—directors, actors, writers, and other artists—wanted to discuss their share of online video revenues. Suddenly, everybody was paying attention.
By 2010, the studios and cable operators realized they had invited a Trojan horse into their midst. Netflix was hardly the size of a regional cable carrier when it obtained the Starz and NBC Universal deals. Two years later its subscriber base rivaled that of Comcast, the largest U.S. cable operator.
“The problem is that Netflix is not the company we thought it was when we started doing these deals a few years ago, it has changed,” a studio executive told Reuters anonymously in late 2010.
To make matters worse, the first-ever decline in pay TV subscriptions ignited a debate about whether recession-weary consumers were canceling their pay TV services to watch videos online via Netflix and other Web-based sources.
Ted Sarandos maintained, however, that Netflix was “absolutely complementary” to cable.
/> When the Starz and NBC Universal contract came up for renewal, the price tags had ballooned to hundreds of millions of dollars, and studios were adding restrictive conditions, in an effort to protect eroding DVD revenues. Sony and Disney yanked popular movies from Netflix’s streaming lineups unexpectedly, after the titles reached caps on the number of subscribers that could view them.
Analysts began worrying about the overhead associated with multiyear content deals and noted that larger competitors entering online video delivery, such as Amazon and Google, had much deeper pockets for buying content. “Netflix is merely a conduit,” Wedbush Morgan analyst Pachter said. “The big boys will take a share of subscribers or bid up the cost of content. Either way, Netflix loses.”
At Marathon Partners, Cibelli knew it was time to sell his Netflix stock. With its stock price at two hundred dollars, and cable outlets treating Netflix like a real threat, it was clear to Cibelli that the online rental company had taken its place in the entertainment industry establishment. He made his money on contrarian bets, and Netflix was no longer an outsider. The risky little company he had backed six years earlier had become a sure thing.
Data showing that Netflix originated six out of every ten digital movies streamed, and accounted for 20 percent of U.S. broadband traffic, brought the service unwelcome attention from broadband providers and cable operators, who downplayed the rental company’s influence. “It’s a little bit like, Is the Albanian army going to take over the world? I don’t think so,” Time Warner chief executive Jeffrey Bewkes told a media industry conference hosted by financial services group UBS that turned into a gripe-fest about Netflix. In another interview, Bewkes denied that the subscription streaming service was a threat to Time Warner’s HBO movie channel. “I would say it (Netflix) is like a two-hundred-pound chimp. It’s not an eight-hundred-pound gorilla,” Bewkes told CNBC’s Julia Boorstin.