by Scott Fearon
The potential mergers of Blockbuster with Hollywood Video and Circuit City were hailed for their potential “operational synergies.” Over the years, I have learned to watch out for the word synergies when two troubled businesses combine. Recently, it’s been bandied about over and over again as money-losing media companies have been consolidating with each other. In 2010, media mogul Barry Diller acquired the moribund Newsweek magazine and merged it with an unprofitable news and gossip website called The Daily Beast, citing—you guessed it—potential synergies. Three years and millions of dollars in losses later, Diller cried uncle and divested himself of Newsweek.† I’m not saying mergers can’t be beneficial. But all of the synergy in the world cannot replace the lifeblood of any business: growing revenues.
The real tragedy of Blockbuster’s history is that it almost escaped its fate. For a little while after Icahn took over, its Total Access online service managed to slow Netflix’s momentum. But without late fees and per-movie charges, it was never going to be profitable for the company—not with the burden of thousands of store leases and tens of thousands of employee salaries to pay. But instead of closing as many stores as they could to cut costs and putting everything they could into its online presence, Blockbuster’s leadership went backward and decided to turn its stores into glorified candy racks.
I am definitely not trying to bash Carl Icahn. I have a lot of respect for him. But as he has admitted, he blew it big time at Blockbuster. The only way it was going to survive was by adapting to the fact that people weren’t going to get in their cars and drive several miles to a store just so they could overpay to rent movies anymore. Instead, he wagered that people would continue to drive several miles to overpay for movie rentals if they could also buy candy and magazines and video games—or maybe a cheap flat-screen TV—at the same time.
Blockbuster Redux
I’ve read varying reports on exactly how much money Icahn lost on his Blockbuster investment. Some media outlets put the figure at over $300 million. The Wall Street Journal said it was more like $185 million. Either way, there’s no doubt that he took a major hit. Icahn himself called it the “worst investment” of his career.
In 2012, Icahn tried to gain control of Netflix. After trying to split its DVD-by-mail business, Blockbuster’s once-thriving rival had hit a rough patch. In just fifteen months, Netflix’s stock price had tumbled from over $300 to less than $60. That’s when Icahn started buying up every share of Netflix he could, professing that he could help turn the company around. Netflix’s directors, no doubt remembering the debacle at Blockbuster, quickly passed a “poison pill” stock agreement that raised the cost of shares for anyone who acquired more than 10 percent of the company.
Icahn’s reaction to the move reminded me of why I decided not to short Blockbuster: “If they want to go to war, then we’ll go to war.”*
*Greg Bensinger and Anupreeta Das, “Icahn vs. Hastings: The Fight for the Future of Netflix,” Wall Street Journal, November 14, 2012.
Compare these desperate attempts to cling to Blockbuster’s antiquated business model with the way Netflix, its onetime chief nemesis, has evolved. The entertainment delivery sector is so fast moving, Netflix’s DVD-by-mail method was already well on its way to obsolescence before Blockbuster went Chapter 11. Netflix’s management recognized this and reacted proactively. Unfortunately, they were almost too aggressive in switching to streaming movies and television shows online. Like JCPenney’s leadership, Netflix infamously fired their customers when they suddenly spun off the company’s DVD service and jacked up prices. After losing hundreds of thousands of subscribers in a matter of weeks, Netflix quickly reversed this misstep and transitioned to the new platform more gradually, which allowed the company to keep its market share and compete with big new players like Amazon. Netflix also began producing its own original content.
Tanks? What Tanks?
There is a famous story from the invasion of Iraq in 2003. Standing out on the streets of Baghdad, some reporters asked Iraqi information minister Mohammed Said al-Sahaf—better known in the West as Baghdad Bob—if US forces had crossed into the city. Mr. al-Sahaf scoffed and declared, “There are no American troops in Baghdad!” just as a column of M1 Abrams tanks appeared behind him.
When I first heard that story, I couldn’t help but think of the executives I’ve interviewed over the years who have assured me their companies are doing just fine while the walls are almost literally coming down around their ears. If anything, Angelika and the rest of the Blockbuster crew seemed proactive in comparison to some of these folks. At least they tried to do something with their retail idea, even if it was misguided. You’d be surprised how rare that kind of initiative is at failing companies whose industries have left them behind. Most of the time, the best people can do in that situation is come up with Baghdad Bob–style denials of reality.
I remember the CFO of another Dallas-based company called PageNet (stock symbol: PAGE) spending a solid hour trying to convince me that pagers would continue to be a profitable business. This was in 1999, several years before the advent of smartphones but well past the time when it should have been obvious that cell phones were going to make beepers historical relics. And yet to hear this executive talk, pagers were the coolest must-have gizmos of the new millennium. They were more lightweight than portable phones, he told me; they had longer battery life, and they were cheaper.
“Our newest model is the size of a matchbook,” he boasted, digging one out of his pocket and presenting it for my inspection. “We see incredible opportunities for expansion in developing markets. Asia, Africa, and Latin America are all prime new areas we intend to pursue aggressively.”
“But cellular technology is getting lighter and cheaper, too,” I said as I handed the beeper back to him. “Why won’t phone companies be able to expand into those markets at the same time as you do?”
The CFO gave me a blank look, then switched to a more scattershot technique, peppering me with a series of dubious rationales. Doctors and other busy professionals would always prefer pagers to phones, he claimed. People could send and receive text messages with new two-way pagers. And pagers generally had better penetration in buildings and other indoor spaces than portable phones.
“We understand that many people will likely adopt cellular technology in the coming years,” the CFO conceded as our meeting neared a close. “But we’re confident that consumers will continue to use pagers so that they can enjoy the added convenience of returning calls on their own time.”
Now it was my turn to give him a blank look.
“Are you saying you expect people to carry both a pager and a cell phone?”
“Absolutely,” the CFO replied with an emphatic nod. I began to get the distinct impression that he was working to convince himself of this as much as me. “We have conducted a number of marketing surveys that have shown many people who own both cellular phones and pagers prefer to give out their pager number while keeping their phone number private. That way, they can screen any incoming communications and return only the calls they want to return. Like I said, it is an added convenience.”
I suspected at the time that PageNet’s CFO was beginning to doubt his own arguments. At least, I hope that’s the case. He seemed like a perfectly intelligent, rational person. I’d like to think he could see the gaping holes in what he was saying.
For one thing, how does having to keep track of two different wireless devices count as an added convenience? And he and his colleagues at PageNet couldn’t have been unfamiliar with the fact that cell phone companies were already offering text messaging and Caller ID as standard features of nearly every calling plan. Why would someone buy an entirely different device to send texts when they could already do so with their phone? And why would they give out a pager number to screen their calls when they could just look at the readout on their phone and decide whi
ch calls to take and which calls to let go to voice mail?
The next morning, I shorted PAGE. For good measure, I also shorted the only other publicly traded paging company still clinging to life at that point. Within two years, they had both gone to zero.
Major secular shifts like the switch to mobile phones and online movie delivery aren’t the only ways businesses get left behind. Far more subtle changes in consumer behavior or industry practices can be just as deadly if a company’s leaders cling to old strategies and fail to adapt. In 2005, I flew to Denver to visit the headquarters of a chain called Ultimate Electronics (stock symbol: ULTE), which specialized in high-end audio equipment and helpful, knowledgeable staff. Ultimate was a haven for audio and video connoisseurs. By the time I flew in to check it out, it was also on the verge of going broke. It had been able to survive longer than most consumer electronics businesses because it had offered specialty equipment that its competitors couldn’t, or wouldn’t, stock. But the bigger chains had caught on to Ultimate’s game. They’d started to sell that same gear for lower prices. Not surprisingly, in the years prior to my visit, Ultimate’s revenues had dropped and its debt levels had mounted.
I sat down with the company’s chief financial officer, who had just moved out to Denver from another soon-to-be bankrupt electronics chain in California called The Good Guys. The first thing I asked him was how Ultimate was going to compete with Best Buy, Costco, and the other larger big-box retailers. His answer was about as convincing as the CFO of PageNet, claiming that people would shell out good money for both a pager and a cell phone.
“Our founder started this company so that he could serve people who loved electronics as much as he did,” the CFO replied. “He wanted to help them find the best quality brands in the world. It was his passion and it still is. And people still value that kind of expertise and service.”
“But these days, Best Buy and Costco have a lot of the same brands that you carry,” I countered. “And they’re able to sell them for a lot cheaper.”
“But they don’t offer the knowledge and the personal touch that we do. Our sales teams work with our customers to make sure they get the absolute top equipment on the market. It’s right there in our name. We want to give people the ultimate best.”
I thanked him and strolled back to my rental car. I didn’t need to hear anymore. The next day, I shorted the company’s stock. I could see that Ultimate’s management was badly misreading the market and refusing to revise their clearly outmoded approach. Just because the founder wanted to help people find good merchandise didn’t mean those people were going to pay a premium for that service—not when they could drive down the street and get the same stuff for 10 or 20 percent less!
Put simply, for almost anything more expensive than small luxuries like Starbucks coffee, most Americans shop on one thing and one thing alone: price. This is especially true when you’re talking about retailers selling identical products. If you’re stocking the same brands as your competitors and they’re selling them cheaper than you are, you’re dead. You can have the kindest, most solicitous salespeople in the world and you’ll still have empty stores. Even affluent people who are willing to pay a lot for top-of-the-line brands like a good bargain. They’ll even push a rickety shopping cart through a giant warehouse store to get one. The guys at Costco figured this out, and that’s why they’ve done so well. But Ultimate’s brass refused to face this fact. They wanted to believe that consumers would sacrifice a deal for convenience and for expert help. That was a fatal delusion. The company filed for bankruptcy less than a year after my trip to Denver.
B Is for Bankrupt
The worst Baghdad Bob–esque pitch I’ve ever heard from an executive clinging to a dying industry came from yet another Dallas-based firm. I already mentioned it in chapter 2, about the dangers of relying too much on formulas. In late 2008, I interviewed the CEO of one of the two remaining publicly traded Yellow Pages companies. His name was Scott, and at that point his company was called Idearc. As I said in that chapter, its headquarters were in the old Braniff Airlines buildings in the middle of Dallas–Fort Worth airport. Floor-to-ceiling windows in Scott’s office looked out on airliners as they taxied out for takeoff and screamed down the tarmac.
It was a weird setting for a weird meeting.
Scott was a tall, hard-charging guy with wavy hair and a natural salesman’s charismatic smile. We bonded for a moment over the fact that we not only shared the same first name, we’d also both lived in Palo Alto, California, and Evanston, Illinois—I as a student at Stanford and then Northwestern, he in his former job as a venture capitalist. After those pleasantries, Scott proceeded to inform me that Yellow Pages were not only going to survive, they were going to thrive.
“In five years, we’ll be making more money than we’re making right now,” he predicted. “First we’re going to cut costs and invest in our new website. Then, once we’ve got our costs under control, we expect revenues will stabilize and we will return to profitability.”
I had checked out the company’s website before the meeting, and I had been less than impressed with it. It was little more than a digital copy of the old-fashioned paper version of the Yellow Pages. I couldn’t figure out why Scott and his colleagues thought users would go through the extra trouble of logging on to their site, then conducting their search for a plumber or a pizza delivery place or whatever else they were looking for. Why wouldn’t they cut out the middleman and just use Google or Bing or Yahoo! or any other search engine? When I asked Scott about this, he didn’t seem terribly concerned. In fact, he was downright blasé about their transition to the web.
“We expect some adoption of our online services, somewhere in the 10 percent range. But our bread and butter will always be our traditional books.”
I had to let that statement sink in. Behind Scott, a big 747 rumbled by on the way to takeoff. Was he seriously saying that he thought consumers would keep hauling out cinderblock-sized publications just to find phone numbers? Remember: this was late 2008, almost two years after the launch of the iPhone.
“If I said the words Yellow Pages to my son,” I told Scott, “he would think I was talking about a coloring book. Most people under thirty are the same way. So how can you say consumers are going to keep using your printed products? The next generation doesn’t even know they exist.”
“Your son grew up in Marin, am I right?” Scott countered.
“Yes,” I answered. “What does that have to do with anything?”
“Everything. Kids in well-to-do communities grow up around technology. It’s second nature to them. But people in the Bay Area aren’t like people in the middle of the country. People in places like Kansas and Arkansas and Oklahoma, they still rely on our books. And they’re not going to stop. They just do things differently there.”
“Are you saying people in the Midwest are too stupid to use a smartphone or to log on to the internet?”
“Not at all. It’s a matter of habits and what people are comfortable with, that’s all. People trust our brand. It’s what their parents used and their grandparents, too. And local merchants know they have to advertise with us if they want to reach the people in their communities.”
If you’ve read the entire book up to this point, you know that I pride myself on, and have made a lot of money by, knowing what most Americans consumers like and don’t like. I’m not an expert by any stretch, and I’m not always right, but I think I’ve shown a knack for it over my career. I knew Americans were never going to get excited about yacht racing, even if they could watch it from dozens of camera angles on the internet. I knew they were never going to buy take-home cholesterol tests or Rollerblades, either. I’m normally the guy telling executives on either coast about how people in the so-called flyover states are likely to behave. So it was surreal to find myself in the opposite position—especially when the guy lecturing me on w
hat Americans preferred was a former venture capitalist.
“Scott,” I said with a laugh. “Didn’t we just spend ten minutes talking about how you’ve lived in Palo Alto, California, and Evanston, Illinois, for most of your life? No offense, but what do you know about people in Kansas or Arizona or the Texas Panhandle?”
For the first time in the entire meeting, Scott’s smile vanished. We went back and forth for another hour or so as planes continued to taxi by us. Scott really thought he could convince me that people would continue to use the Yellow Pages. After a while, I stuck around for the sheer amusement of watching him continue to try. I only met him that one time, but I can say he was the hardest-working—or at least hardest-talking—executive I’ve ever dealt with. Too bad all that effort was going into a lost cause.
Warren Buffett once said, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”‡ Scott’s tenure at Idearc proved this maxim. He was brought in to reverse the company’s decline, and for a little while, he managed to improve its EBITDA (earnings before interest, taxes, depreciation, and amortization) figures enough to boost its stock price. But in the end, he couldn’t overcome the company’s “poor fundamental economics.” Less than a year after that meeting near the tarmac of DFW airport, Idearc filed for bankruptcy.
I’d like to make one thing clear, in case I haven’t already: I am not sharing these stories to mock or disparage Scott, the CFO of PageNet, Angelika, or anyone else involved in failing businesses. These were not incompetent or dishonest people. They were simply caught up in very bad situations. They made good faith efforts to deal with those situations, but like so many before them and many more to come, they did not succeed. There is no shame in that.
When it comes to pagers or the Yellow Pages, there really wasn’t much else the people at Idearc or PageNet could have done to stave off the inevitable. The march of progress hadn’t just left those industries behind, it had trampled them underfoot. Blockbuster, on the other hand, probably could have saved itself. But it would have taken a radical, and very painful, restructuring to do so. Understandably, not many executives are willing to close thousands of their stores and lay off tens of thousands of their employees, even if that is the only way to keep a company in business. So, like the brass at Blockbuster, most choose more hopeful, less draconian tactics. But in my experience, half measures almost always hasten rather than delay the end.