by Gina Keating
The August IPO was considered successful—just—by raising $465 million at a share price that fell $1 below the $16 to $18 target range. Antioco, now CEO of a publicly traded company valued at $2.6 billion, went to work to put Blockbuster on a strong competitive footing against its emerging competitors, including video on demand and the other U.S. store chains.
He meant to keep his road show pledge to investors that Blockbuster would control 40 percent of the video rental market within three years, up from the 31 percent it served with its sixty-five hundred U.S. stores.
The plan that he used to turn around Circle K had centered on cutting the store count, categorizing areas in the stores to better analyze sales, and cosmetic improvements, such as putting in better lighting, card readers, and canopies over the fueling areas.
Although he had little capital to spend to improve the bankrupt convenience store chain, he had also filled the stores with high-margin food items, such as fountain drinks. Since Antioco couldn’t raise the wages of his severely underpaid Circle K store staff, he used his prodigious charisma to improve morale and rally them around his initiatives.
He and Zine went back to that playbook after the Blockbuster IPO to answer the questions he felt were critical to its future: What are we supposed to be doing for customers? What can we give them that is going to make them come back?
Antioco and Zine had arrived at Viacom at an ideal time. The corporation’s management had tried and failed to solve Blockbuster’s problems, so they gave the two executives a fairly free hand.
Since Fields had been unsuccessful at increasing store traffic by diversifying merchandise—a play that Antioco might have tried—he focused instead on customer loyalty programs such as store memberships and coupon giveaways, and he eyed video game sales, rental, and trading as potential growth businesses.
Under Antioco, Blockbuster also began investing in producing and distributing movies through a wholly owned subsidiary called DEJ Productions, after deciding that the digital future may call for exclusive content like that offered by the premium cable movie channel Home Box Office.
Antioco had mentioned Netflix among potential threats to store-based rental during the 1999 road show but had thought little about the online rental chain since that time. But, in 2001, as Netflix looked sure to surpass five hundred thousand subscribers, and DVD households surged toward twenty-five million, he took another look.
He devised an in-store subscription offer to counter Netflix—an unlimited number of movies, two at a time, for $29.99—and enlisted Blockbuster’s cartoon mascots, Carl and Ray, for television ads. Blockbuster wrapped the buses in Netflix’s Los Gatos hometown as part of the advertising campaign. Netflix—still unrivaled online—was thrilled to be publicly acknowledged as a threat.
“Blockbuster is about a hundred times bigger than us, but they’re coming after us,” Hastings told USA Today. “They’re definitely out for a fight.”
Netflix struck back a couple of months later with an offer of free service for the consumers who filed twenty-three class-action lawsuits against Blockbuster over what they alleged were unfair late charges. This exchange occurred as a group of young men inside Blockbuster’s business development arm began to agitate Antioco and Stead to address the lack of a plan for online rental.
Despite being painted as technologically inept, Blockbuster actually was further ahead in 2001 than Netflix in realizing Hastings’s utopian rental scenario of movies piped through broadband fiber optics into American homes.
When they rejected Hastings’s offer to buy Netflix a year earlier, Stead and Antioco were already intending to bypass DVD by mail entirely and go right to the big prize—movies streamed directly to America’s televisions from a central server. Besides, they had it on good authority, in the form of a report by media industry analyst Kagan Research, that the universe of online rental contained 3.6 million users, tops. In light of Blockbuster’s now 65 million U.S. account holders (and 100 million worldwide renters), Stead and Antioco thought the online market was not worth considering.
Gartner analyst P. J. McNealy expressed the prevailing view in a 2001 interview, describing Netflix as a good niche business, but “whether everybody will pay that kind of premium remains to be seen. I don’t know whether Joe Six-Pack is going to shell out $240 a year.”
McNealy set the bar for legitimacy at one million subscribers—or 1 percent of U.S. households—for Netflix. “That’s a goal, but they’re not there yet,” he said.
Antioco had cut a $50 million deal in 2000 with network provider Enron Broadband Services (EBS), a subsidiary of the Houston energy conglomerate Enron, to deliver Blockbuster movies into consumers’ homes via a new type of high-speed data lines called DSL, or digital subscriber lines. The twenty-year exclusive video-on-demand (VOD) deal was supposed to commence by year’s end with a selection of five hundred movie titles to which Blockbuster had obtained digital rights.
The high-speed data was to be carried to televisions and PCs over DSLs that Enron could access as a result of its relationships with Verizon Wireless, Qwest Communications International, Covad Communications, TELUS, and ReFLEX. Movies would be priced the same as on cable VOD services. But less than a year later—after completing a three-month trial—the companies broke off the joint venture, with EBS complaining about the quality and selection of the movies and saying it wanted to pursue its own offering.
It turned out that EBS’s infrastructure did not exist. Antioco and Blockbuster had dodged a bullet.
A federal investigation of financial misdeeds at parent Enron, which would lead to its collapse, included a grand jury appearance by the president of EBS later that year and the sentencing of its chairman, Ken Lay, and two other executives to prison.
Antioco next hooked up with RadioShack to sell set-top boxes that would deliver Blockbuster’s digital content to televisions. But market tests showed that the two retail chains served vastly different consumers, and they amicably pulled the plug on the VOD project a few months later.
In the summer of 2001, Antioco watched with interest as a federal court in California shut down the peer-to-peer music-sharing site Napster for infringing on copyrights owned by musicians and record companies, further obscuring the fate of digital content.
Consumers’ reactions to the infringement lawsuits and subsequent ruling by the Ninth U.S. Circuit Court of Appeals sent ripples of fear through Hollywood. The lawsuits had prompted tens of millions of angry consumers to flock to video-sharing sites to exchange pirated files in protest. It was the first open public rebellion against companies that would try to manage digital rights tightly.
The studios realized that high-speed Internet connections and consumers’ demands to use digital content where and when they wanted would lead to a spike in movie piracy unless a legal alternative emerged, so they got serious about finding that alternative. The first stab was a download venture sponsored by every major studio, except for Disney, called MovieFly, which faced significant technological obstacles—the least of which was the forty minutes it took to download a movie.
The Napster phenomenon made the studios more amenable to issuing online distribution rights, and Antioco obtained the rights to download movies from a number of film libraries, including those owned by Vivendi Universal’s Universal Pictures, Metro-Goldwyn-Mayer, Artisan Entertainment, Trimark Pictures, and Lionsgate.
Antioco suspected that Blockbuster’s digital ambitions had to wait for technology to catch up, so he at last turned to converting his enormous VHS inventory to DVD—reluctantly. The chain took a $450 million charge in late 2001 to eliminate a quarter of its inventory of videotapes and start stocking DVDs. He calculated that despite the huge cost of converting the inventories of fifty-two hundred corporate-owned stores, the cheaper cost and greater durability of the new format would boost Blockbuster’s profit margins by as much as 3 percent in the near
term. In the long term, however, DVD spelled troubles for Blockbuster stores, and he had to find a way to fix them.
• • •
NETFLIX WAS BEING swept along by the record-setting pace of DVD adoption and having no trouble signing up subscribers. But as Hastings rounded the third quarter of 2001, the burn rate at which Netflix was spending investor cash was too great to meet his goal of a 2001 IPO. The company was looking at a net loss of nearly $40 million for the year. He had to cut costs—drastically.
Hastings did not believe in spending money on high-end office space or other luxuries as a way to boost Netflix’s image—that was the kind of thinking that had sunk so many dot-coms just a year earlier. The new University Drive headquarters, a dank, low-ceilinged building with a steamy atrium, was only a couple of steps above seedy. The floor plan featured staff cubicles grouped in egalitarian clusters designed to promote their sharing of, and openness to, data and ideas. Movie posters and an old-fashioned popcorn maker in the tiny lobby provided the only décor. Nearly everyone kept a NERF gun loaded and ready to repel random aerial attacks from rival departments.
As McCarthy saw it, Netflix’s problem in getting an IPO off the ground was not cash. They had plenty to run the business, and every important marker of success—such as subscriber growth and DVD adoption—was trending in the company’s favor. But appearances mattered to the financial community: specifically, the appearance that Netflix could pare its overhead, conserve its cash, and become nimble and lean enough to fight off the likes of Blockbuster and Walmart immediately if the smaller company’s IPO attracted competition to the fast-growing online rental sector.
Another factor weighing against them was that there was no proven financial model for a subscription-based online entertainment rental company, because no one had ever done it. If they wanted to go public, McCarthy argued, they had to get the head count down.
Hastings decided to carry out the layoffs personally. The decision was wrenching, and he wrote every terminated employee a personal note of thanks for his or her contribution.
Every Friday morning he gathered the staff outside Netflix’s office for rousing meetings to revel in progress on new engineering and technology projects, dissect mistakes, and tout new partnerships. They met in a small paved patio area that had picnic tables and was bordered on one side by a knee-high wall that staff members used as a bench. Once a month the company rented the Los Gatos Cinema and brought in pizzas from the Round Table pizzeria two doors down. These gatherings always began with the “initiation” of new employees—many of them shy immigrant software engineers—who were required to dress as characters from a movie of McCord’s choosing, using costumes she kept in a large closet next to her office.
The meetings generally centered on two topics—a report on the state of the company’s finances by McCarthy and a view of marketing initiatives and customer data by Mier. One Friday morning in September 2001, Hastings sent out an e-mail asking the staff to meet on the patio immediately. The summons sent whispered rumors racing among the workers, who quietly filed outside. Hastings attempted the same inspiring tone he assumed every Friday, in spite of the message he was about to deliver.
Their mission was to build the world’s greatest entertainment service, to help consumers get movies they love, and to beat the competition, he told them. Netflix needed to cut costs to do that, and to go public.
“Here’s what’s going to happen today: A lot of you are going to lose your jobs, and for that, I apologize,” Hastings said. “But I thank you for your time and for your commitment. And for those of us who remain, we’re going to continue to move forward and fight with you in spirit.”
Everyone returned to their cubicles and waited for the tap on the shoulder from his or her manager. By the end of the day about 40 percent of Netflix’s workforce had been dismissed. Hastings took many of the newly jobless to lunch.
Randolph and Mier remained behind, too shell-shocked to work. Randolph stretched out on a cream-colored leather sofa opposite his cubicle and tossed a volleyball to himself, over and over. A marketing employee who had just been laid off came over to where they were sitting. “Hey, I just wanted to come in and say thank you, and just check in,” the man said. “Are you guys okay? How are you feeling?”
Several others dropped by over the course of the afternoon to deliver their versions of the same message: “It’s been great. Now keep going, keep up the fight.”
The layoffs and their aftermath claimed the last members of the original team. Vita Droutman, tired out from years of working and reworking the fulfillment and shipping systems, and disappointed that Netflix seemed to be losing its quirky magic, felt a sense near relief when Hastings tapped her on the shoulder.
Having cut expenses to the bone, and holiday DVD sales likely to boost Netflix’s subscriber base above the promised half million, Hastings and McCarthy decided to try again for an initial public offering: to raise at least $80 million, sometime in 2002.
McCarthy had an additional data point this time to entice investors. Netflix would finally be profitable, when it reached one million subscribers sometime in 2003. Investors were still stunned by the September 11, 2001, terrorist attacks on New York and Washington, D.C., when McCarthy and Hastings hit the road to pitch a pared-down business plan that focused laserlike on one thing—DVD rentals by mail. Perhaps because Netflix was one of the few dotcoms to survive the bust and stock market crash that followed the terror attacks, they had surprisingly little trouble securing commitments from the investors they had pitched by early the next spring.
A day or two before the May 23, 2002, IPO, Randolph and his nine-year-old son, Logan, rode a private jet to New York with Hastings, McCarthy, and Netflix board member Jay Hoag. They all stood on the trading floor at Merrill Lynch on the morning of the IPO, waiting for the new symbol, NFLX, to appear on trading monitors, and on the giant stock ticker of the NASDAQ exchange.
The opening was delayed that day because of an order imbalance. McCarthy watched the head trader halfway across the room—and suddenly the float went public, at fifteen dollars a share. The price held and climbed a bit.
The offering raised $82.5 million. Netflix had come a long way from the day in April, more than four years earlier, when Randolph had been thrilled to see his Web site crash under traffic that generated just 150 orders.
From a taxi that evening, headed for a celebratory steak dinner, Randolph looked out at a different world. He felt strangely disconnected from the ordinary cares of the masses of pedestrians hurrying past on sidewalks and in crosswalks. He was suddenly wealthier—at least on paper—than he ever imagined he would be. So this is what it is like to have a dream come true, he thought.
• • •
LOWE AND RANDOLPH’S last collaboration at Netflix turned out to be persuading the Smith’s grocery chain to let them test a new concept for a rental kiosk called Netflix Express inside one of its Las Vegas stores. The two had been toying with ideas about how to counter the immediate gratification of Blockbuster’s store subscription program with physical Netflix locations. They tried out different types of vending machines at Netflix’s offices before deciding to field test the idea without investing in the expensive touch-screen kiosks that they liked best. In lieu of a machine, Lowe designed a store-within-a-store concept manned by a single employee, who had a catalog of about two thousand DVD titles on site. Randolph had a sleek surfboard-shaped Netflix Express sign made out of fiberglass for the booth. He and Lowe moved into a Las Vegas apartment together for a month to set up the kiosk at a Smith’s in the suburb of Summerlin.
The location boasted a higher than predicted volume of rental activity during the short test, and people appeared to love the concept. But when Lowe excitedly reported his findings, Hastings and McCarthy shut him down. The kiosks would plug a hole in Netflix’s convenience proposition, but they were geared toward new-release titles, and th
e inventory costs were just too high. McCarthy argued that Netflix could not afford to invest in another outlet for distributing DVDs when the future of the business was clearly digital distribution that would require expensive content deals and cash for software and technology development.
That summer, a strategy executive from McDonald’s approached Lowe to ask if Netflix would partner with the fast-food chain in testing DVD vending machines at McDonald’s restaurants. Lowe loved the idea and recommended that Netflix participate, but Hastings nixed it, saying he did not want Netflix to be associated with McDonald’s.
The free-spirited Lowe felt strongly that the time for the kiosk business he had been dreaming of for twenty years had finally come—and his experiment with Netflix Express proved it. When he left Netflix in January 2003, he called the McDonald’s executive to see how the kiosk project was going. He subsequently flew out to Bethesda, Maryland, to meet with Gregg Kaplan, the strategy executive in charge of the project. The two men hit it off immediately. Kaplan brought Lowe on as a consultant for the kiosk project, which they later named Redbox.
• • •
THE LAST YEAR or so of Randolph’s career at Netflix was a time of indecision—stay or go? He had resigned from the board of directors before the IPO, in part so that investors would not view his desire to cash out some of his equity as a vote of no confidence in the newly public company. Randolph landed in product development while trying to find a role for himself at Netflix, and dove into Lowe’s kiosk project and a video-streaming application that the engineers were beginning to develop.
But after seven years of lavishing time and attention on his start-up, Randolph needed a break. Netflix had changed around him, from his collective of dreamers trying to change the world into Hastings’ hypercompetitive team of engineers and right-brained marketers whose skills intimidated him slightly. He no longer fit in.
