Netflixed

by Gina Keating

  Icahn, sixty-nine, had made his $8.5 billion–plus fortune twenty-five years earlier by taking over corporations in leveraged buyouts, pulling them apart, and selling the pieces off. He had perfected the art of greenmail—secretly accumulating a big stake in a target company, either by himself or with a cadre of like-minded investors, and demanding a premium to sell back his shares and go away.

  Although he had worked to rehabilitate his image since the days when he was grouped with Michael Milken and Ivan Boesky as a parasite on the financial world, his tactics remained the same. Icahn maintained an office in the General Motors Building in Midtown Manhattan, overlooking Central Park and the Plaza Hotel. The decor, with its rich, bold colors and original artwork depicting famous battles, conveyed a sense of power and state. The conference room, where Icahn had hung framed news clippings detailing the companies he had raided and the CEOs he had fired, drove the point home. He ran a $2.7 billion fund that boasted a stratospheric 30-plus percent annual return on investment most years.

  Icahn liked to purchase big stakes in undervalued stocks and use his leverage as a major shareholder to force management to make changes he outlined. Often these meant cutting costs, selling off assets, and replacing top executives or board members. Icahn’s initial instinct had been to short Blockbuster’s stock, thinking that it was sure to slowly bleed to death as video on demand and online businesses like Netflix came to dominate the movie rental market.

  But Michael Pachter, an analyst at the financial services firm then known as Wedbush Morgan (now Wedbush Securities), who viewed Netflix as a sort of rental Ponzi scheme, convinced Icahn that Blockbuster was a stock to hold. Its strong brand, huge network of stores, and healthy revenue, would lead it to either eventually buy Netflix or put it out of business by starting its own online rental service.

  Icahn quietly bought up shares for his own funds, and his interest in the stock spurred purchases from a number of hedge funds that followed the billionaire investor’s moves in hopes of benefiting from what was known on Wall Street as the Icahn effect—an immediate rise in any stock Icahn bought.

  He called to introduce himself to Antioco, who knew right away that trouble was here. Though Icahn liked to cast himself as a shareholder advocate, the changes that he forced on management generally benefited himself and other hedge funds that assisted in his arbitrage plays in the form of forced share buybacks and board seats for himself and his designees. Antioco’s first instinct was to win Icahn over by presenting the billionaire investor with his road map for Blockbuster, but Stead advised against it: Regulatory rules prohibited such disclosures to a single investor.

  Antioco was determined to resist Icahn’s meddling, and he had a vociferous advocate in Stead, who made a point of being as rude to Icahn as possible every time their paths crossed. Stead related to his Blockbuster colleagues what happened when he and his spouse ran into Icahn and his wife, Gail Golden, at a charity dinner in New York. Golden looked at Stead when she was introduced and laughingly said, “Ah yes, so you’re Ed Fucking Stead. I’ve heard all about you.”

  Alienating Icahn turned out to be a mistake that Antioco would regret. But in late 2004 he finally could turn to running his company without a corporate parent looking over his shoulder.

  Antioco had known for a couple of years that late fees were killing Blockbuster’s relationship with its customers. Late fees originally arose as a means to pressure customers to return rented movies quickly, so that stores could turn them around faster to make more money, and to avoid inventory shortages. Store operators were delighted when the fees unexpectedly became a strong and dependable revenue source. Franchisees were not about to give up late-fee revenue without a fight—even when Blockbuster’s market research showed that the fees turned off existing customers and strangled the company’s ability to attract new ones.

  By 2004, active membership had been declining for several years, and Netflix’s prolific ads promising “no late fees ever” were accelerating the losses. Antioco put Nick Shepherd in charge of changing the company’s dialogue with consumers over late fees.

  Shepherd was a robust-looking man, with close-cropped salt-and-pepper hair and translucent blue eyes, but his sturdy frame and hale complexion belied a somewhat high-strung and exacting personality. He grew up in England’s rough northeast coal-mining district, Newcastle, the youngest child of the eight in his Irish-English, Catholic family. As a young boy he had dreamed of becoming a photographer, but his family was too poor to afford the equipment. Instead, he followed his older brother into restaurant work, eventually earning a degree in hospitality and business management.

  He joined Blockbuster’s UK operations shortly after Viacom bought the rental company in 1995, and had held a number of international operations and marketing posts before moving to Dallas in 1999, to work as head of international operations under Antioco.

  Shepherd strongly supported resuscitating Blockbuster stores even though he knew that online rental in some form ultimately would undermine them. Still, he preferred losing store customers to Blockbuster Online than to Netflix or video on demand. Shepherd ordered market research on attitudes around late fees and discovered that, while only 20 percent of Blockbuster customers were paying late fees at any given time, more than 70 percent had paid them at one time or another, and most felt the stores were not consistent or fair about the way they were levied.

  Intellectually he knew the brand was damaged each time a customer got into an argument with a Blockbuster cashier over unexpected late fees, especially as it frequently happened in front of a long line of customers waiting to check out. But the idea of wiping out an important source of revenue when store sales were declining made his gut churn.

  Blockbuster’s marketing department constructed a number of alternatives to the traditional late fees, such as returning to a per-day rental rate rather than simply tacking on another full rental charge for, say, seven days, as soon as the movie was late.

  However, a test program conducted by a midwestern franchisee that removed late fees altogether convinced Antioco and Shepherd that all of Blockbuster would have to bite the bullet, too.

  That Blockbuster franchisee, Mitch Kerns, had not only definitively reversed the slide in same-store sales, but also actually started building market share and revenue for his store. His program essentially gave his customers twice as long to watch titles and charged their credit cards for the price of the movie if they didn’t return it within a month.

  During a trip to visit Blockbuster’s European stores in September 2004, Shepherd broached the subject to Antioco during an early morning walk beside a canal in the northwestern English town of Warrington.

  “Do you seriously think, if we change the pricing structure and get past this late fees thing, it will make a big difference?” Antioco asked.

  “I think it will fundamentally change the relationship with customers,” Shepherd said.

  Although Shepherd balked at killing late fees altogether, Antioco urged him to test such a program in a few U.S. markets. Shepherd chose to test in Chattanooga, Tennessee, a city where nearly every test initiative went wrong. He sent a second-string team of executives to launch the no-late-fees promotion—to increase its chances of failure.

  To his surprise, the Chattanooga test replicated Kerns’s results, so Shepherd ordered another city tested, and then another. The results were the same in every market: Consumers returned to stores more frequently and spent more money on rentals and other items. At the test’s conclusion, Shepherd gathered managers in the test markets and asked for a show of hands: Which of four initiatives—including 99 cent per day rentals, game rentals and end of late fees—should they launch in January? They unanimously chose the End of Late Fees.

  Although removing late fees would eventually spur store traffic and sales, Shepherd had to cut more than $400 million in costs out of the store business to compensate
for the initial loss of revenue and to fund the growth of Blockbuster Online. He had kept Blockbuster’s franchisees, who ran about eleven hundred U.S. stores, closely apprised of the market tests. When he revealed the results he faced a deep split between those who wanted to try the promotion and those who felt they couldn’t do without the revenue.

  “Do you want the business to go down the pound?” Shepherd asked. “Because that’s where it’s going to go. Or do you want to renovate the business?”

  Although the franchisees accepted that the competitive landscape was changing for movie rental, Shepherd became aware of a deep animosity toward the online business led by one of Blockbuster’s largest franchisees, Fred Montesi III of Southern Stores, who believed that Blockbuster Online would undermine the stores.

  In the end, Shepherd convinced three quarters of the franchisees to try the End of Late Fees program, which Blockbuster would roll out in January with a big advertising push. The Blockbuster board approved the program in December, and the $50 million advertising campaign launched to the strains of Roy Orbison’s “It’s Over” and promised “The End of Late Fees . . . the New Blockbuster.”

  • • •

  SHEPHERD HAD TO switch his focus in the midst of the End of Late Fees rollout and testify before the Federal Trade Commission, which had begun vetting Blockbuster’s bid for Hollywood Entertainment. It was the second time that Blockbuster executives had trod the regulatory path in a proposed merger with Hollywood Video. The FTC’s analysis of the proposed 1999 merger showed that sixteen hundred Hollywood Video stores lay within two miles of Blockbuster locations, and in many cases there was no other competitor in the area to maintain competitive pricing.

  In the ensuing five years, Shepherd testified, the video rental market had diversified to include several new products that directly competed with store-based rental, such as video on demand, DVD sales, and online rental. But from the tenor of the FTC’s questions at his first multihour session in Washington, D.C., Shepherd had the feeling that the regulators were no more open to the merger than they had been five years earlier. In an eleventh-hour attempt to save the deal, Wattles announced that he would buy as many Blockbuster stores as necessary to get it past the government.

  Although Stead wanted Hollywood Video badly, Shepherd was not keen on it—he believed they could take out the number two chain without going to the expense or trouble of buying it. He and Antioco had identified about nine hundred Hollywood Video stores that overlapped with Blockbusters in markets that could not support both. These were the locations Blockbuster needed to eliminate.

  On January 9, 2005, Movie Gallery revealed the details of its bid for Hollywood Video—$13.25 per share, plus the assumption of $300 million of debt—a price tag of $1.1 billion. Lawyers for Movie Gallery argued in a second round of FTC testimony that it was still too soon to say whether the newer movie distribution models competed directly with store rentals—after all, store rental prices had risen since their introduction. Data showed that renters patronized stores for new release titles that would not show up on VOD for months, and many used online rental subscriptions to access older content.

  Antioco thought the FTC inclination to block the Blockbuster-Hollywood merger was wrong, and he was prepared to do the deal and take the government to court. But then Movie Gallery cofounder and chief executive Joe Malugen changed everything with his ridiculously huge offer. Antioco wanted to walk away from the deal and use his stores to attack Hollywood Video, but Icahn would not let the matter rest.

  Icahn insisted in almost daily phone calls that Antioco raise Blockbuster’s bid. The calls became acrimonious, as Antioco insisted that the chain wasn’t worth what Malugen had bid, let alone another $1 or more per share. Cowed by Icahn’s threats and bluster, Blockbuster’s board of directors agreed to consider raising the amount of the offer, against Antioco’s protests. He gave in in the end and launched a hostile bid on February 4 to take over Hollywood Video at $14.50 per share in cash and Blockbuster shares.

  Regulators increased their scrutiny of the hostile bid and asked Blockbuster to provide a detailed list of pricing, discounting, and cost information. Investigators demanded e-mails and other documents that they believed proved the two huge chains viewed each other as direct competitors and not, as the companies were saying, potential partners with complementary markets.

  Blockbuster turned over the documents in late February and stated in securities filings that it had complied with the regulators’ demands. It had given Hollywood shareholders until late March to tender their shares, but again found itself facing uncomfortable media attention when the FTC discovered that the pricing information it had turned over was inaccurate.

  The drama around Blockbuster’s bid put off Hollywood Video’s board of directors, which advised shareholders in a February 21 letter to vote in favor of Movie Gallery’s bid. Although Blockbuster’s bid was higher, it was clear that antitrust problems would likely scuttle or significantly delay that sale, the board wrote.

  The FTC had not decided by mid-March on whether to clear Blockbuster’s bid, and Antioco and Stead vowed to go forward with purchases of Hollywood Video stock until regulators stepped in to stop them. The FTC made it clear it would go to court to obtain an injunction to block the sales, and on March 26, Blockbuster stepped aside to let Movie Gallery complete its purchase of the number two chain.

  “Given the current circumstances, in our judgment it is not in Blockbuster’s best interest to continue to pursue the acquisition,” Antioco said in a statement.

  Icahn, now stuck with Blockbuster stock that had dropped in value, and a smaller than expected profit from the Hollywood Video–Movie Gallery merger, was furious, and he blamed Antioco for blowing the deal.

  He called for Blockbuster’s board to find a private equity buyer for the company; a move that Viacom had tried and failed at before splitting it off. Then Icahn demanded another special dividend for Blockbuster shareholders that would have totaled more than $300 million—again rejected by Antioco and the board. The tension between the two men rose, egged on by Stead, who vowed not to submit to the former corporate raider’s tactics.

  • • •

  AS THE CRISIS with Hollywood Video unfolded, attorneys general in several states started looking into the End of Late Fees promotion with great interest—especially the policies under which Blockbuster charged a $1.25 restocking fee if consumers returned a movie or game outside the seven-day rental window, or the full sale price of the item minus the rental fee if they kept DVDs beyond a seven-day grace period. The state officials also complained that consumers were confused by the fact that several hundred stores owned by franchisees were not participating in the program, and that some of these even displayed End of Late Fees advertising.

  The End of Late Fees ads prompted false advertising lawsuits in forty-eight states by mid-February, a development that proved more embarrassing than expensive. Blockbuster agreed a month later to change its advertising, to more prominently mention the fees, and to pay $630,000 to reimburse the states for the costs of their investigations.

  Antioco began experiencing a crisis of confidence in the program that spring, wondering if Blockbuster should back away from it, as gross margins eroded and store costs proved more difficult to cut than expected. But Shepherd, who had started to see active memberships reversing their decline and slowly growing, dug in. He warned Antioco that he would stick with the program as long as he was in charge and reminded the CEO that the program had been his idea.

  Antioco had warned investors before the split-off that Blockbuster would lose money in 2005, as it moved into new businesses, but the size of the losses from the End of Late Fees promotion, coupled with a steep industrywide downturn in DVD rental revenue, outstripped what analysts had forecast.

  After growing by double digits since 2000, sales and rental of DVDs began cooling faster than expected. Retailers bla
med the glut of product that studios had rushed to market to capitalize on DVD’s high profit margin and a theatrical slate that wasn’t connecting with consumers.

  Although Zine had joked that the massive dividend payment represented “the price of exodus” from Viacom, he not been too worried about taking on the $1 billion–plus in long-term debt, because Blockbuster was still generating plenty of cash. The headline-grabbing losses that Viacom attributed to Blockbuster in previous years represented mainly noncash write-downs of the overpayment that the media conglomerate had made for Blockbuster. Zine believed the video rental giant was healthy enough to bounce back, as long as Antioco did not take on any more expensive initiatives.

  • • •

  AS SOON AS Blockbuster withdrew its bid for Hollywood Video, Antioco reached out to Icahn to try to head off a public feud over the failed deal. Icahn had a long track record of threatening proxy fights unless he got his way—usually in the form of an above-market payoff, management changes, or asset sales. Icahn had recently abandoned a threatened proxy battle at Kerr-McGee after the gas-and-oil company agreed to buy back $4 billion of its shares at a 15 percent premium. But Antioco didn’t like to be threatened, and the discussions went nowhere.

  On March 28, the day Blockbuster abandoned its pursuit of Hollywood Video, its stock price dropped 6 percent, to just under nine dollars—bringing its total decline over the previous year to 43 percent. Winning suitor Movie Gallery saw its shares rise by five dollars the same day. Icahn filed a letter with the Securities and Exchange Commission ten days later, criticizing Blockbuster’s management in blistering terms for failing to close the deal.

  Icahn lashed out at Antioco for taking the video rental chain on a spending spree with shareholders’ money, and he vowed to change the company’s direction by winning the three seats on Blockbuster’s board that were up for election in May. In particular, Icahn also took aim at Antioco’s $51 million pay package, which included a $5 million bonus, restricted stock grants worth $26.8 million, and options valued at $17 million. Icahn called the package “unconscionable.”