Netflixed

by Gina Keating

  “They can continue to bleed at this rate of $14.99, given the usage patterns that we know exist early in the life of the customer, until the end of the second quarter,” Kirincich told the executives.

  The trouble was, the wait was excruciating. The holidays became a season of panic, as Christmas approached and Netflix had not reached the bottom of the range of subscriber additions it had forecast for investors. As staffers took off for the holidays, Erich Ziegler, the marketing analyst charged with subscriber forecasts, tried to calm Hastings, McCarthy, and Kilgore, who were concerned about the slow sign-ups. The adoption rate of the DVD format was expected to reach its pinnacle in 2005, when holiday sales of players went through the roof, he explained. In each DVD player box was a red Netflix coupon for a free trial membership. Most of these would be redeemed on or a few days after Christmas Day. That was the theory, anyway.

  Ziegler then headed to the airport to fly to his parents’ home on the East Coast, confident in his prediction. Kilgore arranged for hourly reports of subscriber additions to be sent to the finance and marketing teams’ BlackBerrys, in case they needed to adjust the marketing mix. They were in the clear. By the day after Christmas, Netflix blew through its subscriber forecast with year-over-year growth of 118 percent. All the same, the uncertainty had been maddening.

  • • •

  POWERED BY HEAVY spending on advertising and in-store coupons, Blockbuster surpassed 750,000 subscribers in four months, a benchmark Netflix worked for four years to reach. The attack on Netflix’s market share drove up both the cost of signing up subscribers and cancellations, as consumers played one service against the other.

  Hastings acknowledged in a January call with investors that Netflix had to pay more attention to beating back Blockbuster. Although Amazon was a more formidable foe from a technology standpoint, Blockbuster was more motivated, because they were defending their core business, he said.

  “It has been a serious effort, and one we clearly underestimated, a mistake we do not intend to repeat,” McCarthy added.

  Despite the aggressive attack, Blockbuster had not managed to interrupt Netflix plans to launch a modest download service, and to make a profit in the last three quarters of 2005, he said. Next McCarthy shared his department’s forecasts, hoping word would get around of the dire financial straits in which Blockbuster would soon find itself.

  “At the fifteen-dollar price point, based on our modeling, we expect their online business to lose money on every subscriber indefinitely, unless they slash their marketing spending, which will slow their growth,” he said. “If we have to match Blockbuster’s pricing to sustain our growth objectives, . . . if we end up in a war of attrition, our operating losses will increase as well. But I believe we are better positioned to survive the battle than Blockbuster.”

  Wall Street practically ignored the warning about Blockbuster’s debt, but short sellers started borrowing large positions in Netflix stock, anticipating another plunge in its share price. Analysts played along by downgrading the stock. “For the third consecutive quarter, we were left with the impression that Netflix management is not acting upon, but reacting to, its competitive environment and subscriber sentiment,” Richard Ingrassia at Roth Capital Partners wrote to clients in a note advising them to sell Netflix shares.

  “Prospects for the business remain cloudy near-term as subscriber growth and profitability hinge on what Blockbuster and Amazon will do next,” Youssef Squali at Jefferies & Co. advised his clients.

  Mario Cibelli of Marathon Partners spent one of the more interesting days of his career as a hedge fund manager at a Netflix distribution center in Long Island, and came away with a different opinion. “There’s not a snowball’s chance in hell that Blockbuster can do this,” he told his colleagues, when he returned to work later that day.

  The warehouse manager, a former aerospace engineer, had shown Cibelli a series of charts posted on the wall; it had about two dozen optimum performance metrics. “As long as my performance is within this band, I won’t hear from senior management,” the man said, indicating the charts. “As soon as I move out of this band, I will get a call.”

  Hastings and his team had spent the time and thought to build a quality business, and management clearly was running Netflix for the long term, Cibelli thought. He laid out his reasons for taking a long position in Netflix shares in an internal memo:

  On the surface, Netflix is a massive video store; taking in cash for monthly renting rights and loaning out DVDs to the consumer. Beneath the surface, Netflix is akin to a think-tank, creating algorithms to maximize the long-term value of each customer that it enlists, orchestrating a complex distribution system and finding ways to reduce its costs of service.

  It is the unseen aspects of Netflix’s business model, and its long head start, which differentiate it from the competition and may allow Netflix to retain the leading position in the industry for some time.

  Although the online business seemed a natural extension of Blockbuster’s core competency, “it is quite rare for a mature company to enthusiastically go after a new business that promises to cannibalize, in part, a corporate cash cow,” Cibelli wrote.

  Blockbuster would soon be “very tempted to raise price at its online unit in the face of the losses it is likely experiencing,” he predicted.

  Cibelli also dismissed the idea that Amazon posed an imminent threat, concluding that the big e-tailer would find it difficult and expensive to build a service to match that of Netflix. But the little company made a tempting takeover target for Amazon, “at an appropriate price,” as long as tax issues related to assuming Netflix’s distribution centers could be resolved.

  No one but his clients and colleagues were privy to the details underpinning Cibelli’s contrarian viewpoint, which was just the way he liked it.

  • • •

  HASTINGS HAD REMARKED on a conference call in April that Blockbuster had thrown everything at Netflix “but the kitchen sink.” When he arrived at the University Drive headquarters the next day, a giant box from a home improvement store was waiting. Inside was a kitchen sink, courtesy of Ed Stead and the executives at Blockbuster. Hastings got a kick out of the gesture, but he had no intention of again underestimating the seriousness of the challenge that Blockbuster had laid down. Netflix was under siege, and Hastings knew he needed to rouse his company to its peak performance. His employees found on such occasions that he could be a stirring speaker and an inspirational leader they would follow to the limits of their endurance.

  He relied on parables and props to make his points, once dressing as Muhammad Ali in a robe and boxing gloves to encourage his staff to roll with the punches in the fight against Blockbuster. Another time he handed out wooden harpoons to managers to exhort them to wait patiently for the whale that was Blockbuster to come up for air. He invoked Sir Edmund Hillary’s lean-and-mean two-man climb to the top of Mt. Everest to explain how Netflix would vanquish better-funded brands with fewer resources.

  The prospect of a full-on battle with Blockbuster unnerved some, especially in light of the bad press they were getting. Kirincich lost a newly hired employee after the man had second thoughts about joining embattled Netflix and decided to ask for his job back at the company where he had just given notice. There was a sense at Netflix’s headquarters of circling the wagons, buying as much of the stock as they could afford, and letting their focus and desperation do the rest.

  Armed with financial and marketing models that showed Blockbuster could not afford the game of chicken it was playing, Hastings maintained a steadfast answer to the criticism and takeover rumors circulating that spring. Netflix would run at break even—sacrificing profits and plowing all of its cash into growing its subscriber base as fast as it could to raise an impenetrable barrier to entry by Amazon and other challengers.

  A subscriber-based business would lose a lot of money until it got
large enough to defray fixed overhead costs. In early 2005, Hastings and McCarthy pegged the cost for a new competitor to enter the market at $350 million to $500 million.

  Hastings restated his warning for Blockbuster at a Reuters conference in San Francisco in March. “How long are you prepared to run at break even?” I asked.

  “As long as it takes to run off the competition,” he answered.

  “So—is that a year? Five years?” I asked.

  “As long as it takes,” he answered.

  Part of Hastings’s break-even strategy called for spending $90 million per quarter in an advertising arms race designed to force Blockbuster deeper into the red.

  • • •

  KEN ROSS WAS that rarest of creatures—a warm and endearingly enthusiastic New Yorker. He still delighted in his work as a corporate spokesman, despite having coped with vicissitudes ranging from Michael Jackson’s hair catching fire during a Pepsi commercial shoot to the clay feet of the executives he served. Ross, fifty-one, liked Faconnable shirts, jeans and loafers, laughed a lot, and embraced reporters he liked as friends. Ross turned down the offer when Hastings and Kilgore first approached him to work at Netflix because it would entail moving from Los Angeles, where he had relocated from New York in 1999, to Silicon Valley.

  Nor did Ross like the idea of reporting to Kilgore instead of directly to Hastings. Working as an arm of Kilgore’s marketing seemed too constrained a role—he wanted to control press and investor relations plus internal communications. But he liked Hastings and Kilgore and Sarandos, and he saw the promise in Netflix—that he could help turn it into a defining lifestyle brand. The second time Hastings made the offer Ross decided that he’d have enough influence to do just that if he was any good at his job. He took the job as vice president of corporate communications in January 2005 and set out to remedy the yawning awareness gap between Blockbuster and Netflix.

  He had taken over the head PR job at Netflix from Shernaz Daver, a fast-talking, energetic consultant who had suffered through a yearlong drumbeat of negative headlines about Netflix since Blockbuster launched its competing service. Daver, an attractive, gregarious woman of Zoroastrian descent, first introduced me to Netflix’s upper management during my first trip to the headquarters she jokingly called “the hole” in Los Gatos.

  Daver had battled so many reporters over stories about Wall Street’s gloom and doom predictions about Netflix’s demise at Blockbuster’s or Amazon’s hands that she had almost no time to actually promote the service. By the time Ross arrived, she had made inroads into mainstream lifestyle magazines but the articles centered mainly on painstaking descriptions of how the service worked.

  As a result, Ross was working with a blank slate when it came to ordinary American consumers.

  First he would find the soccer moms and NASCAR dads in the markets beyond New York, Los Angeles, and San Francisco, and he planned to do it by making sure the company and all of its executives looked and acted like they belonged to an established leadership brand.

  Second, he would establish Netflix as a newsmaker and a “must follow” company among the nation’s top media outlets. Ross focused on journalists at just a few major media outlets—the New York Times, the Wall Street Journal, Fortune, Forbes and BusinessWeek magazines, and the Associated Press, Bloomberg, and Reuters newswires—since they set the business news agenda in the United States.

  He chose forty-seven-year-old Steve Swasey for a second in command, a seasoned PR man who, he reflected, didn’t need directions to get to the Today Show green room. Ross found in Swasey a perfect foil—a bad cop who could unflinchingly deliver a firm company line and not back away in the face of intense journalistic wheedling and abuse.

  Not that Swasey relished his power, as some company flaks do. He was a boyish-looking native Californian who wore his khakis and preppy buttoned-down shirts starched under immaculate blazers and peered anxiously over his frameless glasses when he talked. Swasey was parsimonious with any true scoops about the inner workings of Netflix or its officers but, when strictly necessary, delivered this information almost with shame, as if it had been pried out of him under torture.

  Swasey’s reserved demeanor masked a love of spectacle—especially the elaborately choreographed press conferences and lengthy television stories that he excelled at promoting, and later described with utter satisfaction as “glorious.”

  The first time Swasey saw the clockwork process of a Netflix distribution center, with red envelopes whipping through a postal sorter, the giant racks of movies, and the workers’ hands moving in a blur to pack and unpack DVDs, he envisioned a sublime series of television and photographic events.

  He convinced Ross to let him invite local media for tours of the distribution hub in Phoenix. The event, for which he had workers wear t-shirts with huge Netflix logos on front and back, generated so much positive publicity that Swasey’s “hublicity tours” became a staple of Netflix’s shoestring PR campaign. Swasey eventually won coverage of the humble facilities from the likes of 60 Minutes, Nightline’s John Donvan, and Pulitzer Prize–winner Susan Sheehan, who wrote about her day packing disks for the New Yorker’s Talk of the Town column.

  Ross had worked with press-shy chief executives, and he was relieved to find that Hastings was not one of them. Although abrupt and demanding with staff, Hastings was reliably pleasant and engaging around journalists, and he suppressed his impatient streak under even the most inane questioning. And he demonstrated early on in Ross’s tenure that he had the discipline to moderate his behavior for the good of the brand. During their second earnings call, Ross and Swasey kept a tally of the number of times Hastings mentioned Blockbuster—nearly three dozen—and compared it to his mentions of Netflix, which came in at about half that number. They showed him the scorecard at the end of the call, and Ross remarked, “A leader doesn’t do that.” It was the first and only time he had to tell Hastings to focus on selling his own brand.

  Like most Silicon Valley moguls, Hastings had little interest in his clothing or appearance. Jeans and T-shirts were his workday uniform, and dressy was the bowling shirt he wore to a 2005 presentation for investors, known as an analyst day, at the posh Fairmont San Jose Hotel. As the plan to present Netflix as a company to watch succeeded, and photo shoots became a staple of Hastings’s press schedule, Ross convinced him to hire a consultant to come up with a wardrobe for public appearances.

  “When you are getting photographed in the New York Times or Fortune or the AP, you’re making a statement about the company,” he told Hastings. Hasting liked to be photographed with a fan of DVDs or behind a conveyor belt in the nearby distribution center. He stuck to company-related settings as a safeguard against the embarrassment he had felt after posing on the hood of his Porsche for a photo accompanying a 1995 USA Today article about Silicon Valley start-ups entitled “Boom! You’re a Millionaire.”

  Hastings proved an adept and interested student of mass media, and held up well most of the time as Netflix’s public persona. Occasionally Hastings’s engineer brain would trump his CEO manners. At a 2010 event at the Churchill Club, hosted by former Walt Disney chairman and chief executive Michael Eisner, Hastings ended his ninety-minute appearance, rose, and walked off the stage before the moderator had finished a rather meandering concluding speech—eliciting an audible gasp from the audience.

  But Hastings was a great interview, simply because (to Swasey’s chagrin) he readily answered every question put to him clearly and succinctly, and he was better informed than many tech executives about his own business and the industries touching it.

  • • •

  MIKE KALTSCHNEE RODE a commuter train winding between Connecticut and Manhattan, watched the rising drama between Blockbuster and Netflix unfold in the financial press, and thought, Here is something worth pursuing. Kaltschnee was a software programmer by profession and a writer by avocation, and he became i
nterested in Netflix at around the same time he decided to take up blogging. He decided to combine the two in a new type of online journaling called “brand blogging,” in which a writer shares his enthusiasm (or hatred) for a particular company and invites readers to post comments or information about it, in the spirit of transparency. He was a tall, husky man with a geek’s enthusiasm for taking things apart—especially businesses—to figure out how they worked. In 2003, when a red coupon for a free trial of Netflix floated out of the box of the DVD player he had purchased, he tried the service and was hooked. He loved the vast movie selection and the sleek Web site, of course, but he was equally fascinated by the delivery mechanics. How did Netflix coordinate mailings for more than one million Queues? Why did the turnaround time vary depending on where he dropped off the mailers? How did the company put away so many DVDs each day with so few employees? I wonder how it all works, he thought.

  Kaltschnee had started a Web design firm with three other guys in the mid-1990s that became one of the first subscription services for graphics. They sold the company a few years later, and Kaltschnee stayed on to create a second subscription service for the buyers’ stock photography collection. He knew about subscription businesses from that experience, and he wanted to learn how Netflix had been so successful. In November 2003, he launched the blog HackingNetflix.com, in keeping with his pledge to deconstruct the service and learn how it operated; its masthead was Netflix-red and its observations, gentle.

  Kaltschnee was an unabashed advocate for Netflix from the start, and he’d joined a generation of bloggers who wanted to share their personal experiences with a product or corporation. He and his followers, who soon numbered a quarter million per month, ran commentaries on Netflix news, product launches, legal troubles, and just plain gossip, sometimes shared by anonymous insiders. Blogs were a gold mine of information for journalists about product and price tests, company gossip, and consumer sentiment. I read HackingNetflix devotedly and, eventually, so did most other mainstream journalists.