by Gina Keating
• • •
ANTIOCO AND ZINE had to go to lenders in early 2005 to renegotiate Blockbuster’s credit agreements when they realized that business was not picking up as fast as they had expected as a result of the End of Late Fees promotion. Cutting costs also had proved more difficult than they had predicted. Blockbuster’s creditors, who were familiar with Antioco’s turnaround plans, quickly granted the chief executive more room in his credit agreements to run at a loss, in order that he could grow the online business and get End of Late Fees well under way.
Like the banks, the studios were fairly forgiving about Blockbuster’s slow pay practices, having also seen theatrical revenues declining and sales of DVDs slowing. Zine and Shepherd made the rounds of home entertainment executives in the spring, asking for extensions to pay for DVD inventory and to release shared rental revenue.
But the proxy battle became an issue in the credit renegotiations, with lenders demanding assurances that Antioco—and not Icahn—controlled the company. Some studios saw the rental giant’s financial troubles as a good excuse to end their revenue-sharing deals with Blockbuster. “Antioco has never negotiated in a win-win scenario. There is enormous animosity toward him, because he failed to realize that Hollywood is about long-term relationships,” one home entertainment executive told a Hollywood trade paper. There was a sense that the studios finally had Blockbuster where they wanted it: Sales of DVDs reached $18.3 billion, and consumers’ appetites for owning disks seemed inexhaustible. Overall rental revenue dipped to $8.3 billion from $8.9 billion.
• • •
WHEN HIS MARKETING program reached full swing, Evangelist’s BlackBerry resounded with hourly notices of ten thousand subscriber sign-ups per week in early 2005. Blockbuster Online was on track to reach two million subscribers and thirty distribution centers by the end of the year, benchmarks that Antioco celebrated by pledging to invest $120 million in the online service in 2005.
Blockbuster Online’s solid subscriber growth numbers concealed a serious problem with churn—cancellations that had dogged the young service since its launch. Evangelist had been wooing a former AT&T marketing executive named Lillian Hessel to tackle consumer retention. Hessel had quit AT&T after its merger with Cingular, hoping to find work that involved less travel and more flexibility, so that she could spend more time with her two young children.
Hessel, a tiny blonde with delicate features, wasn’t sure after talking with Evangelist that she wanted the position at Blockbuster Online, which included overseeing customer service and analytics. The job seemed too big for one person, she told Evangelist, and she advised him on how to divide up the duties before he offered the post to someone else. Evangelist called Hessel again a few days after their meeting to press her to take the job, as she wrapped up work on a charity function at her children’s school.
“I’m losing customers I can’t afford to lose—I haven’t even paid for them yet,” he told her. “Can you help?”
The culture shock of working for a start-up, albeit backed by a major corporation, after her well-appointed office at AT&T hit Messel on her first day as Evangelist showed her to the office she would occupy.
“Okay, and who are all these other people?” she asked, indicating the room’s half dozen other occupants, who were working at computers.
“Those are your office mates,” he told her.
“And that smell is—”
“The grease pit from downstairs. It comes in pretty strong every now and then,” one of her new colleagues said.
The fast pace and freedom to improvise quickly won Hessel over to her new job. She was a decade older than most of her new colleagues, and her knowledge of corporate process and adherence to proprieties provided stability and ballast. Hessel was proud to call herself an old-fashioned lady, but she could swear like a sailor when she wanted to make a point, and had no problem telling Evangelist when he had gone off course.
Like Randolph and Kish’s, Hessel’s approach to customer retention came from her direct-mail experience, which meant making customers’ experiences as close to perfect as possible. She realized after studying Blockbuster Online’s Web interface and back-end systems, that a few important details were missing. These issues ranged from the fairly complicated, such as how the fulfillment system selected which disk to send to subscribers when their first choice was not available, to the simple, such as whose job it was to check for scratches on DVDs.
Taken one at a time, as Netflix had done over seven years of careful optimization, the problems were easily solvable. Solving them all at once, in the heat of battle over market share, turned out to be a tangled process. Getting the distribution system right was crucial, because it was the company’s only physical link with its customers. Most consumer complaints centered on long waits for popular DVDs to become available. Slow delivery times, the product of a smaller and hastily configured distribution system that did not take into account where Blockbuster Online customers were clustered, also weighed on customer retention.
The lower prices of Blockbuster Online’s plans mitigated some of the customer service problems, but Hessel sometimes faced an uphill battle convincing Evangelist and Cooper to fix the service’s holes before investing in more customer acquisition channels or new features for the Web site.
Another problem lay in the fact that they had copied Netflix’s fulfillment system without really understanding how it worked. Netflix achieved overnight delivery quickly by letting its subscriber base dictate where the hubs would go, rather than just plunking them down in large population centers, as Craft and Ellis had done.
Slowly they learned the ebb and flow of supply and demand that governed the business. They figured out how to place advertising strategically, in markets where they had solid distribution, and to hold off in places where they would have delivery delays. The programmers tweaked back-end algorithms to make better calls about whether to send a customer the first DVD in his queue if it involved a long wait or a lower-order choice that would arrive faster.
Hessel learned to spot subscribers who were likely to cancel—usually those with few movies in their queues, and those whose queues concentrated on one genre or actor—and started an e-mail campaign to gently persuade them to choose a wider variety of films.
Slowly, retention rates rose and acquisition costs edged down. At last they were getting the hang of it, Hessel thought.
• • •
BY SUMMERTIME ANTIOCO could no longer shield the online program from the company’s financial difficulties. Blockbuster’s financial crisis unfolded just as McCarthy and Kirincich’s models had predicted. The year’s DVD releases had performed woefully so far, and box office revenue—a fair indicator of rental revenue—was down by 5 percent over 2004. It was clear that Blockbuster would miss its earnings targets, meaning that it was in danger of violating its debt covenants. Antioco directed Zine to again press Blockbuster’s creditors for relaxed repayment terms, and broke the news to Evangelist that he would have to suspend marketing spending for a few months, and possibly raise prices to match Netflix’s.
Shepherd was dispatched to the Hollywood studios to beg for more time to pay for the disks it needed to keep up with demand. Most agreed, but Universal insisted on keeping Blockbuster on a strict payment schedule. The result was that the chain and the online service decided not to carry a number of new Universal titles, and to stock their more popular titles lightly.
Antioco called Cooper and asked him to cut his marketing budget by more than half. The cuts were so deep that Cooper had to call some affiliates and apologize for having to turn off their links to Blockbuster Online, or to cut their bounty in half. The experience burned bridges with some of the service’s advertising partners that, along with its vendors, were already annoyed with the parent company’s slow pay practices.
The flood of marketing dollars that Antioco had committed to B
lockbuster Online was crucial to keeping subscriber growth clicking along at record rates, and Cooper feared that cutting off that lifeblood would stop the momentum in its tracks. He was disappointed to be right. The result of the deep cuts to marketing was the same as letting up on a throttle. New subscriber additions barely kept up with cancellations, leaving Blockbuster Online treading water after a few weeks. While Netflix had zoomed past three million subscribers in March, Blockbuster had to abandon its goal of signing up two million by year’s end.
To compensate, Evangelist and Cooper stepped up pressure on the store staff to tout the online service to their customers aggressively. It was a tough sell to managers who were seeing underperforming stores across the country close by the dozens and believed they were putting their jobs in danger. The sign-up rate at air card–equipped computers (Blockbuster stores still were not wired for Internet service) was so abysmal that Cooper and Craft decided to do some snooping around.
They set up “secret shopper” expeditions to a sampling of stores across the country and found that some store managers were actively discouraging their customers from signing up, using passive tactics like hiding the sign-up laptops, and even telling customers who inquired that the online service was no good.
Evangelist was furious. He took his complaints straight to Antioco. During a tense meeting with Shepherd and store operations manager Bryan Bevin, Antioco laid out his ultimatums: Shepherd and Bevin would start getting cooperation from the stores or people would be fired. The stores were losing revenue, and that would not change—but if Blockbuster’s customers were going online and abandoning the stores, Antioco wanted them to go to Blockbuster Online rather than Netflix. That was an order.
Bevin, a taciturn man with a reputation as an enforcer, took Antioco’s threats to heart and took off on a trip to Blockbuster’s remaining five thousand company-owned stores to inculcate the message in store managers’ minds. He and Shepherd devised a rewards system for the stores that signed up the most online customers, and with enthusiastic backing from them—the top two store executives—the initiative started producing results. Shepherd later compared it to a religious conversion.
Adding to Evangelist’s frustration was Walmart’s decision to shutter its online rental service and direct its customers to Netflix—an arrangement that Hastings won over dinner with Fleming by finally convincing the Walmart chief that he was in over his head.
Walmart offered its small online subscriber base the chance to continue their subscriptions at their current discounted price with Netflix, for a year. The retail giant also agreed to promote Netflix on its main Web site, and in exchange, the DVD rental company would remind its subscribers to buy their DVDs at Walmart.
Evangelist and Cooper were caught off guard, but put together a counteroffer the next day: Walmart and Netflix subscribers could get two free months and a DVD movie of their choice for switching to Blockbuster. Walmart ceding the DVD rental battlefield to Netflix and Blockbuster did not do much for either company’s subscriber base, but it did convince Wall Street at last that online rental was not as easy as it looked, and was not a cheap alternative to store rental.
“We believe Walmart’s decision to exit the business and entrust it to Netflix reflects operational excellence at Netflix and high barriers to successful execution and profitability in the space,” Thomas Weisel Partners analyst Gordon Hodge wrote in a note upgrading Netflix’s stock to “outperform.”
• • •
WITH THE DEBT crisis and proxy battle behind him, Antioco and his managers settled in to what would become a draining battle with an increasingly dysfunctional board of directors.
Antioco thought Icahn often seemed distracted and unprepared in board meetings—taking phone calls or rehashing issues that had been resolved in previous meetings. He insisted on having his own company’s staff vet deals that Antioco brought to the board, often delaying action for months or until prospective partners walked away in frustration. A deal to stream movies in partnership with Hewlett-Packard died this way, and an opportunity to buy the studio-owned streaming service Movielink lingered for months before the board finally made a decision.
Eventually Icahn succeeded in having most of the board meetings held at his Manhattan offices—expedient for the now mainly New York–based directors and acceptable to Antioco, who enjoyed the chance to visit his hometown friends. However, meeting in Icahn’s office basically put Icahn in charge, despite Antioco’s status as chairman.
For the sake of the company, Antioco and Icahn papered over their differences, and in public at least appeared to be pulling in the same direction. The executive team at Netflix had remained mum in the press about the proxy battle, but they watched it delightedly as the mounting feud with Icahn distracted Antioco from his fight with Netflix.
With Blockbuster’s marketing program quiescent, Netflix seemed to go from strength to strength—surpassing its forecasts and seeing its stock price soar back into the low thirty-dollar range—territory it had not seen since Blockbuster entered online rental.
Developments in the entertainment industry also seemed to be turning in Netflix’s favor. Theaters suffering through the longest box office slump in twenty years were also fighting the rise in home entertainment systems. Only 22 percent of Americans surveyed in 2005 preferred to see movies in a theater rather than at home on DVDs, an Ipsos poll showed. Walt Disney chief executive Robert Iger angered theater owners over the summer by predicting that DVDs and movies would soon be released together, to save the studios marketing costs and to take advantage of much more lucrative DVD sales.
Billionaire Mark Cuban, founder of the HDNet television channel, vigorously advocated releasing movies in all formats—theaters, DVDs, and pay per view—at the same time, at tiered pricing, so consumers could decide whether they wanted to go to a theater or pay a premium to watch at home. The idea brought protests from the entertainment industry and garnered a wellspring of support from consumers.
Additionally, Mitch Lowe had resurfaced at a new subsidiary of vending machine company Coinstar called Redbox that was testing video rental kiosks inside McDonald’s restaurants. Redbox was still working out glitches with the machines, but a test of twelve hundred kiosks was successful enough for the company to set a goal for installing as many as twenty thousand kiosks across the United States. Netflix managers viewed Redbox, with its one dollar per day rentals and an inventory that focused heavily on new releases, as a near-term challenge to Blockbuster and Movie Gallery.
Although the financial community continued to view Netflix with skepticism, the company aced a couple of consumer satisfaction surveys, beating out the better-known Amazon and QVC.
Netflix finally got the relief, in early April, from the price war that McCarthy had predicted the previous winter when Blockbuster announced it would raise the price of its most popular subscription, the three-out, from $14.99 to $17.99, bringing it in line with Netflix’s prices. Elated, Hastings and his team figured they would soon start soaking up Blockbuster Online’s departing customers.
By summertime it seemed clear that Amazon would not launch in the United States, and McCarthy started spreading the word among investors. Netflix’s most feared rival had unveiled a German DVD rental service that priced its plans almost identically to Netflix—€9.99 a month for three rentals, one movie out at a time, and €18.99 a month for six rentals, three at a time. Amazon appeared to use the services to learn the online business internationally, where it stood a better chance of unseating Netflix.
Only Movie Gallery, occupied with digesting its oversized purchase of Hollywood Video, had completely ignored online rental, a decision that left Hastings equal parts amused and incredulous. Movie Gallery chairman and CEO Joe Malugen made it clear in an earnings conference call in August that he had no interest in entering the overheated online space.
“The online delivery model requires patienc
e and days of planning and waiting. We know that the online model does not meet the needs of most of our consumers, because for most, renting a movie is not a carefully planned activity,” Malugen told analysts. “I continue to believe that online rentals are a niche business that will appeal to only about 5 percent of the market. And I believe this fact is borne out by the recent financial results of both Blockbuster and Netflix, which reflects their ongoing price war.”
Blockbuster’s cash crisis became public a couple of weeks later, when the company said it would not pay a quarterly dividend for the first time since it went public in 1999. Variety reported Shepherd’s urgent meetings with nervous studios and other product suppliers to again beg for extended payment terms, and to ensure Blockbuster would not have its supply of fall DVD releases cut off. The word that Blockbuster would forgo $400 million in revenue by abandoning late fees was getting around, as were stories that some studios were demanding cash up front.
Antioco described the bricks-and-mortar rental industry as “in the tank,” and agreed that movie studios had a legitimate cause to worry, that the disastrous year for both theatrical and home rental revenues portended an upheaval to come.
“I am not trying to portray that everything is hunky-dory with the rental industry. It’s not,” he said in an interview in December. He still predicted, however, that Blockbuster would have a profitable fourth quarter, after losing more than half a billion dollars in 2005.
Meanwhile, Bear Stearns upgraded Netflix to “outperform” from “peer perform,” and raised its price target, as it noted that rental industry statistics finally confirmed what Antioco and Hastings already knew: Mainstream consumers were drifting away from store-based rental. As analysts took apart Blockbuster’s business model in notes to clients and in interviews, noting that its stores and overhead were too bloated, Antioco was busy divesting—jettisoning everything unnecessary. In late 2005, he put DEJ Productions, Blockbuster’s movie acquisition and distribution arm, on the block for $25 million, and he put out the word that he was taking offers for Movie Trading and Video King, retail outlets that were taking the company’s focus away from its core businesses, Antioco said. The company sold $150 million in convertible debt to fend off bankruptcy, and Icahn upped his stake in Blockbuster to 15 percent, at a cost of $38 million.
