Netflixed

by Gina Keating

  As a terrible year wound to a close, the numbers confirmed the bad news: Movie ticket sales finished the year down 12 percent from their peak in 2002, and overall spending on movie rental declined for the first time in twenty-five years. Sales of DVDs, however, were still growing.

  Although its subscriber base had stalled at one million, Blockbuster Online had finally started making a contribution to the company’s overall health, in the form of a growing revenue stream. It had been a rough year for Blockbuster—having to navigate a secular change in its business during a deep downturn—but, Zine told investors, 2006 looked brighter, with new programs like End of Late Fees and Blockbuster Online producing desired results.

  • • •

  NETFLIX ENDED THE year with no debt and 4.2 million subscribers, and it had earned the right to boast that its business, since it relied heavily on back-catalog titles, was impervious to the vagaries of Hollywood’s movie release schedule. The two companies had traded places in market capitalization at about midyear: Netflix was now worth about $1.5 billion and Blockbuster, still more than $1 billion in debt, had dropped to $684 million.

  CHAPTER TEN

  THE EMPIRE STRIKES BACK

  (2006–2007)

  BY EARLY 2006, THE MEDIA and Wall Street were stepping over Blockbuster’s presumably dead body to talk about what was to come next—Netflix or a video-on-demand format that bypassed DVD rental completely.

  Broadband had reached enough American households to make the studios look again at distributing video over the Internet, as they grudgingly began accepting that there was no going back to the golden age of tightly controlling access to content by restricting its use to movie theaters, commercial television, and the nonportable (by digital standards) VHS format. The studios preferred the video-on-demand format, fearing that another Blockbuster would rise up to divert revenue from their coffers and hit on a digital delivery model that would liberate consumers from having to watch advertising or pay for cable. Premium cable programmers, such as HBO, Starz, and Showtime collectively shelled out $1.5 billion each year to the studios for exclusive cable rights to new movies, and the studios were not about to give up that revenue without a fight. Also, every major studio but Sony were part of conglomerates that owned cable channels or cable distributors.

  Overall rental and sales of DVDs, which reached their zenith at $27 billion in 2006, were expected to begin a slow but definite decline starting the following year. Digital video delivery was growing by triple digits, year over year, but still made up just 1 percent to 2 percent of annual revenue from movie sales.

  • • •

  WALT DISNEY’S IGER was the first of the studio chieftains to embrace the Internet ethos of letting content be free—sort of. Disney, fresh from a merger with Steve Jobs’s Pixar Animation Studios, was the first to sell movie and TV episodes on iTunes, the online music store affiliated with Jobs’s Apple Inc. By placing blockbuster movies like Pirates of the Caribbean: Curse of the Black Pearl and hit prime time TV shows like Lost on iTunes, Disney signaled its acceptance of what tech companies had long known: Consumers would watch what they wanted, when and where they wanted, and there was nothing the content owners could do about it. Disney also began testing two of its own digital approaches: a download service called MovieBeam, to rent Disney movies through a set-top box, and an advertising-supported streaming Web site for its ABC television shows.

  MovieBeam was cumbersome, requiring consumers to buy a two-hundred-dollar set-top box, which was similar to a digital video recorder, that trickled one hundred movies per month on a broadcast signal to subscribers’ homes. Customers had to pay again for each movie they ordered, and had twenty-four hours to watch it after pressing play.

  The ABC Media Player proved more successful, because it was free; it only required consumers to watch a couple of thirty-second ads per commercial break. The player application was easy to download to a laptop, and it delivered video streams fast and flawlessly.

  MovieBeam sputtered after less than a year on the market, and Disney spun it off, while the ABC player grew steadily in popularity; viewers requested sixteen million streams during a two-month test.

  Other studios invested in downloading sites that failed to take off, mainly because of the high costs and restrictions of their digital rental models. Movielink, a joint venture of five major movie studios (Metro-Goldwyn-Mayer, Paramount, Universal, Sony, and Warner Brothers) offered fourteen hundred titles for rental and one thousand for purchase via download or by burning to DVD. Vongo, a video download service formed by Liberty Media’s Starz channel, Microsoft, and Sony, tried to interest consumers in both pay per view and subscription, but started with just one thousand titles.

  Download services were also unattractive due to another temporarily insurmountable factor: the slow growth of U.S. broadband penetration. Just under 50 percent of U.S. households had access to broadband service as 2006 dawned, and those that had fast Internet access still had to wait a couple of hours to download a near DVD quality movie onto a laptop or computer. Even when the files were downloaded, the resolution and sound quality were not nearly as good as the new high-definition (HD) DVD and Blu-ray formats, and no one had yet figured out an easy way to get the movie from the Web to televisions, where most consumers preferred to watch them.

  The download methods and business models were clunky, the Web sites not compelling, and the services as a whole could not compete with either Netflix or—even with all its flaws—Blockbuster Online.

  Hastings and McCarthy watched the download services rise and implode, believing that a well-functioning, inexpensive streaming service could win against them but convinced that several fatal flaws had to be worked out before digital delivery could succeed. Getting a decent selection of titles would be difficult, because the studios had signed away the rights to rebroadcast their movies to premium cable companies like HBO, Starz, and Showtime for a decade. To buy those rights would require a bigger subscriber base than the six million Netflix was forecasting for the end of 2006.

  Although Hastings and McCarthy insisted publicly that Netflix would roll out its own download solution in the coming year, they had by then decided instead to create a nimble media player like Disney’s that would stream video straight from the Internet to any portable video-enabled device and, eventually, to the television.

  Though not yet. They felt the cost of a separate set-top box would put digital delivery out of reach for a significant chunk of potential subscribers, and curtail the rapid growth in streaming they needed to convince the studios to cut them in on content deals. Hastings admired YouTube—its easy-to-use software and portability—and he realized that a free video player software program that could be downloaded to any video-enabled device would spread organically. Hastings also brought in digital video recorder designer and ReplayTV founder Anthony Wood to come up with an inexpensive and easy-to-use set-top box for streaming, to enable Netflix to travel that crucial last three feet from the Web to the television.

  Hastings insisted to reporters that Netflix did not compete with the download sites, including Apple, because subscription rental attracted a specific kind of user—one who planned ahead and only occasionally required the spur-of-the moment convenience that the à la carte services offered. He saw the others as complementary to Netflix.

  The six months of having virtually no competition while Blockbuster settled its debt problems left Hastings with the pleasant task of telling the market that his company would deliver better than expected revenue and subscriber growth in 2006. He told investors in April that as many as 20 percent of DVD householders in markets such as Boston and Menlo Park, California, were now Netflix subscribers, and the market showed no sign of saturation. Netflix’s stock price had bounced back to thirty dollars, while Blockbuster’s was marooned at around four dollars.

  Yet Blockbuster Online remained a threat, despite its flatlining subs
criber growth during the last quarter of 2005 and the first quarter of 2006, and Netflix did not want it resuscitated now that its parent’s debt problem was under control.

  Netflix sought the immediate shutdown of its nearly identical competitor. Following the Blockbuster Online beta release, when the resemblance was revealed, Netflix began sending cease-and-desist letters, without result. They went to federal court in San Francisco in April 2006 to seek an injunction to force Blockbuster to take down Blockbuster Online and rebuild it without infringing on two Netflix patents. In response, Blockbuster’s attorneys contended that Netflix’s patents—especially one covering the idea for a subscription DVD by mail service—were too broad. They filed a counterclaim alleging antitrust violations by Netflix.

  Netflix filed its lawsuit shortly after the U.S. Patent and Trademark Office issued the relatively rare business methods patent. A violation of this patent would force Blockbuster to take down and reengineer its Web site or pay Netflix royalties to use it.

  The dueling lawsuits dragged on for a couple of years, and they finally settled out of court with Blockbuster agreeing to pay an undisclosed sum. In exchange, Blockbuster demanded that Hastings stop publicly stating that he had incurred the late fee that prompted the idea for Netflix at a Blockbuster store. Blockbuster had searched its databases after hearing the story, and never found such a transaction. In subsequent interviews, Hastings quietly reset the story at a mom-and-pop rental store in La Honda, California, that had since gone out of business. (These terms were part of a sealed settlement, the details of which were related to me by several sources who knew about it. I did not see the documents. I was not able to confirm this with Netflix’s communications department.)

  • • •

  THE HUMILIATING GROVELING to its bankers and its other creditors, mainly the movie studios and DVD wholesalers, had ended for Zine and Shepherd after a trip to each coast in 2005, but Blockbuster had a lot of catching up to do.

  To satisfy lenders that Blockbuster was cutting noncore operations, Antioco put its international operations and video game and trading businesses on the block. Another two hundred employees were laid off at the corporate offices in Dallas and McKinney, including Stead, who parachuted out with a $1 million payday. Antioco also cut one hundred unfilled positions from Blockbuster’s job rolls.

  The brutal cost cutting seemed to put Blockbuster on a solid footing with analysts and investors, who reacted by boosting the company’s stock rating and price. The decision to cut late fees finally appeared to be paying off. Antioco told investors with relief that Blockbuster’s corporate stores, where late fees had been suspended for a year, had beaten the industry downturn in same-store revenue comparisons, and franchisees who had refused to participate were still in the doldrums.

  Publicly, at least, relations improved between Icahn and Antioco. Icahn passed on the chance to embarrass Antioco further by running another dissident slate at Blockbuster’s 2006 annual meeting, when he and two other directors were up for reelection. Investors reelected Antioco and longtime directors Robert Bowman and Jackie Clegg to new three-year terms without comment, in contrast to the previous year’s fireworks. However, Icahn did step in—more subtly—to shape the board by holding up the replacement of a retiring board member that same month. Icahn discarded several possibilities for an independent director before agreeing to Los Angeles–based entertainment industry executive Jules Haimovitz. Although Antioco viewed Haimovitz’s appointment as another attempt by Icahn to consolidate his grip on the board, he was satisfied with the choice. Icahn publicly expressed confidence in Antioco and his turnaround plan—including online rental—and seemed uncharacteristically loathe to create any more drama that would affect the stock or management’s concentration.

  In private, the power struggle between Icahn and Antioco moved to a passive-aggressive level that almost mired the board into inaction. Board members, cowed by Icahn’s temper and billions, said nothing when he allowed his twenty-six-year-old aspiring filmmaker son, Brett, to sit in on board meetings and offer his unsolicited opinions on business plans presented by Blockbuster’s management team.

  Icahn floated the idea of having Brett take over the online business, and actually sent him to Dallas to take stock of the service and advise Evangelist on how to improve it. Evangelist ostensibly welcomed the younger Icahn but warned that he could not run the online business from his home in Los Angeles. Blockbuster Online needed a full-time general manager who was present for the sixteen- to eighteen-hour days that it took to keep up with Netflix and weather the storms that Blockbuster’s precarious finances were causing. Brett Icahn demurred, but he continued to weigh in on initiatives and attend meetings for both the store and online businesses, as he took on a larger role in his father’s investment company.

  The customers returning as a result of the End of Late Fees promotion had saved the Blockbuster stores from the worst of the 2005 downturn in rental but had not compensated them for the lost earnings. In response, Antioco shifted his marketing budget to Blockbuster Online for a barrage of advertising and coupons for as many as four free store rentals a month.

  They had to do more, however, to catch Netflix, after the long dormancy with virtually no marketing. Evangelist kept his warehouses open on weekends and persuaded the post office to scan incoming Blockbuster Online envelopes with company-provided scanners, so that customers’ next DVDs would clear for delivery as soon as they were checked in at the post office.

  When customers noticed the faster Blockbuster delivery times and queried Hastings about it through an interview with HackingNetflix’s Kaltschnee, the CEO said Netflix would not follow suit because of the cost—to his bottom line and his employees’ psyches. “We will work as hard as we can on the five days when the distribution centers are open,” he said.

  Subscriber additions to Blockbuster Online lurched forward again, enlivened by the new spending. The uptake on the coupons was promising, with new subscribers citing the in-store rentals and faster delivery times as decisive in their choice of Blockbuster Online.

  Netflix began actively investing in worthy low-budget films, hoping that the exclusive content would distinguish it from hit-driven Blockbuster. Most of these films would not get theatrical distribution beyond film festival appearances, so the exposure the filmmakers received by selling distribution rights to Netflix was beyond what they otherwise could have expected. By positioning itself in the burgeoning independent film movement, Netflix built cachet that was good for its image among its increasingly sophisticated consumers, and it built goodwill in the film community.

  Blockbuster partnered with Weinstein Company, the independent movie studio, in what it touted as an exclusive deal to offer films like Miss Potter and The Libertine. The trouble was, once those DVDs hit the market, the First Sale Doctrine allowed Netflix and every other rental outfit to buy the same titles at retail and rent them to their own subscribers.

  Blockbuster created a low-end tier of $7.99 for one-at-a-time limited rentals. Netflix squeezed below it with a $4.99 price for two movies per month.

  The bargain basement prices alarmed analysts, who predicted that the services were encouraging subscribers to trade down to cheaper plans, decimating profit margins rather than boosting subscriptions. Wall Street watched closely as Netflix’s subscriber additions climbed toward the six million Hastings had forecast for 2006. Surprisingly, revenue per user stayed fairly stable, showing that the new lower-priced plans were, for the moment, attracting new trade exactly as they were designed to do. As the second year of the price war wore on, with no decisive victory, Evangelist and Antioco started looking for a knockout punch before they again spent themselves into trouble.

  • • •

  FIVE MILLION SUBSCRIBERS—that was Evangelist’s goal. If Blockbuster Online could get there, it would move past the expensive building phase and into profitability. Blockbuster was spending a worriso
me fifty dollars to add each new subscriber for every thirty-eight dollars that Netflix spent.

  After reviewing marketing studies he had done in 2003, Evangelist realized that Netflix had done a better job of retaining subscribers at the same point in its lifecycle, even with the giveaways Blockbuster Online subscribers were receiving. And Netflix’s customer satisfaction, even among subscribers who had quit the service, sat at a maddeningly unassailable 65 percent, he noted.

  But the data held a bright spot: Netflix subscribers could be persuaded to switch to Blockbuster for the added benefit of being able to rent at least once a month at a Blockbuster store. Since there would be no prying Netflix customers away from the service for anything other than an extraordinary offer, Evangelist knew Blockbuster Online had to blow their minds. The only way to regain momentum was to merge the online and store operations for a hybrid rental offering, but marrying the two separate businesses seemed technologically and financially insoluble.

  “Before we go out and spend a whole bunch of money, let’s go figure out how to make it fascinating,” Antioco said of a combined in-store and online subscription. The problem lay in how to track online subscribers when they went into stores to return movies: Without Internet access, the stores could not connect to Blockbuster Online to track how many DVDs its subscribers had out and what they had returned, or to signal the distribution system to send the next disks in their queues.