by Gina Keating
The next few months will be tough for Blockbuster, Shepherd thought.
• • •
HASTINGS RETURNED TO Los Gatos after Sundance to confront bad news from his market research team and worse news about quarterly earnings. Hastings and McCarthy reported to Wall Street that Netflix was already feeling headwinds from three months of Total Access.
Walmart was about to go live with a video download-to-own service that had the backing of all of Hollywood’s big studios and undercut Apple’s iTunes and Amazon’s new video download service, UnBox, in price. The marketplace for digital delivery, although small, was getting crowded. And Redbox, now with more than ten thousand kiosks nationwide, was growing into a potential threat. The last thing Netflix needed was another destructive battle with Blockbuster.
Nothing Blockbuster Online had done in the past three years—price cuts, free coupons, massive advertising spending—had substantially diminished Netflix’s superiority when it came to luring new subscribers. The year-over-year subscriber growth numbers each quarter were enviable—74 percent, 76 percent, 60 percent, and 51 percent in 2006. The growth forecast for fiscal 2007 had dropped to a comparatively shocking 17 percent.
Netflix’s share of new subscribers looked likely to waste away to nothing by summertime if Antioco carried through on his post-Sundance pledge to spend another $170 million on the program.
Netflix was under siege. For the first time, Hastings had to take down his forecast for annual subscriber growth. He and McCarthy reminded analysts of Blockbuster’s crushing debt and the effect that Antioco’s spending was likely to have on the company’s credit agreements. Netflix had zero debt and plenty of cash on its balance sheet to wait out Blockbuster as long as that took, they pointed out.
But the seriousness of the threat posed by Total Access wasn’t lost on Wall Street.
“I don’t know how Netflix can win this thing,” Pachter, the Wedbush Morgan analyst, said after hearing the bad news on Netflix’s first-quarter conference call. “The only way they get back to growth is if Blockbuster goes away.”
That was exactly what Hastings feared.
After Sundance, Hastings sent over an informal bid to buy Blockbuster Online’s subscribers. The offer was $200 per subscriber, or about $600 million total, and growing, plus fees paid to Blockbuster stores to service Total Access subscribers after the takeover.
Shepherd saw the figure as a starting point and believed that they could command a much higher price through continued negotiation. He thought of the freedom from debt that amount of cash would bring. But Antioco and Evangelist were insulted by the low-ball per subscriber price and, convinced they could do better after Hastings watched his customers flee for a few months, advised the Blockbuster board of directors to turn it down.
The Blockbuster board took up the Netflix offer at a February board meeting at Icahn’s office in the General Motors Building in Manhattan.
Evangelist presented the directors with the pros and cons of selling Blockbuster Online, whose subscriber base was growing at a rate of twenty thousand to twenty-five thousand per day and would surpass four million by summer’s end. The analysis is simple, Evangelist said. We don’t want to sell for what Netflix is offering. Let’s see what they’ll pay when they’ve started losing subscribers. Why sell now, when Blockbuster Online had all the momentum?
Icahn and the board agreed.
After the Sundance meeting with Hastings, Antioco had gently broached the potential sale to Evangelist, who now faced the prospect of losing his job just as the business finally bore fruit. Evangelist’s initial reaction was exultation. When the board voted down Hastings’s offer, however, he was relieved at having a little longer to bask in his success.
The board then turned to a routine agenda item that would affect Blockbuster’s future more profoundly than the decision not to sell Blockbuster Online to Netflix. It was the approval of annual bonuses for the company’s top executives, including a doubling of Antioco’s $3.8 million performance-based bonus. Antioco’s relationship with Icahn remained uneasy, but he had hardly thought about the outcome of his performance review and the bonus vote. Netflix’s offer to buy Blockbuster Online, and the spiraling down of Movie Galley and Hollywood Video, had validated his strategy. When the board came to the long list of bonuses, they voted to approve each award without much discussion, until they arrived at the last name on the list: John Antioco.
As Icahn peered at the bonus amount printed on the page—$7.6 million—his face took on a look of amazement that quickly morphed into anger.
“There is no way we are going to pay you this money,” Icahn told Antioco.
“What do you mean,” the shocked CEO said. “You approved it. You’re on the compensation committee.”
Under the terms of his contract, which the directors had set the previous year, if Blockbuster reached $285 million in adjusted gross income and Blockbuster Online had signed up two million subscribers by December 31, Antioco was due the additional bonus. He had earned it, and he knew it.
In 2005, Blockbuster posted a $500 million loss (although noncash charges accounted for more than half of the loss), as store revenues staggered under weak DVD releases, competition from cheap DVDs sold at Walmart and Best Buy, and the costs of eliminating unpopular late fees. Antioco had to renegotiate the debt-to-income ratios of the company’s credit agreements four times in two years to keep cash flowing to Blockbuster Online. He had turned things around in 2006. The company had eked out a small profit, but its stock price had reached an all-time low of seven dollars and that was the only measure that mattered to investors.
“I didn’t know it was going to be this big,” Icahn said of the bonus.
“Well, you should have done the math,” Antioco retorted.
At Icahn’s urging, the board voted to cut Antioco’s bonus in half. Had his fellow directors asked Antioco to voluntarily forfeit part of the amount to make nice with shareholders who had lost money in the costly war with Netflix, he probably would have agreed. He was, after all, a rich man, and the bonus was merely a way to put points on the board. But asking nicely was not Icahn’s style.
In late February, the board cut Antioco a check for $2 million, and had Zine deliver it to the CEO.
Antioco handed it back, telling Zine, “Thank you very much; you can have it back.” His attorney promptly delivered a copy of a claim for arbitration over alleged board misconduct that Antioco planned to file the following Monday to Blockbuster’s outside counsel. The Blockbuster board voted to set aside $4 million in case it had to fork over the disputed funds and informed investors in a February 23 securities filing that it was officially feuding with its own chairman and chief executive.
The phone rang at Antioco’s home in Dallas on the Friday night before the Monday arbitration. It was Icahn, having had a martini or two and up past midnight New York time, looking for a fight.
Antioco picked up the phone in his bedroom, where he had been watching a movie.
“Hi, Carl,” Antioco said, bracing for battle when he heard the familiar voice. His wife, Lisa, hearing Icahn’s name, wordlessly went downstairs to fetch him a bottle of tequila and a shot glass.
Icahn laid into him immediately. Why was Antioco dragging the company through another embarrassing chapter in this pay argument? Why couldn’t he just accept the lower bonus? Didn’t he care how a double bonus looked to people who had lost 40 percent of their investment in Blockbuster in just three years?
Finally, Antioco could take no more. With the tequila lighting a fire in his belly, he started shouting back at Icahn. He had never before lost his temper with Blockbuster’s largest investor, but he had reached his limit, emotionally and mentally.
As the two men argued, Antioco suddenly realized that the effort—to fight Icahn, to fight for a bonus he would ultimately give to charity—was pointless. He had
enjoyed a decade-long ride at Blockbuster, taking it from a failing unit of Viacom to a colossus astride the world of movie rental. Guided by his grit and instinct, Blockbuster had stolen from a technologically superior rival the title of fastest-growing online rental business. Antioco was on the verge of putting Blockbuster back on top after blows that most companies would not have survived—a technology revolution, a management crisis, credit problems, a revolt by franchisees.
He had put his reputation on the line in a risky bet that the outsized spending on online rental would eventually pay off. The market research flowing in every day proved him right—foot traffic in stores was up, as Total Access made even Netflix subscribers take a second look at Blockbuster Online.
In early 2007, Movie Gallery had had to refinance its $1.4 billion debt from its purchase of Hollywood Video, a sign that Total Access was accelerating the demise of Blockbuster’s store rivals—just as Antioco had predicted. Movie Gallery CEO Malugen had been forced to retreat from his position that online movie rental was a “niche” that his rural customers did not understand. Malugen announced that Movie Gallery would provide an online rental option later in the year and would buy online download service MovieBeam from the joint venture headed by Disney.
Despite Icahn’s public support for Antioco’s vision and the success of Total Access, the CEO could see nothing ahead but struggle. If hard numbers couldn’t convince the Blockbuster board of his worth, Antioco preferred to retire to his ranch and spend time with Lisa and his children.
“Let’s negotiate my exit,” he told Icahn.
Icahn agreed, and the conversation turned to the nuts and bolts of pay and benefits. Antioco would receive $8 million in severance and bonus—a fraction of what he was entitled to under his contract—plus five million stock options that vested by his last possible day on the job—December 31, 2007. Antioco could not have cared less about the pay cut—he felt like a weight that had been drowning him for two years had lifted.
On March 20, 2007, the day Blockbuster announced Antioco’s departure, Icahn told the financial press that the terms of the CEO’s exit “are clearly in the best interests of the shareholders.”
Antioco said only that he was “pleased” to have reached a settlement and would stay on until at least July 1 to provide an orderly transition to the next CEO. In the meantime, he planned to run the Total Access promotion “pedal to the metal” to reap as much subscriber growth as possible while the Blockbuster board searched for his successor.
Antioco had convened a meeting of his top executives a day earlier, including Evangelist, and broke the news. He reminded them that they had a lot of work ahead to make the online business profitable and to keep up pressure on Hollywood Video and Movie Gallery. While the search for his successor was on, Antioco expected them all to maintain their focus on making Total Access sustainable.
The suddenness of the announcement stunned the room, but no one wondered why Antioco had made the decision. They all knew of the struggles he had faced with Icahn and the board, even if he had not explicitly discussed them. After the meeting, Evangelist returned to his office and fired up his desktop computer. It was time to update his résumé. He had been blowing off periodic calls from headhunters—maybe it was time to start returning those calls, he thought.
Antioco’s goal before he left at year’s end was to get Blockbuster through the transition to a smaller store base, launch an electronic movie delivery option to match Netflix’s instant streaming service, and maximize online subscriber growth with an all-out push with Total Access.
In June, he had the unpleasant task of reporting to his lenders that store sales had slipped by nearly 16 percent compared to a year earlier, and he needed another waiver of the company’s credit terms—its fourth since 2005—to commit the $170 million he had pledged to Total Access.
That summer, Movie Gallery signaled that it was in deep trouble and would default on its new debt terms due to poor second quarter results. Soleil Securities analyst Marla Backer cut her rating on Movie Gallery to “sell” from “hold” on its stock, saying that the number two rental chain’s plight “highlights the challenges currently facing video retailers in general, as well as the competitive impact of Blockbuster Inc.’s Total Access program.”
There was no getting around it: Store-based rental was on its way out, and Antioco was determined that Blockbuster would make the transition.
Blockbuster had tripled its online subscriber base in six months, to 3.6 million. By June, Blockbuster Online was signing up every new online rental subscriber, as well as customers who had defected from Netflix. Evangelist was ecstatic. He knew Hastings had to be desperate—now was a perfect time to wring a better deal out of Netflix. Antioco hesitated. He knew that Icahn was eager to replace him, and he did not want to leave such an important deal half done at his departure.
“That’s for the next guy,” he told Evangelist.
• • •
BLOCKBUSTER’S ENORMOUS MARKETING spend to raise awareness of Total Access had pushed average Americans off the fence about online rental. The new customers trying online rental for the first time—ten million of them—proved Hastings’s theory that the market was far larger than Wall Street imagined. Unfortunately for Netflix, most of these new customers continued to sign up at Blockbuster Online as spring turned into summer.
“Our thesis that online rental would become very large appears more and more credible,” Hastings said on Netflix’s first quarter conference call in April. “Our thesis that most subscribers would choose Netflix seems more open to question, at least for now.”
Netflix ended the first quarter at the bottom half of its forecast range for revenue, subscribers, and earnings for the first time in its twenty quarters as a public company. Worse, Hastings and McCarthy had to revise their year-end forecasts, and to renounce their long-range plan of achieving 50 percent annual earnings growth and twenty million subscribers by 2012.
On the other hand, instant streaming was performing better than expected. Hastings and Ted Sarandos and his content acquisition team in Beverly Hills worked full speed to increase the title selection and get the software embedded in enough platforms—cell phones, game consoles, DVD players—to make it a convenient alternative to both the video store and online DVD rental. With video streaming under way, Hastings took the first steps toward sacrificing a critical piece of Netflix’s business model to focus the company on a superior consumer proposition.
Netflix was close to solving the problem of getting the Internet to the television with a set-top box that would be ready to roll out in 2008. The question was, would it be soon enough to save the company from another devastating meltdown of its stock price?
Kilgore started market tests to determine the effect lowering the price of the two-out plan by a dollar had on marketing costs and on subscriber growth and retention. The test showed that Netflix could lower the now record forty-seven dollars to acquire each new subscriber in the overheated atmosphere created by Total Access.
Hastings and Kilgore pushed to cut prices on all three of Netflix’s subscription plans, arguing that they had to stop what by June had become an outflow of customers to Blockbuster Online. For the first time since it adopted its subscription plan in 1999, Netflix was losing its customers. Even peerless word of mouth, the most valuable marketing tool Netflix possessed, was no longer compelling enough to keep its subscribers from what looked like a better bargain.
In July, Hastings faced going to the market with Netflix’s second-quarter earnings report and reporting that the company had lost 1 percent of its subscribers, and would—for the second time in six months—revise its fiscal year forecasts for subscriber growth and net income. Any hope they had of stopping Blockbuster Online through the patent infringement lawsuit they had filed in 2006 also disappeared. They would have to tell the market that the companies had settled the matter out of
court for a nominal one-time payment to Netflix and no hoped-for ongoing license fees.
In the days leading up to the earnings conference call, McCarthy and Kirincich argued against making a second round of price cuts. The Netflix executives agreed as a team to table the discussion of price cuts for another month to see if McCarthy’s prediction that potential losses on Total Access—$200 million or more for 2007—would spur Blockbuster Online to alter the program, either by raising its own prices or stopping the free in-store rentals, to make it profitable.
But the pressure on Hastings and his exhaustion from constant traveling worked on his mind. The next day he unilaterally decided to cut Netflix’s prices across the board.
The about-face shocked some staff members, who felt that Hastings had lost his focus. Yes, they were all scared, and the stock had dropped by more than 30 percent since the beginning of the year. But they had come this far by focusing like a laser on their strategy and executing it by the numbers.
They announced the price cuts along with revised forecasts for smaller subscriber growth and profits in 2008. All the numbers were going in the wrong direction. Revenue, profit, and even the average amount of money subscribers spent on Netflix would all drop in the coming two quarters, McCarthy told investors.
“When Blockbuster decides to operate its online business profitably, our financial results will improve also. But until that time, both sub growth and earnings will remain under pressure,” McCarthy told analysts on the second-quarter conference call on July 23.
The only bright spot in the earnings report: Mitch Lowe’s Redbox was starting to pressure video stores with his growing army of kiosks. “They are still pretty small, so in the background, but have good significant potential over the next three years, mostly to negatively impact stores, which of course has a positive effect for us,” Hastings said.
