How Blockbuster (Almost) Shut The Curtains On Netflix
The amazing story of how, at one point, incumbent Blockbuster brought its challenger, Netflix, to its knees; then it volunteered to go bankrupt.
Teaser
A 1997 Fortune article explained “Why Barnes & Noble May Crush Amazon”, since barnesandnoble.com just launched to complement the nationwide B&N bookstore chain. Amazon, as we all know now, was never crushed by that website. “We expect Blockbuster to be as successful against us as Barnes & Noble was against Amazon,” Netflix founder Reed Hastings told investors in 2004, when asked about Blockbuster potentially launching a DVD-rental website. He was about to find out how wrong he was.
The most amazing part in the book Netflixed was the fact that at one point, Blockbuster – the incumbent in movie rentals – had effectively done it: beating Netflix, the Silicon Valley upstart who challenged Blockbuster’s dominance. Then, instead of cementing their victory, Blockbuster chose to commit what can only be described as business suicide.
“The battle between every startup and incumbent” – as a16z’s Alex Rampell famously described it – “comes down to whether the startup gets distribution before the incumbent gets innovation.” While it is not uncommon to see a tech incumbent leveraging its distribution to crash a potential disruptor – think Microsoft vs. Netscape, Microsoft vs. Slack, or Facebook/Instagram vs. Snapchat – it’s a completely different story with incumbents who are fundamentally – how should I put it – not very technical.
That’s what makes this story so fascinating.
Blockbuster was a 20-year-old incumbent, a subsidiary of Viacom, headquartered in Dallas, Texas, managed by executives with no internet or software background to speak of, hardly employing any software-engineering talent, going against a Silicon Valley upstart, riding the internet wave. It should have been a straightforward, textbook disruption story. And yet, incumbent Blockbuster has miraculously found a way to leverage its distribution advantage and beat Netflix.
Grab your popcorn as the drama is about to start (just don’t forget to be kind and rewind the tape in the end).
Exposition: The Origin Of Blockbuster Online
John Antioco, Blockbuster’s CEO, took note when Netflix went public in 2002 and started reporting its massive growth numbers for its DVD-by-mail service. In response, Shane Evangelist was appointed to create an online initiative for Blockbuster, and started a cross-functional team. The goal was to create a competing offer by Blockbuster, and, six months later, hmm, well, nothing happened. Just like Christensen’s Disruptive Technologies paper explained in 1995:
Using the rational, analytical investment processes that most well-managed companies have developed, it is nearly impossible to build a cogent case for diverting resources from known customer needs in established markets to markets and customers that seem insignificant or do not yet exist. After all, meeting the needs of established customers and fending off competitors takes all the resources a company has, and then some. In well-managed companies, the processes used to identify customers' needs, forecast technological trends, assess profitability, allocate resources across competing proposals for investment, and take new products to market are focused - for all the right reasons-on current customers and markets. These processes are designed to weed out proposed products and technologies that do not address customers' needs.
[...] When the independent and mainstream organizations are folded together in order to share resources, debilitating arguments inevitably arise over which groups get what resources and whether or when to cannibalize established products.
The last sentence describes what happened to the Blockbuster Online project, and the reason it didn’t take off. At this point, one may have concluded that Blockbuster was paralyzed in face of this new internet thing, that is allowing customers to order DVD films by mail. If I were writing this blog in 2003, I would have probably predicted that Netflix is going to rapidly improve and, eventually, take over Blockbuster’s mainstream customers.
This is not how things played out, however. Following an intense management meeting in early 2004, during which Evangelist and other senior executives exchanged accusations, CEO John Antioco decided to dissolve the cross-organizational team. A $25M budget was allocated for the online initiative, but Evangelist was told to figure it out on his own. He was not allowed to bother the store managers or anyone else in the company, nor even access Blockbuster’s existing customer database. To build the online service, Evangelist leased an office in a separate building from Blockbuster’s HQ. This, interestingly enough, is exactly what Prof. Christensen would have recommended:
[...] It follows, then, that senior executives must first be able to spot the technologies that seem to fall into this [disruptive] category. Next, to commercialize and develop the new technologies, managers must protect them from the processes and incentives that are geared to serving established customers. And the only way to protect them is to create organizations that are completely independent from the mainstream business.
Building a separate and independent organization, Evangelist was able to make fast progress; He hired Accenture for building a Netflix-cloned website. Blockbuster’s relationships with movie studios and media companies were leveraged, to make sure the new website offers a greater selection of films compared to Netflix. New partnerships were struck with the leading web portals of the time – like Yahoo and MSN – in order to drive traffic to the new site.
The Blockbuster Online website went, well, online, during Netflix Q3 2004 earnings call. Evangelist was happy to note a burst of @netflix.com subscribers to his new services right after the Netflix call, including those of Reed Hastings, Netflix then-CEO, and Barry McCarthy, CFO.
The online DVD rental battle has officially kicked off; but Blockbuster was consistently behind. Most new subscribers still chose Netflix, who maintained a significant lead over blockbuster.com. It was essentially a well-managed clone that lacked the data-driven and innovative passion that Hastings and his engineers had in Los Gatos. Accenture’s mercenary engineers were being asked to copy new netflix.com features, but by the time they were done – Netflix has made more progress; how could blockbuster.com ever catch up? In this new market, it was Netflix who was establishing itself as the leading incumbent, and kept growing quickly despite Blockbuster’s new offering.
Blockbuster, which at the time had over 9,000 US stores, over 50,000 international stores, and 65 million registered customers, wasn’t leveraging any of this distribution power to promote its online rental service. That was about to change.
The Turning Point Of Blockbuster.com
Fast-forward to Netflix April 2007 Earnings Call:
Subscriber growth was limited by the effectiveness of Blockbuster’s Total Access program. Net subscriber growth is driven by gross subscriber additions and churn. Our gross subscriber additions were up 10% year-over-year, about 150,000 less than we forecast at the beginning of the quarter, and about 400,000 less than the 1.9 million gross subscriber additions we estimate Blockbuster added with their Total Access program.
That serious confession was made by Netflix CFO Barry McCarthy. For almost a decade of its existence, the company had never missed its estimates. Its obsession with data collection and analysis has enabled Netflix to make fairly accurate projections, and plan its growth and marketing budgets accordingly. That’s why it was unusual for the new subscriber numbers to fall short by such a wide margin.
What was even more disturbing was that for the first time, Blockbuster added over 25% more online subscribers than Netflix! What changed between 2004 and 2007, that allowed Blockbuster to start taking over Netflix’s market share? The answer was that Blockbuster, like many clever incumbents, turned the new innovation into a feature of its existing platform.
A year earlier, Blockbuster’s market surveys all pointed to the same conclusion: consumers had a clear preference toward Netflix. But, Evangelist noticed, there was one interesting data point: consumers were willing to switch to Blockbuster Online, if they could occasionally visit a store to rent a movie. Mostly when they’re looking for instant gratification – they have an urge to watch a movie, and don’t want to wait a day or two for the DVD to arrive by mail. Evangelist realized there could be an opportunity to win, if he could integrate his online service together with Blockbuster’s chain of physical stores.
This wasn’t easy to do, due to the typical incumbent challenges: internal resistance to change, financing difficulties – as Blockbuster spun off of Viacom along with roughly $1B in debt – and, of course, technological difficulties due to Blockbuster’s outdated systems. The stores were literally uploading data to HQ every night using satellites. The store computers could not connect to Blockbuster Online’s system in real-time, and therefore could not load nor update customer’s data. Blockbuster was also under pressure from activist investor Carl Icahn, who was pushing for efficiencies and cost cuttings, so it wasn’t exactly the ideal setting to upgrade the tech.
CEO Antioco eventually suggested a hack to cut through the Gordian knot: “Just add a voucher,” he told Evangelist. On the very envelope that wrapped the mail-ordered DVD, Blockbuster would add an in-store return voucher, with a barcode that hard-coded the customer’s profile data. That gave customers a choice: they could either mail back the DVD or bring it to the store, where the customer data would be scanned from the barcode, allowing for the DVD to be replaced in the store. It’s very hacky (and raises so many interesting security issues!) – far from the integrated and modern internet system that Evangelist had envisioned – but it was easy to implement, and allowed for a smooth consumer perspective.
Blockbuster launched this hybrid service as an experiment in Colorado Springs in 2006. The store was flooded with customers. They really liked the new offering. Antioco actually bailed in the middle of a private vacation in Mexico, rushing to his private jet to see it with his own eyes. Excited, he asked to launch the service for the whole country before the holidays. This was going to be a smashing hit.
Quick intermission:
Alright, back to the program -
Total Access Climax
Total Access – the hybrid online/in-store rental service – launched at the beginning of November 2006. Antioco and Evangelist had figured it out. They made mail-ordered movies into a feature. Sustaining innovation, as Christensen referred to technologies that improve the incumbent’s existing products, rather than disrupting them. It was appealing to customers all over the country. By the end of 2006, Blockbuster Online almost doubled its number of subscribers. What a blockbuster.
Reed Hastings, Netflix co-founder and then-CEO, has always demonstrated his logical and practical thinking. He immediately responded to the dot-com crash of 2000, pulling back on his IPO plans and laying off 40% of the company. That allowed him to survive the tech recession of the early 2000’s. When he noticed how well Blockbuster’s Total Access was being received, he didn’t delude himself. Hastings immediately realized that young Netflix was in real trouble. Marc Randolph, Netflix co-founder, told CNBC that this had been a “very scary” moment for the company: “the true strength that they could [and] that we couldn’t match, which was a blended model of online and stores.”
Hastings, willing to pay a hefty price for Blockbuster Online to disappear, set up a meeting with Antioco in January of 2007. Two and a half short months after Total Access was introduced. Both CEOs knew that Blockbuster was holding the leverage.
What was Netflix’s hope? CFO McCarthy explained to investors a few months later:
we believe Blockbuster is growing quickly because Total Access is very aggressively priced. That pricing strategy is driving rapid growth in their share of the online rental business.
We heard a lot about Blockbuster’s sub growth on their Q4 earnings call, but not much about the cost of operating the Total Access program. I expect they will start talking about those costs on their Q1 call, and I expect those costs will imply that the larger Blockbuster’s online business grows, the more money they will lose at current price points. We believe Blockbuster will have to raise prices to sustain the Total Access program.
Hastings made the same point in his meeting with Antioco – Blockbuster was losing money on Total Access, meaning they would have to raise prices, which would push consumers back to Netflix. What do you suggest, then? Antioco asked. Hastings offered to buy Blockbuster Online, making it seem like he was doing Antioco a favor. “I don’t know,” Antioco replied. “I think we will be fine.” Viewing the offer as an admission of defeat by Netflix, Antioco felt victorious.
The official offer made by Netflix was for $200 per subscriber, or about $600M for blockbuster.com’s roughly three million subscribers. Blockbuster’s board of directors discussed the offer during its 2007 meeting, which was held in Icahn’s NYC office. Excited about Blockbuster’s growth momentum, Evangelist highlighted how desperate Netflix was, and convinced the board to reject the offer. “Let’s see how much they offer after they lose more subscribers.”
But the acquisition offer wasn’t the most crucial topic discussed in this meeting; something else has turned out to be more critical for Blockbuster’s future than its competition with Netflix: the executive bonus approval.
The Antioco-Icahn B-Story
The board went over the annual bonuses, approving them line-by-line, until Antioco’s name was reached. He was about to receive $7.5M. “No way we’re paying you that much,” Icahn stated. “But you approved it yourself!” Antioco replied. He was shocked. Icahn was sitting on the compensation committee when – a year earlier – it set two bonus targets for Antioco: one for profitability, and a second for online subscribers. He hit both. “I didn’t realize it was going to be so high,” Icahn explained, and convinced the board to cut Antioco’s bonus in half.
Antioco wouldn’t accept it. Neither would I, if I were in his shoes. Blockbuster was a money-losing company in decline, threatened by an internet upstart; Antioco was able to turn it around– returning to profitable growth, and he had Netflix on its knees, despite all the heat he was taking from Icahn along the way. It wasn’t about the money as much as the humiliating manner in which it was done. When the bonus check arrived, Antioco declined it. Instead, he filed a lawsuit against the company he was leading.
The night before litigation was about to start, Antioco received a late phone call from Carl Icahn, asking him to avoid public embarrassment for the company and settle for the reduced amount. In response, Antioco burst. A few drinks into their night at this point, the two were shouting at each other over the phone. Is it really worth it, Antioco eventually thought to himself. He had a successful 10-year run at Blockbuster, putting the company on the path to success. Maybe that was enough. Why should he continue to deal with insufferable Icahn. “Let’s talk about my retirement package,” Antioco eventually said.
In hindsight, it’s hard to overstate how critical that phone call was going to be for Netflix.
Antioco agreed to stay for six more months to help with CEO transition. It looks like he genuinely wanted to hand the company over in a good state: he cut down on unprofitable store initiatives, and allocated more resources to grow the online business. Here is what he said during the May 2007 earnings call:
The company's first quarter performance was in keeping with our plan to aggressively grow our Total Access subscriber base. Clearly our results were impacted by our investment in the growth of this offering and by an extremely tough in-store rental market [...]
In keeping with our previously stated objectives, we captured share of the overall rental market, continued to contain operating expenses and we believe significantly outperformed our competition, both in store and online. In fact, during the first quarter, we captured more than 60% of the subscriber growth in the online space and since the end of the year, grew our subscriber base by 35%.
Our year-over-year comparison, our online revenues increased 116%, and we picked up 10 percentage points in market share going from approximately 20% of the online market to 30%. During the first quarter, we also improved our total unaided awareness of Blockbuster Online from 40% to almost 60%, exactly what we set out to do. In the five months since launching Total Access, we nearly doubled our online base to 3 million subscribers.
We now have the fastest growing online rental service in the marketplace and intend to keep it that way [...] We intend to continue investing in Total Access in 2007, spending another approximately $100 million on the offering over the remaining three-quarters of the year.
Clearly bad news for Netflix, helpless in the face of the phenomenal growth demonstrated by Total Access. Blockbuster was burning a lot of money to achieve it, but Netflix’s internal models indicated that it would take two more years at this pace before Blockbuster risked triggering its debt covenants. In the meantime, Netflix was bleeding subscribers, and risked falling into a death spiral.
Blockbuster’s subscriber base tripled within the first six months of 2007. Despite Netflix lowering their prices, customers still preferred Blockbuster’s hybrid alternative. Evangelist thought the time was right to leverage this phenomenal growth, and check in with Netflix for a new offer. Antioco was nearing his retirement, however, and knew that such a strategic move would have to be carefully conducted. “It will have to wait for my successor,” he told Evangelist.
New CEO Plot Twist
Who was appointed as Blockbuster’s new CEO? Antioco tried to promote an internal candidate, who was highly familiar with both the stores’ side of the house as well as the fast-growing online business. Icahn, however, preferred an external candidate: James Keyes, who completed a successful chapter of over two decades at 7-Eleven. Keyes had a great understanding of retail, and had created a renaissance within 7-Eleven’s chain of physical stores. Icahn was hoping for him to repeat the same miracle with Blockbuster’s declining stores. Something Keyes didn’t really understand, however, was the internet.
Keyes never appreciated how the internet was transforming the habit and preferences of consumers. He didn’t like the fact that Blockbuster Online was a money-losing operation that required huge growth-marketing investments. He didn’t know how to think in terms of customer acquisition cost and lifetime value. And so he reversed his predecessor’s strategy on its head: whereas Antioco cut back on stores and invested in growing blockbuster.com, Keyes did the opposite, expanding the store activities into selling things like pizzas and popcorn, and other products that worked out well for him back in 7-Eleven.
Keyes’s biggest miss was that, as far as movie rentals were concerned, there was no turning back at that point. Consumers wanted the convenience of a web-based catalog, with a vast inventory of movies, where they could enjoy features like managing their watch queue and personalized recommendations. They liked having the store as an option, for times when they didn’t want to wait for the movie to arrive by mail. But – and that’s what Keyes failed to understand – if consumers were forced to choose between an exclusively online experience and having to go to the store every single time, the store didn’t stand a chance.
Keyes insisted on finding out by himself; here is what he said during the November 2007 earnings call:
… We modified our approach to the online business. What had been an online model was really not a digital solution previously; it was more of a competitive response to the demand for by-mail delivery of DVDs. In fact we credit Netflix with the development of that niche, but recognize that our pursuit of by-mail subscribers was a bit overzealous. Clearly our spending on that one channel was exceeding our returns.
So frankly we believe we fueled much of the growth in the by-mail channel during the past three quarters by aggressively promoting Total Access subscriptions, and particularly promoting it in our stores. As a result we did achieve a significant boost in subscriber count but we attracted some of the most price-sensitive and the heaviest consumption customers with our offer of free in-store exchanges.
Our aggressive growth proved the competitive strength of Total Access but it also demonstrated the cost.
Keyes is presenting online rentals as yet another distribution channel. Alongside a stable channel of in-store rentals, as if Blockbuster had control over the mix of customers across the different channels, which it could have optimized to maximize profitability. That was the strategy Keyes had laid out:
Our objective must be profitable growth, and toward that objective we made two deliberate moves: one to dial back our advertising and minimize the promotion of Total Access in our stores [...] second move was to modify the offerings under our Total Access program to provide better value for by-mail only customers while also capturing greater returns from those seeking unlimited access.
This was a conscious effort to prune the tree and in other words, we were willing to walk away from some of our subscribers, those at the far end of the usage scale who are not willing to pay a higher price for unlimited free exchanges.
In other words: Keyes killed Total Access, by cutting advertising budgets, limiting in-store rentals, and raising subscription fees. Netflix couldn’t have hoped for a better gift. Blockbuster executives–realizing the flaws in their new CEO’s logic–rushed to sell their shares as soon as they heard the plan.
Having poured four years of effort into it – and successfully beating Netflix! – Evangelist refused to abandon Blockbuster Online. However, all his attempts to confront Keyes – and highlight the uniqueness and massive profit potential of the program – failed. Defeated, Evangelist asked to at least negotiate the sale of Blockbuster Online. “Who would want to buy it though?” Keyes wondered. “I don’t know,” Evangelist replied, “maybe this guy in California who already offered $600M a few months ago. Keyes refused to allow negotiations with Netflix, and eventually left Evangelist no choice. He quit Blockbuster.
That was the end of Blockbuster Online.
Blockbuster’s Closing Scene
The new policies introduced by Keyes did not reverse the decline in revenue generated by the Blockbuster’s physical stores; it did, however, reverse the decline Netflix was experiencing in subscriber growth. Struggling since Total Access was introduced in late 2006, Netflix’s customer growth almost ground to a halt by the end of 2007. But in 2008, Netflix was growing again. All thanks to Carl Icahn, and his choice to appoint a physical-retail CEO to run Blockbuster at a time when the internet was transforming the industry.
Burdened by its heavy debt, Blockbuster couldn’t survive the great financial crisis of ‘08-’09, and filed for bankruptcy in early 2010. Netflix, meanwhile, reported positive revenue growth throughout the recession.
The reason I like this story is because Total Access has actually worked. The incumbent was succesfully able to hold off the attack. Despite Hastings’s “we expect Blockbuster to be as successful as Barnes & Noble” smugness. The work done by Evangelist and Antioco at Blockbuster illustrates exactly how incumbents should deal with disruptive innovation: let a passionate single-threaded manager incubate it in a separate and independent organization at first, then leverage the distribution advantage of the legacy business.
Total Access also illustrates how hard true disruption could be. Even archaic Blockbuster was almost able to avoid it. The only reason Blockbuster failed was that it volunteered to go bankrupt. Due to Icahn’s choice of CEO. It’s hard to tell how things would have played out in a parallel universe, where Antioco received his 2006 bonus in full, and kept growing Total Access; It might have pushed Netflix into streaming earlier, but it just as well might have crushed Netflix before online streaming even became a viable product. Now that can make for a great fiction film!