Netflixed: The Epic Battle for America's Eyeballs

by Gina Keating

He and Hastings often met at this café to discuss business—and formed the plan that brought Netflix to fruition. One particular day their debate centered on how to distribute the movies they hoped customers would rent via a hypothetical e-commerce Web site, and they decided they had to test whether the new DVD format that Randolph had heard of could travel across the country on a first-class stamp and survive the hazards of bulk mailing.

Early on they considered and rejected the $12.6 billion video rental and sell-through category as a natural equivalent to the $12 billion bookselling industry that was dominated online by Amazon. Neither Blockbuster nor Hollywood Entertainment’s Hollywood Video chain, the two largest U.S. movie rental companies, seemed to have any interest in potentially cannibalizing their brick-and-mortar stores’ revenues to sell or rent movies online. But others, with deeper pockets—maybe even Amazon—would surely decide to sell movies online soon, and shrinking profit margins would force out all but high-volume players. If it was going to work, Randolph knew, he had to do something to differentiate an online Video Business.

They used the whiteboard in Randolph’s office and spent hours plotting how to convince Blockbuster customers to abandon convenient, familiar video stores for a store that existed only in cyberspace. Customers would also have to wait a week to receive their movies. It seemed ludicrous to imagine that they could challenge Blockbuster by manipulating its own model. By examining Amazon, however, they found their selling point: Their company would boast the largest selection of movies on DVD in the world. They decided the customer interface had to meld the familiar layout of a video rental store with the pictorial and descriptive come-ons of a catalog to make the merchandise seem worth the wait. The ordering process had to be easy; it could not take more steps to choose a DVD online than to pick up a movie from a store and return it.

Based on his experiences as VP of finance and operations at the Internet Shopping Network, Cook saw problems with nearly every aspect of the proposed video rental operation: the labor costs for filling orders were too high and the costs of replacing broken and lost DVDs were unpredictable. DVD players were still too expensive and titles too few to interest mainstream consumers. The technology was iffy—even duplication houses were having trouble standardizing copies so that all DVDs worked in all players. Randolph and Kish went away from their first meetings with Cook and worked out reasonable fixes for each of the obstacles he raised and returned with a modified plan. The moment that Cook decided he wanted to join the venture came when Randolph asked him pointedly, “Jim, don’t you agree that when we solve all these ‘what ifs?’ it will create such a high barrier to entry that there’s no way anybody else could solve this stuff, because it’s so hard to do?”

She pressed Cook, Kish, and Lowe to recruit friends and family members in cities across the country to help field-test each version. They mailed test shipments back and forth for weeks, asking their testers to report by e-mail about the condition of the envelopes and the DVDs. So few people had DVD players at the time that they often had to have their testers send the disks back so they could pop them into the office’s players to see if the disks had been damaged in the mail. The team argued over whether to leave the company’s name off the packaging to discourage theft of the DVDs, and they fussed over minute details in the placement of the crucial bar code that let the mailer bypass the high-speed drum sorters that frequently ripped open envelopes and crushed disks. San Jose post office officials even allowed Cook to dump trays of DVDs into its sorters, day after day, to watch what happened.

DVD player owners were the ideal test market; they were among the most discriminating early technology adopters, already talking about their newest toy online. He set out to influence the influencers—he’d drop into discussion groups posing as a consumer to observe, and then he’d contact the main players secretly to say, “I’m working on something interesting that I think you’ll like.”

Like a real infant, Netflix gave its caretakers many more sleepless nights, and suffered from growing pains associated with disrupting two business paradigms—the VHS format and the bricks-and-mortar rental—in its first year of life.

Netflix was losing money on every transaction, mainly because of the high cost of both the free-rental coupon program and the labor-intensive mailing operation. And Randolph had picked up a troubling trend in the constant market research he and Kish conducted via the Web site: Most customers were not returning to rent at Netflix after exhausting their free rentals.

A few self-inflicted wounds that autumn added to a sense that they might be in over their heads in trying to ride an unproven technology into an unexplored world of online commerce. In September, Lowe and Randolph decided to burn DVD copies of President Clinton’s grand jury testimony in the Monica Lewinsky matter and sell them on Netflix. When the DVD duplication house got backed up with other orders, Lowe agreed to forgo DVD labels to speed up delivery of the already sold disks. Netflix took more than a thousand orders for the Clinton DVD—spurred by news stories about the offer in the Washington Post and New York Times. Randolph and Lowe counted the promotion a big success until a few days later, when they learned that, due to a mix-up at the dub house, a few hundred customers received DVDs containing hard-core Chinese pornography instead of the Clinton testimony. Another rookie mistake cost them more than a little embarrassment: Netflix had not assigned unique numbers for each DVD player coupon, to prevent fraud and duplication when setting up the fast-growing program, because the company’s databases could not handle a matrix so large.

For Hastings, the strife was unnecessary and irritating. He was not one to lose control of his feelings but nevertheless clearly disliked being opposed. In the coming years, those who disagreed with him too often would find their personal capital dwindling and themselves marginalized at Netflix. Shortly after Hastings arrived, he announced without preamble at an executive staff meeting that he wanted to run Netflix, and that he and Randolph would act as co–chief executives. From the wan look on Randolph’s face it seemed clear to some in the room that Hastings either had not discussed the idea with him or had sprung it on Randolph shortly before the meeting. Hastings then turned to Lisa Battaglia Reiss, the human resources manager that Randolph had recently hired from Borland, and laid her off in front of her shocked coworkers, saying he wanted to bring in Patty McCord, his longtime personnel manager from Pure Atria. McCord managed to smooth over his worst gaffes at Pure Atria, and people who knew Hastings well believed that she acted as an emotional sense organ to prevent him from alienating staff—mainly nonengineers—who did not respond well to his blunt observations and pointed criticism.

To the growing contingent of software engineers, however, Hastings was a rock star, a boss with the charisma to gather the smartest people he could find and set them into a productive competition with each other. Rather than the creative family Randolph had gathered around him, Hastings likened the company to a professional sports team, in which players won time on the field on merit alone. Some found the analogy inspiring—others, suffocating.

Randolph and Hastings flew to Seattle and met with Amazon founder Jeff Bezos, who had indicated that he wanted to explore a partnership with Netflix. The two CEOs were willing to trade their DVD sell-through business for a crack at pitching online DVD rental to Amazon’s customers. Hastings also wanted to discuss selling Netflix to Amazon, if the price was right. While Randolph and Bezos hit it off immediately, trading launch-day stories, Hastings was less than impressed with Amazon’s $12 million offer. Instead, they agreed to a cross promotion—Netflix would direct customers who wanted to buy DVDs to Amazon in exchange for placement of Netflix ads on Amazon’s Web site and a royalty for each recommendation.

Randolph and Kish knew from relentless focus groups and A-B testing on the Web site that customers enjoyed their visits to Netflix and understood how to use the site. But their main customers—the coupon-wielding buyers of DVD players—often would not plunk down their plastic and actually pay for rentals when their free disks ran out. There seemed to be no solution for failing to convert the free offers to sales, and it consumed them. As Netflix’s first birthday loomed, the marketing team tested new software that allowed them to personalize e-mails to consumers to prod them to return to the site, sending reviews for movies they had just rented or suggesting films they might like, based on past rentals. The prevailing Internet industry belief was that content-rich sites attracted repeat business, so Randolph hired popular film critic and historian Leonard Maltin of NBC’s Entertainment Tonight to write a monthly online column exclusively for Netflix about new DVD releases. The company signed deals to cross promote with Sam Goody/Musicland stores and Best Buy.

Dillon calculated that it took at least fifteen thousand Netflix customers to support a single distribution center. He developed a “satellite hub” system to achieve faster delivery outside the one-day delivery zones in which trucks delivered outbound DVDs from distribution centers to remote post offices that hand carried them to customers’ homes the next day. The beauty of Dillon’s program was that it continually evaluated and adjusted the optimum locations for distribution centers as Netflix’s customer base grew and changed. The program meticulously tracked postal carriers’ daily rounds by asking customers to disclose when they mailed and received Netflix mailers, leading to a close collaboration between Netflix and the postal service. Dillon first shared his data with postal inspectors in hopes of improving delivery times and tracking occasional bubbles of DVD theft. The relationship later extended to helping postal inspectors nab mail thieves intent on skimming gift cards and checks. As efficient as the distribution system was, the intensive programming demands that attended its rapid growth led to the occasional glitch: Dillon once accidentally ordered the system to deliver every disk in customers’ queues simultaneously. Some delighted subscribers received as many as three hundred disks in a space of a few days.

To improve Netflix’s finances ahead of the IPO, Hastings homed in on the Marquee program as the best bet for a steady revenue stream and eventual profit. He insisted that supporting both subscription and à la carte rental wasted manpower and resources and needlessly confused consumers. He argued strongly for abandoning à la carte rental in a tense meeting in late 1999 or early 2000 with the company’s executive and engineering teams. Several members of both teams had serious doubts about whether the sign-up rate for the subscription service could compensate for the loss of the à la carte business. Kish and Randolph feared the change would anger electronics manufacturers, who were still advertising Netflix coupons on their DVD player boxes. Instead of getting the ten free rentals they had advertised, the manufacturers’ new customers would have to hand over their credit card numbers to receive a free one-month trial subscription. Randolph hoped consumers and manufacturers would not perceive the change as a bait-and-switch tactic.

Losses of $57.4 million loomed in 2000, so Hastings and McCarthy decided to approach Blockbuster again to try for an alliance that would give Netflix a ready source of customers and a link to an established rental brand. It was a bit far-fetched, McCarthy thought, but he admired Hastings for having the guts to pitch it to the company they considered their top rival. Hastings got a call, during a staff retreat in the faux Dutch town of Solvang, that his contact at Blockbuster, Ed Stead, was ready to meet. He boarded a rented private jet that belonged to former game show hostess Vanna White early the next morning, along with McCarthy and Randolph, and flew to Dallas. The summons was unexpected, and none of them had brought business attire along to the retreat. John Antioco stopped in for a few moments to shake hands with them all at the glass-and-steel Renaissance Tower in downtown Dallas, and made a crack about McCarthy’s Hawaiian-style shirt and jeans. McCarthy still retained enough East Coast banking decorum to feel slightly mortified. Hastings laid out his proposal: Why not turn Netflix into an online arm of Blockbuster? The win-win, as he saw it, was that Blockbuster would be spared the expense of converting its huge VHS inventory to DVDs and Netflix would get access to Blockbuster’s twenty million active store users, and pay a fee for the privilege. Netflix would concentrate on back catalog and niche films, leaving Blockbuster with the new-release trade that made up ab...

Talk on the flight back to California was tinged with bravado: Blockbuster was making a mistake that it would soon regret. Antioco was kidding himself if he thought Blockbuster could replicate Netflix’s technological innovations. They now had no choice but to kick Blockbuster’s ass, Randolph vowed.

The executive team made the rounds of the entertainment and financial media to make other predictions, too: Kilgore and Hastings told Billboard in March 2001 that Netflix projected a subscriber base of ten million by 2004, and that a robust catalog of streaming online video would be available to mainstream consumers within ten years. By the time the company reached one million subscribers, Hastings added, independent filmmakers would probably bypass the movie studios and distribute their films online through Netflix. When that happened Americans would already be used to renting online—at Netflix.

true contest with Blockbuster, which had fifty million registered users (twenty million of them active) to Netflix’s three hundred thousand, seemed ludicrous, but it was a great storyline—if only Hastings could get the rental giant to simply acknowledge a potential threat from online rental, thereby legitimizing the business in the minds of consumers, investors, and the media. Throughout the spring and summer Hastings and other executive team members took swipes at Blockbuster in interviews and advertising. “There are ten thousand movies on DVD, and we stock them all. That’s more than ten times the selection of the largest Blockbuster,” Hastings told USA Today in June 2001. “Everybody hates late fees. We never have late fees.” The contrast between the old-world giant and the agile young comer was irresistible to the media, and soon a David-and-Goliath tale emerged that Blockbuster could not ignore.

Once a month the company rented the Los Gatos Cinema and brought in pizzas from the Round Table pizzeria two doors down. These gatherings always began with the “initiation” of new employees—many of them shy immigrant software engineers—who were required to dress as characters from a movie of McCord’s choosing, using costumes she kept in a large closet next to her office. The meetings generally centered on two topics—a report on the state of the company’s finances by McCarthy and a view of marketing initiatives and customer data by Mier. One Friday morning in September 2001, Hastings sent out an e-mail asking the staff to meet on the patio immediately. The summons sent whispered rumors racing among the workers, who quietly filed outside. Hastings attempted the same inspiring tone he assumed every Friday, in spite of the message he was about to deliver. Their mission was to build the world’s greatest entertainment service, to help consumers get movies they love, and to beat the competition, he told them. Netflix needed to cut costs to do that, and to go public. “Here’s what’s going to happen today: A lot of you are going to lose your jobs, and for that, I apologize,” Hastings said. “But I thank you for your time and for your commitment. And for those of us who remain, we’re going to continue to move forward and fight with you in spirit.” Everyone returned to their cubicles and waited for the tap on the shoulder from his or her manager. By the end of the day about 40 percent ...

Antioco’s command that they develop Blockbuster Online separately from the Blockbuster stores meant that the stores’ customer mailing lists were totally off-limits to the online marketing department, and that any online activities couldn’t steal the spotlight from the stores. Blockbuster Online’s ads could not mention, for instance, that the service did not charge late fees, as Netflix did in its advertising, because the comparison could cast a negative light on Blockbuster stores. Evangelist and Cooper had to establish their own relationships with movie studios and negotiate their own terms for buying inventory. When it became clear that corporate headquarters’ benign neglect would not kill the online business, Blockbuster’s franchisees threatened to sue to stop it from going live.

Although Ellis was curious about how Netflix ran its warehouses, he never thought about spying on his competitor or asking his employees to do so. Evangelist, on the other hand, was not quite so principled. He and Cooper recruited consumers in several cities to become Netflix subscribers for the purpose of dissecting the rival service in regular questionnaires sent by the marketing department. The Blockbuster Online team located most of Netflix’s distribution centers on the new consumer blog HackingNetflix.com and studied videos of its warehouse operations that they found on YouTube to figure out how the complex system worked. They encouraged friends and family members to visit the facilities posing as confused subscribers asking to drop off DVDs and have a look around

The consultant had described an integrated in-store/online DVD rental plan that, had it been carried out as described, would have posed a lethal threat to Netflix by giving Blockbuster Online access to the twenty million active customers of Blockbuster’s stores. The convenience of getting a movie in the stores combined with the selection of online rental was something that Netflix could not match. But Hastings was so confident that Blockbuster could not master the complicated technology to integrate the two that he went out of his way to dismiss the service. “In terms of their online efforts, we expect Blockbuster.com to be approximately as successful against us as Barnes & Noble was against Amazon,” Hastings told investors in early 2004. “Until we are sure, however, we plan to watch them closely.”

The first thing that happened, as word of the Blockbuster Online beta spread, was that Netflix’s stock price tanked—again. Netflix investors, now enjoying a brief honeymoon, were notoriously wary. In mid-2002, Netflix’s stock dropped to five dollars on the news that Walmart planned to launch an online DVD rental service. When Walmart launched the site in late 2002, and Netflix’s marketing and analytics staff had had a chance to dissect it, they were underwhelmed. Even before Walmart rolled out its service, at one dollar below Netflix’s subscription price, Netflix had predicted that any entrant into online rental would struggle to replicate the pioneer’s customer experience and functionality. The tiny graphics, the lack of flow, and the clunkiness of the Walmart site revealed its creator’s failure to grasp the idea that an online store had to be more than an animated catalog—it had to engage customers’ imaginations and spark longings strong enough to compensate for the lack of a tactile shopping experience. The market had apparently reached the same conclusion, and slowly bid Netflix’s stock price back up to past its IPO price, to nearly forty dollars a share by early 2004.

“Whenever a competitor says that next year they’ll have a better offering, to me that’s a sign of weakness, because you’re telling competitors what you’re going to do, and you don’t have the service to offer consumers,” Hastings said a few days later.

Shepherd ordered market research on attitudes around late fees and discovered that, while only 20 percent of Blockbuster customers were paying late fees at any given time, more than 70 percent had paid them at one time or another, and most felt the stores were not consistent or fair about the way they were levied. Intellectually he knew the brand was damaged each time a customer got into an argument with a Blockbuster cashier over unexpected late fees, especially as it frequently happened in front of a long line of customers waiting to check out. But the idea of wiping out an important source of revenue when store sales were declining made his gut churn.

Following through on Antioco’s directive, they purchased relatively economical ads that ran before the coin toss and after the last play of Super Bowl XXXIX on February 6 between the New England Patriots and the Philadelphia Eagles. Cooper and his wife, Jess, stayed home to watch the game without interruption. Shortly before the kickoff, Cooper’s BlackBerry buzzed with the hourly subscriber report—two hundred sign-ups. At the hour after the first ad ran, the number was up to nine hundred. The Darth Vader ring tone emanated from his BlackBerry seconds later. “Are you seeing this?” Evangelist asked. “This is big.” Cooper was cautious. “Let’s wait and see what happens next hour,” he said. When his BlackBerry chimed next, Cooper could hardly believe it—two thousand subs. The number kept climbing. Evangelist was ecstatic. That day, Blockbuster Online signed up about nineteen thousand subscribers—nearly four times their daily average. The next day, more than twenty thousand subscribers signed up.

Hastings agonized over whether to drop prices further to meet Blockbuster’s $14.99 holiday price cut, but McCarthy steadfastly objected. With Blockbuster losing even more on every subscriber, relief from its advertising juggernaut was even closer at hand. Kirincich checked his models again—and the outcome was the same. Blockbuster would have to raise prices by summertime. Because Netflix was still growing solidly, McCarthy wanted to sit tight and wait until the inevitable happened. “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.

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 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.

As Antioco rode up into the hills above Park City’s crowded main streets to the address Hastings had indicated, he thought about the three years of gambles, sacrifices, and bravado it had taken to finally gain the upper hand against a foe whose success was riding on the demise of the video store. Still, it had cost him upwards of $500 million to rectify his mistake in not buying Netflix at $50 million when he had the chance. Netflix had gone on to spend a nearly equivalent amount to build and market its service in the ensuing years, but there was no disputing that its superior platform was the product of years of testing and tweaking and perfecting. The cab arrived, and Antioco paid and stepped out onto the porch of the steepled redbrick building where he had been let out. The Netflix chief answered the door himself. As soon as they sat down with their drinks, Hastings cut the pleasantries and turned serious. He congratulated Antioco for the success of Total Access and admitted that the promotion had definitely gotten Netflix’s attention over the holiday quarter. It was a great proposition—and Netflix couldn’t really match it, Hastings continued, but his analysts had calculated that each in-store trade was costing Blockbuster two bucks. With no limits on the number of movies Total Access subscribers—now three million strong and growing—could check out each month, Blockbuster’s debt would add up fast, Hastings observed. Antioco waited for Hastings to come to the point. The ...

Hastings made the proposal sound like he was doing Blockbuster a favor, but Antioco knew it was the closest he’d get to an admission that he had won.

NETFLIX GREETED ANTIOCO’S departure and Keyes’s plan to run Blockbuster for profit with relief. Keyes’s public revelation that Total Access had been killing Blockbuster validated everything that McCarthy and Hastings had been telling analysts and journalists for months. Finally Blockbuster would be forced to run a sustainable business strategy, and they believed Netflix could compete against that approach, and win.

In the spirited discussion that followed, Evangelist learned that Hastings had been prepared to pay Blockbuster Online as much as three hundred dollars per subscriber to put Evangelist and his team out of business. “You had us in checkmate,” Hastings said, conceding that while Netflix knew that Blockbuster Online was burning through money, Total Access was a value proposition they could not match.