How Blockbuster Almost Beat Netfilx

Last week, former movie rental behemoth Blockbuster announced the closure of its approximately 300 remaining company-owned storefronts,  as well as the cessation of its rent-by-mail business by early 2014. While Dish Network (NASDAQ: DISH  ) , the satellite TV firm that bought Blockbuster following its 2011 bankruptcy, has said its franchised stores will remain open and the streaming movie service Blockbuster@Home will continue operation, this decimation of Blockbuster's once-thriving business represents the end of an era in the world of home entertainment.

As told by author Gina Keating, the story of Blockbuster's downfall is also the tale of Netflix's (NASDAQ: NFLX  ) ascent. And the decade-long battle between the two companies over who would dominate America's television screens is far more interesting and complex than the simple narrative of a young, nimble upstart eating the lunch of its slow-moving, monopolistic competitor. The history of the two companies is intertwined with multiple mergers almost coming to fruition and one brief shining moment when it looked like Blockbuster might actually drive Netflix out of business.

Where it all began

According to Netflix CEO Reed Hastings, the company was borne in 1997 after he racked up a $40 late fee on Apollo 13 at Blockbuster, and thought there had to be a better way to rent movies. While Keating, in her book, Netflixed: The Epic Battle For America's Eyeballs, argues that Netflix's inception was more about finding a way to sell things on a data-rich Internet platform than creating a Blockbuster-slaying killer app, the company's focus on a single rival is instructive. At virtually every stage, Netflix designed its system by asking a single question over and over again: How do we make this experience better than renting a movie from Blockbuster.

Netflix immediately started throwing ideas against the wall and seeing what stuck. There were originally late fees on movie rentals and the company initially made much of its profit through the sale of DVDs. However, Netflix eventually eliminated those fees, a big advantage over Blockbuster. And it got out of the DVD sales game when it realized there was no way it could compete with prices at big box stores like Wal-Mart and Best Buy, which sold DVDs below cost as loss leaders just to get people in the door to buy televisions and digital cameras.

Conversely, Blockbuster paid little attention to Netflix, labeling the use of the Internet to facilitate DVD through the mail a ‟fad."

However, Blockbuster wasn't blind to the power of the Internet. In 2000, Blockbuster signed a 20-year partnership with Enron  (yes, that Enron) to use the energy giant's fiber optic network to facilitate the speedy download of movies directly into people's homes. The deal was scuttled the following year, a few short months before Enron itself went down in flames as one of the biggest corporate disasters in American history.

Around the same time, Blockbuster entered tentative talks to buy Netflix. However, Netflix's asking price of $50 million was so high, according to Keating, that then-Blockbuster CEO John Antioco literally laughed Hastings out of his office.

Missing the digital boat

Despite this early-stage interest in getting into the the online world, Blockbuster management didn't pay serious attention to the threat posed by its upstart competitor. ‟Blockbuster execs were all retail or former restaurant guys with MBAs; they didn't have an idea that technology was really important," explained Keating. ‟No one in upper management understood what was happening with digital delivery."

Finally, a few years later, some young Blockbuster officials studied Netflix's earnings reports and realized that everywhere Netflix was making gains, Blockbuster was losing market share. Once convinced, Blockbuster executives decided to get into the online rental business (this was still in the early 2000s and the streaming model that's since become Netflix's bread-and-butter was not yet a technological reality).

Blockbuster purchased a mom-and-pop company that was doing online movie rentals locally in Arizona for a million dollars. Blockbuster moved the new team into a warehouse down the street from its Dallas headquarters, gave them $25 million, and issued an order to build Blockbuster a Netflix to call its own.

The team that built what ultimately became Blockbuster Online was given carte blanche to do whatever they wanted … with one exception. They were prohibited from utilizing what was arguably Blockbuster's biggest asset, the one enormous advantage that the company had over Netflix: its thousands of storefront retail locations. At its height, over 90% of Americans had a Blockbuster location within driving distance of their homes.

The problem was that many Blockbuster stores were franchised, and franchise owners were deeply skeptical about the company's ambitions to rent movies over the Internet. They lobbied hard to prevent resources from going to the online initiative. "They were very short sighted. It's a shame because the ultimate idea with Blockbuster Online was bring it up to speed and then integrate it with the stores," explained Keating.

Even so, Blockbuster Online did surprisingly well after its launch in 2004.  It consistently beat Netflix on price and soon gobbled up nearly half of new entrants into the online rental market.

The grand plan that almost worked

However, it wasn't enough. By 2007, Blockbuster realized it needed to make a major move toward online or the company was doomed. It rolled out a billion-dollar campaign called Total Access. It almost worked. 

In conjunction with a massive marketing campaign, Total Access offered subscribers an amazing deal: people could rent a DVD online and then return it to one of its innumerable U.S. locations and exchange it for a new movie for free.

The offer was immediately a massive hit with consumers. Membership in Blockbuster Online just about doubled in only six weeks. However, the promotion has some serious problems for Blockbuster; namely, every time someone exchanged one of their DVDs in-store, it cost the company $2. Blockbuster hoped Total Access would draw in enough new subscribers to cover the loss and lead the company off the road to irrelevance.

If nothing else, Total Access terrified Netflix, which quickly realized it couldn't compete Blockbuster's newfound dedication to setting a seemingly unlimited amount of money on fire in the hopes of driving a stake through its bright red heart. Hastings met with Antioco and offered a truce where Blockbuster would sell its online arm to Netflix. The two companies would forge a new system where people could return their moves to Blockbuster stores. It would be a win-win for both firms.

The deal nearly happened, but it was ultimately derailed by in-fighting between Antioco and activist investor Carl Ichan, who held a large stake in Blockbuster and was none too thrilled with the company's newfound strategy of losing very large amounts of money. As he often does , Ichan emerged victorious and Antioco was pushed out. Antioco's successor, who shared Ichan's concerns about the costs of the company's transition to the digital marketplace, not only scuttled the deal, he raised the price of Total Access and stopped letting people exchange movies in stores for free. Unsurprisingly, Blockbuster Online's massive growth quickly ground to a halt.

"The best thing that ever happened to Netflix was Antioco getting fired," explained Keating.

What can we learn?

The death of Blockbuster holds two lessons for business. The first is to not be afraid to kill your darlings. Netflix ditched a bunch of its early business ideas—most notably DVD sales—and ended up all the better for it. Blockbuster, on the other hand, stuck with its established model for far too long and ended up in bankruptcy.

The second is to give people exactly what they want. "[Blockbuster died because it had] an outmoded business model," Keating explained. ‟Customers now are extremely accustomed to getting exactly what they want. Blockbuster customers were leaving stores empty-handed because they couldn't find any of the movies they were looking for 20% of the time. Internally, the company called that 'managed dissatisfaction.'"

Keating echos Hastings' prediction that something similar may happen to cable companies if they don't learn from Blockbuster's example and become more responsive to the desires of consumers, if they want to survive.

Specifically, Hastings has targeted cable companies' refusal to allow consumers to select channels on an a la carte basis and instead sell cable packages as a bundle of channels with little choice. The day is coming, they warn, that TV viewers will select channels like they select iPad apps. If cable companies don't accept that, they may eventually go the way of Blockbuster.

What's next?

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 14, 2013, at 7:20 PM, Truth2Power wrote:

    Why would the cable providers - or, for that matter, content providers - want to unbundle their services? It's a win-win for them. The cable providers get to charge larger fees for a "full package" than for a few a la carte channels. Meanwhile, content providers' "niche" channels are being sold to everyone who buys a cable package rather than the extremely narrow demographic who would pay to receive those channels "a la carte."

    Since both content providers and cable companies are complicit and benefiting in this scheme, there's no incentive whatsoever for them to change, and unless there is some government regulation forcing unbundling - which will probably cause a lot of the "niche" channels to go off the air - I don't really see a viable alternative (although I wish there were...)

  • Report this Comment On November 15, 2013, at 12:27 AM, sliderw wrote:

    Your title is misspelled.

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