In this exclusive excerpt from Netflixed, published with permission, author Gina Keating details the immediate response from Netflix – and its investors – when Amazon entered the movie rental business, just when founder and CEO Reed Hastings believed he and chief financial officer Barry McCarthy had a grip on how to deal with the challenge from Blockbuster Online.
IT WAS CLUNKY AND PLAGUED with software and inventory problems, but in its first three months of operation, Blockbuster Online captured more than half of all the subscribers who were signing up for online rental for the first time. The two-dollar price difference helped divert traffic from Netflix, but persuading subscribers to stick to Blockbuster’s service beyond the free trial period would prove challenging in the shifting competitive landscape that both companies faced in 2005.
Netflix felt the squeeze in new sign-ups almost immediately, but Hastings and McCarthy had bigger problems claiming their attention at almost exactly the moment Blockbuster Online launched. The rumors about Amazon entering their marketplace had grown louder over the summer of 2004, and then, in late September, proof surfaced that there was something behind them.
Jeff Bezos had seen forecasts that DVD sales would erode in a pattern suspiciously similar to the way music sales fell off with the advent of Apple’s iTunes store. Like big-box retailers, Amazon was reaping healthy profits from DVD sales and wanted to protect that business until digital movie delivery became as lucrative as iTunes had become with music. Even though Amazon did not have a distribution system that could match Netflix’s speed, it had all the ingredients it needed to run a DVD-by-mail service until digital delivery became a reality.
In late September Ted Sarandos, Netflix’s chief of content acquisition, delivered solid proof from his studio contacts that Bezos was just three to six months away from launching a competing service, using his existing distribution centers. Amazon had purchased reader sorters to process the mailers and was close to completing deals to buy inventory from the movie studios, his sources in the industry said.
In early October 2004, venture capitalist and Netflix investor John Doerr set up a phone call between Hastings and Bezos in the hope that the two CEOs could reach a business arrangement that would keep Amazon out of their market. But the negotiations stalled a week later over Amazon’s demands for steep fees for referring would-be renters to Netflix. “I talked to Bezos,” Hastings told his executive team. “There is no working together that makes sense.”
McCarthy scheduled a series of marathon board meetings for the following three days to come up with a strategy to either drive off Amazon or find a way to survive its challenge.
The company’s major investors were incredulous and angry. How did Netflix not know Amazon was coming, some asked. The stock price surely would collapse again, others said. How could you do this to us?
Netflix’s executive team began working from the supposition that Amazon would come in at a cheaper subscription price to try to spur sign-ups among its six million daily users, so they decided to carry out the most brutal price cut they could afford. Hastings told Kilgore and her team, and Kirincich, who modeled Netflix’s financial forecasts in McCarthy’s office, to figure out how low they could go on the monthly subscription price and still fund their marketing plan. Because Kilgore’s husband worked at Amazon, they spent a weekend at Kirincich’s house running numbers. On Monday they returned with a proposal to cut the three-out subscription plan by 18 percent, to $17. 99.
Less than a week later, on October 14, 2004, Netflix tucked the news of the price cut into the bottom paragraph of a news release detailing its third-quarter financial results. Hastings divulged to investors and the media on a conference call an hour later that the new price, effective November 1, was intended to position Netflix for Amazon’s imminent entry into the U. S. online rental market.
In a curt nod to Blockbuster Online, he acknowledged that the business environment had become increasingly competitive, but he barely mentioned that newest player in the space. McCarthy announced that he would abandon his plan to leave Netflix at year’s end. He would instead stay on as CFO for at least two more years, and possibly indefinitely, until Netflix had weathered the competitive squall.
“There are very few challenges as exciting as the one we face, if in fact Amazon enters the marketplace,” McCarthy said. “This is going to be epic, and it will be part of the lore of Silicon Valley.”
“Besides,” he added later, “you don’t leave your friends in the middle of a knife fight.”
After spending $10 million to open offices and a distribution center in the United Kingdom, Hastings decided to postpone the international expansion for at least a year, reasoning that he did not want a two-front war with Amazon, which had already launched its UK online rental service.
The raft of bad news sent the company’s stock price sliding again.
“Look, everyone, I know the Amazon entry is a bitter and surprising pill for those of you that are long in our stock,” he told investors on the earnings conference call. “This is going to be a very large market, and we’re going to execute very hard to make this back for our shareholders, including ourselves.”
Then Hastings laid out a scenario at once alarming and exciting: If Blockbuster and Amazon matched or beat Netflix’s new eighteen dollar price, video stores in America would be vacant within a few years. The $8 billion in U. S. store rentals would pour into online rentals, setting off a grab for subscribers, he said. The ensuing growth of online rentals would cannibalize video stores faster and faster, until they collapsed.
As video store revenue dropped sharply, Blockbuster would struggle to fund its online operation, he concluded. “The prize is huge, the stakes high, and we intend to win.”
Excerpted from NETFLIXED: The Epic Battle for America’s Eyeballs. Published by Portfolio/Penguin.
Copyright (c) Gina Keating, 2012.
Gina Keating covered media companies, law, and government as a staff writer for Reuters and United Press International for more than a decade. Her articles have been reprinted in newspapers around the world, and her freelance work has appeared in Variety, Texas Monthly, Food and Wine, Southern Living, and Forbes. She lives in Los Angeles. This is her first book.