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Netflix wasn’t the only thing that Killed Blockbuster

27 May, 2020

We’re going to explore the six biggest mistakes that Blockbuster made and explain how Netflix wasn’t the only reason for their downfall. The blue bar shows Blockbuster’s revenue and the red bar shows Netflix’s revenue.

Six Mistakes
  1. Overestimated their value to Warner Bros.
  2. Underestimated the future value of the internet
  3. Didn’t combine online and in store aspects
  4. Didn’t learn from their customers’ behavior
  5. Gave their franchisees too much control
  6. Short sighted management decisions

Now, it is easy for us to dismiss Blockbuster as just another business that went bankrupt because they couldn’t compete with the internet. While there is some truth to this, there is a lot more to the story. You might be surprised to learn that there was once a time when Blockbuster had a fast growing online movie rental business that even Netflix considered to be a serious threat.

During the 90s and early 2000s, Blockbuster was running like a well oiled machine. They were the biggest name in the movie rental business by far. They had exclusive distribution deals with movie studios, and at their peak, they employed nearly 85 thousand people across nearly 10 thousand stores in 25 countries. For many families a trip to Blockbuster was part of their weekly routine. Throughout the early to mid 90s, the company was growing at a healthy rate and was being managed quite well.

This is DVD commercial
"This, is DVD" commercial

The first sign of trouble happened in 1998 as DVDs were gradually gaining popularity. Warner Brothers approached Blockbuster with a deal that would allow Blockbuster to have exclusive rental rights over new DVD releases for a period of time before they would be available to the general public. This meant that when say, ‘The Matrix’ was released on DVD in 1999, if you wanted to rent a copy in the first couple of weeks, you could only rent it from Blockbuster, nowhere else. In return, Warner Brothers wanted a 40% cut of the rental revenue. This was a pretty good deal for both Blockbuster and Warner Brothers, in fact it was the same deal they already had with VHS tapes. Unfortunately, the Blockbuster CEO at the time, John Antioco turned down the deal.

This was a pretty big mistake and you’re probably wondering why he turned down what seemed like a really good deal, right? Well, now it’s easy to see now that DVDs would eventually take over, but at the time, they weren’t as well known. A 1998 survey found that only 37% of video rental customers were familiar with DVDs [2]. Blockbuster was still trialing DVD rentals on a small scale at the time and they didn’t want to commit to a full scale roll out. On top of that, Blockbuster accounted for nearly half of Warner Brothers’ revenue and they likely overestimated the amount of influence they had over them. This was their first big mistake, they overestimated their value to Warner Brothers.

After Blockbuster turned them down, Warner Brothers significantly lowered their DVD wholesale prices and Walmart quickly took advantage of this. They purchased a significant volume of DVDs at this low price and then sold them in their stores for even less, which sounds crazy at first. But their plan was to cover the loss by placing high profit margin inventory in stores near the discounted DVDs. These are recent photos but you can see right next to the DVDs, they have 290 dollar TVs and 98 dollar digital download cards. They advertised the cheap DVDs which brought more customers into their stores and as a result, they increased sales on the nearby high margin products. This is a pricing strategy called the loss leader, and it worked so well that other big box retailers like Best Buy started doing the same thing. Pretty soon, Walmart replaced Blockbuster as Warner Brothers’ single largest source of revenue.

Interestingly, Netflix was also trying to get into DVD sales as well, but when they found that Wal-Mart and Best Buy were selling DVDs at a loss just to get customers in the door, they realized they couldn’t compete with them on price. So they abandoned their DVD sales idea and went with a rental-only approach. Blockbuster’s mistake hurt both them and Netflix at the same time.

The year 2000 was a pretty rough year for Netflix, the dot com bubble had just burst with had severely impacted the growth of the small and not yet profitable online DVD rental business. In fact they were running out of cash quickly and were hoping to get acquired by another company. They managed to get a meeting with Blockbuster and offered to join forces with them. They wanted to sell Netflix for 50 million dollars while continuing the grow the online DVD rental business under Blockbuster’s leadership. Blockbuster CEO at the time, John Antioco didn’t even make a counter offer and more or less laughed them out of the office. This was mistake number two, Blockbuster massively underestimated the future value of the internet and because of that, they missed out on buying Netflix in the year 2000 for just 50 million dollars. It seems obvious now, but at the time, most internet-only businesses weren’t profitable and it wasn’t known if they would ever be profitable.

Blockbuster HQ
Blockbuster HQ
Blockbuster HQ
Enron Broadband Services Commercial

Also, around the same time, Blockbuster was also in talks with the infamous energy company Enron to launch a video on demand service. While we don’t know for sure, perhaps this deal was another reason why Blockbuster was so dismissive of the online DVD rental business. Video on demand was certainly a better option but the technology wasn’t quite ready yet and the Enron deal eventually fell apart shortly before Enron’s spectacular collapse just a year later.

Despite not getting acquired, Netflix managed to tough it out for a couple of years. And in 2002, after seeing Netflix’s growing earnings, Blockbuster realized that Netflix was starting to make a meaningful impact on their bottom line. At that point, they decided to make their first move into the same online DVD rental market that they had laughed off just two years earlier. They acquired a small father and son company in Arizona called DVD Rental Central that had a small-scale online DVD rental program. Blockbuster paid one million dollars for the business and gave the founders another $25 million to expand their service to compete directly with Netflix. This business eventually became Blockbuster Online which was unveiled in 2004.

For a monthly fee of $19.99, Blockbuster Online allowed customers to rent up to three DVDs through the website and have them mailed to their house within a couple of days. Customers could mail the DVDs back whenever they were done and there were no late fees [3]. It was the exact same thing that Netflix was doing except Blockbuster was able to undercut Netflix by two dollars per month. And it was actually working out pretty well for them.

In 2004, two thirds of American households had internet connections, the majority of which were still dial up connections meaning that internet technology still wasn’t quite ready for online video streaming yet. However, just under three quarters of American households had DVD players [6] and Blockbuster still had a very strong brand name that was synonymous with video rental. While they were late getting into the online rental business, they still got in at a pretty good time, however they missed out on a massive opportunity.

This is mistake number three, they didn’t combine their online and in-store offerings. At that point they had grown to their peak with with just over 9,000 stores, 5,800 being in the United States. 90% of Americans had a Blockbuster store within a short drive of their homes. The stores could have been used for a number of thing, they could have promoteed online rentals, they could have accepted online DVD returns instead of making customers mail them back, thus increasing the chances of the customer coming into the store and renting more DVDs. Stores could have even offered a way for customers to mail order DVDs that weren’t stocked in store this would have eliminated some customers’ frustration of not finding the specific movie they were looking for. Across 9000 stores, they had an enormous amount of valuable real estate but they just didn’t use it.

Blockbuster Total Access Commercial
Blockbuster Total Access Commercial

And you might wonder why didn’t they? Well that was because of push back from their franchisees. You see at the time, 1 in 5 stores weren’t actually operated by Blockbuster, they were operated by franchisees who had a lot of control over how they ran their stores. Most franchise owners were deeply skeptical about the company’s new online movie rental business. They lobbied really hard to keep all of the new, online aspects of DVD rental as far away from their stores as possible [4].

It seems hard to justify bending to the demands of the franchisees when they only controlled 20% of the stores, but unfortunately, most of Blockbuster’s senior management were older gentleman with backgrounds in retail. Internet technology definitely wasn’t their specialty and it’s likely they just didn’t push back against the franchisees as hard as they could have. Despite this struggle, Blockbuster online was still doing quite well. They were able to consistently beat Netflix on price and about one year after launch, they reached two million Blockbuster Online subscribers.

They missed out on another massive opportunity here, though. And this is mistake number four. They didn’t learn from their customers’ behavior. They had a huge amount of valuable information about their customers’ taste in movies. They could have used this information to generate movie recommendations which could have been emailed to customers with a link to rent. This would have created a stronger relationship between them and their customers and kept them coming back week after week.

Netflix was already doing this with their Cinematch recommendation algorithm and say what you will about Netflix recommendations in the current day, Cinematch was actually working quite well back then. Netflix had over 5 million subscribers at the time [5] with an outstanding 97% retention rate, meaning that in a single month, only about 3% of their customers would cancel their Netflix subscriptions. [1]

No More Late Fees Commercial
"No More Late Fees" Commercial

In an effort to be more competitive, in 2005, Blockbuster stopped charging late fees. Although it wasn’t that simple. Here were the new rules, they still had due dates to return DVDs, but customers were now given a one week grace period after the due date. After the grace period ended if the DVD still wasn’t returned, Blockbuster would let them keep the DVD and charge them the sale price minus the rental fee. If the customer didn’t want to purchase the DVD, they could return it within 30 days for a credit, minus a restocking fee [7]. If that sounds a little confusing, you’re not alone. Many customers struggled with this, in fact there were lawsuits over it.

To make matters worse, franchisees had the ability to opt out of the no late fees program and continue charging customers late fees under the previous system. This is mistake number five. They gave their franchisees too much power. As mentioned previously, the franchisees lobbied hard against online DVD rentals and they were now working against the no fee policy too. Of course most customers had no idea whether their local Blockbuster was a franchised store or not, so you can imagine there were plenty of frustrated customers who were charged late fees anyway, even though they were promised otherwise. While I’m sure the franchisees, enjoyed having the freedom to control prices and fees. For the sake of customer experience, both franchised and company owned stores should have all followed the same pricing and fee structure. There is also another tidbit about franchised stores which I’ll get to at the end.

In 2007 Blockbuster launched a massive campaign called Total Access to directly compete with Netflix. Customers could rent a DVD from the internet through Blockbuster Online, then when they returned the DVD to a Blockbuster store, they would be able to rent another DVD for free. It was a difficult campaign to get their franchisees on board with and overall quite risky because they were losing about $2 on every free rental. However they expected that over the long term, Total Access would attract enough new customers to cover the loss. The campaign was initially a massive success and doubled Blockbuster Online’s subscribers in just under six weeks. The future was starting to look a lot brighter for them.

Netflix saw how well the Total Access campaign was performing and felt threatened. The Netflix founder and CEO, Reed Hastings approached Blockbuster with a proposal to buy the Blockbuster Online division and set up a mutually beneficial system where Netflix and Blockbuster Online customers could both return their rented DVDs to any Blockbuster store. It would make Netflix DVD returns more convenient for Netflix customers and it would bring more foot traffic into Blockbuster’s stores. It was a promising sounding deal that had potential and would have benefited both of them.

Unfortunately, a large shareholder Carl Icahn who was also a board member wasn’t pleased with the amount of money Total Access was losing. He drew public attention to the fact that they had spent about 200 million to set up and operated Blockbuster Online and the company was now missing out on about $300 million a year in late-fee revenue. He didn’t like the idea of continuing the expensive Total Access campaign even further and now also handling returns from Netflix. Icahn didn’t like the direction the company was going in and had lined up a private equity firm that he wanted to sell Blockbuster to.

Carl Icahn
Carl Icahn

He was able to exploit a dispute over John Antioco’s annual bonus to get him removed as CEO and replaced with James Keyes who was the former president and CEO of 7-Eleven. Keyes had only been with Blockbuster for less than a year and just like Icahn, didn’t approve of the amount of money being spent on the new and currently unprofitable online aspects of the business.

James Keyes
James Keyes

And this is the biggest mistake of all. Mistake number six, short sighted management decisions. With Icahn’s support, Keyes rejected Netflix’s proposal, he raised the price of online DVD rentals and ended the Total Access campaign’s free movie deal. Almost a complete reversal of the progress Antioco, the previous CEO had made. And it’s no surprise at this point that Blockbuster Online’s rapid growth stopped immediately. At the time, that was a short term decision that unfortunately cost them in the long term.

Many years later, Carl Icahn described Blockbuster as the worst investment he has ever made. He felt the company couldn’t afford to keep losing so much money, however he admitted that things might have turned out differently if they had continued growing the Blockbuster Total access program.

By this point, Blockbuster was in pretty bad shape. They did try to get into the streaming business in late 2007 by acquiring the internet movie provider Movielink. But by that point, in addition to Netflix, Apple, Amazon and Wal-Mart were also in the streaming business which made it especially difficult for them. In December of 2008, CEO Jim Keyes claimed that he still did not see Netflix as competition, instead he pointed out Walmart and Apple as competitors. He was determined to keep the DVD business operating in the near-term and said that ‘DVDs are a melting glacier, yes it’s melting but it’s a slow melt.’ Again, this is another example of a short sighted management decision.

They continued closing stores and losing money and eventually filed for bankruptcy in late 2010. The television provider, Dish Network acquired Blockbuster a year later for 320 million dollars which was a very long fall from their once 5 billion dollar valuation just 6 years earlier. Dish Network had plans to keep around 600 stores open and launch a streaming service to rival Netflix, but these plans never ended up happening and they ended up closing the last of their company owned stores by 2013.

One interesting tidbit is that as of 2020 the last remaining Blockbuster store is in Bend Oregon and it happens to be a franchised store, so even through bankruptcy and the eventual sale of the company, that franchisee still had enough power to keep their store running the way they wanted. So while giving franchisees too much power may have been a mistake for Blockbuster, it actually worked out well for that one franchisee in Oregon.

Blockbuster Closing
Blockbuster Closing

So in the end, the thing that killed Blockbuster was Blockbuster themselves. Netflix tried to work with them multiple times but they kept turning them down. They didn’t leverage the value of their most valuable asset which was their stores, they didn’t learn from their customers to try to provide a better experience for them. All of this combined with continuous short-sighted leadership is what eventually killed Blockbuster.

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