Why Blockbuster Went Bust While Netflix Flourished

Blockbuster's $980 million voluntary Chapter 11 bankruptcy filing Thursday marks the end of a very rough road for the video rental company. At some level, Blockbuster's demise was caused by the Internet, which made it easier to download movies and to rent DVDs than to rent VHS tapes. But Netflix (NFLX) faced the same threat from video streaming, and it has handled that transition masterfully. Why the difference? Netflix harnessed technology to create a service that customers like better than their competitors' offerings. Blockbuster was deal-bait.

Blockbuster's bankruptcy will keep some of its stores open and transfer control from Viacom's (VIA.B) Sumner Redstone to corporate raiding veteran Carl Icahn. So if you rent from one of Blockbuster's 3,000 company-operated stores; 400 franchise stores, DVD-by-mail, or rental kiosks you can continue to do so, according to the Dallas Morning News. Not only that, but your rewards programs, coupons and gift cards will continue to be honored.

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Icahn has obtained the financing to keep all this running, helping persuade 80% of Blockbuster's senior secured debt holders to give it $125 million in new debtor-in-possession financing that will allow it to pay suppliers and employees. The new deal cuts its $980 million in debt to about $100 million as the Dallas Morning News reports.

Blockbuster: Doing Deals, but Lagging on Innovation

Blockbuster has an interesting history that features repeated episodes of deal-makers using it to make a quick buck rather than focusing on beating the competition. According to TheStreet.com, Blockbuster was founded in 1985 by a Dallas oilman with a passion for databases. He sold a third of the company for $18 million to Wayne Huizenga, a guy with a record of consolidating fragmented industries like waste management.

By 1989, Huizenga had acquired many Blockbuster rivals and got into some trouble for questionable accounting. At the same time, growth was slowing and new ways for people to see movies -- pay-per-view and cable programming -- were getting more mainstream. By 1993, Blockbuster had 3,400 stores and decided that the growth market was in music. So it proposed a merger with Viacom, which ended with the latter paying $8.4 billion to acquire Blockbuster, according to TheStreet.com.
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Blockbuster struggled with cash flow after Viacom's disappointing August 1999 offering of 18% of its shares to the public, but its deeper struggle was that it was consistently late to the new technology party. Its responses to Amazon's (AMZN) DVD service; Netlfix's mail rental service, and Coinstar's (CSTR) kiosk service all came years too late. In 2004, Icahn -- who had acquired Blockbuster rival Hollywood Video -- bought 9.9 million shares of Blockbuster to push through a merger between the two.

That merger failed, and Icahn sold Hollywood Video to Movie Gallery in January 2005 -- but he still owned his stake in Blockbuster. With today's bankruptcy filing, Icahn has finally gotten his wish to take over Blockbuster, but it seems like a pyrrhic victory.

While it's still the largest U.S. video rental company with 47 million customers, Blockbuster has lost market share to Netflix's DVD by-mail business and Redbox's DVD rental kiosks, according to the Dallas Morning News. Netflix has "15 million by-mail customers to Blockbuster's 2.6 million. Redbox has more than 20,000 kiosks to Blockbuster's 7,000."

NetFlix: Customer-Focused Innovation Leads to Growth

Netflix, by contrast, has been thriving -- even though its traditional model of renting DVDs through the mail is threatened by video streaming. As I wrote in a March 26 article on DailyFinance, Netflix started with a simple, but brilliant idea: Charge people a reasonable flat fee, and mail DVDs to them as often as they want. Later, Netflix took its delivery process one step further: It started allowing people to view streaming videos online.

Netflix's corporate mindset has been key to its ability to adapt as people started gravitating toward online video streaming. It's method is to put new technology at the service of customers while keeping a close eye on changing delivery costs and the competition.

Netflix expects that over the next several years, following the Postal Service's proposed 7% rate hike for DVD mailers, its annual costs to shipping DVDs will climb from $600 million to $700 million. As these charges rise and it becomes more expensive for consumers to rent DVDs by mail, Netflix plans increasingly to focus on online streaming and making more titles available for download.

While the company has grown quickly, Netflix is concerned about the competition -- both old-style movie viewing options and the DVD-rental kiosks. As far as the consumers go, Netflix thinks that busy people see downloading a movie through Netflix as a less expensive -- at $8.99 per month for unlimited rentals -- and more time efficient way to see a movie than making a trip to a movie theater.

The upshot of all those differences in corporate philosophy is that Netflix is prospering while Blockbuster is bankrupt. The contrast highlights why customer-focused innovation trumps deal-doing as a way to grow a business. That our economic system has become so focused on the latter rather than the former helps explain why we're having so much trouble creating enough jobs to employ the 8.4 million people who have been tossed out of work since December 2007. America should take a lesson from Netflix.