Netflix's lost year: The inside story of the price-hike train wreck

One year ago tomorrow, CEO Reed Hastings took the first of a series of missteps that angered customers and nearly derailed his company. Current and former employees disclose what went wrong.

Before he angered customers by raising prices, before he became the butt of Saturday Night Live satire for his Qwikster schemes, Netflix CEO Reed Hastings alienated some of his key executives. Influential voices at the company departed just before Netflix embarked on a doomed attempt to spinoff DVD operations. Montage by James Martin/CNET

Reed Hastings stopped listening, and that's when the trouble started.

In the spring of 2011, Hastings, Netflix's widely admired chief executive, held a meeting with his management team and outlined his blueprint to jettison Netflix's DVD operations. Netflix managers would tell subscribers on July 12 that they planned to do away with a popular subscription that offered access to DVD rentals as well as unlimited on-demand streaming video for $10 per month. DVDs and streaming would be separated and each would cost subscribers $7.99 a month, or $15.98 for both, about a 60 percent hike. The changes would take place in September.

Jonathan Friedland, the new vice president of global corporate communications who had joined Netflix just a few months earlier, asked whether customers on tight incomes might object to the price hike, according to people at Hastings' meeting. Hastings argued that Netflix was a great bargain. He said he knew that some customers would complain but that the number would be small and the anger would quickly fade.

Hastings was wrong. The price hike and the later, aborted attempt to spin off the company's DVD operations enraged Netflix customers. The company lost 800,000 subscribers, its stock price dropped 77 percent in four months, and management's reputation was battered. Hastings went from Fortune magazine's Businessperson of the Year to the target of Saturday Night Live satire.

To Hastings' credit, what he wanted to do made sense. The DVD's best days are behind it. Video streamed via the Internet is slowly replacing the physical disc, and betting a business on a dying product is never a great idea. So Hastings wanted to get ahead of the curve and focus on streaming, to disrupt his own business before someone else did it for him. It was aggressive, far-sighted, and very much in character.

Hastings is someone who knows a thing or two about disrupting businesses. Netflix, after all, is the company that drove the giants of video rental out of the sector with a simple premise: A simple-to-use Web site that delivers DVDs right to your doorstep. Best of all: No late fees. He became one of those executives with the "visionary" label, who can predict where a market is going before it happens, and was asked to join the board of directors of two of the most important companies in tech, Microsoft and Facebook.

But even visionaries can misread their customers when they are blinded by their past success.

Leading up to the first anniversary of the Netflix meltdown, CNET interviewed former and current Netflix employees to find out how a series of missteps turned into a lost year, and whether it has rebounded from those self-inflicted wounds. Most asked to remain anonymous. Netflix declined to comment for this story.

So how did Hastings stumble? Just prior to the attempt to remake Netflix into a streaming-video distributor, there was turmoil in the company's executive offices. Several of Hastings' most trusted lieutenants were no longer as influential with the CEO. Others had left and their replacements did not yet have the clout to convince Hastings he was being too aggressive for a customer base that by 2011 could hardly have been considered on the bleeding edge of consumer tech.

When customers and the press pushed back, the Netflix response was haphazard, culminating with an amateurish, confusing YouTube video heralding the coming of Qwikster, the spinoff that was supposed to be a life raft for Netflix's DVD operations. The Qwikster plan was scuttled three weeks after it was announced.

"Whatever happened to Fortune's Businessperson of the Year?" asks Wedbush research analyst Michael Pachter, referring to one of the many honors Hastings received in 2010. "Whatever happened to the guy who was invited to the boards at Facebook and Microsoft? What happened to that guy? Do you think Facebook would have invited him to their board now?"

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Apocaflix

Important dates in Netflix's drive to divide the company.

July 11, 2011
Netflix shares top $304 in midday trading.

July 12, 2011
Netflix kills hybrid subscription plan. Access to DVDs and streaming video will now cost 60 percent more.

September 1, 2011
Starz, the pay TV service, announces that it won't supply Netflix with Disney and Sony Pictures films for streaming any longer.

September 15, 2011
Netflix announces that it expects to report 1 million fewer U.S. subscribers in 3rd quarter than anticipated.

September 18, 2011
Hastings apologizes for how the price hike was communicated but says Netflix will spin off DVD operations. The new company will be called Qwikster.

October 10, 2011
Netflix reverses itself and kills the Qwikster plan.

October 24, 2011
Netflix reports 23.8 million total subscribers, down 600,000 from the 2nd quarter.

October 25, 2011
Netflix stock plummets nearly 37 percent.

DVD Co.

Hastings has an unwavering belief that streaming video represented the future of home entertainment. He argued that in times of technological advancement companies that had succeeded at one business often clung too tightly to tradition and to what had made them successful. And then they were toast. He didn't want that to happen to Netflix. While few people disagree with that assessment, some within Netflix doubted Hastings' assessment of how quickly Netflix needed to shift to streaming.

But Hastings pressed ahead. Around March 2011, he took his plan to his executive team and then to the company's vice presidents. Some of the execs who heard Hastings talk about spinning off Netflix's DVD operations into a new company, referred to internally as DVD Co. and later Qwikster, left the meeting thinking Hastings was only considering the idea.

That impression was quickly corrected. Within about 72 hours, some of the group learned that Hastings had already offered the new company's CEO position to Andy Rendich, Netflix's respected chief service and operations officer. Hastings, it appeared, wasn't looking for debate.

Netflix rapidly began executing the plan. Some employees were stunned by how quickly and unemotionally DVD operations, the backbone of the business for a decade, was split off from the company. DVD Co. was moved out of Netflix's offices to a space a few blocks away. Netflix's leaders stopped discussing DVDs. Those Netflix executives who moved to DVD Co. stopped attending Netflix management meetings. Some of those people included Allison Hopkins, Netflix's vice president of human resources, Liz Coddington, vice president of financial planning and John Robison, vice president of DVD product development.

Few people who had worked for Netflix for any length of time were surprised that there wasn't more discussion about the plan. As Netflix's business blossomed and as he was personally applauded in the press, Hastings had grown much more confident in his own decision making, less receptive to taking advice from his senior management team. What's more, few of the people who could persuade Hastings or tell him he was making a mistake were around anymore.

The new Netflix

Hastings co-founded Netflix in 1997 and eventually assembled a seasoned management team that he kept largely intact for a decade at the Los Gatos, Calif., company. The competition and long odds united them. In 2004, when the battle against industry heavyweight Blockbuster was at its fiercest, former CFO Barry McCarthy almost left. A 30-year veteran in finance, McCarthy decided to stay and joked with coworkers that "you don't walk out on friends in the middle of a knife fight."

After Hastings, the two most influential voices at the company were McCarthy and Leslie Kilgore, at the time Netflix's chief marketing officer. Smart, experienced and aggressive, they were the people who could challenge Hastings' ideas.

But in December 2010, after nearly 12 years at Netflix, McCarthy left the company following a conflict about his role and his compensation. For a while, McCarthy, who is now an executive adviser at venture capital firm Technology Crossover Ventures, chafed that Hastings refused to expand his responsibilities, sources said.

McCarthy declined to comment.

Adding to the tension, McCarthy learned that Hastings had given him a far smaller annual pay increase than Ted Sarandos, Netflix's chief of content acquisition. According to The Los Angeles Times, Sarandos' compensation more than doubled from $2.4 million in 2010 to $4.9 million in 2011.

The large pay raise for Sarandos was indicative of how Netflix was evolving. The company was headed to a streaming-video future, and obtaining Web rights for movies and TV shows is tricky. Where once Netflix could obtain discs from a plethora of wholesalers and retailers -- even when Hollywood refused to supply the company with DVDs -- there were few ways around the studios when it came to streaming rights. Sarandos had the Hollywood relationships, and his solid gold Rolodex was very valuable to Netflix.

McCarthy was livid, said the sources, and he went to Hastings to discuss his salary. The two men worked on finding a compromise but the damage was done. McCarthy handed in his resignation and within two days Hastings replaced him with David Wells, Netflix's vice president of financial planning and analysis. The same day McCarthy cleared out.

For Netflix, according to Pachter, it meant the loss of a "world-class CFO."

That wasn't the end of the executive turnover at Netflix. Two months after McCarthy left, Ken Ross, head of worldwide communications since 2005, also resigned. In a 30-year-career, Ross had worked for such companies as Pepsi and Overture. Friedland, the man who replaced him, had a successful journalism career, rising to become chief of the Wall Street Journal's Los Angeles bureau, before moving into public relations. Still, when he took over for Ross, he had worked in PR for less than five years.

Ross' exit wasn't nearly as dramatic as McCarthy's. The previous September, when Netflix launched operations in Canada, the company was accused of hiring actors to appear at a press conference and dupe reporters into believing they were fans of the service. Netflix said the actors were hired for a separate promotion and denied they intended to deceive anyone. Ross had little to do with the situation, according to sources. They say the mistake was made by a junior person at an outside PR agency. Nonetheless, Hastings blamed Ross, who resigned in February 2011.

"The flub in Canada was amateurish but not more than that," Ross told CNET. "It didn't impact what was a resoundingly successful international launch but it did bring things into focus. The fact is, after commuting for six years from Los Angeles to Silicon Valley, I'd been contemplating an exit strategy for some time and had been struggling with it. It was clear to me in the aftermath of the Canada launch that the next chapter in the Netflix story needed to belong to someone else."

Hastings can be hasty

Still, in early 2011 Hastings had little reason to doubt himself. Netflix's share price had surged more than 200 percent during 2010, and that February he enjoyed a unique honor. When a dinner was held for President Barack Obama by some of the tech sector's most notable leaders, Hastings was there, alongside Steve Jobs, Larry Ellison, and Mark Zuckerberg.

Obama dinner with tech execs
President Obama has dinner in Woodside, Calif., in February 2011 with tech leaders including John Chambers (Cisco), Larry Ellison (Oracle), Reed Hastings (Netflix), Carol Bartz (Yahoo), Steve Jobs (Apple), and Mark Zuckerberg (Facebook). Official White House Photo by Pete Souza

As for the company's direction, Hastings was unwavering: Streaming, streaming, streaming. He'd been preaching it for years. In May 2008, the CEO predicted that DVD rentals would peak within five years. In February 2009, he told Bloomberg: "We've got one singular objective, which is 'Be successful in streaming.' If we do that, that's a home run."

Netflix had built a streaming video distribution platform compatible with hundreds of Web-connected devices. Some of these gadgets enabled the company to offer for the first time numerous ways for customers to watch Internet video on their TVs. Rivals such as Amazon, Hulu and Google found themselves far behind as the popularity of streaming exploded in 2010. The company added 7.7 million new customers that year, a 62 percent increase, and that brought the total number of subscribers to 20 million. Five years earlier, Netflix's total subscribers numbered 4 million.

Hastings wanted more and he believed Netflix needed to continue to move fast. Netflix's data showed that interest in DVDs was declining. If given a choice, people preferred the instantaneous gratification from streaming video. If not Netflix, someone else soon would supply them with that. But when? That was the big question and the big risk for Netflix. Move too fast, and you alienate customers. Move too slow, and you lose them to someone else. Damned if you do, and damned if you don't.

Pachter argues that the planned shift to streaming was ill-timed because there's still plenty of money left in DVDs.

"DVDs are a cash cow for Netflix," Pachter said. "Why would you kill off that business before it's harvested? Consumers weren't looking for Reed to get out of the DVD business. They were just looking for more streaming content."

'Greed' Hastings

If Hastings didn't understand what customers wanted, they were all too willing to teach him on July 12, when the price hike was announced in what many thought was a poorly worded post on Netflix's company blog.

"We are separating unlimited DVDs by mail and unlimited streaming into separate plans ," wrote Jessie Becker, a Netflix marketing manager, "to better reflect the costs of each and to give our members a choice: a streaming-only plan, a DVD-only plan or the option to subscribe to both. With this change, we will no longer offer a plan that includes both unlimited streaming and DVDs by mail."

Critics immediately seized on the 60 percent price hike for customers who wanted access to both DVDs and streaming. Subscribers lashed out at Hastings on Facebook, Twitter, and in the comments area of the company's own blog. The CEO got a new nickname: "Greed" Hastings.

Netflix's PR team tried to respond. They said the increase was equivalent to a couple of Starbucks lattes. They pointed to all the on-demand movies and TV shows available anytime on the service. But Netflix was spitting into the wind.

Two weeks later, when the company reported second-quarter earnings, Hastings said in a letter to investors that the company was sorry for upsetting subscribers, but he predicted that most wouldn't cancel. In the same letter, Hastings also clumsily added that the increase would likely help Netflix for the first time top $1 billion in quarterly revenue.

Communicating with subscribers was never one of Hastings' strengths, says Mike Kaltschnee, founder of Hackingnetflix.com, a popular blog dedicated to news and information about Netflix. He says Netflix has a long record of changing the service or the site and not properly explaining those changes to users.

"They've done this so many times," Kaltschnee said. "There's this pattern that you come to recognize about Netflix. Sometimes they just don't stop to listen to their customers when their customers are telling them they aren't happy."

It's a bewildering, still-unanswered question: How could a company that had built such customer loyalty be, at the same time, so tin-eared to what those customers wanted and so slow to respond when they made their wishes clear?

Starz doesn't shine on Netflix

Compounding matters, the selection in Netflix's streaming library was getting skimpier. Customers complained that Netflix was asking them to pay more for less. Behind the scenes, Hollywood film studios, which had never been keen on Netflix, began raising the fees to license movies for Internet streaming, or Netflix was prevented from acquiring certain titles because the Internet rights were already locked up by other outlets.

And then Netflix lost its contract with Starz .

Starz is a premium pay TV service that owned the Internet rights for about 2,500 Disney and Sony Pictures movies. In 2008, Starz leased the movies to Netflix for three years. On September 1, 2011, Starz announced that it would not renew the agreement and that the movies would disappear from Netflix's streaming library in February 2012. According to former Netflix employees, the company's managers thought they had a gentleman's agreement with Starz to make a joint announcement about the end of the deal.

"They sucker-punched us," said one former employee.

Netflix said Starz was asking too much money to renew and started doing damage control. The company's public relations execs said the Starz films represented only 2 percent of viewing time. But that's not what the company had said earlier. In January 2010, Netflix leaders called the Starz agreement "one of our most important deals." Starz was one of the few places where Netflix could get its hands on relatively recent movies to stream. For Starz, the announcement was brilliant timing. Ordinarily, Netflix customers would have slammed Starz for being a money-grubbing old-media company. Instead, the announcement came just about the time the Netflix price increase began kicking in for some of the company's subscribers, and Netflix took the heat.

On Wall Street, the failure to sign Starz sounded warning bells. Some wondered whether Netflix could afford the rising costs of streaming video. Netflix shares, which had topped $300 the day before the price increase was announced, were down 25 percent.

Hastings wasn't around to witness much of the fallout from this latest setback. He and some of his managers embarked on a two-week trip to Latin America to help open more than 40 new markets, including Mexico, Brazil and Chile. When the CEO returned in mid-September, his company was in crisis.

On September 15, Netflix issued a startling announcement . Managers said they expected 1 million fewer U.S. subscribers in the third quarter than previously anticipated, a 4 percent shortfall. Wall Street began to panic. At the close of trading that day, Netflix's shares were down nearly $40, or about 19 percent, to close at $169.25.

Qwikster is deadster

Hasting's next move made matters worse. He decided to unveil Qwikster , formerly named DVD Co., a month earlier than planned. He announced the change via a hastily shot YouTube video alongside Rendich, the executive in charge of Netflix's customer service and DVD operations who was supposed to become Qwikster's CEO. Friedland and others that day tried to talk Hastings out of announcing a major change at the company this way, according to sources.

They couldn't talk him out of it.

Andy Rendich (left), the well-regarded Netflix exec who oversaw customer service and DVD operations, was supposed to become CEO of Qwikster. Six months later, there was no Qwikster and he left Netflix in February. Click on photo to watch video. Screen shot by Greg Sandoval
On Sunday, Sept. 18, a professional video crew was hired without Hastings' knowledge and he wasn't happy. He growled that he didn't want a slick-looking video, a Netflix backdrop or studio. He wanted it videotaped in the courtyard of the company's Los Gatos headquarters, no rehearsal and very casual.

Initially, Netflix planned for Hastings to announce Qwikster in a few media outlets with select reporters. Friedland killed that idea, telling colleagues that Hastings was too emotional. The news was also starting to leak and reporters were calling about rumors regarding a new spinoff. Hastings told his staff that if Netflix didn't hurry and announce, someone else would do it for them.

The video was posted to YouTube that night. Critics said it was confusing and both Hastings and Rendich looked uncomfortable.

Unfortunately, the hubbub over the video overshadowed a contrite blog post from Hastings.

"I messed up," Hastings wrote. "I owe everyone an explanation. It is clear from the feedback over the past two months that many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming, and the price changes... In hindsight, I slid into arrogance based upon past success. We have done very well for a long time by steadily improving our service, without doing much CEO communication.

"Inside Netflix I say, 'Actions speak louder than words,' and we should just keep improving our service. But now I see that given the huge changes we have been recently making, I should have personally given a full justification to our members of why we are separating DVD and streaming, and charging for both. It wouldn't have changed the price increase, but it would have been the right thing to do."

Hastings' brutal self-assessment was largely lost upon customers who realized that Netflix would require them to create a new account and video queue, as well as receive an additional bill. Netflix was popular in large part because it was easy to use. Hastings was messing with his company's promise of simplicity.

Qwikster lasted all of three weeks before Hastings killed the plan on October 10 . There was no mistaking it now: Netflix was behaving erratically . The Netflix bashing had gone mainstream a week earlier when Saturday Night Live lampooned the company's YouTube video in a searing skit that mocked everything from the name of the spinoff to Hastings' goatee.

Netflix customers voted on the price hike with their feet. In seven consecutive quarters, the number of Netflix subscribers increased by at least 1 million. In Q3 of 2011, the company lost 810,000 customers. Chart by CNET, data from Netflix

On October 24, Netflix reported earnings and revealed that it had lost 800,000 subscribers in the quarter ending September 30. Prior to that, the number of Netflix subscribers had grown by at least 1 million in each of the previous seven quarters.

The next day, the bottom fell out of Netflix's stock as it lost more than a third of its value. Shares were trading at $77. In the three months since the price hike, Netflix had lost three-quarters of its value.

Aftermath

Netflix appeared to rally in the fourth quarter when it reported revenue of $876 million, a 47 percent improvement from a year earlier. The company started adding subscribers again, mostly from overseas, and investors pushed the stock up 13 percent in after-hours trading to $107.25.

Behind the scenes, Netflix managers were worrying about what to do with the more than 150 Qwikster employees they had started hiring from inside and outside Netflix. A small number stayed on at Netflix, but most were out of luck. For most of the former Netflix employees who moved to Qwikster, their old jobs had been filled. They no longer had a place at the company.

That included Rendich. A 12-year Netflix veteran, he had worked his way up through the management ranks by distinguishing himself time and again, say the sources. Under his supervision, the customer service unit and the distribution centers were huge successes.

Rendich was on track to finally get his reward with the top job at Qwikster, a company that would have come with 10 million subscribers and a large revenue stream. Instead, he quietly resigned from Netflix in February.

Rendich declined to comment for this story.

Some of his former colleagues are still angry about what happened to him. They say that he rarely got the credit from management he deserved and that when Hastings botched the Qwikster launch, Rendich "got tossed under the bus."

"Rendich is gone?" Pachter, the research analyst, asked when informed of the executive's departure. "What was Netflix before streaming? The success was built on customer service and getting those DVDs turned around quickly and that was Andy. His departure bothers me more than the others."

In January, Netflix said goodbye to Kilgore, the company's chief marketing officer since 2000. A former Amazon executive, Kilgore resigned and took a non-executive position on Netflix's board. This was a graceful shift but it was not without some discomfort. The architect for Qwikster had mostly been Hastings, but Kilgore helped. Hastings publicly acknowledged that he screwed up, but plenty of people inside Netflix believed that Kilgore shared some of the blame. Kilgore did not respond to interview requests.

Saturday Night Live poked fun at Netflix and the decision to name the company Qwikster. Fred Armisen, as Andy Rendich, says: 'We've merged with Aflac to make Qwakster.' Click on photo to watch video. NBC

Hastings had considered limiting Kilgore's role at the company long before Qwikster, say insiders. It was Kilgore, the chief marketing executive -- not the chief financial officer -- who oversaw the annual and quarterly subscriber forecasts. Kilgore controlled public relations. Kilgore had let it be known that if her duties were ever reduced, she would leave. Hastings relented until after Qwikster, when he made it clear he would finally restructure marketing. Good to her word, Kilgore stepped down as CMO.

In a little over a year, four of Netflix's top managers -- McCarthy, Kilgore, Rendich and Ross -- were out. Some of them were instrumental in helping take the company public in 2002. They helped lay waste to traditional movie renting, and created one of the most recognizable and respected brands on the Internet.

What now?

The turnaround that Hastings appeared to be orchestrating in the fourth quarter of 2011 didn't last long. Last April, the company issued a first-quarter earnings report that included a $5 million loss on revenue of $870 million . Netflix also predicted light subscriber growth. Hastings asked for calm and said the business was performing well. Wall Street didn't buy it.

"I don't think anyone is ready to give Netflix the benefit of the doubt at this point," Aaron Kessler, an Internet analyst with Raymond James, told the Associated Press in April.

Nonetheless, the prospects for today's Netflix are brighter than the tale of last year's disaster might lead one to expect. Netflix managers still have their distribution platform, which includes more than 800 devices that are compatible with the company's streaming service. They are still aggressively priced at $8 per month for streaming or $16 for DVD and streaming. Nobody, not Apple, Google, HBO or Amazon, comes close to offering access to as much content for the same price.

The company continues to invest in original and exclusive content, such as the upcoming series "House of Cards" and "Arrested Development." Last week, Hastings caused a stir by posting to his Facebook page a note that Netflix subscribers set a new benchmark by watching 1 billion hours of television shows and movies via the service in the month of June. That pushed Netflix shares up 13 percent to $81.72 on Thursday.

Netflix, to some observers, is shaking off its self-inflicted wounds.

"Competition remains a very significant risk," Mark Mahaney, a research analyst for Citigroup, wrote recently. "But Netflix's execution track record -- even with [last year's] pricing and product mistakes -- is relatively strong. And the Netflix Streaming story is still early days."

At close of trading on Tuesday, Netflix shares were down 3 percent to $80.23. That's still down 73 percent from the company's high of $304 back on July 11, 2011.

The challenges, however, are many. There's more competition domestically and abroad. The costs of expanding to new markets looks high, and there are doubts that the company can afford to pay for expansion while it's trying to keep up with the spiking costs of licensing fees. Finally, it's still unknown whether the new version of Netflix's management team can execute as effectively as the old one.

Netflix is in a knife fight again, and now it has to work harder than ever to keep customers on its side.

"I think with the original content Netflix acquires, if they hit on a 'Mad Men,' if these shows start driving traffic and Netflix becomes more like HBO, I think they can make the transition," said Kaltschnee of the blog Hackingnetflix.com. "But people don't see them like they once did. People aren't in love anymore."

Correction at 5:30 a.m. July 12: This story incorrectly stated one of the duties of Leslie Kilgore. Financial planning and analysis was overseen by Netflix's chief financial officer. Kilgore was responsible for quarterly and yearly subscriber forecasts.

 

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