How Blockbuster Failed at Failing

In retrospect, it seems obvious that the practice of driving to a store to rent a movie to watch at home was preordained to extinction. The surprise, and the business tragedy, is this: the company that delivers movies to 15 million doorsteps these days isn’t Blockbuster — the retail chain that once dominated the industry — but an upstart, Netflix, that used little more than a website and knowledge of the postal service to topple a far more powerful and wealthy rival.

It had been clear for years that Blockbuster’s model was unsustainable. Heck, Netflix was operating for six years before Blockbuster launched its own movie-by-mail service. So Blockbuster had more than enough time to adapt. Instead, its bosses hinted they could copy Netflix and crush the upstart. When that didn’t work, they could have smartly managed the demise, handing whatever money the firm made over to shareholders. Blockbuster didn’t do that either. It’s one of those companies that failed at failing. Since 1999, Blockbuster has paid out in dividends just 12% of the cash its operations generated. Worse, a succession of managers squandered cash on schemes to keep the outmoded retail business alive. That just delayed the end. On Sept. 23, Blockbuster filed for bankruptcy, a few weeks shy of its 25th birthday.

(See pictures of retailers that have gone out of business.)

For now, Blockbuster’s more than 3,500 stores will remain open. It has worked out a deal with lenders to wipe out most of its $1 billion debt. In return, those lenders will be Blockbuster’s new owners. Analysts estimate the company will have to close as many as two-thirds of its outlets, though CEO Jim Keyes says no determination has made. The same can be said for Keyes. Blockbuster has reportedly hired executive search firm Korn/Ferry to help the company find a new chief executive. While Blockbuster says Keyes may remain in the company’s top job, he is also playing an active role in evaluating any successors.

Blockbuster’s bankruptcy is more bad news for the struggling economic recovery. The Dallas-based organization has 25,500 workers, of which 7,500 are full time. More than half could find themselves out of work. The bankruptcy will also create more vacant spaces in strip malls, adding to the woes of the lagging commercial real estate industry.

Bankruptcy could finally give Blockbuster the chance to provide movies to customers not only through stores but also via vending machines — it currently has 6,630 DVD dispensers — by mail and through a streaming service for Internet-connected DVD players and wireless TVs. “It’s about being the most convenient for the customer,” says Keyes. “Our business model, with multichannel distribution, is well positioned for the future.”

So Blockbuster may survive. But the market has changed so much that the former giant is unlikely to thrive. Its rival Redbox already has 24,000 video kiosks, more than three times the amount Blockbuster has, at supermarkets and other stores, dispensing DVDs at $1 per rental. Blockbuster has matched that price at its vending machines but gets three to five times that for a new release at its stores. In streaming video, Netflix has a huge lead on Blockbuster, yet Netflix is facing stiff competition from the likes of Apple, Amazon and Walmart. “Blockbuster doesn’t have a clear run at the finish line,” says Steve Harnsberger, who follows the market for the technology consulting firm FreeStyle. “Even if they transition to digital, it’s not going to be what they used to make at the stores.”

(See the 100 best movies of all time.)

A Breakthrough Goes Broke
Blockbuster, ironically enough, was the product of a tech advance. Entrepreneur David Cook founded the outfit in 1985. A computer programmer, Cook noticed that typical movie-rental-store owners had no idea what they had in stock. Customers would pick an empty title case off a shelf and wait while a clerk hunted in the back room to see if there were any copies left. Cook programmed computers to keep track of inventory and give him a daily report of what customers were renting. While every video store had the newest releases, Cook’s computers also allowed him to determine which older, classic titles people wanted and which ones to ditch. That allowed Blockbuster to optimize its movie selection. Today it’s Retailing 101, but back then it was a revelation. Combine Cook’s computers with brightly lit stores that had a family-friendly, no-porn policy and Blockbuster was a retail hit.

Over dinner not long ago at a restaurant in Dallas, Cook, 59, who left Blockbuster in 1987 and has since started two technology companies, says the current situation is a shame. “It didn’t have to be this way,” he says. “They let technology eat them up.” Just as Cook’s larger, better-stocked stores had done in the ’80s, Netflix made it easier to find the films you wanted, especially if you weren’t looking for just new releases.

(See five ways to fix Netflix.)

Cook sold a controlling stake in Blockbuster to H. Wayne Huizenga for $18 million, and the new owner turned it into something worthy of its name. When Huizenga took over, Blockbuster had just 19 stores; he increased the number by some 500 a year. He would go on to own AutoNation and sports teams, including the NFL Miami Dolphins, as well as help bring the Marlins to Florida. These days, Huizenga, 72, seems more interested in the Ab Circle, a piece of exercise equipment in his Fort Lauderdale office, than in film rentals. But before Blockbuster went under, he shared some of its secrets.

See TIME’s Hollywood covers.

See the best movies of the decade.

“We had a saying at Blockbuster,” said Huizenga. “If you don’t come in on Saturday, don’t bother coming in on Sunday. We worked hard.” Blockbuster’s share price soared during its rapid expansion. By ’94, there were nearly 3,000 locations generating close to half a billion in annual cash flow.

One of the keys was something Huizenga and his team called “managed dissatisfaction.” On weekend nights, the most popular movies disappeared fast. But Blockbuster had more movie titles than many of its rivals. So most customers would leave with something, if not their first choice, and would have an enjoyable evening anyway. The tactic kept customers happy and boosted profit. Studios charged less for the nonhits, and older titles were often paid for already. In those days, nearly 70% of Blockbuster’s sales came from less-popular fare.

(See 25 people to blame for the financial crisis.)

Huizenga said he knew technology was going to hurt the brick-and-mortar business at some point. He hired a team to research new ways to deliver movies. “We discussed it a lot and thought about buying a cable company,” he said. “But there were so many ways it could go, and none of us wanted to get into an area where we had no expertise.” Having failed to conquer the tech risk, Huizenga devised a brilliant tactical retreat: he made Blockbuster somebody else’s problem. He sold it in ’94 to Viacom for nearly $8 billion.

Without Huizenga, Blockbuster faltered. Viacom tried to turn the stores into outlets for its Paramount and MTV merchandise, selling T-shirts, toys and books. Sales fell. Within two years, Blockbuster lost half its value. Jim Antioco, a former Taco Bell boss who took over as CEO in ’97, refocused on movies. Profits rose again, for a time.

Then Huizenga’s fears were realized: Netflix launched the year after Antioco took over, and within a few years the company started to eat into Blockbuster’s sales. Rather than charge $5 per movie like Blockbuster, Netflix uses a subscription model. For $16.99 a month, Netflix customers can rent three movies at a time, choosing from its 100,000 films via the website. There are no late fees, which always turned off even Blockbuster’s most loyal customers. Keep the movies as long as you like. Send one back, and Netflix sends you another.

At first Antioco didn’t seem to take the Web or the Netflix threat seriously. Blockbuster introduced a flat monthly-rental fee, but unlike Netflix, it continued to charge late fees. It wasn’t until 2004 that Blockbuster launched a competing by-mail service. By then, Netflix had nearly 3 million customers. In a bid to slow the competition, Antioco finally eliminated late fees. Subscriptions increased, but not enough to compensate for the $300 million the company had been getting from tardy renters. Blockbuster’s frustrated board, led by activist investor Carl Icahn, sent Antioco packing in ’07. Keyes took over.

(See the top 10 movie performances of 2009.)

Blockbuster got some things right. It must have, because these days it’s Netflix that’s taking a page from Huizenga’s playbook. About 70% of Netflix’s sales come from less-popular titles. And that’s more profitable. That’s because Netflix has to pay the studios significantly higher fees for new releases rather than, say, foreign flicks or art-house movies. That and the fact that Netflix doesn’t have stores has made it much more profitable than Blockbuster. Last year, Netflix earned $116 million. Blockbuster lost $518 million.

Still, Netflix will have to watch out; its own business model is quickly becoming outdated. Increasingly, consumers are streaming movies over the Internet, cutting out the middleman. And Netflix has a growing number of well-financed competitors, including Redbox. Amazon already sells movies. You can stream movies from Apple, through its AppleTV device, and at Microsoft’s Zune, through its game console xBox. Scarier still, Walmart recently bought the video-streaming website Vudu. Google’s YouTube, movie studios and cable companies are also measuring the market.

(See the 50 best websites of 2010.)

Blockbuster is now in the streaming game, and Keyes thinks he can compete there. For new movies, Blockbuster has negotiated a 28-day exclusive period with four of the biggest studios. Keyes says the new-movie advantage matters when customers can quickly switch from Netflix to Blockbuster with one click from their couch. They’ll pay a premium. Blockbuster charges $3.99 a rental — though for $8.99 a month Netflix lets you watch all the movies you want. What’s more, Netflix has 20,000 films available through its “Watch Instantly” streaming service. Blockbuster’s service carries mostly recent releases. Netflix, for its part, seems to be adapting to oncoming technology, recently launching a streaming-only subscription service in Canada — dumping its original business model. What’s clear is that whether Netflix, Blockbuster or someone else dominates this new world of rentals, a huge market is resetting.

There are few aneurysms in American business. Few companies drop dead. Instead, most endure a long slide into the grave. Harvard professor Clayton Christensen, who has studied technological change and its effect on large companies, says many of the decisions that led Blockbuster to bankruptcy might have appeared rational at the time. “But when faced with a threat by disruptive competitors like Netflix, the circumstances were different,” says Christensen. “Decisions that in other circumstances would have made sense, instead drove the company into the ground.” Into the ground Blockbuster went. In 2002 it had 8,000 stores and a market value of $3 billion. Today, movie-by-mail Netflix is worth nearly three times that much. And Blockbuster is broke.

This is an updated version of an article that originally appeared in the Oct. 11, 2010, issue of TIME magazine.

See TIME’s Pictures of the Week.

See the Cartoons of the Week.