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Reed Hastings: Leader of the pack

November 18, 2010, 5:00 AM UTC

Executives from Silicon Valley to Hollywood to Wall Street admires his savvy persistence – and his company’s cool culture. The secret to the Netflix CEO’s success? He never stops looking over his shoulder.

Reed Hastings isn’t supposed to be here — not on a list of the year’s top businesspeople, and certainly not on the cover of Fortune. His DVD-by-mail company, Netflix, was supposed to have flamed out by now, a one-trick pony that was destined to be crushed by Blockbuster or Wal-Mart or Apple or you name it. He and his little red envelopes were supposed to be long gone, with Hastings toiling at some new startup, or perhaps enjoying an early retirement in Santa Cruz, Calif., the laid-back seaside city he calls home.

Whoops. Not only has Hastings earned the No. 1 spot on Fortune’s Businessperson of the Year list, he and Netflix (NFLX) are also killing it: The company he founded in 1997 is the stock of the year, up more than 200% since January, vs. the S&P 500’s tepid 7% gain. Its shares have run laps around even Apple’s. Expanding at home, and now internationally, Hastings has built his company on a hard-driving and risk-taking culture that has made him a guru to a new generation of Silicon Valley entrepreneurs. And his reach extends far beyond the Valley. Hastings already upended the movie distribution business; now he’s changing the media game again by streaming movies and television shows over the Internet — at the expense of Netflix’s still-booming DVD business. Cable companies hate him. Hollywood studios aren’t sure whether to embrace him or fend him off. Virtually every movie deal today includes an online-distribution component. Declares film producer Harvey Weinstein: “It’s because of Netflix.”

Now that Netflix is on a tear, perhaps the only person who does dwell on the company’s near-death episodes is Hastings himself. Not because he wants to stick out his tongue at the haters, but because those experiences are what keep Netflix from losing its edge. An obsession with failure inspires Hastings to try new things, like offering $1 million to anyone who can make Netflix’s movie recommendation algorithms better. It also drives him to do what so many CEOs are afraid to do: cannibalize their own businesses.

“Does the firm survive?” Hastings asks. Dressed comfortably in jeans, burnished brown monk-strap shoes, and a white shirt, Hastings, 50, is kicking back in a courtyard at Netflix’s vaguely Italianate headquarters in Los Gatos, Calif. A fountain bubbles quietly in the background. “The turnover in the S&P 500 is terrifying,” he continues. “Most of the time change in the world overtakes you.”

That restless, slightly paranoid attitude, combined with a Steve Jobs-like perfectionist streak, is what sets Hastings apart, says Kleiner Perkins partner John Doerr. “He’s a hero of mine, as a human and as a leader,” says Doerr, whose firm didn’t back Netflix. “Reed was ahead on the technology curve with the DVD and completely changed an industry.”

And he’s about to do it again. Hastings anticipated, virtually from the moment he started Netflix, that consumers would eventually prefer to get movies instantly delivered via the Internet. (Hastings’ foresight is amazing, considering that back in 2000, less than 7% of U.S. homes had broadband.) And so rather than let any number of current and potential competitors — including premium cable channels like HBO (owned by Time Warner, parent of Fortune’s publisher) and some of the biggest companies in the tech world — swoop in and deliver a lethal blow, Hastings is now retooling Netflix as a streaming-video company, disrupting his own business before it gets disrupted.

“We are in a new race, and we are a player with some very large and substantial firms,” he says. “Just to be in that league is an amazing place from where we were.”

Don’t take it personally

In January 2005, Wedbush Securities stock analyst Michael Pachter called Netflix a “worthless piece of crap.” He put a price target of $3 on the stock, at the time trading around $11. The doubters thought Blockbuster, Wal-Mart (WMT), or Amazon (AMZN), with their economies of scale and established customer bases, would simply destroy Netflix. What Pachter and others missed is that Netflix already was the Amazon of online movie distribution. Not only did its enormous library of titles satisfy film snobs and action-movie buffs alike, but Netflix also excelled at customer service — something few people ever said about Blockbuster. Can’t get that DVD to play? Send it back, no questions asked. Lose a few discs? No problem. Netflix didn’t charge you or rake you over the coals.

When competitors did come after his subscribers, Hastings fought back by lowering prices on subscriptions, and thanks to his longtime technology consigliere, Neil Hunt, the CEO sought to make the personalized experience on the Netflix website better and better. Still, Hastings acknowledges that he benefited from chaos at the competition. Blockbuster, which declared bankruptcy earlier this year, had been saddled with $1 billion in debt, and investor Carl Icahn declined to keep pouring more money into the retailer. If he had, Netflix might not have survived.

Hastings says he has never taken the comments of those who underestimate Netflix personally. Instead, he uses them to motivate and spark ideas at Netflix. A black poster emblazoned with Pachter’s photo and his “piece of crap” comment hangs outside a kitchen at Netflix today. (Pachter, with an embarrassed chuckle, now says he regrets making that statement. “Reed is clearly a visionary,” he says.) Running a business is akin to a legal trial, Hasting says, with prosecutors and defenders offering different viewpoints. “I think it is healthy to have smart people make a number of negative arguments about Netflix. It sharpens our thinking.”

And that’s what gets Hastings jazzed, solving subtle yet tough problems alongside the smartest people he can find. “For me the thrill is making a contribution by solving hard problems,” he says. It all sounds wonderfully introspective and balanced, especially coming from a guy in faded jeans and a graying goatee, but Hastings wasn’t always so enlightened. In fact, a couple of decades ago he was as hardheaded as they come. So much so that he earned the nickname “Animal.”

An “Animal” is born

Hastings grew up in Belmont, Mass., a suburb of Boston, and headed to Bowdoin College in Maine, where he ran the Outing Club, organizing climbing and canoeing trips. After a misdirected, six-week officer-training camp with the Marines, Hastings ended up in the Peace Corps, teaching math in Swaziland before returning to the U.S., where he earned a master’s degree in computer science at Stanford. But some of the Peace Corps has never left Hastings. He is still passionate about public education (another big problem he is working to solve), and he loves the peace of being outdoors. Unlike most Silicon Valley denizens who live in Mountain View or Palo Alto, Hastings opted for the more low-key vibe of La Honda, an unincorporated town west of the Valley that was once home to Ken Kesey and other counterculture types. (Today he lives in Santa Cruz.)

When he was 30, Hastings started a company called Pure Software. Neil Hunt was there in the early days of Pure, as was Patty McCord, who now heads human resources at Netflix. Hastings grew Pure, a public company that built tools for Unix software developers, by making three acquisitions in 18 months. “It was chaos,” Hastings recalls. When Pure was acquired by Rational Software in 1997 for $750 million, it made him a wealthy man, but Hastings realized he had helped build a company of which he wanted no part.

Part of the problem, Hastings says, was that Pure had done so many quick acquisitions that it never developed a distinct culture. It was an incredibly hard-driving place, with Hastings leading the charge (thus the nickname “Animal,” courtesy of McCord). So while sales were doubling every year through most of the ’90s, turnover in Pure’s executive ranks was enormous. Meetings were combative. “We were all young and didn’t know any better,” Hastings says.

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The management team at Rational Software (later bought by IBM (IBM) ), by contrast, had been together for almost two decades. “It was so different how they operated — the level of trust and the quality of interaction between them was impressive,” Hastings says. “That gave me a North Star, something I wanted to grow toward.” The next company he built, using some of the money from his sale of Pure, would be Netflix. (A $40 late fee on a movie rental helped inspire the venture.)

From that first day in 1997, Hastings focused on the startup’s culture, making it a place he enjoyed coming to every day, with people who pushed him intellectually, and a company of which he could be proud. He persuaded Hunt and McCord to join him. (“Yes, I relented to work with him again,” McCord says.) Today at Netflix the entire executive team has been with the company more than a decade, and the trust they have in one another is one of the keys to the company’s success.

Believe us when we tell you that Netflix is a workplace like no other. When Hastings made public a 128-page PowerPoint presentation titled “Freedom and Responsibility Culture” in the summer of 2009, the slide deck was inhaled by entrepreneurs across the web. At Netflix there is no vacation policy; employees take what they need as long as they get their job done. There are no strict compensation rules; workers choose their stock-to-cash ratios. There are few formal titles. Netflix employees come to the office, work extraordinarily hard, and they go home. There are no beer bashes. It is a place for adults, now numbering about 600 salaried employees. “If you are looking for perks, this is the wrong place,” McCord says. “The fun we have here is all about building products.”

As for “Animal,” he has changed his approach. “I am much more honest and direct, but not confrontational,” Hastings says. When he hears ideas that seem too silly, he doesn’t roll his eyes. Instead he digs deeper. He’ll respond, “I don’t understand why you think that is smart. Help me to understand that.” Adds Hastings: “I didn’t know how to do any of that at Pure Software.”

Ditching hardware altogether

Even though Hastings knew the DVD’s days were numbered, he was stymied for years trying to find something that could replace it. As early as 2000, Hastings and his technical team were working on ways to bring movies to the home via the Internet. The best the Netflix team could do initially was deliver a movie over the Internet in about 16 hours for $10 in bandwidth fees. (Remember, broadband was in its infancy, and as a small company Netflix could scarcely afford to buy network capacity in bulk.) Hastings shut the effort down and went back to focusing on DVDs and Netflix’s public offering in 2002.

Hastings took a run at the problem of delivering movies via the Internet again in late 2003. The result was a $300 Netflix-branded box with a hard drive that connected to your movie queue. It took six hours for Teen Wolf to download, but the theory was that movies from your queue could slowly arrive in the background while you slept or were at work. Then, in 2005, YouTube came along, showing the world you could watch videos instantly rather than wait hours for a movie to download. For Hastings it was a revelation. “It was immediately apparent that the click-and-watch approach was fantastic,” Hastings says. He killed the hard-drive device and put his team to work on a streaming machine, a sort of YouTube-in-a-box.

Like the hard drive that Hastings killed off, the streaming player was originally meant to be a branded piece of hardware produced and sold by Netflix. In mid-December 2007, with the box finally ready to go on store shelves and an advertising campaign about to launch, Hastings had a crisis of confidence. What he really wanted was a path to the TV. He knew cable and satellite companies weren’t going to help him distribute a Netflix device, since it would compete with their on-demand services. And ultimately he wasn’t convinced that another piece of hardware, and one exclusive to Netflix, was the way to reach the masses.

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Hastings wanted to ditch hardware altogether. Netflix, he suggested, should try to reach consumers through software that could be embedded in all kinds of devices. It could reside in game consoles, DVD players, TVs, anything that could connect to the broadband Internet and deliver the nascent Netflix streaming service. Netflix’s vaunted culture kicked in: An intelligent, no-question-is-too-crazy debate about Netflix’s future ensued. The consensus: Software (today known as apps) would allow Netflix to reach as many screens as possible.

This time the Netflix streaming player wasn’t totally killed; Netflix spun off the technology into an existing company called Roku, which today makes a digital device that plays content via software from Netflix but also from companies such as Hulu and Amazon. (Netflix sold its stake in Roku to other investors about two years ago.) Hasting says backing away from a Netflix-branded box was painful. “But if you are not genuinely pained by the risk involved in your strategic choices, it’s not much of a strategy,” he says.

For Hastings the decline of AOL (AOL) is a reminder of what happens to companies unwilling to take risks. AOL, the dominant dial-up online service, struggled as broadband service proliferated. It had good e- mail and some unique content, but those services didn’t buy AOL loyalty or make it synonymous with broadband, and ultimately AOL lost customers. Hastings knew a similar fate could befall Netflix if it couldn’t find a way to shift its 10 million subscribers from DVD to streaming. Hastings and his team needed to offer customers something so incredible that it would woo them to the new technology before someone else beat them to it. Even as they were wrapping up the spinout of Roku, Hastings, Hunt, Netflix content chief Ted Sarandos, and the head of marketing, Leslie Kilgore, convened in a conference room dubbed Towering Inferno and came up with a radical plan: They would give streaming away.

Getting customers to streaming

Sarandos, who spent most of his career in the home-video business, had forged close ties with all the Hollywood studios, which see Netflix as a key partner in getting newly released DVDs into the hands of movie buffs. But the studios were seeking big premiums to add streaming to their new-releases distribution agreements with Netflix. They also were concerned that the relatively low quality of streaming video would leave consumers with a poor impression of their films.

So how to lure subscribers to streaming via Netflix? Hastings’ team began experimenting with older films and TV shows that were cheap to acquire for streaming, and they layered on Netflix’s personalization technology. The algorithms that directed customers to the new releases they’d love also pointed them to undiscovered, older gems. Hastings figured he could offer unlimited streaming at no extra cost. By buying bandwidth in bulk from outfits like AT&T (T) and Verizon (VZ) and then hiring companies like Akamai (AKAM) to help deliver the data efficiently, it is able to stream a movie to customers for an average of 5¢ a film, compared with about $1 in roundtrip mailing and labor fees for a DVD.

Hastings bet that all-you-can-eat access to a catalogue of content, even if it was older, combined with the immediacy of streaming would trump the lack of blockbusters. The gamble is paying off: In the third quarter of this year, about 66% of subscribers used the streaming service for at least 15 minutes, compared with 55% at the beginning of 2010 and just 37% in mid-2009. The Netflix service is now available on more than 200 electronic devices, from iPads to smart TVs to smartphones — and subscribers can easily watch on their desktops and laptops. In August, Sarandos cut a deal with Epix, a three-studio joint venture, to stream relatively new movies from Paramount, Lions Gate (LGF), and MGM. Valued at about $1 billion over five years, it surprised and unsettled competitors in the pay-TV world. Hastings had thrown down a gauntlet. Streaming over the Internet would be a player.

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Philippe Dauman, CEO of Viacom (VIA), hailed the deal as a victory for his company. Viacom owns a majority share of Epix, and Dauman participated in the negotiations with Netflix. The Epix transaction created yet another distribution window for the content companies, one that not only preserved the cable companies’ exclusive window for offering new releases on demand, but also protected the studios’ DVD sales business. The upshot? Dauman gets incremental revenue from his movies and TV shows. “My only regret is that I didn’t ask for warrants on Reed’s stock,” Dauman says. “It soared as soon as the deal was announced.”

So, too, did the jitters among many of Dauman’s rivals, which are pushing their own streaming services such as TV Everywhere, a strategy — championed by Time Warner (TWX) CEO Jeff Bewkes — that lets existing pay-TV subscribers access television and movies on devices such as smartphones and computers. The idea is to preserve the exclusivity of content for those who subscribe to it. Time Warner’s HBO unit thus far has refused to sell streaming rights to Netflix; it offers its own Internet-based streaming service to HBO subscribers. “I am sure that, in the nicest possible way, in the offices of HBO and Showtime, there is probably a target with Ted [Sarandos] and Reed’s picture,” says Harvey Weinstein. “But so what? That is what makes it all great — the fact that there is competition brewing and that these guys are that good.”

Loving every problem

And is there ever competition. Pundits and analysts like Pachter now are warning that Netflix could be crushed in a twinkling (or acquired) by the likes of Google (GOOG), Apple (AAPL), or some other well-funded company. There are some barriers to getting into the DVD business — for example, Netflix operates 56 warehouses across the country and has built strong ties with the postal service. In the streaming world? Not so much: Everyone can stream bits via contracts with data-delivery companies like Level 3 (LVLT), Limelight (LLNW), and Akamai.

The DVD rental business also has the advantage of hewing to U.S. copyright law, which essentially states that if you own a disc, you can do whatever you want with it. As a last resort, Netflix could always just go to Wal-Mart and buy thousands of copies of DVDs to rent without studio permission. In streaming, which falls under pay-TV rules, that option doesn’t exist. So either Netflix pays the studios what they want or it doesn’t get that content, which can be locked up in “windows” for years following theatrical and DVD release. Content acquisition costs could go through the roof.

Hastings for the most part is unperturbed. Yes, content acquisition costs could soar, but as long as he keeps subscriptions growing, he can maintain his margins. Could a price war develop as some deep-pocketed rival moves in? Sure, but he’s been there before. “Those are at least two of 10 scenarios that worry us,” Hastings says. Others include the arrival of direct competition from HBO,, and DVD kiosk service RedBox. To be sure, Hastings doesn’t think Netflix will ever provide all the entertainment people want. His customers will also go to movie theaters, opt for pay-per-view on cable, or download via iTunes. “We don’t have to be exclusive,” Hastings says. “We just have to provide enough value that you stay with us for $9 a month.”

Perhaps what worries Hastings most is being caught off-guard by a service that has yet to be built, probably running on top of the biggest wave of the moment, Facebook. Everyone gets movie suggestions from friends on Facebook, bypassing Netflix altogether. “You can imagine something being very social-stream-centric that just ignores all the data-driven things we do,” Hastings says. Not that Hastings plans to stand by and watch social media pick off his customers: “If something like that happens, we have to co-opt those advantages quickly and not allow it to become a vulnerability.” Hastings’ face takes on a thoughtful cast, and then he smiles. These are exactly the kinds of cool, knotty issues Hastings built Netflix to tackle. The problems he’s solving are getting thornier, and he’s loving it.

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