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Netflix, Inc. (NASDAQ:NFLX)

Q3 2008 Earnings Call

October 20, 2008 5:00 pm ET

Executives

Deborah Crawford - Vice President, Investor Relations

Reed Hastings - Chairman of the Board, President, Chief Executive Officer

Barry McCarthy - Chief Financial Officer

Analysts

Mark Mahaney - Citigroup

Brian Pitz - Banc of America

Youssef Squali - Jefferies & Company

Barton Crockett - J.P. Morgan

Operator

Good day, everyone and welcome to the Netflix third quarter 2008 earnings conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Deborah Crawford, Vice President of Investor Relations. Please go ahead, Madam.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix's third quarter 2008 earnings call. Before turning the call over to Reed Hastings, the company’s co-founder and CEO, I’ll dispense with the customary cautionary language and comment about the webcast for this earnings call.

We will make forward-looking statements during this call regarding the company’s future performance. Actual results may differ materially from these statements due to risks and uncertainties related to the business. A detailed discussion of such risks and uncertainties is contained in our filings with the Securities and Exchange Commission, including our annual report on Form 10-K filed with the commission on February 28, 2008.

We released earnings for the third quarter at approximately 1:05 p.m. Pacific Time. The earnings release, which includes a reconciliation of all non-GAAP financial measures to GAAP, and this conference call are available at the company’s investor relations website at www.netflix.com.

A rebroadcast of this call will be available at the Netflix website after 5:00 p.m. Pacific Time today.

Finally, as we noted in the press release we issued earlier today, we are going to conduct the question portion of the Q&A via e-mail. Please e-mail your questions to me at dcrawford@netflix.com.

And now I would like to turn the call over to Reed.

Reed Hastings

Thanks, Deborah, and welcome, everyone. I will talk briefly about Q3 and then turn to what I imagine is on everyone’s mind, namely how the recession will affect Netflix.

In Q3, we added 261,000 net subscribers, down 9% on a year-over-year basis, while our total subscriber base grew to 8.7 million, up 23% from a year ago. Our EPS was strong at $0.33, up 43% from $0.23 one year ago.

We continue to improve the Netflix service by adding more content that can be watched instantly on PCs and TVs. We are now up to more than 12,000 choices and with the recent addition of content from Star, CBS, and Disney Channel, have increased the strength of our offering materially.

In Q3, we were very happy with the sales momentum of the $99 Roku device, which provides an inexpensive method for instantly streaming movies and TV episodes from Netflix to the television. Additionally, in early October, LG Electronics released the BD300, the first Blu-Ray player to include instant streaming from Netflix.

Part of our long-term strategy is to get our streaming client embedded in as many Blu-Ray players as possible. LG Electronics was our first such partner and we’ll announce more Blu-Ray partnerships as they are ready for consumers.

In addition to getting embedded in Blu-Ray players, our partnership with Microsoft’s Xbox will help us gain more traction with consumers. Next month Microsoft will release a free software upgrade for all Xbox 360 users that includes instant streaming from Netflix. Xbox 360 owners will have to connect their console to the Internet and join the $50 per year Xbox Live Gold in order to access Netflix streaming. We will know more about its successes and potential a few quarters after it launches.

While our initiatives to deliver content to the TV are gaining real momentum, consumer comfort with watching video on a laptop is also growing, so we are continuing to invest in improving laptop oriented streaming from Netflix.

This quarter, we will begin the rollout of our second generation player software which runs on both Windows and Intel Macs. It’s a huge step forward for online video players and we’ll be announcing the details shortly.

Two of the most significant events in the quarter were our deal to distribute the Starz play content and Starz’s separate decision to close Vongo. Starz is a very successful subscription content wholesaler who had been operating a direct-to-consumer extension called Vongo. Until recently, it looked like we might in a streaming world end up competing with the pay television networks going direct to consumer. Since they have the major studios’ new release content locked up on long-term exclusive deals, this would have led to a very fragmented set of consumer options and slowed the adoption of Internet delivery, so this pivot where Starz distributes its Starz play service through Netflix is very significant.

Our value-add is in our website, in our on-demand streaming model, and in our linking with DVD rental. With this new model, we think we can generate increased profits for Starz, increased profits for Netflix, and over time for the studios.

Now on to the impact of the recession on our business. A quarter ago in July, I told you that we appeared to be substantially unaffected by the then economic climate. Since July, however, the economy has deteriorated markedly. It now appears that the recession means continued subscriber growth for Netflix but not as vast as last year. This quarter to date our net adds are positive -- in other words, we are growing but our net adds so far this quarter are about 30% less than one year ago. For reference, our Q4 subscriber guidance is for our net adds for the fourth quarter to be between 60% below last year net adds on the low end to 6% above last year’s net adds on the high end.

The good news is that our earnings in Q4 will come largely from existing subscribers and not from new subscriber growth, so Q4 earnings are substantially insulated from the current climate. This is the real power of the subscription model.

If there is any effect from slower growth now, it would be more likely to boost Q4 earnings than to shrink them.

A small contributor to earnings in Q4 will be our $1 per month surcharge for those subscribers who have elected to enable access to the more expensive Blu-Ray high definition content. We expect to have about 0.5 million Blu-Ray enabled subs during this quarter and this number will grow over time as Blu-Ray player prices fall from 500 to 300 and below.

In summary, we are in the midst of challenging times that have shaken consumer confidence across the country. But the fact is the people continue to be attracted to the Netflix service and our business continues to grow in both subscribers and earnings. While the economic environment is out of our control and volatile, what is in our control is executing on our strategy, delivering great service with DVDs and instant streaming, and remaining flexible in a fluid environment.

At this point, I’ll pass it over to Barry.

Barry McCarthy

Good afternoon and thank you for joining today’s call. Two weeks ago we preannounced Q3 results and our Q4 guidance. As you know from today’s earnings release, Q3 results were in line with our pre-announcement. Today’s release also updated our subscriber and revenue guidance for Q4, which I’ll say more about in a moment.

As Reed discussed, sub growth slipped below our expectations in Q3 and that’s disappointing news. The good news is that in a difficult economic environment which contributed to slower-than-expected subscriber growth, we managed to grow subscribers by 23% year over year and Q3 financial results demonstrated that our business model is healthy and functioning well.

In Q3, we continued to effectively manage our cost structure and delivered healthy earnings as profit margins expanded 70 basis points on a year-over-year basis. Net income grew by 30% year over year to $20.4 million and EPS grew by 43% year over year to $0.33. This represents an acceleration of growth in both net income and EPS on a year over year and a sequential basis.

With free cash flow of $26.2 million in Q3, the second-highest quarter of free cash flow in our history, with $251 million in cash and short-term investments and with a pristine balance sheet, the business is well-positioned from a financial standpoint to continue to execute on core strategic objectives for growing the business.

Reed summarized those objectives on our last earnings call when he said our goal at Netflix is to materially grow subscribers and EPS every year while expanding the unlimited DVD by mail service to also include unlimited Internet streaming.

My remarks today will focus first on our Q3 performance; second, I’ll comment on our Q4 guidance; and lastly I’ll update you on the progress of our stock buy-back efforts last quarter. Because Reed has already commented on subscriber growth, my comments will address the other key drivers of financial performance last quarter.

With respect to Q3 results, gross margin was an important contributor to strong earnings. On a Q-over-Q basis, gross margin increased by 240 basis points higher than we had initially expected. The primary contributor to margin growth was lower content cost, reflecting a seasonally weak new release calendar. We saw that weakness play out in the mix of new release versus catalog shipments, with catalog shipments reaching an all-time high as a percent of total shipments last quarter.

DVD usage was in line with our expectations last quarter. We have not and we are not seeing increased levels of DVD usage as consumers trim discretionary spending outside the home in response to economic pressures.

Churn for the quarter was 4.2%, the same as it was in Q3 of last year and in Q2 of this year. While we are pleased churn did not increase, we had expected the aging of our subscriber base to produce a slightly lower churn rate in Q3. The state of the economy may explain the modest headwind we have experienced with churn in Q3 and expect to experience in Q4, given the economic climate.

And now a word about SAC -- Q3 saw the first increase in the last six quarters. That’s the bad news. The good news is that SAC declined 15% on a year-over-year basis, which means our economic model remains healthy and we’ve maintained our financial discipline as we continue to grow the subscriber base. The primary reason for the increase in Q3 SAC was the decline in acquisition rates across all channels, including word-of-mouth, once again likely attributable in large part to the economy.

Earlier in my remarks, I commented on our strong balance sheet and I want to spend a moment talking about the composition of last quarter’s cash and short-term investments, which totaled $251 million at quarter end, 62% of which was held in cash, commercial paper, and U.S. government and agency paper. We have no exposure to the sub-prime mortgage market and limited exposure in the asset-backed market. Our portfolio is conservatively invested and appropriately valued and notwithstanding the substantial disruption in credit markets, I think we’re in pretty good shape.

Today’s earnings release lowered our Q4 guidance for ending subscribers and revenue. As Reed mentioned in his remarks, like everyone else we are concerned about the state of the economy, the impact on overall consumer spending and the economy’s impact on our growth rate.

However, on balance we are generally optimistic about our relative growth prospects in the current economic environment because Netflix offers consumers a great service and a good value, and we remain confident we can manage spending and meet our Q4 earnings goals, like we did in Q3. But continued deterioration of the economy in general and consumer spending in particular could slow the rate of subscriber growth.

Finally, I would like to update you on the status of our stock buy-back program. In March of this year, we announced an additional share repurchase program of $150 million. This past quarter, we repurchased 3 million shares at an average cost of $30.09 per share, which leaves $60 million available to buy back additional shares under the current authorization.

Our Q3 buy-back raised our cumulative share repurchases to $11.6 million shares at a total cost of $290 million and an average cost of $25.06 per share.

In closing, we believe the fundamentals of our business model are sound. Our expense structure is appropriately sized to manage our planned growth as well as our strategic objective even in these uncertain times. We are fortunate that our business continues to generate strong free cash flow and that our balance sheet remains healthy.

That concludes my prepared remarks. Now it’s time to answer your questions. As Deborah mentioned at the beginning of our call, we would like you to e-mail your questions to dcrawford@netflix.com as you did last quarter. Deborah will read the questions out loud and Reed and I will do our best to answer them. So Deborah, over to you for the first question.

Question-and-Answer Session

Deborah Crawford

Thank you. The first question comes from Colin Sebastien at Lazard Capital Markets -- can you please comment on pricing trends in your online marketing spend, both on search and display ads?

Reed Hastings

We haven’t seen any material softening of those rates, such that would improve our efficiency. We are sort of watching the trends and hopeful that that from our sake as the buyer of such but nothing has broken yet.

Deborah Crawford

The next set of questions comes from Youssef Squali at Jefferies -- first, can you speak to usage during the quarter? Is there a way to parse out lower usage from the Olympics/blackout in August versus the effect of lower priced plans?

Barry McCarthy

The short answer is no, not really.

Deborah Crawford

Second question -- as we look at fiscal year ’09 knowing what we know today about the economy and the consumer, do you expect the year to be better or worse than ’08 in terms of customer ads?

Reed Hastings

That will depend quite a bit on the economy, so it’s -- normally we expect a relatively similar economy to what we currently have and I think for obvious reasons, that’s not healthy at this point so we will be able to update you on ’09 in January.

Deborah Crawford

Next from Brian Pitz at Banc of America Securities -- we have seen a sharp drop-off in the retail sector in late August and September, even impacting other online names, such as eBay. We were hoping you would comment on subscriber adoption trends in September/October versus July/August, particularly since you have lowered sub guidance in the past two weeks. We assume October was much worse than previous expectations.

Barry McCarthy

In my comments, probably the question was sent in before the comments, for the first time we broke out what we’ve done in the first part of October so for the first three weeks of October, we are experiencing approximately 30% below a year ago in terms of growth, in terms of net additions. So our growth is positive and it’s 70% as big as one year ago October.

Deborah Crawford

Next, also from Brian at Banc of America Securities -- will the Starz deal bear significantly higher costs than your existing online content, in part because the titles appear to be new releases and less “long-tail”? Can you tell us anything about this idea or perhaps if the model is a rev share versus fixed fee versus something else?

Barry McCarthy

We don’t break out details of the contract but all of the costs of it are built into our guidance for the quarter.

Deborah Crawford

From Michael Olson at Piper Jaffray -- why was G&A so low? Is that sustainable?

Barry McCarthy

Michael, there were a number of one-time events in the quarter, the largest of which was our decision to exit the Red Envelope business and those reduced our, on an ongoing basis, spending levels in G&A.

Deborah Crawford

Also from Michael Olson -- what is the percentage of customers using watch instantly? Have you seen the drop-off in DVD by mail for those customers?

Reed Hastings

We’ve seen a growing adoption of the watch instantly as we’ve got more platforms and more content and we expect that to continue. You can’t really see a drop-off in DVD usage because the people who go for online streaming are a different type of person so there’s no good control of what those people would have done, so there’s no easy way to tell that.

What we are feeling good about is with the new Starz content, the breadth of what we have from Disney Channel is we are getting more and more watching, which is exactly what we are aiming for.

Deborah Crawford

From Jim Friedland at Cowen -- what drove the sequential increase in SAC? Was it related to the macro environment?

Barry McCarthy

Well as I said in my comments, there were two effects in the quarter and one is that response rates were down and secondly, we saw less by way of word-of-mouth growth than we thought we would, so the mix of free versus paid was lower than we thought it would be in the quarter, which contributed on average to higher SAC.

Deborah Crawford

Also from Jim Friedland -- DVD purchases are down 2% year over year for the first nine months of the year. Are subscribers watching less content due to the aging base or is the mix shifting to rev-share?

Barry McCarthy

That varies, Jim, quarter to quarter and because the rev-share mix is fluid both as studios switch in and out of rev-share or as studios with rev-share have a hot hand, you really can’t get a read by just looking at the CapEx on it. So overall, I would say it’s pretty steady, which is our spending.

Deborah Crawford

From Barton Crockett at J.P. Morgan -- regarding the Blu-Ray price hike, the idea of percent uptake price hike offset by more product purchases. Does it help ARPU, potential for offset in lower subscriber growth and higher churn from price sensitivity or the opposite -- lower churn, better subscriber growth because of more product?

Barry McCarthy

Can you summarize that, Deborah? I think the question is what’s the overall impact from Blu-Ray adoption and the answer is it remains to be seen. There’s still a relatively small percentage of the subscriber base signed up for Blu-Ray as Reed mentioned in his remarks and we think it will be still relatively small come year-end.

Deborah Crawford

Okay.

Barry McCarthy

Deborah is going to clarify.

Deborah Crawford

Well, Barton, if you have a clarification, would you please e-mail it to me and then I’ll get to it? Let’s go on to the next one, also from Barton Crockett -- what was the gross margin impact of the $6.5 million service credit? Did usage go down? Is it sustainable?

Barry McCarthy

Well, usage did go down, Barton, because during the shipping interruption, we didn’t ship DVDs. We have a rough estimate of what the impact on profit is but it’s hard to know. So I don’t consider it to be a contributor of the higher gross profit in the quarter, probably the opposite but it’s just -- it’s an estimate on my part.

Deborah Crawford

From Michael [Proctor] at Wedbush -- could you please explain the new pricing plan for Blu-Ray access with a simple answer -- is the price increase going to be implemented for all subscribers requiring those who prefer to pass on the Blu-Ray opportunity to opt out? There is some confusion as to whether the pricing is opt-in -- in other words, subscribers who choose Blu-Ray will be charged but those who do not affirmatively choose Blu-Ray will be not charged or opt out as described above.

Barry McCarthy

Michael, it’s opt-in, so if you want Blu-Ray, you go through an additional sign-up as a member saying I would like Blu-Ray and we say it’s an extra dollar, and you say yes or no. The only case that it was opt-out, which is what generated the confusion, was Blu-Ray used to be a free option and of those who had prior signed up for Blu-Ray, they have an opt-out of the Blu-Ray status if they don’t want the charge and that’s what generated the confusion. But for the general subscriber going forward, $8.6 million is opt-in.

Deborah Crawford

From Andy Hargreaves of Pacific Crest -- what was the linearity of churn? Did more people leave late in the quarter?

Reed Hastings

No material change from it -- there’s normal seasonal patterns that we see but there was no significant pattern, for example, related to the economy that we saw during the quarter.

Deborah Crawford

And a similar question, also from Andy Hargreaves -- so linearity of gross additions, was it front-end loaded or consistent?

Reed Hastings

Well as we announced in our pre-release of the numbers, in August, presumably due to the Olympics and to our shipping outage, net additions were light, which is mostly steady churn, so it’s really light, and gross additions, we think from the distraction of the Olympics, and then September was relatively more strong. So it doesn’t tie into the overall retail thesis of things getting worse and worse, and I think the Olympics was a special effect for us in terms of consuming viewing hours and thus obscuring the underlying economy.

Deborah Crawford

From Doug Anmuth at Barclays Capital -- you’ve typically said you grow earnings in the middle of the pack of Internet companies but given the macro environment and even exchange, that pack’s growth rate will seemingly come down over the next 12 to 18 months. Is it reasonable to think you are still in the middle of that pack in 2009 or do you think you can outperform?

Barry McCarthy

Hard to know, as Reed pointed out in his comments, the nature of the subscription business is that it is positioned well to weather the storm of an economic downturn, as compared with a revenue stream that is essentially non-recurring. So we have a lot of optimism about our ability to sustain near-term profits and it’s hard to imagine that there would be a significant sharp downward departure from the overall trend line in earnings growth. Now, it remains to be seen what happens to new subscriber growth on a go-forward in reaction to the economic environment but as I said in my comments, overall we’re pretty optimistic.

So we’ll provide guidance for ’09 on the January call. I haven’t specifically answered your question but I tried to indicate at least our frame of mind as we are thinking about prospects for ’09.

Deborah Crawford

Also from Doug at Barclays -- what are you optimizing more for in tough environments between subscriber growth and earnings growth -- same balance as before and what does that mean for subscriber acquisition costs going forward? You spent more this quarter but you’ve generally pulled back.

Reed Hastings

I would say our balance between earnings growth and subscriber and revenue growth and our thinking on that has not changed materially. If the economy changes materially over the next couple of quarters, it might have to be something we’d look at but assuming that it’s no worse than today, then as Barry said, the power of the subscription model is that it gives us stability through these otherwise turbulent periods.

Deborah Crawford

From Mark Mahaney at Citigroup -- how can Netflix be confident that soft subscriber additions are due to economy and not due to alternative or competition or maturation of the market? Do you have any customer surveys to prove this point?

Reed Hastings

Well, I’m not sure a customer survey would really prove it to you, you know, surveys being as general as they can. It’s definitely something that we think about, which is it is really economy or is it something else? We try to really [key] apart the various competitive and alternative hypotheses and at this point, it strongly points towards economy from a range of sources but it’s something that we keep an open mind about.

Barry McCarthy

I have one additional perspective -- you know, there’s this saying, it goes something like this -- what you see is a function of where you sit and where we sit right now, having underperformed the low end of our guidance expectations for the quarter and lowered our expectations for Q4, it looks like the business is dramatically slowing. It feels like we are underperforming.

On the other hand, if we were to step back to say January of 2008 when our year-end subscriber guidance was 8.4 million to 8.9 million, we’d realize that gee, at the end of the third quarter of the year, we have more subscribers than we were expecting to have at year-end. And in January of this year, we weren’t taking questions about whether or not the market was saturated.

So on a -- what you see is kind of a function of where you sit, I realize that it feels like the economy is slowing and it raises some concerns about future growth prospects for the business but as little as nine months ago, been ecstatic about finishing the third quarter with more subs than we were forecasting to finish the year with. So let’s don’t push the panic button and a little perspective on where we are overall, the business is doing pretty well.

Deborah Crawford

This is from Larry [Wick] at Morningstar -- is Starz free to distribute the content they buy from studios in any form they want? Wouldn’t the studios prefer to deal with Netflix directly?

Reed Hastings

You know, Starz, we’re not privy to what their contracts are with the studios and the studios would prefer to get a lot of money for their content. If Starz pays them a lot of money for, for example, Internet distribution rights, there’s no inherent reason why the studios want to deal with us. So in the current deal, Starz has those rights. They paid for those rights and it makes sense all around to build that market.

We in addition to the Starz deal have lots of other content. The Starz deal is about 2,500 titles in total and we have over 10,000 other titles that are direct with the studios, so we are flexible and we’ll work in both ways.

Deborah Crawford

From Richard Ingrassia at Roth -- what indications do you have, if any, that mainstream consumers are willing to pay a premium for the streaming option or for Blu-Ray?

Reed Hastings

On Blu-Ray, we are charging a premium and we expect to have about a half-a-million subscribers of the 8.6 million, so we have that indication. In streaming, we don’t have any hard indication yet because we don’t have a surcharge on it. Generally people are willing to pay for what they are active users of and don’t want to pay for what they are not using, so the focus for now in the first stage of this is getting the usage up, which is really driven by the content expansion and the platform expansion. And if we are successful on those, as we have been in expanding from 2,000 titles a year-and-a-half ago to 8,000 to 12,000 titles now, to continuing our platform expansion then I think we are really creating consumer value which will be able to be monetized.

Deborah Crawford

Also from Rich Ingrassia -- what happened to the deferred tax assets? Why did this line more than double sequentially?

Barry McCarthy

Let me check that offline and I’ll get back to you -- just off the top of my head, I’m not sure.

Deborah Crawford

From Dan Ernst at Hudson Square -- Blu-Ray, any reduction in Blu-Ray usage after the price cut? What is your outlook for Blu-Ray title selection? Currently rather thin, less than 1,000 titles.

Reed Hastings

While Blu-Ray is thin on a total title count, on a weighted basis it is pretty strong because there is Blu-Ray for all the new releases at this point. So we are optimistic player prices are falling, they are starting to get some volume. It’s the same cycle that we really have seen on DVD. And I think what we will see is like progressive scan was a feature that was only in high-end DVD players and then became a feature in low-end DVD players, and after that was up-scaling with HD [inaudible]. That was a feature on high-end DVD players and then migrated to the middle of the market and into the basic models.

To think of Blu-Ray partially as a player is just a new, better upscaling player and as prices come down, people who even are just DVD watchers are going to get a Blu-Ray player because the prices are low and it upscales the DVD very nicely.

So we really pretty optimistic as prices come down on Blu-Ray players replacing DVD players.

Deborah Crawford

Also from Dan Ernst -- digital content acquisition, title selection numbers moving up but still there are very few of the Netflix 100, as a point of reference, that have the digital option. What is the outlook for adding more popular titles and what are the key obstacles to adding more titles?

Reed Hastings

Well, the key obstacles are really money. The titles are available but expensive and what we have to do is grow the ecosystem of embedded players that connect to the TV, so that we can monetize the content expenses. So what we see is a steady increase in the number of players and devices to over 12,000. So we know there’s a long way to go, it’s going to take many years but we think we are doing, making great progress on that and we’ll continue to do so.

Deborah Crawford

From Barton Crockett at J.P. Morgan -- how much cash do you believe you need to maintain on the balance sheet to be comfortable in this economic environment?

Barry McCarthy

While we have a point of view about that, I think we’ll keep it to ourselves in order to have the maximum amount of flexibility.

Reed Hastings

We’ve been cash flow positive every year for the past six or seven years, including during our big battles with Blockbuster, so --

Barry McCarthy

For as long as we’ve been public.

Reed Hastings

Yeah, as long as we’ve been public so consuming cash is quite unlikely.

Deborah Crawford

From Lloyd Walmsley at Thomas Weisel Partners -- can you please discuss trends in content acquisition with regard to both digital and physical content? Specifically your DVD CapEx growth of 5% this quarter is much slower than ending subscriber growth of 23%. Is the shift you mentioned to more catalog shipments sustainable going forward or more of a quarterly specific trend? As we look to 2009, if we expect the digital product to draw strong subscriber growth and digital content consumption in 2009, should we assume that there is some pressure on gross margin offsetting the revenue gains of subscriber growth?

Barry McCarthy

I think there are two -- I heard what I think are two questions, so correct me as I go. One relates to content purchasing, which Reed already addressed and the mix between any implications of rev-share for CapEx. And as Reed pointed out, it changes from time to time depending on which of our studio partners has a hot hand and at the moment, we have a large studio partner who is in rev-share deals that’s got a hot hand.

And then I think the second part of the question relates to DVD spend -- I’m sorry, ED spending and whether or not increased spending on ED over time will create gross margin pressure on the business, and the answer is in two parts -- one, as Reed has said previously, we are in investment mode in the ED world from a content perspective into 2010 and secondly, at some point, the investments we are making in improving the overall quality of the service, we expect to earn a return on either in the form of lower churn or lower SAC because of higher organic growth or both, or none of the above. In a failure scenario, obviously we are planning for a success.

So we will talk more about our margin impact on ’09 in January when we give our ’09 guidance but suffice it to say, at least with respect to say the Starz content and the dramatic growth in the library during this calendar year, we had baked those increases into our guidance for the current calendar year and we remain on plan from a spending and margin perspective.

Reed Hastings

And one part of that question was is the record high catalog shipments in Q3 sustainable, and the answer is partially yes, as our website gets better at matching people with movies. That tends to shift people to catalog and substantially not in that it’s seasonal. Q3 is the lightest season for new releases. Q4 and Q1 that we are going into are much heavier and this Q3, because of the Olympics, studios really avoided putting out a big new release during that time period. So it was leaner and that was advantageous to us on catalog.

Barry McCarthy

And the catalog mix in this third quarter was the same as it was in the third quarter a year ago.

Deborah Crawford

From Andy Hargreaves with Pacific Crest -- are you concerned about the emerging conflicts between your services, [inaudible] devices and retailers who sell DVDs?

Reed Hastings

Retailers who sell DVDs like Best Buy, Walmart? Not particularly. I think they know that the consumer has a lot of options on cable and over the Internet and we are partnering with them to try to figure out how to sell more devices in a win-win model, especially pushing Blu-Ray, so don’t see a lot of conflict coming on that path.

Deborah Crawford

From Ken Smith at [inaudible] -- what is the Bay area household penetration and the rest of the country household penetration?

Barry McCarthy

Well the Bay area penetration at the end of the third quarter was 18.8% up from 18.5% last quarter, so a 30 basis point improvement. The rest of the country finished at 7.4%, up from 7.2% in the second quarter, so for rest of country, that was a 20 basis point increase, the same as it was a year ago Q2 to Q3, and year ago Q2 to Q3 I think we saw a 40 basis point increase versus the 30 basis point increase this year.

Deborah Crawford

From Youssef Squali at Jefferies -- your year-end subscriber guidance is now lower than what you gave out a couple of weeks ago. Is that an indication of a slower-than-expected October so far?

Barry McCarthy

Yes, a little bit.

Deborah Crawford

From Lloyd Walmsley at Thomas Weisel Partners -- your cost of subscription revenue was down 4% Q-over-Q, while fulfillment expense was up 4%. Was there something related to the usage outage that increased fulfillment costs on a one-time basis or is there something structural that will impact fulfillment expense going forward?

Reed Hastings

There was no big structural change during the quarter, so if there’s a little perturbation there, it might be the outage. But there’s nothing structural going on.

Deborah Crawford

From Doug Anmuth at Barclays Capital -- if the macro environment were to further deteriorate in 2009, would you slow digital content spending versus what you are currently contemplating for the purpose of delivering EPS?

Barry McCarthy

That would definitely be on the table. It depends on what that climate looks like, what the revenue growth and earnings growth look like. But you know, if we’re in an extraordinary situation like that, then there are no sacred cows and we’d look at each element. Keeping subscribers and earnings growing has always been very important to us. You know, we’ve got a great track record on a year-over-year basis, keeping that going and we want to push through this recession with that record intact.

Deborah Crawford

Also from Doug at Barclays -- do you still anticipate one more digital device this year?

Reed Hastings

Yes.

Deborah Crawford

From Scott Devitt at Stifel Nicolaus -- can you speak to the exclusivity of digital distribution agreements, specifically the Roku and Xbox distribution deals? Do partners have the ability to offer their distribution to other content providers? Would you ever have interest in controlling or owning this distribution?

Reed Hastings

The terms generally are Netflix is not exclusive so they can put other video services on those platforms. Xbox already has a very successful video-on-demand service under the Xbox Live marketplace brand and Roku has announced plans to open up the platform and to have their platform have multiple service providers which will help with their sales and help addressable households for us, so we are supportive of that. It’s a pretty wide open heterogeneous world and we are embracing that.

Deborah Crawford

Operator, we would now like to open the call for a few final questions, just in case anyone has an additional question, clarification, or I missed your question. Thank you.

Operator

(Operator Instructions) And we’ll go to Mark Mahaney with Citigroup.

Mark Mahaney - Citigroup

Great. A cost question -- in this [recessionary environment], subscription models should hold up well but in a very limited growth scenario, a severe recessionary, very limited growth scenario, how much leverage do you have over all the cost items? In other words, with almost no revenue growth, can you still deliver material earnings growth? Thank you.

Barry McCarthy

If we maintain our spending discipline at the subscriber level from an acquisition standpoint, then we’ve got a fair amount of leverage and I am highly confident. We’ve never lost that discipline but if we did, then we could -- [a short thesis] on the business has always been that marketing expenses would spiral out of control and the margins on the business would implode. So we use a microeconomic model. It informs us about the lifetime value of a subscriber. We limit the amount of money we are willing to spend at the margin to acquire a subscriber with the knowledge of lifetime value, which is why I am pretty confident that we’ll remain disciplined in terms of how much we are willing to spend at the margin to acquire subs.

Mark Mahaney - Citigroup

Thank you, Barry.

Barry McCarthy

So all of the other costs of the business essentially we think of as variable, although that’s not entirely true -- for instance, the depreciation expense and acquired DVDs is not exactly a variable expense. But the postage and the packaging and the direct labor were all variable expenses associated with getting DVDs out the door. And then the other big expense item are heads. So if you can control your marketing spending at the margin and you control your fixed costs around headcount, you pretty much have your arms around the business, provided of course you continue to provide a good service, subscribers remain happy, and they stick with you.

Now since more than half of our subscriber base has been with us for more than a year, it would take an enormous shock to the consumer ecosystem for the majority of the subscriber base to blow up and leave the service. Not likely to happen.

Mark Mahaney - Citigroup

More shock than we’ve seen already?

Barry McCarthy

More shock than we’ve seen already.

Operator

And we’ll go next to Brian Pitz with Banc of America.

Brian Pitz - Banc of America

Thanks, just a quick follow-up -- any additional color on the one-time charges this quarter? Thanks.

Barry McCarthy

You know, I described them as one-time charges and then I said you can count on seeing them on an ongoing basis and I’m sure I sounded like a fool, at least I felt like one. The majority of the expense savings in G&A related to the decision to exit the Red Envelope business. That will be ongoing savings. It was a smaller, one-time charge that was associated with [inaudible]. That goes away but the majority of the savings I think will be with us on a go-forward basis.

Brian Pitz - Banc of America

Okay, thanks.

Operator

We’ll go next to Youssef Squali with Jefferies and Company.

Youssef Squali - Jefferies & Company

Thank you very much and Deborah, a great job. So as you conduct these exit interviews with customers online, I was wondering if you noticed any pick-up in people maybe leaving Netflix to go to cheaper alternatives like the red boxes of the world. I think historically you’ve talked about how I guess a year-and-a-half ago or two years ago, they weren’t really on the radar screen and the last six to 12 months, they became more relevant. Where do they sit right now?

Reed Hastings

The red box has increased in those exit surveys but when we look at certain areas of the country have very high red box penetration and when we try to see if we can see any increased churn in those areas relative to areas that don’t yet have kiosks, we’re unable to detect any change in the underlying retention. So it seems to be that it’s a substitute for the stores, that is the same people were leaving but they are going to go to a kiosk instead of a store, as opposed to something that inflates our churn.

Youssef Squali - Jefferies & Company

Okay, thanks.

Operator

We also have a question from Barton Crockett with J.P. Morgan.

Barton Crockett - J.P. Morgan

Great. Thanks for taking the question. I’ll try and clarify the one that I mangled in the e-mail -- what I was trying to get at is with the dollar extra you are charging for the Blu-Ray availability, you know, it’s basically charging people for something that they used to get as part of their standard subscription. So what I’m trying to figure out is in your view of it, does that extra dollar result in basically slowing subscriber growth because people are having to pay more for something they used to get as part of the standard feature, or increasing churn? Or does the opposite happen -- do you use that extra dollar charge to buy more product, make it a better service and improve subscriber growth and lower churn?

Reed Hastings

Barton, you imply that doing the dollar surcharge is like a takeaway or something to the subscriber base but almost none of the subs had a Blu-Ray player, so to them, they were never introduced to the feature. The vast majority of our subscribers will only ever know Blu-Ray as the $1 surcharge in this brief intro period that we had for the last nine months where it was too small to even figure out how to charge someone, you know, will be inconsequential. So I think when you look at the local video store, they generally charge $1 more for the Blu-Ray rentals. High definition content on cable and otherwise and on the Internet costs more, so it will seem completely natural to the subscribers that the Blu-Ray high definition content has a small premium attached to it.

Barton Crockett - J.P. Morgan

Okay, that’s helpful and then, a follow-up question, if I could -- what’s going to be the gross margin impact of that higher price? Is it kind of the offset with more spending on Blu-Ray product or is it actually going to be something that boosts the gross margin?

Reed Hastings

We’ve kept our Blu-Ray stock levels in pretty good shape for the last six months and we’ll continue to go on. I think it will be very slow as we get from 0.5 million to a million subscribers. You know, it will ease in over time.

As to whether in the end, you know, it’s positive or negative to current gross margin, is positive or negative to DVD economics, is uncertain. It depends on the pricing of DVD movies compared to Blu-Ray movies and you know, we’re unsure if the current Blu-Ray pricing, which is a considerable premium, will sustain as that becomes a mass product. You’ll probably recall from DVD in its entry 10 years ago that it started off premium priced and then came down, so it’s a bit of an open question on what’s going to happen with Blu-Ray software.

Barton Crockett - J.P. Morgan

Okay, that’s great. Thanks a lot.

Operator

There are no further questions at this time.

Reed Hastings

Great. Well, thank you, everyone, for joining us on the call and I look forward to talking with you again in a quarter.

Operator

That does conclude today’s conference. We do thank you for your participation. You may disconnect at this time.

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Source: Netflix Q3 2008 Earnings Call Transcript
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