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Netflix, Inc. (NASDAQ:NFLX)

Q4 2008 Earnings Call

January 26, 2009 5:00 pm ET

Executives

Deborah T. Crawford - Vice President, Investor Relations

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

Barry McCarthy - Chief Financial Officer

Analysts

Michael Olson – Piper Jaffray & Co.

James Friedland – Cowen & Company

Richard Ingrassia – Roth Capital Partners, LLC

Douglas Anmuth – Barclays Capital

[Snirnivoss Anonca – Oppenheimer & Company]

Colin Sebastian – Lazard Capital Markets

Matthew Hart – Van Kampen Investments

Daniel Ernst – Hudson Square Research

Tony Wible – Janney Montgomery Scott, LLC

Mark Mahaney – Citigroup

Youssef Squali – Jefferies & Co.

Heath Terry – Friedman, Billings, Ramsey & Co.

Derek Brown – Cantor Fitzgerald

Charles Wolf – Needham & Company

Andy Hargreaves – Pacific Crest Securities

Operator

Welcome to the Netflix fourth quarter 2008 earnings conference. As a reminder today’s call is being recorded. For opening remarks and introductions I would like to turn the conference over to Miss Deborah, Vice President of Investor Relations.

Deborah T. Crawford

Welcome to Netflix fourth 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 fourth quarter at approximately 1:05 pm 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’d like to turn the call over to Reed.

Reed Hastings

Welcome everyone to the call. Our goal is to grow subscribers and earnings every year while expanding into Internet delivered video. We made great progress against this goal in 2008. Despite the recession we grew our subscriber base from 8.7 million to 9.4 million subscribers in Q4.

As you can see from our Q1 guidance we expect this strong growth to continue in the first quarter paralleling our strong subscriber growth with strong earnings growth with EPS at $0.38 for the quarter up 65% from a year ago and $1.32 for the full year up 36% from 2007. The strength of our business allowed us to increase EPS at these rates while at the same time substantially increasing our investment levels in Internet delivered video.

In hindsight in Q4 we under-forecast our subscriber growth primarily because we underestimated the positive impact of the introduction of the multi-function CE devices from LG Electronics, Samsung, Microsoft and TiVo that promote Netflix streaming. The second smaller factor in our outperformance was better than expected responses to our marketing.

The precise impact of the recession is unclear but it’s very clear that streaming is energizing our growth. While our streaming success is exciting and we’ll spend some time on it later on this call we continue to invest in improving our DVD buy mail experience. There’s a lot of top and bottom line growth left in online DVD rental.

We expect our DVD and Blu-Ray shipments to continue to grow in 2009 as they did in 2008 as we improve our service levels in this general eCommerce acceptance helps us grow despite flatness in the overall DVD and Blu-Ray rental. We think our annual disk shipments will continue to grow every year for many years and even in the highly penetrated San Francisco Bay area our shipments are continuing to grow.

In terms of Blu-Ray specifically about 700,000 of our subscribers were renting Blu-Ray from Netflix at the end of Q4 and adoption is growing nicely. If Blu-Ray player prices continue to fall as expected driven by next generation chip designs then wide adoption becomes increasingly likely and with it extended life of disk based viewing.

Our growing scale gives us many operational advantages. We’re now up to nearly 60 distribution centers across America and can provide delivery to over 97% of our subscribers in about one business day. This quarter we’ll be testing weekend shipping in parts of the country which will provide even faster service both for those new subscribers who signed up over the weekend and for those subscribers returning movies at the end of the week.

The payoff of this relentless operational focus is the competitive advantage of continuing high levels of customer satisfaction. We once again came in on top of 4C results ranking of customer satisfaction for eCommerce tied this time at number one with Amazon. Our success in DVD by mail is driving our earnings growth as well as fueling our Internet delivery and we’re working hard to ensure that our success in DVD by mail continues.

Turning to streaming in Q4 we substantially increased our investment in streaming content and we plan to substantially increase our spending on streaming content in 2009. We have a basic plan at $4.99 per month that offers some streaming of some content and we have premium unlimited plans starting at $8.99.

One of our content investments is to include Starz Play in all our premium plans. Starz Play includes the major films of Sony and Disney. Most of our streaming content spending however is directly with TV networks and studios. We now have over 12,000 movie and TV choices up from 2,000 two years ago and we plan to spend as much money as we can with the studios, licensing as much content as we can and we are already one of the studio’s largest Internet revenue sources.

Our spending is limited only by what content is available at reasonable prices and what we can afford in total given our earnings goals. Our existing subscribers are watching instantly in ever greater numbers and in just the last month millions of our subscribers got more value from their Netflix subscription by streaming. The more subscribers watch online from Netflix the more likely we think they are to remain subscribers and to watch slightly fewer DVDs in a month.

Since we don’t have a control group of random subscribers who are not enabled for instant watching we can’t tell you exactly how large these positive effects on turn and disk usage are but we believe they exist. Increased streaming content not only helps us with our current subs but also helps us with CE partnerships.

One of the main reasons LG Electronics, Samsung, Microsoft, TiVo and others want to offer Netflix streaming to their customers is instant access to compelling content with the promise of even more content to come. This helps them differentiate their products against non-Netflix ready devices and adds value to the customer.

The LG Electronics and Samsung Blu-Ray players in particular had a very high connect rate during the fourth quarter. That is a high percentage of purchasers are subscribing to Netflix. Xbox and TiVo had a lower percentage but larger total numbers due to their software updates to their substantial installed bases.

While we don’t pay or charge anything to have our software included in devices we do pay our partners to generate new Netflix subscribers. In other words some of our marketing dollars are going to our CE partners to help create demand for new Netflix subscribers and that is included in our subscriber acquisition cost.

Nearly all the CE generated subscribers also rent DVDs from Netflix which really reinforces the importance of the DVD streaming combination subscription. For the long period the DVD period is relevant to consumers. If our CE partners can make more money from promoting us than promoting other services because of our broader relevance than we will be able to maintain our preferred placement over time.

We continue to gain new and deeper partnerships with CE manufacturers. At CES a few weeks ago Samsung and LG announced the expansion of Netflix into a wider range of their Blu-Ray models in 2009 and to have the Netflix application included directly in some of the LG broadband connected televisions. Similarly we announced our first partnership with Vizio to have the Netflix application included in their televisions.

We’re in discussions with nearly every major CE company and one by one we hope to be able to broadly cover the Blu-Ray category and the Internet TV category over the next few years. In terms of having our Netflix application included in additional video game consoles we currently have an exclusive deal with Microsoft Xbox. We’ve been very busy expanding our CE device partnerships but we also added support for Apple Computers and improved our PC based player.

We see the laptop as a significant long term viewing platform not as an intermediate step towards something else and are investing accordingly in continuing to improve our laptop based player. Our first CE partner, Roku, recently announced that their devices including the installed base of Netflix players would be updated to include the Amazon Pay-Per-View service. We are fully in support of this and let me explain why.

There are three primary economic models for streaming, ad supported such as Hooloo and YouTube, Pay-Per-View such as Amazon and Apple and subscriptions such as Netflix. The downside of our CE partners adding the Amazon Pay-Per-View service is more competition for Netflix but the competition is pretty indirect because of the Pay-Per-View business is in big new releases that we don’t offer on streaming subscription.

The upside is that Amazon will also be promoting the streaming CD devices which provides us more households to stream our service to. Similarly CE companies are adding the ad supported services to their devices. The combination of all of these models will accelerate adoption of video streaming.

At some point the ad supported companies or the Pay-Per-View companies may decide to also provide subscription like Netflix. The Netflix competitive advantages are that we combine streaming with DVD rental and that our large subscriber base helps us afford more content and that we are significantly subsidizing streaming content for the next few years.

Our intent is to focus exclusively on our subscription model as it is a large enough opportunity for us and we are more likely to prevail by focusing on subscription. Consumers who subscribe to Netflix also go to movie theaters, buy DVDs, subscribe to cable, use Pay-Per-View services, watch YouTube and Hooloo and even rent DVDs from local stores.

No firm or model owns an entertainment customer and we think there’s room for us to create a large subscriber base while other firms also succeed with their model. All in all we are making solid progress in our online video efforts.

We are still in investment mode for Internet delivery but we can see how between the CE partner promotion and the possibly reduced disk usage we should be able to keep increasing our content investment while at the same time growing earnings in accordance with our desires. In terms of competition the market for entertainment video remains intense.

DVR based television continues to grow, free ad supported Internet video services are growing, kiosk based $1 DVD rentals continue to grow, VOD from both cable and Internet companies is growing and video stores are only shrinking slowly. Despite this intense marketplace activity our consumer proposition is working well and we continue to significantly expand our subscriber base.

I’ll close where I started. We had a strong fourth quarter capping off a solid year. We had good growth in our core DVD offering and growing momentum in our instant watching. We currently expect to hit 10 million subscribers this quarter which is a wonderful, hugely symbolic milestone of which we are proud. Now I’ll turn it over to Barry.

Barry McCarthy

The core performance will be the focus of my remarks. I’ll also comment on our Q1 and full year 2009 guidance and update you on our stock buy back authorization and repurchase activity. Sub growth revenue, [SAC], turn, gross margin, net income, EPS, free cash flow. All these metrics were better than we expected in Q4 especially free cash flow of $51 million which is more free cash flow than we had produced in all of 2007 a new record.

I’ll provide more detail on the quarter in a moment but first I want to acknowledge that our October forecast of slowing growth turned out to be wrong. As Reed indicated our CE partnerships and our expanding library of license content had a positive impact on our growth in Q4. We’ve been heavily investing in Internet delivery for several years and Q4 was the first time we saw the benefits in terms of significantly faster sub growth, lower SAC, more profit and greater enterprise value.

Let’s look at the drivers of Q4 performance in more detail. Subscriber growth accelerated during the quarter and we finished 2008 up 26% on a year-over-year basis. It was our fourth consecutive quarter of 20+% net sub growth remarkable considering we cut marketing spending on a year over basis by 8%. The acceleration in sub growth was accompanied by near record low SAC of $26.67.

In addition to the multi-platform growth I just talked about near record low SAC was driven by stronger growth across paid acquisition channels and word of mouth combined. As the quarter unfolded it became clear from the underlying performance of the business that we could drive faster growth with increased marketing spending of $8 million and still meet street expectations for Q4 earnings.

This increased spending helped drive the outperformance on adding subscribers and we continue to see strong momentum in our business quarter to date. Gross margin improved 140 basis points year-over-year to 35.2% despite the 2008 postal rate increase and the growing expense of licensing Internet delivered content.

With great engineering talent we continued to improve our website’s ability to merchandise long tail content which was an important contributor to margin expansion. The sequential improvement in margins of 100 basis points resulted from the expected seasonal decline in DVD usage in Q4.

Two additional observations about gross margin, one, we are seeing early signs of less DVD usage with some subscribers who are also watching instantly as compared to subscribers who only receive DVDs. Time will tell whether this substitution effect is an attribute of early adopters or a mainstream behavior.

Over the long term if this substitution effect becomes a mainstream behavior and other things being equal Netflix profit margins would expand as postage and packaging expense is replaced by streaming expense. This margin expense would be offset somewhat by higher content cost which would accelerate revenue growth for our studio partners a win-win proposition for us and for them.

My second observation is that one of the primary determinants of gross margins for the foreseeable future will be the overall level of investment spending in online content. The level of spending will be paced by our success with streaming and our determination to continue to deliver strong earnings growth.

As I mentioned in my opening remarks free cash flow of $51 million was remarkably strong and established a new high water mark for the business. The largest sequential growth drivers were a $19 million increase in deferred revenue from the sale of gift subscriptions followed by a working capital increase of $11 million and higher net income excluding non-cash items such as depreciation and amortization expense of $6 million offset by a $15 million increase in content spending.

Some of these seasonal factors and timing differences like the growth in deferred revenues in AP will reverse themselves in Q1 which brings to the subject of guidance. Our Q1 guidance reflects the strong momentum we see in the business today. The full year guidance assumes a continuing difficult economic climate.

From our perspective subscriber growth in the back half of the year is subject to greater uncertainty than in prior years both because of the economic climate and because the increased complexity around Internet streaming. You’ve only to look at our forecasting miss in Q4 to see an example of this.

So while our full year forecast of decelerating net sub growth represents our best and possibly somewhat conservative thinking we acknowledge that the full year could be much better than we forecast like it was in Q4 or it could be somewhat worse.

Given the rapid growth and the popularity of our streamed content as more and more Netflix subscribers are able to consume that content on their TVs we expect the popularity of our $8.99 subscription plan to continue to grow and SAC to continue to remain below $30. Our guidance assumes a $0.02 postal rate increase in May of this year. In the event postal rates increase by less than we forecast we will likely reinvest some of the savings in growing the business faster.

With our without this added investment we will grow on a percentage basis our investment in the Internet delivery of movies and TV content significantly faster than the year-over-year percentage growth in revenue. Over time we expect this incremental investment to generate faster subscriber growth and potentially lower turn and lower disk usage as well as more profit and more enterprise value.

As is customary in Q1 we expect to see a sequential decline in gross margin related to seasonal patterns of disk usage. By way of reminder disk usage tends to tick up in Q1, down in Q2 and Q3 and Q4 is lower still. Gross margins tend to move inversely with disk usage.

At a high level I would say our core financial objective for 2009 is to grow net income by at least 12% even as we significantly increase our investment in Internet streaming and if we begin to outperform our net income forecast our secondary objective is to reinvest some of the additional profit in even more spending on Internet streaming and/or subscriber acquisition expense to drive future profit growth.

Finally I’d like to provide an update on our stock buy back program. During Q4 we repurchased $10 million or 499,000 shares at an average cost of $20. The balance of the unused authorization about $50 million expired on December 31st of last year. For the full year 2008 we purchased a total of 7.3 million shares offset by stock option grants and ESPP issuance of 1.1 million shares for a net decrease in outstanding shares of 6.2 million.

Under previous authorizations we have repurchased a total of 12.1 million shares at a total cost of $300 million and an average cost of $24.85 reducing our year end fully diluted share count by 17%. Today I’m pleased to announce the Netflix Board has authorized a new share repurchase program for 2009. Based on the Board’s authorization we anticipate a repurchase program of up to $175 million.

Future repurchases would be made in accordance with this authorization. In closing and in summary Q4 results were better than we expected actually much better and we continue to see strong momentum in the business today. We’re excited by the early indications and our investment in the Internet delivery of movies and TV content is beginning to bear fruit and we look forward to talking with you about the performance of the business again next quarter.

Now it’s time to answer your questions and as a reminder we’d like to email your questions to Deb Crawford at dcrawford@Netflix.com as you did last quarter. Deb will read the questions out loud and Reed and I will do our best to answer them.

Question-And-Answer Session

Operator

(Operator Instructions) Miss Crawford, I’ll turn the conference back over to you with the first question.

Deborah T. Crawford

The first question is from Michael Olson – Piper Jaffray & Co.

Michael Olson – Piper Jaffray & Co.

What can we expect for the trajectory of watch instantly content acquisitions? First part of that question.

Reed Hastings

As Barry said we’re going to increase the spending faster than revenue growth. If you’re looking for title count, we’re trying not to get measured by that because sometimes a single set of big titles makes a bigger difference than 1,000 small titles. There’s some correlation with title count and it will continue to rise but we want to do is have more and more relevant content for our subscribers and we’ve made good progress on that to date.

Michael Olson – Piper Jaffray & Co.

The revenue and subscriber guidance for Q1 in 2009 is higher than we anticipated but EPS guidance is essentially in line. Can you talk about what expectations are offsetting higher revenue, is it watch instantly or marketing spend?

Reed Hastings

It’s difficult for us to respond to changes in our forecast as compared with your expectations since obviously we’re on slighter different pages. I’d remind you that as the business grows faster we also incur marketing expense associated with the growth in those subscribers and then over the life of those subscribers perhaps your value in terms of lifetime profit and enterprise value.

So it may simply be a timing difference.

Deborah T. Crawford

James Friedland – Cowen & Company.

James Friedland – Cowen & Company

Are the cuts in G&A from the shutdown of Red Envelope and the recent downsizing of watch instantly customer service now behind the company?

Reed Hastings

Red Envelope, yes. We’re not sure what the other.

Deborah T. Crawford

He says downsizing of watch instantly customer service.

Reed Hastings

I think that might be a reference to, we’ve had in our customer support group people who had to debug low level PC issues because our software had low level PC bugs that we did a new release of our PC watching client which is substantially free of those errors and so we were able to release a number of the technical specialists in customer support. I think that’s what that’s a reference to.

Which is there wasn’t work for them to do that was technical in nature.

Deborah T. Crawford

The next question is from Richard Ingrassia – Roth Capital Partners, LLC.

Richard Ingrassia – Roth Capital Partners, LLC

Do you think you’re still pulling the majority of your new subscribers from the pool of current or former Blockbuster members? If not, from where then?

Reed Hastings

I don’t know that we’ve ever pulled the majority of our subscribers from current or past Blockbuster subscribers. I don’t perceive a material change where subscribers come from, a lot of them are multi-use customers. They do Pay-Per-View, they buy, they rent, they’re involved in media so there’s no big shift there that we’ve perceived about where subscribers come from.

Deborah T. Crawford

From Douglas Anmuth – Barclays Capital.

Douglas Anmuth – Barclays Capital

Can you talk about the reclassification in the cash flow statement, etc. for streaming content?

Barry McCarthy

We’ve gotten several questions about this. With the evolution of our acquisition of streaming content we determined in consultation with our auditors that the streaming content should be classified in accordance with FAS 63 which is new and the portion of the streaming content that’s expected to be amortized on a straight line basis over the next 12 months is classified in the current content library.

The acquisition of streaming content is classified as operating activities in the cash flow different from DVD but there’s no impact on the income statement or free cash flow.

Deborah T. Crawford

The next question is from Snirnivoss Anonca – Oppenheimer & Company.

Snirnivoss Anonca – Oppenheimer & Company

I know that the streaming service is currently complementary to the normal subscription service but in the future do you plan to launch a dedicated streaming service?

Reed Hastings

That’s definitely a possibility, there’s nothing that prevents us from offering dedicated. Our view on it is the bulk of the market is interested in the big new releases and in the subscription and we’re able through the DVD combination to provide that. It’s definitely a possibility for the future but we don’t think there’s a big market there for streaming only given the content availability situation which is roughly 100,000 titles on DVD and about 12,000 on streaming.

Deborah T. Crawford

The next question is from Colin Sebastian – Lazard Capital Markets.

Colin Sebastian – Lazard Capital Markets

Do you have any plans to expand Internet delivery from streaming videos into the rental or purchase of digital downloads?

Reed Hastings

That’s not an area as I went through my comments about Pay-Per-View whether Pay-Per-View is streaming or download it’s essentially the same thing. That’s really about our brand, our brand is really about monthly entertainment and subscription and that’s what we’re focused on. So we don’t have any plans to be involved in those markets where Amazon, Apple, Blockbuster and a few others play.

Deborah T. Crawford

From Matthew Hart – Van Kampen Investments.

Matthew Hart – Van Kampen Investments

Would you ever look to acquire Blockbuster’s mail business?

Reed Hastings

Never say never but I think those days were big two or three years and mostly what we’re focused on now is expanding in the streaming direction.

Matthew Hart – Van Kampen Investments

What are some of the key technological hurdles preventing broader adoption of streaming?

Reed Hastings

I don’t know if there are really broad technological hurdles but the board hurdles are just having people get used to it. The first stage is having people watch Internet video on their PC or their laptop from YouTube, from Hooloo, from CNN, from Netflix. The second stage is through Internet based devices, game consoles, Blu-Ray, TV and then what you’ll see is more and more content providers follow ABC, CBS, etc. and provide the streaming on the web.

The ecosystem is building very nicely, Internet video is on a significant rise and that’s bringing in advertisers, subscription, Pay-Per-View and all of the content providers. I think we’ll see very significant growth in online video over the next five years and we intend to participate in that.

Deborah T. Crawford

From Daniel Ernst – Hudson Square Research.

Daniel Ernst – Hudson Square Research

While I realize it’s a small base today if you look at the base of streaming customers using one of the hardware solutions, Roku, LG, Samsung, Xbox, TiVo, what percentage of those subscribers are new to Netflix? In other words, can you give us a sense of the subscriber contribution from those devices?

Reed Hastings

I’m going to hold off, Daniel, on providing any detail on that for competitive reasons.

Daniel Ernst – Hudson Square Research

Despite an increase in subscribers and some new releases like Wall-E and Dark Knight as well as a larger base of Blu-Ray available films, your library acquisition spend was down both sequentially and year-over-year. Can you discuss content acquisition spend trends?

Reed Hastings

Daniel, the thing that’s confusing there is the mix between rev share and purchase so you’re looking at the purchase line on the balance sheet and that only tells a percentage of the picture and in some years depending on what rev shares deals we have and how hot the studios are that we have the rev share deals with. You’ll see that acquisition line move around. It’s not a very useful indicator for you.

We are continuing to invest and provide complete DVD availability and we have every Blu-Ray that’s out too from the major studios. We’re still very committed to that business and it’s on par I would say with the last couple years in terms of where the trends have been.

Deborah T. Crawford

The next question is from Tony Wible – Janney Montgomery Scott, LLC.

Tony Wible – Janney Montgomery Scott, LLC

Are you seeing or do you expect to see any benefit from reduced ad rates for online and/or television?

Reed Hastings

We didn’t see any benefits specifically in Q4. As you’ll recall from prior years we tend to be heavy online advertisers in Q1 when most retailers have withdrawn from the marketplace and we’re able to avail ourselves of attractive pricing because there’s less demand in aggregate for online advertising from other retailers. We expect that trend to certainly be present in Q1 this year.

Deborah T. Crawford

From Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

Are you seeing any change in subscription plans due to the recession? In other words, are people trading down to lower price plans?

Barry McCarthy

No actually. In aggregate we see more people trading up than we see trading down.

Deborah T. Crawford

From Youssef Squali – Jefferies & Co.

Youssef Squali – Jefferies & Co.

Is there a way to parse out the impact to higher subscriber growth from more effective marketing spend and the benefit of streaming? Which one was more impactful?

Reed Hastings

We’d love to be able to separate those for ourselves so that we know where to spend more money but they both reinforce each other. The more we invest in streaming content the more press, the more platforms, the more it helps the rest of our marketing work and similarly the more that we spend on marketing it reinforces all the things with our CE partners and gets people who want Netflix service then to buy those devices. The both reinforce each other in very positive ways.

Deborah T. Crawford

From Michael Olson – Piper Jaffray & Co.

Michael Olson – Piper Jaffray & Co.

I have a hard time thinking of a reason why a CE partner would not want to incorporate watch instantly. Can you talk about any reasons why any potential CE partners have pushed back on watch instantly integration? Also, how many additional CE partners can we expect in the next couple of quarters?

Reed Hastings

Well Mike, [inaudible] good insight that there really is no reason not to include the Netflix offering. It’s purely been technology which is some chip platforms are more able to handle the streaming of DRM and some take a little longer in the porting activity. Some companies perceive it as a high priority to get Netflix in and they’ll allocate the team early, other companies haven’t yet seen it as a high priority.

In all cases it’s not a negative, it’s purely around the amount of work that it takes to get in and the good news is we’re getting better and better as we do more and more of these platforms of making it easier to put in. I think you can expect a broader range of partners over the year. But again, you don’t quite want think about it or strictly think about the number of partners, you want to think about it kind of as the percentage of devices that are sold. That is a few big partners make a bigger difference than a whole lot of smaller ones so I think our efforts are focused in the right place.

Deborah T. Crawford

Your next question is from Heath Terry – Friedman, Billings, Ramsey & Co.

Heath Terry – Friedman, Billings, Ramsey & Co.

Does the success of your streaming service renew your interest in expanding internationally? Is there an important first mover advantage that you would consider in evaluating that decision?

Reed Hastings

Only slightly does it renew the interest. We would be on the international doing streaming only there and I don’t know if there’s enough content and a large enough eco system to do that. In terms of first mover advantage, I’m sure there are. We’d love to be the first mover in those categories, I’m not 100% sure we will be but for now we’re focused on growing and there’s very large opportunity in the US and spending more on content and continuing to grow earnings and subscribers in the US.

Deborah T. Crawford

Your next question is from Derek Brown – Cantor Fitzgerald.

Derek Brown – Cantor Fitzgerald

You’ve mentioned in the past that we should measure, at least in part, your success in the digital realm by the number of Netflix enabled devices in the market by yearend 2009. Could you provide us with the aggregate number of Netflix enabled devices at yearend 2008 and a target for 2009?

Barry McCarthy

We haven’t released specific numbers on how many devices. I think what you’ve seen in from our investments is that our strategy is working, that is we’re getting in devices and its manifesting itself positively in the P&L. The more that it manifests itself positively in the P&L we’ll be able to ask you to judge us purely by the P&L which is easier for everyone than the indirect of how many partners.

Operator

Your next question comes from James Friedland – Cowen & Company.

James Friedland – Cowen & Company

Just a few housekeeping questions, one San Francisco bay area penetration in Q4? Two, is the buy included in the guidance? And three, what should we be using for an effective tax rate in ’09?

Barry McCarthy

In reverse order, 41%, no comment and 19.4% bay area penetration and 8.1% penetration rest of country versus 18.8% in Q3 and 7.4% respectively.

Operator

Your next question comes from Youssef Squali – Jefferies & Co.

Youssef Squali – Jefferies & Co.

Barry, just a quick clarification, I think you said in your answer to a question that was posed before that you have not seen any benefit from lower ad rates in Q4. I’m just trying to reconcile that. Everything that we’re hearing from ad players out there, online ad players that at least on the CPM side and particularly on non-premium inventory where you guys seem to spend a lot of money, we’ve seen double digit declines year-on-year. Given the fact that you’re one of the top 20 online advertisers out there how can you not see a benefit?

Barry McCarthy

You know, I put the question to our chief marketing officer in almost exactly the same tone and he reminded me that we already buy at low rates in mostly the remnant market so what must be happening is that the trickle down affect hasn’t yet hit the remnants space which is already incredibly discounted.

Operator

Your next question comes from Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

Just a quick question on the free trial subs, I know it’s a small number, it did seem to pick up a little bit outside of historical norms, any read in to that? Do you view that as significant at all?

Barry McCarthy

That would be the strong momentum through the end of the quarter. The seasonal growth is very back end loaded in Q4 and tends to be very front end loaded, at least historically, in Q1. So, if you’re carrying faster growth in to the end of the quarter than you have historically then you would see a higher proportion of free trials.

Operator

Your next question comes from Douglas Anmuth – Barclays Capital.

Douglas Anmuth – Barclays Capital

A couple of questions, the first one is just given the overall decline in DVD sales which we saw last year, is there any change to your overall sort of long term view that you’re DVD by mail business peaks between 2013 and 2018? Then, secondly you commented on the digital spend as being greater than revenue growth most likely in 2009, how would you characterize the increase in digital spend ’09 over ’08 versus ’08 over ’07?

Barry McCarthy

Well, we’ve done a good job of not commenting actually on how much we’ve been spending. People tell me you’ve done a pretty good job of estimating how much we spent. So, we grew it a lot last year and we’re going to grow it very fast in the upcoming year. As we said during our prepared remarks, as much as the P&L will afford us the opportunity to grow it constrained by our target growth in EPS and at least 12% and paced by the success we’re seeing in the marketplace.

Reed Hastings

Then you asked about DVD length, nothing has changed our view that our shipments and rentals will continue to grow and peak sometime in 2015 to 2018 as best we can tell.

Douglas Anmuth – Barclays Capital

If I can just follow up with one more, Barry do you think you’re being equally conservative in our outlook for ’09 as you have been in January of other years or is it reasonable to think you’re being even a little bit more conservative just given the overall macro environment?

Barry McCarthy

We clearly are uncertain about what the second half of the year will bring I would say. On balance I think perhaps that tips the scale slightly more towards conservatism than optimism because the cost of missing is enormous as compared with the upside of beating. As the year progresses we’ll have greater visibility in to how it unfolds. I’d like to remind everyone that most of the sub growth historically has come in Q1 and Q4 with very little sub growth in Q2 and a slight acceleration in Q3 so we may not have a whole lot of visibility until about the second half of the year until late in the third quarter.

Operator

Your next question comes from Heath Terry – Friedman, Billings, Ramsey & Co.

Heath Terry – Friedman, Billings, Ramsey & Co.

You mentioned that as you start to see a substitution affect there should be a net impact from the decline in packaging and shipping costs. Can you give us an idea if there’s any impact one way or another on the content front? I guess put more simply, is the revenue share agreements that you have online different in any meaningful way from the cost of serving discs or the revenue sharing agreements that you have for your DVD business?

Barry McCarthy

Heath, your question presumes that content rights are acquired mostly on a rev share basis [inaudible] and there’s a combination of picks and variables just like there is in DVD. I would say that license rights, the variable portion of the license rights simply because of the nature of the rights that we’re acquiring are uniquely different than they are in DVD.

Operator

Your next question comes from Charles Wolf – Needham & Company.

Charles Wolf – Needham & Company

Do you think your business has actually been helped by the recession in the sense that people are not going to theaters as much instead substituting Netflix for that experience?

Reed Hastings

There’s no way for us to tell. We’re very thankful that we’ve done so well but whether that’s because of the recession or despite it, there’s no strong evidence to either side.

Barry McCarthy

I think your question ran to gross subscriber additions which is the context in which we answered it. I think we probably share the view in terms of the churn rate that we are seeing an uptick, a slight headwind related to the recession. So, holding all other things constant in the absence of a recession we would expect to see a lower churn rate and faster nets up growth.

Operator

Your next question comes from Tony Wible – Janney Montgomery Scott, LLC.

Tony Wible – Janney Montgomery Scott, LLC

Barry, a while ago you talked about this vintage churn concept and I was hoping you could just update us and let us know how that base pool of customers is churning and if relatively speaking we should still anticipate as they grow to be a larger portion of the sub base for the overall churn to kind of trend down?

Barry McCarthy

I think Tony you’re referring to the base of subscribers we spoke about at the analyst day that’s been with us for at least 12 months. I think at the time of the analyst day roughly 56% of the pays and a larger percentage today, I don’t know what it is. I confess I haven’t looked at the churn rate for the subscribers who have been with us 12 plus months but I don’t have any reason to think that it has changed in a significant way. It’s been very stable for many years and I imagine that it is now as well.

Tony Wible – Janney Montgomery Scott, LLC

Any update on the number of turns you’re seeing on each individual disc or any change in the breakage rates that you’ve seen in the most recent quarter or quarters?

Barry McCarthy

Well no, I mentioned that seasonally we saw disc usage decline. I’ve seen some sale side speculation that with cocooning usage rates would go up. I don’t think there is any evidence that that’s happening so the quarter came in about what we expected.

Tony Wible – Janney Montgomery Scott, LLC

And on the breakage side, I guess that’s what I was more looking at, are you seeing any envelopes missing, or just how long the discs are lasting?

Reed Hastings

No real change. We make a tiny bit of progress most quarters but, there’s nothing going on.

Tony Wible – Janney Montgomery Scott, LLC

In Blu-Ray versus standard def? I know way back we didn’t know how well Blu-Ray’s durability would hold up, it’s been comparable to DVD?

Reed Hastings

It’s much stronger than DVD relative to its format introduction. So, when DVD came out we had a tough situation and it took us a couple of years to get ahead of. We’re much smarter now so we’re further down that curve than we were in DVD at this point in the life.

Operator

Your next question comes from Andy Hargreaves – Pacific Crest Securities.

Andy Hargreaves – Pacific Crest Securities

Does the expectation for online content acquisition costs to go up quite a bit [inaudible] expectation for loosening rights on premium content?

Reed Hastings

No. We’re not expecting any change in studio windowing or anything dramatic in that way.

Andy Hargreaves – Pacific Crest Securities

So it’s a volume issue not price?

Reed Hastings

Yes. I mean, there’s a lot of content out there from TV networks and some content from studios so there’s plenty to buy as we give our buying group money. So, it’s really just how much can we afford to invest given our desire to continue to grow the total subscriber base i.e. invest in marketing and grow our earnings.

Andy Hargreaves – Pacific Crest Securities

Am I hearing you right that basically the margin compression is embedded in to guidance is almost exclusively more content acquisition?

Barry McCarthy

Well there’s a little bit of postal rate but that would be the other one.

Operator

That does conclude today’s question and answer session. At this time I’d like to turn the conference over to Mr. Reed Hastings for any additional or closing comments.

Reed Hastings

Thank you everyone for joining us this afternoon. Just to recap and close the business performed very strongly in Q4 and it looks great quarter-to-date. We’re really beginning to see the payoff from our investment in Internet delivered video. I look forward to updating you on our continued progress 90 days from now. Thank you very much.

Operator

Again, that does conclude today’s conference. We thank you all for joining us.

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Source: Netflix, Inc. Q4 2008 Earnings Call Transcript
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