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Netflix (NFLX)

Q2 2006 Earnings Call

July 24, 2006 5:00 pm ET

Executives

Reed Hastings - Co-Founder and CEO

Barry McCarthy - CFO

Deborah Crawford - Director of Investor Relations

Analysts

Gordon Hodge - Thomas Weisel

Heath Terry - Credit Suisse

Paul Bieber - Piper Jaffray

Tony Wible – Citigroup

Glen Reid - Bear Stearns

Doug Anmuth - Lehman Brothers

Jim Friedland - Cowen & Co.

Youssef Squali - Jeffries & Co.

Dennis McAlpine - McAlpine Associates

Barton Crockett - JP Morgan

Daniel Ernst - Hudson Square Research

Operator

Good day, everyone, and welcome to the Netflix second quarter 2006 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, Director of Investor Relations. Please go ahead, ma’am.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix's second quarter 2006 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 released earnings for the second 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 5:30 p.m. Pacific Time today.

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 March 16, 2006. Now, over to Reed.

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Reed Hastings

Thank you, Deborah. Welcome, everyone. Our strategy is to grow our subscriber base as fast as possible while generating 50% annual earnings growth and to use our large membership to lead the Internet delivery of movies. Our goal is to exceed 20 million DVD rental subscribers in the 2010 to 2012 timeframe. Our Q2 results represent strong progress against these objectives, as consumers continue to discover the superiority of renting movies online.

In terms of earnings, in our second quarter we delivered $17 million of GAAP net income, up from slightly less than $6 million one year ago. Year-to-date we have generated $21 million of net income. That leaves us in the advantageous position of being only $9 million to $14 million away from delivering on our full-year earnings commitment of $30 million to $35 million, which means we are able to invest more aggressively in growth for the balance of the year.

In terms of subscriber growth in the second quarter, we finished with 5.17 million subscribers, up 62% from a year ago. This is our highest year-over-year growth rate in the past six quarters. While we are thrilled that the subscriber growth accelerated to 62%, we had thought we would be able to push it all away to 63%, or 5.22 million subscribers.

This 1 percentage point difference in subscriber growth is attributable to our Q2 churn, which was higher than we wanted at 4.3%. Churn was as we expected through most of April, and then we got hit with higher churn in May and June. We are encouraged that in the first few weeks of July, churn has improved, but the elevated churn in the May/June timeframe cost us about 50,000 additional cancels.

We believe the primary culprit in the temporary churn increase was seasonality, the onset of glorious summer from dark winter, which increases the churn proclivity during May and June in the colder parts of the country. In Los Angeles and San Diego, for example, where it is perpetual summer, we saw no sequential increase in churn from January to June. In contrast, in Chicago, Detroit and Boston, we saw a 10% to 15% increase in the cancel rate. In frigid Minneapolis, the cancel rate moved up about 20%.

Why didn't we see seasonality in churn last year and the year before? Last year in Q2, our online competition weakened greatly and churn fell sharply, masking the overall seasonal effect. In Q2 of 2004, we took our $2 price increase and churn spiked, also masking the slight seasonal effect that quarter. Next year our forecast models will be even more accurate around this summer-onset phenomena.

The second metric that you may be focused on is SAC, which reached a high point of $44. Higher SAC is the result of two factors: how hard we push the market to grow, and Blockbuster's increased activity. In terms of understanding how hard we push the market to grow, let me point you to our year-over-year growth in marketing spend as the best proxy, because of the seasonality in our business.

If you look at the last four quarters, you will notice that in quarters where year-over-year marketing growth is strong, average SAC is pushed up. In quarters where year-over-year marketing growth is less aggressive, SAC is more modest.

Specifically, in Q3 last year, marketing was up a modest 45% year-over-year and SAC was light at $36. Q4 marketing was up a more substantial 63%, and SAC moved up to a then-record $41. Q1 was back down to 45% year-over-year marketing growth and SAC came down to 38%.

In our most recent quarter, marketing spending increased an aggressive 74% year-over-year, and our SAC hit a new record of $44. In other words, the average SAC depends on how hard we are pushing the market. If the strength of our business allows us to make our earnings goals and to invest in marketing even more heavily, you should expect commensurate average subscriber acquisition costs.

The second but lesser SAC factor is Blockbuster's activity level. When they are marketing heavily, the marginal effect is slightly increased SAC for us. We saw this online in Q2 and expect it to continue.

While we would, of course, prefer lower SAC to higher SAC, most of the increased SAC is the result of our strategic plan to grow as fast as possible on 50% earnings growth. This is consistent with what we outlined for you last year, and with sound economics, in terms of acquiring subscribers for much less than their lifetime value.

In any case, despite the seasonal bump in churn and the higher SAC, we delivered 62% year-over-year subscriber growth and $17 million in earnings; not a perfect quarter, but very strong. Obviously, maintaining a 60% growth rate at our size is extremely challenging, and our year-over-year goal of at least 6.3 million subscribers represents a 51% subscriber growth rate for the full year 2006. This is because our Q3 and Q4 comparable quarters from last year were very strong for us, as our principal competitor suffered through a financial crisis, and was unable to market their service during that time period.

New markets like online rentals generally go through an ‘S’ curve of adoption. Rising net adds is on the first half of the ‘S’ curve, falling net adds is on the second half. Net adds for Netflix in 2004 were 1 million. In 2005 they were 1.6 million. This year we are forecasting at least 2.1 million net additions.

In terms of quarters, in Q2 we added 303,000 net subscribers compared to 178,000 one year ago. This rapid growth in net adds indicates that we are still early in the first part of the ‘S’ curve.

In our bellwether, San Jose/Oakland/San Francisco Metro area, our household penetration continued to climb and reached 14%. More impressively, in the Bay Area, our net adds in Q2 were higher than one year ago. This means that even at 14% penetration, the Bay Area is still on the first half of the ‘S’ curve of growth.

On the pricing front, during the quarter we concluded that adding the $5.99 capped program was worthwhile, although its impact is fairly modest. While subscribers are incrementally attracted to plans starting at $5.99, few subscribers take that program, mostly preferring the higher-priced unlimited plan.

Turning to the broader industry, we now rent both Blu-ray and HD DVD movies. Our view is that the current format war is unwinnable by either Sony or Microsoft in the next several years. They are both powerful enough to maintain a stalemate. Hopefully, early next year the single-format studios will join Warner and Paramount in becoming format-agnostic, the press will declare the format war over, and the consumer adoption cycle for high-definition DVD will begin in earnest.

The DVD rental business as a whole has been quite steady at about $8 billion in domestic revenue the last few years. The industry projections for this year are also $8 billion. The one big change in the rental market is the transition from store-based to online rental. Blockbuster appears to have become so convinced of the inevitability of online dominance that in Q2 they converted many of their stores to primarily feature their online rental service. These Blockbuster video stores now have many large in-store signs saying ‘rent online’.

We expect that going forward, Blockbuster will spend as aggressively as they can to promote online rental, and this will further accelerate the total online rental market. The good news for us is that as Blockbuster converts their store-based customers to online, it only accelerates the tipping point where unprofitable stores are forced to close as their customers migrate to online rental.

A few days ago, for example, a nine-store Blockbuster franchisee in the Pittsburgh area declared bankruptcy and shut their doors abruptly. We think that someday a majority of the $8 billion DVD rental market will be transacted online and we expect to continue to be the clear leader in that very large market.

Looking forward, I want to reiterate that we are focused on delivering full year earnings in the $30 million to $35 million range in 2006, and 50% earnings growth in 2007 and beyond, which is the commitment we first made to you last year. We will invest in growth as aggressively as we can, given those earnings levels.

The financial value of our subscriber growth is clear: it extends the number of years we can deliver 50% earnings growth. The strategic value of our heavy growth investment is equally clear: it hastens the tipping point of video store closures and provides us the pole position for expansion into Internet delivery.

In terms of digital delivery, it seems that every day there are new announcements and stories about downloading. It would be all too easy to conclude that movie downloading was exploding in growth. The reality is the current Internet movie delivery services continue to show no growth in traffic. Nada. As we have discussed before, the whole industry is held back by the exclusive Windows and the Internet to the TV issue. Movie downloading will evolve over the next decade, but it will do so slowly.

Think about the music business for a minute. This year, eight years after Napster, five years after the iPod, over 90% of music industry revenues are plain old CDs. DVD won't be dominant forever, but it will be dominant for a very, very long time.

Nevertheless, we continue our efforts in technology development and content rights acquisition, and we'll provide a full update on our Internet delivery plans on our Q4 call in January. Movie downloading may be a minuscule market, but we intend to be the leader before it starts to grow.

To close on a personal note, some of you know my family and know that my wife and kids are going to live in Europe for the coming school year. I will remain living here in California and visit them as I can. Rest assured that my family remains the third-largest Netflix shareholder, and my focus on Netflix is unchanged.

Before I turn the call over to Barry, I wanted to point out that in just the last 18 months we have doubled our subscriber base from 2.6 to 5.2 million, and we are on track for at least 6.3 million subscribers this year and 20 million subscribers in the 2010 to 2012 timeframe. Online movie rental is a rapidly expanding market, and Netflix is its leader.

From an investor standpoint, that leadership translates into strong earnings growth, 50% annually, for the next several years. Thank you for listening and now over to you, Barry.

Barry McCarthy

Thank you, Reed. Good afternoon, everyone. As Reed indicated, our second quarter results demonstrated continued progress towards our often-repeated objectives of 20 million subscribers and 50% year-over-year earnings growth.

We also have said repeatedly that our overarching objective is to grow the subscriber base as quickly as we can within the parameters of our economic model and our commitment to deliver earnings growth beginning with this year's target of $30 million to $35 million.

We have indicated that we'll do that by investing more in marketing when it is consistent with meeting our earnings objective. In my remarks today I'll focus on how our Q2 results match up with these objectives. I'll begin by reviewing our net income performance and analyzing the drivers of that performance. Next, I will discuss the relationship between our stronger-than-expected earnings and increased investment in subscriber growth. Then I will review our guidance for Q3 and Q4 and the full year 2006. Finally, I will conclude my remarks by talking about last quarter's secondary offering.

First, net income. At $16.8 million, net income was exceptionally strong this quarter; the third highest in our history, nearly triple our profit a year ago, which was untaxed, and significantly above our guidance. On a pre-tax basis, Q2 was by far the most profitable in our history which shows, I think, the profit potential of our model.

Two factors contributed to our strong profit performance: (1) gross margin and (2) average selling price. Let me review each of these in turn. Let's begin with a look at gross margin.

On a year-over-year basis, gross margin improved almost 900 basis points to 37.1% in the quarter. Gross margin also improved on a QoverQ basis by 330 basis points. Nonrecurring content cost savings plus lower rev share expenses contributed to an overall reduction in content cost in the quarter.

The continued popularity of lower-priced plans also contributed to the rise in gross margin. These plans have a higher gross margin than the standard three-out $17.99 a month program, and have grown rapidly to become an important percentage of our overall subscriber mix. For competitive reasons, we don't disclose what that mix is, but the mix change is enabling us to combine lower average revenue per subscriber with higher margins.

As Reed mentioned earlier, we launched a $5.99 plan this quarter. That product accounted for well below 5% of gross subscriber additions in the quarter. While the plan was not a factor in this quarter's financial performance, this opening price point does have an important marketing role in attracting new subscribers to our service.

Now let's discuss average selling price. In the last 12 months our average selling price has dropped nearly $2. Consumer adoption of our $11.99 and $9.99 subscription plans accounts for the drop in ASP. Despite this drop, our average revenue per paid disk shipment was slightly higher in the recently completed quarter than it was in Q2 of last year.

What drives this metric is the relationship between pricing and average usage by plan. We've said very little about this, which has caused some investors to question the economic viability of the lower-priced plans. In fact, we're very pleased with the contribution of these plans: the trend in revenue per disk, the higher gross margins these plans generate, and the incremental subscribers they attract to Netflix; subscribers who wouldn't sign up for a three-out $17.99 plan, which is why we aggressively market these lower-priced plans. So that's the net income story.

Now, what about our commitment to redeploy earnings and invest more to drive subscriber growth? The fact is, in Q2 just as in Q1, we over-delivered on earnings at the expense of faster subscriber growth. Why was that? First, a little perspective. We did in fact invest more in marketing this quarter; 74% more than a year ago. Historically, Q2 has been a low watermark for subscriber growth at Netflix, and that pattern repeated itself again this year. It's also important to note that gross subscriber additions performed on plan during Q2. The constraint on our net subscriber growth wasn't new subscriber additions, it was the unanticipated increase in churn from Q1 levels.

The important point is that the long-term trend for churn is still improving. Q2, like Q1, was below year-ago levels. But we expected more progress then we saw, because we failed to identify the seasonal trend Reed spoke about earlier. To compensate for this miss, our current planning anticipates that for the remainder of the year, churn will be slightly higher than we assumed in our guidance last quarter, although we expect it to decline from Q2 levels.

Given our primary objective of driving subscriber growth as quickly as possible while delivering on our earnings guidance, you might ask why we didn't pour more of this quarter's profit into higher marketing spending to increase subscriber growth.

In fact, we did allocate extra money to marketing this quarter, but some of it went unspent. Why? In the past, many of you have heard us say that there is an absolute limit on how much we're willing to spend at the margin to acquire the incremental new subscriber, and this quarter we couldn't find productive ways to spend all of the incremental marketing dollars at a marginal acquisition cost that worked within the constraints of our model for subscriber lifetime value. So in that way, we self-limited our growth and produced stronger-than-expected profit in the quarter, which of course raises a critical question.

Much of our discussion in the past has been based on the assumption that we can dial up profitable growth by dialing up our marketing spend. Does our inability to productively deploy additional marketing money in Q2 mean that we'll fail to do so in Q3 and Q4 as well? I don't think so, and here is why:

In Q2 we made the mistake of planning to increase our marketing spending on relatively short notice. As it turned out, we needed more lead time to put all that money to work effectively. For Q3 and Q4, we've had greater visibility into the spending increase, which better positions our marketing team to deploy the money productively and cost effectively.

Let me close my discussion of Q2 results with a word about SAC. We don't guide to SAC, but on the Q1 earnings call I told you we'd maintain SAC at about $40, plus or minus 10%, for the second half of the year; depending partially on how aggressively we invest to drive rapid subscriber growth. Because we plan to increase our marketing investments, you may see SAC increase next quarter.

As we've already discussed, last quarter's margins were strong and churn, while slightly higher than we expected, was 40 basis points better than a year ago. So SAC works at these levels, and would even work at higher levels within the constraints of our economic model, given the margin improvement we've achieved elsewhere in our business. As this quarter's profit shows, we were able to exceed our profit guidance even at the high-end of our expectations for SAC.

Now I would like to comment on our guidance for the remainder of '06. Last quarter we raised the low-end of our year end subscriber guidance from 5.9 million subs to 6.3 million subs. On last quarter's call, I reported that before we raised guidance, our forecast model said net income was running ahead of our $30 million to $35 million guidance for the full year 2006. So, we redeployed those additional earnings into marketing to drive faster subscriber growth, which increases the value of our business by accelerating future profitability and raised our guidance for year-end subs and full-year revenue.

Because we've significantly outperformed our forecast year-to-date, our commitment to deliver $30 million to $35 million in full-year earnings has become front-end loaded, which means that some Street estimates for Q3 and Q4 are above our expectations for second-half earnings.

As we've said consistently for some time now, we're focused on growing as fast as we can within the parameters of our earnings objectives in order to reach 20 million subscribers and position the Company to lead the expansion into Internet downloading. So, we'll redeploy the excess earnings from the first half of the year to achieve strong subscriber growth in the second half of the year.

In closing, I'd like to say a few words about the secondary offering we completed last quarter. In late April we raised roughly $100 million in a secondary offering of stock. Some investors have wondered why a company with no debt, strong cash flow, and $200 million in free cash would raise additional cash.

The short answer is because we are building cash reserves to help us compete in a world with Internet delivery of movies against substantially larger companies with much stronger balance sheets. From time to time you may see us issue additional stock, and from time to time you may see us buy back stock. But over time, you'll see us accumulate cash to position the Company to compete for content in a world with Internet delivery of movies.

In summary, in the second quarter we saw acceleration in year-over-year subscriber growth and revenue growth, despite a decline in ASP and a modest increase in churn, which pushed us below the midpoint of our subscriber guidance for the first time ever as a public company. And to be clear, we're not satisfied with that result.

At the same time, Q2 was the most profitable quarter in our history: the most profitable pre-tax quarter ever, and our most profitable second quarter ever. Scale economies in our business and gross margin expansion more than offset the growth in marketing expense as a percent of revenue.

We believe this long-term structural trend in our business is a key competitive advantage as we pursue our goals of 20 million Netflix subscribers and 50% year-over-year earnings growth. That concludes my prepared remarks, and now we'll open the phones to questions.

Question-and-Answer Session

Operator

Our first question comes from Gordon Hodge - Thomas Weisel.

Gordon Hodge - Thomas Weisel

Good afternoon. Just a couple of questions on content costs. Barry, I think you said something -- and I may have misheard it -- about nonrecurring content cost-savings helping the margin. I'm just curious if you could elaborate on that and when we could expect those to stop recurring?

Also, if you could discuss revenue sharing versus the studios where you're purchasing disks: any trends there in terms of costs? Whether you're getting better rev share terms or whether you're benefiting from lower catalog DVD costs, et cetera. Just a comment on content costs would be great.

Barry McCarthy

Sure. Gordon, I'll do the first part of the question, and I'll ask Reed to do the second part. From time to time, generally around end of term, there can be some one-time items that occur in the content area. We've had some in the past. We had a couple this quarter. I don't think we've ever commented on the size of those items, and I'm hesitant to do it this quarter. I would say they weren't material, but worthy of mention.

Reed Hastings

No real difference in our relationships and terms; some studios prefer revenue share, some purchase catalog pricing. DVD pricing has been essentially the same pricing for ten full years now since launch in '97, so really no change.

What does continue to improve is our ability to match people with the right content, to create value by merchandising catalog well. There's no big inflection point; we've just steadily gotten better each quarter at that.

Gordon Hodge - Thomas Weisel

As far as the rev share goes, to the extent you're renewing rev share agreements, are you trying to work digital into the mix, or is that a separate negotiation?

Reed Hastings

It varies by studio. With some studios they put those two groups together in one, and in some studios those are very different groups. You get an introduction to the other group, but it's no more than that.

Gordon Hodge - Thomas Weisel

Thanks.

Operator

Our next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

I was wondering if you would talk a little bit about what you're seeing in the advertising opportunities? You continue to learn more there, both as you take advantage of the advertising space on the mailers more, as well as some of the tests that you're doing on the site.

Barry McCarthy

The mailers are sold out. Incremental revenue opportunities will come from potentially an increase in pricing; and secondly, to the extent we are able to develop revenues with advertising online.

Having said that, our number one priority is to ensure that the Netflix subscribers have a great user experience. If we can find a way for advertising to coexist comfortably on the site without disrupting that experience, then we'll continue to pursue those opportunities.

For the foreseeable future we'll limit the kind of advertising we accept on the site to movie-related content, and in that way we'll self-limit that revenue opportunity.

Heath Terry - Credit Suisse

Does the very limited rollout that you've done in advertising on the site, does that suggest anything about what you've learned and maybe cause you to be more cautious about whether or not that's actually a real opportunity for you longer-term?

Barry McCarthy

We are launched online, after a period of extensive testing. So we are comfortable we found a way for it to coexist well as part of the Netflix user experience. We're working on growing the revenues associated with online advertising as we speak.

Heath Terry - Credit Suisse

Thank you.

Operator

Our next question comes from Safa Rashtchy - Piper Jaffray.

Paul Bieber - Piper Jaffray

This is Paul Bieber for Safa. I was wondering if there's a specific area where you encountered difficulties spending the marketing dollars? Was it in TV, search display, or was it across the board?

Reed Hastings

It's really a phenomena of allocating the money to marketing late. So, there's a spot market in each of these areas that's not representative generally of the underlying condition. So the spot market was not in all of those areas; there was no place to put the money that was as cost-effective as we insist upon. So we saved it up to spend in Q3 and Q4. When we give the marketing group advance notice, as little as 90-days advance notice, then they're very confident of their ability to invest it smartly. So think of it as just a timing issue.

Paul Bieber - Piper Jaffray

I have a quick follow-up. Can you comment on whether the usage patterns at the lower price points are similar in terms of renting new releases versus catalog DVDs of the other programs?

Barry McCarthy

They are essentially, yes.

Paul Bieber - Piper Jaffray

Thank you.

Operator

Our next question comes from Tony Wible - Citigroup.

Tony Wible - Citigroup

I was hoping we can go over once again -- I know you went into it at the end of the call there -- the thought process between the marketing ad budget and the SAC. Are you guys saying that you target a solid marketing dollar now that you look ahead, or are you focusing on SAC? If it is a SAC number, is there a point at which you would say that there is a ceiling there?

Reed Hastings

About a year ago at our Analyst Day, we went through our evolution at that point going forward to target an absolute marketing dollar. So, we allocate to our group a total amount of money to be spent. So that's definitely the way that we do it.

However, they look at it also on a marginal basis, which is simply because it's in the budget, doesn't mean that they should spend it. So, for example, it doesn't get them to go buy Super Bowl ads, because we don't believe that that would be cost effective. So then they would just hold it back, we'd have more earnings than we thought and we'd spent it in later quarters when we can get more advance notice.

Barry McCarthy

As the quarter unfolds, when we update our forecast, we think we're running ahead of forecasted profitability in the quarter. It may be that Leslie Kilgore and I will sit down and explore ways in which the marketing team could deploy those monies productively to acquire more subscribers. Depending on the timing, the amount and opportunities they have, she may or may not decide that they can put that money to work productively.

Tony Wible - Citigroup

Thanks. Outside of the advertising, you had a lot of scale benefits that accrued in some of the other line items. Is there anything that you foresee in the next six months that would cause some of those scale benefits to persist?

Barry McCarthy

Only two line item comes to mind specifically: tech and dev, and the gross margin line. Let's do tech and dev first. We continue to spend aggressively to support Internet downloading of movies, and that spending will continue to scale. Those increases will be reflected in the tech and dev line, one.

Two, if we outperform our forecast for profit, there are several ways we could deploy that money in the business. One is in the acquisition of new subs and the second is investing in providing a better user experience for Netflix subscribers, including in the area of content. To the extent we do that, the improvements we've seen in gross margin may moderate some. If they do, we should see the benefits in improved word of mouth, which will be reflected in possibly faster subscriber growth or lower subscriber acquisition costs, or a combination of both.

Tony Wible - Citigroup

Great. To be clear, the net income guidance you provided does take into account the rollout of a download solution, or the investments in download for this year?

Barry McCarthy

Yes.

Tony Wible - Citigroup

Thank you.

Operator

Our next question comes from Glen Reid - Bear Stearns.

Glen Reid - Bear Stearns

You talked a little bit about competition, both from the digital download emerging services, as well as Blockbuster Online and all the in-store ads. How do you view your competitive positioning relative to Blockbuster's in-store promotional model, and perhaps the lower SAC that they have? I guess we'll hear relatively shortly what their subscribers look like. Given that in-store option, how do you think of that in terms of your competitive positioning?

Secondly, just on the digital download, it's all very nascent at this point, but there's been some chatter in the trade press about Amazon and, of course, Apple and iTunes getting in there. I'm curious to hear your thoughts on at what point you think those types of services, big players like that, start to have an impact and how you think you'd change your strategy, if at all, to respond. Thanks.

Reed Hastings

In terms of Blockbuster's online efforts, the rental market is about $8 billion. If we think about four, six or eight years from now and we take an aggressive case and say it's all online and that ASPs by then with that big a market, stripped it down to $13, then that's about 50 million subscribers to add up to $8 billion of revenue. So there's a lot of room here for us to be hugely successful online and for Blockbuster to be reasonably successful in the number of subscribers.

Their handicap is figuring out what to do with all the store real estate and how to make that evolution. But I think they've definitely gotten religion, that online is the path to the future. What they're doing is quite courageous; it's like going into a Southwest terminal and seeing something that says take Greyhound or something that's the opposite. You go into the store and it tells you to rent online. So it's a pretty extraordinary situation. What it's doing is growing the total online market faster than we thought possible.

But except for a SAC impact on the margin, again we accelerated our growth this quarter from 61% last quarter to 62% year-over-year this quarter. So it's not coming out of us, it's coming out of store-based renters, which is most of the market, given that we're only 1 billion out of that 8 billion for this year.

Your second question's on there's a lot of chatter about Apple, Amazon, et cetera. There is, and they'll launch services over the next month or next year. It will be a big competitive market. But again, if you look at music, where there's really great solutions for online music, and you think five years after the launch of these services, 90% of the revenue is plain old music CDs, that gives you a feel for how slowly consumers evolve to the solutions of which we in the elite tend to think are mainstream. They're not.

So we really don't face any material risks in terms of digital downloading in the near term, in the next three to five years. In the long term there certainly is risk, and in the long term, steadily over this time, we're working on digital downloading to lead that market. But there's no effective competition from downloading today.

As you know, the services that exist today that are well implemented, the movie download services, have had no traction over the last three years. So that's another independent indicator. Again, it's not because of mis-execution, which could always be fixed, it's because the rights for movies are mostly tied up in long-term contracts, and that the Internet doesn't get to the television in most homes in America. So those will be two long-term problems that take five to 15 years to fix, and that's when you'll see the market really start to evolve in digital.

Barry McCarthy

Let me just jump in and observe that the market for licensing of content is bifurcated between TV content and feature film. So PVRs have done a tremendous job of disrupting the business model for television broadcast content, and that is becoming rapidly available on the Internet for download. But the content that they're waiting for is feature film content, and that is not.

Glen Reid - Bear Stearns

Thank you.

Operator

Our next question comes from Doug Anmuth - Lehman Brothers.

Doug Anmuth - Lehman Brothers

Barry, I was hoping you could just clarify on the gross margins. I just want to go back to what the upside drivers really were during the quarter, if it was to be more on specific revenue-sharing trends, or more on the usage levels. Can you give us some more clarity on usage levels on a year-over-year and QtoQ basis, at least directionally? Thank you.

Barry McCarthy

I think the answer is in three parts. Usage was about what we expected. It's hard to have an informed conversation about usage levels as compared with prior years, because the customer mix is changing so quickly that it's almost impossible to normalize for. So the metric that we look at internally is revenue per paid disk shipment. As I indicated on the call, that revenue on a year-over-year basis actually increased.

Now, since we don't disclose how many discs we've shipped to end customers, investors can't calculate that metric. But it helps inform us enormously about usage trends and the viability of the lower-priced plans that we've launched.

Specifically with respect to margin improvement in the quarter, we had margin expansion on a year-over-year basis, both with respect to content costs and with respect to fulfillment costs; the fulfillment costs being reduction in the cost per disk shipment, so a reduction in operating costs. About 80% of the improvement in margin year-over-year came from content, with the balance coming from reduction in operating costs, which are scale-related.

Doug Anmuth - Lehman Brothers

Great, thank you.

Operator

Our next question comes from Jim Friedland - Cowen & Co.

Jim Friedland - Cowen & Co.

Thanks. One of the questions is that with the extra money that you've made in Q2, it seems like there could be the potential for higher subscriber growth in the second half. So are you just being conservative on that? Are you worried about how Blockbuster might spend on marketing in the second half?

Just two quick questions on accounting: G&A, if you exclude stock-based comp, declined about $1 million sequentially. Was there a one-time driver behind that, or is G&A just getting some leverage there?

Also, full-year tax rate, you had said, I believe 41% to 42%, and it's come in lower than that. Can you give us an update on the effective tax rate? Thanks.

Reed Hastings

I don't think it's conservative, I think it's pragmatic in terms of the subscriber guidance. Because again, two years ago, 2004 our net ads were 1 million. Last year, 2005, they were 1.6 million. This year we're forecasting them at least 2.1 million. So that's a pretty healthy increase in net subscriber growth at the goal points of at least 6.3 million. So I don't think that's conservative, I think it's a hugely positive outcome. I'll turn over to Barry on the accounting question.

Barry McCarthy

There were two questions, as I recall Jim, and correct me if I'm wrong. One was on G&A, were there one-time items? There were. As you know, we've been involved in some litigation on what's referred to as the Chavez matter. We were required to re-notice our subscriber base. We did that. The response rates to that re-notice were lower than we had expected, and so we adjusted downward some reserves that we'd taken associated with that matter, and that decreased G&A spending in the quarter.

With respect to the tax rate, it was about 38% in the quarter due to some stock option exercising, and I would expect it for the balance of the year to be in the 40% range.

Jim Friedland - Cowen & Co.

So for the full year we should expect 40%, or for the second half 40% effective?

Barry McCarthy

For the second half.

Jim Friedland - Cowen & Co.

Great, thanks.

Operator

Our next question comes from Youssef Squali - Jeffries & Co.

Youssef Squali - Jeffries & Co.

Thank you very much. Not to beat a dead horse here, but if you look at gross margin, what is embedded in your guidance versus the 37% you just had in this quarter?

Barry McCarthy

We don't guide to gross margin. We don't guide to gross margin, so we have the flexibility to take it up or down, depending on where we think incremental investing during the quarter best serves us. It could be marketing, it could be service improvements. If it were service improvements and we were to significantly increase our investment in content, depreciation might go up and that would impact gross margin.

We might grow faster because of it, but if we guided to a specific number, as we used to do historically, then the Street is unhappy that we miss and we're spinning our wheels trying to explain the strategic advantage and the tactical decision we made. So we just walked away from giving gross margin guidance as a consequence.

Youssef Squali - Jeffries & Co.

I understand that. On the ARPU, ARPU was down by our math by around $0.70 or so, to $16.36 from $17.06. I think you said in your prepared remarks that the $5.99 service accounted for less than 5% of gross ads. But that also implies then that the majority of the subs did not come at $17.99, so they came somewhere at the $11.99 or the $14.99. Does that make sense?

Reed Hastings

The most popular plan for gross subscriber addition remains the three-out $17.99 plan, but the other lower price plans are also very popular and have been for a while.

Youssef Squali - Jeffries & Co.

From a relative basis, you're seeing more success with the lower priced plans, the $11.99, $14.99, than you're seeing with the $17.99. Is that fair?

Reed Hastings

Only if you comp it against last year when those programs were new. But if you look on an absolute basis, again, as Barry said, the $17.99 has remained the most popular program.

Youssef Squali - Jeffries & Co.

Great, thanks.

Operator

Our next question comes from Dennis McAlpine - McAlpine Associates.

Dennis McAlpine - McAlpine Associates

Thank you and good afternoon. A couple of things. One, beating dead horses, I guess, when we talk about usage at $17.99, $14.99 and $11.99, if we make an assumption that the $17.99 customer gets six discs per month, can you comment relative to that, what the two lower-priced ones do? Do they do the same six or do they drop down?

Barry McCarthy

We're not going to comment on that.

Dennis McAlpine - McAlpine Associates

Just directionally, do they come up to that same level?

Barry McCarthy

We're not going to come comment on it at all.

Reed Hastings

What we have said in the past is that the contribution profit from the $9.99 plus profit in absolute dollars, is approximately equal.

Dennis McAlpine - McAlpine Associates

Okay. As you look at the DVD library, it went up marginally in the second quarter versus the end of the first quarter, and your acquisitions were down a little bit, but still up significantly more than what you added to the library. Is there an expectation here that the number of discs in the library will level off at some point, and can you elaborate where that might be?

Reed Hastings

Most of what you're seeing is simply due to seasonality in theatrical output coming to DVD. So historically, studios don't release the biggest hits in Q2. It tends to be Q4 and Q1, around the Christmas season. So there's no fundamental change or improvement in the way that we're buying or using content.

Dennis McAlpine - McAlpine Associates

At what point do you start expecting to make high-def DVDs available in either format, and what sort of an impact do you expect from that?

Reed Hastings

We launched about two or three months ago HD DVD, so that went live. And then about a month ago we launched Blu-ray, along with those format launches. There's only a few dozen titles, so it's pretty inconsequential financially. In general, our view is that high-definition, adoption of either format over the next five years will be fairly slow and steady. So at the current estimates of what the prices will be, there will be no visible impact on the P&L.

Barry McCarthy

I want to expand on Reed's response to the first part of your question with respect to usage under the plans and margin under the plans. We haven't actually updated investors on the comparability of contribution margin between the plans since the quarter when we first introduced the plans, and there were many questions about it. They were comparable at the time, but all of those plans have moved around quite a bit since.

The gross margin, obviously, is more attractive, higher on the lower-price plans and the contribution profit margin on the lower-price plans is higher than the $17.99 plan. That is contributing to the increase year-over-year and QoverQ in gross margin.

But it's also true that we're making a higher margin on lower revenue, and so in some instances, it's possible that we're making fewer dollars of absolute profit. That begs the question: why are we launching the plans, and aren't we leaving money on the table? The answer is we launched the plans because we are acquiring subscribers at lower price points that we wouldn't otherwise get.

So of course, given the choice between signing up a subscriber at $11.99 or signing up a subscriber at $17.99, we would much prefer to sign one up at $17.99. But that's not the choice. The question is, do you get someone at $11.99 or not? So, by introducing the lower-priced plans, we're trying to capitalize on demand elasticity and grow the overall size of the market, and we think that's happening.

Dennis McAlpine - McAlpine Associates

Good. Thank you.

Operator

Our next question comes from Barton Crockett - JP Morgan.

Barton Crockett - JP Morgan

Great, thank you very much. I wanted to ask you a question about Blockbuster. If you could give us a little bit more color on what you were seeing out of their marketing approach that influenced your SAC spending? I know a lot of what they were doing was in-store, and presumably that wouldn't affect you. But maybe there was more online advertising.

Related to that, in the first quarter you had as good a read, I think, as anyone as what they were going to do for net subscriber additions. Do you have any thoughts about their ability in the second quarter to hit their goal to grow net subs sequentially?

Leaving that aside, turning to the movie downloading initiative, could you talk a little bit about strategically how you see proprietary linking to devices, like what Apple does right now with music and iTunes, how you see that playing out in movies, whether there could be a comparable linking that might be material in this business, or whether it's too early even to really think about that?

Reed Hastings

We said that Blockbuster’s effect on our SAC was the lesser of the two affects; our increased spending being the dominant one. Blockbuster was spending online, I don't think much on TV, but online and then, of course, in store.

Second, you asked about how will Blockbuster do this quarter. We don't know specifically. They'll report soon and we'll all find out. But it's a big market, and I think that they will be quite comfortable getting their 2 million subscribers that they set out as the goal, because it's growing the total online market.

Third, you asked about proprietary downloading architectures. We'll give an update on our strategy on all of the downloading areas on the January conference call, so I'm going to hold off to answering that until then.

Barton Crockett - JP Morgan

Thank you very much.

Operator

Our next question comes from Daniel Ernst - Hudson Square Research.

Daniel Ernst - Hudson Square Research

Good afternoon, thank you for taking the call. Two if I might. First, revisiting the usage, can you talk about your overall trend in usage per month across the different price plans? Then, if you looked at it on a like-for-like basis, or $17.99 versus $17.99, the new subs that you're getting today versus a year ago and two years ago, are you still seeing that boost in usage rates when they first sign on whenever margins are a over-pressured, or does that trend level off?

Barry McCarthy

Usage does come down over time after an initial boost of enthusiasm, just as churn comes down over time, regardless of your plan. So the trends that we saw previously in the business continue today. I don't have any specific comments to make about historical trends in usage at the plan level.

Daniel Ernst - Hudson Square Research

Secondly, on the churn rate, chalking it up to seasonality, and that you hadn't seen that in the past, what gives you the confidence that this time around that the boost up in churn here was a result of natural seasonality?

Reed Hastings

What gives us the confidence is that in the warmer areas -- Atlanta, Houston, Los Angeles, San Diego -- there was no increase in churn. It was isolated to the colder areas. When we look back in prior years, we can see the same phenomena in '04 and '05, it's just that we had never looked for it because we weren't trying to explain anything, because in those years we had large churn changes either from the competitive climate or from our own price increase.

So now we're able to see it, we're able to model it and we'll model it in for next year as we should.

Daniel Ernst - Hudson Square Research

But on the other hand, you did expect churn to be higher than you had originally expected in the second half of the year. What is the cause for that?

Barry McCarthy

Churn is one of those metrics, from a modeling standpoint, that's very difficult to recover from if you forecast it incorrectly. Meaning if you're excessively aggressive, and then you find yourself in the unfortunate situation of being below the midpoint in terms of subscribers, and having unhappy investors in a quarter in which you've got record profit and accelerating growth.

So I think we would serve the interests of the Company and investors well if we were appropriately conservative, slightly less aggressive, in the way we model churn in the business, so we don't find ourselves in those circumstances. So that that is why in terms of our guidance being less aggressive than it was previously.

Daniel Ernst - Hudson Square Research

Fair enough. Thank you.

Operator

Our final question comes from Charles Wolf - Needham & Company.

Charles Wolf - Needham & Company

I'd like to go back to marketing spend. Is it simplistic to think of it as spending until marginal revenues equal marginal cost? A related question is, can you differentiate between the customer acquisition costs of a $9.99 plan from a $17.99 plan?

Barry McCarthy

This is as simplistic as thinking about marginal revenue equals marginal cost, although we don't spend up to the point at which the marginal cost equals the marginal contribution profit from a subscriber. That feels overly aggressive to us, but in theory, is the model that caps the amount of money we're willing to spend at the margin to bring in a subscriber. We don't attribute cost by plan; that's generally not how we market the service. There's a lead price point. People come in, they arrive at a landing page that offers them choice.

So in summary, how do we think about it, we think about managing to average values.

Charles Wolf - Needham & Company

Okay. As a follow-up, do you find there is much migration from a lower-price plan to higher-price plans over time, or do people just simply stay with the plan they're on?

Reed Hastings

Mostly they just stay with the plan that they're on. We're experimenting with making it more and more convenient to upgrade and downgrade. Those are on the margin effects as opposed to significant upside.

Charles Wolf - Needham & Company

Thank you.

Operator

That does conclude our question-and-answer session. At this time I will turn the call back over to Mr. Reed Hastings for any closing remarks.

Reed Hastings

Thank you all for listing. Again, to restate what I said before, we recognize that DVD will not last forever, but it really will be dominant for a very, very long time and we are incredibly excited about continuing to grow the DVD rental business as we gain a great position to expand into digital downloading. Thank you all very much.

Operator

That does conclude today's conference. Thank you for your participation. You may disconnect at this time.

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Source: Netflix Q2 2006 Earnings Call Transcript
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