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Netflix stock was hit in late trading last night by disappointing results. One of the key areas of weakness was the high churn rate of Netflix' subscribers, and the associated increase in subscriber acquisition costs, referred to in short as "SAC". To put it plainly: it costs a lot to grow your customer base if a large proportion of your current customers cancel their subscriptions each quarter. Here are the comments on these issues by Netflix Inc. CEO Reed Hastings from the prepared remarks in full transcript of Netflix' conference call last night:

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.

...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.

Source: Netflix Discusses Churn and Subscriber Acquisition Costs