Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Netflix (NASDAQ:NFLX)

Q2 2009 Earnings Call

July 23, 2009 6:00 pm ET

Executives

Debra Crawford – Vice President, Investor Relations

Reed Hastings – Chairman, Chief Executive Officer

Barry McCarthy Jr. – Chief Financial Officer

Analysts

Christa Quarles - Thomas Weisel Partners

[David Miller - Carriss and Company]

Youssef Squali – Jefferies & Co.

Eric Wold - Merriman, Curhan Ford

[Ralph Shakard - William Blair]

Andy Hargreaves - Pacific Crest Securities

Matt Schindler - Merrill Lynch

Tony Wible - Janney, Montgomery Scott

[John Brockage – Credit Suisse]

Barton Crockett - Lazard Capital

Michael Pachter – Wedbush Morgan Securities

[Amil Gupta – Oppenheimer & Co.]

Doug Anmuth – Barclays Capital

Mark Mahaney – Citigroup

Michael Olson - Piper Jaffray

Dan Ernst - Hudson Square Research

[Jim Freedman - Cowan and Company]

[Richard Grosday - Ross Capital]

[Gerald Simon - Apex Capital]

Operator

Welcome to the Netflix second quarter 2009 earnings conference call. Please be aware this conference is being recorded. At this time for opening remarks and introductions, I'd like to turn the call over to Debra Crawford – Vice President of Investor Relations.

Debra Crawford

Good afternoon. Welcome to Netflix's second quarter 2009 earnings call. Before turning the call over the 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 the 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 of Form 10-K filed with the Commission on February 25, 2009.

We released earnings for the second 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 6:00 pm Pacific time today. Finally, as we noted in the press release, we are going to conduct a question portion of the Q&A via email. Please email 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 our call. As I say on each call, our goal is to grow revenue, subscribers and earnings every year while expanding into instant steaming. We continued to execute well in Q2 and Netflix is on track for a record year in 2009.

In Q2, we generated revenue of $408 million, up 21% from a year ago. Operating income was $53 million, up 54% from a year ago. Net income was $32 million, up 22% year over year and EPS was $0.54 up 29% year over year. Driving these results was a 26% year over year growth in subscribers offset by a lower ARPU due to the growing popularity of our lower priced plans that include unlimited content delivered both by streaming and by DVD by mail.

We believe that the inclusion of streaming in our service has broadened the appeal of Netflix and is driving growth in our most highly penetrated market of the San Francisco Bay area where 20.7% of households now subscribe to Netflix versus 9.1% nationally.

The tech innovation factor around streaming is very high and high speed cable broadband is widely available and despite all of that, or perhaps because of it, growth in our subscribing households in the Bay area is increasing at about two percentage points per year. We believe the Bay area is a leading indicator of internet behavior elsewhere in America and are thus encouraged by these large and growing penetration rates.

As in prior quarters, our shipments of DVD and Blu-Ray discs experienced solid growth year over year and we continue to expect disc shipments for Netflix to grow for many years as video stores close.

Our Saturday shipping rollout across our 58 distribution centers is now more than half complete and we expect to have upgraded all of our distribution centers to Saturday shipping by the end of Q3.

Last quarter, we made some adjustments to our Blu-Ray pricing to reflect the higher prices that studios charge for high definition content and we're pleased with the results. As Blu-Ray player prices continue to fall, we are hopeful adoption will accelerate and we offer an unparalled Blu-Ray rental experience.

In terms of our DVD based competitors, we continue to see rapid growth for Redbox and an offsetting decline in video store rentals. Essentially, both Netflix and Redbox are growing at the expense of video stores.

One more remarkable milestone for Netflix last quarter was the progress made in the Netflix prize competition. As you may have read, it appears an amazing team of researchers around the world has qualified to win the million dollar prize for improving recommendations. We will announce the Netflix prize winner later in Q3 as the competition is still open until this Sunday followed by a validation period of a few weeks, but needless to say, this competition has been thrilling.

The knowledge this prize contest has developed is already contributing to the improvement of movie choosing at Netflix and there is more to come.

At the heart of Netflix is the proposition that of the 100,000 movies we offer, there are a unique few hundred that each person will love. The algorithmic scale that we are developing apply equally to the movies that you watch instantly or watch on DVD or watch on Blu-Ray and they allow us to provide more satisfaction from any given set of content than any competitor.

The Netflix prize algorithm is only a small but significant part of our total personalization efforts but these efforts as a whole are a behind the scenes driver of our incredibly high customer satisfaction which we are always striving to improve.

In terms of streaming viewing, the strong growth trends continue in instant streaming to our subscribers and in online video overall due to the consumer attraction of our strong value; DVD's by mail quickly, and movies and TV episodes streamed instantly for one low monthly fee. More and more CE companies are looking to integrate the Netflix streaming client into their devices.

In Q2, we announced and launched Netflix ready devices with a range of partners. They include, Sony, a wide variety of Samsung home theater systems and Blu-Ray disc players and LG digital television, home theater systems and Blu-Ray disc players. We are on pace to have more and more CE product include the Netflix client every quarter. The more devices that support the Netflix client, the more subscribers have easy access and the less dependent we are on any one device.

We're excited in particular by two big improvements to streaming coming in Q3. Microsoft is rolling version three of Silverlight which significantly speeds up video playback so there is less frame dropping for smoother video on PC's and Mac's, and in mid August, Microsoft Xbox is rolling out their new experience which includes a new Netflix client where subscribers can choose movies right on the Xbox rather than going to their laptop to add to their queue.

When we think about the right amount to spend on streaming content each year, we consider not only the retention benefits of more viewing, the acquisition benefits of more subscribers and the cost benefits of DVD shipment substitution, but also the positive effects on the CE ecosystem.

Given our momentum to date, we are continuing to push up our streaming content spending, consistent with our goals for next year of maintaining 10% operating margins and strong subscriber growth.

Thank you for listening. And now I'll turn it over to our CFO, Barry McCarthy.

Barry McCarthy Jr.

Good afternoon folks and thank you for joining today's call. Last quarter, I said we were confident in our ability to deliver strong revenue and earnings growth and the results we announced this afternoon achieved that objective.

Year over year growth in revenue, net income, EPS and free cash flow all accelerated again this quarter as compared with the year over year growth we achieved in last year's second quarter. SAC reached a record low $23.88 in Q2, a remarkable achievement for a consumer business in this difficult economic climate.

We attribute strong growth and low SAC to the broad appeal of our service. Because of our investment in streaming, low prices and the halo effects of market leadership, the financial implications for future Netflix profit are significant.

On the Q4 call, I said SAC would remain below $30.00 for the balance of 2009 and on the Q1 call, we lowered that estimate to $28.00, quite a bit higher than the $24.00 SAC we reported today. For the remainder of the year, we expect SAC to increase in Q3, before dropping again in Q4.

Turning from SAC to other categories of expense, gross margin was 34.1% in the quarter, a 230 basis point improvement versus last year's Q2. Despite the year over year growth from content spend for streaming and the postal rate increase, the year over year improvement was primarily attributable to the popularity of our lower priced plans which have higher gross margins and in addition, like Q1, our margins continued to benefit from our ability to create demand for catalogue titles.

On a sequential basis, DVD usage was seasonally lower than Q1 which was a net positive for gross margins and in line with our expectations and historical patterns of usage. We saw no discernable increase in usage related to people spending more time at home in the current economic climate.

As expected, churn rose slightly in the quarter as it did in last year's second quarter. This was primarily the result of a seasonal shift and channel mix for gross subscriber acquisition. We saw a similar mix shift in last year's second quarter and we expect churn to decline to near Q1 levels in Q4.

Our effective tax rate for the second quarter was 38.8%, a reduction from our Q1 rate related to several discrete Federal and State incentive tax credit recorded during the quarter. As expected, our Q2 tax rate increased significantly from last year's 26%. By way of reminder, last year's second quarter had the cumulative benefit of higher period R&D tax credit. For the remainder of the year, we expect our effective tax rate to be approximately 40.5%.

Free cash flow of $26.3 million established a new high water mark for Q2 results which more than doubled on a year over year basis. On a sequential basis, free cash flow increased 74%. This increase followed a well established pattern related to the seasonal slow down in Q2 subscriber growth, the reduction in marketing expense and resulting in increased net income.

Finally, during Q2, we repurchased 1.6 million Netflix shares at a cost of $73 million with an average cost of $44.56.

That summarized my comments on Q2 performance, and now I'll comment on the implications of that performance for Q3 and full year guidance. Those of you familiar with our business model are accustomed to seeing well established seasonal pattern of slow subscriber growth, higher churn, higher operating margins in Q2, followed by accelerating subscriber growth, lower churn and lower operating margins in Q3 and Q4.

As I said on last quarter's earnings call, we expect that historical pattern to repeat itself again this year. Today's earning release revised upward our full year guidance for subscribers, revenue, net income and EPS. We remain optimistic about the outlook for the second half of the year.

From a year over year subscriber perspective, Q3 will be an easier comp than Q4. Last years subscriber growth slowed to 23% year over year in Q3, probably because of the summer Olympics, the weak economy and the shipping outage, but growth reaccelerated in Q4 to 26% year over year behind the lift from our launch on Xbox 360.

We've maintained that momentum ever since and as you can see in today's guidance update, we expect to continue to grow strongly through Q3 and Q4 with minor differences in year over year subscriber growth. At the end of the day whether we grow subscribers at last year's 23% to 26% rate, or slightly faster, or slightly slower, it's still impressive growth, particularly in this economy.

Looking back over the last several years, we've steadily increased operating margins from 7% to 8% to 9% to what we expect will be a little over 10% this year. We think 10% is about as rich as we should run for the next few years as the streaming opportunity develops. Looking forward, we hope to land at about 10% in operating margins on an annual basis. This will give us plenty of investment power to grow the subscriber base, revenues, earnings and EPS.

In closing, Q2, like Q1 produced strong results and solid progress towards accomplishing the financial and strategic goals we established for the year. The model is working well. Our streaming initiative is on track. We're strategically well positioned and confident about our future growth and profitability.

That concludes my remarks, and now I'll turn the call back over to Debra who will lead us through the Q&A.

Question-and-Answer Session

Debra Crawford

The first question is from Christa Quarles at Thomas Weisel Partners. Can you talk about the quality of the new subscriber that comes in through your less expensive marketing channel?

Reed Hastings

By that you must mean the retention characteristics. In general the lower program have two facts; one is that people on tighter budgets is a negative. The positive is that it's an incredible value that the retention can be strong. What we try to do is get subscribers to the right program for them and offer them a number of options to maximize by quality, the profits and satisfaction around that subscriber.

Debra Crawford

The second question she had was with regard to Redbox. Redbox claims that 5% or so of their customers are coming from you. Are you seeing that?

Reed Hastings

Definitely the subscribers who leave us who used to go to video stores now go to Redbox. I'm not surprised by the 5% and as Barry mentioned at the recent investor conference, we don't see in the two markets that Redbox outlined as very strong penetration for them, Houston and Salt Lake City, we don't see any material degradation in our growth. So it appears that Redbox and Netflix are growing at the expense of video stores.

Barry McCarthy Jr.

I would add one additional thought which is for a long time we've seen a fairly higher percentage of Netflix subscribers who have continued to rent the DVD's from video stores. So to the extent that Redbox is acquiring shares from video stores, they may see some of those customers active as Redbox customers in lieu of store rentals while they remain Netflix subscribers.

Debra Crawford

The next question is from [David Miller at Carriss and Company] and his question is, with regards to EPIX, our understanding of the structure of EPIX is that there will also be a streaming component to the EPIX subscription that will compete head on with Netflix. Given that, what is it about the Netflix streaming service other than price that you feel will be superior to EPIX. Also, do you see negotiating a streaming right deal with EPIX sometime before they launch?

Reed Hastings

On the first count, EPIX's plans are a little unclear to everyone; for example pricing, so we'll really have to see. As you remember, Starz also offered their own subscription service for awhile and then discovered they could make more money wholesaling that to a range of players including us.

Certainly EPIX which has a lot of great content is something we'd like to carry, but at this point we don't have anything to announce.

Debra Crawford

The next couple of questions are from Youssef Squali – Jefferies & Co. How do the terms of your agreement with Sony differ from what Redbox just signed? Does that give you an opportunity to improve your content costs?

Reed Hastings

We don't know what the deal is between Sony and Redbox other than the 8-K that Redbox filed. We're very happy with our Sony deal and our Sony relationship has continued to work very well for us so I don't see an impact either way from a Redbox/Sony deal.

Debra Crawford

His second question is with regard to Starz. When does that contract come up for renewal? How confident are you in your ability to renew on similar terms?

Reed Hastings

When it's time to renew that contract in the future, hopefully we'll be laughing and able to pay them more money. Part of our goal in life is to make the subscribers really happy, but part of it is also making content suppliers happy and we definitely look forward to being able to pay them more money and still grow our profits over time. So we're not even going to try in the future to try to extend it on the "same terms".

How much larger and how much more expensive it is depends somewhat on our subscriber base size. It's a multi-year agreement but we haven't disclosed any more than that.

Barry McCarthy Jr.

Let me jump in and add something I think many participants on the call are aware of but just to emphasize it. The attractiveness or not of the terms of our licensing deals for streaming content is all about our ability to pay for demand for content with our subscriber base. So if we're not very smart about the way we write the content, it mostly goes unused on the website and that isn't a very good economic transaction.

On the other hand is there's broad based appeal and we are able to engage the subscriber base and the content, then it's a very good investment for us, independently with term on any individual contract.

Debra Crawford

The next question is from Eric Wold at Merriman, Curhan Ford. In regards to the increased churn where there any specific trends you saw around that number; for example, greater churn at certain price points or areas of the country. Was churn noticeably higher during the beginning or the end of the quarter?

Reed Hastings

No, particular churns. no.

Debra Crawford

[Ralph Shakard at William Blair] Is Netflix moving closer to streaming becoming a stand alone business versus its current service status? What sort of metrics are you waiting for to turn streaming into a viable stand alone business?

Reed Hastings

The great thing about streaming is the instant and unlimited. But less ideal part about streaming is we don't have all the content we have on DVD and when we talk to our subscribers about streaming only, they really want a lot of content and given the mixed nature of the content availability on streaming, our subscribers are very happy with the hybrid solution.

It gives a really unique differentiator that the new releases are available on DVD, a lot of the catalogue on streaming, so the hybrid is really the core of what we're focused on. We may at some point test streaming only, but we don't believe it will be particularly consequential.

Debra Crawford

He had a second question with regards to international expansion. Netflix has stated its desire to move in this direction one day. Is there any metric hurdle time frame for when you might pursue international markets and does the streaming service accelerate this market opportunity?

Reed Hastings

The real frame work which we look at is when do we have enough money in the P&L to be able to do a substantial investment to begin that global expansion. It as streaming develops, and frankly as our subscriber base develops that we have enough horsepower to be able to do the substantial investments in other countries where we don’t yet have a brand presence. So that the gate to crack so to speak.

Debra Crawford

The next question is from Andy Hargreaves at Pacific Crest Securities and it's with regard to content acquisition. Can DVD acquisition costs continue to decline or are you near a base line from which it must grow in line with subscriber addition?

Reed Hastings

Our mission over the next couple of years is to take out cogs, which is about half postage and half DVD's and streaming and move that more and more to studio revenue as opposed to postal revenue as we do more streaming. So we look at it and say we want to make that shift happen to where the studios are getting about two-thirds of revenue and we're not having to ship DVD's. It's a long term vision.

So have our DVD's bottomed out. I'm not sure, but most of the energy we're putting in is growing our streaming spending and then the studios get the advantage. They get paid on DVD per title, and then they get paid again on the same title under streaming, so that's the real focus for us.

Debra Crawford

The next question is from [George Abco – Stifel Nicolaus] Please provide us with an update of the current number of online titles available for steaming at Netflix. Also, is there a churn number of available of streaming numbers or is the universe of streaming titles available today, the same as the universe available one quarter or one year ago?

Reed Hastings

We don't focus much on title count. That hasn't changed hugely in the last couple of months. What we're really focusing on is getting the right content on the right term, the content that subscribers are really going to want to watch. Does it change? Yes. For example with the Starz content we get a constant flow of new content coming in through that, so there's a lot of freshness in the existing titles.

Debra Crawford

The next question is from Matt Schindler at Merrill Lynch. What was the bigger driver of the nearly 18% year over year drop in subscriber acquisition costs, a higher percentage of growth additions coming in the door for free, or decreased media costs?

Reed Hastings

I'd say the biggest effect on SAC is scale, brand awareness. We've been working this business a long time building a great reputation and as more and more subscribers, more and more prospect know about it, and more reference points from their friends, that increased their overall efficiency. Some of that's manifests as word of mouth it's really a scale effect of brand leadership.

Debra Crawford

The next question is from Tony Wible at Janney, Montgomery Scott. Have you seen any evidence of consumers trading down on their subscription plans as they stream more content on the digital streaming service?

Reed Hastings

No one particularly moves up or down. The effect we do see is more people going to the lower price plans whether that's because it's unlimited streaming or because of the economy, and that's driving the ASP down slightly. But once people are in a plan, there's as much moving up as there is moving down, so they offset each other pretty well.

Debra Crawford

The next question is from [John Brockage – Credit Suisse] Will the streaming initiative be used to increase pricing or offset ARPU declines on the different subscriber plans versus seeing price being offered as a stand alone product in the near term or over time?

Reed Hastings

The streaming initiative, we got a couple of wins out of that in terms of retention, acquisition, DVD usage substitution, and strategically we think of low price as a great competitive weapon. If we can competitive mote, if we can get a very large subscriber base with aggressive prices, it's harder to attack our franchise. So we're continuing to look for ways for which we can grow the subscriber base even faster on lower prices and by emphasizing our lower price plan.

Barry McCarthy Jr.

I think there's generally a perception that the decline in ARPU is a bad thing for the business. If you look at the last page of the earnings release just above the churn line, you'll see a new metric, that couldn't have been provided in previous quarters from the data we provide which is gross profit per paid subscriber, average gross profit per paid subscriber.

If I recall correctly, I don't have it in front of me, it's about $4.53 a quarter in Q2 this year, up from $4.39 a year ago. So even though ARPU is going down, the business per subscriber has been getting more profitable even as the key to the lower price plans and the growth and the functionality of the business where they did some streaming, it has been a net positive with the subscriber.

Debra Crawford

The next question is from Barton Crockett from Lazard Capital. Your subscriber growth in 2009 has been great. Any early thoughts about your ability to maintain that pace in 2010?

Reed Hastings

If you had asked us last year would we still be riding for the eighth or ninth quarter at 25% we would be, that's a little wishful thinking. So it's hard to tell. I will say that the tail winds from video store closures and from the growth in streaming have been very positive influences for us, so we're probably more optimistic than we have been in the past.

But our year ahead predictability on that frankly is not much better than anybody else's.

Debra Crawford

The next question is from Michael Pachter – Wedbush Morgan Securities. It's a more specific question on ARPU. Could you please explain the decline in ARPU in the context of the increase of the Blu-Ray surcharge? Is it attributable to an increase rate of $8.99 sign ups, low acceptance of the Blu-Ray option, late quarter additions of some other reason?

Reed Hastings

It's not great quarter additions. The Blu-Ray price increase helped. The ARPU decline would have been larger without it, but not hugely materially and it is most the second of your questions which it is more people taking the lower priced plans than in the past. Again, as a competitor barrier, we're happy about that.

Debra Crawford

The next question is from [Amil Gupta – Oppenheimer & Co.] Can you remind us about the impact of consumer electronic deals on subscribers in Q3 of '08 and Q4 of '08?

Reed Hastings

The Xbox was launched in Q4 of '08 so that was a help in Q4 in the [inaudible] of '08.

Barry McCarthy Jr.

And remember that consumer electronic devices are largely purchased around the holidays so unless you tap into a large install base like we did in Q4 with the launch on Xbox 360, growth associated with devices would come after the holiday shop through.

Debra Crawford

The next question is from Doug Anmuth – Barclays Capital. Is there anything in particular that's weighing on Q3 earnings given the subscriber and revenue increases?

Reed Hastings

If I were to rephrase the question and ask it in this way, could earnings be higher, the answer is yes. Which begs the question why aren't they? And the answer is because every year we begin by deciding what the earning 'target' is going to be and the goal we've set is an operating margin of 10% which allows us to grow earnings in a round number of 20% range, fast, very fast,

And, push strategically we made that decision as a management team to invest what could be more earnings in a faster earnings growth rate and the future profitability of the business by growing more content, growing the streaming initiative, providing a better service. And that's the reason that Q3 earnings is not higher.

Debra Crawford

The next question is from Mark Mahaney – Citigroup. What impact on your customer base in terms of additional churn or ARPU have you seen in the areas where Saturday shipments have rolled out?

Reed Hastings

We don't a good enough control to be able to tell precisely. What we have found is when we convert an entire area to two day delivery put in a hub, we get a real material benefit and by extension we think when we take roughly 10% of the shipments and give them better service, we'll get a positive affect also. But I think it's relatively new. We know it's a positive, but we're unable to tell you exactly how much.

Debra Crawford

The next question is from Michael Olson of Piper Jaffray. Growth margin was essentially flat quarter over quarter which is surprising given the normal seasonal down tick in Q2 and the postal rate increase in the quarter. Can we expect gross margin in Q3 to be up quarter over quarter as it typically is?

Reed Hastings

We don't guide to gross margin. There generally is a seasonal increase in DVD usage. You should factor that in your model when you're thinking about margins. I think that's all we plan to say about it.

Debra Crawford

The next question is from Dan Ernst at Hudson Square Research. DVD usage was lower seasonally but you did add a record number of subscribers last quarter, and as I recall new subs tend to have higher utilization as they run through your broad library. Was that not the case with these new subscribers?

Reed Hastings

Remember that in the cogs, there's DVD usage and there's streaming and as we take up streaming investment, that has an influence on cogs also and that may be what's causing the model for you to not collide as well as you want. But that is still the general trend, that DVD usage decline let's say during the first year of the subscribers life on a monthly basis.

Debra Crawford

The next question is from [Jim Freedman at Cowan and Company] What percentage of users are on a Blu-ray plan?

Reed Hastings

What we have said in the past it's nearly 10% and it is still nearly that 10%.

Debra Crawford

The next one is from Michael Pachter. Given the weakness at advertising sales at most media outlets, should we expect to see advertising spending decline year over year at holiday since Netflix gets the same benefit for fewer dollars.

Reed Hastings

No, we could take do that. In other words, we could take the great rates available and spend less and earn more but we're choosing to keep earnings growing very nicely but not at the maximum rate possible, and we'll be spending as we would but getting more growth and more reach for our dollars than we would have in the past.

Debra Crawford

The next question comes is from Mark Mahaney at Citigroup. Explain why long term operating margin should be capped at 10% given what should be clear marketing spend leverage in the model.

Reed Hastings

It's not how long we'll keep them capped at 10% when you say long term, but if you mean the next few years, there's a lot of investment that we think is very smart to do as well as the global expansion. So that's what's leading us to not want to at this point grow richer than 10%. In the long term as we think about it, the five to ten years, I would agree with your thesis.

Debra Crawford

The next question is from [Walter Widenski at McKuen Capital] Can you share with the subscriber reactivation rate.

Reed Hastings

I think what we said publicly, you're talking about customers who have joined the service who we can identify as having been a previous subscriber and that's we have said in the past running about a third and then there's a subset of new subscribers who we're pretty confident have joined before but we can't identify them as a rejoin because the credit card has changed, the address has changed, that sort of thing.

Debra Crawford

The next question is from [Richard Grosday at Ross Capital] Last quarter you said you had no interest in entering the kiosk business. Has that sentiment changed at all now that it appears studios are warming up to the concept?

Reed Hastings

No particularly. The kiosk business is very good. Vending machine businesses, Coin Stars have been doing vending machine businesses for a long time. They have a wide range of vending solutions and presumably they'll come with more and more vending innovations, so they're organized horizontally as a vending machine company.

We're organized vertically. We happen to be in DVD's now and DVD and streaming as a movie brand and Netflix will always be in movies not in various to ship or move discs or any other aspect. So the businesses are really organized quite differently and we have no intent to go into kiosks. We're putting all of our innovation efforts on going into streaming.

Debra Crawford

Your next question is from [Gerald Simon at Apex Capital] Barry mentioned picking up marketing spending Q3 which is consistent with seasonality. Blockbuster has recently been spending more dollars as well. Is their higher spend noticeable in your market. Could it have any impact on marketing costs?

Reed Hastings

It's always a bit of a wildcard what Blockbuster is going to choose to do. It really depends upon the level of spending. If they decide to spend like they spent back in '07 then that's something that we would notice. At the current levels, not particularly.

Debra Crawford

The next question is from Barton Crockett at Lazard. Explain what is driving the more optimistic view of subscriber growth for the year given that Q2 came in at the high end of your guidance.

Reed Hastings

It would seem to be reinforcing Q2 came in at the high end of guidance, and that's part of what gives us confidence on the rest of the year. The wonderful thing is that we don't seem to be affected by the recession. I don't think we're particularly helped either but to be able to grow 25% to 26% in subs in this climate is a wonderful thing.

Barry McCarthy Jr.

I would say also, as the year unfolds and we have more insight into what the next several months will look like, we sometimes have the opportunity to be more aggressive than we had been six months ago when we began to talk about what the year might hold for us. So the business has performed remarkably well. As the calendar year has progressed we made remarkable progress with the streaming initiative on several different fronts so that gives us reason to make us feel more optimistic than we did six months about our ability to execute through the remainder of the year.

Debra Crawford

The next question is from Christa Quarles - Thomas Weisel Partners. Are you happy with your churn rates as they stand now? How do you benchmark your churn relative to other consumer businesses?

Reed Hastings

I think it's a false dichotomy to benchmark versus other businesses. You think about churn relative to a value proposition of the service and the rate of growth in subscribers and not in the abstract. So for instance, it may be that over time the growth in streaming we become more transactional and at a lower price and with many more subscribers and we see an increasing number of subscribers coming in and out of service.

That would result in higher a higher churn rate because it's more transactional and that flow of various entry, but it may result in more profitable business. I think a business with those attributes would also have significantly lower acquisition costs.

So we think about between gross margin churn which I have no idea as the key drivers of the business in terms of overall profitability of the business not churn in the abstract, because churn in the abstract always would lead me down the path of concluding that lower is better. But that may not lead to a better economic model in the context of gross margin.

Barry McCarthy Jr.

I'd just mention that transactional in that context, we don't mean it as pay per view. We mean that a streaming subscriber might join, stay with us for the fall, be off for the summer, join winter, come back in the spring. We make it very easy for people to enter and exit the service and so that drives SAC's down but you get a lot of rejoin activity that drives churn up. So we may end up in a place where SAC is lower than it would otherwise be and churns a little higher than it would otherwise be, but most importantly we're operating the way consumers want us to operate, not trapping them in a service. So we're focused on matching what they want out of the service.

Reed Hastings

Another observation, which is churns also function as a new subscriber build so if we're going to shrink the subscriber based from 20% to 2% we're going to see a dramatic increase in churn because all the customers transpose the new customer. But nobody on this call thinks that would be a good idea either.

Debra Crawford

Your next call is from Youssef Squali of Jefferies & Co. Now that you're going to be holding improvements in operating margin at approximately 10% for the next few years, is most of that investment going into content acquisition or international expansion and how do we track your success now that the investment in that will become substantially more material than before?

Reed Hastings

Most of it will go in content. And how you track our success is are we growing the top line significantly which because we're staying in approximately 10% operating income growth, operating income very significantly. So ultimately it comes down to earnings and EPS growth which we have ambitious plans for.

Debra Crawford

The next question is from [Amil Gupta – Oppenheimer & Co.] Is the split of rental transactions 70% library or catalogue and 30% new release?

Reed Hastings

That's right.

Debra Crawford

And then from [John Brockage – Credit Suisse] what is the percent of subscribers are using the streaming service currently?

Reed Hastings

We've said in the past that millions of subscribers of ours are using it and that's the case today also.

Debra Crawford

I think that's it for questions.

Reed Hastings

Thank you all for joining us this afternoon. To recap the conversation, our business has continued to perform very strong in Q2 and our outlook for the full year is on track for record net additions. Consumers are responding to the Netflix proposition, unlimited movies delivered in two ways, DVD's by mail and streaming for one low price. And I look forward to updating you on our continued progress in October. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Netflix Q2 2009 Earnings Call Transcript
This Transcript
All Transcripts