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Netflix, Inc. (NASDAQ:NFLX)

Q3 2009 Earnings Call Transcript

October 22, 2009 6:00 pm ET

Executives

Deborah Crawford – VP, IR

Reed Hastings – Co-Founder and CEO

Barry McCarthy – CFO

Analysts

Christa Quarles – Thomas Weisel Partners

David Miller – Caris & Company

Steve Frankel – Brigantine Advisors

Ralph Scharkar – William Blair

Youssef Squali – Jefferies & Company

Mark Mahaney – Citigroup

Barton Crockett – Lazard Capital Markets

Doug Anmuth – Barclays

Tony Wible – Janney Montgomery Scott

Imran Khan – JPMorgan

Daniel Ernst – Hudson Square

Michael Olson – Piper Jaffray

Brian Fitzgerald – UBS

Jason Helfstein – Oppenheimer & Company

Eric Wold – Merriman Curhan Ford

Heath Terry – FBR Capital Market

Nat Schindler – BoA/Merrill Lynch

Ben Hur [ph] – Battle Road Research

Scott Devitt – Morgan Stanley

Jim Friedland – Cowen and Company

Operator

Good day everyone and welcome to the Netflix third quarter 2009 conference. As a reminder, today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Deborah Crawford, Vice President of Investor Relations. Please go ahead ma’am.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix’s third quarter 2009 earnings call. Before turning the call over to Reed Hastings, the company’s Co-Founder and CEO, I'll dispense with the customary cautionary language and comment about the webcast for this earnings call. We will make forward-looking statements during this call regarding the company's future performance. Actual results may differ materially from these statements due to risks and uncertainties related to the business. A detailed discussion of such risks and uncertainties is contained in our filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K filed with the commission on February 25, 2009. We released earnings for the third quarter at approximately 1:10 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 re-broadcast of this call will be available at the Netflix Website after 6 PM Pacific time today. Finally, as we noted in the press release, we are going to conduct the question portion of the Q&A via e-mail. Please e-mail your questions to me, dcrawford@netflix.com.

And now, I'd like to turn the call over to Reed.

Reed Hastings

Thank you, Deborah, and welcome everyone to our call. As I say every quarter, our goal is to grow revenue, subscribers and earnings while we expand into streaming. In Q3, we again delivered on that goal and Netflix is on track for a record year in 2009. In Q3, we grew our subscriber base 28% over the prior year, due to our compelling consumer proposition of unlimited streaming and unlimited DVD rentals for $9 a month. In Q3, we generated record revenue of $423 million, up 24% from a year ago. Operating income was $49.3 million, up 45% from a year ago. Net income was $30.1 million, up 48% year-over-year, and EPS was $0.52, up 58% year-over-year. Of the 115 million estimated households in America, 9.6% now subscribe to Netflix. In the greater San Francisco Bay Area, which we believe is a leading indicator of Internet behavior elsewhere in America, 21.2% of households now subscribe to Netflix, up 13% or 240 basis points from 18.8% one year ago. As you can see from these metrics, our momentum is strong and growing. In terms of our DVD base competitors, we see no change in trend. Stores are closing, while DVD by mail and kiosks are growing.

Our disc shipments continue to increase last quarter, and we expect disc shipments for Netflix to grow for several more years as video stores close and as our subscriber base expands. Our rollout of Saturday shipping is now complete across our 58 distribution centers, and we have been working on automation of our distribution centers for many years, and shortly, we will place a roughly $40 million automation order for rental return machines that can accept the returning DVDs, open them, clean them, inspect them, and prepare them for reshipment. These machines will save us some money and improve the quality of our service. They make financial sense because our DVD shipment volume is still growing and we expect to be renting DVDs until 2030. This is the last of our DVD automation project and these machines will be installed over the next 18 months.

Stepping back to look at the DVD market as a whole, the studios are wrestling with declines in DVD sales, while the DVD rental market has been modestly growing. Some of the sales decline is due to tighter consumer budgets and some of it is due to the emergence of $1 rental. One of the mitigating steps that some studios are considering is introducing a DVD retail sales-only window for a few weeks. The vast majority of DVD sales happen in the first few weeks of a title’s release. By way of comparison, the book industry generally releases more expensive hardback versions first and then releases some less expensive paperback version of its best-selling books. If studios adopted this model, it would likely increase studio profits on DVDs. In the EU, due to different law, studios can and do dictate differential sales and rental purchasing terms. In some studios, you sales only windows in the EU today. In the US however, unlike the EU, rental firms can purchase DVDs at retail and rent them legally. So, rental and retail are offered concurrently to the consumer, even though this is not likely the profit maximizing strategy for the studios.

Occasionally, a studio tries to find ways to restrict a rental firm’s ability to buy at retail. But retail is so big and diffused, this strategy has never worked. Four [ph] years ago, Blockbuster in an attempt to have an exclusive in rental, paid the Weinstein company to block all purchases of their films by Netflix. This attempted blockade continues today. But we have never had a problem buying Weinstein DVDs, such as the Academy Award winning Vicky Cristina Barcelona through retail and third parties. Along the way, we have also found that buying used copies of Weinstein titles was very attractive and saved us money. The larger a title is, the better our used purchase works, because there is liquidity in the supply chain. Returning to the theme of rental or segments of rental coming after DVD sales in the US, we are fortunate that this would be a voluntary option for us and would only happen if it made economic sense. If some studios choose to support a sales-only window and rental and delay rental, it would shrink the rental market a bit, but it would grow sales revenue for those studios. If we can agree on low enough pricing for delayed rental, it could potentially increase profits for everyone. Because we are less dependent on new releases than our DVD-based competitors, we may be in a position to move to this model earlier than our DVD-based competitors. A short sales-only window would be a benefit to DVD sales and therefore to the health of the DVD ecosystem, plus it would allow us to spend less on discs and more on streaming content.

For now, there is a lot of modeling and strategic discussions going on, and we will see if sales-only windows become a reality at some studio or to over the next year. In terms of streaming, we continue to spend heavily on streaming content. We think our new content deals will pay off in terms of greater consumer appeal and therefore more CE companies will want to include our service in their TVs, their Blu-ray players and their video game consoles. How do we gauge our success with streaming? Mostly, we focus on the overall health of the business, growing earnings, revenue and subscribers. But the percentage of subscribers watching instantly is a good, early proxy metric for streaming success. Title count for streaming is not a good proxy, since quality is more important than quantity, and device partnerships also need to be weighted by volume. We will be using title count and platform count metrics less going forward, and instead, we are going to expand our quarterly disclosure to include what percentage of subs watch instantly at least one TV episode or movie in the quarter or to be precise streams at least 15 minutes of such content in a quarter.

One year ago, approximately 22% of our subs instantly watched a TV episode or movie in Q3. Most of those 22% watched more than one TV episode or movie, but all 22% instantly watched at least 15 minutes. For Q3 of this year, that figure has grown to about 42% of subscribers. When you consider there our sub base is 28% larger than a year ago, this means that the raw count of subscribers engaged in streaming has more than doubled over the last year. Eventually, there will be seasonality in this number as there is a DVD usage, but in the near term, it is a good marker of increasing streaming adoption. For comparison, nearly every subscriber took one or more DVDs in the quarter, which is testament to the importance of the hybrid model. We don’t see watching one TV show or movie in a quarter as sufficient, but it’s a good start, and we hope to expand the number of subs doing at least that as we move forward.

When I look at our forecast for 2010 and beyond, I am struck by the fact that we expect our postal expense will be approximately $600 million and growing as our disc shipments grow. We expect it to be over $700 million the following year in 2011. In the long term, as we license more and more content for streaming and as consumers use streaming more, that enormous and growing postal expense will start to flow to content owners, and we will become one of the studio’s and network’s largest customers. The rate of evolution for this depends both on how much streaming content we can license and how many homes have a Netflix-ready device or enjoy watching video on a laptop. Assuming that video develops, where sometimes that is just a threat to cable companies overtime. Well, cable has several businesses. As to their video business, Internet video such as Hulu, Netflix, and Mob.com are of course over the long term a possible substitution threat for some customers.

For the cable broadband business however, Internet video is not a threat, but instead is the killer app driving adoption of high-end broadband packages. The broadband business for cable has won huge advantage over the video business. No content costs and therefore huge gross margins. In terms of broadband competitors, other than fiber, none of the other companies are technologies such as DSL, satellite Internet, power line Internet, or wireless are very promising for streaming high-definition content. So, while cable video has intense competition from local fiber and two national satellite companies, cable broadband has only local fiber to content with for true high-speed Internet. As we see it, the growth of Internet video is like to boost overall cable profit. If we arrive, satellite will shrink in subscribers eventually, and we should overtime be able to do co-promotional deals with cable and fiber broadband providers, as our service is one of the Internet videos key applications that showcases the high-end broadband packages.

In terms of subscriber guidance, you will notice that we raised our Q4 numbers. We intend to launch a partnership with a CE firm later this year that has a material installed base, and growth from that partnership is now included in our guidance for Q4. We will have more to say about this partnership shortly but no more on this call for contractual reasons.

Looking at next year, given our success to date on streaming with domestic consumers, with global studios and with global CE companies, we are planning our first international effort in the second half of 2010, which would include streaming but not DVD. Our basic approach is to start small, prove out our model and then expand into other countries one by one. For competitive reasons, we won’t be more specific at this time about which market is first in our expansion. We intend to maintain a 10% operating margin in the business overall as we expand internationally, and we believe our global expansion is compatible with 10% annual operating margins. At this point, we don’t see any need to invest more aggressively when this enables. We will understand more about our potential to become a global firm after we have succeeded in some specific international markets.

To close, Internet video is growing industry wide, and our strategy of not competing in the big crowded markets of pay-per-view and add supported video is working well for us. Commercial-free movie subscription is big enough for us, and in that segment, Netflix has many unique strengths. Thank you for listening, and now we will turn it over to Barry.

Barry McCarthy

Echoing Deborah’s comments, I would also like to thank you for joining today’s call. As we said, we made great progress in transitioning our business model to a hybrid service, which includes both streaming and DVD distribution of content. We made our first investment in streaming content 11 quarters ago in early 2007. For competitive reasons, we have said little about our progress to date, including subscriber engagement with streaming and the economic model associated with the hybrid service or how it would scale. Today is the first time we talked a bit about the substantial degree of subscriber engagement with our streamed content, even if DVD shipments continue to grow strongly. And we disclosed our plans to make Netflix available on an additional device in Q4, which will accelerate our already fast sub growth. We see that faster growth reflected in our upwardly revised guidance for Q4, our third consecutive quarter of upwardly revised guidance. For the full year, we are now projecting net sub growth of more than 2.7 million subscribers measured from the midpoint of guidance. That’s 77% higher net sub growth than the midpoint of our January full-year guidance forecast.

I think it’s clear from our Q4 guidance as well as our Q3 results that the consumer appeal at streaming is broadening our available market and contributing importantly to our strong growth in revenue, net income and EPS as well as subscriber growth. The business continues to outperform our expectations, and I would like to spend a few moments talking about the key drivers of performance for the quarter. Next, I will update you on our guidance for Q4, comment briefly on our expectations for Q1 of next year, and close by summarizing our share repurchase activity last quarter.

For Q3, growth and net subscriber additions accelerated on a year-over-year basis for the second consecutive quarter. Acquisition was strong across all marketing channels. Organic growth related to the broad appeal of the streaming service sustained the trend of year-over-year decreases in SAC. Record low Q3 SAC of $26.86, down 17% year-over-year and up slightly as impacted from Q2. As we said last quarter, we expect SAC to drop in Q4. Momentum associated with the launch of a new CE device will be the primary contributor to lower SAC in Q4. Gross margin of 34.9% improved to 80 basis points sequentially. In spite of a small seasonal increase in DVD usage, lower content spending on DVD was the primary driver of the sequential margin expansion. Free cash flow in the quarter was $25.5 million, down 3% on a year-over-year basis and 3% sequentially. Increased CapEx for DVD almost entirely offset the growth in net cash provided by operating activities and together with an increase in purchases of hardware explains the decline in free cash flow on a year-over-year basis.

The sequential decline in free cash flow is also related primarily to increase CapEx spending for DVD and hardware purchases to support growth, partially offset by an increase in cash provided by operating activities. And now, a word about our upwardly revised Q4 guidance. Another CE device launch means accelerating sub growth. The threshold questions are when will we launch in Q4 and how broadly will our service appeal to the installed base of device owners. There remains some uncertainty that the answer to both questions and this uncertainty is reflected in our Q4 subscriber guidance. Launch of the new partnership has important implications for next year’s Q1 growth and profit. We are expecting to grow a much faster than the Street’s consensus forecast and as a result the consensus Street estimate for subscriber growth and marketing expense is too low. And the consensus Street estimate for operating income and EPS growth is too high as compared with our expectations for the business. As many of you know from historical experience, Netflix marketing expense climbed as a percent of revenue in periods of rapid sub growth. This growth pressures operating margins and net income. In addition, because we are forecasting faster sub growth, I expect Q1 operating margins to climb slightly on a year-over-year basis.

As is our custom, we will provide more complete Q1 and full-year guidance when we report Q4 results in January. But we remain committed to approximately 10% operating margins for the full year 2010. In closing, I would like to update you on the status of our stock buyback efforts. Since inception of our first buyback program in Q2 of 2007, we repurchased a total of 17.8 million shares for a net reduction in total outstanding shares including stock option grants of 18%. In total, we have spent approximately $545 million, which is more than we have in total assets at the end of the third quarter. In Q3, we repurchased 3 million Netflix shares at a cost of $130 million. In the process, we completed the buyback authorized in December of 2008 and began repurchasing shares under the $300 million buyback authorization we announced in August. Under the $300 million authorization, we have repurchased a total of 2.7 million shares at a cost of $122 million, including 1.2 million shares purchased Q4 to date.

Last quarter, we announced plans to modestly leverage our balance sheet to fund future share repurchases and that remains our objective. We recently closed $100 million revolving credit agreement with Wells Fargo and BOA to begin the process of leveraging the balance sheet, and we will likely consider additional debt financing.

In summary, the business has outperformed our expectations and growth is accelerating. At the same time, we are making great progress with our streaming initiative. The model is strong and the balance sheet is healthy. That concludes my prepared remarks, and now I will turn the call back over to Deborah for the Q&A portion of the earnings call. Deborah?

Question-and-Answer Session

Deborah Crawford

Thanks, Barry. The first question is from Christa Quarles at Thomas Weisel Partners. She is asking for an update on epic, is there still a possibility to strike a content arrangement?

Reed Hastings

It’s Reed. We are talking to a really broad range of content providers all the time, trying to work out deals. So, nothing specific and no specific comments on epics, but we are all talking to all of them.

Deborah Crawford

And our second question, does the new CE deal cover international and does the new Xbox deal extend internationally?

Reed Hastings

We will be able to give you more details on international probably later next year. For now, we just wanted to give everyone a heads up, but you know, it’s coming and it fits within the 10% operating margin model.

Deborah Crawford

The next question is from David Miller at Caris & Company. Can you confirm whether or not you have reached with Microsoft on your Xbox streaming deal, if so can you disclose economics?

Reed Hastings

I can’t disclose on either of those.

Deborah Crawford

The next question is from Steve Frankel at Brigantine Advisors. At this point, does watch-instantly have more impact on customer attention or customer acquisition?

Reed Hastings

There’s no easy way to separate a positive impact of streaming between acquisition, retention and also on DVD substitution or costs, because we don’t have a set of customers that are not permitted to get streaming to compare it with. So, what we are seeing is we are investing a lot in streaming, and overall subscriber base is growing at a fantastic and accelerating rate. So, we are very encouraged by that. Streaming is gets news broadly, you know, we talked about a year ago, roughly 20% and now over 40% of subscribers using it. So, we are feeling very good about that evolution, but we don’t – without a control group, we can’t be certain which of those attributes are most affected by streaming.

Deborah Crawford

And a second question, if most of the new customer acquisitions tend to be at the lowest cost monthly plan, does the company need to modify its customer acquisition methods to lower SAC in order to maintain margins?

Reed Hastings

No, we are extremely happy with our customer acquisition engine. It’s working very well for us.

Deborah Crawford

The next question is from Ralph Scharkar at William Blair. Is competing digital service offerings ruled out on Blu-ray, HDTV, cell phones, etcetera, both electronic sell-though and digital VoD, will this be complementary to the Netflix digital service or a competing digital service?

Reed Hastings

When we look at pay-per-view and advertising-supported video as mostly complementary, obviously there is some substitution for time, but their difference in those models that coexisted on many systems quite well. We are staying focused on the one segment of subscription with commercial-free, there are other companies, Hulu, YouTube, etcetera on the advertising and then many firms on the pay-per-view, Amazon, Blockbuster etcetera. So, I would say it’s substantially complementary to the degree that those other services are on devices.

Deborah Crawford

The next question is from Youssef Squali at Jefferies & Company. Q4 guidance implies net margins of 5.3% at the midpoint, the lowest we have seen in seven quarters. What is driving that?

Barry McCarthy

We are on a pace to slightly overshoot the 10% operating margin that we got into for the full year and in my remarks, I implied that we would be taking steps to further leverage the balance sheet. And so, those costs fall between the operating margin and the net income line. And so, you see that reflected in net income as a percent of revenue, but then there will be some additional reductions. If we incur those expenses and the number of outstanding shares, which would offset those costs before they show up NTF [ph].

Deborah Crawford

And second question. Both Comcast and Time Warner Cable are preparing to launch online on-demand services, allowing their subscribers to stream TV content at no extra charge. How do you expect that to affect your on-subscriber signups and the proposition from the streaming service?

Reed Hastings

We will have to see overtime, you know, the demos that we have seen early of the, you know, Comcast experience are quite impressive, they are doing a great job through the Fancast outlet of offerings, you know, the shows that you subscribe to on cable. So, their advantage is that they have also got customers as cable subscribers; our advantage is we have also got them as DVD subscribers. And it may be that there is really not much conflict that people subscribe to cable to get all the sports and all the incredible variety, and they subscribe to Netflix to get the DVDs and they use our streaming and cable streaming quite comfortably. So, we will have to see how that evolves. Presumably overtime, cable will expand beyond the particular footprints. Right now, most of the models are, you know, you can only use it at home, you can’t use it like when you are at a hotel, the portable, the Internet focus, which of course, our service you can. Those are probably things on the margin. I think the core thing is that consumers may not see it as a conflict, though they will think that Netflix is streaming a DVD and they subscribe to that and they think of cable as all of the sports program, the hundred channels and they will stay subscribing to that.

Deborah Crawford

The next question is from Mark Mahaney at Citigroup. What are the top three complaints that you hear from your existing watch-now customers and what are you doing to address them?

Reed Hastings

Mark, we really don’t have watch-now customers. We have Netflix customers and virtually everybody, well first say, everybody does DVD and then is increasing percentage to streaming. But if you mean what are the complaints about the streaming service, you are probably at the top of the list of desired improvements would be more content, broader content selection. Other ones would be on more of My TVs [ph] or more TVs. So today, we are on a few devices, we are trying to get that expanded to many more devices, and we are making great progress on that. So, first is content, second is platforms, and then third is being able to choose right on the TV. We made a real step forward on our Xbox user interface where you can on Xbox choose a particular movie as opposed to choose them on their PC and then watch them on the device. That technology for choosing on the TV is something we will spread to other devices and other platforms. That will continue to make progress. So, those would be the big three that we are working on.

Deborah Crawford

The next couple of questions are from Barton Crockett at Lazard Capital Markets. The first, Liberty CEO, Greg Maffei stated that the company – at the company’s recent Investor Day that Netflix should pay more for STAR’s content, can you update us on your outlook for retaining STAR’s content and the amount you may have to spend for that? Do you expect to retain STAR’s content through all of next year?

Reed Hastings

STAR’s deals multiyear ahead, and we feel good about it. So, no issues there.

Deborah Crawford

The second question is regarding the share repurchase and debt facility. You spent $130 million on share repurchases this quarter and exited with $156 million of cash and short-term investments, you have another $100 million available under your new debt facility, under what circumstances would you tap that facility to fund more share repurchases and how much cash and investments do you intend to keep on the balance sheet?

Reed Hastings

We do have a minimum number of – the minimum amount of cash that we intend to keep on the balance sheet that we are not commenting about that publicly. And to rephrase the question, and I think they are asking, would we be prepared to buy at current levels, and the answer is, yes. And just a question, why, and through it does, being it for the value obviously.

Deborah Crawford

The next question is from Doug Anmuth of Barclays. Is lower fulfillment due to fewer discs and a shift of streaming your 11.7% operating margin was much higher than the 10% outlook that you laid out last quarter, how should we think about that going forward before the international launch? I guess there’s two parts.

Reed Hastings

About the 10% operating margin, we said on last quarter’s call that we were targeting an annual average on a calendar year basis, so there will be some perturbations quarter-to-quarter. And with respect to fulfillment expense, I mean the question was, was the down field the same?

Deborah Crawford

Fewer discs and shift of streaming?

Reed Hastings

Not so much. Last quarter, we wrote off a prototype expense with automation that we have talked about, and we moved to Baywatch facility into the Midwest, and this quarter saw some labor savings associated with that transition.

Barry McCarthy

Last quarter, in Q2 right?

Reed Hastings

I see that.

Deborah Crawford

The next question is from Tony Wible at Janney Montgomery Scott. Your guidance on subscribers and revenues seems to imply, ARPU will decline more in 4Q. If this is the case, it would also imply that you are expecting the year-over-year decline in ARPU to accelerate in the fourth quarter. If this is correct, what is the driver? Are there seasonal factors or subscribers downgrading their plan?

Reed Hastings

Subscribers are not downgrading their plan. Existing subscribers are not downgrading their plan. Two, let’s remember that historically and our expectations are that Q4 growth will have a heavy backend seasonal component to it, and so, those subscribers remain in a free trial period often, when we cross the quarter boundary, generate no revenue. We expect and you should expect ARPU to continue to decline for the foreseeable future. We are very excited about that. If that happens, we will grow rapidly, and if we grow rapidly, we will grow operating profit quickly and roughly at 10% operating margin.

Deborah Crawford

He had a second question. What percentage of your rentals are new releases such as catalog and has those ratios changed with newer subscribers being added?

Barry McCarthy

No, there’s no material change. It generally can vary some like quarter-to-quarter based upon what new releases are offered. But on a long-term basis, you know, it trends approximately a third of the DVD shipments.

Deborah Crawford

The next questions are from Imran Khan at JPMorgan. How much should we expect you to boost marketing in the coming quarter? Also, how much have you benefited from lower prices on display inventory online?

Barry McCarthy

We don’t guide opening spending, that’s why we don’t guide to SAC. So, that seasonally marketing spending 10% increase in Q4 primarily because consumers are active in Q4 and its efficient spending. If the business is running more, let’s say, generating more profits than we forecast in the course of the quarter, then we will probably have the opportunity to accelerate our marketing spending by reallocating what would be profits, like we go into business at about the 10% operating margin this year. If now, we would term ourselves a little bit. Historically, we have had the opportunity to increase spending as the quarter progresses.

Deborah Crawford

And a second question from Imran Khan. What are the drivers of greater use of the streaming product?

Reed Hastings

Just go back on those display, question on display at rates helping us or not? And we haven’t seen any material change that helps us or hurts us. And then what are the material barriers –?

Deborah Crawford

What are the drivers of greater use of the streaming product?

Reed Hastings

It’s same one, two, three that I listed earlier, which is one is content, two is platforms, and three is movie choosing on the devices.

Deborah Crawford

The next question is from Daniel Ernst of Hudson Square. First, in the June 2009 quarter, net subscribers grew 71% year-over-year, and in the September quarter, you just reported they grew 95% year-over-year, do you think that acceleration is more a function of weaker competition or more a function of increasing attractiveness of your service?

Reed Hastings

You know, when you do the derivative of the derivative, you can get tangled up, you know, some eye-popping numbers as you quote. We tend to look at the year-over-year subscriber growth rate, which also tell us a wonderful story. We have been increasing those growth rate, 24%, 25%, 26%, 27% now 28% for Q3, and so that strengthening is a combination of weakening competition in terms of video stores and the power of streaming. There’s no particular way for us to separate those two. And it feels a lot more like streaming. It’s having a big positive impact with consumers, but forward taper [ph] costs, we are very painful to see the accelerating subscriber and revenue growth.

Deborah Crawford

Yes, the second question, those that track the industry are aware that Redbox is having some issues with the studios, but do you think that their customers are aware and/or has that harmed the customer experience? If the answer is yes, has that been a benefit to you?

Reed Hastings

Don’t have any insight of Redbox’s customers.

Deborah Crawford

The next question is from Michael Olson of Piper Jaffray. You said you are increasing spending on streaming, but nearly all subscribers are still using DVD by now, can you just talk about conceptually how you are continuing to grow gross margin while at the same time spending on new content for watch-instantly that subscribers aren’t using DVD by now to a lesser degree?

Reed Hastings

We are getting more efficient in our DVD usage and buying that helps, and that’s probably the core way that fits in. As we grow the subscriber base, you know, we are able to rent DVDs either that’s fully depreciated that are post rep share from several years ago. So, there’s a nice benefit with rapid growth associated to our P&L that gives us some room to essentially purchase the content twice. We are purchasing the content on DVDs across the board and then some period later we are purchasing some of that content again on streaming. We think we will be able to continue to do that to basically grow our streaming spend aggressively, while not aggressively growing our DVD spend. That will create some tensions with some studios, but that’s the basic mix. And when you look at the possibilities of our studio and network spend, five years from now, we may be, well we will almost certainly be in the top five customers and we may be in the top three behind that by Wal-Mart.

Deborah Crawford

The next question is from Brian Fitzgerald at UBS. Reed has mentioned in the past that A la carte [ph] pricing plan is something that Netflix considers in mind from time to time, any update or thoughts here?

Reed Hastings

A la carte can settle things. It’ part of its pay-per-view, that’s not something that we are considering or have thought about or would. If A la carte means streaming only with the DVD sort of a – it’s something we think about, look at, we are open minded to. So far, we just haven’t seen much demand. Nearly everybody wants to also get DVDs, all the new releases are on DVD, the vast catalogs on DVD. But when there is demand, it will make sense for us to meet that demand for streaming-only.

Deborah Crawford

The next question is from Jason Helfstein at Oppenheimer & Company. At current prices, is it likely Netflix will acquire more new release or premium content for streaming in the near term, can you walk us through how you determine whether you will or will not acquire our movie for streaming, i.e., Transformers II?

Reed Hastings

The way we look at content is how much is it going to get viewed, how impactful and how positive is it for customers, I mean what’s the cost. And as we take up the spending, we try to find the best deals in the market. So, we don’t particularly look for new releases versus old or you know, animated versus drama. We really look at what our subscribers are watching and try to get more of that.

Deborah Crawford

The next question is from Eric Wold at Merriman Curhan Ford. Although churn cam down sequentially, it remains elevated compared to prior periods. As Netflix continues to gain market share and at the same time face competition from Redbox, what do you consider to be a healthy and sustainable churn level?

Reed Hastings

Do you want to take it Barry?

Barry McCarthy

Over the next couple of years, we are going to learn quite a bit about, as we stand in the marketplace with an appeal of watch-instantly where we weren’t quite a bit about the behavior of the new consumer demographic, and we weren’t quite a bit about what the acquisition costs are associated there, growing our subscriber base is we continue to improve their quality of watching streaming service. So, it remains to be seen there. Two theories, one is the subscriber base continues to mature, churn is going to ratchet down a little bit and the other theory is it becomes more transactional description and we described of younger demographic, they are making in and out more rapidly, that had a lower SAC, and high level we are very optimistic about the way that the economic bottle is evolving and our ability to drive future profit. There will be some puts and calls for sure between SAC and churn.

Reed Hastings

And if churning customers hated us and never were willing to come back, we would be pretty concerned about the churn rates, but that’s not the case. Churning customers won’t deserve as there is – just not watching movies right now at all, or they can’t afford it, they would write off, and they indicated both cases high likelihood to come back. So, really think of it as some customers will come in and out seasonally. And the substitute metric to give you a more accurate read on the business is weak household penetration or regional penetration, how is the sub base growing relative to the population at any point in time. And it doesn’t get so tangled in the churn calculation.

Deborah Crawford

The next question is from Heath Terry at FBR Capital Market. Has the rollout of Saturday’s shipping increased the number of discs per month being used by customers?

Reed Hastings

Not that we can tell.

Deborah Crawford

I have a second question. What impact do you anticipate your DVD processing automation to do to operating costs of the company?

Barry McCarthy

Bring them down. Yes, but I would say that the postal costs are rising. You know, even though next year is flat, you know, will be offsetting. So, it’s not of huge leverage. From a modeling standpoint, it’s not material. We will bring it up, because there’s a little bit of CapEx associated with it, the $40 million next year, which we haven’t had historically, but other than that, the good service improvement. It’s a symbol that we are continuing to invest in the DVD side if that makes sense, but unlike the other factors that we talked about, unlikely to be a material driver.

Reed Hastings

I would say it’s noteworthy for its symbolism. I think we are going to earn a very attractive rate of return on the investment. From an investor perspective, it’s eggs the question whether or not margins will expand, in the sense, margins are a managed outcome, to the extent that we are able to shift costs out of operations, we will shift them into making it a more compelling service in the form of more compelling content to drive streaming adoption.

Deborah Crawford

The next question is from Nat Schindler of BoA/Merrill Lynch. Your DVD library acquisitions have been decreasing year-over-year fairly substantially for the last six quarters until this quarter when they jumped significantly. The same is true with CapEx spending, what sort of the increases and do you believe your capital investment levels were appropriate over the last 18 months?

Barry McCarthy

We are enormously pleased with how the business is performing, and we are projecting rapid growth and confident that infrastructure we built for the business will comfortably support an 11% [ph] growth that we are projecting. So, to answer the question, should we invest specifically in the business over the last 18 months, the reasons – yes. That or not in any particular quarter, CapEx is up or down associated with DVD purchases, depends entirely on which studio is hot and which is not, and who will rep – and who will not. We manage the business to ship from 1Q metric and that metric is performing really well versus our internal objectives. So, service levels are good, CapEx happens to be up, because the studio that we acquire some content has particularly odd hand and we want to make sure that we maintain the shipment on 1Q metric. So, I don’t think you can extrapolate a trend from that single data.

Reed Hastings

And remember that the vast majority of DVD acquisition and new releases and the depreciation of the new releases is 12 months accelerated. So, you know, it’s barely CapEx.

Deborah Crawford

The next question is from Ben Hur [ph] with Battle Road Research. Can you comment on the company’s future plans to develop and produce original content for video streaming or allow the upcoming Splatter series?

Barry McCarthy

We don’t have any plans to produce content generally. From time to time, our marketing group does something unique like the collaboration with Roger Corman, but that’s aimed around customer acquisition and attention as opposed to the core part of the service.

Deborah Crawford

The next question is from Scott Devitt at Morgan Stanley. Can you talk about the cost of that and whether you would expect leverage to be accretive to EPS?

Reed Hastings

Let’s have that conversation on next quarter’s call.

Deborah Crawford

He had one more question. Could you talk about the constraints involved in gaining distribution on other gaming devices, i.e., PS3 and Wii?

Barry McCarthy

Well, there’s two parts. One as we said is our Xbox deal is exclusive at the current time, and then two would be deals with the other game companies that made sense to them. So, you probably would expect.

Deborah Crawford

The next question is from Doug Anmuth at Barclays Capital. Based on your comments on 1Q, it seems like you would be doing a lot of co-marketing with the CE partner, is this right, because your marketing as a percentage of revenue dropped substantially in 4Q08 and 1Q09 as the Xbox kicked in?

Reed Hastings

Could you read the first part of the question?

Deborah Crawford

Sure. Based on your comments on 1Q, it seems like you would be doing a lot of co-marketing with the CE partner, is this right, because your marketing as a percentage of revenue dropped substantially in 4Q08 and 1Q09 as the Xbox kicked in?

Reed Hastings

So, we do co-marketing with all of our CE partners. We will probably add several this quarter if it’s like every other quarter. We flagged it, one as a material install base, and then that’s the underlying reason our guidance was higher than it would have been by historical standards.

Barry McCarthy

I would say, Doug, in my comments about Q1, I am not trying to signal to you a shift in our cost structure or the economics around subscriber acquisition, I am trying to signal that there’s going to be much more growth than the Street is expecting, and that there will be marketing costs associated with the growth. But I am not trying to signal to you that they are breaking the model or that we are spending amount on a per-subscriber basis, it’s going to be a big tax on the business.

Deborah Crawford

The next question is from Jim Friedland at Cowen and Company. What percentage of users are on Blu-ray subscription?

Reed Hastings

Blu-ray stayed pretty steady for us just under 10%, and you know, particularly change that, probably the love with the Holiday season and the fantastic deals for our Blu-ray players.

Deborah Crawford

A follow-up question from Christa Quarles at TWP. What subscriber growth estimate were you referencing for 2010 that is too low? She just wants to make sure she’s on the right page.

Reed Hastings

You mean specifically a number? Specifically Street expectations.

Deborah Crawford

The next is from Brian Fitzgerald at UBS. Does the watch-instantly viewing match your DVD business, i.e., 80% or older titles and 20% of newer releases?

Reed Hastings

You know, in the narrow sense, we have virtually no new releases on streaming. So, it doesn’t match. In a broad sense, you will always have some titles that contribute a lot, and other titles you know, sort of long tail that contribute less, in which case you could get a similar scale effect.

Deborah Crawford

Another question from Brian Fitzgerald at UBS. In terms of A la carte services and digital formatting standards, namely Disney’s Keychest and the DECE or Digital Entertainment Content Ecosystem, do you see one DRM initiative as gaining more traction?

Reed Hastings

No, because we are the subscription, not active participants and those, you know, very important efforts to establish a standard for digital ownership and what the standard will be.

Deborah Crawford

The question is from Mark Mahaney at Citigroup. Why not expand internationally with physical DVDs as well?

Reed Hastings

You could – it’s a perfectly reasonable argument, there’s some good market, but postal systems in many nations make that tricky and streaming is a huge opportunity. So, we are focused on that, which of course, you know, whether or not as when you can strain since it’s a larger available market.

Deborah Crawford

The next question is a follow-up question from Barton Crockett at Lazard. If Netflix has delayed access to new DVD releases as Warner is suggesting, how much was subscriber growth low? Clearly, new DVDs are a minority of usage but important to users and later access could make this service less appealing?

Reed Hastings

It could depend on a range of things. We are focused on making the service better and depending on the way the deal is structured, if it’s only a few weeks delay, it may work out that it’s actually in overall better experience, because it could be at the several week mark, but then we have a very large supplier content of discs. So, there’s a lot of way to cut that. We are not going to do anything that would materially harm the customer experience. We are focused, you know, we get those huge customer sat ratings, we are continued to focus on great customer satisfaction, but it is true that there may be ways to put together a deal that helps studio sell more DVDs, helps us to be more efficient on our rental expense and then allows us to put that expense into streaming. And if we did something, it would only be because we were confident that it would not negatively affect our growth.

Deborah Crawford

And I think we have time for one more question. It’s Scott Devitt at Morgan Stanley. Can you update us on San Francisco household penetration and lesser country household penetration?

Reed Hastings

Yes, that was in my script, so, we will throw back to that.

Deborah Crawford

That’s it. I think we are out of time.

Barry McCarthy

Thank you all for joining us on the call. We continue to be very excited about the progress we are making. Our DVD proposition is very strong and growing and streaming is adding to that, and we feel blessed to be growing at these enormous rates. With that, we look forward to talking with you all in the quarter.

Operator

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

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