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Executives

Deborah Crawford – VP, IR

Reed Hastings – Co-Founder and CEO

Barry McCarthy – CFO

Analysts

Steve Frankel – Brigantine Advisors

Youssef Squali – Jefferies & Company

Ralph Scharkar – William Blair

Aaron Kessler – Kaufman Bros.

Daniel Ernst – Hudson Square

Michael Pachter – Wedbush Morgan Securities

Mario Cibelli – Marathon Partners

Ben Rose – Battle Road Research

Marianne Wolk – Susquehanna Financial Group

Brian Fitzgerald – UBS

Imran Khan – JPMorgan

Scott Devitt – Morgan Stanley

Nat Schindler – BoA/Merrill Lynch

Mark Mahaney – Citigroup

Sandeep Aggarwal – Collins Stewart

Doug Anmuth – Barclays

Michael Olson – Piper Jaffray

Jeetil Patel – Deutsche Bank

Jason Helfstein – Oppenheimer & Company

Mark Harding – Maxim Group

Tony Wible – Janney Montgomery Scott

Heath Terry – FBR Capital Market

Jim Friedland – Cowen and Company

Barton Crockett – Lazard Capital Markets

John Blackledge – Credit Suisse

George Askew – Stifel Nicolaus

Guy-Charles Valois – Galliant Capital

Netflix, Inc. (NFLX) Q4 2009 Earnings Call January 27, 2010 6:00 PM ET

Operator

Welcome to the Netflix fourth quarter 2009 earnings conference call. As a reminder, today’s call is being recorded. At this time for opening remarks and introductions, I this time I will turn things over to Ms. Deborah Crawford, Vice President of Investor Relations. Please go ahead ma’am.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix’s fourth quarter 2009 earnings call. We released earnings for the fourth quarter at approximately 1:05 p.m. PT today. The earnings press release and the webcast of this conference call are available at the company’s Investor Relations Website at ir.netflix.com. In addition, as noted in the earnings press release, management’s commentary on the quarter’s results is also available at our Investor Relations website.

This conference call will consist solely of Q&A. As we have done for the past several quarters we are going to conduct Q&A via email. Please email your questions to me at dcrawford@netflix.com.

We may make forward-looking 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 SEC on February 25, 2009. A rebroadcast of this call will be available at the Netflix website after 6:00 p.m. PT today.

Before moving into Q&A I would like to turn the call over to Reed for some brief opening remarks.

Reed Hastings

Thanks Deborah and welcome everyone to today’s call. As you can tell from our press release and from our commentary we posted on our website, Q4 was a great quarter. Over one million net new subscribers, strong earnings and a significant expansion in streaming. As our guidance for 2010 indicates we expect the momentum to continue.

With that let’s go directly to Q&A.

Question and Answer Session

Deborah Crawford

The first question comes from the line of Steve Frankel – Brigantine Advisors.

Steve Frankel – Brigantine Advisors

Is the bounty paid to the game platform manufacturers materially different than that paid to other customer acquisition channels? Is it higher or is it lower?

Reed Hastings

We don’t disclose individual deals as you probably would expect. But what you can see is that as we have expanded with the various CD platforms including the game platforms that our subscriber acquisition cost has continued to come down nicely. From that you can intuit there is no significant model shift.

Steve Frankel – Brigantine Advisors

Is the decline in SAC driven by more decline in ad rates, increased brand awareness or a reduction in the bounty you are paying for customer acquisitions?

Reed Hastings

Mostly brand awareness and the improvement in the product. The product fundamentally the service is better than it was 2-3 years ago because of the streaming. So that increased attractiveness makes it easier to sell, if you will, that combined with the large scale we are operating at is what is driving down the SAC as opposed to some change in the display ad markets or outside factors.

Steve Frankel – Brigantine Advisors

With HBO, Starz and Showtime so focused on original programming do you expect as their respective studio output deals come up for renewal they will be less willing to lay out large amounts of cash, potentially opening up content for you to acquire?

Reed Hastings

On the first part they have had great success with episodic first HBO then Showtime and most recently Starz where Spartacus just launched and is a huge success for Starz. It hasn’t lowered their appetite for movies. As an example, HBO pioneered episodic probably 7-9 years ago and has continued to renew their deals and be very focused on movie content. We are focused on being a distributor for those services. We are a distributor for Starz now. We would like to be for Showtime, HBO and Epics. That is the relationship that we want as opposed to trying to bid against them. That is just not necessary for us.

Deborah Crawford

The next question comes from the line of Youssef Squali – Jefferies & Company.

Youssef Squali – Jefferies & Company

Will you be renegotiating content rights with the studios along the lines of what you have done with Warner Bros. for [day and date] releases? Help us understand the cost benefit to you.

Reed Hastings

I will broaden the question flatly to the 28 day question which is why did we do the Warner deal. I don’t think it impacts the streaming directly. With Warner Bros. they wanted to create a window to improve sell through. As you well know in the book industry there is hard cover books for awhile and then paperback. That is a proper profit maximization strategy. They, and I think quite reasonably, would like to have DVDs for sale at Amazon, Wal Mart, Best Buy, etc. for some period of time before they are available for rental. We were willing to agree with them to work within that system which we hope and they hope will improve DVD profits and the DVD ecosystem. For us most consumers are not sure if DVDs come 90 days after the theatrical release, 120 days, 150 days, 180, it is all over the map. It constantly changes not only between studios but also between specific releases. So there is not a high expectation of any perfect day when it is supposed to be out.

There is potentially competitive risk if Redbox and others continue to be able to have availability [day in date] and it certainly appears that Warner is going to try and do, and the other studios, is to have us and the kiosks ultimately at the 28 day which creates the window for the studios. Video stores we are not sure what will happen there but they are closing so quickly it may not be that relevant in the next couple of years and kiosks and rental by mail together could create that window.

The advantage to us in doing the deal is cost savings. Warner has given us a huge number of copies up to 29th day at a very attractive price so we are able to fulfill all of the consumer demand and then we are able to use those savings to pour that into more streaming content. It is really a win all around in terms of what we are doing and that is why we are looking forward to expanding with other studios over the next two years as our deals come up.

Youssef Squali – Jefferies & Company

The Wii deal, what is the percentage of the total Wii installed base that is actually addressable in that relationship? Arguably you need connectivity to stream content which many older devices don’t have.

Reed Hastings

Well that is actually one of the amazing things about the Wii. 100% of the devices of WiFi include [inaudible] of the 26 million installed base 100% are addressable by Netflix. So we are very excited about that.

Deborah Crawford

The next question comes from the line of Ralph Scharkar – William Blair.

Ralph Scharkar – William Blair

Can you talk about Netflix’s digital content acquisition strategy as it relates to new content? In other words, is it possible to get digital content closer to DVD release or possibly longer term getting DVD windowing rights? What are the business model pros and cons for offering newer digital titles?

Reed Hastings

We are not terribly likely to have equipped with the DVD streaming content in newness in the service. That is true for frankly any subscription service including HBO, Starz, etc. so the biggest advantage that Netflix has competitively is we can offer this subscription for the new releases on DVD and a vast catalog is potentially available for streaming. We fit into the subscription TV window in studio [par widths] which is the same window with HBO, Starz and others and within that there is a lot more content we can get that we haven’t yet licensed which is fundamentally us writing bigger and bigger checks to be able to purchase more and more content which is coming along nicely.

I would say the strategy is not particularly focused on how do we break through to get the newest new releases on streaming. It is much more how do we get every TV episode, every movie ever made, that catalog, an incredibly rich catalog and then to use our personalized merchandising to figure out which parts of that are relevant to each consumer so that when they turn on their TV or they go to the Netflix website the 20 or so movies listed are 20 movies that consumer is just dying to watch.

Ralph Scharkar – William Blair

Can you talk about the subscriber? How did this quarter in terms of how many were purely streaming digital subscribers? Perhaps more broadly, are you seeing any measurable mix shift to subscribers renting less DVDs and converting to streaming only?

Reed Hastings

All of our subscribers pay for hybrid service so they get both DVD and streaming. Nearly all of them also take DVDs. So they really use both and again on DVD we have over 100,000 titles so it is just incredibly comprehensive. You can see why someone would do that.

In terms of the substitution question you asked, our long-term model is to be able as a percentage of our costs to pay a little bit less each year on DVD and Blue-ray as a percentage and to put more and more money into streaming. That is eventually where you will see this substitution. We are not able at this point to be conclusive about any substitution that exists because we don’t have a good control set of subscribers that don’t get streaming. So when we look at it we are very happy with the effect streaming is having but it is mostly coming in terms of additional growth. That is the one where we see it directly where it gets lower SAC and lower turn. More than it is a cost substitution. As you can tell from our P&L margin structure we are able to get enough digital content to have significant expansion in streaming and we are moving along each quarter in getting more and more content.

Deborah Crawford

The next question comes from the line of Aaron Kessler – Kaufman Bros.

Aaron Kessler – Kaufman Bros.

It doesn’t appear you were as aggressive as you would have liked to have been in terms of purchasing digital content in 2009. What prevented you from acquiring the rights to more content in 2009? What is the outlook for availability of content in 2010 and any comments or concerns with studio thoughts on Starz licensing digital content to Netflix?

Reed Hastings

There are a couple of key questions in there. We are very happy with the content that we have been acquiring. It is a small part of the content for streaming we eventually want to have but it is enough content that the percentage of subscribers viewing or streaming has significantly increased. In one quarter we went from 41% to 48% of our subscribers and remember the subscriber base is growing over that time also. I know we don’t have everything that we want but we have a ton of content for subscribers and they are super happy with it. Again, as we write checks and are able with a larger P&L to write larger checks we get more and more content.

In terms of Starz specifically and Starz Disney we don’t have any reason to believe there is going to be any change in that in the short-term. That is working well for us. We have a good agreement in place. In terms of long-term we are not dependent on any one content source particularly. The strength of Netflix is to have a very broad range of content. So we are not particularly troubled by those press reports.

Barry McCarthy

Let me supplement Reed’s answer with perfect foresight we have been able to forecast the profit performance of the business and the subscriber growth we would have landed within the range of guidance. We would have spent to acquire content roughly the amount of money we had forecast. The business outperformed and we weren’t able to forecast that accurately and as a consequence we dropped more profit to the bottom line in Q4 than we had planned. If we had planned for it we would have managed to the 10% number and spent more on content. So perhaps your question in part is the weight of the outperformance in the quarter and that narrowly is a planning related issue.

Reed Hastings

That is a great point Barry. For investors typically, it is all a little variable, but it is at least six months from when we start to talk with a studio or network about a particular set of content to when a deal is signed and the content is flowing. So it is not stuff you call up and 30 days later you spent more money on the P&L. So these are long-term deals and each one takes quite awhile to negotiate. At any point in time we are in negotiation on a very broad range of content.

Aaron Kessler – Kaufman Bros.

How did PS3 launch compare to Xbox 360 realizing you can’t give any specific numbers?

Reed Hastings

PS3 was a huge success for us. Its advantages are that it has WiFi built into every unit. You can use Netflix without being part of an add-on subscription like [Gold]. The disadvantages are that it has a disc and we have to mail the disc to the consumer. Once they have the disc then it is very easy to use but that does introduce a delay. We are super happy with the traction the PS3 has had. Then in the fall we will be offering a downloaded option directly in the PS3 to the PS Network.

Aaron Kessler – Kaufman Bros.

What data are you looking at that suggests streaming is the big reason for lower churn, i.e. exit surveys?

Reed Hastings

No, we are actually looking at retention data, the inverse of turn for specific cohorts of customers segmented by behavior. So there is some portion that don’t stream. There is some portion that gets in hybrid behavior. There is some portion that streams only. I am looking at year-over-year comparisons in Q4 of retention behavior by subscriber period. First month and the individual months after that over their entire life.

Deborah Crawford

The next question comes from the line of Daniel Ernst – Hudson Square.

Daniel Ernst – Hudson Square

Roku says they have sold 500,000 boxes, an impressive number. I assume most of those have connected to Netflix. If I added up all of the direct TV options you have; Roku, LG, Samsung, Sony, Xbox, etc. can you give me a sense of how many direct to TV Netflix homes there are?

Reed Hastings

I can’t give you a direct sense. For one thing there are many people who use a laptop and then use a HDMI cable to the TV. That shows up as laptop usage. Then there is the class of Mac Mini’s where people do a similar thing and it shows up to us as a computer usage that goes to the TV. So you really don’t want to think about it as the screen size. If the screen size is 12 inch in one category. If the screen size is 36 inch it is a different category. So when we thought about this over the last year we came up with a metric for your benefit and the benefit of investors which is the percentage of subscribers that we are streaming in the quarter and taking advantage of it. Again, the actual screen size is not the main factor.

Deborah Crawford

The next question comes from the line of Michael Pachter – Wedbush Morgan Securities.

Michael Pachter – Wedbush Morgan Securities

Subscribers grew by 2.88 million in 2009 yet guidance for subscriber growth ranges from 3.23 million to 4.03 million. Does this guidance incorporate the introduction of the streaming only service during the year and if so would you please break out by mail subscribers expected compared to streaming only?

Reed Hastings

There is no formal plan, nor is it included in our guidance to introduce streaming only. Nor do I think it would change the forecast. In other words, if we thought it would open up an entirely new market of course we would do it. So we look at it and from our work with our subscribers and at $8.99 the hybrid is just so incredibly powerful that for now we are just going to ride that horse, concentrate on the brand proposition on that.

Barry McCarthy

One minor caveat by way of cleanup, the sub guidance is for domestic and international. International is very small. International will be streaming only. Domestic will not have a streaming only product. I want to emphasize international is very, very small.

Deborah Crawford

The next question comes from the line of Mario Cibelli – Marathon Partners.

Mario Cibelli – Marathon Partners

Could you break down at all where streaming is coming from? PC, Xbox, Blue-ray players, Roku, etc.? If not, are there any standouts in the mix that might be of interest to you?

Reed Hastings

All of the devices you would think are significant that have big installed bases which are laptops, Windows and Macintosh and game consoles are very big. The next big category are Blue-ray because we got started early and that is continuing to grow really well for us. When we look at 3-5 year picture, being built into the TV is an obvious winner. We think that most TVs, almost all Blue-ray players sold this year in 2010 will have internet connectivity and Netflix. A substantial faction of TVs will have internet connectivity and almost all of those will have Netflix. Within 2-3 years my sense is WiFi is so inexpensive to add to TVs that they will be in every screen and we believe that Netflix will be part of that. So the long-term picture really driven by TVs, Blue-ray, but in the short-term video game and laptops are big contributors also.

Deborah Crawford

The next question comes from the line of Ben Rose – Battle Road Research.

Ben Rose – Battle Road Research

Will Netflix simply absorb the gross margin improvements that occur to a rising percentage of streaming versus DVD shipments or can we expect the purchase of new Hollywood productions to offset such gross margin gains?

Reed Hastings

Hopefully we will see it coming in which case we will reinvest it in improving the quality of the user experience in more content.

Barry McCarthy

At least this year, we are targeting 11% operating margins and we will take it year by year. There is a pretty big prize out there and if we can reinvest additional margins essentially saved into more content that seems the smarter thing to do in the next few years.

Deborah Crawford

The next question comes from the line of Marianne Wolk – Susquehanna Financial Group.

Marianne Wolk – Susquehanna Financial Group

The year-over-year decline in SAC was much lower than we have seen in the last few years. Should we anticipate positive growth in marketing spend per subscriber going forward and how does the marketing for Wii affect this?

Reed Hastings

If you look over the last 3-4 years marketing has declined as a percentage of revenue each year and as our revenue grows we think that will continue to happen including the special Wii marketing we will be doing. So that is included in our model.

Barry McCarthy

Returning back to Reed’s comment earlier in the call, he observed one of the drivers of declining SAC was the organic growth which was tied to the quality of the service. To the extent we are able to improve the content offering and be the beneficiary of more platforms capable of streaming content to TV sets that should be a boost for organic growth which would be a plus for subscriber acquisition costs.

Deborah Crawford

The next question comes from the line of Brian Fitzgerald – UBS.

Brian Fitzgerald – UBS

It looks like your DVD library is pretty consistent at about 100,000 titles while streaming titles are up from roughly 12,000 in the summer to 17,000. How should we expect that to grow going forward? Would you expect 30,000 by year-end?

Reed Hastings

I should have avoided publishing the 17,000 update because it gets everyone focused on title count and you can imagine we could quickly license if we wanted to 100,000 irrelevant titles. So you really don’t want to use title count as a proxy for attractiveness of the service. If we had 1,000 of the biggest titles that would make a much bigger difference than 10,000 others.

The substitute for title count that is more valid to think about is the percentage of our subs that are streaming. The way that increases is by adding more content, more platforms, better user interface, all of those coming together. Of course that metric moved up from 41% a quarter ago to 48% this quarter. So we are really thrilled with the progress of that and we are going to continue to push content in. So think of it as we put in content and get streaming content as we get the user interface better and the platforms all of those drive that up. We are trying to back off of title count as a significant metric.

Brian Fitzgerald – UBS

Regarding the outlook for content acquisition are the discussions with Showtime, HBO or Epics for their content?

Reed Hastings

I guess the question is are there discussions ongoing and we have discussions with everybody so a very broad range. That doesn’t imply that there is anything close on that. It is just an ongoing set of conversations with a wide range of networks and studios.

Deborah Crawford

The next question comes from the line of Imran Khan – JPMorgan.

Imran Khan – JPMorgan

You bought back 7.4 million shares last year. Do you have any optimal number in your mind going forward?

Reed Hastings

Sorry, I am trying to think of how I want to answer that. We are going to be active as far as the stock this quarter and I anticipate we will continue to purchase shares throughout the year. Have in mind, we as a management team and our board think about using cash like we would any other productive asset. There is some minimum amount of cash we want to keep on the balance sheet and then we want to smartly deploy all the rest of it. If we can’t deploy it in the business then we will deploy it to repurchase shares provided that the share price at which we would repurchase makes sense from an IRR perspective.

Now if you were optimistic about our ability to grow the size of the market, the subscriber base and future profits you probably have some pretty aggressive price expectations for the stock and if you don’t you probably don’t. Obviously we are pretty bullish on our ability to continue to grow subscribers, revenue, profit and free cash flow. So some pretty aggressive price points at which we are willing to acquire.

Deborah Crawford

The next question comes from the line of Scott Devitt – Morgan Stanley.

Scott Devitt – Morgan Stanley

To what extent do you believe the ability to update ones queue via iFlix, Flixster and most CE partner interfaces have or will change Netflix website traffic patterns as measured by third-party services?

Reed Hastings

That is a nice oblique way to ask the comp store question. That is a credit to you. I am not sure how much. We will get more and more viewing from devices. Not that much queue additions per se from devices but certainly your point is right which is if someone is only measuring web interaction for Netflix they are going to miss more and more of the picture over time. That may contribute to a difficulty for web measurement firms in terms of measuring Netflix accurately.

Deborah Crawford

The next question comes from the line of Nat Schindler – BoA/Merrill Lynch.

Nat Schindler – BoA/Merrill Lynch

What was the cause of the large quarter-over-quarter step up in CapEx and what are your expectations for capital expenditures in 2010?

Barry McCarthy

Let me take the 2010 question first. I think that would be roughly flat. They were flat 2008 to 2009 and 2009 to 2010. I think they will be flat in 2010 and vary deal on how successful we are or not pushing IT infrastructure into the cloud. The answer with respect to Q4 is we as I said were busy investing in route of return information for our Op Centers, our hubs, and that was the largest single CapEx expenditure in the quarter.

Nat Schindler – BoA/Merrill Lynch

What do you expect for the quarterly interest expense going forward?

Barry McCarthy

Well the interest expense is fixed and the yield on the bonds was 8-8.5 and we sold them at par.

Deborah Crawford

The next question comes from the line of Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

First, what kind of response if any have you sensed from your subscriber base with regard to the 28 day sales window? Any complaints?

Reed Hastings

No material complaints. Again, subscribers are just not that aware of when DVDs come out relative to theatrical. The first title that is so affected is the Invention of Lying which is just hitting. So we really even if there were complaints they wouldn’t come up yet. From everything we have done before deciding to do this and seeing the results afterwards we are very happy with the decision.

Barry McCarthy

Let me just chime in and say that we have frequently spoken about the rental mix of new release versus catalog and in the most recent quarter I think catalog was 73% so the new release was 27%. Some people have speculated that is not a true measure of demand on the subscriber base and that if we released key demand by street date we would see an entirely different picture. In fact we see exactly the same picture. Key demand for new release in December was 27% which was the average disc shipment in the quarter. So you might not imagine that somehow we are frustrating demand and that is the reason that we primarily ship by catalog. There is no data to support that conclusion.

Mark Mahaney – Citigroup

Currently what is the biggest obstacle to getting more streaming content?

Reed Hastings

Money.

Mark Mahaney – Citigroup

What caused the bump up in free subscribers in the quarter?

Reed Hastings

Typically each Q4, Q4 more than our other quarters is back loaded so there are more subscribers in their two week free trial at the end of the quarter. So that is a timing thing that is true each Q4.

Barry McCarthy

I will comment that the year-over-year accelerating growth you will see a shift towards free.

Deborah Crawford

The next question comes from the line of Sandeep Aggarwal – Collins Stewart.

Sandeep Aggarwal – Collins Stewart

As we get more subscribers signing up because of streaming can we see churn going down even further?

Reed Hastings

Certainly it is possible that as consumers use the streaming more and more they end up having a more consistent relationship with Netflix rather than say turning it off in the summer and coming back in the fall. But it is also possible it is the other way that we get a broader demographic of subscribers that come in and they are very comfortable going out for a few months, going on, going out. So I would advise you to try to really focus on the net additions in the growth rather than the SAC and churn. That combination isn’t the most material part of the business. It is really the net additions that I focus on.

Sandeep Aggarwal – Collins Stewart

By when can you have streaming titles more than 35% of total titles you carry?

Reed Hastings

If we had chosen to we could have had that years ago because we would have taken the 35 smallest titles, such and such yoga, studio blah and had it. So again, title count can be super misleading. What you really want to ask is when are we going to have 2/3 of our subscribers streaming. When is the content so good that 2/3 of our subscribers choose to stream and the answer to that question for you, I would guess about 1.5 years just based on current trends of what we have seen growing.

Barry McCarthy

I would think you also…I have heard you observe in the past that it is not just about content. It is also about platforms. So it is about building the ecosystem around streaming and we have made a tremendous amount of progress in 2009 and we will continue to in 2010 with respect to platform growth and so that makes a larger investment in content economical.

Deborah Crawford

The next question comes from the line of Doug Anmuth – Barclays.

Doug Anmuth – Barclays

Q4 content acquisition was the highest it has been in two years. Should we think about that as a one-time step up related to the new Warner deal or is that more of a run rate going forward?

Reed Hastings

More of the latter than the former. It had a lot to do with moving out of rev share in Q4 and back into rev share in Q1 and timing of payables coming out of Q3.

Doug Anmuth – Barclays

Curious to know why there is no on-screen presence for the Wii. I assume this is for contractual reasons with Sony?

Reed Hastings

He probably means with Nintendo. Yes, that is just reference on the way for systems to operate like any other game and we will go off and market the service as an incredible internet video streaming on the Wii.

Deborah Crawford

The next question comes from the line of Michael Olson – Piper Jaffray.

Michael Olson – Piper Jaffray

Also with regards to the Wii, Wii is certainly a larger installed base than the other consoles but how do you feel about the Wii demographic versus the Xbox and PS3?

Reed Hastings

You know we will know a lot more after we launch but I think it is certainly true the PS3 and Xbox because they are more expensive, higher end boxes that do Hi Def are more video intensity so the question is the Wii installed base is significantly larger, and how do those wash out against each other? We look at all three as just great opportunities for us and we are continuing to push forward on all three.

Deborah Crawford

The next question comes from the line of Jeetil Patel – Deutsche Bank.

Jeetil Patel – Deutsche Bank

What do the demographics of the new customers added in the past year look like relative to the existing subscriber base?

Reed Hastings

I don’t think we know of any very big change in the demographics. It is people who love movies and TV episodes and that is pretty broad. We are getting the benefit of that.

Jeetil Patel – Deutsche Bank

Do your newer customers have any different propensities? In other words, higher streaming usage, lower or higher churn, two DVD rental plan, lower utilization?

Reed Hastings

I would say over the last three years we have continued to gain confidence there is great competitive [notes] in commercial value and profits in our lower price plans. So if you look at us four years ago we were only the $17 and $18 three out. We got into the $9 one out and we expanded and we continued to do that driving low prices, large subscriber base and substantial profits because it is frankly a more defensible way to hold onto those profits. So continuing with that trend more and more new subscribers are taking the $8.99 hybrid, rent all the DVDs you want one at a time and all the streaming you want. You see that reflected in ARPU. Again, we see that as a competitive strength which is we can make money at these price points and that is hard for anyone else to attack us and be able to do the same thing. So it is a scale advantage we are investing in.

Barry McCarthy

You see that advantage translate in terms of profit in the gross profit per average paying customer. I think…I am doing this from memory, $4.96 in the quarter. You have to look back two years before you find profit per sub number that is actually higher. So notwithstanding the lower price points and the investment in streaming the profit dynamics of the model, the scale advantages that Reed just talked about are clearly present.

Deborah Crawford

The next question comes from the line of Jason Helfstein – Oppenheimer & Company.

Jason Helfstein – Oppenheimer & Company

Have you started to started to negotiate with studios for international streaming rights? If so, how are prices for streaming likely to compare to US prices?

Reed Hastings

It is unclear how the pricing will work out on something we are still experimenting in and looking at. We will be able to talk more about international in the second half of the year.

Deborah Crawford

The next question comes from the line of Mark Harding – Maxim Group.

Mark Harding – Maxim Group

Does full-year 2010 subscriber guidance include expectations from an international launch? If so can you provide any color about a likely country service offering or pricing?

Reed Hastings

The narrow question from a modeling perspective is yes. But it is really small.

Barry McCarthy

We don’t plan on giving any more information about what country, what price plans, what timing until we launch in the second half of the year.

Reed Hastings

We are doing that for competitive reasons, not to be difficult.

Operator

The next question comes from the line of Tony Wible – Janney Montgomery Scott.

Tony Wible – Janney Montgomery Scott

How do you balance the need for cash for digital rights and repurchases? What is your willingness to increase leverage?

Reed Hastings

The first priority is to improve the service because that part of the cycle drives all kinds of good things; subscriber growth, revenue, profit and free cash flow. After that if there is surplus cash we think about repurchasing the stock. We are growing free cash flow by in round numbers sort of one-third each year. So we have ample opportunity over time to go back to the capital markets for more debt and maintain the same amount of leverage in the business and the business grows and streaming…I don’t want to say the streaming service, as the hybrid service becomes more mature and as we acquire more content and as we gain more scale and the business becomes more predictable then we might think more aggressively about slightly increasing the amount of leverage on the business. So we are at 1.3 times when we close the transaction. Is 2 conceivable? Possibly but I don’t foresee a capital markets transaction in the foreseeable future.

Barry McCarthy

Your question implies some tension between digital content acquisition and repurchase which doesn’t exist. The digital content is not free cash advance oriented. So we are P&L constrained in terms of generating profit as opposed to cash constrained on the digital content.

Tony Wible – Janney Montgomery Scott

Was the sale of Roku recorded as a gain this quarter?

Reed Hastings

It was recorded as a gain. You can see it in the statement of cash flows and you have seen it in our SEC disclosures. The investment was carried at $5.7 million. We booked a gain pre-tax of about $1.7 million. After tax that translates to $1,035,000 on an EPS basis it equates to just around $0.02.

Deborah Crawford

The next question comes from the line of Heath Terry – FBR Capital Market.

Heath Terry – FBR Capital Market

Are there any reasons, legal, technological, etc. that you couldn’t develop a streaming application for the iPod? Would your current streaming service work on the device?

Reed Hastings

We haven’t yet done or submitted an iPhone application. We are optimistic that post the Google Voice brouhaha it would be approved. There is really no way of knowing in advance what Apple’s stance would be on that. Of course that application if it works on the iPhone it would work on the iPad. It is not a huge priority for us because we are so focused on the larger screen. Until we get our TV ubiquity and our Blue-ray ubiquity and we are getting close on video game ubiquity we would next turn to the small screen. It is just not a primary movie watching. It is something we will get around to but it is not in the near-term.

Heath Terry – FBR Capital Market

How many of your studio relationships come up for renewal this year?

Reed Hastings

Think of it as there is a ton, over 50 varied content deals. So it is not one per studio. It is hundreds of content deals. So they are individual sets of content that are negotiated and priced with varying durations and of course we are careful to make sure they are fairly distributed and staggered in their expirations so that we can manage it to a fairly steady flow of content coming in and us buying more and more content.

Deborah Crawford

The next question comes from the line of Jim Friedland – Cowen and Company.

Jim Friedland – Cowen and Company

The rate of decline in ARPU has slowed over the past four quarters. Is it reasonable to assume that as the streaming catalog and watch instantly usage grows ARPU will trend towards $8.99 or will you introduce multiple pricing tiers for different usage levels of streaming content?

Reed Hastings

The thing to think about is the Blue-ray so we are a little over 10% with Blue-ray and that is a $2 supplement. There is the trend towards the $8.99 but for those subs that want Blue-ray it is $2 more so $10.99 and that gives a little softening effect on the ARPU decline.

Deborah Crawford

The next question comes from the line of Barton Crockett – Lazard Capital Markets.

Barton Crockett – Lazard Capital Markets

With regards to paid TV rights, will Netflix seek to bid against paid TV networks such as Starz for exclusive rights to new movies in the pay TV window?

Reed Hastings

At this point we are looking to try to work with the existing pay TV services; Epic, Starz, HBO and Showtime and to be a distributor so we are writing them big checks partially because that includes all of their amazing original content. That is our primary strategy at this point.

Deborah Crawford

The next question comes from the line of John Blackledge – Credit Suisse.

John Blackledge – Credit Suisse

After console deals where does growth come from in 2011 and beyond?

Reed Hastings

That is a great question that we ask ourselves too which is the incredible accelerating growth we have seen in the past three years is it mostly linked to the expansion first of streaming on laptops and then to the devices that have large installed bases. Frankly we are just not sure. That is one thesis. The other thesis is we are on the beginning of the streaming adoption S-curve and we will continue to grow into the installed bases. That is all of our subscribers have laptops to watch movies on and many of them have internet enabled Blue-ray players so we may be able to string that together. We will know more in the second half of this year as to the shape of those curves but even in the more conservative case in the midpoint of our guidance for the year we are looking at about 30% subscriber growth annually which is phenomenal.

Barry McCarthy

To supplement Reed’s response, he made I think the most important point. A minor point links back to an earlier observation which is that WiFi is becoming ubiquitously available in TV sets so game platforms and other devices are sort of Gen One of the technology as it evolves into sort of a more general purpose device accessible by anyone and any competitive service but also accessible by Netflix. So with every television set purchased in the United States in 2011 can connect to the Internet they could all be Netflix subscribers.

Reed Hastings

That is a great point. In the optimistic case we will ride the broadband to the TV market which will grow hugely year after year after year for the next 10 plus years.

Deborah Crawford

The next question comes from the line of Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

With regard to household penetration can you give us the updated numbers for Q4 for San Francisco Bay area and the rest of the country?

Reed Hastings

Bay area in Q4 was 22.6% up from 21.2% and the rest of the country was 10.8% in Q4 up from 9.6% in Q3.

Deborah Crawford

The next question comes from the line of Nat Schindler – BoA/Merrill Lynch.

Nat Schindler – BoA/Merrill Lynch

Long term can you sustain unlimited streaming with an $8.99 price point?

Reed Hastings

We are not sure. It depends on how many subscribers want to have because the content is mostly fixed cost to produce and divide. Certainly if you had enough subscribers you could make the content holders very happy by writing them large checks and still have a big profit. So it is all a scale opportunity and we are focused on trying to be the largest scale of this internet, commercial free subscription services.

Deborah Crawford

The next question comes from the line of George Askew – Stifel Nicolaus.

George Askew – Stifel Nicolaus

You state that 48% of subscribers use streaming content in the fourth quarter. What is the percentage if you look only at subscribers added in 2009 or in the last few quarters?

Reed Hastings

We don’t have separate breakouts for each of the cohorts, at least not that we are doing for public disclosure. It is certainly true that newer subscribers that are introduced to streaming right in the beginning as part of their Netflix service are using Netflix at slightly higher rates than someone who has been a DVD subscriber for us for six years and in their heads we are a DVD service. That will change over time and those cohorts will come together.

George Askew – Stifel Nicolaus

With regards to the Wii advertising what is the nature of the advertising online as opposed to offline and what might be the range of your spend?

Reed Hastings

The spend is included in our marketing plans. I don’t have a break down for you of the type of advertising. We will do what we view as most effective.

Deborah Crawford

The next question comes from the line of Guy-Charles Valois – Galliant Capital.

Guy-Charles Valois – Galliant Capital

Would you expect operating margin to be higher or lower than current levels on a 100% streaming business model?

Reed Hastings

I think the long-term operating margins will be determined more by the amount of competition. If there is 3-4 fairly equal players in a large market you would expect the operating margins to be lower. If there is 1-2 you would expect the operating margins to be higher. So the actual streaming costs are quite low. The content costs, there are no hard costs it is just what we pay for it. Again, I think the way to think about it is what will be the likely competitive structure of the future market and from that you can get a model of what the long-term operating margins would be.

Barry McCarthy

Along the way for a number of reasons [inaudible] a market share gain and driving hard for growth. We could in the alternative pursue a skimming strategy and take operating margins up. It is a conscious decision to do the former and not the latter.

Reed Hastings

To deepen our competitive modes with large scale, low prices.

Deborah Crawford

The next question comes from the line of Brian Fitzgerald – UBS.

Brian Fitzgerald – UBS

Any color or numbers you can share with us on the average number of Netflix streaming devices in the household? How has that penetration been trending?

Reed Hastings

The average number of laptops in a house in America is probably 1.5. I am just making up numbers. I don’t really know. You have ever laptop you have the Roku, the video game consoles. I guess I don’t have any value to add in that answer.

Brian Fitzgerald – UBS

A related question, are you seeing any substitution within the household from one device, say a Sony TV, over another, an Xbox or a TiVo?

Reed Hastings

No, our main focus is on streaming per se and it doesn’t really matter to us if it is streaming to a laptop, streaming to a laptop plugged into a TV, streaming to a Blue-ray to a TV, streaming directly to a TV. That is all a great consumer experience so we are just trying to make all of those experiences better and better.

Deborah Crawford

Operator that was the last question that I have.

Reed Hastings

Thank you everyone for joining us on the call. Q4 was a record setting quarter and it capped off a great year in which we saw accelerating subscriber growth powered by streaming. We expect the growth to continue which you will see reflected in our guidance and I look forward to reporting on our progress with you on our next quarter’s call. Thank you very much.

Operator

That will conclude today’s conference call. Thank you all for joining us. Have a great afternoon.

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Source: Netflix, Inc. Q4 2009 Earnings Call Transcript
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