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Netflix, Inc. (NFLX)

Q3 2006 Earnings Call

October 23, 2006 5:00 Pm ET

Executives

Deborah Crawford - Director, Investor Relations

Reed Hastings - Chairman of the Board, President, Chief Executive Officer

Barry McCarthy - Chief Financial Officer, Secretary

Analysts

Gordon Hodge - Thomas Weisel Partners

Heath Terry - Credit Suisse First Boston

Safa Rashtchy - Piper Jaffray & Co.

Barton Crockett - JP Morgan

Doug Anmuth - Lehman Brothers

Jim Friedland - Cowen & Co.

Tony Wible - Citigroup

Youssef Squali - Jefferies & Co.

Daniel Ernst - Hudson Square Research

Charles Wolf - Needham & Co.

Mario Cibelli - Marathon Partners

Chad Bartley - Pacific Crest

Eric Fischer - Broadmark Asset Management

Operator

Good day, everyone, and welcome to the Netflix third quarter 2006 earnings conference call. Today’s call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call to Deborah Crawford, Director of Investor Relations. Please go ahead, Madam.

Deborah Crawford

Thank you, and good afternoon. Welcome to Netflix's third quarter 2006 earnings call. Before turning the call over to Reed Hastings, the company’s co-founder and CEO, I will dispense with the customary cautionary language and comment about the webcast for this earnings call.

We released earnings for the third quarter at approximately 1:05 p.m. Pacific Time. The earnings release, which includes a reconciliation of all non-GAAP financial measures to GAAP, and this conference call, are available at the company’s investor relations website at www.netflix.com. A rebroadcast of this call will be available at the Netflix website after 5:30 p.m. Pacific Time today.

We will be making 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 filing with the Securities and Exchange Commission, including our annual report on Form 10-K filed with the commission on March 16, 2006.

Now, over to Reed.

To sponsor a Seeking Alpha transcript click here. Reed Hastings

Thank you, Deborah, and welcome, everyone. In the third quarter, we delivered strong results across our key metrics -- subscribers, revenue, and earnings. Combining the best customer experience with the lowest costs continues to power our success.

In the third quarter, we grew our customer base by nearly 0.5 million subscribers, and we are on track for achieving our goal of at least 6.3 million subscribers this year. More precisely, net additions in Q3 were 493,000 subscribers, compared to 396,000 last year in Q3, and 136,000 two years ago in Q3. This growth in net additions is a sign that we are still on the first-half of the s-curve of consumer adoption for online rental.

On top of our growth in net additions, we were more profitable than we anticipated, due to a mix of higher revenue and lower costs that Barry will discuss shortly. We delivered about $3 million additional profit beyond the high-end of our guidance range.

On our last call 90 days ago, we told you our churn in Q2 was higher than we had expected because we had failed to recognize and predict some underlying summer seasonality, especially in the more variable northern climates. Happily, our churn in Q3 was 4.2%, down sequentially and down from a year ago, which is as we expected. We have gained confidence that we now understand the seasonal churn pattern and will benefit from it in Q4, as the northern climates get cold and dark.

In marketing, our scale and gross margin allowed us to increase our quarterly marketing investment to $59 million and still surpass our profit goals for the quarter. $59 million is an all-time record for our quarterly marketing investment for any quarter, and at up from $33 million one year ago.

This aggressive spending is what pushes up average SAC, which this quarter was $45, an all-time high. In Q4, we are going to be able to set new records on marketing investment and still deliver on our increased Q4 profit guidance.

At our scale, we are able to generate growing profits and to invest heavily in subscriber growth, which positions us for larger profits in the future.

Turning to profits and the future, we had said this year we would generate $30 million to $35 million in profit, and that we expected to increase that 50% for several years, which would be $45 to $53 million in 2007.

This year, however, we have been more profitable than we expected, and we have been unable to officially invest all the excess profits into more marketing. Therefore, we are taking up our profit forecast for this year to $42 million to $48 million. We are also moving up our 2007 guidance to $55 million to $60 million, or more precisely, $0.76 to $0.83 GAAP EPS.

Let me note that going forward, we will generally guide to EPS rather than absolute profits, to bring ourselves more in line with how financial markets track earnings.

Purists will note that $55 million to $60 million for next year is not 50% above $42 million to $48 million for this year. Our response is $55 million to $60 million is more than 50% above the $30 million to $35 million we expected to generate this year. Whichever side you agree with, you can probably agree it is a nice argument to be able to have, and we are excited about another year of great subscriber, revenue, and earnings momentum.

For 2007, we are increasing our investment in marketing. We will begin much more substantial investments in Internet delivery, and we will deliver record earnings. Barry will give you more color on this in a moment.

In addition to growing our earnings nicely, we continue to make progress towards our $20 million subscriber goal. A large subscriber base and trusted brand will be key competitive advantages as we add the option for Internet delivery to our service. Part of our strong reputation is from astoundingly fast shipping of DVDs, but another big part of our brand is from our award-winning website that helps customers find the particular movies they are likely to love from the 65,000 available. That is why our relentless focus is on making our website even more engaging and useful.

You saw that commitment again this past quarter, as we added website enhancements, including an improved friends experience, our previews feature, and we launched our $1 million Netflix prize for progress in the accuracy of web recommendation systems.

Turning to Internet delivery, Apple and Amazon launched their services in Q3. Their solutions will improve over time, both in technology and selection. They are primarily targeting the download-to-own market, where price points are $10 to $20 per movie, and they primarily compete with DVD sales, which is a $16 billion market domestically.

DVD rental has always competed with DVD sales for its piece of consumer spending, and DVD rental will be minimally affected by these new entrants in the movie ownership market.

Our market is movie rental, an $8 billion market with approximately $3 per movie pricing in stores and online. In terms of the download rental market opportunity, we have been patiently learning through prototyping and consumer research. While there may be little near-term threat to physical DVD rental, that does not change our view on the importance of Netflix leading the download rental market.

In our next earnings call, we will talk in more detail about our Internet delivery plans. We think our solution will offer superior ease of use and value, but as with all Internet movie services, we will initially have significant content availability constraints imposed by the TV network windowing system for movies.

Fortunately, physical DVD remains ubiquitous in nearly 100 million U.S. households which, by combining Internet delivery with DVD by mail delivery, gives us a huge advantage in competing for consumers’ entertainment dollars.

In terms of DVD rental, our fundamental thesis about online taking share from store-based rental is playing out. Blockbuster says it is on target for 2 million online subscribers by the end of the year, and we are on target for 6.3 million. So that is 8.3 million active renters not paying video stores to rent movies.

Online rental provides a better consumer experience and greater value than store-based rental. The larger online gets, the more difficult store-based rental becomes economically, and we think the major chains will close 5% to 10% of their stores next year.

As more stores close, the online market is further strengthened. Our view is the trends of online rental growth and store rental decline will continue for many years. In the long-term, as our base grows and our strong word-of-mouth spreads, our marketing as a percentage of revenue and our SAC should decline.

Rental is an $8 billion industry, and we believe much of it will move online over the next 10 years.

Within the industry, the only dark cloud we see is high-definition DVD, which has become trapped in the video game boxing ring. There are two competing formats -- HD-DVD, backed by Microsoft, and Blu-ray, backed by Sony. Because of their video game interests, Microsoft wants to make sure Sony’s high-def DVD format is not the winner, and Sony wants to make sure Microsoft’s is not the winner. Neither of these companies can be defeated in the short run. As long as the press writes about the format war, most consumers will stay away. The only practical solution is for studios to announce the war is over because everyone is supporting both formats.

Two formats are not hard. We have had VHS and DVD the last 10 years, with minimal trouble. Two movie studios are already supporting both high-def movie formats. Now we just hope other studios will do the same, the press will declare the war over, because both formats are supported by all studios, and the consumer adoption cycle will begin in earnest.

To close, I will note that 14.9% of the 2 million-plus Bay area households now subscribe to Netflix, up from 14.1% one quarter ago. The Bay area is also blanketed with Comcast VOD, Internet broadband, Tivo and Apple, yet the Netflix movie service continues to grow more popular here every quarter.

In thinking about our national market share, remember that the Bay area is our oldest market, which we served with generally next-day delivery for seven years. The rest of the country, time-lagged by the commencement of generally next-day delivery, continues to follow the Bay area’s growth trajectory. In fact, Seattle, Washington, D.C., and Austin, Texas, are all now above 10% of households subscribing to Netflix.

Our ability to continue to increase penetration in our oldest market demonstrates the strength and potential of the online rental market, and reinforces our confidence that we can deliver on our growth objectives for both profits and subscribers.

Thank you, and now over to you, Barry.

Barry McCarthy

Thank you, Reed. Most of our listeners know that Netflix became public in May of 2002. In the four-and-a-half years that followed, we have grown our quarterly revenues from $36 million to $256 million, and subscribers from 670,000 to 5.7 million. Against this framework of historical performance, covering the 18 quarters that Reed and I have reported on quarterly earnings, our business model has scaled profitably.

This quarter’s results are a great example of how well the model can perform.

My remarks today will focus on the key drivers of our earnings performance this quarter. Then, I will talk about how we managed the trade-offs in Q3 between marketing spending, subscriber growth, and earnings, and lastly, before opening the call to questions, I will discuss our guidance for Q4 and for the full year 2007.

Sometimes the numbers tell a clear story and this is one of those quarters, so my remarks today will be brief.

Before I discuss the P&L performance, I would like to say a word about free cash flow. In Q3, we produced $22.3 million, the second largest quarter of free cash flow in our history. To put this in historical context, we have produced nearly as much free cash flow last quarter as we produced for all of 2005. For the 12 months ended September 30, we produced $64 million in free cash flow.

I think this shows that our model is working well, even as we grow rapidly and even at current levels of subscriber acquisition cost. We expect that success to continue.

Let’s turn now to our P&L.

There were three drivers of strong performance last quarter. The largest of these drivers was content costs, which was approximately $3 million lower than we expected in the quarter. These cost savings resulted from a favorable mix of owned versus rev share content. We expect these content costs to increase in Q4, and I will say more about that in a moment.

The second-largest source of that performance was technology and development spending, primarily due to lower headcount and lower data center spending than forecast.

The final source of earnings upside resulted from a favorable variance in ASP, which contributed $1.5 million more in net income than we expected last quarter.

Because we outperformed our earnings guidance in Q3, I want to spend a few moments discussing how we manage the balance between growth and earnings. As many of you know, we have a long-term goal of reaching 20 million subscribers. That goal is founded on the belief that the key competitive advantage in the emerging downloading market will be strong relationships with a large customer base that, as Reed mentioned, is accustomed to getting their video entertainment from Netflix.

Against the framework of this overarching objective, we articulated three important goals for 2006:

  1. Finish the year with at least 6.3 million subscribers;
  2. Generate $30 million to $35 million in net income, which we have already accomplished; and
  3. Position the company to grow earnings at 50% per year for several years.

Along the way, we said we would invest excess earnings in faster subscriber growth if we could acquire subscribers cost-effectively, relative to their lifetime value as Netflix subscribers. Given these objectives, why did we outperform our earnings guidance for the third consecutive quarter, without redeploying all of our excess profit and a faster subscriber growth?

For those of you who follow the company closely, this might sound like a replay of last quarter’s earnings call when I posed a similar question. I answered that question by saying that for Q3 and Q4, we had greater visibility into the out-performance, which better positioned our marketing team to deploy the money productively and cost-effectively.

On balance, we largely accomplished that objective in Q3. We planned to increase marketing spending in the quarter by about $7 million. That increase was factored into our subscriber guidance, and we put 100% of that money to work in the quarter. During the quarter, we identified another $1.5 million of profit which we were not able to redeploy cost-effectively, and so it fell to the bottom line.

The rest of the upside was pure out-performance, which we just failed to forecast accurately.

So at this point, let’s ask ourselves how our performance for Q3 and year-to-date positions us for Q4 and 2007 guidance.

As many of you know, from reading today’s earnings release, we raised our Q4 guidance. I want to comment on two aspects of that increase.

First, let’s talk about gross margin. Earlier in my remarks, I said we expect to see content costs increase in Q4. This means increased margin pressure, but we also expect to see a seasonal decrease in [dis-shipment], which will fully offset the increased costs we forecast for content, which means steady as she goes in terms of gross margin.

Second, with respect to marketing spending, we do not currently foresee opportunities to increase our already large planned expenditures to drive faster subscriber growth in Q4. If opportunities present themselves during the quarter, you may see us end Q4 in the low-end of our upwardly revised earnings guidance. If they do not materialize, and the business outperforms our forecast expectations again this quarter, you should expect to see us land at or above the high-end of our earnings guidance for Q4.

For 2007, we expect to produce $55 million to $60 million in net income, or $0.76 to $0.83 per share in net income. We will continue to guide to ending subscribers and revenue, as well as EPS, and will give you our full 2007 guidance on the Q4 earnings call in January.

As Reed mentioned earlier, we also plan to discuss our digital downloading strategy on the January call. As you think about your Netflix model for 2007, bear in mind that we plan to significantly accelerate our spending on digital downloading in 2007 from less than $10 million this year to more than $40 million next year.

So in summary, Q3 was a beat-and-raise quarter for Netflix, with:

  • Rapid subscriber growth of 58% year over year;
  • Better-than-expected net income of $12.8 million, net income growth of 84% year over year; and
  • Exceptionally strong free cash flow of $22.3 million.

We expect another strong quarter in Q4, and today we upwardly revised our guidance to reflect that optimism.

That concludes my prepared remarks, and now we will open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We will take our first question from Gordon Hodge with Thomas Weisel Partners.

Gordon Hodge - Thomas Weisel Partners

Good afternoon, thank you. Just two questions. Barry, I think you have mentioned in the past that advertising sell-out has been really high on the mailers, and I am wondering if that is starting to now kick in as a major source of profit for you, or a meaningful source, anyway, and also if you could comment on usage trends during the third quarter. I think you indicated in the fourth quarter you expect it to tick down, but any commentary just in terms of how it behaved in the third quarter would be great. Thank you.

Barry McCarthy

With respect to ad sales on the mailer, we are sold out -- substantially sold out in Q3 and Q4, so that business is progressing well. I do not think it will emerge as a line item for a year or two, so early indications are that we are on the right path, also trying to build out the online piece of that. We will probably have more to say about it next year, but it looks promising. The targeting is being well-received by the studios, and I think we are perceived to be a value-added player with a valuable target market.

With respect to usage, no real news, actually. During the quarter, subscribers behaved very much as we expected. We finished on plan. The seasonal pattern that we are expecting in Q4 is the seasonal pattern that we have seen in each of the prior years.

Gordon Hodge - Thomas Weisel Partners

The break-out on ad sales, at what level would that have to be to become a line item that you would break out?

Barry McCarthy

Under SEC rules, 10%.

Gordon Hodge - Thomas Weisel Partners

Not until 10, okay, great. Thank you.

Operator

We will take our next question from Heath Terry with Credit Suisse.

Heath Terry - Credit Suisse First Boston

Great. I was wondering if you could talk a little bit about your studio relationships and how the revenue share agreements are changing, or if they are, as you move into the HD-DVD, Blu-Ray world. Are the current relationships that you have on the DVD front changing as you start to negotiate this next round?

Reed Hastings

Rev share, not much change. You know, over the past two or three years, some studios get more favorable on it, other studios get less favorable on it, but the overall mix for us is approximately the same.

HD-DVD and Blu-Ray, it is too early to tell. I mean, we are talking microscopic volumes of players. I think it is probably 10,000 or 20,000 or 30,000 total units sold, of hardware players. The market is so small right now that you just cannot tell anything.

We think as it grows, it becomes pretty much parity with DVD, but it could be three or four or five years until it gets to 10 million or 20 million households, depending on how you want to count PlayStation 3.

Heath Terry - Credit Suisse First Boston

Then, on that revenue share front, as you evaluate the buy versus share decision, as those relationships change, and you said they have not changed that much, but could you just talk to us about the thought process that goes through there, just from an accounting perspective on how you evaluate which discs you are going to buy versus the ones that you are actually going to go into a revenue share agreement on?

Reed Hastings

Sure. We do not really get to choose on a title-by-title basis. It is really studio by studio, and a rev share agreement would generally cover all of the new releases from the studio. In terms of the overall evaluation, it tends to be I think heavily influenced by what the studio prefers. If a studio prefers revenue sharing, they will generally revenue share with a number of companies, including us. If the studio prefers not to, then it will be typically wholesale with all of the rental companies. It follows those broad patterns.

Heath Terry - Credit Suisse First Boston

Great, thank you.

Operator

We will go next to Safa Rashtchy with Piper Jaffray.

Safa Rashtchy - Piper Jaffray & Co.

Good afternoon, Barry and Reed, and congratulations on a great quarter. A couple of questions here. First, I just want to begin to understand where you might be spending the money. You mentioned if one is a purist, it would look like you are lowering your 50% growth, but either way you look at it, you have achieved, whether it was out-performance or otherwise, you have achieved a base now, and you are going from this higher base, so I am trying to see if you are being conservative in the guidance for next year, if there are some spending plans, or if you are trying to grow the EPS a little slower. I have a quick follow-up.

Barry McCarthy

Safa, it is our most accurate -- remember we have the guidance for next year. It is our view of the expected case. Next year, relative to this year, we have this much larger downloading investment going on, so that is one of the factors involved in that.

Reed Hastings

I think that is a perfect summary. If we were not spending upwards of $40 million or more on downloading -- let’s see, on an after-tax basis, that is another $20 million, so instead of looking at $60 million in profits, you are looking at $80 million in profit, and that is maybe more consistent with upper bounds of your expectations pre-downloading expenditures.

Safa Rashtchy - Piper Jaffray & Co.

That is actually the perfect segue for my follow-up, which is can you give us at least some qualitative sense of what you need to do. What are you going to spend the $40 million on? You had done some preliminary work on downloading already, and obviously content, as you said, is the key, and that does not require a lot of infrastructure build-up, so can you give us some sense of what you need to do to get going?

Reed Hastings

We will be able and willing to talk about it in detail, Safa, next quarter on our conference call. I will defer your question until then.

Safa Rashtchy - Piper Jaffray & Co.

Okay.

Operator

We will go next to Barton Crockett with JP Morgan.

Barton Crockett - JP Morgan

Great, thank you very much. I wanted to ask a couple of things about a couple of the numbers, and then a larger question about another issue.

The Q4 churn you said should benefit seasonally, so are you suggesting then, as I understand it, that the churn rate should be a little bit better than the 4.2%, which we saw in the third quarter? That would be the first number question.

Secondly, related on the SAC, you are going to be spending more in total on marketing, but does the SAC per gross addition also go up in the fourth quarter? Those are the two number questions.

Then, more broadly, when we look at the download services that have been launched -- in particular, Amazon -- they have a number of titles available for download for purchase, a few hundred, I guess, available for rental. Is there anything that they have done that has changed your view of the licensing restrictions that you thought were going to be a content bottleneck? I was surprised that they have so many titles available for download, but of course, they are purchased, and maybe that is factored into the contracts. Would you guys expect to have a comparable number of titles available for rental, or maybe comparable to what they have for download available for rental, some idea of whether your size would be like what they have come out with? Thank you.

Reed Hastings

Sure. On churn and SAC, for the past couple of years, we have not guided to them, so if you -- that does not mean we will give some color on it, but if you look at last year’s churn pattern, that gives you a sense of the degree of seasonality in the business, Q3 to Q4. Then, on SAC, it really depends on how much we are able to grow the marketing investment and still make our profit goals, so the bigger, the more we spend, the marginal $10 million is always less efficient than the rest of it. By definition, we would want to spend our most efficient first, so that would tend to drive up average SAC. So it depends on how much we are able to deploy within the context of our profit goals.

Then, you asked on licensing. There is no surprise in the licensing in what Apple and Amazon have. It is approximately the same as Movielink has had for four years now, which is a pretty broad set of the Comcast VOD, or any cable VOD system has. That has been a pretty stable window. That is what is there.

You referred to the [day-in date] with DVD, which is there for purchased titles. Again, from my perspective, that is their main -- it is the only focus for Apple and it is the main focus for Amazon in terms of title breadth. That is available at essentially DVD prices, at the same time as DVD.

No surprises, consistent with Movielink licensing over the last couple of years.

Barton Crockett - JP Morgan

Would that be consistent with a selection that you guys would be able to have, do you think, at the outset?

Reed Hastings

I know it is hard for us to throw this out, about what we are spending the money on downloading but now we are not going to tell you what we are spending it on, but we are going to give you a full briefing next quarter, and so I will have to hold you off like I did Safa and say in 90 days, we will give you a full briefing and give you all the context.

Barton Crockett - JP Morgan

Great, thank you very much.

Barry McCarthy

Let me jump in and explain why we mentioned downloading at all, and the expected increase in spending for 2007. In the context of giving you guidance on earnings, so that you would not run away from our own expectations, we anticipate that it would be nearly impossible for you to reconcile to our net income guidance, given your projections for subscriber growth and revenue, unless you had some perspective on how much money we anticipated spending on additional downloading.

That is the reason that we mention the dollar amount, and we appreciate your patience in waiting until next quarter before we put some meat on the bones.

Operator

Thank you. We will go next to Doug Anmuth with Lehman Brothers.

Doug Anmuth - Lehman Brothers

Thank you. I have two questions. The first one is regarding churn. Reed, you mentioned that you benefited in terms of seasonality during this quarter, especially in some of the colder climates. Can you talk about anything that you were able to do specifically on your own in terms of pulling that lever a little bit, whether maybe it was marketing to existing subscribers a little bit better, anything there?

Then, the second question in terms of your free cash flow, Barry, which you mentioned. It looks like you had a $20 million working capital benefit. Could you talk about the details there and if there is anything specific in driving that number higher? Thank you.

Reed Hastings

Doug, on the seasonality, what I said is we anticipated benefiting in Q4 as the northern climates get cold and dark and people basically stay at home and watch movies more, and cancel at proportionately slightly smaller rates. That is what we were focused on.

In terms of separating from what we were able to do, it is pretty hard to separate with any confidence. That is, we improved the service, we added a couple of new distribution centers, we made these improvements on the site, but there is no really scientific way for us to separate the improvements due to that, so we continue to believe they are good things. We continue to drive churn down, but we work forward on that basis.

I will turn it over to Barry on the free cash flow.

Barry McCarthy

Doug, with respect to the free cash flow, there was nothing out of the ordinary that happened in the quarter. We happened to benefit from an increase in AP, and you will notice that was a reversal of the prior quarter, which was a reversal of the quarter before that. So it is following a normal pattern. There is nothing unusual in the business. Next quarter, we will see a big swing in free cash flow again, unrelated to AP but this time related to the strong in-flow of cash from the sale of gift certificates, which lifted the free cash flow boat dramatically in the fourth quarter of last year.

Doug Anmuth - Lehman Brothers

Thank you.

Operator

We will go next to Jim Friedland with Cowen and Company.

Jim Friedland - Cowen & Co.

Thanks. A couple of questions. First, on some of the social networking features, like friends, can you tell us about what percent of the users use it on a regular basis, or maybe at least users that have been with the service for six months, a year? Then, the second question is on the last call, you talked about how even though you have a range of price offerings and the average selling price is going down, I think you said the majority of gross adds is still going for the three-DVD product. Is that a correct statement? Could you talk about how that played out in the third quarter?

Reed Hastings

The three-out program has remained our most popular program in Q3. Then, in terms of friends, we are really excited about what we have been doing and the improvements on it. We have not given, really for competitive reasons, any precise breakdowns on it. It is growing very nicely and one of the great aspects of friends is the virile network nature to it, so the more people that get in it, the more there is benefits to the other members. So we are continuing to push on that very aggressively.

Jim Friedland - Cowen & Co.

Would you say on that, Reed, that the people that use friends regularly churn at a lower rate?

Reed Hastings

Yes, that is definitely true, that those who are active in friends are great customers for us. The only question is how much of that is an indicator of fact and how much of that is causal from friends. Do you follow what I mean by that?

Jim Friedland - Cowen & Co.

Sure, sure.

Reed Hastings

Yes, if it were pure causal, we would be celebrating all day long, because we know some of it is an indicator of those are -- you know, people who live their lives on the Internet. We continue to work on it but we do not say it is why the churn is lower for them.

Jim Friedland - Cowen & Co.

Great, thanks.

Operator

We will take our next question from Tony Wible with Citigroup.

Tony Wible - Citigroup

I was curious, in your ’07 guidance, what your assumptions are on postage that are implicit in that?

Reed Hastings

We are expecting a postage increase, Tony, in the first quarter of next year.

Tony Wible - Citigroup

Great, thanks. On the gift certificates that you guys sell in the fourth quarter, should we expect any kind of holiday promotion or any kind of special push on the marketing side to try and increase those types of sales?

Reed Hastings

Sorry, Tony, I am just getting passed a note, an errata on my last answer. I said Q1, and the increase is Q2.

Tony Wible - Citigroup

Okay, so like April.

Reed Hastings

May, I think we are expecting it.

Tony Wible - Citigroup

All right, and on the promotional front for the gift cards, are you guys planning to do anything abnormal there that would increase the sale of those gift products?

Reed Hastings

Nothing that we have not done particularly in prior years.

Tony Wible - Citigroup

There have been a couple of technologies proposed for triple layer for HD, to handle the duality issue. Are you seeing any of the studios pushing any closer to HD, now that there is some solution to have one disc that can carry both formats?

Reed Hastings

No, we have not seen any move towards those technologies. The market is reasonably frozen, pending PlayStation’s arrival. If I had to guess, it will be Q1 before we start seeing some movement.

Tony Wible - Citigroup

Last question -- the use of cash, any update?

Reed Hastings

No updates.

Tony Wible - Citigroup

Okay, thanks a lot, guys.

Operator

We will go next to Youssef Squali with Jefferies.

Youssef Squali - Jefferies & Co.

Thank you very much. Congratulations, guys. A couple of questions. First, Barry, the sequential decline in your ARPU, or average revenue per user, is the lowest we have seen in about seven quarters. While you obviously have been pushing lower and lower price plans, at the same time, we have gotten word today that Blockbuster had cancelled their $5.99 service, or at least planning on doing that. Are we seeing a price stabilization across the industry yet?

Barry McCarthy

Well, I cannot comment on Blockbuster’s plans. In terms of our sub-growth in the most recent quarter, it was as we expected. It has been true in prior years and was true this year that there is, on a sequential basis, a relatively large decrease in ARPU has been -- a relatively large decrease in ARPU in the second quarter, as compared to the first, as compared with the third. That has everything to do with the number of days in the second quarter, and not much to do with structural changes in the business.

I think some investors were concerned that the large decrease last quarter signaled some structural change in the business, but it was a calendar issue, and I think change this third quarter reaffirms the historical trend that we have previously seen.

Youssef Squali - Jefferies & Co.

Okay, so it is just seasonal. I guess on a different point, I do not know if you will answer this, but on your ’07 guidance, the 76 to 83, could you just -- I guess yes or no -- you have added about, or you are planning, you are on track to adding about 2.1 million new users this year. To get to your 20 million in the 2010-2012 period, at some point you are going to have to see some acceleration in that net add. Is it fair to assume that your ’07 number sub add should be higher than your ’06 number?

Barry McCarthy

You do the math correctly, which is the net adds have to continue rising for us to stay on track for 20 million by 2012. That is a correct assumption.

Youssef Squali - Jefferies & Co.

Okay, that is helpful. Thank you.

Operator

We will go next to Daniel Ernst with Hudson Square Research.

Daniel Ernst - Hudson Square Research

Yes, good evening. Thank you for taking the call. Two questions, if I might. First, on the DVD acquisition line, up to 50 million plus in the quarter, or almost up, or up a little more than 2X year on year versus net sub growth of 22% year on year. Is there a trend here, or did something happen in the quarter to, or you are preparing for a bunch of new releases, or a big sub-growth coming up in the winter months?

Reed Hastings

Neither, particularly. We have been working on the inventory state, and improving operating metrics of the business. We have increased slightly our investment in content, but in particular, on a year-over-year basis, we have increased in absolute terms the number of DVDs that we acquire directly from studios and are engaged in, at least proportionately last quarter, less rev share.

Daniel Ernst - Hudson Square Research

Should we assume that this trend continues, or was it more of a catch-up here?

Reed Hastings

The funny thing about watching our content costs is an arbitrary part of it flows to the balance sheet in terms of DVD purchase, and then a second arbitrary part goes to revenue sharing, goes directly to the P&L.

They end up, from a P&L standpoint, if you account for depreciation, to be about the same, and we move back and forth between them, again depending on studio preference. So some of what you are seeing was a shift in one or more studios away from rev share between a year ago and now, so therefore we have more purchasing going on. But the total content cost has been very favorable for us over that year. We continue to seek deals that make economic sense for us, and you will see, if you only look at one-half of this, i.e. rev share or purchase, you can get thrown off. You really want to sum those two.

Daniel Ernst - Hudson Square Research

Understood, that helps. The second question, on ARPU, down about 7% year on year, which is relatively modest in light of the teaser ads we see push the $5.99 plan. Obviously there is not a big uptake of those. Could you give us some sense of what the current distribution is on your plans?

Barry McCarthy

We do not actually disclose it for competitive reasons.

Daniel Ernst - Hudson Square Research

But could you give us a little bit of flavor?

Reed Hastings

You could do any, you know, approximate split to generate the ASP, and you would not be far off. It is not very sensitive, so you know, take some normal distribution around the ASP and you will be pretty close.

Daniel Ernst - Hudson Square Research

Thank you.

Operator

We will take our next question from Charles Wolf with Needham.

Charles Wolf - Needham & Co.

Yes, hi. I wanted to ask about your experience in the Bay area and what it might say about your prospects going nationally. I was wondering, if you could, directionally, is your subscriber acquisition cost in the Bay area less than they are nationally? Second, is the churn rate in the Bay area less than nationally or more? Could you give us a direction on that?

Reed Hastings

Sure. We have said in the past and reaffirmed today that they are both substantially lower, favorable, both SAC and churn, in the Bay area.

Charles Wolf - Needham & Co.

Let me ask a different type of question about the long tail. In terms of the movies that are being rented, what percentage are new releases and what percentage are library?

Reed Hastings

It varies somewhat quarter to quarter, depending on what the studio is releasing. Generally, it is about a third of the shipments are new releases, and about two-thirds are long tail content.

Charles Wolf - Needham & Co.

Fine, thanks a lot.

Operator

We will go next to Mario Cibelli with Marathon Partners.

Mario Cibelli - Marathon Partners

I wonder if you have any comments about the store-in-a-box concepts that are coming out now, like Red Box and other things like that, where you could reserve a copy. Do you think this is a viable business model, longer term?

Reed Hastings

Kiosk business has the sort of ATM style. It may well be a viable business. They certainly seem to be proliferating. They are very new release focused, so they tend to hold 20 or 30 titles of the big new releases, so in that way, fairly complementary to our market and another squeeze on video stores.

But again, they seem to be spreading, from all the press reports.

Mario Cibelli - Marathon Partners

Thank you.

Operator

We will go next to Chad Bartley with Pacific Crest Investors.

Chad Bartley - Pacific Crest

Thank you. I have one follow-up on the digital side. I think you have commented before. Could you talk about the pricing model for digital delivery? Do you expect to offer that under the subscription plan, or will it be something different? Thank you.

Reed Hastings

I will have to hold you off again until next quarter. Again, I know it is frustrating for us to dangle this out and not really complete the sentence, but we will complete it next quarter on this call for you.

Chad Bartley - Pacific Crest

Okay, all right. Thank you.

Operator

We will go next to Eric Fischer with Broadmark Asset Management.

Eric Fischer - Broadmark Asset Management

Gentlemen, great quarter. I just have a few questions. On average postage costs round-trip in the third quarter, could you give me that, give us an idea of what that is? Is it $0.74, $0.76?

Reed Hastings

We do not actually break it out. We pay first class postage each way and then we have the benefit of some zip code sorting that we do, which gives us some discounts, but we do not get any special breaks with the post office that are not available to any other company in the United States.

Eric Fischer - Broadmark Asset Management

But you have a system put in where you get some kind of a break with the sorting system, right?

Reed Hastings

Yes, we do.

Eric Fischer - Broadmark Asset Management

That is what, about $0.015, $0.02 maybe?

Reed Hastings

You could look up on the USPS website and the variations as to how finely you pre-sort, for any pre-sort mailer, but no, the discounts can go as much as $0.07, if you have enough volume and you are willing to spend the time and effort to sort it. It can be bigger than that, but of course, there is the labor to do that, and then you have to have enough density in any one geography to be able to take advantage of those discounts.

Eric Fischer - Broadmark Asset Management

The rev share cost in the quarter, I know you do not really break that out, but would you say it was less than the cost component of the DVD amortization in the gross margin?

Reed Hastings

No comment.

Eric Fischer - Broadmark Asset Management

No comment -- SAC for the quarter, was that about $45.30?

Reed Hastings

Correct.

Eric Fischer - Broadmark Asset Management

Usage about 5.6?

Reed Hastings

No comment.

Eric Fischer - Broadmark Asset Management

How about ARPU? Did you say what that was?

Reed Hastings

I think we disclosed it in the release.

Eric Fischer - Broadmark Asset Management

G&A was up about $3 million versus second quarter. I was just wondering what that was, exactly.

Reed Hastings

Continuing build-out of the infrastructure.

Operator

Thank you. That is all the time we have for questions today. At this time, I will turn the call back over to Mr. Reed Hastings for any closing remarks.

Reed Hastings

Thank you, everyone. We look forward to talking to you in a quarter, and again, we will have more details for you then on the beginnings of the Internet delivery option for Netflix. Thank you very much.

Operator

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

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Source: Netflix Q3 2006 Earnings Call Transcript
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