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Netflix, Inc. (NFLX)

Q4 2006 Earnings Call

January 24, 2007 4:30 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

Youssef Squali - Jeffries & Company

Barton Crockett - JP Morgan

Douglas Anmuth - Lehman Brothers

Jim Friedland - Cowen and Company

Heath Terry - Credit Suisse

Paul Bieber - Piper Jaffray

Tony Wible - Citigroup

Derek Brown - Cantor Fitzgerald

Gordon Hodge - Thomas Weisel Partners

Brian Pitz - Bank of America

Mario Cibelli - Marathon Partners

Charlie Wolf - Needham & Company

Maurice McKenzie - Signal Hill

Chad Bartley - Pacific Crest

Operator

Good day, everyone, and welcome to the Netflix fourth 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 over to Deborah Crawford, Director of Investor Relations. Please go ahead, Madam.

Deborah Crawford

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

We released earnings for the fourth 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 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 March 16, 2006.

Now, over to Reed.

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Reed Hastings

Thank you, Deborah, and welcome, everyone. Netflix had a great fourth quarter. We had our highest pre-tax Q4 profits ever, our highest Q4 net additions ever, and our all-time lowest churn. Once again, we were independently recognized for having the highest customer satisfaction in the entire e-commerce world, edging out such great companies as Apple and Amazon.

In the digitally obsessed San Francisco Bay area, our household penetration climbed to 15.7% of households subscribing to Netflix, and it seems likely we’ll be over 18% by the end of 2007.

The Bay area is important in two ways: it was our initial market, and with the subsequent markets tracking the growth trajectory of the Bay area, it is a leading indicator of the potential market size nationwide. Second, the Bay area has Comcast VOD in many homes, iPods and laptops outnumber television, and it is Tivo heaven. In short, the Bay area is the most competitive entertainment delivery region in America, and Netflix's extraordinary and growing success here indicates just how much consumers continue to prefer the simplicity and selection of Netflix for movies.

Not only was Q4 very strong for us, but 2006 as a whole was a remarkable year. We grew from 4.2 million to 6.3 million subscribers, and grew our pre-tax profit from $8 million to $80 million. 2007 looks like another solid year for us, with our guidance of 8 million to 8.4 million subscribers, and EPS of $0.77 to $0.83.

As we’ve said many times before, our scale now allows us to generate both growth and profits. Moreover, in 2007, our scale allows us to generate both growth and profits and to inject at least $40 million in our online video efforts.

One of the consequences of all this growth is that it has become clearer to all that online DVD rental is the future, and Blockbuster has refocused on this area. Their new program allows nearly unlimited free store rentals, whereas their prior program only allowed weekly free store rentals. The economics of so many free store rentals are certainly open to question, but their commitment to online rental is not.

For perspective, two years ago Blockbuster also aggressively marketed their service, cutting their $18 price to $15 and blanketing the television networks with advertising in order to gain share.

The first quarter of this effort in 2005 gave us a modest headwind, bumping up our churn by about six people in a thousand, and ticking down our net additions from the year prior. We expect a similar headwind this quarter, as our competitor spends aggressively on TV and online.

In 2005, this headwind subsided in Q2 despite their continued $15 price, because they had already captured in Q1 the few consumers most likely to switch. Similar to 2005, we expect the headwind effect this year to be less in Q2 than it is in Q1.

Why do most subscribers stay with Netflix, despite the competition? Because our website and our operational excellence are extraordinary, and being consistently great matters to consumers. Blockbuster recently said their churn for new subscribers is more than 20%. Our is under 10%. That is operational excellence and an award-winning website in action.

We invented this category. It’s all we do and we do it better than anyone on the planet, which leads us to our competitive strategy over the coming year.

Our plan is to continue to make the best online service even better. We’ll be operating over 50 distribution centers by the end of this year. We will expand our trucking network to 50 additional central post offices. Together, this will extend our reach to over 100 mail entry points, providing over 95% of our subscribers with overnight delivery.

We’re deploying this year an entire new class of inventory management software, which builds on our experience over the last eight years and will improve service levels while reducing costs.

In addition, we continue to improve our website by helping consumers find lots of movies they are likely to love. We think we can extend our advantages in customer satisfaction and lower costs by focusing on our core business and doing it better every quarter.

As part of this focusing effort, we are phasing out online banner advertising on our website. We’ll keep our mailer advertising but we want to make every pixel on our website work for us in terms of customer satisfaction.

America is fast becoming a nation of online renters. Netflix and Blockbuster combined now have over 8.5 million subscribers, and the space seems likely to grow to over 12 million subscribers this year. Together, the two companies are growing online DVD rental faster than either could on its own.

While 12 million subscribers in ’07 may seem large, in comparison, there are over 60 million pay television households, and if all DVD rental subscribers moved online at a $15 average monthly price, that would be about 45 million subscribers, so there is plenty of room for growth in online rental, as video stores continue to shrink and close.

While the online DVD rental business continues to grow at astounding rates, we’ve already begun our efforts to broaden our model to include online video distribution and are very proud of our initial offering.

When we asked our subscribers about our DVD service, they say they love the pricing, they love the selection -- they just wish they also had the option of instant viewing. So our focus is all about instant, real-time delivery of video content. Our instant watching feature is as easy to use as YouTube, but with full DVD video quality.

Delivering real-time DVD quality video is quite demanding, so we have our own servers spread around the country and are doing a phased rollout of our service over the next six months to ensure a quality experience.

Our key advantage in online video is our massive DVD rental subscriber base, so of course we want to link these programs as seamlessly as possible. Our typical $18 per month subscriber will get 18 hours of online, instant movie viewing included at no extra charge in their membership. That is enough for about nine movies, or 20-plus TV shows, or any mix.

Our belief is that over the coming years, as our online video is used by our subscribers more and more, they will watch fewer DVDs and we’ll be able to approximately maintain our gross margin model.

We fully recognize there are two shortcomings to our current online video offerings -- selection and TV screen access. We’re working on both of them, and over the coming quarters and years, we will make substantial progress. In the meantime, online DVD rental will make the most sense for most movie fans.

Online video has huge potential in the long-term. In our view, in 20 years, you won’t click through 80 or 500 channels that a cable or satellite company has pre-selected for you. Instead, you’ll have a million or more sources of online video to enjoy on a TV screen that is huge and cheap. With a web user interface that is as improved from today’s as today’s is from DOS 20 years ago. The possibilities in this space for Netflix are vast.

Today thought, the online video business is still embryonic and not well-understood. If you think of shipping, you immediately understand sea, air and land as different segments that compete only on the margin. Similarly, DVD rental, DVD sales, and ad-supported TV content are three big, fairly distinct segments in the video market today.

In the online video world, we expect there to also be three large segments. Ad-supported online video, led by YouTube, Yahoo!, NBC, and others will be one segment. Digital purchase of video files, led by Apple, Wal-Mart, and Amazon, will be another big segment of online video. Digital rental of video content will be the third distinct segment, led we think by Netflix.

Why Netflix and not others? Because we have the advantage over other companies of a large online DVD rental subscriber base, with which we can bundle digital rental. If a consumer is into the Internet and movies, they are or will be an online DVD rental subscriber first. By bundling digital rental with DVD rental, we think digital rental will be led by the leader in online DVD rental, Netflix.

To summarize, the $8 billion DVD rental business is moving online, and approximately 20% of the DVD rental spending has already moved online. Next, online DVD rental will evolve through bundling into full online video. Netflix is leading both transformations, which will take ten to 20 years to complete.

In the near-term, in 2007, we expect to be over 8 million subscribers, to deliver about $0.80 EPS, and to be leading the digital rental segment of the online video space.

Thanks for listening, and now I’ll turn it over to Barry.

Barry McCarthy

Thank you, Reed, and good afternoon, everyone. This time last year, we announced three financial goals for 2006. These goals included ending subscribers of at least 5.9 million, revenue of at least 960 million, and pre-tax income of $50 million to $60 million.

Against the backdrop of our 2005 performance, all three were challenging goals for 2006 -- 40% growth in subscribers, 41% growth in revenue, and 563% in pre-tax income. A year ago, CES was abuzz with development in Internet video delivery. Investors were concerned about the size of the online DVD rental business and the platform risk posed by online delivery. It’s fair to say we had our share of challenges and skeptics.

Now, fast-forward 12 months to today’s earnings call. In some respects, the world is a very similar place. CES was buzzing again this year, with news of Internet video delivery. Investors still question the size of the online DVD rental business. Internet video delivery is seen as a fundamental long-term threat, and we still have our fair share of skeptics who doubt the sustainability of our business model.

Despite the similarities between this year and last year, Netflix has made significant progress in the past 12 months. For one thing, we beat all the financial goals we set for the business last year. We beat the sub goal by 400,000, the revenue goal by $37 million, and the pre-tax income goal by $25 million, or 46%. And we did this with a fast-growing competitor, which strongly suggests to me that online DVD rental still has plenty of growth potential.

Additionally, after talking with investors about online video delivery for more than a year, last week we launched our instant watching initiative, which incorporates streaming as one of the delivery options for enjoying Netflix content.

As a result of these achievements, the rapid growth in our subscribers, the increased profitability of our business, and the recent launch of our instant watching feature, we’re better positioned today to achieve our long-term strategic objective than we were one year ago.

Last year, you heard me say that most people, Reed and me included, accept the premise that Internet video delivery will become an important business. The question is when and for whom.

From our perspective, online video delivery presents challenges, and enormous growth opportunities for our business. On the opportunities side of the equation, for us the path to market leadership begins with our ability to grow a large and profitable DVD subscription business even larger and to transition these subscribers to online video delivery as part of their Netflix subscription offering. That’s one of the reasons we continue to invest in growing our subscription DVD business rapidly.

The other reason to invest, which I discussed at our investor day in September of 2005, is that large scale and dominant market share ensure a sustainable, competitive advantage for us.

We begin with the understanding that online video is just another way to deliver content, an alternative to the mail or the local video store, or to cable or satellite delivery. Participants in the market will get the technology. Good technology is just the price of entry.

The winners will be the companies that also provide the best content and the best consumer experience, and that’s what we do best.

Last year on this call, I told you we believe that delivering the best consumer experience helped make us the leader in online DVD rental and will make us the clear leader in the world of online video rental content. That’s still our view today.

Now I would like to comment on our Q4 results and our ’07 guidance. I would also like to say a word about competition.

Financial results for Q4 were strong, with revenue and net income at or above the high end of guidance, and with free cash flow just north of $22 million again this quarter. As a footnote, let me remind you that in Q4 last year, we enjoyed a $35 million, one-time tax-related benefit that skews the GAAP net income comparison year over year.

Three key metrics contributed to our strong results last quarter. First, gross margin was up again in Q4, reaching 38.9%, an all-time high watermark, seen only once before when our three out plan was priced at $22.

The primary contributor to the stronger gross margin was a seasonal decrease in disc shipments, which I spoke with you about on last quarter’s earnings call. Second, as Reed already mentioned, churn hit an all-time high -- excuse me, an all-time low of 3.9%. The principal contributor to the reduction in churn was the aging of the Netflix subscriber base and the popularity of our lower-priced subscription plans, which have a lower churn then our core three out program.

I’ll have more to say about our Q1 expectations for churn when I talk about guidance in a moment.

Lastly, SAC declined about $1 in Q4 to $44.31. The decline was expected, paced by the slowdown in year-over-year growth in marketing spending, from 77% in Q3 to 39% in Q4. In previous quarters, we said that SAC and the year-over-year percentage change in marketing spending typically move up and down together. We saw that relationship play out last quarter.

On the Q3 earnings call, we said we didn’t see opportunities to increase our already large planned marketing expenditures during the fourth quarter. Because the business out-performed our forecast expectations in Q4, and because we weren’t able to redeploy those profits to accelerate our subscriber growth within the marginal SAC constraints of our economic model, the out-performance fell to the bottom line as incremental profit, and we beat the high-end of earnings guidance.

Let’s turn now to guidance for 2007. Today’s earnings release reaffirmed our guidance of $55 million to $60 million in full-year net income, and $0.76 to $0.83 in EPS, and we introduced our ending subscriber guidance of 8 million to 8.4 million.

The release also presented our Q1 guidance of $9 million to $13 million in net income, and ending subscribers of 6.7 million to 7 million, on revenue of $304 million to $310 million.

Our guidance includes more than $40 million of online video delivery expenses in 2007. This spending has three basic components:

  1. Headcount;
  2. Encoding and network services; and
  3. Content.

We have no plans to break out the components of spending.

With last week’s launch of our instant watching feature, content spending will increase as a percent of revenue and gross margin will decline on a year-over-year basis in 2007.

In addition, we’re forecasting a postal rate increase for first-class mail of $0.03 beginning in May of this year. That’s around $0.06 per roundtrip shipment. This increase, if implemented by the post office, will also lower gross margins this year.

Reed already commented on competition, and I want to put his remarks in context with our guidance. We’re assuming Blockbuster continues to aggressively market their total access program in Q1 and for the remainder of the year. Their goal is to reach 4 million subs by year-end. We think this means that operating losses for Blockbuster’s online rental service reached $150 million to $200 million this year before they absorb the costs of launching an online video service, and excluding any impact that free in-store rentals have on their base store business.

But, if Blockbuster scaled back their marketing spending or increases their pricing to reduce their operating losses, our churn should improve on the order of 20 to 60 basis points, if our experience from two years ago holds true today, and we should see our subscriber growth accelerate.

In closing, I’d like to summarize my remarks this way:

  • Q4 results were strong, our fourth consecutive quarter of great performance last year;
  • The business is scaling nicely. We’re managing our fixed and variable cost structure well, and profit margins have expanded, even with the added expense of launching our new instant watching initiative;
  • On the competitive front, we entered the year facing a bit of a headwind, but it’s not the first time we’ve been in this position. Our team is focused and executing well, and based on our track record over the last seven years, I’m confident we’ll deliver again in 2007.

I’d like to thank our employees for a great 2006, and I’d like to thank our shareholders for their continued support. We’ve come a long way together and the future looks bright.

That concludes my prepared remarks, and now we’ll open the phones to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We’ll take our first question from Youssef Squali with Jeffries & Company.

Youssef Squali - Jeffries & Company

Thanks a lot. A couple of quick questions. Your subscriber guidance implies about 1.9 million net adds for the year, down from about 2.14 in ’06. Historically you’ve talked about a 20 million subscriber goal in the 2010-2012. I’ve noticed that you have not talked about it. Are you backing away from that goal at this point? If not, to get there, you certainly need reacceleration. I was wondering if you could share with us, what do you think is going to cause that?

Secondarily, I was wondering if you could comment on the unit economics of the instant serving product. I know you’re not going to go into too much detail, but is the unit economic cost of that service similar to your DVD business?

Reed Hastings

I’ll take the first one, on sub guidance. No, there’s no change in our belief on 20 million subscribers in the 2010-2012 timeframe. There’s a lot of time between now and then and we’re focused on growing the business, including the online video side, and extending our competitive advantage.

As to the costs, I’ll turn it over to Barry.

Barry McCarthy

It remains to be seen, is the short answer. It depends a lot on the usage attributes of the program. We’ll learn more about that over time.

As you know, the service is part of the basis subscription offering, so from a user perspective, I suppose you could say it looks like a price discount. The question is what happens to usage, as I mentioned, and subscriber growth and churn, which will round out for us the economic value equation, and we’ll talk more about that over time.

Youssef Squali - Jeffries & Company

But does content there also follow the buy flash web share possibility that you have in the traditional DVD business?

Barry McCarthy

It varies quite a bit. Some contracts have up-front payments, some have a variable pay component, and some have a combination of both, and in that sense look similar to the content deals we have on the DVD side of the business.

Youssef Squali - Jeffries & Company

Thank you.

Operator

We’ll take our next question from Barton Crockett with JP Morgan.

Barton Crockett - JP Morgan

Great, thank you for taking the question and first thing I wanted to do was congratulate you on a good quarter. There were some things out there I think that made me and others a bit nervous coming into this, from the warm weather to the competition to a little bit of light Internet traffic to the website, based on third party data. You guys navigated all of that quite well.

I wanted to ask you a question about the spending on the online downloading in 2007. You indicated that a portion of that is going to affect gross margins. You guys have talked about a $40 million incremental spend. Could you give us some sense of how much of that $40 million incremental goes into the cost of goods and how much is also on the income statement?

Additionally, on top of that, is there a meaningful number that we should think about in terms of capitalized spending that’s not expensed that would be hitting in the cap-ex and the free cash flow? That would be one question.

The second thing is, I was just hoping you could kind of recap what you were saying about the sequential change in churn from the fourth quarter to the first quarter with Blockbuster to the second quarter. I’m just not quite sure I fully captured all the numbers that you were putting out there and what the impact is, so if you could go over that again, I’d appreciate it. Thank you.

Reed Hastings

I’ll let you do the first one, Barry. I’ll do the second one.

Barry McCarthy

The question relates to spending on the Watch Now features and geography of expenses, and capitalization. I think that a simple way to think about it is that most of the expenses will find their way into cost of revenue. And to the extent possible, we will expense as much as we can and capitalize as little as we can, still complying with FASB, but in order to adopt as conservative an approach from an accounting perspective as we reasonably can.

In any event, the $40 million that I described is more than $40 million as a P&L number.

Reed Hastings

Then, on the churn, I was pointing out that in 2005, when Blockbuster cut their price from 18 to 15, December 22nd or 23rd of the prior year, so it’s a reasonably good comparison period.

What we saw there is churn bumping up about 60 basis points, or six people in a thousand, from Q4 of 2004 to Q1 of 2005. And then Blockbuster kept their $15 price into Q2, but we saw a recovery in churn and a recovery to positive year-over-year comps and net adds by the second quarter.

Again, that’s because the new programs like Blockbuster’s new program have their biggest effect up front. In Q1, the few subscribers that are enticed to switch do so, and that’s mostly done by the time we get into Q2. So that’s where the lesser effect in Q2 comes from.

Does that answer your question?

Barton Crockett - JP Morgan

Yes, that helps. I appreciate that.

Barry McCarthy

To add one additional dimension to Reed’s answer about churn, two drivers really coming into Q1: the effect that Reed mentioned, related to competition, meaning Blockbuster competing for subscriber growth now really for the first time outside of the stores in Q4, with an in-store sign up, Q1 is out-of-store sign-up, we think. Secondly, there’s a seasonal aspect of churn in Q1. You’ll recall that much of the Q4 new subscriber additions happened late in the quarter. A large percentage of folks are still in a free trial period. They make a decision about whether to extend the service or not early in the first quarter, and you’ve got growth in Q1 that begins in Q1. Folks rolling off of their free trial period in Q1.

So what we’ve seen historically is a slight up-tick in churn in Q1 as seasonal trend, absent competition. We expect that to be present in Q1 and we also expect there to be small increase associated with the new competitive presence in the market.

Barton Crockett - JP Morgan

If I could just follow-up with one other thing on the competitive presence, could you give us a sense of the Blockbuster, what portion of your subscribers are Blockbuster members, the people that you’re adding, the new subscribers that you’re adding? Is that a big part of the target market that you are pulling into Netflix, or is that a small part of it?

Reed Hastings

Most people in America have rented from Blockbuster at some point in time, so I think it would really depend on how you define it, but I don’t have any precise data on that. It’s not one of the things that we track.

Barton Crockett - JP Morgan

Okay. All right, thanks a lot.

Operator

We’ll take our next question from Douglas Anmuth with Lehman Brothers.

Douglas Anmuth - Lehman Brothers

Thank you. I have two questions. The first one, Barry, you mentioned in terms of talking about Q4 marketing, how you didn’t reinvest as much in the quarter perhaps as you have in other quarters. I am just wondering if you could provide a little bit more than in terms of color on what you saw in the market. Was that related directly to the competition? My understanding is that Blockbuster did not spend that much in terms of marketing dollars in 4Q. It’s also at a time that I would think that maybe you would actually look to reinvest more to maybe get ahead of some of their aggressive spend in 1Q, unless you just thought it would be wasting money.

Then, the second question is regarding the lower-end plans. I think you made a comment that made me think that some of the lower-end plans had gained a little bit more traction. Is that still in the $10 and $12 plans, or is that actually down to the $5.99? And now, what’s the thinking in terms of going to the $4.99 plan? Thank you.

Barry McCarthy

Let me begin by addressing the marketing spending, and taking us back in time to the Q2 earnings call, when I found myself in the unusual position of having to explain why we had so much profit and why we hadn’t reinvested it. We said on that call, and again in Q3, that our plan, that we had significantly increased our marketing spending versus our earlier expectations for the year. On the Q3 call, about Q4 I said we’ve already increased our planned spending quite a bit and it doesn’t look like we’re going to be able to deploy much more incremental spending at the margin. So if the business is more profitable during the quarter, probably that money will fall to the bottom line and we’ll beat the high-end of earnings guidance. That is in fact what happened.

Now, there is a discipline internally which looks at the marginal acquisition costs of a new subscriber and compares it with an analysis of their lifetime value, which varies by price point. In theory, we should be willing to spend until marginal cost equals marginal revenue. We don’t actually go that high.

So in periods of time when additional money drops to the bottom line and we’re not able to redeploy it for additional growth once we’ve met our earnings commitment to the street, as a general rule, it’s because the marginal cost of acquisition is more than we’re willing to spend.

Or it’s because we didn’t figure out soon enough in the quarter that we would have that money available and there’s too much lead time for network TV or radio or direct mail or whatever channel it is that the marketing group decides is cost-effective for the incremental spend.

About the lower-end plans, Reed will comment on strategically how we think about lowering prices, but before he does, I just want to comment on all the hand-wringing around the price testing we’ve been doing on $4.99.

In terms of total revenue, the $4.99 subs are completely inconsequential to the business model. So it signals absolutely nothing about future trends in prices or subscriber mix or overarching strategy.

Reed, perhaps you could comment on the strategic view.

Reed Hastings

Sure. We’re always looking to find ways to lower price, as long as it increases profit and growth. So we’re often testing the elasticity of the market. The lower the prices are, the bigger the competitive motive. We’ve had great experience with that to date, and again within the framework of finding ways with lower prices to get larger profits and larger subscriber base.

Operator

We’ll take our next question from Jim Friedland with Cowen and Company.

Jim Friedland - Cowen and Company

Thanks. To follow-up on that ARPU question, given that you launched the $5.99 price, or at least made it more commercial, call it Q2 of last year, at some point, do you think you anniversary that low-end and the ARPU stops declining, as we look at our models longer term?

Then, the second question is what effective tax rate should we be using for ’07? Thanks.

Barry McCarthy

The second part of the question is probably 40%.

The first part of the question is, even in a perfect world, we’d continue to drop prices forever, and you should be glad if we do. It passes prologue, because each time we’ve dropped price, we’ve grown faster, margins have expanded, and we’ve been more profitable.

It might be worth to you, along those lines, if you look at gross profit per subscriber per month, as opposed to ASP, you get a pretty impressive picture of stability.

Jim Friedland - Cowen and Company

In terms of where the new subscribers are coming on, last quarter I think you said that the majority of gross adds are still going for the three DVD plan. Was that the same in Q4?

Barry McCarthy

You know, as the competition has increased here, we’re going to be a little more cautious on how much information we give our competitors on plan breakout, so we’re going to not really comment on plan breakout. Obviously the ASP is out there, but the best mix to get there, we’re going to keep to ourselves.

Jim Friedland - Cowen and Company

Okay then, one last question: when you went through the last round of Blockbuster competition a couple of years ago and you saw that increase in churn, what was the quality of the customer base? Did it exactly reflect the Netflix base, or did you see your higher usage customers jump? Basically, I’m asking are your higher usage, lower profitable customers the ones that we’re going to lose here, or is it not going to really show up?

Barry McCarthy

I don’t think there will be any material skew in that. The number of additional cancels being at six people in a 1,000 are pretty small, so it’s not really going to make any difference what type they are to the economics.

Jim Friedland - Cowen and Company

Thanks a lot.

Operator

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

Heath Terry - Credit Suisse

Great, thanks. You mentioned that you’re phasing out your banner ads. Could you talk to us about the reasoning behind that? Were the banner ads in the group that you were testing with leading to higher churn or changes in usage that that made you feel like that was necessary, or was there some other reason?

Reed Hastings

Sure, Terry. It was interesting. Studios liked it, but just not big enough. We figured we can use that space to increase retention and customer satisfaction just as well by merchandising the movies that people wanted. So that was it. It wasn’t that big an issue or opportunity.

Because again, on a subscriber business versus a free business like Yahoo!, the number of visitors are not large, the reach isn’t large compared to a visitor-oriented site.

Heath Terry - Credit Suisse

Great. Thank you.

Operator

We’ll take our next question from Safa Rashtchy with Piper Jaffray.

Paul Bieber - Piper Jaffray

Hi, this is Paul Bieber for Safa. Can you give us some broad comments about the product in terms of the selection of movies that’s available for Watch Now and watching movies on your TV? Are there any goals for the number of titles that you hope to have on the Watch Now functionality, over whether it’s the next year or so?

Reed Hastings

Sure. We feel very good about getting up to -- we started at around 1,000 titles. That’s what we have now. We feel very good about getting to 5,000 by the end of the year.

Paul Bieber - Piper Jaffray

And with regard to the number of subs that have access to it, our understanding is right now, it’s in the thousands. What is the timeframe in terms of ramping it up to the rest of the sub base?

Reed Hastings

Over the next six months.

Paul Bieber - Piper Jaffray

Okay. And then, in terms of other cities, are they still following the same trends as San Francisco in terms of penetration rates and the things that you’ve learned from San Francisco? Are you seeing them in other cities that are evolving?

Reed Hastings

Yes, generally we do it by hub. The year of which the distribution centers are open, we look at our class of ’02, our class of ’03, and generally continue to follow the Bay area pattern, as it has been.

Paul Bieber - Piper Jaffray

Okay. Congratulations on a good quarter.

Operator

We’ll take our next question from Tony Wible with Citigroup.

Tony Wible - Citigroup

Thanks. Barry, I hope you can start by just clarifying your comments earlier on SAC. Should we be anticipating SAC to increase or maintain around the current level?

Barry McCarthy

Well, as you know, we don’t guide to it. It’s been fairly steady. It’s moved in a narrow band during the calendar year, and that will probably remain true in the future. It depends a little bit on how intense the competitive environment is, and for how long that competition sustains its current level of spending.

Tony Wible - Citigroup

Okay. I think I understand that.

Barry McCarthy

Our overarching objective, as you know, is to land in that net income number and deliver the subs that we’ve committed. If we have the opportunity to allocate additional monies to marketing during the calendar year, constrained by the unit economic model of lifetime value versus acquisition costs, we will.

Tony Wible - Citigroup

Great. That clears things up. In light of total access, is there anything that you guys feel any more compelled about with partnerships or new product offerings? For instance, games is something that you guys have dismissed in the past. Now that the total access program has game rentals, does it make any more sense to expand into that or expand the scope of the service in some way?

Reed Hastings

Just to clarify, the online part of total access does not have game rentals, just the in-store part.

Tony Wible - Citigroup

Right, the free coupon.

Reed Hastings

Correct, for the in-store rental. So no, we don’t have any plans there. Our competitive plan, as I went through, is not to add extraneous doodads of various sorts, but to continue to improve our core metrics, percentage of homes we can get to with overnight delivery, consistency of our fill rates. It’s our steady execution that has differentiated us in the past from competition and we’re just continuing to work on that, with the one big expansion being online video, which is really a compelling differentiator for the class of consumers that are willing to watch movies on their laptops, which we recognize is not everybody.

Barry McCarthy

Some new opportunities present a compelling economic upside, and those, you are also aware then, it challenges you to remain focused and disciplined. Others appear to not be very attractive models, and I would say games is, for us, not an attractive economic model.

So there lingers this perception, I’m not sure why, amongst investors that it’s some low-hanging fruit that contributes incrementally to the consumer value proposition and the overarching profitability of the business. I think the second presumption is just wrong.

Tony Wible - Citigroup

Should we take it then that partnerships would also be out of the question?

Reed Hastings

Well, we have numerous partnerships today and we’ll continue to build on them where they gain us competitive advantage.

Tony Wible - Citigroup

Last question is just with Movie Gallery, I guess, this upcoming year, if they were to file for bankruptcy, is there any way that you could capitalize on that? Do you have any specific plans in the event that does happen?

Reed Hastings

No, but I don’t know if Movie will chapter or not, but no matter what, they’ll keep operating the stores, so it’s just like people fly United when, you know, it’s in reorganization. I don’t think there’s going to be much commercial effect on us.

Tony Wible - Citigroup

Thank you, guys.

Operator

We’ll take our next question from Derek Brown with Cantor Fitzgerald.

Derek Brown - Cantor Fitzgerald

Thank you. Two questions. The first is that if you look at the combined net additions of yourselves and Blockbuster, there’s a material increase in the growth rate for the overall online category. I’m wondering if you view this as some sort of collective tipping point for the category, and if so, what do you think the fallout from that might be?

Then, the second is as it relates to competition, there have been a few news articles that sort of talk about this being sort of the Hail Mary from Blockbuster, and I’m wondering if you would agree with that viewpoint.

Reed Hastings

No, I wouldn’t agree with that point. I think they realize online’s important and they’re an aggressive and innovative competitor in what they’re doing. Whether the economics work out is a little more open to question, but they know that better than we do.

In terms of your first question, will this extraordinary growth in Q4 in net additions, when you look at the combined two companies, accelerate the tipping point, yes, absolutely. The bigger that online gets, the tougher it is to meet the economics of the video store work.

We look at it and say let’s go, let’s make a really big combined online market, which only drives more and more subscribers online.

Derek Brown - Cantor Fitzgerald

Great. Thank you.

Operator

We’ll take our next question from Gordon Hodge with Thomas Weisel Partners.

Gordon Hodge - Thomas Weisel Partners

Good afternoon, a couple things left. Just curious longer term, when you might have an opportunity to start negotiating with the studios as their output deals expire with Showtime, HBO and Stars? How should we think about your strategy there?

Then also, on the ad sales, just curious if you could give us a rough sense of how much it contributed in the quarter.

Then, just longer term, having the flexibility of selling banner ads, is that something that you just ultimately deemed was not strategically important? I’m thinking in terms of, could you face a competitor three years from now that’s providing movies on an ad-supported basis? Would you not want to have that arrow in your quiver as well? Thanks.

Reed Hastings

Well, Gordon, that’s the right framework to think about the advertising, which is sort of the competitive positioning over time. The more that we came to understand the market, the more we realized that online video is going to shake out in three fairly distinct segments, and that the advertising supported segment would be quite large, fairly distinct and have its own competencies, companies that do advertising supported video such as YouTube, Yahoo!, and others are going to be very good at that and have huge monetization and advertising sales efforts in a very broad way. That was their unique competence.

Ours, in doing subscription rental, is quite different. It’s its own unique competence. Again, these are different. Some consumers will tolerate ads in their movies to get it free and others are willing to pay to have an ad-free experience. Thus, that’s where the segmentation is created from.

You asked about the studios. The way the pay TV contracts work for listeners that don’t know as much as you do, Gordon, is they’re multi-year contracts and they are usually renegotiated one to three years before they expire, as opposed to going right to the brink. So many of those negotiations have begun already in various ways.

I don’t think we’ll be a major player. We’re certainly not going to be bidding instead of those companies for an equivalent set of rights, but there’s lots of people looking to be creative and we’ll continue to work with them. That underlies our confidence in our ability to grow our title count from about the 1,000 today to 5,000 by the end of the year.

Gordon Hodge - Thomas Weisel Partners

Terrific. Just a follow-up, just some small items. Barry, any sense for what we should look for in terms of cash taxes in ’07, and then stock compensation? Your cash taxes run lower, obviously.

Barry McCarthy

Well, we’re going to become a cash taxpayer in ’07, going to burn through the NOLs this year, beginning the second-half of the year. I think the NOL at year-end was down to $50 million, something like that, roughly 55.

In terms of compensation expense, it depends a lot, of course, on stock price. The dilution depends on the stock price, and I think that will be down 20% this year as compared with ’06.

Gordon Hodge - Thomas Weisel Partners

Okay, great. Thanks.

Operator

We’ll take our next question from Brian Pitz with Bank of America.

Brian Pitz - Bank of America

Thanks. Most of the questions answered, a couple of follow-ups on Barton’s and Gordon’s questions, and Reed, your comments. Recently, Ted and/or Neal have kind of commented that of the $40 million you earmarked for digital downloads in ’07, a vast majority of that was actually going to the content owners for licenses, so I’m wondering if towards the tail-end of ’07, do you see incremental additional expenses needed as you roll out your digital platform? Or will that start to hit as you build out infrastructure in ’08? Any color on that would be great.

Reed Hastings

Well, clearly we have to rope those guys in a little tighter, because our staff is -- we’re really not going to break out the $40 million. We tried to signal early last quarter $40 million so you guys could build out the model, but we want to preserve a lot of flexibility for ourselves to optimize the business in the right way.

I’m sure by the time we give guidance for 2008, we’ll have a little clearer picture and we’ll have some history on it all.

Brian Pitz - Bank of America

Great.

Operator

We’ll take our next question from Mario Cibelli with Marathon Partners.

Mario Cibelli - Marathon Partners

Hi, some questions about the view now. If you could give us some general ideas and traits of the new rights. Were these multi-year rights or were they exclusives? I assume there must be some type of distinction made if one were to watch a movie for five minutes or is watching the full movie. Any comments you could make on those?

Reed Hastings

I think it’s safe to say that we don’t view exclusive as a winning strategy on the Internet. Obviously in the constrained distribution environment like cable channels, exclusive content has played a big role. The Internet is fundamentally about open choice and broad choice, and so we have not chosen to go down the exclusive path.

On the other questions, I don’t think -- do you have any comment?

Barry McCarthy

I would say several of the agreements are multi-year, and I don’t think we want to comment beyond that.

Mario Cibelli - Marathon Partners

You mentioned ending the year with 5,000 movies. Would that mean you would be adding some every month, every quarter? If so, would the $40 million, or at least $40 million I think is what you said, would that include adding additional movies and rights fees?

Reed Hastings

Correct. Both of those are -- the $40 million is the number for the year, or least $40 million, and 5,000, so that’s all built into our plan.

Mario Cibelli - Marathon Partners

Okay, and then, I assume there isn’t a whole lot of friction between Red Envelope and getting on the Watch Now on Netflix. Maybe that’s not true, but it would seem to me that you could get a lot of that -- content would end up pretty quickly on your site. Is that true?

Reed Hastings

Great insight. Sherry Baby’s coming to DVD in a week, the Maggie Gyllenhaal film that got nominated for a Golden Globe. That will be day-in date with DVD on our Watch Now service. So that’s a great example.

Mario Cibelli - Marathon Partners

Say out of the thousand that are there now, how many would be Red Envelope movies?

Reed Hastings

I’d guess a few dozen at most.

Mario Cibelli - Marathon Partners

Out of a few thousand? I didn’t quite get that. There’s a thousand offered --

Reed Hastings

I said I would guess a few dozen right now. I don’t have a count right in front of me, but it’s not a material part of the equation. Most of our efforts are focused on the studio movies.

Mario Cibelli - Marathon Partners

Lastly, I wonder if you have any comments on some of the studios experimenting with video on demand. There’s been a couple cities, and I guess what was most interesting is the pricing was a bit of a surprise to me. It looked like pretty low price points. I wonder if you had any thoughts or comments on that.

Reed Hastings

Studios test things all the time, as any good business does. As has been reported it the press in a few cities, there are tests going on with $4 VOD day-in date with DVD. But just because they are running tests does not really indicate much, except a desire to learn and understand the trade-offs. So not significant at this point.

Operator

We’ll take our next question from Charles Wolf with Needham and Company.

Charlie Wolf - Needham & Company

Yes, I’m trying to get a handle on Netflix's addressable market. I read in, actually the Blockbuster annual report of last year, that the video rental market consisted of about 30 million households. In your prepared remarks, you mention that there were 60 million homes with pay TV. I was wondering, what number is closer to your addressable market between those two?

Reed Hastings

You know, that’s a good judgment call for analysts and investors like yourself to make. I mean, we’re trying to put out the hard numbers of what we know exists. It’s an estimation and a judgment call in terms of the available market.

Charlie Wolf - Needham & Company

Okay, let me ask one additional question. In the past, you’ve indicated the churn rate for subscribers who have been with the service for more than one year. Is that still in the 2.5 to 3 range?

Reed Hastings

Yes, roughly.

Operator

We’ll take our next question from Maurice McKenzie with Signal Hill.

Maurice McKenzie - Signal Hill

Thanks for taking the question. I just have one. Could you talk about with your planned plant expansion, where you see capacity utilization, both today as well as the end of 2007?

Reed Hastings

The advantage we have with our distribution centers is they are very compact, and we have short-term leases on them. They are a fairly industrial space without a lot of build out, so it means that we’re always running at a pretty high utilization, and then we move without really any economic issues around those.

Maurice McKenzie - Signal Hill

How should we think about cap-ex related to PP&E for this year, for 2007, related to the plant expansion?

Barry McCarthy

Unfortunately for investors and analysts, we’re not very helpful. We don’t guide to cash flow or cap-ex. Notice that it was up in Q4. It will be up a little bit in 2007 as well.

We are taking a couple of automation initiatives in the hubs to try to continue to drive ourselves down the unit cost curve by reducing labor costs. So that will account for some of the increases. As we’re successful in developing the online video business, there will be some small incremental additional costs associated with that as well.

Operator

We’ll take our next question from Chad Bartley with Pacific Crest.

Chad Bartley - Pacific Crest

Thank you. Really only one left. I actually wanted to go back to the first question in the Q&A. I think the Q3 call you implied net adds for ’07 would likely be up versus ’06. Now having backed off that a bit, I wanted to ask is that entirely due to Blockbuster or are there other dynamics that you guys are taking into account there?

Reed Hastings

It’s mostly a competitive effect. If you look at Q4, our net adds were up compared to Q4 a year ago. With Blockbuster doing the aggressive giveaways and the aggressive advertising, we will see it on the margin. But we’re feeling great about being over 8 million subs by the end of the year and delivering on our $0.80 EPS guidance.

Operator

That does conclude today’s question-and-answer session. At this time, I will turn the call back over to Mr. Reed Hastings for any closing remarks.

Reed Hastings

Thank you. Obviously Q4 was pretty amazing in the growth of the whole online video market. This market may turn out to be bigger, faster than even we could have believed. Thankfully, Netflix has a huge head start in that market. Now, we’re opening up the online video front and we also are developing a big head start in that area.

Thanks again for your support and we’ll talk to you all next conference call.

Operator

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

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Source: Netflix Q4 2006 Earnings Call Transcript
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