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Netflix, Inc. (NASDAQ:NFLX)

Q1 2007 Earnings Call

April 18, 2007 8:30 am ET

Executives

Deborah Crawford - Director, Investor Relations

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

Barry McCarthy - Chief Financial Officer, Secretary

Analysts

Tony Wible - Citigroup

Doug Anmuth - Lehman Brothers

Jim Friedland - Cowen & Co.

Youssef Squali - Jefferies & Co.

Barton Crockett - JP Morgan

Heath Terry - Credit Suisse

Gordon Hodge - Thomas Weisel

Daniel Ernst - Hudson Square

Maurice McKenzie - Signal Hill

Brian Pitz - Banc of America

Operator

Good day, everyone, and welcome to the Netflix first quarter 2007 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, ma’am.

Deborah Crawford

Thank you and good morning. Welcome to Netflix's first quarter 2007 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 first quarter at approximately 5 a.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 6:30 a.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 February 28, 2007.

Now, I would like to turn the call over to Reed.

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Reed Hastings

Thank you, Deborah and welcome, everyone. I will start with the issues that are on everyone’s minds, our performance in the first quarter, our growth and earnings projections for the balance of the year, and the change in our competitive climate. Then, I will provide you with an update on our success in online video.

In Q1, we added approximately 500,000 net subscribers, growing from 6.3 million to 6.8 million subscribers, and we delivered $0.14 of EPS. Both were within the guidance ranges that we outlined in January, but in the lower half of those ranges. Our earnings were our highest ever Q1 earnings, and more than double Q1 a year ago.

Our churn was pretty much as we expected in Q1, and our incremental losses from Q4 were only five people in 1,000 per month; mostly, the battle is for new subscribers. Clearly, the big change from last year is the emergence of Blockbuster as an aggressive online player enjoying strong subscriber growth. The key for them has been their new online program introduced in Q4, where for every online rental they allow one free store-based rental. For subscribers who live near a Blockbuster store, this can be twice as many DVD rentals as online-only, creating significant operating margin pressures for Blockbuster as their online business grows.

Obviously, when you quite literally give away the store, you are going to see both share growth and market growth. Blockbuster’s share of gross additions has rapidly grown to slightly over half of online DVD rentals, and the overall online business has exploded from about 6 million subscribers one year ago today to approximately 10 million subscribers today. Our thesis that online DVD rental would become very large appears more and more credible. Our thesis that most subscribers would choose Netflix seems more open to question, at least for now.

If we thought the proposition of giving away one free store rental for every online rental, while maintaining price parity, was an economically viable proposition, we would be concerned about our long-term leadership and would take appropriate steps. But we are confident Blockbuster’s online offering is not economically viable at current prices.

What makes us confident in this view of Blockbuster’s economics is that for the last nine years we have been working to make our operations more efficient and our costs lower. In Q1, with nearly 7 million subscribers and over $300 million in quarterly revenue, our operating margin was only 4%. From everything we can observe, Blockbuster is materially less efficient than we are. And then you add in a free store rental for every online rental, and well, you are looking at some serious operating losses.

So to us, it is not a question “if” Blockbuster will raise their online prices, but only when and how much. And when they do, it will reset the competitive calculus as well as increase their profits. If online is going to be as big as we think, there should be room for two profitable firms.

Despite the likelihood of a Blockbuster price hike at some point, we of course have no sense of when or how large it might be, so when updating guidance for the year, we have to assume there is no price hike this year. Given that, we are maintaining our EPS guidance for approximately $0.80 for the year, and cutting our ending subscriber guidance to 7.3 million to 7.8 million. If there is a positive change in the pricing environment, we would expect to upwardly revise our subscriber guidance after that.

Growing our earnings steadily and letting our marketing investment flow is the strategy we first outlined two years ago, and continue to use today. Our marketing spend will still be aggressive, nearly 20% of revenue, and larger than last year.

In the past, we have talked about 50% annual earnings growth and 20 million Netflix subscribers by 2012. To state the obvious, if Blockbuster stays on the “tolerate losses for growth” model long enough, these earnings growth and subscriber goals would become unattainable. We will have to see how the year plays out before we can offer any thoughtful update on these goals.

In the meantime, we are charging forward in our competitive differentiation as the world’s best online rental service. We are continuing to improve our service levels and reduce our costs. Our website and in particular, our movie recommendations, have continued to improve and are getting even more usage by our subscribers. We offer an amazing 75,000 unique DVD titles for rent, and now we offer all subscribers online video included free in their subscription.

Turning to the terrific progress we’ve made in Q1 on our online video efforts, we had thought it would take us six months to get online video fully rolled out to our nearly 7 million members, but we completed the roll out in less than three months. Since launch approximately 90 days ago, we have increased the number of TV shows and movies from 1,000 to over 2,000 and we think we can be at 5,000 by year end.

The response to our offering has been very positive, with the New York Times calling it “deliciously immediate”, “incredibly economical” and because it introduces movie surfing, “impressively convention-shattering”. The consumer response has been even more positive, and just during our roll out phase, we have delivered over 1 million movie and TV show streams to our members.

Of course, the big opportunity for Netflix online video arrives when we can deliver content to the television without requiring a laptop or a media center PC as an intermediary device. We are working hard with various partners to make this a reality in 2008.

To remind everyone, we see three likely segments in online video emerging. One is advertising-supported free content of which YouTube is the leader today; and this segment is akin to free, ad-supported television. The second segment is download digital file ownership, in which Apple is the leader today, and this segment is akin to $15 DVD ownership. The third segment is online subscription viewing, which is akin to video rental and pay television. This is the online segment we are leading.

As big and important as online is for movies, for at least the next ten years we think that a hybrid DVD/online subscription service will be the winning offering. We have, for example, 75,000 titles on DVD, and it may take a full decade for all of those to get cleared for online. Plus, there is the window issue where DVD gets great advantages, which is another reason we think a hybrid service is critical for at least the next ten years. We intend to continue to be the leading subscription service, and hybrid DVD online is our key advantage.

In summary, building a great business requires a strong team, endurance and good strategy. We have those three, and we remain focused on building a growing, profitable business. Now I will turn the call over to Barry.

Barry McCarthy

Thank you, Reed and good morning, everyone. I would like to begin today with several comments about our Q1 performance, and then I will talk about our guidance for Q2 and our revised guidance for the remainder of the year. Lastly, I am going to discuss the stock buyback program we announced today, after which we will open the phones to questions.

Operating results for Q1 were somewhat mixed. Ending subscribers of 6.8 million grew 40% year over year, which was strong; but not as strong as we were projecting at the start of the quarter. GAAP net income grew 124% and was the largest Q1 profit in our history, but was not as large as we were projecting at the start of our quarter.

For the first time in our 20 quarters of reporting as a public company, we announced quarterly results in the low end of our guidance range for subscribers, revenue, net income and EPS. Our goal is to land at the mid-point of guidance; that has been true since we took the company public in 2002. Given our track record of performance versus guidance, Q1 results were disappointing to us.

As I mentioned a moment ago, we ended the first quarter with nearly 6.8 million subscribers. Subscriber growth was limited by the effectiveness of Blockbuster’s Total Access program. Net subscriber growth is driven by gross subscriber additions and churn. Our gross subscriber additions were up 10% year over year, about 150,000 less than we forecast at the beginning of the quarter, and about 400,000 less than the 1.9 million gross subscriber additions we estimate Blockbuster added with their Total Access program.

As Reed mentioned, we believe Blockbuster is growing quickly because Total Access is very aggressively priced. That pricing strategy is driving rapid growth in their share of the online rental business.

We heard a lot about Blockbuster’s sub growth on their Q4 earnings call, but not much about the cost of operating the Total Access program. I expect they will start talking about those costs on their Q1 call, and I expect those costs will imply that the larger Blockbuster’s online business grows, the more money they will lose at current price points. We believe Blockbuster will have to raise prices to sustain the Total Access program. That belief informs our own competitive strategy and the trade-offs we’re willing to make between growth and earnings. In the last six months, you heard me say that if forced to choose between earnings and subscriber growth, we would choose earnings. You see those choices reflected in our revised full-year guidance, which I’ll talk more about in a moment.

Churn was about in line with our expectations in the quarter. On last quarter’s call, we said we expected a 60 basis point increase in churn in response to Blockbuster’s Total Access pricing. At 4.4% in Q1, churn was 10 basis points better than we expected. In the current competitive environment, we expect churn to remain elevated on a year-over-year basis for the remainder of the year. As we mentioned in last quarter’s call, we expect that gap to narrow through the remainder of the year.

Q1 net income of $9.9 million fell below the mid-point of guidance for two principal reasons: revenue was shy of expectations and content expenses were somewhat higher than expected for the quarter. The revenue shortfall was related in equal parts to subscriber growth and lower than expected ASP.

In terms of key metrics, gross margin of 36.1% was 230 basis points higher than it was a year ago, reflecting a 4% year-over-year growth in revenue per paid disc shipment. This growth in revenue per paid disc shipment is tied to the popularity of our lower-priced plans. On a quarter-over-quarter basis, gross margin declined as expected by 280 basis points, due to a seasonal increase in DVD usage in Q1. Content costs for Internet-delivered video were also expensed to cost of revenue in Q1, which further pressured gross margin. For the quarter, gross margin landed about where we expected. By way of reminder, gross margin will decline again in the second quarter as we absorb the cost of the postal rate increase which becomes effective in May.

In Q1, SAC reached an all-time high of approximately $47 even though the year-over-year growth in marketing spending slowed in the quarter as compared with Q3 and Q4 of last year. In past quarters, we have told you to expect an increase in SAC when marketing spending accelerates and a decrease in SAC when marketing spending decelerates. So, I want to explain why that pattern changed this quarter and what it means for the rest of the year.

In a slightly over-simplified view of subscriber acquisition, we acquired subscribers in one of two ways: either from a paid advertisement or for free because somebody heard about the service from a friend and decided to join Netflix based on that word-of-mouth recommendation. SAC was up in Q1 because word-of-mouth subscriber growth was weak, and we don’t expect this organic growth to strengthen again unless Blockbuster raises prices for Total Access; which means that for the remainder of 2007, we expect higher SAC than we saw a year ago.

Before concluding my remarks about Q1 performance, I would like to comment on free cash flow for the quarter, which was negative $18 million, down from a positive $22 million in Q4, and a positive $12 million in Q1 2006. Several factors contributed to the large swing in cash flow in the quarter, including a decline of cash from operating activities as a result of a reduction in the average days payable for accounts payable and accrued expenses; and a reduction in deferred revenue as gift subscription sold in Q4 were redeemed in Q1. In addition, we saw an increase in acquisitions of both our content library including both DVDs and Internet video license fees and fixed assets. For the full year, I expect free cash flow to exceed GAAP net income like it did last year.

Today’s earnings release includes guidance for Q2 and an update to guidance for the full year. The full year guidance lowers the midpoint of the range for ending subscribers by 8% and lowers the midpoint of the range for revenue by 3%. Our guidance for GAAP net income remains unchanged at $55 million to $60 million. The new lower guidance for subscriber growth and revenue reflects our best assessment of the competitive impact of Blockbuster’s Total Access program on our growth.

Our guidance assumes that Blockbuster holds the line on current pricing through year end. If they raise prices before year end, we would expect to grow faster. For Q2, which is normally a period of seasonally slow growth, we are forecasting gross subscriber additions and subscriber churn to be roughly equally for essentially no net subscriber growth in Q2. With this slower subscriber growth, we expect sequential net income growth of 52% to the midpoint of guidance of $15 million.

Earlier in my remarks, I said we valued earnings more than subscriber growth, and I want to explain why. If we could grow subscribers faster by spending more to acquire the marginal new subscriber, we would lose money on each new subscriber, like Blockbuster does with Total Access, which means there is no [inaudible] there in pursuing subscriber growth at the expense of subscriber lifetime value because the bigger your subscriber base grows, the more you lose. So, we are content to grow more slowly, but profitably, while we wait for Blockbuster to rationalize their pricing, at which point we expect our growth to accelerate.

Today’s earnings release announced a program to buy back $100 million in Netflix stock. We expect to complete that program by year end. At the time of our secondary offering a year ago, we said we plan to accumulate cash to position the company to successfully license digital downloading rights for Internet delivery content. Today, we think that licensing this content will require less upfront cash than we envisioned a year ago, which allows us to put that cash to more productive use. We expect to have about $500 million in cash by year end without the buyback program; and of course, we have no debt. So, $100 million or 20% of projected year end cash is a conservative but meaningful amount of money with which to begin our first-ever stock buyback program.

In summary, we have record first quarter profit, but fell about 10% short of our profit expectations for the quarter. Our subscriber growth has slowed and our acquisition costs have increased because Blockbuster is aggressively pricing Total Access. At current pricing levels, we believe Blockbuster loses money on each Total Access subscriber. We don’t believe that is sustainable and so we expect them to raise prices. If they raise prices, we expect our growth to accelerate as the subscriber value proposition shifts back in our competitive favor. But until they raise prices, we think the wise course is to grow more slowly, but profitably.

That concludes my prepared remarks and now operator, if we could open the phone lines we will take our first question.

Question-and-Answer Session

Operator

We will take our first question from Tony Wible - Citigroup.

Tony Wible - Citigroup

What are your thoughts are on pricing yourselves, considering that you are alluding to Blockbuster having a difficult time sustaining price levels, is there any thought on changing pricing at Netflix?

Reed Hastings

It’s something we always look at. We are constantly testing. It remains one of the various tools that we may use. What I think is more likely to happen is for Blockbuster, they have indicated that they are looking at a price increase, doing some testing on it, and that we have situation where we have two profitable firms growing in the market. I think that’s the more likely outcome at this point, but we continue to test and look at the price cut option.

Tony Wible - Citigroup

With your commentary of about getting content to the TV set by 2008 or in 2008, could you provide a little more framework about qualitatively how you are hoping to achieve that?

Reed Hastings

No, I really can’t at this point for competitive reasons, mostly. We announced when we started online video that we wanted to get it to every Internet-connected screen over time, from the cell phone to the laptop to the plasma screen in the living room. There are a variety of partnerships that we are working on and we hope to have the right amount of content, the subscriber interest and those relationships in place in 2008.

Operator

Next we will hear from Doug Anmuth – Lehman Brothers.

Doug Anmuth - Lehman Brothers

Can you talk a little bit about how fragmentation of online ad inventory has altered your marketing spend? if you have been able to do any better in terms of non-premium inventory? Secondly, around digital costs, can you give us a sense for, is at least $40 million for the year, is that number still intact? Is there a way to breakdown the digital spend in 1Q? Thank you.

Barry McCarthy

I will take the digital cost piece of it and Reed will take the question about fragmentation in online advertising. I expect we will be fully spent with respect to the guidance we gave about full-year digital content and related costs, it will be north of $40 million we will fully spend in the quarter. We had at least 100 basis points of ED related costs in round numbers in Q1. I don’t think we will break it out beyond that.

Reed Hastings

We haven’t seen any material changes in online advertising environment in the last three months.

Operator

Your next question comes from Jim Friedland – Cowen &Co.

Jim Friedland - Cowen & Co.

First on the ARPU, it looks like it’s holding steady. Do you feel like you’ve reached a steady state in terms of the distribution between the multiple DVD plans?

Second question relates to PP&E up in Q1 and tech and dev spending, I’m assuming that’s all related to the online initiatives in terms of video on demand. Could you talk a little bit about how tech and dev and PP&E might play out over the next couple years as you build out the online product or the download product?

Barry McCarthy

Let me begin with the ARPU piece of the question. I don’t think we’ve reached equilibrium yet Jim, but you are right it didn’t move much in the quarter, $0.07 from $15.73 to $15.66, something like that. But I am expecting it to continue to move a little bit by price point amongst new subscribers moves towards the average mix of what’s called the installed base.

The second question I think related to tech and dev, and you’re probably observing that on a percent of revenue basis tech and dev was up slightly; 30 basis points on the quarter and has been moving up since the third quarter. That trend will probably continue as we make additional progress in the Internet delivered video content area. Although, we are keeping an eye on the bottom line and of course trying to find the right level of spending relative to profit in the business so that we maintain the overall profit integrity of the business as we try to scale out the Internet video opportunity.

And then with respect to PP&E we did have some frontloaded costs associated with bringing data centers online to support the distribution of content, so I don’t think that will scale at quite the same rate on a go-forward basis.

Operator

Next, we’ll hear from Youssef Squali – Jefferies & Co.

Youssef Squali - Jefferies & Co.

Thank you very much. Good morning. A couple of questions, you spent about $69 million in acquisition of a DVD library; that’s about 50% more than what you spent last year. Your revenues year-on-year up 36%, is the delta there primarily due to your increased spend on the digital download? If not, are we seeing any kind of scale in just the pure DVD library spend versus the core business?

Barry McCarthy

Right. We spent $68 million versus $30 million Q1 on a year-over-year basis and as a percent of revenue which is a metric we sometimes use as a framework for overall spending, we were about 22% versus 13%.

Youssef Squali - Jefferies & Co.

In Q1 of last year was it $30 million or $45 million?

Barry McCarthy

It was roughly $30 million. Consistent with my comments on last quarter’s call, there has been a shift in the mix of DVD purchasing from rev share towards purchased, and you see that reflected in the DVD purchasing mix, and that’s primarily the overall driver. Notwithstanding the mix change, we have been able to expand the gross margin and on a year-over-year basis seen reductions in content cost -- let’s say on a per disc shipped basis.

So we like the way the economics are playing out for the business, it has changed slightly the cash flow attributes, but we have been able to utilize the content that we have purchased effectively and expand margins.

Youssef Squali - Jefferies & Co.

What’s baked into your ‘07 guidance in terms of gross margin and churn?

Barry McCarthy

Well, we don’t guide to either, as you know.

Youssef Squali - Jefferies & Co.

Basically you are talking about Q2 seeing, I think you just said a slight decline in gross margins, driven by the postal increase, so is it fair to assume that Q2 should be a low water mark?

Barry McCarthy

Again, we don’t guide.

Operator

Your next question comes from Barton Crockett - JP Morgan.

Barton Crockett - JP Morgan

Barry, I wanted to ask you a question about Blockbuster Online, which seems to be very key to your outlook for the year. You have in the past kind of forecasted what you think their online business is losing --

Barry McCarthy

Much to their chagrin.

Barton Crockett - JP Morgan

Yes, much to their chagrin. I was wondering if you can update us on what your thinking is there now if they don’t raise rates and maybe just some sense of what the key assumptions are there and the level of certainty on those assumptions? That will be one question.

The other question would be the $40 million investment this year on online video, can you tell us how much of that showed up in the first quarter and where it hit in terms of the expense lines? As we look to ‘08, should we assume that $40 million number goes up as you ramp up the DirecTV initiative? Thank you.

Barry McCarthy

Let’s begin with giving an answer to the Blockbuster question. I want to try to keep the Netflix call – notwithstanding the fact that we have emphasized the importance of Blockbuster’s overall pricing strategy, they have an upcoming call on May 2 and I am sure they will shed light on the success of their model.

Our internal forecast for their online business has them growing slightly faster than we had them growing a quarter ago. Because of the pressure on margins created by subscriber growth, we now project them to be losing more money than we were projecting on last quarter’s call when I said I thought they would lose something in the neighborhood of $150 million to $200 million this calendar year. I think the losses will be north of $200 million. So the faster they grow the more money, that’s the good news and the bad news at current pricing levels. We think.

Now, how accurate is our insight about their business? Depends entirely on how accurate our assumptions are in two dimensions. One relates to usage under the Total Access program, both online and in store. Secondly, how much ancillary revenue, if any, is being generated by online subscribers who travel to the stores to exchange DVDs. We think the answer to the second question is not much. I think Blockbuster is forecasting something like three bucks.

With respect to usage, I think the good news and the bad news is that Total Access customers really like the service, based on our research and use it a lot. A lot of the business model is where I think real economic pressure is created. On Blockbuster’s website, they say they are offering $42 in value at a $18 cost. Well that’s great for subscribers and bad for shareholders.

Now with respect to our ED content costs, I am going to frustrate you and say we are not going to break out on a quarterly basis how much we are actually spending on ED. We will say that ED-related costs showed up for the first time in the cost of revenues as we have launched the service across the entire subscriber base. There are some components of costs that are showing up in tech and dev as well.

In general, there are three categories of cost. One is content, that’s the largest bucket. Those costs are showing up in cost of revenues in the P&L. The second bucket is all the encoding-related costs, creating the digital files; and then thirdly there is a bunch of engineering work to support the current embodiment of the product and the future embodiment of the product that we are not pre-announcing and not yet willing to talk about publicly.

Operator

Your next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

Not to draw this back into the Blockbuster conversation, but when you look at what they are spending when you are making your assumptions around the cost associated with their business, is there a timeline that you can put on them reaching the breaking point and raising prices, or what you feel like, at least the way you are modeling your guidance is the timeline around that?

Barry McCarthy

That will be a great question for them on their call. We are assuming that they stay the course this year.

Heath Terry - Credit Suisse

When you look at the increasing subscriber acquisition cost, to what extent is that your advertising becoming less effective in the presence of the massive spend on the part of Blockbuster versus the cost of advertising units going higher?

Reed Hastings

Heath, it’s almost all the former of the competitive impact.

Barry McCarthy

I would say it’s also to reiterate my remarks about SAC, it’s about the mix of folks who come in for free and the folks you pay to acquire.

Operator

Your next question comes from Gordon Hodge - Thomas Weisel.

Gordon Hodge - Thomas Weisel

Reed, I was wondering if you could give us your perspective on the HBO Universal renewal of their output deal? I’m wondering if you had a chance to discuss that possibility of getting involved with Universal and what that might mean going forward in terms of your electronic distribution rights, subscription rights?

Barry, I think you mentioned you thought you’d have $500 million of cash by the end of the year without the buyback. I’m curious, that would imply about $100 million of free cash over the next three quarters. Did I interpret that correctly? Thanks.

Barry McCarthy

I will deal with the cash piece and Reed will answer. I said roughly $500 million; I didn’t mean to imply specifically that it would be $100 million. Gordon, I was just rounding up.

Reed Hastings

For those of you on the call who don’t follow the pay television market that closely, last week HBO and Universal announced an extension of their business relationship from 2011 to 2016, involving exclusive access for Universal films with HBO. So it’s a continuation of the pay television exclusive window system. There is always a chance, Gordon, that we find a way to work with Universal and HBO in a way that makes us all more money. But at this point, they are focused on their businesses, and of course, HBO is quite a large business, can put a lot of money upfront. This whole exclusive rights issue is one of the many things that prevents online video from being as big as it might otherwise be, and extends the life and importance of DVD in this medium, because the rights are all chopped up in these pockets.

In this example, it’s a pocket of Universal Pictures’ content that’s now licensed exclusively for the next ten years until 2016. So again, these are all the things that continue to keep DVDs such an important part of the overall movie ecosystem.

Operator

Next we will hear from Daniel Ernst - Hudson Square.

Daniel Ernst - Hudson Square

One, can you share with us all color on the gross margin differential of delivering the digital version versus delivering the physical movie, taking aside the one-time cost, I assume, that digitizing a single movie and getting that up and running, but the ongoing cost?

Secondly, more broadly speaking on competition and your positioning in the digital domain, there are a lot of different people trying this from yourselves to Apple to Amazon and Sony has got an Internet TV; they are talking about Xbox, maybe all those are partners for you. The interesting thing about your business today is that you standalone, you don’t necessarily need those partners to deliver a movie for you. You’ve got the post office, they are completely indiscriminate. In the digital world, there are a lot of bigger players that want a piece of this pie. Where do you think you differentiate yourselves in that digital world longer term? Thanks.

Reed Hastings

You asked about gross margin, what we’ll find is delivery will cost much less than it does over postal. Content will cost more, partially because of all those different players trying to get into the space and bidding up content costs. So you’ll see some trade-offs there with content cost increasing and delivery cost shrinking.

In terms of the long-term competitive structure, again I’ll bring it back to my comments on the different segments of the market. While Apple is a very strong player, they are focused on this digital file ownership model, which makes a lot of sense given that that has been so successful for them in music; it’s the next extension of the iPod. They have great advantages in that.

Then there is the ad-supported market, which will probably be the largest of the three segments. Obviously, YouTube is out there in front, Yahoo and lot of others are coming after that. The content providers themselves like nbc.com and espn.com own a piece of that. So I think you’ll see a huge market there.

Then there is the subscription and video rental and pay TV segment, which where we are focused on. For now, there is not that much focus on that segment by the other players, and we are clearly the leader. It’s going to be up to us to continue to build and differentiate.

Your second question or aspect of it was about all these big companies not having uniform access like the post office, and our fundamental view with the Internet, it is going to get to the television in an open manner. If it turns out that the only way to get to the television is to go through someone’s pipe that has an exclusive access, well of course they are going to tax everybody severely and that wouldn’t generate a very open or profitable market. We think that’s not likely to happen, we think that the traditions and the technology underlying the Internet is going to mean that there is broad amounts of bandwidth to televisions in America over the next ten years and that it is going to be pretty open access, which leads to a lot of great possibilities for independent services such as Netflix.

Daniel Ernst - Hudson Square

You brought the idea of access to the pipe, obviously cable TV operators truly want to sell video-on-demand and subscription video, and they have invested billions in putting together the pipe that gets you there. So, are we talking about this as a regulatory issue that you assume you will be able to have open access through that pipe? I think I would compare that to the experience of competitive telecoms, using someone else’s pipe to give their differentiated service to customers?

Reed Hastings

We do think it will be open access, that’s what has been historically; that is what it is today. Economically, remember, that when various people sell Internet access such as cable companies, they are charging $20 to $40 a month and they have no content fees associated with that. Selling Internet access -- especially big bandwidth Internet access -- is a great business for those companies also.

We look at and say they’ll make a lot of money and their customers want content not just from Netflix, they want content from YouTube and 100 other video sources also and this open architecture is part of why we were able to deliver over a million streams of entertainment content to our subscribers just during our roll out period where we only had partial availability. So, I think we’ll see just a great traction on that option over the next coming years.

Operator

Your next question comes from Maurice McKenzie - Signal Hill.

Maurice McKenzie - Signal Hill

A couple of questions. The first relates to your facility automation plant. Can you just give us an update on where you are, what percentage of plant has been automated? If there was any spending in the CapEx line this quarter and then also, the potential margin benefit going forward?

The second question is really on the Watch Now program and it relates to utilization. What percentage of your subscriber base had access in the first quarter and what their overall utilization of their available hours look like?

Barry McCarthy

Sure. On the automation it is not a one shot; a distribution center is not automated and then it becomes automated. There are various steps, a dozen or so that our distribution centers go through and it is automating one step at a time and rolling those out. So, it is much more continuous and steady. Yes, there was automation spending both in Q4 and in Q1, as part of PP&E.

Maurice McKenzie - Signal Hill

The third part of that is, from the ongoing improvements and facility automation, what margin impact do you think that could have in future years? What is the return on this current investment?

Barry McCarthy

Fairly modest. We’ve been reducing our costs substantially over the last couple of years. So, there is not a lot of low hanging fruit there. If we are able to offset the postal increases to come down the pipe, we feel great, so nothing dramatic there.

You asked about online video, a percent of the subs. All of our subs have access to online video; over the quarter it was gradually rolled out. So maybe call it a kind of weighted average of a third or half of the subs at any point in time.

Maurice McKenzie - Signal Hill

Utilization among those subs of the available hours that they had?

Barry McCarthy

It is kind of early to give any color on that, specifically. We are still learning a lot as we grow the content, but everything feels good about the approach that we’ve taken. All the key points of what we are doing have been validated. Of course, the big opportunity comes as we can deliver directly to the television.

Operator

Your final question comes from Brian Pitz - Banc of America.

Brian Pitz - Banc of America

Any update on the endeavors to improve your recommendation engine?

Secondly, we know of some of your recent announcements with respect to a potential evolving relationship with Microsoft, including Silverlight video player technology. Can you comment on longer term potential plans on how your relationship may grow with Microsoft, especially in the context of a more competitive environment with Blockbuster, Apple, Time Warner, Wal-Mart and others?

Reed Hastings

On the Microsoft front and maybe you ask because Mike got appointed to the Board of Directors on Microsoft. But those are two very disconnected things that don’t have anything to do with the Silverlight aspect. It looks to be great technology and our guys are doing some stuff with them and that is great, but I wouldn’t view it as the key to our future, in some way. They are a great partner, but it is not at the core of what we do. They are playing in the platform at a very different space than we do.

Brian Pitz - Banc of America

Any updates on the recommendation engine?

Reed Hastings

Steady progress. We’ve got our Netflix prize contest out there that we’ve continued to see every month, more and more progress towards someone winning the Grand Prize. The current leader is a Hungarian mathematician and we’ve got contestants in 124 countries that are trying to win the prize and to improve the algorithms. So, we are waiting until someone wins the Grand Prize, and then we will see about incorporating all of those improvements.

Operator

Due to time restraints, we will no longer be able to continue with Q&A. At this time for closing remarks, I’d like to turn the call back over to Mr. Reed Hastings. Please go ahead.

Reed Hastings

Well, thank you everyone. To close, I will just reflect on something that I said in the beginning of the call, which is what’s really astounding is the total growth in this market. Four quarters ago, we were about 4.8, Blockbuster about 1.2 for 6 million total subscribers. In just one year, we’ve gone as a total market from 6 million to 10 million subscribers. There are not many markets that grow at that speed, at that size. I think everyone should feel very good about total online rental subscriber base. We look forward to giving you an update next quarter.

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Source: Netflix Q1 2007 Earnings Call Transcript
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