Here’s the entire text of the prepared remarks from Netflix’s (ticker: NFLX) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Good day, everyone, and welcome to the Netflix Third Quarter 2005 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 Ms. Deborah Crawford, Director of Investor Relations.
[Deborah Crawford, director of Investor Relations]
Thank you and good afternoon. Welcome to Netflix third quarter 2005 earnings call. Before turning the call over to Reed Hastings, the company's co founder and CEO, I'll dispense with the customary cautionary language and comment about the webcast for this earnings call.
We 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 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 filing with the Securities and Exchange Commission including our annual report on Form 10-K filed with the commission on March 15th, 2005. And now, over to Reed.
[Reed Hastings Co-founder and CEO]
Thanks, Deborah. Good afternoon, everyone, and thank you for joining us. Our performance in Q3 provides a clear view of the power and potential of the Netflix model. We combined strong subscriber acquisition with cost leadership resulting in large growth and healthy earnings. We have made huge progress over the past year since cutting prices. Our churn has dropped from 5.6% one year ago to 4.3% last quarter, a new record. Our subscriber acquisition cost has dropped from $38.18 to $35.69. Net adds have nearly tripled from a year ago growing from 136,000 to 396,000.
Ending subscribers are up from 2.2 million a year ago to 3.6 million today. Our competitors are weakened or gone. And our earnings, while not as strong as one year ago, are positive and are above the high end of our guidance. Because of our momentum, we feel very comfortable about delivering $50 to $60 million in pretax GAAP net income in 2006. And 50% pretax earnings growth for several years after that. At the heart of our success is a superior business model and an intent focus on the consumer experience.
Our large scale and deep personalization technology enable us to provide the studio a large new revenue stream, to provide investors substantial and growing earnings, and to provide consumers an unrivalled movie rental experience. Our scale and technology allow us to make money a price point no competitor can sustainably match. Dell and Southwest are two similar examples, both of which capture 100% of their industry profit. Let's talk about Q3 results in some more detail. We launched our subscription service six years ago. And over the last six years, our churn has steadily declined, except for $2 price increase and blockbuster's Super Bowl advertising binge promoting its temporary $15 price. This quarter we continued our long-term trend of churn reduction, which results from our improving service, more aggressive price points, weakening competition, and our customer base aging. At some point, this churn reduction trend will flow, but already, that low 4% churn we have a terrific economic model.
In addition to the drop in churn, our gross subscriber additions were strong in the quarter. The big drivers were strong word of mouth, our variety of pricing options, and well executed advertising. One factor to keep in mind, however, is that in Q3 last year we were at a $22 price point with light gross adds, which provided of this quarter with a relatively easy comparable period. In Q4 last year we cut price and we saw large growth spurt. So we will have a more challenging comparable period this Q4. In terms of total marketing spend, and subscriber acquisition cost, we have in all past quarters had a fluid total marketing budget and managed internally to a specific average quarterly SAC.
When we had room to take up total marketing spending, and still hit the specific SAC target we did so. Sometimes negatively impacting that quarter's earnings. Last quarter, we moved to managing to a fixed total marketing budget each quarter, and letting SAC float up or down.
Our first quarter on this more traditional model was quite a success in terms of delivering great growth and strong earnings. Our fixed marketing budget will make SAC somewhat more fluid than in the past. SAC may well rise in Q4, but the fixed marketing spend model has the overriding virtue of stable expenses and more predictable earnings. Barry McCarthy will talk more about this in a few minutes. Combining falling churn and increasing gross additions, net adds is the best indicator of our growth.
As I mentioned, we had 396,000 net ads last quarter. This acceleration in growth is very exciting to be nearly 4 million subscribers and to have net adds still accelerating I am plays the market for on-line rental is extremely large. Finally, we drove a nice increase in gross margin in Q3. This is partially due to the increased acceptance of our lower priced programs, which have higher margins than our standard program, and partially due to efficiency from our personalization efforts, merchandising catalog movies, more effectively than ever.
One of the reasons our last year has been so successful is the market's elasticity in response to our price cuts one year ago. And to our offering of lower priced one and two plans this year. So naturally we want to test this elasticity further as we continue to realize cost efficiencies in the business. As we said at our analyst conference last month, we expect to run a number of pricing tests over the next six months to determine if at lower prices we can deliver faster subscriber growth, lower SAC, lower churn, higher competitive barriers, and still deliver on our earnings commitment. Obviously, if there's enough elasticity to make additional price cuts work, this would increase the economic pressure on video stores, and the additional store closures would further increase Netflix growth for many years ahead. This positive feedback loop between Netflix growth and video store closures is the tipping point for on-line rental.
Now let me turn from Netflix to the broader movie industry, where there continues to be consternation about falling theatrical revenue. One view is that this is a temporary lull in compelling theatrical releases that may soon be remedied. Supporting data is the (ph) 8:39 lull in some prior years that have proven to only be temporary. A contrary view is that the low cost of large screen televisions is, family by family, changing American movie watching habits. For less than $1,000 today, you can buy a 52-inch RCA hi-def television from Wal-Mart. If home theater is the growth engine of the future, then we will see more studio heads join Disney's Bob Iger's call for DVDs to be released earlier, which has the potential to grow the DVD market substantially.
The other big potential growth factor in the DVD market is high definition DVD. In the past three months, the battle over Hi-Def DVD has changed from a stalemate to one favoring blue ray. We are agnostic. We do expect the launch of high definition DVD to happen next year, and that this will be the beginning of another 10 to 20-year product cycle that will extend our leadership for many years.
As we have said before, there is minimal inventory obsolescence risk for Netflix because the conversion of the 80 million existing standard-def DVD households in America will be steady but gradual like DVD over VHS. Well, DVD and hi-def in addition DVD show great promise, the near term for downloading is not so bright. TV channel, such as NBC, Star, and TNT, have been paying large sums for many years to have and maintain exclusive access to many studio films. Because of this, movie link and Comcast, despite impressive technology and management, had so far been unable to license most of the 50,000 titles available on DVD.
The same holds true for apple, which recently launched their video iPod with essentially no studio movie. Of course, we face the same obstacles as movie link, Comcast, and apple, in terms of licensing for downloading. As such, we are going to hold off on a launch of our movie downloading service. We will continue to enhance our technology and infrastructure, and we will be ready to quickly launch when the content climate begins to thaw and it becomes possible to deliver a compelling consumer experience. How long will it take, and who will help us get there? Interestingly, while you might think of Comcast, movie link, and apple as our potential competitors, they are, for now, our allies. We all four want broad, nonexclusive licensing of movies, as with music today.
Our shared opponents are the TV channels who pay large sums to get multiyear exclusive access to studio films. In a music context, imagine a Clear Channel, or FM, had paid big money to get five years of exclusive rights to all Warner music, and that the entire Warner catalog was then not available for legal downloading. That is the current movie situation, which is why no one has been able to license the 50,000 DVD titles for downloading. This will shift, over time, as those exclusive contracts are renegotiated and Netflix and its allies can collectively deliver more profits to the studios than the exclusive TV channels. When the content climate does shift, we will have broad camp content for downloading and the next generation of movie delivery will begin in earnest. Whether this happens in two quarters or 20 quarters is hard to say.
In the near term fortunately, DVD is king, Netflix continues to grow rapidly, and we prepare for the emergence of downloading in the future. As we grow towards our 20 million subscriber goal, we are comforted by the reality that the bigger we are when the content logjam breaks, the more likely we are to be one of the leading companies in the downloading space.
Speaking of 20 million subscribers, I'm often asked why we feel confident about such an enormous number. There are three parts to the answer. Part one, is that the markets that we upgraded to overnight delivery in 2002 and 2003, such as Boston, Atlanta, and Dallas, continue to follow the bay area growth trajectory. Part 2 is that in the bay area, over 11% of households now subscribe to Netflix and our net adds are still accelerating. Part three is the tipping point, we think that once on-line gets big enough, video store economics fall apart, and stores start closing, driving more people to try on-line rental. We are just seeing the beginning of the tipping point in the bay area with more and more video store closures.
These three factors are what give us confidence that 20 million Netflix subscribers is very achievable in the 2010 to 2012 time frame. And we are committed to achieving it while delivering on our earnings guidance. At this point, I'll turn the call over to Barry McCarthy, and I look forward to taking your questions.
[Barry McCarthy, CFO]
Thanks, Reed Hastings. On last quarter's earnings call, I said we were feeling pretty good about our business. And you saw us raise our net income guidance for 2005. Then at our analyst day in early September, we talked at length about our first mover advantages and the momentum we were seeing in the business which caused us to raise our guidance in late September for third quarter subs and net income before net settlement expense. And today we announced results that outperformed our revised net income guidance for Q3 and continue the trend I commented on last quarter as key metrics like subscriber growth, gross margin, SAC, churn, and net income all beat our initial expectations. As Reed mentioned, our momentum continues to build, which gives us the confidence to increase our guidance for Q4 2005 and for next year. Because Reed has already reviewed the highlights of our third quarter performance, my comments today will focus primarily on our guidance for Q4 and 2006. And I'll close with a discussion of our financial expectations through 2006 for new initiatives like ad sales and the sale of previously viewed DVDs.
But first, I want to amplify Reed's comments on SAC. Three months ago, I told you we would increase our marketing spending in Q3 as a percent of revenue and, in fact, we increased marketing spending about 300 basis points from 16% of revenue in Q2 to nearly 19% in Q3. I also told you we expected to increase SAC above the $37 intent in Q2, in fact just the opposite happened. As we increased our marking spending, subscriber growth accelerated faster than we expected, and SAC dropped almost $2 in the third quarter to $35.69. Its lowest level in five quarters. About $4, lower than we forecast in early April. So the obvious question here is what will SAC be going forward. For Q4 and for 2006 we're planning on a fixed marketing budget. And as I indicate in my guidance discussion, given this level of spending, our planning assumes that SAC rises in the fourth quarter of 2005 and 2006, but if we're wrong and growth accelerates, as did it in Q3, we'll see lower SAC than we're expecting and more sub growth. Either way, we expect to deliver the earnings we had guided to by managing the amount of our marketing spending. For the fourth quarter, our revised guidance is for GAAP net income of $4 million to $7.5 million, up from our previous guidance of $1 million to $6 million.
For 2006, we're raising our guidance for pretax income to range of $50 million to $60 million from our previous guidance of $50 million. I'm emphasizing our income guidance because our plan is to deliver the maximum growth consistent with our profit objective. The new guidance assumes higher revenues and higher gross margins. It also assumes that we spend a fixed dollar amount on marketing in Q4 and next year, and that SAC increases in both periods. Of course, as Q2 and Q3 demonstrate, it's entirely possible that SAC could land below our expectations, and if SAC runs lower than forecast, ending subs will beat our guidance. And if SAC runs true to forecast, we'll meet our subscriber goals for the quarter. But either way, we plan to cap our marketing spending just like we did in Q3 and meet our earnings guidance.
Our focus on achieving maximum growth consistent with our income goals also means that if we get ahead on earnings, we'll invest the incremental profit back into the business to drive additional growth. As our third quarter results make clear, this is a business in which scale delivers significant cost and strategic advantages, so growth remains an important objective for us. Today's earnings release raises our Q4 guidance to 4 million to 4.2 million subscribers, and revenue in the range of $191 to $196 million. For 2006, we expect in the year with at least 5.65 million subscribers, and at least $940 million in revenue, and with $50 million to $60 million in pretax income. Think of the sub and the revenue guidance as the bottom of our range.
On a pro forma basis, if the company were fully taxed in 2006, GAAP net income would be in the range of $29 million to $35 million. As a reminder, because of NOLs, Netflix doesn't pay taxes currently. But I expect we'll become taxable, for GAAP purposes, sometime in 2006, and possibly as early as Q4 of this year, but that seems unlikely. We expect the same seasonal patterns of high marketing spending and fast subscriber growth in Q1 of next year that we 2004 and 2005. This means we expect to increase marketing spending as a percent of revenue in Q1, which will pressure profit margins in the quarter, and we may post a net loss for GAAP purposes in Q1 because of our rapid growth, like we get in Q1 of '05 and in Q1 of '04. Built into our forecast is opposed to rate increase of $0.37 to $0.39 in January 2006 for first-class postage, which is a$0.04 impact for Netflix on every round trip DVD shipment. Scale economies in our business and the automation initiatives I discussed last quarter were more than offset the increased in postal expense.
I'll close with a few words about two new initiatives at Netflix. Selling previously viewed DVDs on our website, and add sales. Both initiatives will remain small through year-end while we complete consumer research, although both will become more visible to Netflix investors and subscribers during the fourth quarter. Revenues from the combined initiatives in 2006 will be in the broad range of $8 million to $16 million and neither initiative will be a material contributor to increased profitability next year. For the foreseeable future, the primary engine for growth and profitability will continue to be our core DVD subscription rental business.
In summary, three-quarters ago, we said the competition would help define the on-line DVD rental market, and showcase our strength in this market. The first quarter showed we could maintain our leadership position. We grew fast despite blockbuster's aggressive pricing, and heavy marketing spending. The second quarter helped solidify our leadership position in the on-line subscription market. We remained on track to achieve our goal of four million subscribers by year-end, we returned the business profitability, and we raised financial guidance for the remainder of the year to reflect the improving economics of our model.
The third quarter extended our leadership position enabling us to raise guidance again, and its subscribers net income which show cases the themes we highlighted in September at our analyst day meeting. Namely, that scale drives profitability, margin expansion, and competitive advantage. That concludes my prepared remarks and brings you to the Q and A part of the call. So, operator, we'll turn the call back over to you and take our first question, please.
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