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Netflix (NASDAQ:NFLX)

Q4 2005 Earnings Conference Call

January 24th 2006, 5:00PM.

Executives:

Deborah Crawford, Director, Investor Relations

Reed Hastings, President and Chief Executive Officer

Barry McCarthy, Chief Financial Officer

Analysts:

Gordon Hodge, Thomas Weisel Partners

Glen Reid, Bear Stearns

Derek Brown, Pacific Growth Equities

Heath Terry, Credit Suisse First Boston

Safa Rashtchy, Piper Jaffray

Tony Wible, Citigroup

Hagit Reindel, Jeffries & Company

Daniel Ernst, Hudson Square Research

Mario Cibelli, Marathon Partners

Justin Post, Merrill Lynch

Imran Khan, JP Morgan

Presentation

Operator

Good day, everyone, and welcome to the Netflix fourth quarter 2005 earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn call over to Deborah Crawford, Director of Investor Relations. Please go ahead, ma'am.

Deborah Crawford, Director, Investor Relations

Thank you and good afternoon. Welcome to Netflix's fourth quarter 2005 earnings call. Before turning the call over to Reed Hastings, the Company's co-founder and Chief Executive Officer, I will 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 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.

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Reed Hastings, President and Chief Executive Officer

Thank you, Deborah, and welcome everyone. Let me say right at the outset, that we enter 2006 with great confidence in achieving the major goals we have outlined, $50 million to $60 million of pretax profit this year, 50% annual earnings growth for the next 3 to 4 years, and 20 million subscribers in the 2010 to 2012 time frame. This confidence springs from all that we were able to achieve in 2005, and some key marketplace trends I will discuss in a few moments.

A quick recap of the year just ended. First, we added approximately 1.6 million net new subscribers last year, growing from 2.6 million to 4.2 million. This is up from 1.1 million net additions in 2004, and 600,000 in 2003. Our guidance for 2006 is for at least 1.7 million net adds, for an ending subscriber count of at least 5.9 million, and you should think of this as the bottom of the range.

Second, we continue to improve the Netflix service, and for the second straight time we're independently ranked number 1 in web retailer satisfaction nationally, just above Amazon, Apple, and others. The benefits of our service improvements show up in our churn, which dropped from 4.3% in Q3, to 4.0% in Q4, our lowest churn ever. Consumers are signing up for Netflix, and staying with Netflix.

Third, we generated $24 million of free cash flow in 2005, 13 million of pretax profit, and including a one-time tax benefit of $30 million, a total GAAP profit of $42 million. Our earnings guidance for 2006 remains $50 million to $60 million of pretax income, which is $29 million to $35 million of GAAP net income.

Fourth, by closing the year with nearly 4.2 million subscribers, we are on a trajectory to cross our original 5 million subscriber goal in the middle of 2006. Some of you may remember that back in 2002, when we were less than 1 million subscribers, we set the goal of 5 million in 2007 to 2009. This seemed ambitious then, and yet, we are going to beat it. Now, of course, our goal is 20 million subscribers in 2010 to 2012, and we remain on track to reach that ambitious target.

Fifth, through the benefits of scale, we were able to raise our Q4 marketing investment to $47 million, a sequential increase of nearly 50%, and still exceed our earnings target for Q4.

Bottom line, Netflix now has the scale to generate huge net subscriber additions and strong earnings. Of course, increasing our marketing spending pushes up average subscriber acquisition costs, because the marginal subscriber acquired is more expensive than the prior, and our Q4 subscriber acquisition cost was $40.65. This is still far below the contribution profit from a subscriber, and thus, a prudent investment. As we discussed at our Analyst Day last September, our strategy is to grow as fast as possible while delivering on our earnings target. And that is exactly what we did in the fourth quarter. This strategy is enabling us to build a very large and profitable business.

Looking ahead, there are several marketplace factors I want to touch on. The first is the continued expansion of the DVD market. According to the "The Wall Street Journal" and Adams Media Research, the DVD market, both rental and sales, grew domestically from $22 billion in 2004, to $24 billion in 2005. Fox is now forecasting the DVD market will grow to $30 billion by 2010. And as the DVD release window moves up against the theatrical window, DVD benefits strongly. At December 9th JP Morgan report says that if the studios move to full simultaneous release of movies on DVD and in the theatre, the DVD rental market would grow by over 50%. The first concurrent release is this week, in fact, of film "Bubble" directed by Steven Soderbergh. While full simultaneous release may take some time for all studios to support, the economic logic of it is unstoppable in our opinion.

Another of the long-term drivers of DVD growth will be the adoption of high-definition DVD. Today, you can order a Toshiba high-def DVD player at bestbuy.com for $499 and it will be delivered in 8 weeks. High definition DVD is here, launching this quarter. And Netflix today announced that we will offer all HD-DVD titles for rent the day they launch, at no extra cost. Just as exciting, Blu-ray will launch later this year, anchored by PlayStation III, and we also intend to carry all Blu-ray movies as they hit the market.

Very simply, we see high-def DVD as the next big wave of excitement in the home entertainment market, and we will be there at its inception. I should mention that in the high-definition format debate, we see 3 possibilities. One, is that a single format emerges as the clear winner in the minds of studios and consumers. The second possibility is that Samsung and others, create DVD players that play both Blu-ray and HD-DVD. The third possibility is that most studios publish in dual formats, like most game publishers do, for PS2 and Xbox today. Any of these scenarios would be acceptable to Netflix, and we remain neutral in the debate.

We are bullish on high definition DVD because consumers in significantly increasing numbers are purchasing large screen televisions at an investment of $1,000 or more. In fact, the Consumer Electronics Association estimates that 2006 will be the first time that sales of high-definition DVDs will outpace regular DVDs. This is a clear indicator that consumers want the superior viewing experience of high-def, and we believe that preference will naturally migrate to high-def DVD as it becomes available. We anticipate that the mass conversion from standard DVD to high-def DVD will take approximately as long as VHS to DVD, about 10 years, and keep DVD at the center of consumer interest.

The second factor I want to touch on is competition. You may think that VOD or Blockbuster Online is our primary competition. But all of our research shows that local video stores remain the primary alternative to Netflix for consumers. And it is clear that the local video store economic model continues to weaken. As Blockbuster Online invests more in marketing in 2006 to approach 2 million subscribers, and as we grow to nearly 6 million subscribers this year, the awareness and size of the online rental market expands greatly. The result in economic pressure on Movie Gallery stores, Blockbuster stores, and the smaller chains will intensify. In the San Francisco Bay Area, where online rental is ahead of the nation, Blockbuster closed 10% of its stores in 2005. This is part of the reason that in the Bay Area, Netflix saw an acceleration of net additions in Q4, with Netflix now in over 12% of all households in a market that serves as a remarkably accurate indicator of our national trend line.

We expect that more video stores will close in 2006, and our penetration will continue to grow. If total online subscribers gets large enough, it will be hard for any local video store to generate a profit. Consumers prefer the value, selection, and convenience of online movie rental, and the economics of online are very powerful. 40 small distribution centers teamed with the U.S. mail, instead of 4,000-plus local video stores. That is 100-to-1 efficiency gain. As the tipping point kicks in, the future for video stores gets bleaker, and the future for online rental gets brighter.

The third factor I want to touch on is downloading movies. A lot has been said and written about digital distribution in recent months, and so I want to be clear about what we see, and where we stand. We remain absolutely focused on positioning ourselves to lead in this market, as it becomes material at some point down the road. Most importantly, we are building towards 20 million DVD rental subscribers, and continuing to enhance our website, so that when we offer downloading, we will have both a mass audience and the most compelling consumer experience in the market. We are continuing to develop our download technology, and we will invest $5 million to $10 million in this area in 2006. When we offer downloading to our consumers, it will be simply a second delivery option for those consumers who desire it.

Our brand, our subscriber base, our personalized website, it all remains the same in the presence of a second delivery option. Unfortunately, there are 2 big constraints to creating a large, interesting, downloading market: content availability and getting the Internet to the television.

Let's first talk about content availability. Netflix consumers enjoy a very wide variety of DVD content, with more than 55,000 titles. The leading downloading service, Movielink, which is owned by the movie studios, launched several years ago. Today, it arguably has the best downloading selection in the world, and offers less than 2,000 titles. That is about 4% of the titles available on Netflix. Of course, not all titles are equal. So we looked at the specific titles on Movielink, and their 2,000 titles account for less than 15% of Netflix rentals last week. So if you think of selection not in absolute title count, but in an interest weighted manner, then Netflix has over 7 times larger selection than the best downloading service.

Now why would a downloading service that is owned by the studios not have all 55,000 titles available? Because of the Exclusive Window Distribution System unique to the movie business, where exclusive TV rights are sold for certain time periods to TV channels, such as TNT and Showtime, in long-term contracts. This Exclusive Window Distribution System prevents any movie downloading service, from Movielink, Netflix, Comcast, Apple, or anyone else, from carrying the full 55,000 titles consumers want. Unfortunately for Internet consumers, many of these contracts are long-term deals, and the TV channels that hold these contracts are loath to enable broad, nonexclusive movie downloading.

Someday, however, we believe nearly all movie content will be available online, on a noninclusive basis, as with music today. Our allies in this desire are Comcast, Movielink, Apple and others, and it is up to us to collectively find ways of generating enough revenue for the studios, that the studios carve downloading out the Exclusive Window System. Only when downloading is specifically carved out of the Exclusive Window System, as DVD is carved out today, there will be broad movie content available for consumer downloading, and real consumer appeal for movie downloading services.

The second impediment to the growth of downloading is getting the Internet connection to the television. Our subscribers report that only 4% of their DVD movie watching is done on a computer. And as consumers buy more and more large-screen televisions, we don't see this percentage changing materially. Fortunately, technology solutions are finally emerging for getting the Internet to the television. As an example, Cisco Linksys just announced a Wi-Fi DVD player to be available later this year. And the new gaming systems are mostly Internet connected. We hope that by 2010, as many as one-third of households will be able to display high definition Internet video on their high definition television screens.

To summarize our views on downloading, on the one hand are consumer and retailer desires for broad, nonexclusive movie downloading. On the other hand, is the Exclusive Window Distribution System, and the challenges in getting the Internet to the television. These latter forces will slow, but not stop, downloading adoption. Our course is to build the largest DVD rental subscriber base possible, build the most compelling and sticky movie websites, develop the strongest movie retail brand, and then drop in the additional delivery option of downloading.

For the next several years, however, online DVD rental is unrivaled in its selection, value and convenience for consumers, and this is propelling our growth. The San Francisco Bay Area is the most technology-obsessed region of the nation, with very high penetrations of TiVo, Comcast VODs, iPods and broadband Internet. Yet, Bay Area consumers love their Netflix, and subscribe to Netflix in record and accelerating numbers. In 2005, we grew in the Bay Area from 9% household penetration to over 12%, and we believe we will achieve 20% household penetration in the Bay Area in the next 3 years. Technology does increase consumers' options, and in a region of the country with the most technology options, Netflix is an integral, expanding part of the digital consumers lifestyle.

So, when we look at our surging net adds, when we look at the DVD market growing and taking share from the theatrical market, when we look at the continued deterioration of local video stores, when we look at the stunning visual experience of high-definition DVD and the consumer excitement it will engender, we see that Netflix is on track to achieve our goals of $50 million to $60 million in pretax income this year, 50% earnings growth for the next 3 to 4 years, and 20 million DVD rental subscribers in 2010 to 2012. Thank you for listening, and now I will turn the call over to Barry.

Barry McCarthy, Chief Financial Officer

Thank you, Reed, and good afternoon, ladies and gentlemen. On each of the last 2 quarterly calls, I have spoken to you about the strong momentum in our business, which was reflected in a series of upward revisions of our financial guidance. As last year progressed and our business outperformed our expectations, we raised guidance a total of 4 times including an upward revision of our Q4 targets. Measured against that benchmark, Q4 was another strong quarter. We had 4,179,000 ending subscribers, at the high end of a more revised range, record net subscriber growth, record low churn, significantly improved gross margin, and GAAP net income of $38.1 million and pretax net income of $9.1 million, well above the high end of our revised guidance of $4 million to $7.5 million.

Now that we have exceeded our Q4 goals and raised our subscriber guidance for 2006, we are full of confidence and great anticipation as we set our sights on growing the business to 20 million subscribers. At the same time, we also understand that others might not share our confidence. In particular, the recent CES show and various digital downloading announcements have led many investors to question whether growth in digital downloading will erode our business, and if so, when and how rapidly.

A moment ago, you heard Reed, excuse me, Reed say that there is uncertainty about how long it is going to take before digital downloading emerges from its infancy and becomes a mainstream service. But most people, Reed and me included, would accept the premise that downloading is going to become an important business. Plain and simple, the long-term growth of digital downloading poses a real challenge to our business. With every challenge comes opportunity, and there is no question that downloading is a great opportunity. The real question is, opportunity for whom.

In my remarks today, I would like to explain why I think it is our opportunity, why I believe we can lead the future of digital downloading. If we intelligently manage the rapid growth of our online subscriber base, and the evolution of our business model to incorporate digital downloading as one of the delivery options of enjoying Netflix content. But first, because we believe our ability to lead the future of digital downloading begins with our ability to grow a large and profitable DVD subscription business even larger, I am going to turn my attention to the present, and talk about our performance in the fourth quarter. Then I will conclude my remarks by talking about our view of the digital downloading future. My comments on our Q4 performance will focus on 4 aspects of the business: net income and the impact of our tax status going forward, SAC, gross margin, and free cash flow. Let's take them 1 by 1.

First the NOL. In the fourth quarter we made an accounting determination that caused us to recognize the tax benefits related to our cumulative net operating loss. That determination resulted in a large one-time noncash gain of $30.2 million. As a result, under GAAP, future earnings will be fully taxed beginning in Q1, 2006. We expect our effective Federal and state tax rate to be 41%. From a cash perspective, we expect to pay $1 million to $2 million in AMT taxes in 2006.

Now let's turn to SAC. As planned, SAC was up sharply in the quarter. The increased spending accelerated our growth, which serves our long-term strategic objectives for the business. And in spite of the increase, we beat the high end of our earnings guidance for the quarter. As long as our profit margins and churn remain healthy, you can expect us to maintain a high level of marketing spending in order to drive rapid subscriber growth. Competitors who spent less will fall farther and farther behind.

That leads me to gross margins. The fourth quarter's gross margin was 47.1%, up nearly 400 basis points from the third quarter. Lower cost of content was the primary driver of margin expansion. The second contributing factor was consumer adoption of our new lower priced plans. The popularity of these plans means not just that RPU is falling, but also that gross margin is rising. Because new lower-priced customers produce higher margins on lower revenue. That's largely why gross margin improved in each of the last 4 quarters. That trend will reverse itself, however, in Q1, as we absorb the effect of January's postage rate increase, before climbing through the remainder of the calendar year.

Finally free cash flow, which was $24.3 million in the quarter, significantly higher than in any quarter in our history. There were 2primary contributing factors to its growth. Strong holiday sales of gift subscriptions, which boosted deferred revenue, and growth in accounts payable, which resulted in growth in our core business and not an increase in days payables, which remained nearly unchanged from historical levels.

As for the first quarter of 2005, I expect that free cash flow will turn negative in Q1 before turning positive again in Q2, and for the remainder of the year. An increase in purchase content, probably in the range of 20% of revenue, will be a contributing factor to the negative cash flow in Q1 this year, as it was in Q1 last year. Earlier today, we announced our support for high-def DVD. This support will not increase our content cost in 2006.

Now back to the digital downloading opportunity and why we believe it is ours. In his remarks today, Reed mentioned there are a slew of difficult issues that need to be solved before the downloading ecosystem can begin to flourish. These include licensing enough content to matter to consumers, and delivering that content to the TV. We also said that 1 of the primary strategic objectives for our business is to get big on DVD as fast as possible. Why? We have 2 objectives. 1 is to grow our profits, and the other is to better position the Company to compete in the downloading arena, when downloading finally gets here.

We begin with the understanding that downloading, whatever its current buzz, is just another way to delivering content, an alternative to the mail, or the local video store, or to cable, or to satellite delivery. The players in the downloading market will be companies that get the technology right, but that's 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. We believe that delivering the best consumer experience made us the market leader in online DVD rental, and will make us the clear leader in the world of downloadable content.

The specific assets we bring to bear include our large, loyal, and rapidly growing subscriber base and an intuitive website that keeps those subscribers engaged. They find great movies on our site. They find those great movies because we merchandise content that is right for each subscriber. We do that better than anyone else on the planet, because we know more than anyone else on the planet about our subscribers' likes and dislikes. That's because they've told us a billion times and growing, what they like and what they don't. Nobody links people with movies like Netflix.

It seems to me that reasonable people can disagree about how long it is going to take before digital downloading emerges from its infancy and becomes a rapidly growing market. Our goal is to lead the business whenever its rapid growth begins. And keep in mind that managing an accelerating market from its inception through its transition from infancy to rapid growth, is a core management competence at Netflix.

In just 8 years, we will have grown this business from nothing, to about a billion in revenue this year. I don't mean to suggest that it is a "gimme," or that we have a sense of entitlement. Whether we end up on the long or the short end of the digital opportunity will be determined by choices we make over the next 5 to 10 years. And over our history, Netflix has demonstrated its ability to make the right choices. And perhaps just as importantly, to recognize when we've made the wrong choices, and fix them quickly. Our track record leads me to believe that we can leverage the size of our subscriber base and our relationship with those subscribers to lead the downloading market. And if we do, digital downloading will be the engine that drives Netflix to heights we can only imagine today.

In closing, I would like to briefly comment on our 2006 full-year guidance. First, I want to remind you to think of our subscriber and revenue guidance like it is the bottom of the guidance range. And second, I want to comment on our earnings guidance with respect to our price testing. As many of you know, we have been testing lower prices, and we will continue to test lower prices for at least the next several months. If the test results convince us that we can cut price, grow faster, and offset the revenue hit from lower pricing with an equivalent reduction in marketing spending, we will drop our prices.

Today's earnings release reaffirms our goals of $50 million to $60 million in pretax income, and 24.5 to 35.4 million of net income, regardless of the changes we make, or don't make, to product pricing. So, to be unambiguously clear, we have no plans to cut our earnings guidance for the year. That concludes my prepared remarks. And now, operator, we will open the phones to questions.

Questions & Answers

Operator

Thank you. Today's question and answer session will be conducted electronically, if you'd like to ask a question, please signal by pressing '*' key, followed by the digit '1' on your touchtone telephone. If you are using a speaker phone, please make sure your mute function is turned off to allow our equipments to reach your signal. Again, that is '*' 1' on your touchtone telephone. We will pause for just a moment assemble our roster. And we will take our first question from Gordon Hodge with Thomas Weisel Partners.

Q - Gordon Hodge

Yeah, good afternoon. A couple of questions. One, I was just wondering if you can comment on any usage trends you saw in the quarter. And then maybe dissect that into, or separate impact of the low price plan in the mix versus what you are seeing in the core group. And then you talked about lower content costs. I am just wondering if you could quantify it a bit. We have been hearing Catalog price something down from our studio contacts but new release price something up can you comment with that in terms of purchases and also on rev share side, thanks.

A - Barry McCarthy

Gord, if I don't answer the question comprehensively, just chime back in and remind me what I missed. Let's see, with respect to usage. With the popular, the popularity of the new plans average usage is on the debt Klein and has been through the course of the year. I can tell that you revenue per disk is on the rise, and that if I normalized for the mix change and looked, say, at just the three I planned and get a sense of the overall trend in usage on a normalized basis I would say the trend is down.

Q - Gordon Hodge

Okay.

A - Barry McCarthy

Typically we see a seasonal increase in the business, and those trends have been dampened as compared with prior years so we are encouraged, especially given the record low churn.

Q - Gordon Hodge

Yep.

A - Barry McCarthy

And the second question I think related to content cost. If you looked at our statement of cash flow, I think you would see that year-over-year purchase content is up about 10%. But growth in subscribers is up 60% year-over-year, and there haven't been much of a mix change in rev share as a percent of granules, sorry as a percent of purchases over the course of the year.

Q - Gordon Hodge

Okay.

A - Barry McCarthy

And so we are doing a better job on utilization, and I think our scale has enabled us to work in partnership with studios, increase our buying and lower some of our average cost per disk in the process. More profits for them and slightly lower per disk cost for us.

Q - Gordon Hodge

Great, thank you.

Operator

We will take our next question from Glen Reid with Bear Stearns.

Q - Glen Reid

Hi, good afternoon. A couple of questions. You said marketing cost will stay at a high level, you know, with a pretty significant sequential growth. Can we sort of take that $47 million and run that out. If you can make maybe point us in a specific maybe range of spending that will be helpful. Secondly, if free cash flow, you kind of gave us some help on where that will trend but if you can maybe point us to a range of what you kind of target in free cash flow this year. And then finally ad sales this year, if you see, it maybe, you could see maybe a pick up there and maybe give us an idea what you are expecting. That will also be helpful. Thank you.

A - Barry McCarthy

I am going to do it in reverse order, ad sales and free cash flow and the First question related to marketing. In terms of the ad sales, we are very encouraged but it is still early. My guidance on the last quarter's call was for combined revenue in the calendar year for ad sales and previously viewed DVDs in the range of $8 million to $16 million. It is early and we will know more about the size of those opportunities as the year progresses. And we continue to do some testing in ad sales and the result of that testing will inform us about the scope the revenue opportunity. With respect to free cash flow, we don't provide guidance on free cash flow, but we do have in the past given you an indication of what we expect in terms of DVD content purchasing and I think it will be consistent with historical levels, which is in high teens as a percent of revenue. With respect to marketing spending, you'll recall on last quarter's call, I think the quarter before, we indicated our objective is to grow the subscribers as fast as possible and to wither earnings within the range of guidance we have given for the by. So if response rates are up and margins are up for whatever reason, we will take incremental profits and reinvest them in acquisition of additional subscribers to grow the business faster, which increases enterprise value, and if for some reason response rates are down and margins are down, we will shrink the marketing spending and manage the business and the bottom line within the range of guidance that we've given to $50 million to $60 million. Having said that, of course, results have been enormously strong for the last four quarters, and our expectation is that we will continue to have the economic wherewithal to continue to spend marketing dollars at a high-level to acquire subscriber. What that means in fact depends on the efficiency of our marketing spending in any given quarter and you can see it has been within quite a broad range and we are happy with that range. In last quarter's call indicated wouldn't be displeased at all if it was at about current levels, meaning Q4 levels. We will have to see how it fleshes out. So we are looking at the interaction between the gross margin and the churn and overall marketing spending.

Q - Glen Reid

Okay. Thank you.

A - Reed Hastings

Glen, this is Reed. You expressed early in the quarter some concerns about the potential impact of VOD on the general DVD market over the next couple of years, and I just wanted to point out that the same studio Fox, that is being innovative and aggressive on VOD is predicting that the DVD market, rental and sales will grow from 24 billion last year 2005 to over 30 billion by 2010, and what you have to watch out for is the sort of zero sum assumption problem. If you assume that the growth of any entertainment channels at the expense of another, then you do get a net zero sum logic. But, if you think about the 25-year history in the movie business, 25 years ago there was only the movie theatres, there was no HBO, no video, no DVD, and so it was about a $6 billion business. And it has grown as new channels have developed to be close up to a $40 billion business 25 years later. So while there are new channels such as VOD, that have consumer interest, and I think will be financially successful, that doesn't inherently take away from DVD, and, again, the same studio experimenting with novel VOD is also predicting that DVD is going to grow to $30 billion.

Q - Glen Reid

Okay. Thanks. I appreciate your perspective, Reed.

A - Reed Hastings

Thanks.

Operator

We will take our next question from Derek Brown from Pacific Growth Equities.

Q - Derek Brown

Thank you. Two questions. The first is a ton of noise about video on demand digital distribution. Is it fair to characterize, it as just kind of a lot of experimentation going on, number one. And number two, how long do you believe the market will be in the experimentation mode and as a related part, what would you use as a signal to say we are no longer in this experimentation mode and on a completely other subject, can you update us on your thoughts about International expansion at this point?

A - Reed Hastings

Sure Derek. It's Reed. I will do International first. It is something that we look at from time to time, and we look at it in the context of meeting our $50 million to 60 million of pretax earnings growth and our 50% earnings growth year after year after that. So if it's in the budget for doing that, it is something that we will look at seriously. In terms of the kind of phase of innovation and experimentation going on in digital distribution, you know, I think the driving thing is the parallel to the music market. I mean both disk, you know, one is audio and one is video. And it is really easy to think if it happened in audio, it will happen in video, you know, with just a small number of bandwidth separating two of them. And there is surely fundament differences in these two markets and music and in video, and the difference is what is the consumers' interest? In music, we mostly listen to music in the background, in the car, walking around, running with little puny headphone so the interest in higher and higher quality of music is fairly low and thus, for example, high definition music was not a big success. I am referring there to DVD audio and SATV, and instead portability convenience won the day out with things like the iPod. Now if we look at video, what we see is that higher and higher quality is something the consumers care about with large-screen television. We are looking at 40 and 50 and 60-inch television, in another five years I think most people will agree we are going to be looking at 100-inch televisions as the defining thing in people's living rooms. And so what's happening here is that the quality expectation and, thus, the bandwidth around the ecosystem is actually growing significantly, again a big difference from music in that way. So, yes, you are seeing a lot of experimentation, you are seeing a lot of talk, you are also seeing, I think, people over focus on that fact that isn't it just like music when actually it is quite a bit different in terms of a consumer appetite. So I imagine that this phase of interest in downloading, you know, will continue, because music will continue. We are continuing to work and invest in our downloading technology and, again, ultimately it will be about the solving these two big barriers that I outlined, which is selection barrier due to the exclusive downloading window, and how one gets the Internet to the television. Because once you buy those large-screen television, you want it to show up on television.

Q - Derek Brown

Great, thank you.

Operator

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

Q - Heath Terry

Great, thanks. Reed, I was wondering if you can talk a little bit more, I know you guys have been asked this question in a couple of different ways, but on the subscriber acquisition cost issue, what level when you look at subscriber acquisition costs do you kind of hit break even or where you are simply not willing to go a certain level on a break-even base I. And then if you could also talk about there was no real mention of how you are handling the option expense side of the GAAP calculation. I was just wondering if you could just talk about that as well.

A - Reed Hastings

Sure, I will pass the GAAP on over to Barry in a moment. In terms of how we think about subscriber acquisition costs, at, you know, $40.65, we are so far below the lifetime value of a subscriber calculated almost any way you want, that we are not particularly concerned about imprudent spending. So on a practical basis, it is about how much marketing we can afford given our earnings targets. So essentially our process is we want to grow as fast as we can on the earnings target. What we saw this quarter is when in Q4, is when we moved up the total spending from 32 million in Q3 to $47 million in Q4, that necessitates more marginal subscribers that are inherently slightly more expensive than the prior ones if you are doing your marketing well. And we are. And that's what generates the higher SAC, but the way I would think about it is we are going to continue to invest not guided by SAC but guided by meeting our earnings targets and growing as fast as possible, and the SAC will be determined largely by how much we can spend. If we can spend a lot more, you will see SAC creep up. If we end up spending less in total, then SAC will move down again because of the marginal efficiency. I am going to jump in…..

Q - Heath Terry

Throw it over to Barry.

A - Reed Hastings

But we do run a micro economic model that is adjusted for the mix by price points of new subscribers, and we do look at lifetime value and that does inform us at the margin, inform, entertainment margin about how much they are willing to spend, we will be willing to spend. Now having told you, we have an absolute cap, we never discuss what that cap is. It is a relatively easy thing on the back of an envelope to calculate lifetime value. It is one divided by the churn rate times ASP, and as you fold cost from the P&L from that revenue stream you get a pretty quick snapshot of what customer life looks like. It is not precisely accurate, but it's accurate enough to hit the side of a barn. With respect to option expense are, you may recall we were one of the fortunate few to early adopt and we have been expensing for a long time. So no change in our GAAP accounting related to stock option expense.

Q - Heath Terry

Great, thank you.

Operator

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

Q - Safa Rashtchy

Thank you, good afternoon. Couple of questions, first, Barry, in fact, can you discuss why SAC should continue to increase when you are acquiring customers for lower-priced services which should be easier, and, also, your word of mouth is increasing. I would assume that despite having exhausted some lower-cost channels, your SAC at worst should have stabilized and possibly get lower because you are going after easier customers with a better service proposition, and I will have a follow-up.

A - Reed Hastings

Safa, it's Reed here. Again, the SAC you want to think of as relative to total marketing spend. If in Q1, we reduced total marketing expense which we are not thinking of, but, for example, hypothetically only spent 30 or 40 million dollars, you would find this hugely efficient in fact. If we had enough gross margin that we are able to beat our earnings target or meet or beat our earnings conference and spend a huge number, let's call it $100 million in marketing, you would see us get the average SAC would climb. Either of those scenarios I think makes sense for the business, again, because we are at $40.65, so far below the total lifetime value. So think about it the more we invest in marketing we are pushing the market and what we are willing to do is push it hard as long as we meet our earnings target. Why are we in such a hurry? Why are we trying to push the market so hard? Because the prize that is out there is making video stores uneconomic triggering the tipping point and mass closures of video store. We are getting very close in the Bay Area where we are at 12% penetration. So we look at it and say, let's push it as hard as we can on 50% earnings growth and 50 to 60 million pretax this year because the prize of collapsing the video store infrastructure is very powerful because that is going to push us to very large penetration when we look at the total market. That is our strategic motivation and we are constrained on delivering on the earnings and we are not going to violate that.

Q - Safa Rashtchy

Okay, thanks, Reed. Well, can you talk about the impact of potential collapsing of the window as you mentioned with the test movie "Bubble." If there were more mainstream movies available on DVD at the same time, what kind of impact can you see on your rental business?

A - Reed Hastings

Well, the best research I have seen on this of really documented consumer research, again, is that December 9 JP Morgan report which attempted to answer that question by looking at proclivities and, excuse me, their estimate was that the DVD sales market and the DVD rental market would both grow by over 50%. That it would be very significant growth and theatrical would fall by some large number, I don’t' recall. But, that it was significantly…

Q - Safa Rashtchy

Yeah, but my question is actually more on the rental side from your perspective, not from others. What do you think will happen to the rental market?

A - Reed Hastings

I don't see any reason to doubt the research. It would certainly increase the size of the rental market. And we are seeing some of this today with shorter and shorter release windows. If you think about it as simultaneous like "Bubble" that is a highly aggressive case. I think, what we will see over the next three years is 60-day windows, 45-day windows, and you will see it continuing to creep up on the theatrical and that will continue to grow the DVD ecosystem, and again whether it's 25%, 50% or 75%, those are all hugely positive outcomes for Netflix.

Q - Safa Rashtchy

Okay, thank you. Great quarter.

A - Barry McCarthy

Safa, it's Barry. I just want to jump in on the SAC question that you posed to Reed and emphasize that SAC is entirely a managed outcome which was the point Reed made. It helps to think of the alternative. What if we managed the business for no growth, but managed it for cash and profit. We lost in churn about 570,000 customers this quarter even as we have record net subscriber growth, and if we spent the same money on a per subscriber basis, to replace those people so that we ran in place but we didn't grow, we would have had 33 million in pretax profit instead of the 9.1 we had. But, of course, we are choosing to grow the business as fast as we can within the constraints of our earnings guidance. So the point being SAC is entirely a managed outcome as a result our choice of growth rates and the level of profitability we are trying to dial in.

Q - Safa Rashtchy

Okay. Thanks, Barry. Thanks, Reed.

Operator

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

Q - Tony Wible

Thanks. Two questions. One, I was hoping you could recap the gift card activity in the fourth quarter that you alluded to. And historically have you seen those subscribers who received gift cards convert to higher plans down the line? And the second question has to do with HD and the titles, and what you guy have found as far as durability from initial tests. Is one particular format more durable than the other? Thanks.

A - Reed Hastings

I will do gift cards quickly. We had very strong growth in the fourth quarter on the cash flow statement, I think on the balance sheets you will see the change in deferred revenue account, and that's largely driven by the growth in gift subscriptions that was about 14 million in the quarter. And we see a large percentage of those redeemed over time.

Q - Tony Wible

And typically, are those subscriptions going to people who don't have subscriptions today?

A - Barry McCarthy

There is a mix there. I wouldn't think typically one way or the other.

Q - Tony Wible

Okay.

A - Barry McCarthy

And durability. The data advantage of HD-DVD is that it is precisely the same physical process. It's just that the data pits are closer together. So we don't anticipate any effect with HD-DVD. In terms of Blue Ray, it is too early to tell. There are a number of number of factors in the format that haven't been nailed down yet, but we should know that within the next six months from the early samples we have seen, we are not anticipating any problem at all.

Q - Tony Wible

Initially it looked like the laser is kind of what the issue with the disks are exactly the same format. Have you noticed any more sensitivity, the scratches, any other thing to require to buff the DVDs before shipping them?

A - Barry McCarthy

No, we haven't noticed anything like that.

Q - Tony Wible

Thank you, great quarter.

Operator

And we will take our next question from Youssef Squali with Jeffries & Company.

Q - Hagit Reindel

This is Hagit (ph) for Youssef, First to clarify Barry's comments regarding guidance in Q1. Are you baking any price cut into the numbers, because it seems like the uptick in revenues is a little smaller than the uptick in subscribers. Secondly, the shortening of the VOD release window, I wonder if you can quantify the percentage of rentals that happened in the first four to six weeks of a new release out of the total rentals to quantify the impact that could have on Netflix. And third, a question about SAC, with that evenly distributed throughout the quarter and more happen toward the end of quarter. Thank you.

A - Barry McCarthy

I will tackle the testing in the SAC and then I will turn the shortening of the window impact over to Reed. With respect to the testing, yes, there is a financial impact, and that has also been factored in that there was a financial impact in the fourth quarter and that has been factored into our guidance. With respect to SAC, the marketing spending, let me say subscriber acquisition has a large seasonal component to it, both in the fourth quarter and in the first quarter. Weight toward the holidays, and early in the first quarter as a result of the holidays, and so the spending tends to be up seasonally in response to subgrowth. Reed, do you want to do the….

A - Reed Hastings

I don't see any impact from the VOD window stuff. It is just too small to influence the DVD market as a whole. The DVD market, again, fox is forecasting a growth from 24 billion to over 30 billion by the end of the decade. The half of billion of revenue of movie of VOD, you know is just too small for growth in that to impact the total DVD market for at least the next couple of years.

Operator

We will take our next question from Daniel Ernst with Hudson Square Research.

Q - Daniel Ernst

Good evening. Thanks for taking the call. Two questions. First, your churn, down nicely to 4% Reed, can you talk about what you think some of the contribution to that was, was it largely priced or can you measure other elements of customer satisfaction that have been driving that trend. And then secondly, can you talk a little bit about on HD-DVD, you know, any form of economic charge required for them. What are you anticipating in terms of managing budgets for carrying dual formats. Do you anticipate, you know, any short-term costs of handling that. Thanks.

A - Reed Hastings

Sure. On the short-term cost on HD-DVD. We don't see any that will be the same content cost that we will be planning on spending. There is no impact in this year and probably for several years out, and we will see where HD pricing goes over time. In terms of churn, the drivers of it, one is, some of the pricing plans being better matched to a subscriber's usage pattern. If a subscriber is only going to watch two movies a month because that is their lifestyle, than the $9.95 plan is a better fit for their life than the $18 plan and they are more likely to stay and we see that as increased churn. The second is the continued work we do on a better web site and better delivery of the movies. That continues to drive our satisfaction ratings, and, again, you know, it is really quite extraordinary of all of American web retail companies to be rated number one in the nation by independent agency, the University of Michigan and research is really quite extraordinary and it is that focus on customer satisfaction that is continuing to drive the churn down.

Q - Daniel Ernst

So, going back to your comments on matching the pricing plans to the usage patterns, is that something that your customer attention team can suggest, in other words, look at your past trends and then suggest to your customer, well, perhaps you would be more comfortable with this plan given your usage rates?

A - Reed Hastings

It is something we definitely are testing as proactive outreach. Does that help or are there reasons? Some subscribers are very happy watching to paying $18, because they want the three choices at home. So, you know, it is an interesting idea if you right-size someone early. Do you keep them longer? Sometimes do, sometimes you don't, it is one of the hundred things that we test nearly every quarter in a very tightly controlled AV test, looking at how do we improve satisfaction, improve retention, and improve the margin.

A - Barry McCarthy

There is one-third contributing factor, of course, which is the aging of the subscriber base, and some investors who have watched the Company over a period of time have heard us tell you that churn falls over the first 12 months of the subscribers' life and then begin to plateau and we think that the long-term floor on churn is two and a half percent a month and as the subscriber base continues to age, as long as we continue to manage our business well for the long-term structural competitive advantage in the form of persistently lower and declining churn driven by a maturing subbase.

Q - Daniel Ernst

Great. Thanks a lot.

A - Barry McCarthy

A long way of saying 4% ought to continue down.

Q - Daniel Ernst

Fantastic. Look forward to seeing the trend continue. And just one last follow-up on gross margin. Are, given that we are now baking in, that the postal rate increase. What should we expect the first quarter in terms of gross margin?

A - Barry McCarthy

We don't guide any more to give ourselves flexibility to manage those key metrics like SAC and churn and gross margin find the right mix.

Q - Daniel Ernst

Understood. Thanks.

A - Reed Hastings

And if you look back on our churn over the last couple of years, you can see that most of the time in Q1, it is higher than in Q4, because slightly higher because of the surge in new members that comes in late Q4. So the long-term trend is exactly what Barry said. Some history that says Q1 is also higher than Q4.

Q - Daniel Ernst

Understood completely. Thanks a lot.

Operator

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

Q - Mario Cibelli

Yeah, hi, a couple of questions. We talked about accelerated growth in the San Francisco Bay Area, I was assuming the percentage growth and I was wondering if you can say a little more gross, net, year-over-year, sequential. Did you say anything else? Maybe I missed it.

A - Reed Hastings

What I said it was an acceleration in net additions in Q4. So Q4 '05 net additions were higher than a year prior. So that's the acceleration. On a percentage basis, you definitely have large numbers, and you have smaller percentage growth.

Q - Mario Cibelli

Great. That forecast you mentioned about Fox, I just want to make sure, I assume that they are not making a forecast or that forecast assumes that video on demand stays out of home video window, is that made some time ago before some of the recent announcement?

A - Reed Hastings

We made last summer and I think it is inclusive of their thinking. The biggest variable in it is frankly high-definition DVD and how fast, you know that is the $10 billion market. Remember, VOD is talked about but only a 500 million market. The amazing thing is we have grown a single company now this year at 680 million of revenue to be larger than the entire U.S. VOD market. So just to give it a sense of scale and we are continuing to grow very rapidly. So I don't think there's any update, well, there is no update from fox that is other than the $30 billion by the end of the decade for the entire market.

Q - Mario Cibelli

Okay. And if we do see some movement there for the studios, I guess, I would assume that pricing would have to be somewhat similar to, you know, a DVD. Is that sound correct to you? Or would I be missing something here if I would assume that there would be roughly equivalent, talking to the consumer.

A - Reed Hastings

We will have to see what the formats are. The prices I have talked about are actually quite a bit higher than DVD, and again, I think what we are seeing at Fox is an innovative company. They're going to try a number of different things, as well as other companies to see what improves the overall economics of the movie business, and that is very promising for us because the DVD is such a big driver.

Q - Mario Cibelli

Thanks. And lastly, in the markets have you experimented in lower pricing. Anything you can share there? That you've seen.

A - Reed Hastings

No, we are running a number of tests, but we don't have any conclusive results. And the way we look at it, as Barry said have if it preserves our earnings and has faster growth, then that's positive. So we are not contemplating anything that potentially cuts earnings.

Q - Mario Cibelli

And where the decrease at all levels or just some levels in your experiments? Test markets?

A - Reed Hastings

Yeah, we've got a pretty wide range of experiments going on at different times and scales of them. So I don't want to get into commenting on each one.

Q - Mario Cibelli

Thanks a lot.

A - Reed Hastings

Okay.

A - Barry McCarthy

Let me jump in and follow up on something Reed said. I am sure people were struck to hear that our business was larger than the entire VOD industry, and so I want to define that for you precisely so there is no confusion. We are talking about cable industry, VOD, pay-per-view, VOD near VOD revenues as forecast by Kagan and Adams Media Research for year-end 2005 excluding adult film and TV only.

Reed Hastings, Chief Executive Officer

Is there another question?

Operator

We will take our next question from Justin Post from Merrill Lynch.

Q - Justin Post

Hi, Reed, can you talk a little bit about subscriber base. Any metric this year remember versus last year at a percent over a year old and maybe help us understand churn that way and maybe about the lifetime value assumptions we should be making that have important ramification force understanding your subscriber acquisition cost.

A - Reed Hastings

Let me jump in on both. We don't actually disclose except from time to time when it suits us, of course, the percentage of the base that is older than a year. And I don't think we will provide an update on this call. With respect to the lifetime value analysis, I'll give you a framework for it. It requires a number of judgments. You are best equipped to decide how you want to handle those. If you didn't, if you run the math one divided by the churn rate, it generates N number of month time the ASP equals lifetime revenue an the question is what kind of gross margin you want to use and what SAC do you want to use and how do you want to treat all the other expenses in the business and you could use the current quarter's SAC, you could use the current quarter's gross margin and could you extract from the P&L other costs of G&A on a percent of revenue bases. Could you do that in the current quarter or make some assumptions about how some of those fixed costs are going to decline as a percent of revenue over time, and use some other percentage and calculate some different value. And you could look at the statement of cash flows and figure out what content, other depreciation is as a percent of revenue and you could add that back or adjust it and come up with a lifetime EBITDA number a proxy for free cash flow if you are going to get sophisticated about it.

Q - Justin Post

Great, thanks for that framework. You did indicate that the subscriber is aging, any way to quantify that at all?

A - Reed Hastings

No.

Q - Justin Post

Thank you.

Operator

We will take our next question from Imran Khan from JP Morgan.

Q - Imran Khan

Yes, hi, thank you for taking my questions. A couple of questions. A lot of focus on video download. So I was wondering, Reed, if you can talk about your perspective in terms of video download comes really, if you can expect in competition like portal players like yahoo will basically try to compete in the music market and have technology capability and a lot of cash to compete on guy like Amazon and secondly in terms of the DVD download future, a lot of comments from AT&T and SBC in terms of how charging more money for the pipe and premium content and how that will impact the future of DVD download, thanks.

A - Reed Hastings

Sure, two questions there. One is downloading additional competitors. You know the barriers to downloading aren't so much the competitors eBay, Yahoo!, Movielink and Apple. Because for now the competitors are the television stations or television channels or networks which have so much of the content locked up. Again, you know, the downloading site Movielink with the best selection has about 1/7 of the volume that Netflix has on DVD. And again, it's not their fault, because the rights have been sold to TV channels. So, until that issue gets worked out, we will not see much downloading because, again, the selection is weak. And the only way it gets worked out is when our peer companies such as Apple, Movielink collectively with Netflix are able to generate more revenue for the studios for downloading, than the current TV channels with the exclusive relationship. Then again the second factor is getting that Internet to the television, again, to repeat myself only 4% of our subscribers indicate that they watched the last DVD on computer. The 5% on the television. So we have got a long way to go before this come becomes a big market, because a long way before consumers get enough Internet to the television.

So those are two of the major constraints. It doesn't mean it won't happen. It will happen, it is just going to be long and slow, and what we are doing in the meantime is building this giant DVD subscriber base to be positioned for it.

Second, you asked a question about basically open access, which is a controversial issue now. You know, the FCC hasn't made any strong indication, are they going to legislature this particularly. I think you are seeing a lot of companies feeling each other out. To put the AT&T comments in context: they were not about the standard Internet, they were about their fiberoptics System (FiOS) to the home. So, but you will definitely see some battles around the Internet.

Ultimately the consumer is going to decide, and if the consumer is buying high bandwidth broadband Internet from a company to be able to watch movies, then the deliverer of the Internet (network company) can't cut off access to the movies, because that's why the consumer bought it. I think the economics will work out very favorably, but it will be an interesting, contested area over the next five years.

Q - Imran Khan

Okay, thank you.

Operator

That does conclude our question-and-answer section. At this time, I would like to turn the call back over to you Mr. Hastings for any additional or closing comments.

Reed Hastings, President and Chief Executive Officer

Thank you everybody for listening, and I look forward to speaking with you all over the quarter and see you on the next quarter's earnings call.

Operator

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

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