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Netflix, Inc. (NASDAQ:NFLX)

Q4 2007 Earnings Call

January 23, 2008 5:00 pm ET

Executives

Deborah Crawford – Vice President of Investor Relations

Reed Hastings – Founder and Chief Executive Officer

Barry McCarthy – Chief Financial Officer

Analysts

Barton Crockett – J.P. Morgan

Heath Terry – Credit Suisse

Hagit Reindel – Jeffries & Company

Ronald Josey – Lehman Brothers

Lloyd Walmsley – Thomas Weisel Partners, LLC

Jim Friedland - Cowen and Company

Mike Olson - Piper Jaffray

Tony Wible - Citigroup

Daniel Ernst - Hudson Square Research

Bill Lennan - Broadpoint

Andy Hargreaves - Pacific Crest

Analyst for Brian Fitzgerald – Banc of America Securities

Operator

Good day everyone and welcome to the Netflix’s fourth quarter 2007 earnings conference call. Today’s call is being recorded. At this time, for opening remarks and introduction, I would like to turn the conference over to Deborah Crawford, Vice President of Investor Relations.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix’s fourth quarter 2007 earnings call. Before turning the call over to Reed Hastings, the company’s co-founder and CEO, I will dispense with the customary cautionary language and comment about the webcast for this earnings call.

We released earnings for the fourth quarter at approximately 1:05 PM Pacific Time. The earnings release, which includes the reconciliation of our 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 3:30 PM 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 10K filed with the Commission on February 28, 2007.

And now I would like to turn the call over to Reed.

Reed Hastings

Thank you Deborah and welcome everyone. Our goals at Netflix are simple: build the world’s best Internet movie service by combining DVD rental with Internet streaming, and deliver growing EPS and subscribers every year.

In 2007, we made progress on all of these goals despite aggressive competition. Our confidence in extending this momentum is reflected in our guidance for 2008. Our EPS growth was strong in 2007, at $0.97, up 37% from the prior year. Our midpoint guidance for 2008 is for a $1.18 EPS, a 22% increase over 2007.

We continued to add subscribers in 2007, though our growth of 1.2 million net additions was down from 2006, where we grew by 2.1 million subscribers. The increased competition from Blockbuster, in which they incurred large losses, was a primary reason for the fewer net additions in 2007.

For 2008, we expect to have more net adds than 2007, with a positive factor being less aggressive competition from Blockbuster Online and the negative factor that we’re investing less in marketing going forward, both on an absolute basis and as a percentage of revenue.

This past year, we’ve been made meaningful and industry leading improvements to our movie service, by offering unlimited streaming of more than 6 thousand movie and T.V. shows as part of the Netflix subscription; by improving our customer support with our representatives answering phones every hour of every day; by adding more shipping points around the country, in cities like Butte, Montana and Little Rock, Arkansas for more next-day delivery; and by improving our website’s ability to merchandise more content consumers will enjoy.

In independent surveys of Internet customer satisfaction by Nielson Online and Foresee Results, Netflix was once again rated number one in American ecommerce, etching out such giants as Apple and Amazon.

We see great service and low prices as a strategy for strong financial performance of our business, and you see the results of that strong word of mouth in our rapidly driving subscriber acquisition cost.

Turning to the competitive landscape, Blockbuster Online is still active and still has several million subscribers. While they appear to have shifted to valuing profit over growth, they can change their mind again at any time. We are widening the gap between us however, and any further attack is unlikely to be as painful as their 2005 or 2007 thrusts.

The small, but rapidly growing DVD kiosk competitor, redbox is a double edged sword for us. On the negative side, the dollar per day are a great value for the top new releases; on the positive side, redbox hits video stores much harder than it hits Netflix due to our customers valuing broad selection, and if redbox causes more video store closures, it may prove net beneficial to Netflix.

Unless video stores are reinvented, it may be that in five years, there are tens of thousands of kiosks, millions of online DVD renters and very few video stores.

Despite the increasing speculation about the threat to the entire DVD industry from cable and Internet video on demand, we do not regard these services as material short-term threats for several reasons.

Cable VoD has been around in volume for the past five years, and cable companies are using it to differentiate their services from satellite. Internet VoD, from Movielink and CinemaNow have been offered for the past five years, and now Apple has also joined them in Internet VoD.

Cable and Internet VoD have similar pricing and content availability at approximately $4.00 per movie, with content available 30 to 45 days after DVD. You only have 24 hrs in which to complete watching the movie, so if you watch over two nights, you pay twice. The only difference between Internet VoD and cable VoD is that Internet VoD has laptop portability, and cable VoD has broad entry T.V. connectivity. But they are otherwise very similar in their consumer model.

DVD continues to have many advantages over cable and Internet VoD. DVD rentals advantages over VoD are ubiquity of content, ubiquity of DVD players, an early window for new releases, and lower prices. VoD advantages over DVD are convenience and immediacy.

Despite the growth of VoD over the last five years, DVD rental has been stable, with online rental and kiosk rental making up for store losses. In the U.S., DVD spending, including purchase, is still approximately 20 times larger than cable and Internet VoD combined, according to Adams Media Research. DVD is simple, cheap and ubiquitous, all of which make it very appealing to customers.

Looking forward, it appears that Blu-ray has the advantage in the format war, and consumer adoption of Blu-ray will likely accelerate if Blu-ray can maintain the advantage. The milestones to watch for are Blu-ray player prices falling below $200, and Universal and Paramount also announcing their support for Blu-ray.

If these two milestones are reached, the consumer adoption of Blu-ray will take off. This would be a positive for the studios and a positive for Netflix, as it would fuel another decade of robust disc-based entertainment.

Nevertheless, despite our confidence in DVD spending growing over the next few years, we know there will be a transition at some point to Internet delivery of content. Netflix is investing somewhat ahead of the Internet delivery opportunity to ensure that we enjoy a similar leadership position in that delivery mode as we have with online DVD rental.

Despite that incremental investment in a nascent market, we have grown earnings over the past three years and expect to do so in 2008 and beyond, while positioning ourselves to fully capitalize on Internet delivery as it gains critical mass.

We expanded one year ago from a DVD rental service to a service that both streams content and mails DVD for one low price. Over the last year, we tripled the amount of content we stream from 2,000 to more than 6,000 movies and T.V. shows. And last week, we simplified and enhanced the Netflix streaming feature by offering unlimited streaming.

Netflix now offers for one low price, unlimited DVD rentals and unlimited movie streaming. We pioneered the subscription model for online DVD rental and our growth clearly demonstrates that consumers love the unlimited subscription model.

Over the years, we have developed particular confidence in making unlimited subscription work economically. For Netflix, the cost of online content is just another service cost, like standard DVDs or high-definition DVDs and our service costs need to be balanced against other aspects of our model, such as SAC, retention, usage and price.

Today, Netflix is streamed to Windows PCs only. We’ve been very happy with the viewing of our content by our subscribers, particularly our younger subscribers. Web-based video viewing is becoming mainstream, as a wide range of content companies make their content easily accessible on the web. We hope in 2008 to be able to support web-based viewing on the Macintosh also. The hold-back has been a lack of a DRM solution on the Mac.

In addition, during 2008 and beyond, we will work to expand our streaming to high-definition DVD players, to game consoles and to dedicated Internet set-top boxes. Our relationship with LG Electronics is the first of several and we hope to expand the partnership pool by making LG very successful. As we announced several weeks ago, we think working with partners is a smarter strategy for us than a more proprietary approach.

Our biggest advantage in online streaming is not our technology or content contracts, but our ability to bundle streaming with DVD by mail for a large and growing subscriber base. If a consumer spends time on the Internet and enjoys movies, they are likely to become a Netflix DVD rental subscriber.

As we grow a larger and larger DVD rental subscriber base, our ability to offer both online streaming and DVD rental at one low cost means that we have a great advantage over any stand alone Internet delivery service − at least for the next ten years, while DVD is so significant.

In addition, the DVD rental website that we have developed and continue to improve includes billions of movie ratings, millions of customer reviews and an engaged community. It is the perfect website for streaming movies.

Let me wrap up where we began. Our goals are to be the world’s best Internet movie service and to grow subscribers and EPS every year. Our 2007 results demonstrate progress towards those goals and our 2008 guidance reflects our belief that our progress will continue.

And now, over to Barry.

Barry McCarthy

Thank you Reed. Good afternoon everyone. On last quarter’s earnings call, I said we were encouraged by our results quarter-to-date and we revised upward our Q4 guidance. Today we announced results at or above the high-end of this upwardly revised guidance. This is the second consecutive quarter of better-than-expected performance.

My remarks today will cover our Q4 performance and the guidance we issued in today’s earnings release. But first I want to comment on recent announcements involving Internet delivery, including our own announcement of unlimited streaming of video content to Netflix subscribers.

Two years ago, in January 2006, and again in January 2007, CES was abuzz with developments in Internet video delivery. Investors were concerned about the size of the online DVD rental business and the platform risks posed by online delivery. And again, this year, for the third year in a row, CES was buzzing with news of Internet video delivery and questions about platform risk and market size remained.

I would like to point out that in the intervening years, from December 2005 to December 2007, our subscriber base has grown by 79% to 7.5 million subscribers. Revenue has grown by 77% to $1.2 billion. We’ve nearly doubled our free cash flow to $46 million and we’ve deployed our instant streaming video feature, which is more popular today than any of the other Internet movie delivery sites.

On top of all this, as Reed mentioned, Netflix has continued to be the number one rated ecommerce site for customer satisfaction. Those of you who are familiar with our strategic view of the market, know that we believe the digital landscape will take form slowly but steadily over time.

Our market view is informed by two assumptions: first, the consumer demand for Internet video will remain small as long as the consumer viewing experience is limited to the computer. Over time, new devices will enable consumers to watch Internet delivered content on their T.V. sets. That transition will open the mass market to Internet delivered content. But it will take years for these devices to reach a critical mass of consumer adoption.

By way of example, DVD players, the fastest growing consumer product launch in history, took five years to reach 50% household penetration, and these devices will take longer.

Our second assumption is that consumer demand for Internet video will remain unlimited as long as the quantity and quality of licensable content remains limited. Content availability is limited for two reasons: first, for license content to grow, it needs to be additive to studio revenue and not cannibalistic. The studios will protect the current revenue streams; 41% of studio revenue comes from selling DVDs − that is what they are protecting.

Second, in a subscription model, the distribution rights to many newly released movies have been licensed exclusively to the pay networks, such as HBO, Stars and Showtime. The studios sold those rights and for a great deal of money without the ability to resell them again during the pay window. Before and during the pay window, that content is effectively off the market.

The longer the market transition to Internet delivery takes, the more established our brand will become and the more sustained our competitive advantage will be versus free-standing Internet delivery services. Because we offer subscribers a compelling bundled service of DVDs delivered quickly through the mail and instantly over the Internet, we think we can remain the market leader as the market transition occurs.

Now I would like to comment on our Q4 results and our 2008 guidance. Financial results for Q4 were strong, with ending subscribers and revenue at the high-end of guidance and net income significantly above the high-end of guidance.

Gross margin of 33.8% was sequentially flat with a small increase in revenue per disc shipment offset a 2% decline in ARPU and a modest increase in overall content cost per shipment. Free cash flow for the quarter of $21 million was down sequentially on increased content spending. On a year-over-year basis, free cash flow was nearly unchanged as content spending remained flat.

Faster subscriber growth in Q4 was accompanied by a 22% year-over-year decline in marketing spending and SAC, (?) less than $35 − and that is the lowest subscriber acquisition cost we’ve seen in four years.

From our perspective, this past quarter’s combination of better-than-expected sub-growth, near record low SAC, sequentially lower churn and raised guidance for accelerating subscriber growth, are proof points of an expanding market. In a shrinking or saturated market, all these metrics would trend in the opposite direction as leading indicators of a mature business.

But that wasn’t the trend in Q3 or Q4 and that is not our expectation for Q1 2008. Our guidance for 2008 assumes the market continues to grow. This guidance also projects that we will end the year with 8.4 to 8.9 million subscribers. As in past years, much of that subscriber growth will be front-end and back-end loaded in Q1 and Q4 respectively, reflecting historical patterns of growth.

We expect to end Q1 with 7.85 million to 8.05 million subscribers. In addition to solid subscriber growth, we expect strong earnings growth as well. The mid-point of today’s guidance for 2008 projects growth in net income of 18% and EPS growth of 22% for the full-year 2008, and net income growth of 17% and EPS of 21% in Q1.

While delivering solid subscriber and earnings growth, our 2008 guidance includes a substantial increase in our investment in our online delivery initiative. For competitive reasons, we will not be discussing the size or components of this spending, except to say that the majority of it will be included in cost of revenue in 2008.

Finally, our guidance also anticipates another postal rate increase of $0.01 beginning in June of this year, which translates to $0.02 per round trip shipment. Despite these cost increases, today we raised our full-year guidance for net income.

In closing I would like to summarize my remarks this way. Q4 results were strong and momentum has continued to build quarter-to-date, our second consecutive quarter of strong momentum and this momentum is reflected in our guidance.

Like last year at this time, I would say the business is scaling nicely, particularly as it relates to the trade-off we made this past year between reduced marketing spending and increased investment in the overall value of the service, both in terms of lower pricing and service features like unlimited viewing of Internet delivered video content, and significantly improved customer service.

Because we are managing our fixed and variable cost structure well, including our investment and expanding our Internet delivered video feature, profit margins grew 70 basis points last year and are expected to expand again in 2008.

I would like to thank our shareholders for their continued support. The market continues to evolve more or less as we predicted two years ago, with continued growth in DVD subscription rental market and the slow and steady evolution of the Internet delivered video segment.

Over the last three years, we more than tripled net income, with compound earnings growth of 46%. Along the way, we had to overcome some costly competitive challenges, which slowed our growth and pressured our margins. Stepping back from the competitive fray, I think we can say with confidence, that the business is as well positioned today as we could have reasonably hoped, and we are optimistic about the future.

That concludes my prepared remarks. Now we will open the phones to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We will take our first question from Lloyd Walmsley – Thomas Weisel Partners, LLC.

Lloyd Walmsley – Thomas Weisel Partners, LLC

Good afternoon. Your guidance seems to imply an acceleration in either gross sub adds or an improvement in churn. Can you talk how sub growth progressed through the quarter and what you are seeing now to give you that confidence?

And then, specifically if you could talk a little bit about how the sub mix is changing on the various plans and how the profit dollar contributions might be different or similar on those plans?

Reed Hastings

The growth over the prior year is mostly in gross add improvement. Those two, between gross add and churn, there are some interesting dynamics between them that you have to be conscious of.

As an example, we made it easier to put yourself on a vacation hold, which for financial reasons, we consider that a cancel even though the person’s on hold and has agreed to be restarted. And that inflates the gross add number larger than it would otherwise be and makes churn larger than it would otherwise be.

On the margin, you just have to be conscious that there are some trade-offs between SAC and churn. But most of the growth this year would be in increased gross adds.

Your second question was on profitability of the different plans and mix, and we haven’t historically provide you any specifics on that difference in mix between plans other than the total ARPU which we give out.

Barry McCarthy

I would add Lloyd that there is no particular change in the mix in Q4 versus Q3 or in the profit attributes of those plans − so steady sailing. The big change we saw during the quarter, between the fourth quarter and very late in the fourth quarter and the last couple of days of course was the competitive shift in pricing and the change in the momentum that resulted from that.

Operator

We will take our next question from Douglas Anmuth – Lehman Brothers.

Ronald Josey – Lehman Brothers

This is actually Ron Josey calling for Doug. Where do you think your net adds are coming from? Is it from Blockbuster, is it from (BBI?) or is it from Netflix subs or just overall expansion of the market? And could you quantify that mix please?

Reed Hastings

Ron if you look at the domestic rental revenue for the public companies over the last five years, and do a stats bar chart, you can see that the totals are steady and that online is basically taking from stores. Essentially all of our growth comes out of video stores.

Operator

Our next question comes from Youssef Squali – Jeffries & Company.

Hagit Reindel – Jeffries & Company

Thanks. This is Hagit Reindel for Youssef. Guidance assumes or implies that the midpoint about a 6% net margin for 2008, and I understand you don’t want to talk about the cost of digital delivery but is it safe to assume that the difference between the 7% you did in Q4 and the 6% you are guiding to is all in those costs?

Barry McCarthy

I think operating costs increase on a year-over-year basis so I’m not sure what you are referring to actually.

Hagit Reindel – Jeffries & Company

I am referring to the net income margins.

Barry McCarthy

And I think net income margins will rise on a year-over-year basis as well.

Hagit Reindel – Jeffries & Company

I will check the numbers again then.

Barry McCarthy

I will be happy to jump offline and resolve that with you.

Hagit Reindel – Jeffries & Company

Thank you. Just another quick question: since the subscriber acquisition cost did come as low as it did, why did you not decide to spend a little more in grow factor?

Reed Hastings

You remember two quarters ago when we lowered the price of the service, we said there were several ways to invest in value proposition: one was increased marketing and one is lower marketing spending, coupled with a price decrease. And we said at the time that if the business continued to outperform, that would help us pay for the cost of the price decrease over time.

So that strategic path we embarked on, and you should expect us to continue down that path for the foreseeable future.

Operator

Our next question is from Heath Terry – Credit Suisse.

Heath Terry – Credit Suisse

I was wondering if you could give us an idea of, as you start to learn more about your watch instantly customer base, if you are seeing any kind of changes in either their usage levels or their churn rate, specifically within those that are finding watch instantly useful and using it?

Reed Hastings

Amongst those that are active users of our streaming, they skew young and young people have different churn and usage profiles than other people. We don’t have a good control group there for us to be certain. It does appear that − and it makes sense − that the more someone uses streaming, especially with the unlimited streaming, that they are going to consume less DVDs, though we can’t tell you the degree of that, partially because it’s relatively small numbers and there is not a clean control group that didn’t get streaming.

Heath Terry – Credit Suisse

And you kind of touched on this a little bit but can you give us an idea, since the Blockbuster increase went into effect at the end of December, have you seen any changes in the rate of new customer acquisitions, churn, subscriber acquisition, costs relative to what you were seeing prior to the price increase?

Reed Hastings

We see a modest improvement in acquisition. We ask when a customer leaves us, “what are you going to do for movies?” No material change in the number of people who say they are going to Blockbuster Online, which is why we want to point out to investors that it would be too soon to conclude Blockbuster Online has gone away or something black and white like that. They are still pretty active in the market; they’ve a good value proposition; they’ve got a big brand. So they are still active in the market.

Operator

Our next question is from Barton Crockett – J.P. Morgan.

Barton Crockett – J.P. Morgan

I wanted to drill down a little bit more on the subscriber growth issue here. Your guidance assumes more net adds in ‘08 versus ‘07, but if you look at what happened in the fourth quarter of ‘07, you actually had less net adds in the fourth quarter of ‘07 than you had in the fourth quarter of ‘06.

All the dynamics that we have seen in the fourth quarter of ‘07 presumably will be there in 2008. So what changes incrementally from the fourth quarter of ‘07 into 2008 that gives you the confidence that basically your gross adds growth will do better than it was in this quarter, which is flat. What changes that?

Reed Hastings

It is mostly a comp quarter question. So Q4 that we just completed was comp against Q4 a year ago before Total Access was broadly advertised, whereas Q1 of 2008 it will comp against the quarter in 2007 in which Blockbuster was very aggressively advertising Super Bowl, Academy Award, and Total Access program.

Barton Crockett – J.P. Morgan

Okay, all right that helps there. And then in terms of the online content cost for the Watch Now feature, can you give us any sense, is that anymore or less expensive per minute of content to view it online versus for a customer to view it on DVD? Does it cost you more for an equivalent minute online or if you get it on tape or DVD?

Barry McCarthy

I am not sure that looking at it per minute is really that helpful. People tend to watch different kinds of content, a little more TV shows online with the online streaming and a different value perception in what they are willing to pay for between online streaming and DVDs.

What we can say is when you think of our content spending there’s three buckets: there is the high definition DVDs, there is the standard DVDs, and there is the online content. We look at it that way as three different content buckets that we try to invest wisely in relative to their value perceptions by consumers and by value perceptions I mean retention value, to balance out our total acquisition or subscription equation.

Barton Crockett – J.P. Morgan

Are you seeing evidence that the online usage is reducing the DVD usage?

Barry McCarthy

Well you know that was Heath’s question and there’s no clean way to do that because we don’t have a control group that doesn’t have streaming.

The differences, there are seasonal differences also and so without a control group, if we guess at it and we do, we like what we are seeing but there is nothing we would feel comfortable saying okay, we cracked the formula here is the trade-offs, etcetera.

Barton Crockett – J.P. Morgan

The writers’ strike, to what extent do you think it’s helping you now and do you think it might be a help when the thing is finally settled in terms of TVs and reruns probably less appealing if more people wanted to watch a DVD?

Reed Hastings

I am not sure. It’s certainly no material help if it’s a help, it may be a slight help or a slight hurt. It’s like a recession in consumer spending. I mean you could argue it hurts because we have credit card customers; you can argue it helps because rental is such a good value.

But these are both very background kind of factors; they don’t affect our business in any dramatic way.

Barry McCarthy

We think about it the same way we think about new release movies. So, in the bricks and mortar world they talk about the new release calendar, they are talking about macroeconomic events and generally you don’t hear us quarter to quarter talk about either.

Operator

Your next question comes from Jim Friedland - Cowen and Company.

Jim Friedland - Cowen and Company

First on the churn pattern, now that Blockbuster has eased off should we expect to see that Q1 picks up a little from Q4, then Q2 picks up a little bit more then drops in Q3, drops in Q4, again as the annual pattern there?

On gross margins in thinking about gross margins this year, Barry, are you willing to give us any more insight into how much online maybe either weighing on that and outside the postal increase is there any other impact that we should be thinking about?

Barry McCarthy

Let me jump on gross margin and I’ll turn it over to Reed. The increased spending in the ED content is going to weigh on gross margin. We have forecast all of the costs and none of the benefits which seems the right course of actions since we can’t identify any benefits specifically attributable to retention or SAC or such substation between DVD usage and online usage.

So yes there will be some erosion in margin as the calendar year progresses.

Jim Friedland - Cowen and Company

And on the churn trends then?

Reed Hastings

On the churn I think you are implying is the 2006 seasonal pattern the more relevant one likely than 2007 and I think the answer is yes on that.

Jim Friedland - Cowen and Company

Reed, thinking about unlimited usage given that it is such a small segment of the user base today, if we look out -- I don’t know what the year is, ‘09 or 2010 -- is there a point where you will not be able to offer unlimited usage or is that something you just think is so far in the future it is not worth thinking about at this point?

Reed Hastings

Oh no, we think very much about it trying to line up our consumer proposition along the lines of things that will be great economic propositions now and going forward. So all of our testing, the usage of our online streaming while confined to PCs its still pretty broad and we have been very happy with it. So I don’t see anything that would disturb that unlimited viewing ability.

Operator

Your next question comes from Mike Olson - Piper Jaffray.

Mike Olson - Piper Jaffray

A quick question on LG relationship, obviously that’s an important step in getting integrated into CE devices, but I am sure your goal as you talked about is to make Netflix ubiquitous among a lot of different devices. When can we expect more devices beyond LG? Is it ‘08 or is it more likely in ‘09? What gives you confidence that CE manufacturers are going to want to partner with Netflix?

Reed Hastings

I think the thing that will make us popular in the CE community is if we do a great job with LG and they sell a lot of their devices because of the Netflix service and make a lot of money off of that. Then other people are going to want part of that success.

So our core focus is not to see how broad can we license today, but instead how successful can we make LG in terms of growing their share of the very segment that they participate in. We may see a few more agreements this year, but a very small number given that we think that the best strategy is to really do a good job on the total CE integration where it’s a great job for the consumer, the customer score works, well the total experience works well and then expand that much more broadly in 2009.

Mike Olson - Piper Jaffray

As far as the streaming service, any metrics you can give as far as number of streams or any changes, any uptick or anything since the change to unlimited usage?

Reed Hastings

No, we proved out to our satisfaction by doing testing beforehand that the unlimited watching made economic sense for us. But its increased attractiveness to the consumer was greater than its increased cost. We haven’t given any metrics on number of streams or users or those kinds of things.

Mike Olson - Piper Jaffray

Did you say that absolute marketing dollars will be down in ‘08 versus ‘07?

Barry McCarthy

That’s correct, that’s our intention.

Operator

Your next question comes from Tony Wible - Citigroup.

Tony Wible - Citigroup

I understand that you can’t provide details exactly on the streaming content cost, but can you let us know if it’s a little bit more front loaded as you build out that platform? In other words, do you anticipate as you go through different distribution partners, expenses kind of rising with the revenues or do you see the revenues coming later and the expenses more upfront?

Barry McCarthy

We’ve got no comment.

Tony Wible - Citigroup

Subscriber acquisition cost, do you anticipate being more aggressive just in the first quarter in light of Blockbuster pulling back on their advertising? I understand you said year over year you anticipate marketing down but do you see any opportunities in the near term to benefit from Blockbuster’s lack of advertising?

Barry McCarthy

On a per subscriber basis, Tony, although we don’t guide to SAC the short answer is no. There is increased momentum in the marketplace, some of that in the form of word of mouth, organic growth and so to the extent we are riding a wave of momentum owing to the change in competitive pricing, rather than seeing SAC go up, you might see it go lower.

Tony Wible - Citigroup

Any thoughts on pricing on the Blockbuster’s changed pricing, do you see any reason to either increase or lower pricing?

Reed Hastings

We try to do careful testing on those. This year you may see us testing additional price cuts. You may see us testing price increases, trying to figure out the elasticity and has the elasticity changed in a new competitive climate. But these are all things that are very much on the margin; remember that when you cut price as we did last summer you get benefits and lower SAC like we are seeing today and if we increase price there will be costs and increased subscriber acquisition cost. So there is a complicated tradeoff metric there and we will continue to test and refine. Still no big shifts in the competitive climate.

Operator

Your next question comes from Daniel Ernst - Hudson Square Research.

Daniel Ernst - Hudson Square Research

Can you give any metrics on overall usage of high definition discs, either Blu-ray or DVD and what your subscribers mix is? Secondly, returning to the question of marketing spend in 2008, it seems that at the moment you’ve got tailwinds again as Blockbuster has pulled back a bit, but maybe in a year from now you are going to experience some additional headwinds as potentially Apple has a more robust offering, how do you do more with how many films they can actually offer.

At some point in the future you will have more headwinds; now you have tailwinds, so why not accelerate a little bit here to lock in some more subs as the battle heats up? Thanks.

Reed Hastings

To the degree that the climate would get tougher, I suppose you might consider that and you referred to Apple service in particular, but remember this year there is about $1.3 billion in video-on-demand spending already that we compete against and have been competing against. Apple announced they did about 6 million movies to-date. Let’s say that goes up by a factor of 5 or 6 or 10 or something, it is still pretty much in the background noise in terms of the video-on-demand market.

So we actively compete with video-on-demands from Comcast and others and have for the last five years. I don’t see any material shift in the climate in the near term possible from that. So we don’t look at it and say boy, the climate is going to get harder in the future.

Daniel Ernst - Hudson Square Research

On the Blu-ray side?

Reed Hastings

Blu-ray, sharp growth in the last couple weeks in CES since the announcement of Warner flipping over. We have been in that camp before, then the HD DVD camp pulls out a surprise as they did with Paramount a couple months ago. Definitely the winds are shifting to Blu-ray but nothing done yet.

Daniel Ernst - Hudson Square Research

HD or high-definition DVD overall as a percentage of your subs, is it a meaningful percent of your subs that are using one or the other?

Reed Hastings

Not yet. Maybe a percent of subs yes, but meaningful percentage of shipments, not particularly because there is not that much content released on it yet. But in terms of subs it’s definitely growing. I would say we have a big crew of Internet connected early adopter, savvy subscribers. So they are going to be all relatively early.

Operator

Your next question comes from Bill Lennan - Broadpoint.

Bill Lennan - Broadpoint

Can you give us an idea of what you are expecting ARPU to be in Q1? Going backwards in the ending subs, assuming some trials and I am coming up with ARPU ticking up sequentially; that doesn’t seem right to me?

What’s your best guess for how many subs Blockbuster ended ‘07?

Barry McCarthy

We don’t guide to ARPU but I will give you some color. I will remind you that there tends to be in the fourth quarter new subscriber growth is back-end loaded and they become paying subscribers early in Q1 and generate revenue throughout the quarter.

New subscriber growth in Q1 tends to be front-end loaded and they become revenue-paying subscribers early. That tends to move the revenue per sub number in a way that’s different than you see in the rest of the quarter or the year. Every year we face the same question where ARPU moves in a way more positively that puzzles investors.

We continue to expect over the long term ARPU to move down until the mix by price point of new subs and installed base normalizes, but you may see some seasonal fluctuation due to the number of revenue months per sub.

Reed Hastings

You asked on Blockbuster, they probably went down modestly, but I don’t know. We don’t have any specific information about it. So we will wait and see what they talk about on their call.

Bill Lennan - Broadpoint

Would you guess it’s like a net loss of 100 versus 500 if you had to pick one or the other?

Reed Hastings

That’s a really good question to pose to them. I think we want to really stick to reporting on our metrics. They were very aggressive at converting store-based customers to store-based subscription rental with an online component. When they changed pricing last quarter there lost some of those subscribers and it is reasonable to expect that trend will continue for a while, I suppose.

Operator

Your next question comes from Andy Hargreaves - Pacific Crest.

Andy Hargreaves - Pacific Crest

The LG partnership, I am wondering as you guys looked at the CE space, can you talk about at all what you weighed in terms of whether or not to partner or whether or not to build hardware yourselves? What was the determining factor in ultimately partnering?

Reed Hastings

We never thought about not partnering, so it was only we also have our own thing in addition to all of the partners and what we came to realize is there was enough partner interest and enough consumer interest that we researched that we really didn’t need to do our own thing also.

Andy Hargreaves - Pacific Crest

Can you give us any insight into how the real estate on the device will be put out or how you guys will show up?

Reed Hastings

In the press reports LG released, essentially the home page screen you see Netflix as one of five icons there; the other being music and another being playing the DVD, I forget the other two. But you can get a sense there for the prominence of Netflix from that.

Andy Hargreaves - Pacific Crest

Back to Blu-ray, can you just give us a sense for how you think the pace of adoption, now that the format is more or less decided, how that affects your content acquisition costs? Does it have a material effect if Blu-ray players start growing a lot faster?

Reed Hastings

You are assuming that Blu-ray is going to win there and I made the mistake -- I don’t know, a year or two ago before the HD DVD camp flipped Paramount – of thinking the same. So remember that we are all judging it by studios and if they manage to flip another studio to their camp then we’re back to stalemate again.

But if one format, presumably Blu-ray, takes off that will have an effect; the Blu-ray disc costs a little more so that will have an effect upon us in terms of content costs. But also the perceptions of consumer around HD are that every other HD option costs them more. So for example, video on-demand HD usually cost $5 or $6 instead of 4; or video or HD channels from Comcast and others cost an additional supplement.

It may be that we have room to be able to do HD-specific pricing as we get to volume on this because the competition for the consumer retention on HD is all around that also. So that is something we will know you know more maybe by the end of the year as we look at the success of the HD formats.

Operator

Your next question comes from Brian Fitzgerald - Banc of America Securities.

Analyst for Brian Fitzgerald – Banc of America Securities

You mentioned the studios had sold exclusive rights to digital content to cable channels like HBO and Showtime. I was wondering what kind of timeframe you expect for this content to become unlocked?

Barry McCarthy

Well, there are some contracts that are up for renegotiation and some that haven’t been renegotiated and we will see how that shakes out over the next couple of years. I think we will have a clear view of that landscape certainly by 2010 and there are some negotiations that are happening now in anticipation of some expiry dates.

Analyst for Brian Fitzgerald – Banc of America Securities

I was wondering about the rationale for switching to an unlimited streaming plan? Is it because a lot of your subscribers were hitting against their time limits?

Reed Hastings

No, the primary rationale is to simplify the proposition. It’s now much easier to communicate unlimited DVD rentals plus unlimited streaming for one low price as low as $8.99 a month. You don’t have to explain one cap per hour and what happens if you run out of your hours in the middle of a show and what happens if four other cases. We found the power of unlimited is very strong with consumers, which means it’s a much easier and simpler proposition to market. So that’s the driving rationale.

Barry McCarthy

Back in October of ‘99 we had a cap on the DVD subscription program until we figured out how to manage the economics to a happy outcome for Netflix and a good user experience for subscribers. That promise of unlimited unlocked broad-based consumer appeal of the service and we are headed down the same path, unlimited usage for the Internet on delivering video as well.

Operator

Your next question comes from Barton Crockett - JP Morgan.

Barton Crockett – J.P. Morgan

Reed, just a follow-up question for the model. You guys will give us in disclosures or other conferences year-to-year change in mailings and year-to-year change in postage and packaging expense? Can you give it to us now?

Barry McCarthy

No.

Reed Hastings

It comes out in the K.

Barton Crockett – J.P. Morgan

Are you saying you are waiting for the K on that?

Barry McCarthy

Yes.

Reed Hastings

That’s right.

Operator

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

Reed Hastings

Thank you everyone for your support and I look forward to speaking with you again over the quarter and at the next call.

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Source: Netflix, Inc. Q4 2007 Earnings Call Transcript
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