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Executives

Deborah Crawford - Vice President, Investor Relations

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

Barry McCarthy - Chief Financial Officer

Analysts

Douglas Anmuth - Lehman Brothers

Tony Wible - Citigroup

Lloyd Walmsley - Thomas Weisel Partners

Heath Terry - Credit Suisse

Netflix, Inc. (NFLX) Q1 2008 Earnings Call April 21, 2008 5:00 PM ET

Operator

Good day, everyone and welcome to the Netflix first quarter 2008 earnings release conference. As a reminder, today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Deborah Crawford, Vice President of Investor Relations. Please go ahead, Madam.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix's first quarter 2008 earnings call. Before turning the call over to Reed Hastings, the company’s co-found and CEO, I’ll dispense with the customary cautionary language and comment about the webcast for this earnings call.

We released earnings for the first quarter at approximately 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 3:30 p.m. Pacific Time today.

We will make forward-looking statements during this call regarding the company’s future performance. Actual results may differ materially from these statements due to risks and uncertainties related to the business. A detailed discussion of such risks and uncertainties is contained in our filings with the Securities and Exchange Commission, including our annual report on Form 10-K filed with the commission on February 28, 2008.

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

Reed Hastings

Thank you, Deborah and welcome, everyone. Our goals in Netflix are simple -- to be a great Internet movie service by combining DVD by mail with Internet streaming and to deliver growing EPS and subscribers every year. In Q1, we made significant progress on those goals and our momentum is reflected in our increased subscriber guidance for 2008.

We currently expect at the midpoint of our guidance 9.4 million subscribers by year-end, an increase of 26% from 2007. In terms of EPS growth at the midpoint of our guidance, we expect $1.23 in EPS for the year, up 27% from 2007.

In Q1, the most telling metrics were subscriber net additions at $764,000; SAC at least than $30; and churn at 3.9%. All three were record performances over our six years as a public company.

We’ve been executing very well for many quarters as we steadily improve our service metrics, our customer satisfaction, and our competitive strength. Q1 was consistent with this strong trend as opposed to something new, but in late December our most direct competitor further rationalized their pricing, which contributed to our Q1 surge in growth.

Some of the positive impact from our competitor’s price hike will be long lasting and some of it was a one-time benefit that had their subscriber base responded to their price increase.

So while Q1 was an all-time record in net additions, we don’t expect Q2 to be a record second quarter, or 2008 to be a record year in terms of net additions.

In addition, we are planning on spending slightly less on marketing over the next three quarters than in the comparable periods of 2006, our biggest net additions year. We are very pleased, however, with our strong growth expectations of approximately 160,000 net adds for Q2 and 1.9 million for the full year, assuming the midpoint of our guidance, because these growth levels are allowing us to aggressively fund our instant watching efforts.

On the industry front in Q1, the high def format war ended, which is great for consumers and great for those of us with a vested interest in disk-based movie watching. Over the coming years, Blu-Ray DVD players will fall in price and become more widespread. With the success of Blu-Ray and its emerging economic importance to the studios, the DVD market is more likely than ever to remain enormous for many years into the future.

As you are aware, purchasing Blu-Ray DVDs costs more both at retail and wholesale than standard definition DVDs, and consumers are used to paying more for high-definition content in every other channel, including video rental stores, video-on-demand, and cable channels. Because of the higher cost of Blu-Ray and the consumer expectations around high-def content, we are planning on implementing a modest monthly premium for access to Blu-Ray some time this year.

Today the percentage of our subs who rent Blu-Ray is in the low single digits but it is sure to grow going forward.

While the success of Blu-Ray is important to us, just as important are the improvements we’ve made to watching instantly over the Internet. Our selection continues to grow and we now have over 9,000 movies and TV episodes available. Today our instant watching functionality is only available on Windows PCs, which works well for our subscribers who are comfortable watching video on their laptops and for our technophile members who hook up their computers to their TVs.

We’ve been happy -- we’ve been very happy with the response to date amongst these groups and viewing is growing rapidly. For many subscribers, however, watching instantly will expand in relevance as we make TV viewing easier and cheaper.

As we talked about last quarter, we’ve adopted a partnership strategy in terms of Internet TV connectivity. As we increase our online content spending, our service becomes more attractive to consumers, which in turn makes us more attractive to CE partners. In particular, we want our client software integrated into Internet connected Blu-Ray players, game consoles, TVs, and standalone set-top devices.

In January, we told you we were working with LG Electronics for a second half of 2008 product launch. At this point, I can tell you we have LG plus three additional partners actively working on integrating our technology into their products.

Three of the four partners are major companies which each sell millions of devices per year and will enable the Netflix functionality in some of those devices likely in Q4 of this year.

The fourth partner is a small company with which -- which will likely launch sooner than Q4.

Understandably, there has been investor excitement -- and along with it rumors -- about who we’ve partnered with. Despite our great success attracting major partners, about which you’ll see announcements in the coming quarters, these partnerships only demonstrate our success at providing Internet delivered content to our subscribers at no additional charge. Nothing about these agreements will be material to our financial results for the foreseeable future.

While our efforts are a necessary first step as we expand into Internet delivery, providing free access to content is not a long-term formula for profitable growth.

My second observation is that while we are off to a good start, providing consumer access to Internet delivered content on their TVs will require many partnerships in addition to the big ones to be announced this year.

My third and final observation is these partnerships have some execution and implementation risk, as with all new technology. We’ll take it year by year and model by model as we and our CE partners come to understand the opportunity better.

The big challenge for us remains the same as it was when we first launched our Internet deliver initiative -- to satisfy ourselves and our shareholders that our online content spending will result in increased subscribers and profits.

Despite my warnings to you about the many hurdles ahead, I would say we are thrilled with the progress we have achieved to date. Of course, as we succeed at new and improved consumer models for online movie enjoyment, we are sure to attract more competition.

Our competitive advantage is that if a consumer spends time on the Internet and enjoys movies, they are likely to be or become a Netflix subscriber. As we grow a larger subscriber base, our ability to offer both online streaming and DVD by mail at one low price means that we have a major advantage over any standalone Internet delivery service, at least for the many years ahead while DVD is significant.

In addition, the Netflix website, which we constantly improve, includes billions of movie ratings, millions of customer reviews, and an engaged community which makes it particularly well suited for choosing movies to instantly watch.

Let me wrap up where I began -- our goals are to be a great Internet movie service by combining DVD by mail with Internet streaming and to grow subscribers and EPS every year. The midpoint of our 2008 guidance of 27% EPS growth and 26% sub growth showed the effectiveness of our approach.

And now I’ll turn the call over to Barry.

Barry McCarthy

Thank you, Reed and good afternoon, everyone. Three quarters ago on the July earnings call, we announced a price cut on some of our most popular subscription plans. Lower prices, we said was an investment in faster growth. Faster growth is also what we expected when we raised guidance in February of 2008. Faster growth is what we reported today and faster growth is what we are forecasting for the remainder of 2008, both because of the ongoing benefits from lower prices and because of the current competitive environment.

For the first time in six quarters, we saw an acceleration in year-over-year sub growth in Q1 to 21%. Gross and net subscriber additions set an all-time high. Churn returned to its all-time low of 3.9% and SAC reached a six-year low of $29.50. Looking back on our history as a public company, I would say that on balance, this was one of our strongest quarters.

We even saw strong growth in the Bay area, our highest penetrated market, where household penetration reached 18.6%, up from 17.6% in Q4. Growth was also strong in the rest of the country where average household penetration reached 7%, up from 6.3% in Q4.

My remarks today will cover our Q1 performance; next I’ll talk about our updated guidance for the remainder of the year; and lastly, I’ll comment on the $150 million buy-back we announced in March. And rather than repeat the information presented in today’s earnings release, my comments will focus instead on four metrics. These are gross margin, marketing spend, other income, and free cash flow.

Gross margin of 31.7% declined 210 basis points sequentially in Q1. All of the decline was caused by a seasonal increase in disk usage, which resulted in higher postage and packaging expense and fulfillment expense in the quarter. These costs were partially offset by an expansion in margins related to content cost, which declined sequentially as a percent of revenue. The seasonal increase in usage in Q1 was in line with our expectations.

Marketing expense of $55 million increased $3 million sequentially but declined by $17 million on a year-over-year basis for reasons that I’ll explain in a moment. But first I want to remind you that not only was this quarter’s SAC of $29.50 the lowest it’s been since Q1 of 2002, but it also declined 15% sequentially and 38% on a year-to-year basis.

Lower SAC was driven by changes in the competitive environment combined with the July 2007 price decrease, both of which contributed to better response rates to Netflix advertising and more organic growth.

For the remainder of the year, we expect lower marketing expense on a year-over-year basis, along with faster subscriber growth. Given the trend towards lower SAC over the last two quarters, the question investors often ask me is why aren’t you spending more money on marketing to grow faster. The answer is we are investing more to grow faster -- quite a bit more, actually, so let me explain where.

Last July we said there were two ways to invest in faster growth -- one, more marketing spending or two, price cuts. The path we chose was price cuts and judging from our accelerated growth these past two quarters, the investment seems to be working well.

Interest and other income of $7.7 million grew 55% sequentially in Q1, as we realized $4.3 million in gains from the sale of short-term investments. Next quarter and for the remainder of the year, we expect other income to consist primarily of interest income without the benefit of additional one-time gains.

Free cash flow of $4.7 million in the quarter was $22.7 million better than the negative cash flow we saw in last year’s first quarter and several million dollars better than we expected. Like last year, we saw a decline in free cash flow from Q4 to Q1. This seasonal decline was caused by a decrease in cash from operations as gift subscription sales slowed. We also increased our CapEx spending on content to support new subscriber growth and brought 80,000 square feet of new office space online here in Los Gatos.

That concludes my comments on our Q1 performance and now I’d like to share a few observations about guidance. Like last quarter, our guidance for the balance of 2008 assumes the market continues to grow. As in past years, we expect much of our subscriber growth will be front-end and back-end loaded in Q1 and Q4 respectively, reflecting the historical pattern of seasonal growth.

For the same reasons, we expect Q2 will again be our slowest quarter of subscriber growth. We expect to end Q2 with 8.3 million to 8.5 million subscribers and to end the year with an upwardly revised 9.1 million to 9.7 million subscribers.

Revenue growth will continue to lag subscriber growth on a year-over-year basis throughout 2008 because of the price reduction we implemented in Q3 of last year. But we expect both subscriber growth and revenue growth to accelerate on a year-over-year basis in every quarter of the year, with the growth of the growth accelerating in Q3 as the effects of last year’s price decrease disappear. In other words, the second derivative will increase a bunch in Q3.

Gross margins will remain steady for the calendar year with a slight up-tick in Q4 despite the cost of our growing library of content rights to Internet delivered movies and TV content, and despite an expected increase in postage expense of $0.02 per round-trip mailer beginning next month.

With respect to guidance, I want to make a brief comment about expected tax rates. We’ve determined that some of our research and development efforts in recent years qualify for federal and state tax credits. We anticipate filing appropriate refund claims in Q2. The credits attributable to 2007 and prior years will be recorded as a one-time benefit in Q2 and those benefits will lower our effective tax rate in Q2 to roughly 26%. For Q3 and Q4, we expect the tax rate to return to a normalized rate of 41% because these tax credits are no longer available at the federal level.

And finally I would like to provide an update on the status of our stock buy-back programs. During the first quarter of 2008, we announced and completed a $100 million buy-back program, repurchasing 3.8 million shares at an average cost of $25.99 and raising our cumulative share repurchases to 8.6 million shares at a total cost of $200 million and an average cost of $23.31 per share. In March, we announced an additional share repurchase program of $150 million. All $150 million remains available to buy back shares.

In closing, I would like to summarize my remarks this way; we are off to a strong start in 2008. Operating results were strong in Q1. We’ve reported strong results for three consecutive quarters and this momentum is reflected in the upwardly revised subscriber guidance issued in today’s earnings release.

Today we reported record growth in gross and net subscriber additions, a reacceleration in subscriber growth, the lowest SAC we’ve ever reported as a public company and record low churn. These metrics show the model is working well.

At the same time, the market for DVD by mail subscription services remains strong and the competitive landscape remains favorable. Finally, as Reed mentioned, we are on track with our expansion into Internet video delivery and pleased with our success to date.

That concludes my prepared remarks. Thank you all for joining us today and now Operator, I think we’re ready to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Douglas Anmuth of Lehman Brothers.

Douglas Anmuth - Lehman Brothers

Thank you. I have two questions. The first one is regarding Blockbuster’s online subs. Can you just talk about how you would think about them if they were potentially to come for sale in the market?

And then secondly, in terms of the profitability outlook that you have for 2008, it’s a little bit lower than we would have expected, given some of the increase in subscribers and also in revenue. What else in particular is keeping down the profitability a little bit and how much is that due to higher-than-expected digital spending for the year? Thank you.

Barry McCarthy

Let me do the second part of the question, which is profitability and I’ll flip the first part of the question over to Reed to do with the Blockbuster online subs in the event of sale. So with respect to profitability, the model from our perspective, from an operating perspective is actually performing extremely well. And to the extent that earnings for the calendar year are on a trajectory less than you were expecting, probably the differential relates to the amount of spending that we are actually doing as compared with your forecast to bring on stream the capability to deliver movies over the Internet to different devices. Primarily the spending is on the content side and as Reed said and I reiterated, we’re enormously pleased with the progress we are making there.

Reed Hastings

A couple of years ago, we were able to work out a soft landing for walmart.com because they had made a strategic decision that it didn’t make sense for them. If for some reason Blockbuster made such a decision, we could probably work something out but it’s -- they’ve been in the business for a couple of years. They’ve got a big investment in their model. I would anticipate them to stay in the business for the foreseeable future.

Douglas Anmuth - Lehman Brothers

Okay, great. Thank you.

Barry McCarthy

Let me make one additional point about profitability; people who have been following us for a long time realize this and investors who are new to this story may not -- because we expense 100% of the cost of acquiring subscribers when they walk in the door, their tends to be an inverse relationship in the current period between subscriber growth and profit, to which several orders before an acquired subscriber becomes profitable. So to the extent that subscriber growth is running stronger than forecast, that pressures in the current period the P&L.

So if for instance our subscriber growth is stronger than you were forecasting, it stands to reason that our net income would be lower than you were forecasting.

Douglas Anmuth - Lehman Brothers

Thank you.

Barry McCarthy

Next question, Operator.

Operator

Just one moment. I apologize. We are experiencing some technical difficulties. Please stand by.

Barry McCarthy

Operator, if you want to e-mail us the next question, maybe we could answer it that way.

Operator

Just one moment.

Deborah Crawford

So a more productive way to keep this moving might be to have people e-mail me the questions, and my e-mail address is dcrawford@netflix.com and then we can just address them in order.

Reed Hastings

Okay, and if the Operator comes back, we’ll flip back to the voice.

Operator

Thank you, Ms. Crawford and I will let you know when our computer system has updated.

Barry McCarthy

So we’ll see which analyst can type their Blackberry message fastest to us.

Deborah Crawford

Okay, so Brian Pitz at Bank of America; can you talk about where the growth in subscribers is coming from? Is it from offline or new users? To what extent did Hollywood Video impact your growth?

Reed Hastings

Brian, certainly Hollywood’s closures of stores helps but when we’ve done specific studies of neighborhoods, we haven’t seen a super strong correlation, so I’d call it a positive background influence as opposed to a specific big driver.

We definitely saw a positive increase beyond our initial expectations for the quarter because of the Blockbuster price increase, so that was the other contributor. Other that than, no material difference from the standard flow of the past couple of quarters.

Deborah Crawford

Okay, Brian, I’m going to do one more for you and then I’m going to keep going. Next question from Brian at B-of-A; can you comment on if you have seen any decrease in online advertising, CPC, CPM rates, due to a weaker economy?

Reed Hastings

No material change for us in the advertising climate.

Deborah Crawford

Dan Ernst at Hudson Square; can you quantify online spend? Where is it accounted for?

Reed Hastings

Online content, I think that is, Barry.

Barry McCarthy

Assuming that the question is online content, Dan, it’s accounted for in the cost of revenue line.

Deborah Crawford

Okay, from Michael Olson at Piper; when you said gross margin will remain flat for the rest of the year with a slight up-tick in Q4, just to clarify, are you saying Q2 and Q3 gross margin will be flat with Q1?

Barry McCarthy

I am, yes.

Deborah Crawford

Second question -- what kind of devices will the partners integrate Netflix with? Is it standalone set-top boxes or devices that consumers are already buying, like flat panel TVs or Blu-Ray players?

Reed Hastings

Where we see the largest opportunity in multi-function devices, such as Internet connected TVs, Internet connected Blu-Ray players, Internet game consoles, but the set-top into standalone is a little more flexible. So some of the early partners may do those because they are easier to get to market but it will be a mix and over time I think the volume will be in a hybrid devices.

Deborah Crawford

This is from Heath Terry at CSFB; with the benefit from the lower tax rate to net income, why isn’t there more of a positive impact to net income guidance? Is there an offset in some other part of the expense structure?

Barry McCarthy

No, there is no offset someplace else in the expense structure, except that we continue to invest strongly in growth and we continue to invest strongly in delivering ED content to increase the number of titles that we’ve licensed. So said in the alternative, if net income -- if we forecast lower net income as a result say of a higher tax rate some place in the P&L we would be paring our investment in future growth.

Deborah Crawford

Okay, from Andy Hargreaves at Pacific Crest Securities, what other models are you considering for instant watch? Do you expect to have a distinct model for CE customers versus current customers?

Reed Hastings

Andy, I’m not sure exactly what you meant by CE customers so I am going to have to guess a little bit here but today, consumers who are Netflix subscribers can rent DVDs and in the same subscription for the same price, also watch movies on their PC. What we would like to be able to do is make that watch movies extend to be able to watch movies on other devices, so think of it as a different viewing option, not a different subscription or commercial option.

Barry McCarthy

It will fall under the subscription rubric.

Reed Hastings

As Barry said, all under the subscription rubric. Our focus as a brand is really around unlimited subscription entertainment.

Deborah Crawford

From Lloyd Walmsley at TWP; you increased your subscriber guidance but maintained net income guidance. Are you seeing something in terms of SAC or lower content cost making you comfortable you can increase subscriber growth and maintain profitability?

Second question -- are you seeing lower online advertising prices or is it content driven?

Reed Hastings

Do you want to do the first part, Barry?

Barry McCarthy

Sure. The model is more profitable than we were expecting it to be and that enables us to increase the growth and maintain the profitability. It’s also true that we are seeing better yields on the advertising we are doing and more organic growth, as I mentioned in my comments for this call, all of which enables the economic model to deliver incremental sub-growth without a deterioration in profitability.

Reed Hastings

And I think the extension of that, Lloyd, is that it’s not fundamentally -- it’s not that we’re getting lower CPMs materially; it’s that the CPMs we are buying are more effective with a better competitive climate and are increasing brand awareness and reputation.

Deborah Crawford

From Tony Wible at Citigroup; any change in thoughts on kiosks? Do you see them as potential viable distribution models?

Reed Hastings

I don’t see them particularly viable for us or important to us. They are viable. I think the will be around for a long time and as I said in the last call, they hurt us a little bit and they help us a bunch in terms of triggering store closures because the kiosks focus really on the top 50 titles. They are very new release focused in their business, so it’s a net benefit to us, we believe.

Barry McCarthy

And I would say absent a competitive threat to the economic wellbeing of the business, which we don’t see, we have the resources to make one large strategic investment and we’ve chosen to make that investment in growing our ability to deliver content over the Internet to TV sets and other devices, in lieu of reinvest doubling down in the physical world.

Deborah Crawford

Derek Brown from Cantor Fitzgerald, two questions; first, is watch instantly usage incremental to disk usage or replacement of disk usage or can you tell? Two, were BBI to go through with the acquisition of Circuit City, how could you see this helping/hurting your business?

Reed Hastings

On the incremental versus replacement, we can’t tell at this point. The types of consumers that are active users of instant watching are different types of users than others, so there is on clean control group. We are optimistic over time that there is only so many hours people are going to watch content that there will be a substitution effect.

Second in terms of Blockbuster and Circuit City, I’m not sure what it means. It’s just too early to tell. We’ll see what they decide to do.

Deborah Crawford

From Ken Smith at Munder Capital; can you comment on average revenue per subscriber? It appeared to be down sequentially quite a bit.

Barry McCarthy

Two comments; one is I think sequentially, no, not so much -- at or on par with prior quarters. And secondly, you may recall that there have been sources of ancillary revenues from advertising and from an affiliate called Red Envelope and both those lines of business pared back their revenues, and so it made the drop in ARPU look different than it would have looked if you were looking strictly at the ASP for the subscription business, which was almost flat. So I’m not concerned about it. I would encourage you to not be either.

Said differently, no structural change in the mix by price point of new subscribers and no structural changes other than improvement in churn and the installed base.

Deborah Crawford

From Youssef Squali at Jeffries; on gross margin, 31.7% is the lowest you’ve had in seven quarters. Can you speak to why usage has increased?

Second question; Red Box is getting a lot of traction. How do you see your value proposition versus theirs?

Barry McCarthy

I’ll let Reed to Red Box and I’ll do usage. Usage is actually down. It’s down for two reasons; one because of the plan mix that sports lower price points and lower caps, and then secondly because of the aging of the subscriber base. And content cost in the aggregate have increased over what they have been say three years ago because of the investment we are making in the rights for Internet delivery.

So this really gets back to the question that Derek asked, which is about switching if any substitution between users of Internet delivered movies and TV content and DVDs and this is a real time experiment. We are driving strong growth and profitability from the core DVD business and in effect, investors have a pre-option for the moment on our ability to grow the business of delivering movies over the Internet to television sets and we’ll only know over time how we need to fine-tune that value proposition so that it works for consumers and works economically for Netflix.

So the short answer is the usage is the trend is down, up seasonally as we expected, exactly what we expected, and an increase in content spending around growth of the new initiative.

Reed Hastings

And Youssef, you asked about Red Box, I think I answered that. I think your question probably was just written before I did that.

Deborah Crawford

Next is from Jim Friedland at Cowen; will you disclose percent of customers using instant watching, target titles for year-end on instant watching? That’s the first question.

The second is quarter-over-quarter growth in R&D was up a lot in Q1 this year and last year. Is there anything seasonal about spending in R&D or should we expect a steady increase each quarter in R&D?

Reed Hastings

Jim, overall I would expect R&D pretty steady. We do do the annual salary reviews at the end of Q4 company wide, so maybe that’s a trigger for it.

In terms of usage, we’ve been very pleased with the adoption of the instant watching by our consumers but we’ve chosen to not give out specific metrics on that. Similarly with target titles. We are up to 9,000 titles, up from I think it was 2,000 or 3,000 when we launched a year-and-a-half ago, so we’ve made great progress and we continue to make great progress.

Barry McCarthy

Jim, I’ve been here from almost nine years and used to tease Reed that he never met an engineer he didn’t want to hire, but that notwithstanding, we’ve been pretty disciplined about the investment spending in R&D. We are growing it aggressively but those investments we’ve recouped in longer subscriber lifetimes and increased subscriber profitability with reductions in retention by making the features and functionality on the website more attractive to consumers and better help us utilize our investment in the DVD library, one.

Two, we also are making an engineering investment associated with driving content to the Internet and some of the increase you are seeing reflects that R&D investment. So the bulk of the investment spending to drive content across the Internet to TV sets and the like is content and the other part of that shows up in R&D.

Deborah Crawford

Daniel Ernst from Hudson just had a clarification; I meant can you quantify the level of online content spend?

Barry McCarthy

For competitive reasons, Dan, we are ducking that question.

Deborah Crawford

Next question is from Neil Warner at Fox Hill Capital; what percentage of your customer base do you think will be renting Blu-Ray by the end of the year?

Reed Hastings

Neil, I’d guess it’s still in the single digits. Christmas there will be a lot of players sold, so right at the end of the year, it’s a little bit of a fluctuation in improvement there but probably single digits.

Deborah Crawford

Okay, next question from Barton Crockett; ARPU declined Q-over-Q, thought had said before mix change leveling out, that not the case now? Wouldn’t seasonally the trend have been to increase? I don’t see that from here. That’s the first question.

Barry McCarthy

The mix change, I don’t think we’ve said in the past, Barton, that the mix change had leveled out and even when the mix change does level out, because of differences in churn rates due to different subscriber ages of new subscribers and old subscribers, there will tend to be a slight differential.

I think the majority of the change that you saw this quarter in ARPU is not due to revenue changes or pricing changes in the subscriber base. It’s due to ad revenue and other revenue, which in aggregate account for the decline in ARPU sequentially.

Deborah Crawford

Next question, also from Barton; $4.3 million non-cash gain from sale of short-term investments -- what was that? Was that contemplated in guidance?

Barry McCarthy

It wasn’t originally contemplated in guidance but as the quarter progressed, two things happened. We decided to increase our investment in marketing spending above the levels that we had forecast when we gave guidance. And then secondly, we forecast as the economy improves an increase in interest rates and from my perspective, it was a good opportunity for us to realize to realize a gain in our investment portfolio that might not be there in quarters to come. So we used the sale of the gain on the -- in the investment portfolio to in effect fund some incremental investing in additional marketing and faster growth, and to pull the P&L [cost in].

Deborah Crawford

From Doug Anmuth at Lehman Brothers; is there any significant change in your view on digital spend for ’08 versus what you thought three months ago? Question number -- let’s start there.

Reed Hastings

No, Doug. I would say our spending plan is about where we thought it would be three months ago and it does continue to proceed nicely for us. As we’ve seen the validators are the significant usage and it’s because we have a lot of online content that we’ve been able to get these great partnerships that we’ll be talking about later this year.

Deborah Crawford

Next question also from Doug at Lehman; any change in competitive landscape in the last three months? Seeing Blockbuster be anymore aggressive with spending?

Reed Hastings

Well obviously Blockbuster has changed many times and they may change again, but for the last three months, there have been fairly minimal amounts of marketing from Blockbuster.

Deborah Crawford

From Youssef Squali at Jefferies, and after this I think we can go to the Operator to see if there are any final questions. The last one that I have hear from Youssef Squali; your GAAP net income for fiscal year ’08 is unchanged but your GAAP EPS is lower. Why is that? Is it option related?

Barry McCarthy

Great question. Thanks for asking. Yes, it is. We use a treasury method and because the price of the underlying stock has -- the price of the stock has increased, under the treasury method it takes fewer options for a net exercise. As a result, the number of outstanding shares is assumed to be greater, which has resulted in I think it’s a penny decrease in the projections for EPS on the same GAAP net income.

Deborah Crawford

Operator, can we open it back up or do you want me to continue reading questions?

Operator

We can open it back up. (Operator Instructions) First we’ll hear from Tony Wible with Citigroup.

Tony Wible - Citigroup

Good afternoon. I was hoping you guys could comment on if you’ve seen any change in some of the metrics on some of the share gain subs, and some of the newer subs coming on, do they have any better or worse ARPU, margin, or churn trends? I know it’s maybe a little early on the churn question, but any color would be helpful.

Reed Hastings

No, we don’t see any difference in the character of the new subs and the share gain over Q1 than in prior quarters.

Tony Wible - Citigroup

And what do you still feel is the best use of cash after you burn through the $150 million roughly that’s remaining?

Barry McCarthy

More buy-backs.

Tony Wible - Citigroup

All right. Thank you.

Operator

Next we’ll hear from Lloyd Walmsley, Thomas Weisel Partners.

Lloyd Walmsley - Thomas Weisel Partners

I was wondering if you guys could comment on the landscape for digital content rights acquisition and in particular if you see any changes coming out of the new pay TV plans announced yesterday by Paramount, MGM, and Lionsgate? And then if you could perhaps as a follow-up to that just talk about how you structure those deals in terms of fixed costs versus variable cost driven by usage.

Reed Hastings

Obviously there’s a lot changing in terms of the specific new Viacom/MGM/Lionsgate initiative. It’s too early to tell what the impact of that will be in the marketplace. And then we contract for content, try to get the best deal we can. Sometimes that’s fixed, sometimes it’s pay-per-view, sometimes it’s other -- you know, a mixed model. So we’re pretty flexible on that in the search for a good deal.

Barry McCarthy

Operator, I think we’ll take one last question, if we have one. Otherwise we’ll --

Operator

We’ll take our final question from Heath Terry, Credit Suisse.

Heath Terry - Credit Suisse

Thank you. I was going to ask; the watch instantly customers that you’ve got, can you give us an idea of what kind of -- if you are seeing any difference in the churn rate among those that are using watch instantly and what kind of penetration you are getting for the service among the subscriber base?

Reed Hastings

You know, we’re really excited by the usage because you don’t keep using something unless you are satisfied with it. But again, without a control group to identify what to compare the churn to, you know the base of people who watch a lot of movies and watch content on their PC are different than the other subscribers, so we can’t tell you kind of the direct retention impact.

But we can tell you that the usage has really impressed us, that there’s many more people willing to watch a lot more content than we thought on the PCs and we are looking forward to then expanding that to the television and the more that people interact with Netflix, the more they feel good about it, consumers, and the more they tell their friends about it.

So I’m very confident that it’s a positive influence for us but I just can’t give -- without the control group, can’t give you a perfect sense of the size of that gap.

Heath Terry - Credit Suisse

Great. Thank you.

Reed Hastings

Thank you, everyone for joining us on the call. I’m sorry for those technical difficulties but you all got your questions in very well and look forward to talking to you over the quarter and then on our next call. Thank you.

Operator

That does conclude today’s Netflix conference. We thank you all for joining us.

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Source: Netflix Q1 2008 Earnings Call Transcript
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