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Netflix, Inc. (NASDAQ:NFLX)

Q1 2006 Earnings Conference Call

April 24, 2006, 5:00 p.m. EST

Executives

Reed Hastings - Chief Executive Officer

Barry McCarthy - Chief Financial Officer

Deborah Crawford - Director, Investor Relations

Analysts

Lloyd for Gordon Hodge - Thomas Weisel Partners

Derek Brown - Pacific Growth Equities

Heath Terry - Credit Suisse First Boston

Glen Reid - Bear Stearns

Safa Rashtchy - Piper Jaffray

Tony Wible - Citigroup

Analyst for Youssef Squali - Jefferies & Company

Daniel Ernst - Hudson Square Research

Doug Anmuth - Lehman Brothers

Jim Friedland - Cowen and Company

TRANSCRIPT SPONSOR
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Operator

Good day, everyone, and welcome to the Netflix First Quarter 2006 Earnings Conference call. Today’s call is being recorded. At this time, for opening remarks and introductions, I’d like to turn the call over to Deborah Crawford, Director of Investor Relations. Please go ahead, Madam.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix’s first quarter 2006 earnings call. Before turning the call over to Reed Hastings, the company’s co-founder and CEO, I’ll dispense with the customary cautionary language and comment about the web cast 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 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 10K filed with the commission on March 16, 2006.

And now, over to Reed.

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Reed Hastings

Thank you, Deborah, and welcome everyone. At Netflix, our overarching objectives are to extend and accelerate our subscriber growth momentum while meeting our quarterly and annual profit goals and continuing to deliver an extraordinary customer experience.

I’m pleased to report that the first quarter of 2006 represented another strong step forward in the pursuit of these objectives, with excellent performance in all of the key measures of our business.

We generated $4.4 million of GAAP net income, the first time in our history that we have delivered a profit in the high growth first quarter. We grew our subscriber base from 4.18 million to 4.86 million, an all-time record increase of nearly 700,000 net new subscribers in a single quarter.

Our customer satisfaction was outstanding, and we have the lowest Q1 churn in our history.

This performance, together with developments in the broader marketplace, has strengthened our confidence in achieving our goal of 20 million subscribers in the 2010 -2012 timeframe, and 50% annual earnings growth for the next three to four years, starting with $30 million to $35 million of GAAP net income we intend to deliver this year.

Let’s talk about the most significant aspects of our strong Q1 performance.

First, we continued our outstanding customer satisfaction levels in Q1. We were number one in customer sat across all of e-commerce, as measured by independent consumer studies not commissioned by Netflix, and this showed, as we had the lowest Q1 churn in our history.

The first quarter tends to run seasonally higher in churn than other quarters because of the post-holiday surge in free trial subscribers, which is included, as always, in our churn calculations. A year ago, we saw 5.0% churn. This year, we were down to 4.1%, a year over year reduction of almost 20%, and our second-lowest level in history.

Our shipment speed and our new release availability are at amazing levels, and it shows in our falling churn. We expect to see churn continue to fall this year as we improve our service even more, as our large and growing subscriber base continues to mature, and as our lower cost, low return plan continue to be popular.

Second, in Q1, we were able to invest $53 million in marketing, up from $37 million a year ago, and yet generate $4 million plus in GAAP net income, compared to a loss of $9 million one year ago. In other words, our scale now allows us to rev up our subscriber acquisition engine and also generate profits.

Our only regret in the quarter is that we did not spend $2 million more in marketing, delivering even higher subscriber growth and have our earnings come within rather than above our guidance range.

Recall that with our strong subscriber lifetime value, well in excess of our SAC, that each incremental subscriber acquired now represents both more profit from the future and more subscribers in the future from word of mouth. Thus, the high strategic priority we put on growth within the context of meeting our profit guidance.

Third, our marketing investment remained efficient and productive. Each quarter, we spend as much on marketing as we can afford, and whether our subscriber acquisition cost is $35 or $45 has only marginal effect, given the strong lifetime value of a Netflix subscriber.

The efficiency of our marketing investment is partially due to our marketing expertise, and partially due to our high customer satisfaction, generating word of mouth subscribers. We generated nearly 700,000 net additions in a single quarter, an all-time record for Netflix, and the second consecutive quarter of record subscriber additions.

For the calendar year, we are now on track for 2.1 million net adds, taking us from 4.2 million to 6.3 million.

For purposes of comparison, in 2004, we had 1.1 million net adds. In 2005, we accelerated to 1.6 million, and this year, as I said, we expect to have 2.1 million net additions.

Interestingly, in our most penetrated market, our SAC is lower, and our rate of net addition continues to climb. For example, as the San Francisco Bay area reached 13% household penetration in Q1, we generated more net adds there than ever before. What we’re observing is that through strong word of mouth, high penetration levels in a market generate even higher penetration in that market.

In fact, in several high digital communities, such as Menlo Park, California, we’re now running at 22% household penetration, and we see no signs of saturation even at those high penetration levels.

These high penetration communities are not limited to California. Jamaica Plain in Boston is ringing in at over 19% of households subscribing to Netflix, and climbing every quarter. Moreover, the rest of the country is following the adoption trajectory of these leading communities quite nicely.

We are reaching subscriber milestones much more quickly than anyone expected, ourselves included. In 2002, with less than 1 million subscribers, we hit the goal of reaching 5 million subs in 2007 to 2009. We will cross the 5 million threshold this quarter, one to three years earlier than we forecast in 2002.

We are now focused on our path to 20 million subscribers in 2010 to 2012.

Now let’s talk about the broader industry and competition. To begin, we see a slowdown likely in DVD sales this year, as avid buyers become more aware of the onset of high-definition DVD but do not yet own a high-def DVD player. We’ve seen this phenomenon in the video game market where transitions to a new generation hardware platform cause a 10% to 25% drop in software sales for the year preceding the launch of a new platform.

Fortunately, DVD rental is unlikely, in our opinion, to be affected by this hiccup in DVD collecting. In the long-term, we believe the success of high-definition DVD will grow studio DVD revenue and the film market generally, as well as reconfirm the consumer’s love of the DVD format, and so we will do everything we can to help high-definition succeed.

In Q2, both HD DVD and Blu-ray are soft launching, in preparation for a larger retail push in Q4. We believe Microsoft sees studio support of HD DVD as very important to their game format battle with Sony. We also believe that X-box and Vista will support HD DVD more directly with every one of their product updates.

Therefore, since neither Sony nor Microsoft will concede nor win in this format war for at least several years, there will be a protracted competition which will hurt the adoption of high-definition DVD, despite everyone’s best intentions to avoid a format war.

There is, however, a practical solution. If all studios were to embrace both formats agnostically, consumers would be reasonably comfortable buying either format and presumably making their purchase decisions based on hardware, price and features.

Studios have supported VHS and DVD for years, so supporting two formats is not something new.

While two formats is not ideal, it is better than consumers delaying adoption of all high-definition formats while we wait for either Sony or Microsoft or Toshiba to blink.

As we previously announced, Netflix will carry both high-definition formats as titles are released, and high-definition access is free to Netflix subscribers for now. Last week, we started mailing high-definition DVD’s to our early subscribers. High-definition DVD is here today. It is our hope that the studios will consider support for both high-def formats and therefore make consumer adoption of either format safe.

Warner Bros. and Paramount have already started the movement towards agnostic support of both high-def formats.

Also on the studio front, Q1 saw the emergence of a new competitor to DVD sales, namely Download-to-Own, offered in the DVD window. This recent re-launch of the Movielink service is very nicely implemented technologically. The new release pricing is generally $20 to $25, and does not include DVD burn rights.

We believe this demonstrates the importance that studios attach to maintaining or increasing DVD sales price points, and the unlikelihood that the movie equivalent of the $0.99 song download will be offered in the next few years by the studios.

The most visible downloading service today is Movielink, owned by the major movie studios. If you look at its web traffic over the past two years, you can see it has remained fairly flat. While the next big wave is going to be high-definition DVD, someday Internet delivery will be important, and we are continuing to invest in our technology.

We talked on the last call and in subsequent investor presentations about the Internet and content challenges that prevent large, near-term movie downloading adoption. We won’t repeat them here, but we do believe we are making significant progress on our download efforts.

By the end of this year, we will communicate a clear timeframe for launching the additional option of internet delivery for Netflix subscribers.

Finally, on the competitive front, in Q1, Blockbuster stepped up advertising for their online service, and we estimate they added 200,000 net subscribers, from 1.2 million to 1.4 million.

This compares, as I mentioned earlier, to our nearly 700,000 net ads in the quarter, and means that nearly 900,000 households in total moved from store renting to online rentals in the quarter.

Our primary focus remains, as before, enhancing our superior service and continuing to outdistance our online competitor in terms of net additions.

The fact is, however, that our biggest competition remains local video stores, and the fundamentals in that market continue to weaken. As video stores close, more and more consumers go online for their movie rentals, and our available market growth, and the store-based economic model weakens, leaving us closing to the tipping point when the video store chains begin mass closures.

In conclusion, and for all the reasons I’ve outlined, we are measurably more confident than we have ever been in our ability to deliver $30 million to $35 million in GAAP net income this year, and 50% earnings growth for many years ahead.

Thank you for listening, and at this point, I’ll turn the call over to Barry.

Barry McCarthy

Thank you, Reed, and good afternoon, everyone. We continue to see strong momentum in our business, as we did last quarter and the quarter before that, and the quarter before that.

Once again, we exceeded our subscriber goals and profit expectations. For the second time this year, we raised our year-end subscriber guidance to reflect the acceleration we see in our business.

Last quarter, I told you that 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.

In the first quarter, we continued to make strong progress towards our long-term goals of reaching 20 million subscribers by 2010 - 2012, and growing GAAP net income by 50% year over year off a base of $30 million to $35 million in 2006. By way of reminder, this is a [fully-taxed] number.

My remarks today will focus on four areas. First, I’ll discuss the quarter’s performance. Next, I’ll discuss the accounting changes we made in our financial statements with the filing of our form 10K, and the impact of these changes on the current quarter. Then I’ll talk about our upwardly revised subscriber and revenue guidance for the full year 2006, and finally I’ll conclude my remarks by talking about our price testing and patent infringement lawsuit against Blockbuster.

At our analyst day last September, I showed a slide labeled “Scale Drives Profitability�?, and I made the point that the business is scaling and margins are expanding with scale. Our Q1 results illustrate that trend. In particular, there are four aspects of our business that I’d like to highlight in talking about our Q1 performance -- net income, subscriber acquisition cost, which I’ll refer to as SAC for the balance of my remarks today, gross margin, and free cash flow.

Let’s take them one at a time.

First, net income. For the first time in our history, Netflix was profitable in the first quarter of the fiscal year. A GAAP net income of $4.4 million exceeded the high end of our earnings guidance, which ranged from a loss of $1.5 million to a profit of $2.5 million. Historically, and again this year, subscribers grew rapidly in Q1.

In past years, this rapid growth was accompanied by an increase in marketing spending. In prior years, the increased marketing spending contributed to a net loss in the quarter. That was not the case this year. We realized the benefits of scale and produced a profit despite the increase in marketing spending. With perfect forecasting and execution, we would’ve landed earnings within the range of our guidance, and invested all of the surplus earnings in more marketing and faster subscriber growth.

But our expense forecasting wasn’t precise enough to better manager the trade-offs between subscriber growth and profit, and we overshot our earnings target by about $2 million at the expense of faster subscriber growth.

Lower SAC also contributed to the quarter’s out performance. Despite the fact that gross subscriber additions reached an all-time high in Q1, our second consecutive quarter of record gross additions, SAC was down this quarter. I think it’s worth noting that increased marketing spending by Blockbuster Online had no apparent effect on our ability to beat the Q1 growth and profit objectives we established for Netflix.

On the Q4 earnings call, I told you we would maintain SAC at about $40 in order to drive rapid subscriber growth as long as profit margins and churn remain healthy. We began the quarter expecting to see SAC at Q4 levels, but our marketing acquisition programs across multiple acquisition channels were more productive than we forecasted them to be. We expect SAC to return to Q4 levels this quarter and remain there, plus or minus 10%, for the second half of the year, depending partially on how aggressively we can invest and still meet our earnings guidance.

Now let’s discuss gross margin. In January, I told you we expected gross margins to decline in Q1 as we absorbed the cost of the postal rate increase and a seasonal increase in disc usage. The postal increase became effective in January and margins declined as we predicted. Usage also increased seasonally as we expected, and was the principal contributor to the decline in gross margin from Q4 levels.

Last year, gross margin improved during the calendar year. We expect this secular trend to continue this year.

As some of you know, we changed the way we define gross margin with the filing of last year’s form 10K. I’ll talk more about this change in a moment.

The final point I want to make about last quarter’s performance relates to free cash flow. Free cash flow of $11.7 million was significantly higher than we expected, as it was in Q4. Last quarter, I told you we expected free cash flow to turn negative in Q1 before turning positive again for the remainder of the year.

There were two primary contributing factors to the quarter’s strong cash flow performance.

First, we had higher revenues and higher profit than was forecasted. Second, and more importantly, certain DVD purchases and marketing spending came later in the quarter than we anticipated, which threw our payables and raised our free cash flow this quarter.

That late Q1 spending will hit cash flow in Q2, so the net effect across both quarters will be a wash.

The overall level of content purchasing in Q1 was about 20% of revenue, in line with expectations, and was not a contributing factor for the stronger-than-expected free cash flow in the quarter.

Now I’d like to briefly review the accounting changes we made in our 10K filing in March and their effect on our Q1 results.

We made two changes in the presentations of our financials in the 10K filing, which is here collected in the results we reported today. First, we reclassified for fulfillment expense in the cost of revenues. Gross margin declined as a result of this change, but the underlying economics of the business were unchanged.

Second, we moved revenues from the sale of previously viewed content out of total revenues, and the cost of content out of cost of revenues, and presented them on a net basis with other operating expenses. This change reduced reported revenues in Q1 by about $2.5 million. Without this change, we would’ve reported revenue of $226.6 million, and beaten the high-end of our revenue guidance for the quarter.

The guidance was issued before we made the accounting change, and we made these changes at the suggestion of the SEC.

Now I’d like to comment on our 2006 full-year guidance.

As I mentioned in my opening remarks, we continue to see strong momentum in the business today, and expect strong performance in Q2 and for the remainder of the year. This momentum is reflected in the 400,000 increase in the low-end of our subscriber forecast to 6.3 million subscribers, and in the $30 million increase in the low-end of our revenue guidance to $990 million.

However, we did not raise our earnings guidance, even though we’ve beaten the high end in each of the last two quarters. To explain why earnings guidance did not increase, let’s remember what we said last quarter, and earlier in my comments today. If we’re running ahead of our full year’s earnings guidance, we intend to invest in higher marketing spending to drive faster subscriber growth, and that’s because, as we’ve said consistently for some time now, we’re focused on growing as fast as we can within the parameters of our earnings objectives in order to reach 20 million subscribers and position the company to lead the expansion into digital downloading.

We would raise our full year guidance for earnings only in the unlikely event we couldn’t deploy the excess earnings at a marginal SAC that worked within the constraints of our economic model.

You saw us make these trade-offs between earnings and growth in today’s guidance increase. Before upwardly revising our subscriber guidance today, our forecast models had pre-tax earnings running ahead of our $50 million to $60 million guidance, pre-tax guidance, for the full year 2006. Today’s revised guidance redeploys those additional earnings to grow the business faster by acquiring additional subscribers, which increases the value of our business by accelerating future profitability.

In closing, I’d like to say a final word about price testing and the patent infringement lawsuit we recently filed against Blockbuster.

On the subject of price testing, we continue to test various pricing scenarios in search of models that generate more subscribers on the same 50% annual earnings growth that we see today. Because price testing isn’t visible on our website, questions about our pricing strategy have been top of mind for investors. We continue to monitor our test results and have made no decisions yet about new price points and plans. Today’s upward revision in guidance assumes no change in pricing and no new plan introductions.

As I said last quarter, if the test results convince us we can introduce new plans which enable us to grow faster and still meet our earnings guidance, we’ll launch those new plans and upwardly revise our subscriber guidance while we reaffirm our earnings guidance.

A few weeks ago, the U.S. Patent Office issued Netflix an additional patent, and that day, we filed suit against Blockbuster. The estimated costs of prosecuting this lawsuit are included in our guidance. The new patent is a continuation of the business method patent that was issued in June, 2003. These patents, among other things, cover our subscription rental service.

Suits like this typically take several years to litigate, but the value can be significant if we prevail. Of course, Blockbuster says the suit is without merit and, of course, we think Netflix has a strong case, the cost of which represents a small prudent, high leverage investment on our part.

Having said that, we remain focused on enhancing our superior service and continuing to outdistance our competitors in terms of subscriber growth.

In summary, Q1 was another quarter of record results for Netflix, our second consecutive quarter of record subscriber growth and record revenue, our second lowest churn ever, record high Q1 earnings, and record high Q1 free cash flow.

Last year our business outperformed our expectations and we raised guidance a total of four times. So far this year, we’ve raised our subscriber and revenue guidance twice to reflect the acceleration we see in our business, which is why I began my remarks today by saying we continue to see strong momentum and expect strong performance in Q2 and for the remainder of the year.

That concludes my prepared remarks, and now we’ll open the phones to questions.

Question-and-Answer Session

Operator

Thank you. Today’s question and answer session will be conducted electronically.

(Operator Instructions)

We’ll take our first question from Gordon Hodge with Thomas Weisel Partners.

Gordon Hodge - Thomas Weisel Partners

Hey, guys, it’s Lloyd in for Gordon. I was just wondering if you could comment a little bit on the mix of the $17.99 subs versus the lower-priced subs, and talk a little bit about the usage trends you’re seeing in those two different subscriber sets?

Reed Hastings

It’s Reed, Lloyd. We don’t break out the different plans, so we’re successful on matching subscribers to the plan that makes sense for them, and usage has been on plan and as we expected in both of those categories.

Gordon Hodge - Thomas Weisel Partners

Okay, thank you.

Operator

We’ll take our next question from Derek Brown with Pacific Growth Equities.

Derek Brown - Pacific Growth Equities

Thank you. I’ve got a question about content acquisition and the strategy around that. It’s certainly been a little bit more news related to you guys getting into the kind of exclusive content business, and I’m wondering your thoughts on that and your expectations for that going forward.

Reed Hastings

Sure. They’re fairly modest at this point. You know, we’ve got a team that’s working on it. We’ve been acquiring some small titles over the past couple of years, but it’s fairly modest today. It has the potential to grow into something interesting as we grow from 5 million subscribers to 20 million, and that’s why we’re investing in the confidence, getting our hands around it at a small scale today, because of its potential value when we have a 20 million subscriber platform.

Derek Brown - Pacific Growth Equities

Great, thank you.

Operator

We’ll take our next question from Heath Terry with Credit Suisse First Boston.

Heath Terry - Credit Suisse First Boston

You mentioned that you felt like Blockbuster had added a couple hundred thousand subscribers this quarter. Can you also comment, and you guys always seem to have a pretty good view into what’s going on there, as to how many more subscribers you feel you like they need before they hit break-even in that business, or how close to that they are?

Barry McCarthy

Sorry, they’ve got a call coming up in a couple of days, and I think that question is better posed to them.

Heath Terry - Credit Suisse First Boston

Okay, great. Then if you could also talk to us a little bit on what you expect to the extent -- that is, what you expect seasonality to look like over the next couple of quarters, both in regard to the subscriber acquisition cost that you gave, or subscriber acquisition cost that you get as well as the churn side of things.

Barry McCarthy

I’ll tell you, roughly like last year. I don’t see anything that is going to be materially different. Q1 tends to be the largest in total subs, and because of all the new subs, the highest in churn, and so it should roughly follow last year’s pattern.

Heath Terry - Credit Suisse First Boston

Okay, great, thanks.

Operator

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

Glen Reid - Bear Stearns

Hi, just real quick. You talked about, Barry, I guess the subscriber acquisition costs in the quarter, you know the drop-down to 38, 50, roughly, and I guess you’d mentioned that you’d gotten better response from some of your marketing initiatives. Maybe you could kind of detail for us, or a little bit more color on what sort of marketing channels you maybe tried to exploit more this quarter, and which ones maybe you found were more successful than others, just kind of help us out with what was going on there. Thanks.

Barry McCarthy

We’re actually using all channels all the time, with no particular emphasis on any one. The marketing budget has become quite large, so there was no particular emphasis on any one channel. I don’t have any particular color for you, and on a go-forward basis, we expect to utilize all of the channels fully.

Glen Reid - Bear Stearns

Okay, I guess maybe anecdotally, I’ve been hearing, you know, and kind of had seen sort of maybe towards the end of the quarter, a bit more sort of advertising on television. Would it be fair to say that you guys sort of watch the spot markets and, depending on how your subs are trending, will sort of be a little bit more practical and try to exploit some of those opportunities?

Barry McCarthy

Well, it has less to do with how subs are tracking than it has to do with the cost of acquisition and opportunities that Leslie and her team are seeing in the market place. So yes it’s true that if we see opportunities, and we have money to spend, we’ll go spend it, and if there aren’t opportunities, we won’t.

Reed Hastings

That’s true not only amongst TV, as you’re referring to, but between TV, direct mail, radio, online, wherever we see a bargain, then our marketing teams tend to push money in that direction.

Glen Reid - Bear Stearns

Okay then I guess one last thing. You’d said the subscriber acquisition costs will sort of get back to that fourth quarter level of about $40, plus or minus 10%, so that’s pretty consistent over the balance of the year, you’d expect to call it, $40 SAC or $42 SAC?

Barry McCarthy

Well, we don’t guide specifically to SAC, and whether we land at $38 or $42 isn’t a matter of great concern to us as we plan out the business. Reed articulated the reasons clearly, which is to say that whether it’s $38 or $42, that has almost next to nothing to do with the life and value of a subscriber. Now, it informs us a lot about our ability to make the earnings guidance we’ve given, but we care about the absolute level we’re spending, but less about the marginal cost.

Glen Reid - Bear Stearns

Okay, thanks.

Barry McCarthy

Provided that it works within the micro-economic model that we’ve set up.

Glen Reid - Bear Stearns

Sure. Okay, thank you.

Operator

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

Safa Rashtchy - Piper Jaffray

Hi guys, great quarter. A couple of questions. As you mentioned, Reed, or Barry, you mentioned, I guess, you are still testing prices. Can you give us some qualitative color on what you’re finding out? Are people still continuing to demand lower and lower prices? Is there some stability in the price thereabouts? What have we learned from the experiments you’ve had in pricing? Because it seems like you’ve left the door open for further price reductions, and I have a follow-up.

Reed Hastings

Sure, Safa, it’s Reed. We’re continuing to test -- you characterized it as what consumers are demanding, but it’s not really that dynamic. We’re the best value in the market already. What we’re finding is that when we push price down, that we see an elastic response of more subscribers and lower churn, and the question is does it pay for itself?

So in direction, it’s very positive and the question is as we balance out those factors, do we find any models that generate the same earnings stream that we’re looking at today with more subscribers, in which case we would tend to adopt that. It may be through all the testing that we conclude that the current family of price points is the optimal family of price points.

We wouldn’t normally talk about this in advance, except the price testing is so visible and so sensitive with investors who want to go in and know what we’re doing. Again, it may be that we conclude that we’ve got the optimal portfolio now, and maybe that we find one where we’re able to keep our earnings guidance and upwardly revise our subscriber guidance.

Safa Rashtchy - Piper Jaffray

Okay, and second, can you comment on what you’re seeing in terms of margins from the lower-based price packets? In the past, you had said that -- somewhat surprisingly, at least to some people -- those actually had high margins because of the lower usage. Now I understand seasonally this quarter is different, but it’s still within different price points, you have a way of comparing them. Are you still seeing that dynamic, or are margins not better anymore with the lower price points?

Reed Hastings

We still like what we’re seeing, Safa, and you can see that in the increased momentum in the business.

Safa Rashtchy - Piper Jaffray

Okay, and one last question then, can you give us an update on your plans for international expansion, especially in the U.K.?

Barry McCarthy

In the U.K, as you might have heard, is the two venture-backed independent private firms that lead DVD rental, that is LoveFilm and Video Island, agreed to merge, so that will happen. They’ll have about 65% to 70% of the U.K. market, and we don’t have any near-term plans at international, but the U.S. market is just so large and growing so fast, that we’re focused here for now.

Safa Rashtchy - Piper Jaffray

Okay, thanks.

Operator

We’ll take our next question from Tony Wible with Citigroup.

Tony Wible - Citigroup

Quick question, how much of the optimism in your guidance is relating to the improving rental industry trends that we’re just starting to now see over the past seven weeks, and what looks to be like a strong box office over the summer?

Barry McCarthy

None.

Tony Wible - Citigroup

None? And still presumably, they would be upsized from there, taking into account the 10% swing in the rental industry?

Barry McCarthy

No, our business isn’t very hits driven, and I think it’s much less dependent on box office than the store-based model because it’s so much less dependent on new release. We’re about helping people find good movies, which is not the same as helping people find new release movies, and the mix of new and back catalogue is practically unchanged today from the mix when we went public in May, 2002.

Tony Wible - Citigroup

So what’s the percentage from new release?

Reed Hastings

It’s about a third of the movies are new releases, and that’s been pretty consistent in the last four or five years.

A proof point to Barry’s point is last year, when other video chains were stating that their sales were off because the movie, the rental industry, etc., you know, we upwardly revised our subscriber guidance, so is shows you we’re unaffected on the down side, which presumably means we’re unaffected on the upside in terms of these swings of theatrical releases.

Tony Wible - Citigroup

Great. One last question is on the gross margin, not under the new method with the fulfillment costs included, but just looking at the content costs, is there a way to kind of pinpoint what you would say is the long-term potential for that margin, if we just kind of looked at some of the traditional in-store businesses, and you had kind of a 70% gross margin, what would you state in a long-term view on where the margins could head from here?

Barry McCarthy

I wouldn’t say. We haven’t given long-term guidance on it, and we don’t have a comment on it.

Tony Wible - Citigroup

Okay, great, thank you.

Operator

Youssef Squali calling, with Jefferies & Company.

Youssef Squali - Jefferies & Company

Hi, this is [inaudible] for Youssef Squali. Just a quick question on the free subs as a push into the trial subs, why are the clients sequentially… is it because the conversion rate was higher, or the free subscribers was just less this quarter?

Barry McCarthy

I think it’s just seasonal artifact. At the end of the fourth quarter, there were quite a few subs who sign up in the post-holiday rush, and those subscribers tend to roll off in the first couple of weeks of the first quarter.

Youssef Squali - Jefferies & Company

I see, and then a follow-up on the access program. How is that progressing? Could you add any color on that?

Barry McCarthy

Good. We’ve been actively selling ads on mailers for some time. That business is progressing well. We’ve been testing putting ads online on a targeting basis, and those tests are progressing well, so we’re quite pleased.

Youssef Squali - Jefferies & Company

Thank you.

Operator

We’ll go next to Daniel Ernst with Hudson Square Research.

Daniel Ernst - Hudson Square Research

Good afternoon, thanks for taking the call. Just looking again at the guidance. In this quarter, you under spent on marketing yet over delivered on subs growth, so presumably your ads spending was more effective than you anticipated, but yet you’re raising your sub target but not the earnings target, so are you assuming the effectiveness of your ad spending is reduced in the coming quarters, or is it just a degree of conservatism that colors the guidance here? Thanks.

Barry McCarthy

Well, in the first quarter, we actually increased during the quarter our marketing spending as compared with our plan at the beginning of the quarter, and we increased again in Q2 slightly our marketing spending during the quarter, so it’s true that on a per acquired subscriber basis, the cost was down a little bit, but in absolute dollars, the marketing spending is up, enabled by the overall profitability of the business.

Daniel Ernst - Hudson Square Research

Right, but if you do the math on that, you still had a slightly lower SAC, or SAC roughly in line. If we continue that trend, I guess I just have trouble coming to an EBIT level as low as you suggest, given the sub-growth and given the relatively nominal declines you see in ARPU. I mean, just given your current economic model and the top line numbers and what we know about your effectiveness in ad spending, it just seems hard to come to those numbers. Again, I think you did give the answer we want to hear, but if you could help us understand the guidance a little better, relative to how effective you’ve been the last couple of quarters.

Barry McCarthy

Well, let’s see, we have increased our marketing spending going forward as compared with our plans at the beginning of the year. As in past quarters, we have a fairly conservative assumption about the rate at which we’re going to acquire subs, meaning SAC, and if that rate proves to be enormously conservative, then earnings will run ahead of our forecast or, as the year unfolds, we’ll recapture those earnings and reinvest in it more marketing dollars and drive the sub growth even faster, and with perfect execution, that would be our preferred outcome.

Daniel Ernst - Hudson Square Research

Okay, thanks a lot.

Operator

We’ll go next to Doug Anmuth, with Lehman Brothers.

Doug Anmuth - Lehman Brothers

Thank you. Reed, I just wanted to clarify the comment you made about the fact that you communicate the product on the digital side by the end of the year, and I’m just curious why the timing is sort of at the end of the year, is that more a function of what is happening in the market? Is there anything in particular from a competitive standpoint that’s sort of forcing that type of time frame, or is it more just a product development thing from your end? Thank you.

Reed Hastings

It’s mostly product development on our end as opposed to anything external. It’s still going to be many years until this is a large market, but by the end of the year, we’ll be able to announce the time frames of our subscribers being able to get downloaded content from Netflix.

Doug Anmuth - Lehman Brothers

Okay, great. Thank you.

Operator

We’ll go next to Jim Friedland with Cowen and Company.

Jim Friedland - Cowen and Company

Thank you. Most of my questions have been answered, so just a quick question on drill down on usage. Reed, in terms of the free DVD products, you’ve noted in the past that those usage trends have been improving, so on a like for like basis, your free DVD customers in Q1 versus your free DVD customers in Q1 of last year -- flat, up or down, can you give us any additional color?

Barry McCarthy

Jim, it’s Barry. Down slightly.

Jim Friedland - Cowen and Company

Okay, and one other quick question on the tax rate, are you still targeting an effective rate of 41%?

Barry McCarthy

Yes, roughly. It could be 42%, it could be 41%.

Jim Friedland - Cowen and Company

Okay, great, thanks.

Operator

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

Reed Hastings

Thank you, Operator, and thanks to all of you for participating in the call -- look forward to talking to you over the quarter.

Operator

That’s it for today’s conference. Thank you for your participation. You may disconnect at this time.

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Source: Netflix, Inc. Q1 2006 Earnings Conference Call Transcript (NFLX)
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