Netflix, Inc.
Q2 2006 Earnings Call Transcript

Published: 24 Jul 2006

[Operator:]

Good day, everyone, and welcome to the Netflix second quarter 2006 earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Deborah Crawford, Director of Investor Relations. Please go ahead, ma’am.

[Deborah Crawford:]

Thank you and good afternoon. Welcome to Netflix's second 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 webcast for this earnings call. We released earnings for the second quarter at approximately 1

[Reed Hastings:]

Thank you, Deborah. Welcome, everyone. Our strategy is to grow our subscriber base as fast as possible while generating 50% annual earnings growth and to use our large membership to lead the Internet delivery of movies. Our goal is to exceed 20 million DVD rental subscribers in the 2010 to 2012 timeframe. Our Q2 results represent strong progress against these objectives, as consumers continue to discover the superiority of renting movies online. In terms of earnings, in our second quarter we delivered $17 million of GAAP net income, up from slightly less than $6 million one year ago. Year-to-date we have generated $21 million of net income. That leaves us in the advantageous position of being only $9 million to $14 million away from delivering on our full-year earnings commitment of $30 million to $35 million, which means we are able to invest more aggressively in growth for the balance of the year. In terms of subscriber growth in the second quarter, we finished with 5.17 million subscribers, up 62% from a year ago. This is our highest year-over-year growth rate in the past six quarters. While we are thrilled that the subscriber growth accelerated to 62%, we had thought we would be able to push it all away to 63%, or 5.22 million subscribers. This 1 percentage point difference in subscriber growth is attributable to our Q2 churn, which was higher than we wanted at 4.3%. Churn was as we expected through most of April, and then we got hit with higher churn in May and June. We are encouraged that in the first few weeks of July, churn has improved, but the elevated churn in the May/June timeframe cost us about 50,000 additional cancels. We believe the primary culprit in the temporary churn increase was seasonality, the onset of glorious summer from dark winter, which increases the churn proclivity during May and June in the colder parts of the country. In Los Angeles and San Diego, for example, where it is perpetual summer, we saw no sequential increase in churn from January to June. In contrast, in Chicago, Detroit and Boston, we saw a 10% to 15% increase in the cancel rate. In frigid Minneapolis, the cancel rate moved up about 20%. Why didn't we see seasonality in churn last year and the year before? Last year in Q2, our online competition weakened greatly and churn fell sharply, masking the overall seasonal effect. In Q2 of 2004, we took our $2 price increase and churn spiked, also masking the slight seasonal effect that quarter. Next year our forecast models will be even more accurate around this summer-onset phenomena. The second metric that you may be focused on is SAC, which reached a high point of $44. Higher SAC is the result of two factors

[Barry McCarthy:]

Thank you, Reed. Good afternoon, everyone. As Reed indicated, our second quarter results demonstrated continued progress towards our often-repeated objectives of 20 million subscribers and 50% year-over-year earnings growth. We also have said repeatedly that our overarching objective is to grow the subscriber base as quickly as we can within the parameters of our economic model and our commitment to deliver earnings growth beginning with this year's target of $30 million to $35 million. We have indicated that we'll do that by investing more in marketing when it is consistent with meeting our earnings objective. In my remarks today I'll focus on how our Q2 results match up with these objectives. I'll begin by reviewing our net income performance and analyzing the drivers of that performance. Next, I will discuss the relationship between our stronger-than-expected earnings and increased investment in subscriber growth. Then I will review our guidance for Q3 and Q4 and the full year 2006. Finally, I will conclude my remarks by talking about last quarter's secondary offering. First, net income. At $16.8 million, net income was exceptionally strong this quarter; the third highest in our history, nearly triple our profit a year ago, which was untaxed, and significantly above our guidance. On a pre-tax basis, Q2 was by far the most profitable in our history which shows, I think, the profit potential of our model. Two factors contributed to our strong profit performance

[Operator:]

Our first question comes from Gordon Hodge - Thomas Weisel.

[Gordon Hodge:]

Good afternoon. Just a couple of questions on content costs. Barry, I think you said something -- and I may have misheard it -- about nonrecurring content cost-savings helping the margin. I'm just curious if you could elaborate on that and when we could expect those to stop recurring? Also, if you could discuss revenue sharing versus the studios where you're purchasing disks

[Barry McCarthy:]

Sure. Gordon, I'll do the first part of the question, and I'll ask Reed to do the second part. From time to time, generally around end of term, there can be some one-time items that occur in the content area. We've had some in the past. We had a couple this quarter. I don't think we've ever commented on the size of those items, and I'm hesitant to do it this quarter. I would say they weren't material, but worthy of mention.

[Reed Hastings:]

No real difference in our relationships and terms; some studios prefer revenue share, some purchase catalog pricing. DVD pricing has been essentially the same pricing for ten full years now since launch in '97, so really no change. What does continue to improve is our ability to match people with the right content, to create value by merchandising catalog well. There's no big inflection point; we've just steadily gotten better each quarter at that.

[Gordon Hodge:]

As far as the rev share goes, to the extent you're renewing rev share agreements, are you trying to work digital into the mix, or is that a separate negotiation?

[Reed Hastings:]

It varies by studio. With some studios they put those two groups together in one, and in some studios those are very different groups. You get an introduction to the other group, but it's no more than that.

[Gordon Hodge:]

Thanks.

[Operator:]

Our next question comes from Heath Terry - Credit Suisse.

[Heath Terry:]

I was wondering if you would talk a little bit about what you're seeing in the advertising opportunities? You continue to learn more there, both as you take advantage of the advertising space on the mailers more, as well as some of the tests that you're doing on the site.

[Barry McCarthy:]

The mailers are sold out. Incremental revenue opportunities will come from potentially an increase in pricing; and secondly, to the extent we are able to develop revenues with advertising online. Having said that, our number one priority is to ensure that the Netflix subscribers have a great user experience. If we can find a way for advertising to coexist comfortably on the site without disrupting that experience, then we'll continue to pursue those opportunities. For the foreseeable future we'll limit the kind of advertising we accept on the site to movie-related content, and in that way we'll self-limit that revenue opportunity.

[Heath Terry:]

Does the very limited rollout that you've done in advertising on the site, does that suggest anything about what you've learned and maybe cause you to be more cautious about whether or not that's actually a real opportunity for you longer-term?

[Barry McCarthy:]

We are launched online, after a period of extensive testing. So we are comfortable we found a way for it to coexist well as part of the Netflix user experience. We're working on growing the revenues associated with online advertising as we speak.

[Heath Terry:]

Thank you.

[Operator:]

Our next question comes from Safa Rashtchy - Piper Jaffray.

[Paul Bieber:]

This is Paul Bieber for Safa. I was wondering if there's a specific area where you encountered difficulties spending the marketing dollars? Was it in TV, search display, or was it across the board?

[Reed Hastings:]

It's really a phenomena of allocating the money to marketing late. So, there's a spot market in each of these areas that's not representative generally of the underlying condition. So the spot market was not in all of those areas; there was no place to put the money that was as cost-effective as we insist upon. So we saved it up to spend in Q3 and Q4. When we give the marketing group advance notice, as little as 90-days advance notice, then they're very confident of their ability to invest it smartly. So think of it as just a timing issue.

[Paul Bieber:]

I have a quick follow-up. Can you comment on whether the usage patterns at the lower price points are similar in terms of renting new releases versus catalog DVDs of the other programs?

[Barry McCarthy:]

They are essentially, yes.

[Paul Bieber:]

Thank you.

[Operator:]

Our next question comes from Tony Wible - Citigroup.

[Tony Wible:]

I was hoping we can go over once again -- I know you went into it at the end of the call there -- the thought process between the marketing ad budget and the SAC. Are you guys saying that you target a solid marketing dollar now that you look ahead, or are you focusing on SAC? If it is a SAC number, is there a point at which you would say that there is a ceiling there?

[Reed Hastings:]

About a year ago at our Analyst Day, we went through our evolution at that point going forward to target an absolute marketing dollar. So, we allocate to our group a total amount of money to be spent. So that's definitely the way that we do it. However, they look at it also on a marginal basis, which is simply because it's in the budget, doesn't mean that they should spend it. So, for example, it doesn't get them to go buy Super Bowl ads, because we don't believe that that would be cost effective. So then they would just hold it back, we'd have more earnings than we thought and we'd spent it in later quarters when we can get more advance notice.

[Barry McCarthy:]

As the quarter unfolds, when we update our forecast, we think we're running ahead of forecasted profitability in the quarter. It may be that Leslie Kilgore and I will sit down and explore ways in which the marketing team could deploy those monies productively to acquire more subscribers. Depending on the timing, the amount and opportunities they have, she may or may not decide that they can put that money to work productively.

[Tony Wible:]

Thanks. Outside of the advertising, you had a lot of scale benefits that accrued in some of the other line items. Is there anything that you foresee in the next six months that would cause some of those scale benefits to persist?

[Barry McCarthy:]

Only two line item comes to mind specifically

[Tony Wible:]

Great. To be clear, the net income guidance you provided does take into account the rollout of a download solution, or the investments in download for this year?

[Barry McCarthy:]

Yes.

[Tony Wible:]

Thank you.

[Operator:]

Our next question comes from Glen Reid - Bear Stearns.

[Glen Reid:]

You talked a little bit about competition, both from the digital download emerging services, as well as Blockbuster Online and all the in-store ads. How do you view your competitive positioning relative to Blockbuster's in-store promotional model, and perhaps the lower SAC that they have? I guess we'll hear relatively shortly what their subscribers look like. Given that in-store option, how do you think of that in terms of your competitive positioning? Secondly, just on the digital download, it's all very nascent at this point, but there's been some chatter in the trade press about Amazon and, of course, Apple and iTunes getting in there. I'm curious to hear your thoughts on at what point you think those types of services, big players like that, start to have an impact and how you think you'd change your strategy, if at all, to respond. Thanks.

[Reed Hastings:]

In terms of Blockbuster's online efforts, the rental market is about $8 billion. If we think about four, six or eight years from now and we take an aggressive case and say it's all online and that ASPs by then with that big a market, stripped it down to $13, then that's about 50 million subscribers to add up to $8 billion of revenue. So there's a lot of room here for us to be hugely successful online and for Blockbuster to be reasonably successful in the number of subscribers. Their handicap is figuring out what to do with all the store real estate and how to make that evolution. But I think they've definitely gotten religion, that online is the path to the future. What they're doing is quite courageous; it's like going into a Southwest terminal and seeing something that says take Greyhound or something that's the opposite. You go into the store and it tells you to rent online. So it's a pretty extraordinary situation. What it's doing is growing the total online market faster than we thought possible. But except for a SAC impact on the margin, again we accelerated our growth this quarter from 61% last quarter to 62% year-over-year this quarter. So it's not coming out of us, it's coming out of store-based renters, which is most of the market, given that we're only 1 billion out of that 8 billion for this year. Your second question's on there's a lot of chatter about Apple, Amazon, et cetera. There is, and they'll launch services over the next month or next year. It will be a big competitive market. But again, if you look at music, where there's really great solutions for online music, and you think five years after the launch of these services, 90% of the revenue is plain old music CDs, that gives you a feel for how slowly consumers evolve to the solutions of which we in the elite tend to think are mainstream. They're not. So we really don't face any material risks in terms of digital downloading in the near term, in the next three to five years. In the long term there certainly is risk, and in the long term, steadily over this time, we're working on digital downloading to lead that market. But there's no effective competition from downloading today. As you know, the services that exist today that are well implemented, the movie download services, have had no traction over the last three years. So that's another independent indicator. Again, it's not because of mis-execution, which could always be fixed, it's because the rights for movies are mostly tied up in long-term contracts, and that the Internet doesn't get to the television in most homes in America. So those will be two long-term problems that take five to 15 years to fix, and that's when you'll see the market really start to evolve in digital.

[Barry McCarthy:]

Let me just jump in and observe that the market for licensing of content is bifurcated between TV content and feature film. So PVRs have done a tremendous job of disrupting the business model for television broadcast content, and that is becoming rapidly available on the Internet for download. But the content that they're waiting for is feature film content, and that is not.

[Glen Reid:]

Thank you.

[Operator:]

Our next question comes from Doug Anmuth - Lehman Brothers.

[Doug Anmuth:]

Barry, I was hoping you could just clarify on the gross margins. I just want to go back to what the upside drivers really were during the quarter, if it was to be more on specific revenue-sharing trends, or more on the usage levels. Can you give us some more clarity on usage levels on a year-over-year and QtoQ basis, at least directionally? Thank you.

[Barry McCarthy:]

I think the answer is in three parts. Usage was about what we expected. It's hard to have an informed conversation about usage levels as compared with prior years, because the customer mix is changing so quickly that it's almost impossible to normalize for. So the metric that we look at internally is revenue per paid disk shipment. As I indicated on the call, that revenue on a year-over-year basis actually increased. Now, since we don't disclose how many discs we've shipped to end customers, investors can't calculate that metric. But it helps inform us enormously about usage trends and the viability of the lower-priced plans that we've launched. Specifically with respect to margin improvement in the quarter, we had margin expansion on a year-over-year basis, both with respect to content costs and with respect to fulfillment costs; the fulfillment costs being reduction in the cost per disk shipment, so a reduction in operating costs. About 80% of the improvement in margin year-over-year came from content, with the balance coming from reduction in operating costs, which are scale-related.

[Doug Anmuth:]

Great, thank you.

[Operator:]

Our next question comes from Jim Friedland - Cowen & Co.

[Jim Friedland:]

Thanks. One of the questions is that with the extra money that you've made in Q2, it seems like there could be the potential for higher subscriber growth in the second half. So are you just being conservative on that? Are you worried about how Blockbuster might spend on marketing in the second half? Just two quick questions on accounting

[Reed Hastings:]

I don't think it's conservative, I think it's pragmatic in terms of the subscriber guidance. Because again, two years ago, 2004 our net ads were 1 million. Last year, 2005, they were 1.6 million. This year we're forecasting them at least 2.1 million. So that's a pretty healthy increase in net subscriber growth at the goal points of at least 6.3 million. So I don't think that's conservative, I think it's a hugely positive outcome. I'll turn over to Barry on the accounting question.

[Barry McCarthy:]

There were two questions, as I recall Jim, and correct me if I'm wrong. One was on G&A, were there one-time items? There were. As you know, we've been involved in some litigation on what's referred to as the Chavez matter. We were required to re-notice our subscriber base. We did that. The response rates to that re-notice were lower than we had expected, and so we adjusted downward some reserves that we'd taken associated with that matter, and that decreased G&A spending in the quarter. With respect to the tax rate, it was about 38% in the quarter due to some stock option exercising, and I would expect it for the balance of the year to be in the 40% range.

[Jim Friedland:]

So for the full year we should expect 40%, or for the second half 40% effective?

[Barry McCarthy:]

For the second half.

[Jim Friedland:]

Great, thanks.

[Operator:]

Our next question comes from Youssef Squali - Jeffries & Co.

[Youssef Squali:]

Thank you very much. Not to beat a dead horse here, but if you look at gross margin, what is embedded in your guidance versus the 37% you just had in this quarter?

[Barry McCarthy:]

We don't guide to gross margin. We don't guide to gross margin, so we have the flexibility to take it up or down, depending on where we think incremental investing during the quarter best serves us. It could be marketing, it could be service improvements. If it were service improvements and we were to significantly increase our investment in content, depreciation might go up and that would impact gross margin. We might grow faster because of it, but if we guided to a specific number, as we used to do historically, then the Street is unhappy that we miss and we're spinning our wheels trying to explain the strategic advantage and the tactical decision we made. So we just walked away from giving gross margin guidance as a consequence.

[Youssef Squali:]

I understand that. On the ARPU, ARPU was down by our math by around $0.70 or so, to $16.36 from $17.06. I think you said in your prepared remarks that the $5.99 service accounted for less than 5% of gross ads. But that also implies then that the majority of the subs did not come at $17.99, so they came somewhere at the $11.99 or the $14.99. Does that make sense?

[Reed Hastings:]

The most popular plan for gross subscriber addition remains the three-out $17.99 plan, but the other lower price plans are also very popular and have been for a while.

[Youssef Squali:]

From a relative basis, you're seeing more success with the lower priced plans, the $11.99, $14.99, than you're seeing with the $17.99. Is that fair?

[Reed Hastings:]

Only if you comp it against last year when those programs were new. But if you look on an absolute basis, again, as Barry said, the $17.99 has remained the most popular program.

[Youssef Squali:]

Great, thanks.

[Operator:]

Our next question comes from Dennis McAlpine - McAlpine Associates.

[Dennis McAlpine:]

Thank you and good afternoon. A couple of things. One, beating dead horses, I guess, when we talk about usage at $17.99, $14.99 and $11.99, if we make an assumption that the $17.99 customer gets six discs per month, can you comment relative to that, what the two lower-priced ones do? Do they do the same six or do they drop down?

[Barry McCarthy:]

We're not going to comment on that.

[Dennis McAlpine:]

Just directionally, do they come up to that same level?

[Barry McCarthy:]

We're not going to come comment on it at all.

[Reed Hastings:]

What we have said in the past is that the contribution profit from the $9.99 plus profit in absolute dollars, is approximately equal.

[Dennis McAlpine:]

Okay. As you look at the DVD library, it went up marginally in the second quarter versus the end of the first quarter, and your acquisitions were down a little bit, but still up significantly more than what you added to the library. Is there an expectation here that the number of discs in the library will level off at some point, and can you elaborate where that might be?

[Reed Hastings:]

Most of what you're seeing is simply due to seasonality in theatrical output coming to DVD. So historically, studios don't release the biggest hits in Q2. It tends to be Q4 and Q1, around the Christmas season. So there's no fundamental change or improvement in the way that we're buying or using content.

[Dennis McAlpine:]

At what point do you start expecting to make high-def DVDs available in either format, and what sort of an impact do you expect from that?

[Reed Hastings:]

We launched about two or three months ago HD DVD, so that went live. And then about a month ago we launched Blu-ray, along with those format launches. There's only a few dozen titles, so it's pretty inconsequential financially. In general, our view is that high-definition, adoption of either format over the next five years will be fairly slow and steady. So at the current estimates of what the prices will be, there will be no visible impact on the P&L.

[Barry McCarthy:]

I want to expand on Reed's response to the first part of your question with respect to usage under the plans and margin under the plans. We haven't actually updated investors on the comparability of contribution margin between the plans since the quarter when we first introduced the plans, and there were many questions about it. They were comparable at the time, but all of those plans have moved around quite a bit since. The gross margin, obviously, is more attractive, higher on the lower-price plans and the contribution profit margin on the lower-price plans is higher than the $17.99 plan. That is contributing to the increase year-over-year and QoverQ in gross margin. But it's also true that we're making a higher margin on lower revenue, and so in some instances, it's possible that we're making fewer dollars of absolute profit. That begs the question

[Dennis McAlpine:]

Good. Thank you.

[Operator:]

Our next question comes from Barton Crockett - JP Morgan.

[Barton Crockett:]

Great, thank you very much. I wanted to ask you a question about Blockbuster. If you could give us a little bit more color on what you were seeing out of their marketing approach that influenced your SAC spending? I know a lot of what they were doing was in-store, and presumably that wouldn't affect you. But maybe there was more online advertising. Related to that, in the first quarter you had as good a read, I think, as anyone as what they were going to do for net subscriber additions. Do you have any thoughts about their ability in the second quarter to hit their goal to grow net subs sequentially? Leaving that aside, turning to the movie downloading initiative, could you talk a little bit about strategically how you see proprietary linking to devices, like what Apple does right now with music and iTunes, how you see that playing out in movies, whether there could be a comparable linking that might be material in this business, or whether it's too early even to really think about that?

[Reed Hastings:]

We said that Blockbuster’s effect on our SAC was the lesser of the two affects; our increased spending being the dominant one. Blockbuster was spending online, I don't think much on TV, but online and then, of course, in store. Second, you asked about how will Blockbuster do this quarter. We don't know specifically. They'll report soon and we'll all find out. But it's a big market, and I think that they will be quite comfortable getting their 2 million subscribers that they set out as the goal, because it's growing the total online market. Third, you asked about proprietary downloading architectures. We'll give an update on our strategy on all of the downloading areas on the January conference call, so I'm going to hold off to answering that until then.

[Barton Crockett:]

Thank you very much.

[Operator:]

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

[Daniel Ernst:]

Good afternoon, thank you for taking the call. Two if I might. First, revisiting the usage, can you talk about your overall trend in usage per month across the different price plans? Then, if you looked at it on a like-for-like basis, or $17.99 versus $17.99, the new subs that you're getting today versus a year ago and two years ago, are you still seeing that boost in usage rates when they first sign on whenever margins are a over-pressured, or does that trend level off?

[Barry McCarthy:]

Usage does come down over time after an initial boost of enthusiasm, just as churn comes down over time, regardless of your plan. So the trends that we saw previously in the business continue today. I don't have any specific comments to make about historical trends in usage at the plan level.

[Daniel Ernst:]

Secondly, on the churn rate, chalking it up to seasonality, and that you hadn't seen that in the past, what gives you the confidence that this time around that the boost up in churn here was a result of natural seasonality?

[Reed Hastings:]

What gives us the confidence is that in the warmer areas -- Atlanta, Houston, Los Angeles, San Diego -- there was no increase in churn. It was isolated to the colder areas. When we look back in prior years, we can see the same phenomena in '04 and '05, it's just that we had never looked for it because we weren't trying to explain anything, because in those years we had large churn changes either from the competitive climate or from our own price increase. So now we're able to see it, we're able to model it and we'll model it in for next year as we should.

[Daniel Ernst:]

But on the other hand, you did expect churn to be higher than you had originally expected in the second half of the year. What is the cause for that?

[Barry McCarthy:]

Churn is one of those metrics, from a modeling standpoint, that's very difficult to recover from if you forecast it incorrectly. Meaning if you're excessively aggressive, and then you find yourself in the unfortunate situation of being below the midpoint in terms of subscribers, and having unhappy investors in a quarter in which you've got record profit and accelerating growth. So I think we would serve the interests of the Company and investors well if we were appropriately conservative, slightly less aggressive, in the way we model churn in the business, so we don't find ourselves in those circumstances. So that that is why in terms of our guidance being less aggressive than it was previously.

[Daniel Ernst:]

Fair enough. Thank you.

[Operator:]

Our final question comes from Charles Wolf - Needham & Company.

[Charles Wolf:]

I'd like to go back to marketing spend. Is it simplistic to think of it as spending until marginal revenues equal marginal cost? A related question is, can you differentiate between the customer acquisition costs of a $9.99 plan from a $17.99 plan?

[Barry McCarthy:]

This is as simplistic as thinking about marginal revenue equals marginal cost, although we don't spend up to the point at which the marginal cost equals the marginal contribution profit from a subscriber. That feels overly aggressive to us, but in theory, is the model that caps the amount of money we're willing to spend at the margin to bring in a subscriber. We don't attribute cost by plan; that's generally not how we market the service. There's a lead price point. People come in, they arrive at a landing page that offers them choice. So in summary, how do we think about it, we think about managing to average values.

[Charles Wolf:]

Okay. As a follow-up, do you find there is much migration from a lower-price plan to higher-price plans over time, or do people just simply stay with the plan they're on?

[Reed Hastings:]

Mostly they just stay with the plan that they're on. We're experimenting with making it more and more convenient to upgrade and downgrade. Those are on the margin effects as opposed to significant upside.

[Charles Wolf:]

Thank you.

[Operator:]

That does conclude our question-and-answer session. At this time I will turn the call back over to Mr. Reed Hastings for any closing remarks.

[Reed Hastings:]

Thank you all for listing. Again, to restate what I said before, we recognize that DVD will not last forever, but it really will be dominant for a very, very long time and we are incredibly excited about continuing to grow the DVD rental business as we gain a great position to expand into digital downloading. Thank you all very much.

[Operator:]

That does conclude today's conference. Thank you for your participation. You may disconnect at this time. To sponsor a Seeking Alpha transcript click here.