Netflix, Inc.
Q3 2006 Earnings Call Transcript

Published: 24 Oct 2006

[Operator:]

Good day, everyone, and welcome to the Netflix third 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 to Deborah Crawford, Director of Investor Relations. Please go ahead, Madam.

[Deborah Crawford:]

Thank you, and good afternoon. Welcome to Netflix's third quarter 2006 earnings call. Before turning the call over to Reed Hastings, the company’s co-founder and CEO, I will dispense with the customary cautionary language and comment about the webcast for this earnings call. We released earnings for the third quarter at approximately 1

[Barry McCarthy:]

Thank you, Reed. Most of our listeners know that Netflix became public in May of 2002. In the four-and-a-half years that followed, we have grown our quarterly revenues from $36 million to $256 million, and subscribers from 670,000 to 5.7 million. Against this framework of historical performance, covering the 18 quarters that Reed and I have reported on quarterly earnings, our business model has scaled profitably. This quarter’s results are a great example of how well the model can perform. My remarks today will focus on the key drivers of our earnings performance this quarter. Then, I will talk about how we managed the trade-offs in Q3 between marketing spending, subscriber growth, and earnings, and lastly, before opening the call to questions, I will discuss our guidance for Q4 and for the full year 2007. Sometimes the numbers tell a clear story and this is one of those quarters, so my remarks today will be brief. Before I discuss the P&L performance, I would like to say a word about free cash flow. In Q3, we produced $22.3 million, the second largest quarter of free cash flow in our history. To put this in historical context, we have produced nearly as much free cash flow last quarter as we produced for all of 2005. For the 12 months ended September 30, we produced $64 million in free cash flow. I think this shows that our model is working well, even as we grow rapidly and even at current levels of subscriber acquisition cost. We expect that success to continue. Let’s turn now to our P&L. There were three drivers of strong performance last quarter. The largest of these drivers was content costs, which was approximately $3 million lower than we expected in the quarter. These cost savings resulted from a favorable mix of owned versus rev share content. We expect these content costs to increase in Q4, and I will say more about that in a moment. The second-largest source of that performance was technology and development spending, primarily due to lower headcount and lower data center spending than forecast. The final source of earnings upside resulted from a favorable variance in ASP, which contributed $1.5 million more in net income than we expected last quarter. Because we outperformed our earnings guidance in Q3, I want to spend a few moments discussing how we manage the balance between growth and earnings. As many of you know, we have a long-term goal of reaching 20 million subscribers. That goal is founded on the belief that the key competitive advantage in the emerging downloading market will be strong relationships with a large customer base that, as Reed mentioned, is accustomed to getting their video entertainment from Netflix. Against the framework of this overarching objective, we articulated three important goals for 2006

[Operator:]

(Operator Instructions) We will take our first question from Gordon Hodge with Thomas Weisel Partners.

[Gordon Hodge:]

Good afternoon, thank you. Just two questions. Barry, I think you have mentioned in the past that advertising sell-out has been really high on the mailers, and I am wondering if that is starting to now kick in as a major source of profit for you, or a meaningful source, anyway, and also if you could comment on usage trends during the third quarter. I think you indicated in the fourth quarter you expect it to tick down, but any commentary just in terms of how it behaved in the third quarter would be great. Thank you.

[Barry McCarthy:]

With respect to ad sales on the mailer, we are sold out -- substantially sold out in Q3 and Q4, so that business is progressing well. I do not think it will emerge as a line item for a year or two, so early indications are that we are on the right path, also trying to build out the online piece of that. We will probably have more to say about it next year, but it looks promising. The targeting is being well-received by the studios, and I think we are perceived to be a value-added player with a valuable target market. With respect to usage, no real news, actually. During the quarter, subscribers behaved very much as we expected. We finished on plan. The seasonal pattern that we are expecting in Q4 is the seasonal pattern that we have seen in each of the prior years.

[Gordon Hodge:]

The break-out on ad sales, at what level would that have to be to become a line item that you would break out?

[Barry McCarthy:]

Under SEC rules, 10%.

[Gordon Hodge:]

Not until 10, okay, great. Thank you.

[Operator:]

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

[Heath Terry:]

Great. I was wondering if you could talk a little bit about your studio relationships and how the revenue share agreements are changing, or if they are, as you move into the HD-DVD, Blu-Ray world. Are the current relationships that you have on the DVD front changing as you start to negotiate this next round?

[Reed Hastings:]

Rev share, not much change. You know, over the past two or three years, some studios get more favorable on it, other studios get less favorable on it, but the overall mix for us is approximately the same. HD-DVD and Blu-Ray, it is too early to tell. I mean, we are talking microscopic volumes of players. I think it is probably 10,000 or 20,000 or 30,000 total units sold, of hardware players. The market is so small right now that you just cannot tell anything. We think as it grows, it becomes pretty much parity with DVD, but it could be three or four or five years until it gets to 10 million or 20 million households, depending on how you want to count PlayStation 3.

[Heath Terry:]

Then, on that revenue share front, as you evaluate the buy versus share decision, as those relationships change, and you said they have not changed that much, but could you just talk to us about the thought process that goes through there, just from an accounting perspective on how you evaluate which discs you are going to buy versus the ones that you are actually going to go into a revenue share agreement on?

[Reed Hastings:]

Sure. We do not really get to choose on a title-by-title basis. It is really studio by studio, and a rev share agreement would generally cover all of the new releases from the studio. In terms of the overall evaluation, it tends to be I think heavily influenced by what the studio prefers. If a studio prefers revenue sharing, they will generally revenue share with a number of companies, including us. If the studio prefers not to, then it will be typically wholesale with all of the rental companies. It follows those broad patterns.

[Heath Terry:]

Great, thank you.

[Operator:]

We will go next to Safa Rashtchy with Piper Jaffray.

[Safa Rashtchy:]

Good afternoon, Barry and Reed, and congratulations on a great quarter. A couple of questions here. First, I just want to begin to understand where you might be spending the money. You mentioned if one is a purist, it would look like you are lowering your 50% growth, but either way you look at it, you have achieved, whether it was out-performance or otherwise, you have achieved a base now, and you are going from this higher base, so I am trying to see if you are being conservative in the guidance for next year, if there are some spending plans, or if you are trying to grow the EPS a little slower. I have a quick follow-up.

[Barry McCarthy:]

Safa, it is our most accurate -- remember we have the guidance for next year. It is our view of the expected case. Next year, relative to this year, we have this much larger downloading investment going on, so that is one of the factors involved in that.

[Reed Hastings:]

I think that is a perfect summary. If we were not spending upwards of $40 million or more on downloading -- let’s see, on an after-tax basis, that is another $20 million, so instead of looking at $60 million in profits, you are looking at $80 million in profit, and that is maybe more consistent with upper bounds of your expectations pre-downloading expenditures.

[Safa Rashtchy:]

That is actually the perfect segue for my follow-up, which is can you give us at least some qualitative sense of what you need to do. What are you going to spend the $40 million on? You had done some preliminary work on downloading already, and obviously content, as you said, is the key, and that does not require a lot of infrastructure build-up, so can you give us some sense of what you need to do to get going?

[Reed Hastings:]

We will be able and willing to talk about it in detail, Safa, next quarter on our conference call. I will defer your question until then.

[Safa Rashtchy:]

Okay.

[Operator:]

We will go next to Barton Crockett with JP Morgan.

[Barton Crockett:]

Great, thank you very much. I wanted to ask a couple of things about a couple of the numbers, and then a larger question about another issue. The Q4 churn you said should benefit seasonally, so are you suggesting then, as I understand it, that the churn rate should be a little bit better than the 4.2%, which we saw in the third quarter? That would be the first number question. Secondly, related on the SAC, you are going to be spending more in total on marketing, but does the SAC per gross addition also go up in the fourth quarter? Those are the two number questions. Then, more broadly, when we look at the download services that have been launched -- in particular, Amazon -- they have a number of titles available for download for purchase, a few hundred, I guess, available for rental. Is there anything that they have done that has changed your view of the licensing restrictions that you thought were going to be a content bottleneck? I was surprised that they have so many titles available for download, but of course, they are purchased, and maybe that is factored into the contracts. Would you guys expect to have a comparable number of titles available for rental, or maybe comparable to what they have for download available for rental, some idea of whether your size would be like what they have come out with? Thank you.

[Reed Hastings:]

Sure. On churn and SAC, for the past couple of years, we have not guided to them, so if you -- that does not mean we will give some color on it, but if you look at last year’s churn pattern, that gives you a sense of the degree of seasonality in the business, Q3 to Q4. Then, on SAC, it really depends on how much we are able to grow the marketing investment and still make our profit goals, so the bigger, the more we spend, the marginal $10 million is always less efficient than the rest of it. By definition, we would want to spend our most efficient first, so that would tend to drive up average SAC. So it depends on how much we are able to deploy within the context of our profit goals. Then, you asked on licensing. There is no surprise in the licensing in what Apple and Amazon have. It is approximately the same as Movielink has had for four years now, which is a pretty broad set of the Comcast VOD, or any cable VOD system has. That has been a pretty stable window. That is what is there. You referred to the [day-in date] with DVD, which is there for purchased titles. Again, from my perspective, that is their main -- it is the only focus for Apple and it is the main focus for Amazon in terms of title breadth. That is available at essentially DVD prices, at the same time as DVD. No surprises, consistent with Movielink licensing over the last couple of years.

[Barton Crockett:]

Would that be consistent with a selection that you guys would be able to have, do you think, at the outset?

[Reed Hastings:]

I know it is hard for us to throw this out, about what we are spending the money on downloading but now we are not going to tell you what we are spending it on, but we are going to give you a full briefing next quarter, and so I will have to hold you off like I did Safa and say in 90 days, we will give you a full briefing and give you all the context.

[Barton Crockett:]

Great, thank you very much.

[Barry McCarthy:]

Let me jump in and explain why we mentioned downloading at all, and the expected increase in spending for 2007. In the context of giving you guidance on earnings, so that you would not run away from our own expectations, we anticipate that it would be nearly impossible for you to reconcile to our net income guidance, given your projections for subscriber growth and revenue, unless you had some perspective on how much money we anticipated spending on additional downloading. That is the reason that we mention the dollar amount, and we appreciate your patience in waiting until next quarter before we put some meat on the bones.

[Operator:]

Thank you. We will go next to Doug Anmuth with Lehman Brothers.

[Doug Anmuth:]

Thank you. I have two questions. The first one is regarding churn. Reed, you mentioned that you benefited in terms of seasonality during this quarter, especially in some of the colder climates. Can you talk about anything that you were able to do specifically on your own in terms of pulling that lever a little bit, whether maybe it was marketing to existing subscribers a little bit better, anything there? Then, the second question in terms of your free cash flow, Barry, which you mentioned. It looks like you had a $20 million working capital benefit. Could you talk about the details there and if there is anything specific in driving that number higher? Thank you.

[Reed Hastings:]

Doug, on the seasonality, what I said is we anticipated benefiting in Q4 as the northern climates get cold and dark and people basically stay at home and watch movies more, and cancel at proportionately slightly smaller rates. That is what we were focused on. In terms of separating from what we were able to do, it is pretty hard to separate with any confidence. That is, we improved the service, we added a couple of new distribution centers, we made these improvements on the site, but there is no really scientific way for us to separate the improvements due to that, so we continue to believe they are good things. We continue to drive churn down, but we work forward on that basis. I will turn it over to Barry on the free cash flow.

[Barry McCarthy:]

Doug, with respect to the free cash flow, there was nothing out of the ordinary that happened in the quarter. We happened to benefit from an increase in AP, and you will notice that was a reversal of the prior quarter, which was a reversal of the quarter before that. So it is following a normal pattern. There is nothing unusual in the business. Next quarter, we will see a big swing in free cash flow again, unrelated to AP but this time related to the strong in-flow of cash from the sale of gift certificates, which lifted the free cash flow boat dramatically in the fourth quarter of last year.

[Doug Anmuth:]

Thank you.

[Operator:]

We will go next to Jim Friedland with Cowen and Company.

[Jim Friedland:]

Thanks. A couple of questions. First, on some of the social networking features, like friends, can you tell us about what percent of the users use it on a regular basis, or maybe at least users that have been with the service for six months, a year? Then, the second question is on the last call, you talked about how even though you have a range of price offerings and the average selling price is going down, I think you said the majority of gross adds is still going for the three-DVD product. Is that a correct statement? Could you talk about how that played out in the third quarter?

[Reed Hastings:]

The three-out program has remained our most popular program in Q3. Then, in terms of friends, we are really excited about what we have been doing and the improvements on it. We have not given, really for competitive reasons, any precise breakdowns on it. It is growing very nicely and one of the great aspects of friends is the virile network nature to it, so the more people that get in it, the more there is benefits to the other members. So we are continuing to push on that very aggressively.

[Jim Friedland:]

Would you say on that, Reed, that the people that use friends regularly churn at a lower rate?

[Reed Hastings:]

Yes, that is definitely true, that those who are active in friends are great customers for us. The only question is how much of that is an indicator of fact and how much of that is causal from friends. Do you follow what I mean by that?

[Jim Friedland:]

Sure, sure.

[Reed Hastings:]

Yes, if it were pure causal, we would be celebrating all day long, because we know some of it is an indicator of those are -- you know, people who live their lives on the Internet. We continue to work on it but we do not say it is why the churn is lower for them.

[Jim Friedland:]

Great, thanks.

[Operator:]

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

[Tony Wible:]

I was curious, in your ’07 guidance, what your assumptions are on postage that are implicit in that?

[Reed Hastings:]

We are expecting a postage increase, Tony, in the first quarter of next year.

[Tony Wible:]

Great, thanks. On the gift certificates that you guys sell in the fourth quarter, should we expect any kind of holiday promotion or any kind of special push on the marketing side to try and increase those types of sales?

[Reed Hastings:]

Sorry, Tony, I am just getting passed a note, an errata on my last answer. I said Q1, and the increase is Q2.

[Tony Wible:]

Okay, so like April.

[Reed Hastings:]

May, I think we are expecting it.

[Tony Wible:]

All right, and on the promotional front for the gift cards, are you guys planning to do anything abnormal there that would increase the sale of those gift products?

[Reed Hastings:]

Nothing that we have not done particularly in prior years.

[Tony Wible:]

There have been a couple of technologies proposed for triple layer for HD, to handle the duality issue. Are you seeing any of the studios pushing any closer to HD, now that there is some solution to have one disc that can carry both formats?

[Reed Hastings:]

No, we have not seen any move towards those technologies. The market is reasonably frozen, pending PlayStation’s arrival. If I had to guess, it will be Q1 before we start seeing some movement.

[Tony Wible:]

Last question -- the use of cash, any update?

[Reed Hastings:]

No updates.

[Tony Wible:]

Okay, thanks a lot, guys.

[Operator:]

We will go next to Youssef Squali with Jefferies.

[Youssef Squali:]

Thank you very much. Congratulations, guys. A couple of questions. First, Barry, the sequential decline in your ARPU, or average revenue per user, is the lowest we have seen in about seven quarters. While you obviously have been pushing lower and lower price plans, at the same time, we have gotten word today that Blockbuster had cancelled their $5.99 service, or at least planning on doing that. Are we seeing a price stabilization across the industry yet?

[Barry McCarthy:]

Well, I cannot comment on Blockbuster’s plans. In terms of our sub-growth in the most recent quarter, it was as we expected. It has been true in prior years and was true this year that there is, on a sequential basis, a relatively large decrease in ARPU has been -- a relatively large decrease in ARPU in the second quarter, as compared to the first, as compared with the third. That has everything to do with the number of days in the second quarter, and not much to do with structural changes in the business. I think some investors were concerned that the large decrease last quarter signaled some structural change in the business, but it was a calendar issue, and I think change this third quarter reaffirms the historical trend that we have previously seen.

[Youssef Squali:]

Okay, so it is just seasonal. I guess on a different point, I do not know if you will answer this, but on your ’07 guidance, the 76 to 83, could you just -- I guess yes or no -- you have added about, or you are planning, you are on track to adding about 2.1 million new users this year. To get to your 20 million in the 2010-2012 period, at some point you are going to have to see some acceleration in that net add. Is it fair to assume that your ’07 number sub add should be higher than your ’06 number?

[Barry McCarthy:]

You do the math correctly, which is the net adds have to continue rising for us to stay on track for 20 million by 2012. That is a correct assumption.

[Youssef Squali:]

Okay, that is helpful. Thank you.

[Operator:]

We will go next to Daniel Ernst with Hudson Square Research.

[Daniel Ernst:]

Yes, good evening. Thank you for taking the call. Two questions, if I might. First, on the DVD acquisition line, up to 50 million plus in the quarter, or almost up, or up a little more than 2X year on year versus net sub growth of 22% year on year. Is there a trend here, or did something happen in the quarter to, or you are preparing for a bunch of new releases, or a big sub-growth coming up in the winter months?

[Reed Hastings:]

Neither, particularly. We have been working on the inventory state, and improving operating metrics of the business. We have increased slightly our investment in content, but in particular, on a year-over-year basis, we have increased in absolute terms the number of DVDs that we acquire directly from studios and are engaged in, at least proportionately last quarter, less rev share.

[Daniel Ernst:]

Should we assume that this trend continues, or was it more of a catch-up here?

[Reed Hastings:]

The funny thing about watching our content costs is an arbitrary part of it flows to the balance sheet in terms of DVD purchase, and then a second arbitrary part goes to revenue sharing, goes directly to the P&L. They end up, from a P&L standpoint, if you account for depreciation, to be about the same, and we move back and forth between them, again depending on studio preference. So some of what you are seeing was a shift in one or more studios away from rev share between a year ago and now, so therefore we have more purchasing going on. But the total content cost has been very favorable for us over that year. We continue to seek deals that make economic sense for us, and you will see, if you only look at one-half of this, i.e. rev share or purchase, you can get thrown off. You really want to sum those two.

[Daniel Ernst:]

Understood, that helps. The second question, on ARPU, down about 7% year on year, which is relatively modest in light of the teaser ads we see push the $5.99 plan. Obviously there is not a big uptake of those. Could you give us some sense of what the current distribution is on your plans?

[Barry McCarthy:]

We do not actually disclose it for competitive reasons.

[Daniel Ernst:]

But could you give us a little bit of flavor?

[Reed Hastings:]

You could do any, you know, approximate split to generate the ASP, and you would not be far off. It is not very sensitive, so you know, take some normal distribution around the ASP and you will be pretty close.

[Daniel Ernst:]

Thank you.

[Operator:]

We will take our next question from Charles Wolf with Needham.

[Charles Wolf:]

Yes, hi. I wanted to ask about your experience in the Bay area and what it might say about your prospects going nationally. I was wondering, if you could, directionally, is your subscriber acquisition cost in the Bay area less than they are nationally? Second, is the churn rate in the Bay area less than nationally or more? Could you give us a direction on that?

[Reed Hastings:]

Sure. We have said in the past and reaffirmed today that they are both substantially lower, favorable, both SAC and churn, in the Bay area.

[Charles Wolf:]

Let me ask a different type of question about the long tail. In terms of the movies that are being rented, what percentage are new releases and what percentage are library?

[Reed Hastings:]

It varies somewhat quarter to quarter, depending on what the studio is releasing. Generally, it is about a third of the shipments are new releases, and about two-thirds are long tail content.

[Charles Wolf:]

Fine, thanks a lot.

[Operator:]

We will go next to Mario Cibelli with Marathon Partners.

[Mario Cibelli:]

I wonder if you have any comments about the store-in-a-box concepts that are coming out now, like Red Box and other things like that, where you could reserve a copy. Do you think this is a viable business model, longer term?

[Reed Hastings:]

Kiosk business has the sort of ATM style. It may well be a viable business. They certainly seem to be proliferating. They are very new release focused, so they tend to hold 20 or 30 titles of the big new releases, so in that way, fairly complementary to our market and another squeeze on video stores. But again, they seem to be spreading, from all the press reports.

[Mario Cibelli:]

Thank you.

[Operator:]

We will go next to Chad Bartley with Pacific Crest Investors.

[Chad Bartley:]

Thank you. I have one follow-up on the digital side. I think you have commented before. Could you talk about the pricing model for digital delivery? Do you expect to offer that under the subscription plan, or will it be something different? Thank you.

[Reed Hastings:]

I will have to hold you off again until next quarter. Again, I know it is frustrating for us to dangle this out and not really complete the sentence, but we will complete it next quarter on this call for you.

[Chad Bartley:]

Okay, all right. Thank you.

[Operator:]

We will go next to Eric Fischer with Broadmark Asset Management.

[Eric Fischer:]

Gentlemen, great quarter. I just have a few questions. On average postage costs round-trip in the third quarter, could you give me that, give us an idea of what that is? Is it $0.74, $0.76?

[Reed Hastings:]

We do not actually break it out. We pay first class postage each way and then we have the benefit of some zip code sorting that we do, which gives us some discounts, but we do not get any special breaks with the post office that are not available to any other company in the United States.

[Eric Fischer:]

But you have a system put in where you get some kind of a break with the sorting system, right?

[Reed Hastings:]

Yes, we do.

[Eric Fischer:]

That is what, about $0.015, $0.02 maybe?

[Reed Hastings:]

You could look up on the USPS website and the variations as to how finely you pre-sort, for any pre-sort mailer, but no, the discounts can go as much as $0.07, if you have enough volume and you are willing to spend the time and effort to sort it. It can be bigger than that, but of course, there is the labor to do that, and then you have to have enough density in any one geography to be able to take advantage of those discounts.

[Eric Fischer:]

The rev share cost in the quarter, I know you do not really break that out, but would you say it was less than the cost component of the DVD amortization in the gross margin?

[Reed Hastings:]

No comment.

[Eric Fischer:]

No comment -- SAC for the quarter, was that about $45.30?

[Reed Hastings:]

Correct.

[Eric Fischer:]

Usage about 5.6?

[Reed Hastings:]

No comment.

[Eric Fischer:]

How about ARPU? Did you say what that was?

[Reed Hastings:]

I think we disclosed it in the release.

[Eric Fischer:]

G&A was up about $3 million versus second quarter. I was just wondering what that was, exactly.

[Reed Hastings:]

Continuing build-out of the infrastructure.

[Operator:]

Thank you. That is all the time we have for questions today. At this time, I will turn the call back over to Mr. Reed Hastings for any closing remarks.

[Reed Hastings:]

Thank you, everyone. We look forward to talking to you in a quarter, and again, we will have more details for you then on the beginnings of the Internet delivery option for Netflix. Thank you 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.