Netflix, Inc.
Q4 2007 Earnings Call Transcript

Published: 24 Jan 2008

[Operator:]

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

[Deborah Crawford:]

Thank you and good afternoon. Welcome to Netflix’s fourth quarter 2007 earnings call. Before turning the call over to Reed Hastings, the company’s co-founder and CEO, I will dispense with the customary cautionary language and comment about the webcast for this earnings call. We released earnings for the fourth quarter at approximately 1

[Reed Hastings:]

Thank you Deborah and welcome everyone. Our goals at Netflix are simple

[Barry McCarthy:]

Thank you Reed. Good afternoon everyone. On last quarter’s earnings call, I said we were encouraged by our results quarter-to-date and we revised upward our Q4 guidance. Today we announced results at or above the high-end of this upwardly revised guidance. This is the second consecutive quarter of better-than-expected performance. My remarks today will cover our Q4 performance and the guidance we issued in today’s earnings release. But first I want to comment on recent announcements involving Internet delivery, including our own announcement of unlimited streaming of video content to Netflix subscribers. Two years ago, in January 2006, and again in January 2007, CES was abuzz with developments in Internet video delivery. Investors were concerned about the size of the online DVD rental business and the platform risks posed by online delivery. And again, this year, for the third year in a row, CES was buzzing with news of Internet video delivery and questions about platform risk and market size remained. I would like to point out that in the intervening years, from December 2005 to December 2007, our subscriber base has grown by 79% to 7.5 million subscribers. Revenue has grown by 77% to $1.2 billion. We’ve nearly doubled our free cash flow to $46 million and we’ve deployed our instant streaming video feature, which is more popular today than any of the other Internet movie delivery sites. On top of all this, as Reed mentioned, Netflix has continued to be the number one rated ecommerce site for customer satisfaction. Those of you who are familiar with our strategic view of the market, know that we believe the digital landscape will take form slowly but steadily over time. Our market view is informed by two assumptions

[Operator:]

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

[Lloyd Walmsley:]

Good afternoon. Your guidance seems to imply an acceleration in either gross sub adds or an improvement in churn. Can you talk how sub growth progressed through the quarter and what you are seeing now to give you that confidence? And then, specifically if you could talk a little bit about how the sub mix is changing on the various plans and how the profit dollar contributions might be different or similar on those plans?

[Reed Hastings:]

The growth over the prior year is mostly in gross add improvement. Those two, between gross add and churn, there are some interesting dynamics between them that you have to be conscious of. As an example, we made it easier to put yourself on a vacation hold, which for financial reasons, we consider that a cancel even though the person’s on hold and has agreed to be restarted. And that inflates the gross add number larger than it would otherwise be and makes churn larger than it would otherwise be. On the margin, you just have to be conscious that there are some trade-offs between SAC and churn. But most of the growth this year would be in increased gross adds. Your second question was on profitability of the different plans and mix, and we haven’t historically provide you any specifics on that difference in mix between plans other than the total ARPU which we give out.

[Barry McCarthy:]

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

[Operator:]

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

[Ronald Josey:]

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

[Reed Hastings:]

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

[Operator:]

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

[Hagit Reindel:]

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

[Barry McCarthy:]

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

[Hagit Reindel:]

I am referring to the net income margins.

[Barry McCarthy:]

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

[Hagit Reindel:]

I will check the numbers again then.

[Barry McCarthy:]

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

[Hagit Reindel:]

Thank you. Just another quick question

[Reed Hastings:]

You remember two quarters ago when we lowered the price of the service, we said there were several ways to invest in value proposition

[Operator:]

Our next question is from Heath Terry – Credit Suisse.

[Heath Terry:]

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

[Reed Hastings:]

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

[Heath Terry:]

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

[Reed Hastings:]

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

[Operator:]

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

[Barton Crockett:]

I wanted to drill down a little bit more on the subscriber growth issue here. Your guidance assumes more net adds in ‘08 versus ‘07, but if you look at what happened in the fourth quarter of ‘07, you actually had less net adds in the fourth quarter of ‘07 than you had in the fourth quarter of ‘06. All the dynamics that we have seen in the fourth quarter of ‘07 presumably will be there in 2008. So what changes incrementally from the fourth quarter of ‘07 into 2008 that gives you the confidence that basically your gross adds growth will do better than it was in this quarter, which is flat. What changes that?

[Reed Hastings:]

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

[Barton Crockett:]

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

[Barry McCarthy:]

I am not sure that looking at it per minute is really that helpful. People tend to watch different kinds of content, a little more TV shows online with the online streaming and a different value perception in what they are willing to pay for between online streaming and DVDs. What we can say is when you think of our content spending there’s three buckets

[Barton Crockett:]

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

[Barry McCarthy:]

Well you know that was Heath’s question and there’s no clean way to do that because we don’t have a control group that doesn’t have streaming. The differences, there are seasonal differences also and so without a control group, if we guess at it and we do, we like what we are seeing but there is nothing we would feel comfortable saying okay, we cracked the formula here is the trade-offs, etcetera.

[Barton Crockett:]

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

[Reed Hastings:]

I am not sure. It’s certainly no material help if it’s a help, it may be a slight help or a slight hurt. It’s like a recession in consumer spending. I mean you could argue it hurts because we have credit card customers; you can argue it helps because rental is such a good value. But these are both very background kind of factors; they don’t affect our business in any dramatic way.

[Barry McCarthy:]

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

[Operator:]

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

[Jim Friedland:]

First on the churn pattern, now that Blockbuster has eased off should we expect to see that Q1 picks up a little from Q4, then Q2 picks up a little bit more then drops in Q3, drops in Q4, again as the annual pattern there? On gross margins in thinking about gross margins this year, Barry, are you willing to give us any more insight into how much online maybe either weighing on that and outside the postal increase is there any other impact that we should be thinking about?

[Barry McCarthy:]

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

[Jim Friedland:]

And on the churn trends then?

[Reed Hastings:]

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

[Jim Friedland:]

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

[Reed Hastings:]

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

[Operator:]

Your next question comes from Mike Olson - Piper Jaffray.

[Mike Olson:]

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

[Reed Hastings:]

I think the thing that will make us popular in the CE community is if we do a great job with LG and they sell a lot of their devices because of the Netflix service and make a lot of money off of that. Then other people are going to want part of that success. So our core focus is not to see how broad can we license today, but instead how successful can we make LG in terms of growing their share of the very segment that they participate in. We may see a few more agreements this year, but a very small number given that we think that the best strategy is to really do a good job on the total CE integration where it’s a great job for the consumer, the customer score works, well the total experience works well and then expand that much more broadly in 2009.

[Mike Olson:]

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

[Reed Hastings:]

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

[Mike Olson:]

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

[Barry McCarthy:]

That’s correct, that’s our intention.

[Operator:]

Your next question comes from Tony Wible - Citigroup.

[Tony Wible:]

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

[Barry McCarthy:]

We’ve got no comment.

[Tony Wible:]

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

[Barry McCarthy:]

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

[Tony Wible:]

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

[Reed Hastings:]

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

[Operator:]

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

[Daniel Ernst:]

Can you give any metrics on overall usage of high definition discs, either Blu-ray or DVD and what your subscribers mix is? Secondly, returning to the question of marketing spend in 2008, it seems that at the moment you’ve got tailwinds again as Blockbuster has pulled back a bit, but maybe in a year from now you are going to experience some additional headwinds as potentially Apple has a more robust offering, how do you do more with how many films they can actually offer. At some point in the future you will have more headwinds; now you have tailwinds, so why not accelerate a little bit here to lock in some more subs as the battle heats up? Thanks.

[Reed Hastings:]

To the degree that the climate would get tougher, I suppose you might consider that and you referred to Apple service in particular, but remember this year there is about $1.3 billion in video-on-demand spending already that we compete against and have been competing against. Apple announced they did about 6 million movies to-date. Let’s say that goes up by a factor of 5 or 6 or 10 or something, it is still pretty much in the background noise in terms of the video-on-demand market. So we actively compete with video-on-demands from Comcast and others and have for the last five years. I don’t see any material shift in the climate in the near term possible from that. So we don’t look at it and say boy, the climate is going to get harder in the future.

[Daniel Ernst:]

On the Blu-ray side?

[Reed Hastings:]

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

[Daniel Ernst:]

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

[Reed Hastings:]

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

[Operator:]

Your next question comes from Bill Lennan - Broadpoint.

[Bill Lennan:]

Can you give us an idea of what you are expecting ARPU to be in Q1? Going backwards in the ending subs, assuming some trials and I am coming up with ARPU ticking up sequentially; that doesn’t seem right to me? What’s your best guess for how many subs Blockbuster ended ‘07?

[Barry McCarthy:]

We don’t guide to ARPU but I will give you some color. I will remind you that there tends to be in the fourth quarter new subscriber growth is back-end loaded and they become paying subscribers early in Q1 and generate revenue throughout the quarter. New subscriber growth in Q1 tends to be front-end loaded and they become revenue-paying subscribers early. That tends to move the revenue per sub number in a way that’s different than you see in the rest of the quarter or the year. Every year we face the same question where ARPU moves in a way more positively that puzzles investors. We continue to expect over the long term ARPU to move down until the mix by price point of new subs and installed base normalizes, but you may see some seasonal fluctuation due to the number of revenue months per sub.

[Reed Hastings:]

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

[Bill Lennan:]

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

[Reed Hastings:]

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

[Operator:]

Your next question comes from Andy Hargreaves - Pacific Crest.

[Andy Hargreaves:]

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

[Reed Hastings:]

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

[Andy Hargreaves:]

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

[Reed Hastings:]

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

[Andy Hargreaves:]

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

[Reed Hastings:]

You are assuming that Blu-ray is going to win there and I made the mistake -- I don’t know, a year or two ago before the HD DVD camp flipped Paramount – of thinking the same. So remember that we are all judging it by studios and if they manage to flip another studio to their camp then we’re back to stalemate again. But if one format, presumably Blu-ray, takes off that will have an effect; the Blu-ray disc costs a little more so that will have an effect upon us in terms of content costs. But also the perceptions of consumer around HD are that every other HD option costs them more. So for example, video on-demand HD usually cost $5 or $6 instead of 4; or video or HD channels from Comcast and others cost an additional supplement. It may be that we have room to be able to do HD-specific pricing as we get to volume on this because the competition for the consumer retention on HD is all around that also. So that is something we will know you know more maybe by the end of the year as we look at the success of the HD formats.

[Operator:]

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

[Analyst for Brian Fitzgerald:]

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

[Barry McCarthy:]

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

[Analyst for Brian Fitzgerald:]

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

[Reed Hastings:]

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

[Barry McCarthy:]

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

[Operator:]

Your next question comes from Barton Crockett - JP Morgan.

[Barton Crockett:]

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

[Barry McCarthy:]

No.

[Reed Hastings:]

It comes out in the K.

[Barton Crockett:]

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

[Barry McCarthy:]

Yes.

[Reed Hastings:]

That’s right.

[Operator:]

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

[Reed Hastings:]

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