Netflix Inc (NFLX) 2003 Q3 法說會逐字稿

Welcome to today's Netflix third-quarter results 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 the Director of Investor Relations, Deborah Crawford.

Welcome, ladies and gentlemen. I'm pleased to join you today in this, my first Netflix quarterly earnings call as Director of Investor Relations. I look forward to working with you in the months and years ahead on our way to reaching our goal of 5 million subscribers. Before turning the call over to Reed Hastings, the Company's founder and CEO, I'll dispense with the customary cautionary language and comments about the Webcast for this earnings call. We released earnings for the third quarter at approximately 1:05 p.m. today 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 p.m. Pacific time today. We will make forward-looking statements during this call regarding the company's future performance. Actual results may differ materially from these statements due to risks and uncertainties related to the business. A detailed discussion of such risks and uncertainties is contained in our filings with the Securities and Exchange Commission including our annual report on form 10-K filed with the commission on March 31, 2003. Now over to Reed.

Today I'm pleased to report record results for the third quarter of 2003. By all measures our business performance was strong, reflecting the broadbased consumer appeal of our service and our ability to execute on our strategic priorities. Last year we set several long-term financial objectives. They were achieving 5 percent household penetration, $1 billion in revenue, and 100 to 200 million in free cash flow in the next four to seven years. Every quarter we have made steady, reliable progress towards achieving these goals, and this quarter was another stellar quarter. Specifically our sequential subscriber and revenue growth accelerated, outperforming the high end of our guidance. Gross margins also outperformed our guidance, reflecting the evolution in our content buying strategy which we outlined for you on our earnings call six months ago.

Subscriber churn dropped to 5.2 percent, the lowest level in our history, down from 5.6 percent in the prior quarter and 7.2 percent in the prior year. Subscriber acquisition costs were in the low end of our guidance fueled by rapid growth in word-of-mouth as an acquisition source. Net income was $3.3 million, nearly 3 times the high end of our guidance. Our quarter was stellar for one reason, consumers love our service. This is the core of our strategy. Every quarter we work hard to make our service even better, growing our base of passionate subscribers which in turn drives churn down, word-of-mouth up, and makes the barriers to entry even more formidable. The better our service becomes, the more profitable and faster growing our company becomes.

This quarter we continued to undertake initiatives designed to improve the consumer experience. Most visible of the changes was the redesign of our Website which significantly increased the speed of our Website and improved the presentation and merchandising of our movie content. We also continued to refine the deep computer science in the Netflix recommendation system which drives the personalized movie recommendations and merchandising throughout our Website. Second, we continued to expand our next day delivery service to more of our subscribers which we believe contributes to increased penetration. The San Jose, Oakland, San Francisco, Greater Bay area is our oldest market, and there we surpassed 5.4 percent household penetration last quarter, up from 3.5 percent one year ago. We continue to replicate our success in the Bay area across the United States in every market in which we provide fast delivery service, like that provided in the Bay area.

You can see this performance graphically on the webcast of this earnings call at IR.Netflix.com or through the link in our earnings release. This graph is labeled Netflix market penetration. On this graph the Greater Bay area, the longest line on the chart, clearly shows continued steady growth. We pushed through the 5 percent mark this year, as we predicted we would, and this performance indicates that Netflix could reach an incredible 10 percent household penetration in the Greater Bay area over the next four to seven years as momentum behind DVD and the brand awareness for Netflix accelerates.

This graph also shows you the progress we've made in our other metro shipping markets where we've introduced fast delivery. You can see that on average they look as if they will hit the 5 percent household penetration mark slightly faster than the Bay area did. Today approximately 70 percent of our subscriber base is served by fast delivery. We will continue to steadily grow that coverage as we have over the last seven quarters. By year end we expect to provide next day delivery service to 80 percent of our subscriber base.

The third improvement in our service last quarter was we continued to grow our title offerings to our customers. New titles included the critically acclaimed and award-winning film that made their DVD debut at Netflix before enjoying broader distribution, we added four such titles in Q3. Our studio relationships continue to be strong. As before, some studios prefer to have us purchase DVDs, other studios prefer to have us revenue share their titles. We work well with both methods as we manage our gross margin and improve our inventory availability to our subscribers. In general, as we get better terms we tend to increase our inventory buying so the improvement in terms over time shows up mostly as increased satisfaction and decreased churn rather than increased gross margins.

On the competitive front it was another quarter of steady growth for Netflix and lack of traction for our competitors. Wal-Mart's online service was launched one year ago and continues to make little progress. Of course, Wal-Mart is a great company and a trusted retail brand, but Netflix has 1.3 million subscribers telling their friends how great Netflix's subscription rental is. Wal-Mart, on the other hand, has only a few thousand online rental subscribers telling their friends how the Wal-Mart subscription service is adequate at best. That difference in evangelist power is a nearly insurmountable barrier to entry as we are seeing in Wal-Mart's failed entry attempt.

Increasingly our rapid growth and our no late fees model is becoming a strategic issue for Blockbuster. Initially they felt no need to react to us. Now the pressure has built and they have introduced a no late fee subscription model in 1000 of their stores. In fact, during Q3 Blockbuster advertised heavily in the San Jose, Oakland, San Francisco, Greater Bay area on radio promoting their no late fee subscription model which is fully available in the Bay area. Anecdotally I can do you that their media buy was impressive, and almost daily I heard their advertisements even on public radio. The great news for our investors is even when Blockbuster saturates the airwaves promoting their no late fees rental program we continue to grow strongly.

You can see from our household penetration data in the Bay area just how steady our growth was in Q3 despite Blockbuster's heavy media spending. We believe this surprising result is because the Blockbuster brand is very tied in consumers' minds to late fees. After all, Blockbuster collected nearly $1 billion worth of late fees from consumers last year. When consumers hear Blockbuster and no late fees many of them perceive those words as not credible. Repositioning the Blockbuster brand away from late fees is as difficult as repositioning a low quality brand into a high-quality brand. Mere advertising will have little effect.

Each year Blockbuster is becoming more reactive to Netflix. Within a year Blockbuster will be offering a no late fees rental program in all of their domestic stores, and offering a mixed mode online/off-line hybrid. As the Bay area advertising shows, it won't slow our growth one bit. It's not really about specific (technical difficulty). Excuse me, ladies and gentlemen, we may have had audiovisual or an audio issue here. I will try to get confirmation. All of you can hear me and then I'll continue.

I can you, sir.

Okay, and we think the audience can?

Yes, the audience can hear you as well.

Well, clearly Blockbuster is more tricky than I ever would have imagined. Let's see where we are here. Okay. Excuse the interruption, everybody. We would be remiss to not give credit for our success where it is due, which is really to the studios for backing DVD. DVD is a monster success and is still building momentum. A little over 50 percent of households have DVD with 50 percent still to go. DVD players are becoming the cool new feature in family automobiles, and portable DVD players are available for under $200. According to Adams Media Research, home video has already grown to a whopping 59 percent of studio revenues and looks poised to grow even bigger. Between the studio economics and consumers' love, DVD will be substantially more dominant in five years than it is today. Netflix, of course, both benefits from that in terms of increased availability as well as helps move it forward by creating the world's best DVD rental option. With that I'll pass it over to Barry and look forward to your questions after he's concluded his remarks.

Reed, thank you. And thanks to all of you for joining today's call. I'm very pleased with our third-quarter results which exceeded our expectations in many respects. Our GAAP net income of $3.3 million was 3 times the high end of our guidance. We delivered strong performance on all key metrics and record free cash flow of 7.9 million was nearly twice our free cash flow of last quarter. These exceptional results are attributable to strong performance on all the key business drivers which, in combination, delivered results significantly above our expectations. The cumulative effect generated 19 cents of non-GAAP EPS and drove 10 cents of EPS to the bottom line.

Some of you may recall that earlier this year on our first-quarter earnings call we told you that we'd grow our business faster and more profitably by providing a better user experience to Netflix subscribers. We said better service meant, one, faster delivery of DVDs to more of our subscribers; and two, more inventory availability for all subscribers. We also told you that better service meant lower gross margins but better future profitability for the business. Well, the future is now and our third-quarter results show the financial leverage of our Q1 strategy shift.

The primary drivers of financial performance this quarter were record low churn, an increase in average revenue per paid subscriber, lower content costs and low subscriber acquisition costs. So why don't we talk about how we performed with respect to each of the drivers. One, record low churn of 5.2 percent versus 7.2 percent one year ago meant more paying subscribers for less marketing expense per dollar of revenue. This is the fourth consecutive quarter of declining churn, a solid indication that marketing continues to acquire good quality subscribers, and that improvements in the quality of our service driving higher customer satisfaction. Churn improved across all customer classes in the most recent quarter.

Two, ASP rose in the third-quarter from $19.93 to $20.27, a small 2 percent sequential increase spread across a very large base resulting in $1.2 million of additional revenue. While insignificant as a revenue line item, this incremental revenue falls mostly to the bottom line as incremental profit where it contributed materially to net income for the quarter. Three, content costs were lower than expected in the quarter. Gross margin was 46.5 percent, above the high end of our guidance by 250 basis points. Lower rev share cost drove improvements in gross margin. As a percent of revenue rev share cost declined as our rental mix shifted proportionately in favor of purchased disks and away from rev share disks. This shift is the result of the increase in our DVD purchasing over the last several quarters. Disk usage, which increased slightly in the quarter, did not contribute to the rise in gross margin.

Four, SAC for the quarter was $31.81, 4 percent higher than the prior quarter and in the low range of our guidance of $31 to $34 for the quarter. Word-of-mouth continues to be our fastest-growing source of acquisition. Together with online, these two sources of acquisition continue to account for more than 80 percent of all acquired subs.

Today's earnings release includes our updated guidance for the fourth quarter and full year of 2003. Not surprisingly, we've increased our guidance for revenue and net income. On last quarter's earnings call I guided you to expect inventory purchasing in the range of 18 to 21 percent of revenue in Q3 and Q4. And in fact, in the third-quarter we purchased $13.5 million of DVD content which equaled 18.7 percent of revenue. Because these purchases continue to drive down churn, in the fourth quarter we plan to increase our inventory buying to the range of 22 to 25 percent of revenue. This increased spending will reduce gross margins in Q4 to Q2 levels. We expect this ongoing investment in providing a better Netflix service will continue to reduce churn and SAC because happy subscribers persuade their friends to join Netflix and strong word-of-mouth is one of the most effective and efficient marketing tools we have.

This quarter has demonstrated the effectiveness of our operation strategy in delivering extraordinary financial results. As we look forward we will continue to focus on our strategic priorities and key performance drivers. As we did last year, we will issue guidance for fiscal 2004 on our January conference call. In January we will have completed our fiscal 2004 plan and will have the benefit of seeing how the business performs during the holiday season as well. I would, however, like to point out that the 2004 cash on First Call for non GAAP EPS currently range from 60 cents to $1.16, quite a broad range. I can say with some degree of certainty that I believe the range of $1.10 to $1.15 is more likely. On the January call I'll be happy to share our financial objectives in more detail. So this concludes my remarks on financial results for Q3 and now I think we'll open the phones to questions.

(OPERATOR INSTRUCTIONS) Gordon Hodge with Thomas Weisel.

You talked about disk usage being up slightly, I'm just wondering if you could comment on -- give us a little more specifics on that if possible? And then also, in the markets where you've had hubs for 12 months or so, what are you finding to be that -- what is the leveling point in terms of disk usage as you, I guess, relieve the burden of the constraint of delivery? That's one question. The other question would be -- you're taking your churn number down for Q4, is that in part for seasonal reasons or are you just seeing that number continue to trend down and then also have you changed your marketing plans that would lead you to a lower subscriber acquisition cost? Thanks.

No change in our marketing plans leading to lower acquisition costs due to the seasonal increase during Q4, and acquisition costs may be in the low end of the range if we continue to see rapid growth in word-of-mouth which, as you know, comes to us for free, meaning no bounty payments. With respect to the churn question, we are continuing to see a longer customer lifetime value related to lower churn, so it's not seasonal, it's a structural shift in the business. With respect to usage, we don't disclose what the ceiling is on hubs. We feel like we're close in terms of average usage, usage in the quarter actually increased less than we had anticipated in preparing our original guidance. On a seasonal basis we tend to see a heightened level of rental activity, during third-quarter we saw it, but not to the degree we expected. The usage in the quarter was up about a third of a disk and on a normalized basis, meaning adjusting for the fact that there are more shipping days in the third-quarter than in the second-quarter, about to tenths of a disk.

Great, thanks.

Safa Rashtchy with Piper Jaffray.

Congratulations, Barry and Reed. Can you guys hear me well?

Yes, thanks.

A couple of questions. One is maybe a little bit more conceptual, I tried to be clear on this. It seems that the growth and improvement in metrics, especially on your margins and churn and so forth, are going a little faster than you had anticipated given that you knew you had some knobs that you can kind of turn and get them to -- within the range that you want. But I wonder, now that you've had some time to play with these different factors that increased the overall cash flow and profitability, are you able to update your longer-term model yet given I believe a $200 million EBITDA cash flow projection. And are you seeing anything that is kind of surprising to you in terms of how much the consumers react in terms of the good churn rate?

And let me just complicate this a little more by a second part if I may. Now that the competitive landscape seems to be not nearly as threatening as the skeptics have thought, and you constantly are growing despite the competition, do you think that you could be moving a little bit more aggressively than perhaps you had in the past trying to preserve some cash to confront the competition in terms of customer acquisition and faster penetration and getting to a bigger critical mass a little sooner? Thanks.

In terms of the long-term objectives of getting to 5 million subscribers, a billion in revenue and 100 to 200 million of free cash flow, I think your question number one is could it be above 200? And it would be too early to conclude that. We are still definitely learning how to tune the knobs in the model. And I think it partially depends on the rate of growth at the time. The steeper the rate of growth obviously the more we'd still be in the 100 to 200 million range. So we remain comfortable with the long-term guidance that we set last year. We're making steady and reliable progress towards achieving those pretty big goals of getting to a billion in revenue and feel good about that.

With respect to competition, you never want to count Wal-Mart and Blockbuster out. Wal-Mart is approximately 1000 times larger than us in terms of revenue. So while we have a compelling lead and big barriers to entry, we don't look at it as we're done. We look at as we are watching them like a hawk, we're spending a lot of time analyzing Blockbuster, what they are doing, what they could be doing, and so we remain in a sort of cautiously optimistic as opposed to gee, we've won the thing and now we can go start spending in new and interesting ways.

Great, thank you.

Dennis McAlpine with McAlpine & Associates.

Could you talk about where your new subscribers are coming from? Are they people who have had DVDs, or is your growth tied at all now to increased penetration of DVDs? Could you talk about specifically how much revenue sharing was as a percentage of purchases?

In terms of the new sub sources, no material change in that. Some of the new subscribers come from people opening the DVD player, particularly right after Christmas. It is why Q1 is generally our largest quarter. We get a -- you know, it's a 20 percent bump, and that is the new player contingent. As you know, about 50 percent of DVD players are sold in Q4, delivered in the Christmas time frame, and then opened in Q1 effectively. So again, no material change there.

In terms of revenue sharing, also similar attributes to the last several quarters. It varies somewhat. We rev share with some of the studios. With some of the studios, they want to work on a purchase term and it depends on whose titles are streeting at a certain time. Revenue share percentages were up slightly in last quarter, but not strategically more, just a title mix mode.

Thank you.

Youssef Squali with First Albany.

I have a few questions. Number one, about the turn, you obviously have done a great job in lowering that pretty impressively, over 400 basis points. Can you just give us some, I guess an idea of exactly what you did this quarter that may be new that may have contributed to the drop? And then looking at it generally, is there any reason why we should not see churn continue to drop even, I guess, over time to maybe the low 4s, which would be somewhat in line with other business models? One that comes to mind is in the ISP model where the churn there is about 4 percent? Moving on to a couple of P&O questions. I noticed that on the margin side, fulfillment costs, product development and G&A were sequentially up very slightly, but they did go sequentially up after six quarters of decline. If you can just comment on how we should think about that going into the fourth-quarter.

There's no one thing that we've done with churn. You should look at it plus or minus sort of 0.2 is statistical noise. In other words, you're talking about 3000 or 4000 people out of 1.3 million staying or not staying gets you 0.2. So factoring than in, it still is a statistically significant difference from going from 5.6 to 5.2. What really caused that, that's the continued investments we've made. We saw improvements when we launched the new site version where it's a much better layout and more dynamic and more fast. We saw improvements in terms of inventory and fulfilling that more consistently, opening more distribution centers and all of those things accumulate.

If you look at churn over the past seven quarters since we've been public you see more or less a straight line with a blip up in Q3 of last year of about half a point going up from 6.7 up to 7.2 percent. That's a half-point variation that's sort of off the generally declining pattern. I think what we can be fairly confident of is that we'll continue to see general steady declines, but there is some statistical noise in it moving around quarter to quarter. And again, you just have to look back at Q3 a quarter ago to see the range of that noise in any given quarter. In terms of our long-term model, we're still pushing down but there's nothing that gives us enough confidence to guide you specifically much lower than where we are. We're certainly optimistic and we're trying hard on it, but it's not a thing that we can tell in advance. For the P&O I will pass it over to Barry.

I'll make one additional comment about churn, we have in prior calls articulated for you the shape of the churn curve, if you will, by saying that first period churn is approximately 10 percent at six months, people are churning at five, and the long-term churn rate is about half of that, 2.5 percent. So it is also true that if the marginal rate of growth in subscribers slows, and results in an aging of the customer base over time the reported churn number will come down, even if the churn behavior for customers at each stage of their lifecycle, in the first, the second, the fourth or six month, whatever, remains the same.

With respect to departmental expenses, this quarter, as we did a year ago in the third quarter, we had salary adjustments in all of the departments whose expenses increased Q over Q. That, of course, is a onetime adjustment and so on go forward basis as a percent of revenue I don't anticipate that you'll see any additional increases. I expect that expenses will rise slower than revenue and that those categories of expenses as a percent of revenue will decline.

Okay. And just a housecleaning questions. Your guidance for stock based comp is I guess is in the mid 3's or so, up from 2.7 million. I guess what accounts for that, how should we be thinking about it in '04?

We had kind of a non-traditional stock comp plan. We award vested options on a monthly basis, different than say a four year plan. And as the price of the stock increases -- has increased over time, then each new grant is separately valued and each dollar increase in stock price equates to roughly a 33 cent increase per award. So that's why as the price of the stock has gone up the stock comp charge has moved. In our guidance we're absolutely arbitrary in the way we established a range for stock comp. We pick $45 and went plus or minus 20 percent in terms of closing price to run a calculation on what the stock comp charge might be.

Okay. The way we got it is any $1.00 increase in stock relates to roughly a $300,000 increase in stock compensation, okay. That helps. Thanks a lot.

(OPERATOR INSTRUCTIONS) Derek Brown with Pacific Growth Equities.

Two questions. First of all, did you change any of your, in particular I guess, marketing behavior during the quarter as you saw Blockbuster's marketing strategy unfold, number one? And number two, can you give us a sense for your current thinking in terms of international expansion at this point?

Sure. On number one, we've made no changes in our marketing behavior whatsoever. In terms of number two in international, something we're continuing to look at, explore the options but we have not made any decisions or set up a timetable for that.

Thank you.

Morgan Frank with Manchester Management.

Congratulations, it was a great quarter. Two questions. One sort of specifically on tech and development now that the Website redesign is completed, might that cost taper off a little bit next quarter, or is that going to stay sort of more in the range it was in September? And then second, you guys have talked about doing some preliminary TV advertising to get a sense of how that medium would work for you, and I'm wondering what you got back from that and sort of how much might have been spent on that during the quarter?

Good questions. On the TV testing we ended up pushing it into this month. Just that is was timing of one when we could get the buys. So those tests are running now and we'll be able to talk if they're indicative of anything important at the next call. And then your first question?

The first question was whether the tech and development costs were going to taper off a little bit now that the Website redesign was completed?

No, we still feel the increased investment in tech and dev is paying off in terms of the lower churn, in terms of more efficiency throughout, so we'll continue to invest in that in terms of building really the efficiency of the system throughout.

Okay, thanks.

Gordon Hodge with Thomas Weisel.

Barry, I think your comments about the expenses, was that for bonus accruals I gather? You stepped that up a bit since you're so far ahead of plan, is that what you meant? Or the adjustments?

No, they were salary increases that we passed through.

Got it. And then -- I guess a similar thing, but then as far as the tech and development spending goes, can you share with us any of the -- are there any new projects or things that you're exploring in terms of future growth initiatives that are in there that we could look forward to at some point?

The investments -- we continue to really make the site better, we continue to do a lot of AB testing, improving testing, if we improve the performance what kind of lift do we see, continuing to work on the Netflix recommendation system, building out some things, but nothing that I can tell you in advance. What we do is we want to verify that these things actually make a positive difference. So think of it as a continued investment in lowering churn and improving the word-of-mouth, but we're deciding experiment by experiment which ones really do do that.

But you're not experimenting with digital distribution ideas or gaming or anything like that?

You know, we haven't really talked about what we're not experimenting with or we are experimenting with, so I don't want to take anything off the table. We continue to experiment with lots of things, but these are experiments that are visible to a substantial fraction of the base. So you can certainly tell we're not doing videogames live at this point.

Great, thanks

Stewart Barry with Delafield Hambrecht.

The Internet has obviously been a crucial marketing channel for you -- for you to source traffic, and it's been a cheap channel the last couple years. What we learned from the third quarter from Yahoo! is that demand for online advertising, the price per listing and the cost per impression is going up and it's going up significantly. How do you guys plan on keeping your lower SAC -- acquisition cost in the low 30s, particularly when next year you're going to see a lot more Fortune 500 companies advertising and sort of paying for the same space that you've enjoyed, really not competing for -- in the marketing budgets?

We got two things going on. One is the advertising recovery, in addition there's a lot of new inventory that's coming along. For example, all of the paid search which just didn't exist two years ago as inventory. So when we look at it we don't feel particularly exposed to sort of steady recovery in the advertising market that everybody has been forecasting for quite a while. Remember that lots of our subscribers come to us straight from word-of-mouth, that is not through online, and only a portion of our new subscribers is from online. We've looked at it as we put together our guidance for Q4 and thinking about next year and we're comfortable including, and having baked in already, those steady improvements in the advertising market.

Okay, thank you.

Tom Barrett with Serios (ph) Capital.

Just a question on the ARPU, and I'm sorry if I missed it, I had to step out for a second. You said the ARPU was up sequentially, I think to 20.28, we're just hoping you could help us understand what drove that, and is that a sustainable -- kind of directionally can we see ARPU going higher from here, or was there some kind of blip in the quarter? Anything to help us understand that would be great. Thanks.

I would say it's not something we drove necessarily, it had happened to us, that's the good and the bad news about it. We're talking about very small percentage changes in the customer mix, and we saw a slight decrease in customers at the very low end of the price points that we offer. There are different price points for different size programs. And we saw a very slight increase in the number of customers both at 19.95 and at the high end of the price range, 24.95. So in combination we saw on average a slight increase in ARPU.

Barry, are you using -- to calculate ARPU are you just using average kind of beginning paying subs and ending paying, or was that like more of a monthly average whereby maybe the average would've been skewed a little higher if the subs were skewed to earlier in the quarter? Do you see what I'm getting at? In terms of how you calculated that?

Beginning and end, yes. I'm sorry -- I think I said that we saw an increase at the 24.95 price point and I misspoke, it was at the 29.95 price point.

Okay, great.

You might think that that would've contributed incrementally to increased usage because people have bigger library sizes, but it didn't appear to.

Okay, thanks

And that was our final question. I'll go ahead and hand the conference back to Mr. Reed Hastings for our closing comments.

Thank you all for participating in this call. Sorry for the AV hic-cups, and look forward to talking and meeting with you over the rest of the quarter. With that, we'll close. Thank you.

And that does conclude today's conference. We thank everyone for their participation. We hope you have a great day.