Netflix Inc (NFLX) 2003 Q4 法說會逐字稿

Good day everyone and welcome to today's NetFlix Fourth 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 Deborah Crawford, Director of Investor Relations. Please go ahead, Ma'am.

Welcome, ladies and gentlemen, to our Fourth Quarter 2003 earnings call. Before turning the call over to Reed Hastings the company's founder and CEO, I will dispense with the customary cautionary language and comments about the webcast for this earnings call. We released earnings for the fourth quarter at approximately 1:05 PM 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 PM Pacific time today.

We'll 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 risk 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. And now over to Reed.

Thank you Deborah. In 2002 we announced plans for NetFlix to reach $1 billion in revenue in the 2007 to 2009 time frame. We are proud today to announce an acceleration of that guidance. Our new guidance is for NetFlix to achieve $1 billion in revenue in either 2006 or 2007. Many factors underlie our increasing confidence in our business. First, DVD adoption continues to grow with $29 entry level DVD players. DVD players in many family automobiles and many homes getting multiple DVD players. Household penetration is now estimated at over 55% and growing steadily.

DVD is the rocket propelling studio profits and we believe that DVD movie revenues will continue to fuel studio growth for many years to come. The second factor supporting our increase in confidence in our business is the steady march forward of internet shopping and broadband deployment. Each year consumers are getting more comfortable using the Internet for more of their life and all the leading eCommerce companies, including NetFlix , are growing impressively. The third factor underlaying our accelerated guidance is the large and growing barriers to competitive entry.

Very large companies have tried to gain a foothold in our market and have not succeeded after 15 months of effort. We estimate we continue to maintain over 95% market share. Our service is superior, very hard to duplicate and our 1.5 million subscribers are very satisfied. We have great momentum. The fourth factor building our confidence is that our growth in our initial market, the San Francisco Bay area, has been very steady over the past 4.5 years. To reach $1 billion in revenue we need approximately 5% of U.S. households to subscribe to NetFlix. The Bay area reached the 5% penetration level and then kept right on growing.

It may be possible that the 5% penetration level is conservative and we may be able to reach 10% of households in the Bay area over the next four years. If so, it would indicate that the $1 billion revenue mark is not the finish line, but merely the first watering station. We will continue to actively monitor our initial market to see just how large the market for on line movie rental could become. The fifth factor propelling us forward is our falling subscriber churn. This quarter for the first time ever, our churn is below 5%. While we may or may not have certain quarters in the future with churn above 5%, we are now confident that for the full year 2004 churn will be below 5%. Finally, the sixth factor behind our increasing confidence is great execution.

Every week we ship over 2 million packages from 23 locations with incredible reliability and precision. We buy millions of DVDs every quarter and maintain strong relations with nearly 100 studios. We grow steadily every quarter without material operational hiccup. We are vigilant about threats both long and short-term. We care deeply about providing consumers a great movie service. And work every day to make our service better and better.

Looking forward to 2004 and beyond you can expect more of the same steady execution that has distinguished us in the past. We continue to be focused on the virtuous cycle of improving the NetFlix service. Service improvements result in lower churn and friends telling friends about our service, both of which contribute to our faster growth. As we grow we become more efficient. These efficiencies pay for the next round of service improvements. It is our continued execution of this virtuous cycle that lowered our churn over the past two years and kept us growing at an astounding 70% plus annual rate. In addition to our core focus of driving the virtuous cycle we have several new initiatives in 2004.

In 2004 we plan to blend TV advertising into the mix of acquisition channels we use to grow our subscriber base. Subscriber acquisition cost will increase approximately 10% to cover the cost of television. But because we are a subscription business with a large recurring revenue stream we expect total marketing spending to fall slightly as a percent of revenue in 2004 as compared with 2003. Given the potential of TV advertising to grow our subscriber base, I anticipate there will be many questions about our approach.

To put it in perspective, however, in our internal plan TV is responsible for less than 10% of our gross subscriber addition in 2004. On line advertising and word of mouth will continue to generate the bulk of our subscribers. I encourage you to think of our TV expansion as a healthy diversification of our subscriber acquisition strategy rather than think of it as the strategy itself. During 2004 we are preparing to expand internationally in 2005. Our first markets are likely to be the UK and Canada. It is possible that we will launch one of those markets in late 2004. If so, we will update our guidance at that time.

Both markets are good expansion markets for us. But in the next few years, while the U.S. market is growing so fast, international will contribute less than 20% of revenues. Nevertheless it is prudent and exciting for us to begin moving from a domestic to a global company. Also during 2004 we're developing some solutions. We're downloading movies to consumers in 2005 and beyond. Our core strategy has been and remains to grow a very large DVD subscription business and offer our subscribers the choice under one subscription of receiving their movies on DVD or by downloading, whichever they prefer.

2005 will be early for downloading and we expect only modest consumer interest initially. But it will grow steadily for us over the next ten years. We are currently $100 million plus customer of the studios and they have been receptive to our desires to expand the consumers movie option. For competitive reasons, we will not be discussing more details of our downloading initiatives until we are closer to consumer launch. One of the most satisfying aspects of NetFlix's success is that our employees get closure to their personal dreams, whatever they may be.

Barry McCarthy has been instrumental in our success over the past five years. But he has also been yearning for a COO or CEO role. Since I am quite likely to continue actively running NetFlix for many years to come we both agreed he should look outside NetFlix at some point in the future. While a transition is always difficult, our extraordinary momentum this year made it a good time for such a transition. So at the end of 2004 Barry will resign as CFO. Given the long notice it will be a very thoughtful and orderly transition to a new CFO.

Barry will have a great career as a operating guide and will be a friend of the company for many years to come. In the long-term we intend to be one of the world's leading media companies. Creating a very large on line DVD movie business is our first goal, which we now clearly have the momentum to achieve. Our next steps are to begin our global expansion and our expansion into downloading. We approach these steps with excitement, but also knowing that for many years, the domestic DVD business will be at the core of our success. At this point I would like to turn it over to Barry.

Reed, thank you and thanks everyone for joining today's call. For some the timing of this call is inconvenient and I apologize for the overlap with eBay. Our announcement today of record earnings, together with our pre-announcement of these results on December 17th, demonstrate solid progress toward reaching our long-term goals of $1 billion in revenue and 100 to $200 million in free cash flow. Because the numbers tell a compelling story of rapid growth and catagory dominance and because our results are in line with prior guidance, my prepared remarks touch briefly on the Q4 highlights but focus primarily on our 2004 guidance.

Financial results for the fourth quarter were in line with the strong results we pre-announced on December 17th and at the high-end of street expectations of non GAAP EPS of 19 cents. We produced record revenues of 81.2 million, record low churn of 4.8%, record non GAAP net income of 6.1 million and record free cash flow of $9.2 million. A 17% increase over last quarter's record free cash flow. Subscribers embraced our holiday gift certificate offering which resulted in strong growth in free cash flow for the quarter. ASP continued to rise this quarter as it did last quarter. And for the third consecutive quarter we saw a small shift in our subscriber base to higher price points. For the full year 2003, ASP increased by 1.3% or 26 cents per subscriber.

I'm calculating ASP as the average price paid by all paying subscribers. This means by way of example in a two subscriber model that one sub paying 19.95 who joins NetFlix in the beginning of a quarter and one sub paying 24.95 who joins Net Flix at the end of the quarter have an ASP of 22.45. Gross margin of 45.2% beat the high-end of our guidance by 70 basis points but as expected this out performance represented a decline from third quarter of 130 basis points. As planned the margin decline was caused by an increase in content cost. Higher rev share and depreciation expense contributed in roughly equal measure to the lower gross margin. 90 days ago I told you we would increase our Q4 inventory buying to the range of 22 to 25% of revenue. Actual purchases were 23% of revenue. These purchases drove an increase in depreciation expense this quarter. The increase in rev share spending represented an increase in the unit cost per rev share disk.

Disk usage was not a contributing factor to lower gross margin in the quarter. Usage declined slightly in the fourth quarter, as it did one year ago, to less than 6 disks per paid subscriber in line with our forecast. We reported subscriber acquisition cost of $32.89 in the quarter and the low-end of our guidance and one dollar higher than last quarter. Our second consecutive quarter of gradually rising acquisition cost. The increase this quarter was attributable to Q4 television testing. In total television testing increased SAC by just north of $2 in the quarter. With the rollout of television testing in 2004 we expect to increase SAC to $35 for the year. If we continue to be successful with television testing in 2004 it could play an important role for us in 2005.

The question institutional investors ask me most often is this - can NetFlix spend more money on SAC and grow the business faster and the answer has been no, not within the financial constraints we've established for the business. But test results for television look promising. enough for us to want to invest additional resources this year to try to grow faster. Later in my remarks I will tell you why we can afford this increase and what it means for 2004 guidance. For the first time if our history average monthly churn dipped below 5% to 4.8% in Q4 as compared with 6.3% one year ago and 5.2% last quarter. This is the fifth consecutive quarter of declining churn.

Churn continued to drop and retention rose across all customer periods because of the investments we made in 2003 to provide more rapid DVD delivery and better content availability for our subscribers. In the last four quarters the impact of declining churn, and to a lesser extent the gradual rise in ASP, have dramatically increased the life time value of the Net Flix subscriber by 75% from $40 of non GAAP operating income per subscriber in Q4 of 2002 to $70 of non GAAP operating income per sub in Q4 of 2003. You can link to an exhibit showing this growth from the IR section of our website. We last reported the lifetime value of a NetFlix subscriber on April 17th in our first quartet 2003 earnings release. Since that release, and in spite of of our increased SAC, subscriber life time value has increased 48%.

In previous quarterly calls you have heard me speak about the importance balancing three key metrics, Sac, churn and gross margin in order to maximize the financial performance of of our business. Because the lifetime value is up strongly, we can afford to invest in sustaining our rapid rate of subscriber and revenue growth by increasing the amount of money we spend to acquire new subscribers and with that segue, let me comment on our 2004 guidance. We expect revenues of 450 to $475 million for the full year 2004, above the high-end of street estimates. To put this in perspective we expect to grow faster than we thought possible one year ago and faster even than we thought possible on the third quarter earnings call in October.

As Reed said we now expect to reach $1 billion in revenue in the 2006 to 2007 time frame, one to two years earlier than we predicted previously. We expect pro forma net income in the range of 38 to $45 million for the full year 2004. Gross margins will be in the range of 44 to 46%, assuming continued heavy investment in inventory for the full year. This guidance is in line with actual results for 2003. Sack for the full year will be in the range of 34 to $36 per acquired sub. As Reed mentioned we plan to increase SAC approximately 10% to cover the costs of television advertising. In technology and development spending we'll continue to invest in web engineering initiatives which enhances the subscriber experience on our website, International growth initiative and at a low level of investment digital downloading initiatives.

For Q1 of this year we expect to report $1.75 to 1.825 million ending subscribers and revenues of 94 to $99 million. The quarter is off to a strong start and we expect subscriber growth to establish a new record for NetFlix in Q1. Rapid subscriber growth will pressure operating margins in the quarter. The increase in SAC will be a contributing factor to lower margins but the primary driver will be rapid new subscriber growth. With the start of a free trial we expense 100% of the cost of acquiring a new subscriber which increases marketing expense initially followed by an increase in subscriber profitability. With an average life time value of $70 in operating income per subscriber, fast growth is a good thing for enterprise value, despite the short-term hit to margins. On last quarter's earnings call I said we would update you on our thinking about international expansion on this call.

We are interested in Canada and possibly the UK and could begin to launch in one of these two markets later this year, possible in Q4. But it's premature to say definitively that either market will launch in 2004, so you can expect us to update you and our financial guidance during the year if and when we firm up launch plans. Our earnings release today announced a 2 for 1 split of NetFlix common stock. Shareholders of record on February 2nd, 2004 will be entitled to the split. The payout date will be February 11, 2004. This is the first, but probably not the last stock split we'll announce on our way to 1 billion in revenue.

To some this will sound like false bravado. But, I don't think so and history tells you that's not been our management style. I would like to thank you for your continued support and confidence in our ability to meet our objectives for the business and I look forward to reporting on our results as the year progresses. And now, operator, we'll open the phones to questions.

Thank you. The question and answer session will be conducted electronically. If you would like to ask a question, you can do so by pressing the star key followed by the digit 1 on our touchtone telephone. If you are using a speakerphone please make sure your mute function is turned off to allow your signal to reach our equipment. Once again it's star 1 if you do have a question or comment and we'll pause a moment to assemble our roster. Our first question comes from Gordon Hodge with Thomas Weisel Partners.

Good afternoon. Couple questions. One, just wondering if you are seeing, yet, any seasonality in churn, would you be -- I think first quarter last year churn ticked up a little bit from the fouth quarter, should we look for that kind of seasonality again and then had a question on capital expenditures a little higher in this last quarter than it had been running in the past. I'm just curious if you could detail what is in that number and then lastly as far as subscriber acquisition costs go, are you seeing any increased pricing on your online ad spending? Thanks.

Gordon, it's Reed. I will take your first and third questions and let Barry do the second on CapEx. In terms of churn, there isn't seasonality for any given customer class but there is customers stay with us more the longer they stay with us. That is after one year the churn is significantly less than it is in the first month. So when you have concentrations of new customers, which we do in Q1, overall churn can rise slightly.

Yep.

Now that can be offset by overall churn improvements and Q1 last year we had thought that churn would go up but, in fact, it went down from Q4 to Q1 and this year it's likely to go up a little bit, but it can be offset again by the improvement in the underlyings in the service and therefore the underlying proclivity to churn. Your third question was on subscriber acquisition cost, which we're managing in the $35 range now and yes, we have seen at times some increasing on online costs but also some improvements in efficiency in terms of placement, in terms of other things that have offset themselves. So the effective cost to us has been very steady.

Great.

And I'll turn it over to Barry on that capitalized.

Gordon, Barry. Let me just add to Reed's answer on SAC. Our overall strategy is to acquire as many subscribers as we can for $35. As brand awareness grows and the popularity of the service grows, as word of mouth increases as a source of acquisition, viral growth component drives growth, we are able to reach into channels of acquisitions that today are cost effective for us on a cost per acquired sub that were not a year ago. So even though there is a trend of increasing cost in internet among some select real estate, one it's subject to seasonality, so for instance there were sites we weren't active on late in the fourth quarter because costs were being bid up by other companies but those other companies were not in the market then, the cost is low and you will see us prominent on sites you didn't see us on around the holidays. And then secondly, the overwhelming macro trend is that our spending is more and more and more efficient. So that is overwhelming the micro trend of increased costs on a rate card basis. With respect to CapEx, in Q1 of this year you should expect us to spend roughly, as a percent of revenue, at the level we spent in the fourth quarter.

Okay.

And on a go forward basis I expect it to drop as a percent of revenue and I expect the average to be down from first quarter levels for the year.

4.5 million in the fourth quarter, what is in there? Are they some of the new initiatives you're talking about?

Sorry, Gordon, perhaps I misunderstood. I assumed your question about CapEx related to inventory buying.

I'm sorry, I meant the PP&E part.

Sort of steady state.

That 4.5million a quarter or 8 million a year?

I would think about it on a quarterly basis.

Okay. Thanks.

And we'll move next to Dennis McAlpine with McAlpine & Associates.

Thank you and good afternoon. Would you talk about taxes and when that word might creep into your P&L and also as you go into '04, what your plans are for rev share versus outright purchases and what you see shifting as the year goes on?

It's Reed, here, can we just did the second part again.

What you anticipate will happen in percentage of product acquired through rev share as opposed to direct purchases?

Sure. Rev share and purchases we move back and forth between those on a studio by studio basis as we have in the past. Partially determined by where we get the best deal and partially determined by where the studio prefers us to be. So as we have in the past, we have managed to the steady gross margins in the neighborhood of 45% that we have been at and managing to keep free cash flow positive, but within those constraints we move fluidly between rev share and purchase. With that said, I don't see any significant shifts for us over the coming year. And then on taxes I will turn over to Barry.

In the current quarter it was announced it was roughly equally 50-50. In terms of taxes we've got about a $90 million NOL for federal purposes and as the stock price continues to rise and people make disqualifying dispositions for tax purposes, NOL continues to grow even as the business turns profitable. So in the current year they were on the order of, meaning '03, they were on the order of up between 16 and $20 million of disqualifying dispositions. So the short answer is no time soon. Possibly in three years and probably not over the next two.

And then also would you just talk about your plans for additional fulfillments centers or are you satisfied with having the 23 that you have got?

Dennis, it's Reed. We'll continue to open more centers, but we now have 80% of our subscribers and 70% of domestic households in one day coverage, so the incremental coverage is nice, but not particularly significant to the overall business momentum.

Thank you.

And our next question comes from Richard Ingrassia with Roth Capital Partners.

Thanks. Good afternoon, guys. Tell me in the increase in deferred revs and payables on the balance sheet, anything there other than what we'd expect and seasonality and increased content cost?

No. In terms of payables we are current, as always, and so it reflects the purchase of content and the payment under normal terms and circumstances. In terms of deferred revenue, it's also what you'd expect. We typically see a large growth in the number of subscribers late in the quarter and so to the extent that - and we particular quarter we saw an increase in the number of paying subscribers in the first quarter because we saw an increase in the number of returning subscribers. And so that happens late in the quarter. most of the revenue gets deferred. For the purposes of all of our listeners, the rev recognition here is plain vanilla and very formulaic. If you come in on the first day of the month, we recognize 100% of $20 of revenue. If you come in the middle of the month we recognize 10 and defer 10. If you come in the last day of the month we're going to recognize one thirtieth of it. So it's a straight pro-rata based on when you start .

Thanks. And can you give us a little bit more around the Q1 guidance? It looks like you are looking at a GAAP net loss and I'm assuming maybe most of that is due to stock-based comp. Maybe if you can include a little discussion on how you model for stock-base comp, that would help.

We guess at it, just like you do, honestly. It depends entirely on how much of an increase in stock price you estimate and you notice last quarter we estimated a range, this quarter we picked a point estimate. The reason we change the process is it's an absolute guess on our part. So I think the number was $4 million roughly in Q1 . So there is an increase in stock-based comp which is contributing to the increase lose also. Marketing expense is a percent of revenue is increasing because of the dramatic increase in the number of acquired subs that we are projecting in Q1. Those are the two principle contributing factors. Many of the other categories of expense are actually dropping as a percent of revenue. But for the increase in marketing expense the stock-based comp we would see improvement in margins.

Just lastly on Gordon's question, I'm not sure I caught what exactly was in the $4 million CapEx in Q4, the PP&E CapEx?

It's hardware primarily, system's related stuff as we build out infrastructure to accommodate increased traffic.

Okay. Thank you.

Yea. A lot of those deals tend to be back-end loaded when hardware manufacturers are trying to make their budgets for the year and are aggressive on pricing.

I see.

We'll move on to Safa Rashtchy with Piper Jaffray.

Hey, guys, this is actually Jason calling in for Safa. Congratulation, first off, on a great quarter, again. Couple of questions. First, wondering if you could give us little bit of sense, especially within the UK, of market size, just in terms of DVD penetration of total households and then secondly, wondering about mix of media, especially TV, in terms of purchasing, is it going to be cable, is it going to be network, is it going to be a combination of the two? Any thoughts there? Thanks.

Hi, Jason, it's Reed. On the UK market size, it's about 60 million consumers, so about one fifth of the US. Canada is about 30 million or 0.10 of the US and DVD penetrations proclivity to rent and all of those factors are very similar to the US. So it's pretty much a population extension in terms of potential market size. In terms of TV buying strategies, we'll use all of the above in any range and our commitment is to manage it within the $35 subscriber acquisition.

Great. Thanks.

Our next question comes from Haget Reino(ph) with First Albany Capital.

Hi, Haget Reino for Youssef Squali. Following up on the churn question, can you comment on churn in the month of December? You mentioned that it was declining over the quarter.

Well, we don't break it out by month. I would say that we have seen continued reduction in churn and a continued increase in retention for month over month and quarter-over-quarter for some period of time across the entire subscribe base regardless of age of subscriber out through the 12th month and beyond when we are still asymptotic in the range of 2.5% to 3%.

Thank you.

Our next question comes from Stewart Barre with Delafield Hambrecht

Hey guys.

Hi, Stewart.

In 2004 we certainly see the phenomenon of online music and I was wondering if you think in 2005 you'll see the similar phenomenon in DVD and the change in distribution and whether or not that's going to allow the likes of Yahoo and AOL and others, who have great online distribution and traffic, to start competing and how do you think your brand can withstand that type of distribution should it happen?

It's Reed here. 2005 is probably early because of two factors. One is total number of households in internet bandwidth to the home and then second is sort of last ten feet problem, which is using YiFi to get to the television. Until it becomes a television viewing experience, it will remain a very small and niched market, basically viewing on laptops for travelers. So it's really the thing to keep your eye on is YiFi and the progress of devices such as connect to DVD players which are YiFi enabled, linked as media adapters, and it's as that infrastructure starts to get into several million homes that you have got an interesting market in downloading video content to consumers and so we look at it and say well, the devices are starting to be there, they're pretty clunky but time will work that out and by 2005 maybe there will be a million or two devices that one could download to that are TV connected. And so it starts at that time roughly like the DVD market in 1997 and then it will take 3 to 5 years for that to get to 50% of homes, where you have quite an interesting market, like today's DVD market, that is again you've got a TV connected Internet. So that's really the gaining factor. As that happens over the next five years, no doubt AOL, Yahoo, a number of others will enter the market to some degree like the music services and one of our major strengths is being able to intermix content with DVD because very few services, if any, will offer DVD or downloading in that choice and we think that's a critical issue for the consumer because much content, such as new releases, will only be available in DVD. So it's the intermixing of the two that give us this very important key edge in the 5 to10 year transition to the downloading world.

Okay, thank you very much.

You bet.

Our next question from Sean Collie with Radiant Capital.

Hi, actually my tax and CapEx questions have been answered, but I guess I'll just touch on the lifetime value for subscriber calculation. I think when you guys first disclosed this in the March quarter I think you'd based it on EBITDA per sub and now it looks like you're doing it more on an operating income. So I guess really the question really just becomes any guidance you think you could give, I think you touched on it, as far as this year or maybe in the out years, what percentage of revenue you think you will have to spend per sub after the DVD library. Just so I can work that into my cash flow per sub numbers.

Well, we're sort of spending in the 15% range now of revenue. So I would use 15% of revenue probably as an estimate. Might be as high as 17 at the outside in periods where we are making heavy inventory investments and content. But probably something steady, stay at 15% range.

So I think it was 23% of revenues this quarter, and 19 last quarter, so you are expecting it will trend down? Over what time fame?

But let's think about it differently. You are talking about a CapEx expenditure

For the DVD library

Your question ran into depreciation.

I'm sorry, I meant for the CapEx so I can look at the lifetime value for sub on a cash flow basis.

Something in probably the 19 to 20% range for the year and probably trending down over the long-term.

Okay. Any particular percentage you could guide to?

No.

Okay. But you don't expect it will scale the way marketing does?

I think there will be some scale opportunities, but we're in the process of learning what those are, which is why I am hesitant to give your guidance out that far. But I would say for purposes of this analysis, if it's a straight EBITDA calculation, in the DA you want to add back, it's about 15 to 17% of revenue

I actually just want to look at it on an actual cash flow basis.

Got it.

Thank you.

Of course then you want to back out of the calculation, the depression expense. If you are going to subtract out the Cap Ex

Absolutely. Thank you.

Yep.

And once again as a reminder please press star one if you have a question or comment and we'll move to Morgan Frank with Manchester Management.

Hi, guys. I just have a couple of what I hope are pretty quick question. First, and just sort of modeling what your marketing might look like in absolute dollars for the March quarter and it looks like maybe it will be up 30 - 35% in absolute dollars. Does that seem about right?

I think on a percentage basis it won't be too terribly different than it was in Q4.

As a percentage of revenues?

Yeah.

Okay. And then my second question was what has the percentage of revenue spent on your new title acquisitions been over the last couple quarters? You gave it to us for this quarter but what was it for the last couple of quarters and then what you do anticipate it to be in the March quarter of next year?

It's Reed here. It's been reasonably consistent within 3 or 4 percentage points up and down and again it depends if we're on a purchase relationship with the studio and for their own internal reasons they'd like to move us to rev share and we get great terms on that. We'll make the shift and switch into rev share which we meant it for the P&L and keeping our 45% gross margins, but that would shift that mix between depreciation and revenue share. Similarly if the studio is on rev share with us and they decide that is would perverse to purchase and offer us great terms on those including payment terms such that the cash effects show up as payable. But in any case then we would move freely between that. So we wouldn't want you to build in - we'll move those numbers around to grow the business, but at keeping the gross margin consistent.

Morgan, Barry. Let me jump back in here. I was reading from the wrong line, as it turns out, marketing expense can be up in the 23% range not in the 18% range in Q1

I was about to ask you how you got that because it didn't make any sense

You're wondering what else is broken.

I was tying to figure out what was wrong with my model and now apparently - that makes a lot more sense

And then for the year it's the marketing expenditures, again doing the same math out or more in the 17 - 18% range. Q1 it's front-loaded

Sure, but then it looks like it kind of dips maybe down to about 16 by the end of year?

Correct, paralleling, for example, the trend in the four quarters of 2003.

Great. Thanks very much, guys.

But bet.

And we move on to Dennis McAlpine with McAlpine & Associates.

One of the concerns had been, of course, the competitive threat from Hollywood, Blockbuster and they seem to be saying, gee, we can do an in-house subscription service but they both have pulled back from doing an online subscription service. Can you talk about the differences between the two? Why an online service is so much harder, apparently, to pull off and whether you would be amenable to offering a service that would fit inline or instore with some other distributors?

Sure Dennis. It's Reed here. I think both Blockbuster and Hollywood are great at store operations, at building the brand, embodying movies and they will do that well, whether that is store based subscriptions or the ala carte models that they use now and it turns out that eBusiness is considerably more software intensive and it has favored companies that are really built for software, such as Amazon, such as ourselves, such as eBay and I think probably the primary difference is one of our top three competencies in the company is software and that hasn't had to be true for Blockbuster or Hollywood and they find any very significant software project, even though they typically contract them out, just managing and overseeing that is substantially difficult. So I think you will see as you referred to Blockbuster postponing its plans in terms of online and my guess is eventually they will do a very go job in the stores and then either lackluster or no job at all on line. We'll see how that pans out over the next year or two. In terms of working with others. We've talked through a range of different models over the last three or four years and we've never found an economic model that works both for us and for the stores. It simply is too cannibalistic for the stores, cause once the store customers find out about NetFlix they really don't want to do much with the stores. Anytime we talk about doing hookup with either the big chains or some of the smaller ones, both of us realize that it's essentially them selling us their customer base. Because, again, once the customers find out about NetFlix and try it they don't really want to go stand in line and do the whole rigamarole that they have to do in the stores.

And as you look at the international market can we assume that both Canada and UK the minimum postage cost, weight wise, is enough to ship one DVD?

That is correct. Both the postal systems work close enough to the U.S. in terms of sorting postage and all the critical aspects

And as a percentage of revenue they come out about the same?

That is correct.

Thank you.

And that does conclude our question and answer session. I will turn the call back over to Mr. Hastings for any closing remarks.

Thank you all for your support in 2003. That was really an extraordinary year for us in terms of maturing as a company, steadily delivering and it's what we look forward to repeating in 2004 with your support. Thank you very much. Bye-bye.

That does conclude today's conference call and we do thank you for your participation.