Netflix Inc (NFLX) 2004 Q1 法說會逐字稿

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

Thank you. Welcome, ladies and gentlemen, to our first quarter 2004 earnings call. Before turning the call over to Reed Hastings, the Company's founder and CEO, I will dispense with the customary and cautionary language and comment about the Web cast for this earnings call.

We released earnings for the first quarter at approximately 1:05 PM 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 web site at www.netflix.com. A rebroadcast of this call will be available at the Netflix website after 5 PM 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 filing with the Securities and Exchange Commission including our annual report on Form 10-K filed with the Commission on Feb. 27th, 2004. And now over to Reed.

Our Q1 results announced today were the strongest in our history. Record revenue of over $100 million. Record low churn of 4.7 percent, down from 5.8 percent one year ago. Impressive 84 percent year-over-year subscriber growth to nearly 2 million subscribers. Steady $35 subscriber acquisition costs as forecast.

And now in the Oakland, San Jose, San Francisco Bay area over 7 percent of all households subscribe to Netflix. Our core strategy continues to be providing our consumers the world's best new movie service. Quarter after quarter we relentlessly improve our service with faster delivery, better selection, and a more individually tailored website.

Our strategy continues to pay off in terms of increased satisfaction, reduced churn and faster growth. Five key factors propelled our tremendous 84 percent year-over-year growth.

The first is increased satisfaction, which generates more word-of-mouth for Netflix. Consumers who have heard great things about Netflix from their friends are more likely to respond to our online TV and inbox advertising. While we have many internal measures of increasing subscriber satisfaction, the best external indicator is our falling churn.

The second factor fueling our growth is the effectiveness online advertising spending. We advertise across many platforms and with many different economic models. Our multiyear expertise in this field allows us to be both efficient and effective. In February, Nielsen net ratings wrote that we were the number one advertiser on the Internet.

The third factor driving our growth is our success with television advertising. We were able to advertise moderately and stay within our $34 to $36 subscriber acquisition cost budget. In the months ahead, we will be refining our media buying strategies and creative content in order to continue to increase our efficiency and effectiveness.

In Q1, we were only in regional spot markets. In Q2, we will use regional spot markets plus some limited national cable.

Each quarter, we tailor our television spending to stay within our $34 to $36 sack (ph) model. The fourth and fifth factors driving our growth are the rise of DVD and Internet commerce, which, of course, are two of the biggest trends ever in the history of the American consumer.

It was one year ago during our 2003 first quarter earnings call that I told you that we were going to invest more in content and provide a better Netflix subscriber experience. I predicted then that these investments would result in faster subscriber growth, lower churn, and increased subscriber value over 2003. And, indeed, all three predictions came true.

Now we are ready to take the next step. Getting to sub 4 percent churn next year. To do this we are going to increase our spending on content to improve the new release experience for our subscribers and two, we are going to change the price of our service from $20 to $22 per month effective mid-June.

By charging more and spending more, we can run a better service with lower churn and in particular sub 4 percent churn next year. Why do we think that our subscribers will except a 10 percent price increase? The key reason is, we have succeeded in getting our typical subscriber to watch more movies from us by providing faster delivery and better selection.

Over the past two years, we've helped our subscribers go from watching under five movies per month to watching nearly seven movies from a period at $22 and nearly seven movies per month our typical subscriber is still getting a terrific value. In addition, this is the first price increase we've done in nearly four years.

This price increase will take effect in mid-June so that our subscribers have appropriate notice. Because of the price increase we may experience of a slight temporary increase in churn in Q2 and a slight decrease in our year-over-year subscriber growth rate.

While increasing our prices 10 percent creates some temporary pressure on growth and churn, it will pay off handsomely in the second half and beyond in terms of lower churn and increased profitability because of the improved service we can offer at $22 per month.

Thus, we are increasing our revenue and profit guidance for the year.

In addition to expanding our profitability, we have continued to expand our success in growing the movie market as a whole. We are using our Cinematch (ph) software to help each subscriber select committee that will be most enjoyable for them. In doing so, we are making subscribers happier, thus increasing their movie viewing.

In addition, we are helping the movie studios to find markets for good but difficult to market films. For example, The Hulk performed well for us as a mainstream film. No surprise. But Whale Rider -- a small delightful empowerment film which was released the same week as The Hulk -- instead of withering performed on par with The Hulk in terms of rentals and revenue to the studio. In short, a $26 million film is performing like a $100 million film.

Obviously if we can have this impact at 2 million subscribers, the positive impact for the studios we can have at 5 or 10 million subscribers is truly profound.

Switching to international expansion. Our plan is to enter the UK in Q4 and Canada in 2005, subject to completion of our studio purchasing agreement for those territories.

Our UK investment in 2004 will be less than $10 million or 2 percent of this year's revenue. The primary launch cost will be subscriber acquisition spending and our investment in acquiring DVD inventory.

In terms of competition, in Q2, Blockbuster will be expanding their store base subscription program from the current 1,000 stores through all of their domestic stores. They launched their store base subscription program in the Oakland, San Jose, San Francisco Bay area nearly a year ago and our growth has continued unabated. So, we expect little to no impact from their program expansion.

In terms of their online efforts, we expect Blockbuster.com to be approximately as successful against us as Barnes&Noble.com was against Amazon. Until we are sure, however, we continue to watch them closely.

During the quarter, there was more confirmation of cable Video On Demand's weak potential. An influential investment analyst documented it, why VOD makes little sense to the studios because their profits with DVD are so much larger. This echoes the theme outlined in our February analyst conference.

Nevertheless, we are continuing the plan for a modest launch of our own electronic delivery service in 2005. Simply put, it is better to be too early than too late and we will be very early.

Lastly, we are very happy to see the Oakland, San Jose, San Francisco Bay area continue to keep growing. This quarter we achieved 7 percent household penetration and are on track to reach 10 percent of all Bay AREA households in 2005. More impressively the growth in all of our other one day markets continue to track the Bay Area growth, implying that 10 percent of all U.S. households may be achievable some day.

I'm enormously proud of our success in Q1 and I look forward to taking your questions after Barry concludes his remarks. Now I'll turn the call over to Barry.

Thank you, Reed, and good afternoon, everyone. Today we announced strong results in the high end of our upper (indiscernible) revised guidance for the quarter. We reported Q1 revenue of $100.4 million, up 24 percent on a Q over Q basis and 80 percent on a year-over-year basis. This Q over Q growth was the strongest we've seen in the last two years.

Record new trial growth and record low churn both contributed to record high revenue in the quarter. Online and word-of-mouth continued to be our primary sources of acquisition in the quarter. Online results were particularly good. In anticipation of a strong demand for our service in the first quarter, we were aggressive in our first quarter online purchasing and that -- combined with improved placement and creative -- led to strong results across all of our online partners.

We also saw strong results in the handful of markets where we tested television advertising. TV advertising accounted for approximately 10 percent of total new trials, reflecting the still limited role of television advertising in our overall acquisition mix and strong results in online acquisitions during the quarter.

Gross margins for the quarter was 43.6 percent in the low end of our guidance and 160 basis points lower than the prior quarter. Excluding nonrecurring adjustments to rev share deals gross margin would have been 42.3 percent in the quarter. Gross margin was pressured in the quarter by increased usage among paid subscribers. Monthly usage was up across all user classes by approximately 8/10ths of the disk (ph).

No one customer class accounted for disproportionate increase in usage. Usage was up for new and old subscribers alike.

The non GAAP net loss in the quarter was $1.4 million, about the midpoint of our guidance. Despite our strong new trial growth and the marketing acquisition expanse which accompanies new sub growth. As in past quarters, the cash flow remains strong at $9 million. For the 10th consecutive quarter, we generated more cash than we consumed despite our average growth. We also maintained our high level of CapEx spending on DVD inventory as we did last quarter.

Today's earnings release included financial guidance for the second quarter and updated guidance for the full year. As we forecast 30 days ago, we expect the overall business to return to GAAP profitability in Q2.

Slower subscriber growth and reduced marketing expense will be the primary contributors to the expansion in operating margins. Q2 may be a transitional period for the business with modest net new sub growth and increased churn resulting from the planned price increase and lower gross margins associated with average usage of about seven discs a month. In addition to GAAP profitability we expect to generate positive free cash flow for the 11th consecutive quarter.

To put our Q2 guidance in context, I would like to say a word about seasonality. Historically, the first calendar quarter has been a period of rapid subscriber growth. That pattern repeated itself this quarter. The seasonal pattern of growth has been slowest in Q2, higher in Q3, higher still in Q4 and highest in Q1 of the following year. We expect that pattern to repeat itself again this year.

Typically when growth slows, as we expect in Q2, profitability of the Netflix business accelerates as marketing acquisition expanse declines as a percent of revenue. This is the opposite effect of what happens in periods of rapid growth when the upfront cost of subscriber acquisition expense pressures the P&L, which we saw happen in the recent quarter.

For the full year, we expect to more than double profits on the same number of ending subs we guided to in February. Our February guidance for net income before international expansion was $4 to $10 million. We now expect to generate $18 to $26 million of net income before international expansion.

Our international expansion to the UK will generate operating losses in the range of $7.5 million. On a consolidated basis, after deducting start up costs in the UK, we expect consolidated GAAP net income of $10.5 to $18.5 million for the full year.

So in summary, I would say that results for Q1 were exceptional. Q2 will bring a return to profitability, a price increase and continued gross margin pressure followed by a return to rapid revenue growth and much greater profitability.

Well. That concludes my remarks for the quarter and now, Operator, we would like to open the phone lines to questions.

(OPERATOR INSTRUCTIONS)

Gordon Hodge with Thomas Weisel Partners.

Couple of questions about the price increase. Can you talk about... I mean, there's Probably no way to really test it and see how customers respond to it so the churn guidance or your anticipation of higher churn, I'd be curious what kind of studies you've done or what kind of analysis you could share with us as to what will get you comfortable with that customer reaction. And then, can you talk about just I guess, you've already got a tier level of pricing with various disks out and so forth. I am curious, I gather price increase will probably go across all various tiers.

correct Gordon.

So maybe you could talk a little bit more about analysis you've done, the price increase and your sense for what it does to churn?

Sure this is Reed. To answer your second question there are proportional increases in the other programs which is 90 percent of the subscribers approximately on a primary program focusing on that having this call and then in terms of churn. Couple of factors. One is we look back, when we did a sale, when we implemented a sales tax across the United States which has the effects to a customer of an increase between 6 and 8 percent depending on their state. That was about three years ago and we saw no increase in churn from that incident. Now this case, sales tax is something that consumers clearly know is not the Company doing (MULTIPLE SPEAKERS) from the government.

So we put some increased churn in there because I think it's prudent to do so. But the historic record is pretty good. And you're right that quantitative research is not accurate in terms of asking subscribers whether are they going to stay with the service at a certain price. But we have done a fair amount of qualitative research. And the thing that's convinced us of the wisdom of this action is that if we can make this incredible movie service just below a little bit better in terms of fixing the new release experience, I think we're going to see sub 4 percent churn next year. So it's well worth paying a short-term price in terms of a modest churn increase of pressure on acquisition and the pressure on acquisition comes, really, just from confusion. Customers advertised at $20 come to the site, it's $22. There's just a little bit of temporary friction in that interface.

Then we get into the second half and into next year, we are in a much stronger fiscal position because we can run an even better service.

Dennis McAlpine from McAlpine Associates.

Thank you. Good afternoon. Could you go a little more in-depth on the TV side as typically how much money you spend on TV advertising and what, if any, difference you're seeing in the subscribers that are generated by TV advertising versus the online? And then, the second item. Would you talk about in the acquisition of DVDs, when you said you wanted to increase satisfaction, is that what you were talking about? That you increased that to 23.6 from the 18.7? And does that mean we should look for a 23 percent acquisition percentage? And did rev share get in there somehow?

Hi, Dennis. It's Barry. Let me do the second part of the question and Reed will do the first part. With respect to DVD acquisition I think in the second quarter we may be a few points higher than 23 percent. It's important to remember by 23 percent we're talking about CapEx on DVDs as a percent of revenue. Correct?

: Right.

About half of the disks required during the quarter were acquired directly from studios. The other half of the DVDs we acquired were acquired under rev share agreements under studios. So it's a combination of rev share acquisition plus the purchased DVDs which together consist of the entire library of DVD content acquired in the quarter. And, yes, it's our intent to reinvest proceeds from the price increase, providing better availability of more titles so they are more broadly merchandised across the site so we provide users a better user experience.

And, Dennis, it's Reed. You asked about TV. We haven't broken out how much in aggregate dollars. But you could ball park. It's -- since we used to be pretty consistently at $32 subscriber acquisition costs now are at 35 times the number of new trials. In terms of the effectiveness in how that works, remember that subscribers who see an advertisement on TV are then positively predisposed to click on a banner to come to us or to come to the site directly. So you don't want to think of TV as a direct source in the way that you might say online was uniquely tracked. And remember that the average new trial for Netflix has heard about Netflix from several different places. They've heard from their friends, they've read a press report, they might have seen the TV ad and then they try the service.

So you want to look at it a little more holistically as an effective part of the mix. So although in the past, Dennis, we've talked about the percentage of subs that come from one or two or several sources of acquisition as Leslie Kilgore, our marketing officer, reminds me frequently we've done you a bit of a disservice, because to Reed's point, it's a multi impression sale when all we are capturing in those statistics is the last impression made.

: Could, also as you enter more formal plans for Video On Demand are you finding assessability to new titles from the studios?

I think we're going to be playing by the same rules that Movieline, MovieBeam, INDemand, etc., play by. We don't see it as plausible or likely that we would get better terms than any of them in our first go round here and that's part of why we said before that electronic delivery option to Netflix subscription will probably have modest consumer demand, initially.

Yusef Squally (ph) with Jeffries & Co..

Couple of questions. First in your churn assumption. I was wondering. It's interesting you're saying you feel that in the third and fourth quarter your churn will come down. For the year it will come down even further and I was wondering how will you or what are you planning on doing to lower churn other than -- other than for it to just spec up in the second quarter and go down as the price increase matures? What else are you doing? And number two, what assumptions of usage do you have to get back to that 42 to 45 percent gross margins?

Great. On your question on what gives us confidence in the churn coming down, the churn, of course, as you know, for the past eight quarters, has steadily come down as we've improved the service. Faster delivery, we're now overnight delivery at over 80 percent of subscribers. More content so that subscribers get their top choice more often. More new release availability. All of those factors. What we're doing with the price increase is being able to spend more money on new releases to improve the new release experience. And that fundamentally is what gives us the confidence that the underlying churn rate will steadily decrease during this year and get below 4 percent next year. So then, in Q2 the reason the churn plausibly will go up slightly is simply because of the price announcement. And you get a short-term turbulence of just around that announcement. In terms of usage I will pass that over to Barry.

Chime in first on the churn part of the question. It's also true, I think, that if the behavior of the subscriber base from a churn perspective remains constant, period to period, meaning period 1 to 2 to 3 to 4 to 6 because we will see a maturing in the subbase and, because older subs churn at a lower rate than newer subs, we will see a decline in charge if the behavior the subs remains constant.

With respect to usage. We forecast a slight increase through year end on a quarterly basis. And then, we superimpose on that some seasonality that we expect to see through the remainder of the year so I realize that is somewhat vague, but we have some headroom built in but I'm not inclined to disclose exactly how much.

Khartik Ramashandran (ph) with Deutsche Bank.

Hi, guys, congratulations on the quarter. Question on the customer experience with churn. I think you may have mentioned expanding Cinematch (ph) and wanted to know if ... how that would look, how that would feel for the customer if that's going to change the look and feel of the site or the experience in any way.

Those of you on the call that are subscribers will have noticed that over the past year we continued to upgrade the site section by section area by area with the recommendations getting more accurate, easier to distinguish, and generally more helpful. And we have a series of internal metrics that guide us in that search for the more perfect customer solution. So that's really what drives it. And I think the way to look at it is it's a steady incremental investment that we make in Cinematch and in the customer experience that continues to build bigger and larger barriers to entry for any future possible competitor.

Also, if I could follow on a different point. You talked a little bit about Blockbuster. Have you noticed any sort of impact on growth or customer acquisition in Wal-Mart's market?

Well, Wal-Mart is not very active in the market and as to your question, no, they ship out of the Bay Area and out of Atlanta. And neither of those markets have been impacted but they nominally serve the whole country. I just think it's a fairly minor initiative for them.

Ed Shapiro from Park Capital.

Barry can you explain it to me. It seems to me, the drop in the gross margin was somewhat unexpected unless you accounted for the nonrecurring piece in your guidance and the second quarter drop before you have the ability to offset it with the price increase must be a function somewhat of higher disk cost to you which I would guess is coming on the revenue share. Can you talk about any changes that have occurred since the beginning of the year? It's a pretty significant drop from the trend that you've been experiencing on higher disk usage and been able to offset up until now?

Ed, the content cost in the quarter were about what we expected them to be when we began the quarter. Usage during the quarter was higher than we expected. And so, the reduction in the margin relates almost entirely to the increase in usage. Some of you on the call may recall a year ago in the first quarter that we saw a spike in usage. And we attributed that spike to a change in software that we pushed since this spike coincided within a day of the software push, which made disks more available to subscribers.

This year, we saw exactly the same phenomenon occur in the month of January. And we were very much surprised by it. It is not often that you see nearly 2 million subscribers change their behavior overnight if you will -- I am being somewhat dramatic for (indiscernible) purposes. And so, there's no question that usage in the quarter was higher than we expected it to be.

And expect to continue presumably through the second quarter hence the 42 percent margin (MULTIPLE SPEAKERS)

Well during the quarter, we saw the usage rate flatten. So as I sit here today I have no reason to think that the usage rate will continue to climb, we won't have the benefit of the onetime adjustments and we are at this quarter in anticipation of the price increase have been -- have aggressively increased our buying both on rev share and purchased DVDs to drive the better user experience and the retention numbers.

Which by the time we get to the third quarter we will be offset by the price increase presumably.

Correct, yes.

Is it realistic to think -- I mean, not to variables but as you get to next year having a 10 percent higher price than you've had historically will result in lower churn than you've experienced historically?

We definitely believe so. That's why we're forecasting it. The churn really is not related to micro price aspects. In other words when we've done testing on an $18 service, a $20 service, a $22 service. That's not why someone churns off. They churn off because the service doesn't work for their life. They're not watching movies, it's big variables like that and the key about the $22 price is that we will be able to afford a better new release experience and maintain the 42 to 45 percent margins. And that's why we believe that we can continue to extend the reduction that we've seen over the last two years moving from 7 percent churn two years ago steadily down to six steadily down to 5 and now to a record 4.7.

Is there anything or, Barry, can you collaborate at all on the nonrecurring nature of the revenue share and if there are in fact any new revenue share deals?

We renegotiated the terms of one deal and that was favorable to us. And there were some retro aspects to it which resulted in some accrual adjustments and we also came to the end of the term on a rev share deal. And there were some accruals which got relieved at the conclusion in the final negotiations surrounding that rev share deal. That studio is now on a purchase basis. So...

Arvin Batteo (ph) with Selless (ph) Securities.

I was wondering if you can comment on what other categories you might be thinking about if it's video games or other categories you might have in mind for future expansion? If you could collaborate on that?

Sure, video games remains an interesting category for us. Right now, we're growing 80 percent on a year-over-year basis. So we are growing as fast as you want to be in terms of keeping great service levels up so we're not looking to expand in categories in a very short-term but it remains an interesting category.

Have you done any kind of analysis at all? Any tests that would suggest it's a feasible market for you guys?

Well I'm confident it is a feasible market. Blockbuster's been renting for many many years. It's the same disk format. So I really think it's a question of focus and right now the movie market is so large and we're growing so fast that we don't want to get distracted by it. But at some point, it would make a lot of sense.

Just taking that question further and talk about Blockbuster real quick here. Obviously what they're focused on, online category and your commentary on you expect them to have modest success but not tremendous modest success, do you not think that a combination of the in-store and online model would inherently end and having a strong amount of cash flow on an annual basis would provide them with a headstart in terms of their ability to really focus on this category and go after your market very aggressively? Just curious, why you'd think they couldn't get a bigger share than what you're thinking of right now?

I think the key is to look at a history of pure plays in the store basis stores. Because there are many sectors that this has played out in. And if you, obviously, look at the toys business, Toys R Us did not distinguish itself against Amazon until it really became essentially part of Amazon Store. And if you look at Barnes & Noble they had integrated with the store also for returns for all the kind of key store aspects pick up and it was not -- did not materially help them.

And of course if you compare Barnes & Noble and Blockbuster in their brand strength, you'd have to say Barnes & Noble is really quite loved by their customers and Blockbuster, you know they've had pockets of affection but it is certainly not consistently loved. So, given all the advantages of Barnes & Noble had to have it do as modestly and as you know probably from using the service, Barnes & Noble, it's not that it didn't work. It worked fine. It's much more about the brand and about the reputation, how customers think about what service they want to use. So for all of those macro factors, you know, we're keeping an eye on them and watching them but we don't see it as very material.

Which markets have you I mean, you talked about the West Coast but do you see any other markets really go after any of your customers aggressively yet?

Any other markets? Do you mean other markets that we've opened one-day deliveries?

Yes.

Yes, absolutely. We published in our press release -- you can see a link there to chart that shows the growth in the Bay Area for the last four years and then it shows the growth in the 12 cities that we opened overnight delivery in '02. And that growth has gone steadily to 1 percent to 2 percent to nearly 3 percent. That's the yellow line for those of you looking at it. And then we also showed the graph of the growth in household penetration and the ten hubs that we opened last year in '03, and that's up nearly 2 percent also. So those areas are paralleling the growth of the Bay Area which is what gives us confidence that we can get to 7 to 10 percent of the entire nation using that over the next several years.

Did that answer your question?

Yes. Last question. Could you refresh us on what your longer-term goal is, you given metrics in the past on kind of what you think the off size of the market is and what sort of share you hope to obtain over the next several years.

Three years ago we announced that we would get to 5 million subscribers and a billion in revenue in the 2007 to 2009 time frame. Then, about six months ago we pulled that up and said we were confident that we would get it in the 2006 to 2007 time frame and then recently we said that we would get it to 5 million subscribers and the billion in revenue in 2006. And that remains our guidance.

Safa Rashtchy with Piper Jaffray.

Hi guys. Actually most of my questions have been asked by the time I go on. Just a couple for you. For film and expense spent dramatically to 10.8 percent. Can you fill us in as to what's driving it. And what should we expect? And second. If you could tell a bit more about the gross margin trend. I understand that it is going down because of the usage and because of improvements that you're making in selection and delivery and so forth. Do you have a sense of what is a limiting factor? Can you keep improving it and you say gross margin could go further down maybe below 40 percent or do you have confidence that it will -- it is bound by certain range and why do you have that confidence? Thanks.

Let me touch on that fulfillment part of the question first. It did drop dramatically in the quarter, ironically, more akin to expectations we had a year ago for fulfillment in this time frame. When we began, when we made our software push a year ago and moved content closer to subscribers and shortened the shipping time we incurred some additional labor costs that have been, if you will, a tax on fulfillment system all year. This quarter, we were able to automate those labor costs out of the system, and reduction and labor cost resulted in the reduction and fulfillment expanse. And so, I anticipate that we should be able to operate in the, conservatively, 11 percent range. Aggressively 10 1/2 percent range. On a go forward basis barring some unforeseen impact related to continued use of our automation in the distribution path. With respect to gross margin. There are a couple of macro trends.

First of all, the two components of gross margin, of costs associated with gross margin, cost of goods or one, content, and two, postage and packaging. Packaging and the postage costs I expect are fixed and so their impact on margin directly relates to the number of DVDs we ship. The second component of cost is purchase content and rev share content. Ted Sarandos, who runs that group, working closely with our studio partners as we grow, has done a tremendous job reaping the benefits of our increased size in negotiating better deals for the studio as we increase our purchases. And that has resulted in a slight reduction of content cost at the per disk level. Throughout the year and I expect that that macro trend will continue going forward.

So then the biggest by process of elimination, the biggest factor to consider with respect to future gross margins are 1, the amount of revenue per subscriber we collect, which is fixed; and then, 2, the number of disks we ship. And then at a high level we can say is certainly the number of disks we ship is constrained by your lifestyle. Some of us have to get up off the couch and go back to work. Which is why, over time, we have seen fairly consistent trends as it relates to usage quarter over quarter and month over month, absent the seasonality effects.

And I expect those macro trends have not changed notwithstanding the increase we saw in January, which flattened in Feb./March. So, how is it then that more inventory contributes to a better user experience and increased usage?

Well I think if you're better able to find DVDs on the site that you want to watch you are more inclined to rent them and you are more inclined to watch them sooner and get them back to us center. The way that a deeper inventory experience translates into a better merchandising experience is that, in part, the front end and back end are linked, meaning if it's in our warehouse and available for shipment we will merchandise it on the site. And if it's not in the warehouse and not available for shipment we don't merchandise it to you. And that's linked real time.

So if we have more of what you want and we merchandise it to you, you're more likely to rent it and if you're happy with what you rent, if you're excited about it and Cinematch is getting you engaged in great content then you're likely to rent more often, be more engaged in movie content and stay with us longer, which is a great thing. Let's talk about the implications on usage if you're staying with us longer.

Some of you have heard me mention that new users use more disks than older users. There is a dramatic difference between a subscriber in their first period and the subscriber in their six period and 12th period. It's between sort of your first paid Month and sixth paid month, average disk usage drops almost a disk and a half and then between the 6th and 12th month it drops another 7/10ths of a disk.

And so if we're able to keep you more engaged by providing a better user experience as you age, usage will come down. So there are several crosscurrents here as you can see. Rapid growth brings in new subscribers to use lots of disks and to the extent we would provide better user experience we will use more disks but over time you use your disks.

And now I'll stop and I probably totally confused you.

Gordon Hodge. Actually a follow-up question from Gordon Hodge.

Yeah, I was just looking at your subscriber guidance and it strikes me that -- and correct me if I'm wrong -- but one of the things that might be, one of the catalysts for looking at a price increase might be the fact that your subscriber growth may be so strong that it may be stronger than maybe you can handle or more than you would like, given your service standards. And looks like you're looking for 87 -- at the high end of the range -- 87 percent growth in subs in the second quarter which would imply an acceleration, at least at the high end at least from the first quarter. And I am just curious if I'm reading that right and then, obviously, you're raising the low end of the range for the year which would imply the same thing. A little counterintuitive that you would prices and then also expect subscribers to go up so my guess is you're seeing heavy new subscriber growth and just wondering if you could comment on that?

You're right indirectly, Gordon. The strength of the business gives us the confidence to do a price release, a price increase. Because the customers are really accelerating their adoption of Netflix. We've seen that even in our highly penetrated markets but also in our low penetration markets across the board. We've seen the high success and, again, that gives us confidence that a 10 percent price increase will be accepted by the customer base. We have had great price stability for the last four years at the same price. So it's really quite a modest effect but it is not directly a conscious attempt to limit growth. We're not worried about growing too fast except above doubling. You're arguing 87 (ph) percent that's pretty close to doubling and that's true. If we get in 110 percent, 120 percent we can have that discussion but at 80, 85 percent, we're comfortable that we are managing the service levels very well.

Tim Maxwell with Falconer Capital.

I don't know if you said this earlier but what was the -- did you qualify the disk usage per customer per month this quarter?

We did. We said it was about 7.

About 7. And have you ever said what the differential between the overall disk usage per customer per month is and all the customers within the one mile area, one day delivery area?

We have not. But about 80 percent of the subscriber base is covered by one day delivery.

Bill Lennon. With WR Hambrecht.

Some interesting comments earlier about getting off the couch. Since your results are pretty much heavily influenced by the Bay Area where we have some of the greatest weather in the world, I'm wondering if you see any difference, material difference, in usage by geography? And if so, do you anticipate as you get bigger, say in the Northeast and the UK, do you expect parts of the world where weather isn't as favorable as the Bay Area to be more active users?

I think that's a great question. It seems to me as I look across the data that it's less a function of broad geographic markets. And it's more a function of cultural alternatives available within a local market. And so, for instance, there are California markets in which we see extraordinarily high usage. I would say people in the San Francisco market have lots of entertainment alternatives.

Okay. Sort of on a similar vein, are you seeing any emerging demographic themes that are becoming -- or surprised you in the quarter? Women vs. men, age, geography, that sort of thing. Are there any emerging categories that are customer that are significantly more active?

With DVDs so mainstream at over 50 percent of household obviously Internet over 68 percent of households now that the demographics are quite stable. We're slightly more female than male in sign ups. But there's no significant trends there. Really the movie viewing is partially a factor of us doing a great job of getting the right content in front of people. And it's up modestly across the entire base. It's not driven by one subgroup.

As compared with the average for the Bay we became slightly less well educated and slightly less well compensated during the quarter. And interestingly for the first time, I think, shifted, saw a decrease in the percentage of when and who are coming to the site to Reed's point. We were predominantly male and we are or have become predominantly female with slightly less of an effect in the current that occur quarter that in prior quarter.

Okay and then, last question similar as well. Any emerging trends by genre -- romantic comedies vs. action? Any particular types of genre stand out as more profitable vs. less?

No, those are all again consistent themes. The business is very much as it has been for the last several quarters which is the breadth of selection is really the one unique aspect, that 99 percent of our titles rent to someone during the quarter. Somewhere in America there are people who want any movie, virtually, that we have. So other than that, there's nothing thematic.

Mark Chiasen (ph) with Knott Partners.

Two quick questions. One, the drop-off in the diluted share count by 13 million shares puts your stock roughly at an all-time high? Was curious about that.

Mark, when the Company moved from a profit position to a loss position and the number of shares used for purposes of calculating fully diluted under GAAP converts to the primary share account.

Another quick question. The stock based comp should that run roughly 4 1/2 percent sequentially?

This is Reed. That's correct for Q2. And then it will drop a little bit in Q3 and Q4.

Russ Alente (ph) with Rocker Partners.

Couple of questions on the cash flow. I noticed that your payables were up 10.5 million in the quarter which, obviously, was a big deal for the cash flow numbers you reported, can you tell me what that's due to?

Look on a year-over-year basis, cash payables was 22 million a year ago. And so it grew from 22 to 42. It's up approximately the rate of revenue growth so there's nothing unusual going on there. It's just our continuing to grow larger purchases, larger payables.

To Reed's point. It reflects the increase in partner shift and acquisition strategy for content away from rev share and towards purchase DVDs. In addition to an overall increase in buying. If you look at -- if you were to do a day's payable analysis by way of example, you'd actually find that it's flat to slightly down.

Okay so should we expect that trend to continue towards purchase disks away from revenue-sharing?

It varies by quarter. We are in the 50-50 range now and will be plus or minus 5 percentage points within that range for the foreseeable future.

Okay but that's not, so that's not a shift in strategy?

Not -- it's a shift in strategy from a year ago and Reed was drawing your attention to payables one year ago. But not within the last several quarters now.

And on the purchase DVDs, what is the depreciation period on those?

It's one year, some of the months. So 70 percent of the value is written off after six months.

Okay and then one more question just about pricing. So at $22, will that make you higher on a monthly basis than Blockbuster service?

Blockbuster uses a range of price points if you're referring to their store base subscription service. Is that what you're referring to? And different markets from $17 to $25. So it's somewhere in the mix.

Yusef Squally.

Barry I was wondering if you can reconcile something for me? I think you said earlier that 10 percent of trailers came from TV advertising channel. And that caused your (indiscernible) to go from 32 to 35 yet your guidance is still 34 to 36 between now and the end of the year. I understand that the 10 percent is obviously going to be higher as you continue to spend more on TV. Could you elaborate on that a little bit?

How we're going to make that happen?

Yes how are you going to be able to maintain your sack basically flat, as your TV advertising keeps going up and my assumption here -- and I may be wrong -- but my assumption is that subscriber acquisition cost on TV is higher than the rest.

Yes, well, we could analogize what is going on in online space with the price of impressions is going up. But the overall brand awareness and the effectiveness for Netflix is going up. So you haven't seen a dramatic increase in our cost which some of you have been expecting. And so some of the same will happen in TV and I expect we will also see an increase in word of mouth and then, lastly, you'll see some artful management by our marketing group, make sure they hit that $35 number.

And as we mature in TV markets, you'll see the cost per TV impression fall and as we switch from spot market buys to national cable buys you'll see the cost drop as well. So there are increased efficiencies available to us as Leslie Kilgore's group rolls out their advertising initiatives.

Would you venture to say how much of your trailers or what's the mix, say, by the end of the year meaning, what's that 10 percent can't be (MULTIPLE SPEAKERS) (indiscernible) 30 percent, half?

We're going to sit on that for the moment.

Keeping, Yusef, the 10 percent approximation, because again the TV subscribers come TV influence come through many different sources. And so there's a lot of double and triple counting so for economic efficiencies we do track and approximate the things internally. But the key is that we're able to manage all of those pools cohesively to deliver the $34 to $36 sack.

Dennis McAlpine.

Couple of quick things. The number of shares fully diluted if profitable?

I think it's 64 million, roughly, Dennis.

: Okay. Typically in the second quarter your new trial subscribers is about 75 percent of what you had in the first quarter. Given the big increase that you had this year do you expect that relationship to still hold?

I don't track the 75 percent. Try me again?

If you take the number of new trial subscribers in the second quarter, that has typically for the last three years been 75 percent of the number in the first quarter. But this year you had a much bigger number in the first quarter. Do you think you can still hold at the 75 percent?

I think part of the reason that we set the guidance a little bit wide on Q2, being 1935 to 2140, was to reflect that growth. And we usually track it on the year-over-year basis but it's equivalent, to what you're asking, might be slightly atypical because of the price increase and a particular, for example, being advertised, too, in April that there's $20 coming to the site in June. And it's at 22 and that creates a temporary short-term friction. So in general the seasonal pattern holds, I think Q2, we had this slight degree of turbulence that we are forecasting as we switch into this more profitable, higher customer satisfaction model.

And you made reference to a rev share deal that has run out. Do you expect a significant change in that 50 percent of business acquisition of titles from rev share?

No. It might increase slightly, Dennis, but we will update you on a quarterly basis to the extent that it does. I said plus or minus 5 percent around 50 percent. So could we be 60 percent purchase by year-end? It's possible.

That is all the time we have for questions. I will turn it back over to our speakers for any additional or closing remarks.

Well, thank all of you for joining us on the call. I hope we got to all of your questions and, again, we're very excited about completing this quarter in such a strong format and it gave us really the confidence to do this change in price to improve the service and to continue our momentum building so that we can get to the sub 4 percent model for next year.

Again, thank you very much.

That does conclude today's conference. Thank you for your participation. You may now disconnect.