Netflix Inc (NFLX) 2004 Q2 法說會逐字稿

Good day, everyone.

I would like to welcome you to today's Netflix second-quarter results conference call.

Reminder that today's call is being.

At this time for opening remarks and introductions, I would like to turn the call over to Director of Investor Relations for Netflix, Ms. Deborah Crawford.

Please go ahead, ma'am.

Thank you and good afternoon.

Welcome to Netflix's second-quarter 2004 earnings call.

Before turning the call over to Reed Hastings, the Company's co-Founder and CEO, I will dispense with the cautionary language and comment about the Web cast for this earnings call.

We released earnings for the second quarter at approximately 1:05 PM Pacific time.

The earnings release, which includes as applicable a reconciliation of non-GAAP financial measures to GAAP and this conference call, are available at the companies Investor Relations Web site at www.netflix.com.

A rebroadcast of this call will be available at the Netflix Web site after 5:00 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 February 27, 2004.

And now over to Reed.

Thanks, Deborah.

Welcome, everyone.

In 2002 with revenues of 150 million, we set the goal of getting to $1 billion in revenue by 2009.

Earlier this year we upwardly revised that goal to achieving $1 billion in revenue in 2006, three years early.

This quarter we made great progress on reaching our goal.

Our year-over-year revenue growth, which has been hovering around 80 percent for the past five quarters, accelerated to 90 percent in Q2.

Furthermore, our guidance for Q3 and Q4 called for year-over-year revenue growth of approximately 100 percent.

Despite this extraordinary revenue growth, we returned to profitability in Q2 as we had committed to do.

We expect to grow domestic net income considerably Q3 and Q4 to 11 million and 14 million respectively.

On the growth versus earnings spectrum over the past four years, we have been strongly on the growth side.

For example, in Q1 we saw the opportunity to efficiently spend more money in marketing, and we did so, growing faster but depressing earnings.

We believe that now we are large enough to be able to focus on both earnings and growth.

Specifically in terms of our domestic business, you should expect no more higher growth, lower earnings announcements.

Our goal now domestically is to grow as fast as possible while generating growing predictable earnings.

In keeping with the theme of moving from growth at almost any cost to a balance of growth and earnings, we took a major step forward with our first price increase in four years from $20 to $22 a month for most subscribers.

As you know from the math, a 42 percent gross margin business that does a 10 percent price increase moves to a 47 percent gross margin, keeping costs steady.

But our guidance is that we will increase gross margin from 42 percent to 44 percent in Q2.

In keeping with our focus of providing our subscribers an ever improving movie experience, we are spending most of the additional 3 percentage points on content.

Consumer reaction in Q2 to the price increase was as expected.

A 1 percentage point increase in churn and a slight decrease in year-over-year trial growth rate.

However, while we correctly estimated the magnitude of the price increase impact, we have underestimated the length of the effect.

We had thought that the price increase effect would be substantially contained in Q2, but we are still feeling it in Q3.

And so we are expecting an extra .5 percentage points of churn in Q3, half of the extra churn that we saw in Q2.

In seaming tension was a theme of increased earnings focus as our take SAC up from $35 to $38.

We are one of the largest online advertisers, and as you may know, the online advertising market is recovering and the market has gotten tight.

So this 10 percent increase in SAC is due to the increased cost of advertising.

To prevent further concentration risk, we are diversifying our channel mix to include more television advertising.

The more diversified we are the broader reach we have and the less sensitive we are to rate changes in any one channel.

We don't expect online ad rates to return to their lows of the past two years, and thus you should expect that we will continue to spend $38 for the foreseeable future.

This $3.00 increase across 600,000 new subscribers amounts to $1.8 million on a quarter with domestic net income of $11 million.

As expected, on May 25th Blockbuster went nationwide with a $25 store base subscription service.

It appears to be doing very well for them as consumers definitely respond to the benefits of unlimited rentals and no late fees.

As we found during the Blockbuster regional testing, we have yet to see any impact from their subscription service.

In particular, there are several cities such as Boise and Albuquerque in which Blockbuster franchisees have not implemented the subscription plan.

So by comparing our results in those cities against comparable small cities which do have the Blockbuster subscription plan, we are able to get an estimate of their impact upon us.

Six weeks into their launch there is no visible impact upon us in acquisition or in churn.

We believe this is because the benefits of online rental, including deep selection, free home delivery, lower prices, and customer recommendations, are substantial.

Over time we do, of course, expect some impact, but we are confident that if the impact were going to be large, it would already be visible using this comparable geography methodology.

Assuming that the Blockbuster franchisees continue to not implement the subscription plan, we will report back to you in another quarter on the Blockbuster impact.

In Q3 Blockbuster is likely to launch their stand-alone online effort.

But until they integrate it with the stores in 2005, we find it unlikely that they will promote their online service effectively.

In general we have great respect for Blockbuster's savvy in-store operations.

But their track record in online technology and marketing is less well-developed.

Since the best defense is a good offense, we are focused on continuing to effectively compete against their stores and to establish for more consumers the compelling benefits of online rental.

On the international front, we continue to prepare the launch of our UK subscription service in Q4.

We believe subscription rental in the UK can become a large profitable business, and we are not alone in that belief.

Several competitors have already launched online subscription models in the UK including Blockbuster.

We have found though that while online rental is an easy market to enter, it is a hard market in which to turn cash flow positive.

It took us considerable capital domestically to get efficient enough and large enough to become cash flow positive, and that was in a noncompetitive environment.

We believe that with our knowledge base and capital we can enter in Q4 of this year and become the market leader by the end of 2005.

In addition to the UK effort, we continue to make progress in our electronic delivery initiative for launch next year.

As before we will say little about the details for competitive reasons until we are ready for launch.

As I said last quarter, our strategy is to build a very large DVD business and use that to expand and win in electronic delivery.

To build a very large DVD business, we focus on providing consumers the world's best movie service.

The quality of our user experience has never been better in terms of customer satisfaction and inventory metrics.

In particular, we have made great progress improving our new release experience for our consumers, as well as improving the quality of our catalog rental experience.

We are currently 2.1 million subscribers strong with phenomenal word-of-mouth that continues to be our largest source of subscriber growth.

I'm proud of our progress in the recent quarter, and I look forward to taking your questions after Barry concludes his remarks.

And now I will turn the call over to Barry.

Thank you, Reed, and good afternoon, everyone.

Today we announced a return to profitability and upwardly revised earnings guidance through year-end.

Reversing last quarter's loss we returned to profitability in the second quarter with GAAP net income of $2.9 million and non-GAAP net income of $7 million.

Both metrics were above the midpoint of our guidance.

As I discussed with you on last quarter's call, seasonally slower Q2 subscriber growth and reduced marketing expense were the primary factors contributing to the expansion in operating margins in the second quarter.

As a percent of revenue, marketing expense declined by 10 percentage points from Q1 to 17 percent of revenues in Q2.

The decline in marketing expense was offset somewhat by a modest increase in fulfillment expense to 11.9 percent of revenue in the quarter from 10.8 percent in the prior quarter.

Costs associated with the relocation of our San Jose facility to Sunnyvale, coupled with the opening of two new distribution centers, as well as the expansion and relocation of three existing distribution centers, accounted for this expense increase.

We expect these costs when measured as a percent of revenue to return to Q1 levels next quarter.

Despite the seasonal decline in subscriber growth, new trial subscribers grew 78 percent year-over-year, double last year's Q2 year-over-year growth rate.

This is the second consecutive quarter in which we doubled last year's new trial growth rate.

As best we can determine, we have not seen any competitive impact from Blockbuster's launch of their Movie Pass service.

As Reed mentioned, when we examined our performance in markets that don't have Movie Pass with those that do, we see no differences in our growth rate.

I will talk more about the acquisition environment any moment when I talk about SAC.

We reported record revenue in Q2 of $120.3 million, up 20 percent on a q-over-q basis, and 90 percent on a year-over-year basis.

This why y-over-y percentage growth was the strongest we have seen in the last six quarters.

Last quarter's rapid subscriber growth fueled this quarter's rapid revenue growth.

With the full benefit of the price increase in Q3, we expect our y-over-y revenue growth rate to accelerate again.

Gross margin was virtually unchanged from last quarter's 42.3 percent pro forma gross margin after adjustments for recurring credits.

At 42 percent, gross margin was at the high end of our guidance range.

As expected, usage declined sees only from Q1 to Q2, which resulted in slightly lower postage and packaging expense as a percentage revenue in Q2.

This savings was offset by higher Rev share expense.

The June 15th price increase for the Netflix service had minimal revenue impact in Q2 but is expected to expand gross margins in Q3 and Q4 this year.

As expected churn for the quarter increased from 4.7 percent in Q1, a record low, to 5.6 percent in Q2, unchanged from last year's second quarter and slightly above the midpoint of our churn guidance for Q2.

The subscriber cancellation rate increased for about a two-week period during the quarter after we announced the price increase on April 15.

Following this increase, the cancellation rate declined and since late May appears to have settled in at the rate and followed the pattern we experienced in the comparable time period last year.

SAC was $35.12 in the second quarter, unchanged from Q1.

Online and word-of-mouth continue to be our primary sources of acquisition in the quarter.

Television played a larger role in our overall marketing mix in Q2 as we expanded our media buys from local markets and national cable spots.

Through the remainder of this year, we expect SAC to increase to a range of $37 to $39.

Two factors are driving costs higher.

First, online advertising rates increased during the second quarter, making it harder for us to hit our $35 SAC target given the larger role online advertising plays in our overall acquisition mix.

Second, in response to the rising cost of online advertising, television advertising is expected to play a larger role in our overall acquisition mix going forward.

And while we expect the cost of TV advertising per acquired sub to fall over time, the initial costs of TV advertising are expected to remain high while we build brand awareness for Netflix.

Today's earnings release included financial guidance for the third and fourth quarters of 2004.

For the full year, we raised guidance for GAAP and non-GAAP net income.

For the U.S. domestic business, in February our net income guidance was $4 to $10 million.

Last quarter we raised this guidance to $18 to $26 million, and today we raised this guidance slightly to $19 to $26 million, despite also increasing our guidance for churn and SAC, which costs will be offset in part by higher gross margins over the next two quarters.

We expect international expansion in the UK to generate total operating losses in the next six months of $4 to $6 million or roughly $2.5 million in Q3 and Q4, down from our prior guidance of $7.5 million.

Our calendar year 2005 quarterly losses could reach $5 to $8 million while we build our presence in the UK market.

The '05 numbers are preliminary, and our operating plan for next year has not been finalized.

For 2004 on a consolidated basis after deducting startup costs in the UK, we expect consolidated GAAP net income of $12.6 to $22.1 million, up from our previous guidance of $10.5 to $18.5 million for the full year.

In summary we are pleased with subscriber reaction to our price increase, we are pleased with our return to profitability, and we are pleased with our rapid revenue growth in Q2.

In terms of the challenges we face exiting Q2, it is clear we have work to do to maintain rapid sub growth and to manage subscriber acquisition costs and to achieve the sub 4 percent churn objective we set for the business for next year.

Despite these challenges, our second-half forecast for rapid revenue growth and increased profitability are well within our grasp, with gross margin improvements funding our increased costs of subscriber acquisitions.

That concludes my prepared remarks for the quarter, and now we will turn the call over to the operator so Reed and I can take your questions.

(OPERATOR INSTRUCTIONS).

Lanny Baker, Citigroup.

A couple of questions.

First of all, can you talk about the working capital?

It looks like your free cash flow was a little bit lower than last quarter.

Just looking at the numbers, it looks like your CapEx was also pretty lean.

So was there something -- did the price increase cause some change in the deferred revenues that impacted the free cash flow this quarter?

And did it continue at that rate?

And then secondly, you wrapped up, Barry, in your comments saying you feel like you have work to do to maintain the rapid sub growth.

Is there anything that you have seen since over the last four or five months other the price increase that has you more anxious about that today?

Are you trying to say with your final comment there that you're more worried about maintaining rapid sub growth, or is this kind of a consistent message?

I guess I will leave it at that for now.

With respect to the second point, I will let Reed talk in detail, but I was simply trying to be balanced in my marks and give due credit where there are pressure points on the business and where clearly we need to step up and perform.

With respect to the working capital comment, a couple of things.

If you looked at the cash flow statement, you will see that last quarter we had a big increase in payables related to large purchases of DVD inventory primarily, and we paid for those purchases this quarter and had no similar increase.

Also, the nature of TV advertising payment streams, which is primarily a pay in advance, with online acquisitions primarily we pay after the fact so there are some timing differences that were coming into play.

The CapEx expenditures in the quarter were actually just about flat, slightly up from the prior quarter, and DVD purchases were roughly the same, although they fell as a percent of revenue.

So do you think going forward that this is sort of a onetime set of changes in terms of the impact on free cash flow, or is there a change in the business' production of free cash flow?

Not so much.

You should just think of it as a relatively light quarter, and we have a bunch of payables to deal with from last quarter.

Although if you calculate the days payable, you will see that I think the grand total is a change of about three days.

So there is no big structural shift.

And then you asked about rapid sub growth.

The dominant factor for us is really cost of online advertising.

There have been really great rates over the last two years and the market has certainly tightened, and what you see is us adjusting to those change in conditions both in the $38 and in expanding into more effort on TV and diversifying the channel mix.

In terms of Blockbuster, I think we addressed that.

We have got a pretty solid methodology there to establish for ourselves and for you that that is not the cause-and-effect.

And on the price increase when we look at the day that we put the price increase up on the Web site versus the day before, we see essentially no difference in acquisition.

So any upside we have going forward is not related to fixing price increase or Blockbuster, it is related to getting better ad rates and being able to get back to the level of online advertising that we have done in the past.

Thank you.

Gordon Hodge, Thomas Weisel Partners.

A couple of things.

I was curious if you could talk about usage trends as you look at Q3?

And then also if you could expand a little bit on the subscriber acquisition costs and the plans?

It sounds like -- am I correct in reading this right that you're spending less with third-party -- I gather that is third-party networks -- so that would be the low-end of the food chain there?

And are you still working with affiliates as much as ever and with the likes of Yahoo! and so forth that would be the higher end more targeted ads?

Why don't I take the usage question, and Reed will address the SAC and the mix.

We expect the usage will be up seasonally in Q3.

Of course, I think we discussed on our last call it went down seasonally in Q4.

But from the Q1 to the Q4 quarter, we expect to see a fluctuation of about .3, .4 disks from the peak of the trough.

Nothing that occurred during the quarter gives me reason for concern or reason to believe that we are departing from the seasonal patterns we have previously seen.

Sorry.

Do you mind repeating it, just Q1 -- Q1 to Q3 is what you said?

Q1, Q2, Q3, Q4, the seasonal pattern has peaks and troughs for minimum usage to maximum usage of about .3, .4 disks.

Okay.

So if 6, 7 is the peak in Q1, 6 --

It will be just above 7 at the peak.

Okay.

Got it.

And then below -- I think I said just above -- just below 7 is the peak.

Yes.

You asked, Gordon, for a little more on SAC.

You know online advertising rates are driven by the expansion of inventory as more people use the Internet compared to the expansion in advertising dollars spent.

And recently the dollars spent has outstripped the inventory growth, and what we have seen is an increase in ad rates across the various portals, channels, etc..

Our mix in terms of how much affiliates, how much paid search, how much banners, CPM, CPA, there have been no material shifts in that.

It has just been cost increases making us pull back a little bit and then use TV a little more.

Gordon, I just want to jump back in on the usage question because I know some investors during the quarter have asked me what effect, if any, do we think the priced increase has had on usage.

Did we push out light users or not?

That would be interesting --

Which would be disadvantageous, of course.

As does as I can tell from analyzing usage patterns before and after the price increase, roughly a 12 week period forward and back, it looks like surprisingly the average usage amongst the people who cancelled after the price increase, has increased faster than the usage for the people who remain subscribers.

So across the base, the usage was roughly flat.

And pre and post increase, the usage on the folks that cancelled was up about 8.5 percent.

So it looks like the price increase pushed out more heavy users who I suppose are bargain shoppers than it did light users.

One another question, I am sorry.

On churn you said it would return to seasonal or the patterns that you saw last year.

Does that mean it returned to the levels of last year because Last year churn was flat year-over-year.

I am just curious.

It sounds like it spiked in April beyond where it was last year, and then it has returned to last year's level, or is it trending down like you saw the trend in the first quarter?

No, it has returned to last year's level, and then last year's level during the quarter bounces up-and-down and is following that same pattern.

Heath Terry, Credit Suisse First Boston.

I was wondering, I know there is probably not a whole lot you can say here, but if you can update us on at least your timeline in terms of the CFO search, and if you could also maybe talk a little bit more about the subscriber acquisition cost side of things?

Where specifically are you seeing it if there is any difference in terms of the increase in your online advertising pricing?

Is it happening on your cost for acquisition advertising?

Is it happening on your cost per impression advertising?

Is there much of a difference between the two?

And besides shifting more dollars towards television, is there any other plan to try and keep that subscriber acquisition cost towards the lower end of the new guidance?

On the CFO search, I have engaged a search firm.

We've gotten through an initial list of candidates, and we are generally very much on target to bring in someone in fourth quarter, have a brief transition with Barry and on target for end of year.

In terms of the CPA and CPM stuff, it is a pretty fluid mix.

You know what happens is as one set of advertisers raise their rates -- let's say the major portals -- they generally lead the way.

Then us and other advertisers flood into secondary markets, which then raises the rates there.

So there is a natural (inaudible) mechanism amongst those.

We have not seen significant let's say shifts between the CPA, CPM and the variations there.

So it has really been across the board economic I suppose economic-like recovery and people spending more online that has been the effect.

Got you.

And just one quick question on the television advertising.

Assuming that there is kind of a certain saturation point that you need to get to in terms of television advertising before you reach your full effectiveness on a run-rate basis, how far off do you think you are, how many more quarters do you think you're going to need before your television advertising is as effectiveness it is going to be?

Well, we are one of the largest online advertisers, but we are one of the world's smallest television advertisers right now.

Obviously very large companies like P&G will spend several billion dollars on TV.

But on an individual brand, it caps out at $100 to $200 million per year, and we are spending, as you can tell by our numbers, a tiny fraction of that.

So am I saying that we're going to move our television spending up to 100 million a year?

No.

What I am saying is that the saturation point for a brand in the domestic market is very far north of the numbers that we are spending.

So we have got lots of head room there before we are, say, oversaturated.

Does that answer your question?

Yes, that helps.

Safa Rashtchy, US Bancorp Piper Jaffray.

A couple of questions on the marketing side.

The rate increase in the advertising and the online world has been happening for some time, and I think in the past you have been saying that you been able to absorb it.

So my question is, why a sudden increase now especially that you presumably have more leverage than some of the other advertisers in terms of maybe buying more upfront and negotiating better rates given your size?

And relative to that, what gives you the confidence that the rates will not continue to go up and why are you capping it at 38?

And I have a follow-up.

Well, let's see.

The rates have been going up as you know from tracking the portals and others over the last year.

But it has been fairly modest, and we have been effective at negotiating, etc.. $35 to $38 is a 10 percent increase, and that is a pretty small rates card increase.

So the effective increase that we are absorbing and now passing on in the P&L is approximately 10 percent from 35 to 38.

So it is really quite modest, and it is noticeable mostly because we have been so steady on the $35.

In terms of what we want to spend going forward and why we are confident at 38, you know we can pick what number we want to spend.

That's really our decision and it comes down to what we think is live, and then the growth rate adjusts from that.

So what we are saying is $38 is we think the right balance at this point, partially because the profitability is accelerating.

As I mentioned, the difference between 35 and 38, about $2 million in Q3 on a quarter when we are generating 11 million domestically in net income.

So I would say what informs us is why we did not go to $50 or something extraordinarily high.

Why did we go to 35 to 38?

Because it gives us enough leveraged to develop these other channels like television, and it is a very modest hit to the P&L.

In other words, $2 million on what would have otherwise been a $13 million net income quarter domestically.

Okay, I understand.

Now a second question.

You mentioned that the impact or the duration of the impact of the price increase is longer than you had anticipated, while the level of the impact has been as you anticipated.

How did you base your prediction on the fact that most of the impact will be observed in Q2, and how are you looking at how long the impact of the price increase will last?

What parameters are you using for that prediction?

Well when we had to sort through those protections, that was before we did the price increase.

So we had precious little actual facts, and it was purely a judgment call in terms of how long would the price effects take place in churn.

Now we have got a measure base, and we have watched our churn rate drop back, as Barry had mentioned when we first announced the price increase.

It was up in the first two weeks, and then it had steadily dropped back and is now on top of its year ago pattern.

So I think now what we are doing is projecting that continued improvement going forward, and we have got a pretty sound basis for it.

But does it mean that it will have to come down from the point that you were last year or would have come down faster so it can get to the level you had in Q1?

Well, I don't think, and we are not predicting that we will be at the level that we were at in Q1, which was 4.7 percent in Q3.

I think given that we have seen that in Q2 the 1 percent bump in churn this quarter a half a percentage point, it might be reasonable to predict that if that continued 50 percent per quarter decay and it will only see a quarter point delta from where we might have otherwise been in Q4.

Okay.

Great.

Youssef Squali, Jefferies & Co..

Thank you very much.

A couple of questions.

If I take the midpoint of your subscriber guidance for the third quarter and your revenue guidance, it gets me to an ARPU that is less than 10 percent increase from what you guys were in Q1.

Does that imply that there is a downgrade or a shift in some subscribers going from the new $22 data point to maybe the cheaper $15 or $16 price?

And I have a follow-up.

No, it just means you're using a different methodology than I use to put together the mid-max range.

The price mix distribution of subscribers across the pricing range has been pretty constant.

It gets 94 percent now that subscribers are at three-out program or higher.

Okay.

Can you talk a little bit more about the fulfillment costs that went up.

That was a surprise to us.

So when you say that in Q3 it should go back to Q1 levels, are you talking in absolute dollars, or are you talking in percentages?

And also what was the extra money that was spent on these extra onetime items?

I was talking about it on a percent of review as if the money was spent on equipment, most of the incremental spending was on equipment.

Some was for incremental labor.

Most of the equipment had a price win of less than $2500.

So that expense is not capitalized for things like PCs and label printers and scanners and stuff that we use in our office facilities both in Sunnyvale and around the country to ship and return DVDs.

So in that expansion space, it brought on about 202,000 square feet of space through upgrades through expansion, primarily a small portion through new hub in the quarter.

Okay.

Then I guess last question, maybe Reed.

When you look at the new guidance for SAC, what kind of assumptions are you making about potential increases in TV CPMs?

The increases in online advertising rates?

Not online advertising, but off-line since you're switching the mix away from online into TV?

In terms of this quarter, our buys are all in place.

So I don't think we have any rate risk in terms of Q3.

In terms of on a go-forward basis, I am not sure what -- I imagine that we are assuming a stable rate climate for television advertising in the near-term such as Q4.

Okay.

Thanks a lot.

Alden Mahabir, Vintage Research.

Good afternoon.

I have two questions.

The first one relates to your subscriber guidance.

It seems that your guidance was implying a pretty wide net addition range of 57,000 to 257,000.

I was wondering being that we are a little bit into the quarter already if you could comment on whether we are tracking closer to the 57,000 number or the 257,000 number?

The reason why I'm asking is because in my opinion one number represents bad growth and the other one represents good growth.

My second question relates to SAC.

Last quarter we saw margins pressured by higher DVD costs and increased postage, and this quarter we are seeing SAC rise.

I was wondering if you were concerned in seeing the rise in SAC?

And if I am recalling correctly, you mentioned in your Analyst Day in April that you did not see SAC rising from its current $35 level anytime soon.

Also, if you could provide some color as to your long-term expectations for SAC in 2005/2006, that would be great.

Why don't I start from the end.

It is Reed here.

And I would say in terms of how we manage the model, because as we mentioned we decide what we want to spend on SAC, what we are focused on is generating the stable predictable earnings.

So as we have as we look forward at future quarters for next year and for 2006, what you will see us be be guided by at least domestically for now, is how to generate those stable predictable earnings, and we will dial in the appropriate SAC to achieve those goals.

And, Barry, I will let you do the first part.

Let me first address guidance.

A couple of things.

I read a quote yesterday that said the marketplace is expecting companies like Yahoo! and Netflix to beat guidance.

Everyone who has followed Netflix since we became a public company in May '02 I think understands that our guidance strategy is to give you our best guess of what it is we are going to accomplish in the quarter, and then we try as hard as we can to meet the guidance objectives we set for the business.

We are not -- it is not our strategy to play the game of setting guidance low and then beating guidance to create the impression that we are outperforming.

And I think if you look back in time, we have done a reasonably good job in predicting the performance of the business.

One or two stumbles.

Usage last quarter being an example of a stumble.

And for the most part we tend to try to land the business somewhere around the midpoint of the range, the upper midpoint of the range of guidance.

So I hope that answers your question with respect to subs.

With respect to SAC, I understand you to say that SAC had risen in the quarter.

I think probably you --

No, we were expecting SAC to rise.

Yes, we are expecting SAC to rise.

It is true that in the Analyst Day in January certainly our view of the future reflected in our guidance was that we would be able to spend $35 a sub and grow the subscriber base at the levels that we had predicted in our guidance.

And while we try to be financially responsible in the amount of money and generate a reasonable overturn over the life of the subscriber based on the amount of money we spend, sometimes the marketplace moves independently of that link the online space.

In order to maintain our growth, we need to step up and pay slightly more, and if it happens to be a fortunate and coincidental thing that is because of the price increase and the increase in ARPU, we can certainly afford to pay incremental dollars and still get a very attractive return on our acquisition.

Jason Avilio, First Albany.

Thanks for taking my question.

I'm wondering specifically on the churn rate I understand that there is some lingering impact from the price increase into Q3.

But headed into Q4, you know the bottom end of your churn rate is about 4.6 percent as versus the previous guidance range of about 4 percent.

So I'm wondering if there's anything underlying fundamentally that maybe we are not picking up on the churn rate going into Q4?

And then secondly, I'm wondering how you were thinking about new entrants entering the marketplace, particularly in Q4 as it relates to subscriber acquisition costs?

I was wondering if you have any empirical evidence of what would happen with Blockbuster's market entry into the online space in terms of your subscriber acquisition costs?

And then, Barry, I think you might have mentioned something about international impact in 2005 on the bottom line.

If you did, would you be able to repeat that, please?

Let me do the churn and the international impact piece, and I will let Reed do the new entrants competition piece.

The pattern last year, if we continue to follow this year last year's pattern, then we ought to see a gradual decrease in churn as we did last year as we progressed through the calendar year.

Also, as the subscriber base ages, which it is doing since order subscribers churn off at a lower rate than newer subscribers, we ought to see a gradual decrease in churn, and that, of course, was baked into our expectations when we set as a goal achieving a sub 4 percent churn rate in '05, as well as a reflection of steady improvements we have made in the quality of service primarily and most recently reflected in the content investment we have made and improvements we have made in the new release section on the site.

With respect to international, I think your question is with respect to '05?

Yes, I thought I heard you might have mentioned --

Yes, I mumbled something about '05, and I said that on a preliminary basis quarterly, we expected that the net -- the spending -- the net loss in the UK would be in the range of $5 to $8 million quarterly possibly U.S. dollars while we build our presence there.

And then you asked about, if Blockbuster spends heavily online, would that effect us?

I don't think so.

There's so much advertising going on online that Blockbuster spending $10 or $20 million would be such a drop in the bucket of total spending, that it would be extremely hard for us to notice that in any way.

So I would be very surprised if Blockbuster per se has an effect.

I guess the question was really more as it relates to subscriber acquisition costs, more than inventory levels online.

Would it sort of -- are you baking anything into your current guidance as it relates to Blockbuster coming out and spending aggressively as it relates to SAC?

Because presumably they would be able to acquire some of the subscribers that you guys would be going after?

You know I really think the Blockbuster effect, we have seen the store-based effect and that has not been measurable or visible, and next year when they do the integrated play, then they will really start potentially promoting online from the stores.

It is pretty awkward when there are separate plays for them to do much promotion of online.

So my hypothesis is that when they launch the online later this year that they will be working out kinks, developing it and really focused on when they had it integrated with the stores.

So our plans have -- our belief is that they will have very little impact over the next 12 months until the integration comes, and then we will look and see.

Even when the integration comes, there is no data to go on.

But I don't think it will have a material effect at that point.

Bill Lennan, WR Hambrecht.

One follow-up on this fulfillment.

You explained the components of the variances.

I wanted to just talk a little bit more about the communication of it.

Back in the Q1 conference call, there was a comment about fulfillment perhaps ranging from 10.5 to 11 percent going forward.

I guess the one driver that could throw fulfillment off is increased usage and in terms of forecasting not being able to foresee a large fulfillment expense with the usage.

But that did not occur this quarter.

The usage is actually down.

So my question is, when the comment was made about a range of 10.5 to 11 percent, were you planning the moves and relocations of the centers, or was that baked into that number, or was that something that was extraordinary above the 10.5 to 11 percent range?

That is part one.

I think we missed it a little bit in terms of spending, and some of the spending was front-end loaded.

So it was a timing difference.

Does that answer your question, Bill?

Yes.

I guess another.

For the remainder of the year, do you foresee any such relocations that we should think about baking in to our fulfillment costs?

Yes, I think the question is, do I expect another tidal wave to wash over us like this one?

We have no plans to bring on another 200,000 square feet during the year that would require a facilitization like this.

So it will be normal course of business, stuff which is at a much lower run-rate.

Got it.

As for the UK, apart from Blockbuster who obviously has deep pockets, I think Reed made the comment earlier that capitalization seems to be the key metric for success.

Everybody and their brother seems to be doing this in the UK if you type in on Google, but do you see anybody besides Blockbuster who looks like a serious competitor in terms of having capital and going about this in a grownup way versus a fly-by-night way?

Well, I would say there is a number of companies there that are definitely grownup.

But what we have found is being grownup is not enough, that the business is very capital intensive to both the acquiring DVDs and acquiring customers and building the technology out.

When you're doing all three of those simultaneously, it is quite expensive.

You can go back and look and see what we have spent over the past in the U.S. market you know four to five years to get an inkling of what those numbers are.

So I don't see anyone that is able to raise those kinds of dollars in the UK.

At least not with the prospect of competing against two well-funded competitors.

Lanny Baker, Citigroup.

Two quick questions, one simple.

The international office, that range that you gave, Barry, do you have at this point any slope of that line?

Does it start at 5 and end at 8?

Does it start at 8 and end at 5?

Is it consistent across the air?

Do you have any view of that?

And I have a follow-up.

It is Reed.

We will probably go in in Q1 and Q2 higher in that range and look at the efficiency of the spend before making decisions for the back half of the year.

Okay.

I think the big strategic mistake would be to underfund and then misread the results because of it.

Let me ask you to Monday morning quarterback a little bit.

You had a price increase 10 percent in the quarter.

You cut your marketing spending by 20 percent or so from the first quarter to the second quarter.

Retrospectively do you think that is the right combination, and do you think you lost any momentum on subscribers as a result of those twin moves that you had not really factored at the start?

Great question.

Let me give you a different framework for thinking about spending in the quarter and the change in spending from Q1 to Q2.

It is still because of the way in which we acquire subs has been through Q1 and Q2 primarily a variable pay model.

So the reason that marketing spending declined quarter over quarter is because of the seasonal lull in new trial subscribers.

If we had had more new trial subscribers, we would have had more spending.

And, of course, on last quarter's call, we said, look, in each of the prior years that we've seen a seasonal lull into Q2, and we expect that to happen again, and that will result in a decline in marketing spending and that will result in return to profitability in the quarter.

As we shift out of a variable pay model, pay for performance sort of things, and more into a fixed spending kind of mode, that will set up a different set of dynamics and business risks.

And if you look at the -- most of the decline as Barry mentioned is seasonal, and you can see that because the year-over-year subscriber growth rate.

You know we are fairly stable between Q1 and Q2.

I think it is like 82 percent and 78 percent in Q2.

So you know essentially the same.

So what you're really seeing is just a straight seasonal factor with no change off of the seasonal pattern.

So the only reason that we would have decided to spend more in Q2 is if we wanted to change that pattern and we were comfortable with maintaining it at approximately 80 percent year-over-year subscriber growth or trial growth.

And so you kind of make it sound like you don't feel like you lost momentum and so which I think kind of then feeds back to Reed's suggestion earlier that the lower end of your guidance range on subscribers for the next quarter is a pretty conservative view?

Well, as Barry mentioned, we set the guidance now and we target the middle of the range.

So if you had to ask our very best private guess, you know where we will end up, it is right in the middle of the range.

Jim Friedland, SG Cowen.

All my questions have been asked.

Thanks.

Then I will turn the conference back over to the speakers for any closing comments.

Well, thank you, everyone.

Again we feel great about having executed the price increase successfully.

It is a big step forward, and we are on track for our billion dollar in '06 goal.

Thank you for your support in that.

(technical difficulty) -- Netflix's second-quarter earnings release conference.

Thank everyone for dialing in.

You may now disconnect.