Netflix Inc (NFLX) 2004 Q3 法說會逐字稿

Good day everyone and welcome to today's Netflix third quarter results conference call.

Just as a reminder, today's call is being recorded.

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

Please go ahead.

Thank you and good afternoon.

Welcome to Netflix's third quarter 2004 earnings call.

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

We will (technical difficulty) the third quarter approximately 1:25 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 off this call will be available at the Netflix Web site after 5 PM Pacific time today and until October 20, 2004.

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 27th, 2004.

And now over to Reed.

Thank you, Deborah, and welcome to everyone.

Over the past five years, we have grown from $5 million in revenue to over $500 million in revenue, from nothing to over 2 percent of nationwide households subscribing, from nothing to over 8 percent of households subscribing in the market longest served by local overnight delivery, the San Francisco Bay area.

In our most recent quarter, we delivered GAAP net income of $19 million, free cash flow of 14 and revenues of 142 million, up 96 percent from one year ago.

It was our most profitable quarter ever.

It is now clear to all that this market is going to be very large, perhaps even exceeding the $2 billion of the domestic online book market.

Subscription movie rentals with unlimited rentals, no late fees and Internet movie selection is a compelling entertainment offering from many of the consumers who still spend over $8 billion in domestic video stores.

In addition to this market's very large size, it has become clear to many that whichever Company leads the Internet DVD market is very likely to be able to extend that leadership into the era of Internet electronic delivery of movies.

Specifically, we had the insight that the movie delivery methods, be it first-class mail or electronic delivery, is only a small part of the overall consumer solution.

We're developing and perfecting Internet movie choosing, subscriber acquisitions, personalization and other network (indiscernible) technologies and most importantly, the brand, all while using first-class mail delivery.

Starting in 2005, we will offer electronic delivery as an option on films which the studios allow availability.

This will be available to the same subscribers under the same brand using the same Internet movie selection and the same personalization as we have today in our DVD business.

If we are able to achieve 20 million Internet DVD subscribers and then can offer them the option of electronic delivery, we will have more reach than any satellite or cable company in America, other than Comcast.

We are building a huge strategic asset in our subscriber base.

Initial conventional wisdom was that Internet DVD rental was a niche business and DVD would be quickly obsoleted (sic) anyway.

This conventional wisdom partially presented Blockbuster, Amazon and others from entering when we were young and vulnerable.

Now we are cash-flow positive, have a great balance sheet, tremendous momentum and over 2 million subscribers strong.

Of course, a $500 million market growing 100 percent year-over-year cannot escape attention forever.

Blockbuster admitted the potential of this market recently and we believe they will need to spend heavily to gain any material share.

In addition, we recently learned from several sources that Amazon is likely to enter our market soon.

Amazon's planned entry, while surprisingly late, only validates our view that this is a large and strategically important market, or they would not be trying to enter at this stage in the market.

Given the size of the economic prize involved and the changing competitive landscape, the conservative strategy is for us to extend our market leadership, deepen our competitive motes by making three positions that are painful in the short term but will ensure long-term sustained leadership.

First, we are postponing our UK launch for at least one year so we can put all of our focus on domestic market leadership.

Second, we are reducing the price of our service from $22 to $18 of effective November 1st.

Third, our strategy for 2005 is to grow as fast as possible while maintaining profitability on an annual basis.

These decisions, while difficult, will enable us to maintain our leadership against strong competition in this period of rapid growth.

If we had known in Q1 that Amazon was planning to enter this market, we would not have raised our prices from $20 to $22 and we would not have planned our UK launch.

For all of you, a year of minimal profits in 2005 is, I'm sure, quite a shock.

We believe this evolution and strategy is the right step.

Given the new information on the competitive landscape, our decisive and strong actions today will protect and grow long-term shareholder value substantially.

Given our competition's strategic motivations, what will happen if our competitors match or beat our $18 price?

If that happens, the only certainty is that the video stores in America will be vacant.

The $8 billion of video store rental revenue will pour into online and the land grab for the Internet DVD market will be in full fury.

As the online market grows larger and larger, the same-store sales comps for video stores will drop even faster.

The resulting economic pressure on the stores reduces their quality.

The volume increases in the online segment fuel further efficiency and the Internet DVD market followed the path of the travel market to a substantially online world.

Moreover, as video store revenue decreases sharply, Blockbuster will struggle to be able to fully fund their online ambition.

We at Netflix have the most efficient DVD rental operations on the planet with a sole focus on DVD rental and are prepared to win in this critical phase of the market battle.

We ship over 3 million packages per week with and average revenue per package of $3 and 100 percent returns; tough metrics for any competitor to match.

The specialized software and operations we have developed allow us to be the Dell of this market and remain one or two generations ahead in cost efficiency.

Our 2005 strategic objective is to strengthen our competitive differentiators by growing very fast, while maintaining breakeven for the year.

We plan on exiting 2005 with over 4 million subscribers and continued market leadership.

Our $18 price point and our great service will attract ever more video store renters to come online, substantially expanding the Internet DVD market.

A large subscriber base will be a key strategic asset in the coming opportunities for the electronic delivery of movies.

The prize is huge, the stakes high and we intended to win.

And now I will turn it over to Barry before we open it up for Q&A.

Good afternoon, everyone.

For the third quarter, we achieved record revenue of 141.6 million, record net income of 18.9 million and record cash flow of $14.1 million.

Given the changing competitive landscape and the significant shift in our business model which we described, my remarks today will focus primarily on our financial guidance resulting from the shift in strategy.

Before I review guidance, however, I would like to comment on the depreciation change we made in the quarter, as well as the trends in SAC (ph) and churn in the recent quarter.

Effective July 1, 2004, we changed our accounting treatments for the estimated useful life of catalog DVD.

We also lowered estimates for the salvage value of purchase DVDs.

This change lowered depreciation expense and increased gross margin 290 basis points and net income by $4 million in the quarter.

For depreciation purposes, a catalog DVD is defined to include any disk purchased within three months after its release to the home video market.

This means by way of example that a new release title, like Passion of the Christ, which we purchased before street date, is categorized as new release content and depreciated over the first 12 months of its life.

Now fast forward three years to October of 2007.

If we buy an additional 4000 copies of Passion of the Christ, those 4000 disks will be categorized as back catalog and depreciated over three years.

For depreciation purposes, a DVD is classified as either new release or back catalog when we purchase it and is never reclassified from new release to back catalog during its depreciable life because a reclassification would extend the depreciable life of our inventory and undermine the integrity of our financial reporting system.

Previously, we depreciated our DVDs over one year.

The one-year estimate was our best judgment of the useful life, given our limited operating experience.

But with several years of operating history behind us and following a detailed analysis of the new release and back catalog utilization covering 27 million DVDs, we now believe that the useful life of our catalog content is three years.

You can see a graphical presentation of our analysis of this data on the Web at irnextflix.com.

So while a one-year estimate is shorter and seemingly more conservative in its short life than a three-year estimate, conservatism of this sort is not sufficient reason under GAAP for management to maintain an estimate which it believes is no longer accurate.

From a GAAP perspective, our accounting treatment is appropriate.

SAC for the quarter in the United States was $37, at the low end of our guidance of $37 to $39.

Online rates remained high during the quarter, on a par with last quarter's rates and we shifted our spending from online to TV to drive incremental sub adds.

Response rates to our advertising remained steady during the quarter, despite Blockbuster's launch of its online service.

Average monthly churn for the quarter was 5.6 percent, at the high end of our guidance for the quarter.

On last quarter's call, I told you the churn appeared to have settled in at a rate and followed the pattern we experienced in the comparable time period last year.

Based on that trend, we expected a Q3 churn rate of 5.2 percent, the same churn rate we experienced last year.

The churn was higher this quarter.

The increase in churn above last year's rate seems to coincide with the launch of Blockbuster's lower priced online service.

For the fourth quarter, we expect any subscribers in the range of 2.3 to 2.5 million, revenues in the range of 138 to 142 million, GAAP net income in the range of 2 to 6 million after costs of discontinuing our operations in the UK and EPS in a range of 3 cents to 9 cents.

For the year 2005, we intend, as Reed said, to grow our subscriber base as rapidly as possible, while operating the business at breakeven.

As the year progresses and the competitive landscape unfolds, we will have more to say about our performance expectations for the business.

Given the new competitive environment and our desire to compete with maximum flexibility, we intend to reduce the number of metrics we provide guidance for.

In the future, we will guide to ending subscribers, revenue, GAAP net income and EPS.

By reducing the number of metrics we guide to, we preserve our ability to react quickly and effectively to the changing dynamics of our business by making real-time trade-offs during the quarter between SAC, gross margin and churn -- key levers which drive revenue and growth profitability.

Today's announcement represents a nimble shift in our strategy.

In this shift, I see the opportunity to make a good company great, to become an enduring part of the entertainment landscape if we build a large and satisfied subscriber base by extending our market leadership in Internet DVD rental and then extending that leadership position into downloading.

As Reed mentioned, we have grown our business from 5 to 500 million in revenue in five years.

Along the way, we were exceptionally nimble -- fearless innovators with good judgment in periods of rapid change.

From today's announcements, you can see that we remain wedded to our core values of nimble innovation.

Not since the launch of our subscription business in September of 1999 have I been as energized by the challenges and opportunities we face today.

The world was a different place in January 2004 when we announced my plans to leave Netflix at year end.

Today, I am announcing my plans to the extend my stay at Netflix for at least two years, and maybe longer.

Great challenges bring their own reward, and this challenge with this team which I trust and deeply respect will be as rewarding as our growth was to 500 million in revenue.

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

(Operator Instructions).

Lanny Baker, Citigroup.

First of all, you said your goal would be to remain profitable for next year.

You also said in 2005 you will be pushing harder to introduce something on the download side.

Can you quantify what the download investment is, in terms of technology; what you think it might cost you, in terms of any kind of upfront content engagements you might have to enter into?

Just give us a sense of how big that expense is in '05, relative to what you are saving with the change in UK.

And then I have a follow-up.

The downloading expense we have loosely talked about as 1 to 2 percent of revenue on an ongoing basis, so that will give you some color for it.

Obviously, any advanced payments on various things might hit the P&L.

So I'm not telling you that we're going to not have them.

But what we're forecasting is P&L breakeven.

And you will see continued investment in downloading, but it's not significantly expensive compared to acquiring the many hundreds of thousands of subscribers that we will make sure.

And then, you have some experience now with acquiring subs at a couple of different price points.

Do you think -- and I know you're not going to talk about SAC going forward -- but are you anticipating right now that the SAC goes up next year, or that the price increase, sort of that lowest price on the market, is going to give you big efficiencies on SAC?

And then final question to attach to that is -- does that price increase also impact your other plans, other than the main three-out (ph) plan?

I will take the last one.

There's modest changes on the other plans, but approximately 90 percent of subscribers are on the three-out, so that's the dominant plan.

The tensions on SAC are as you say.

Other things being equal at $18, consumers are much easier to convince to try the service and stay with the service.

And other things being equal, you will see improvements in churn and lowering in SAC.

So, the question is -- how those play out against the new competitive environment.

And part of the reason that we're giving the more general guidance; i.e., on revenue and in earnings to give us flexibility to manage within the constraints of revenue and in earnings, can give us flexibility to manage within the constraints of revenue and earnings that manage the competitive environment and the changes they are in.

Thanks a lot.

Gordon Hodge, Thomas Weisel Partners.

Good afternoon, just a couple of questions.

On usage, I think in the subscriber release earlier last week, you talked about you are thinking usage came down in response to the Olympics.

And I guess if you could just talk about how you exited the quarter on a usage basis and what that might look like in the fourth quarter so far.

And then also as it relates to subscriber growth, it looks like, given how your strong your revenues were in the quarter, that maybe you had -- or, the bulk of your new subscribers came early in the quarter, and maybe that growth rate slowed as the quarter went on.

I'm just wondering if that theory is correct?

And then lastly, when you talk about breakeven, I assume you're talking about GAAP net income breakeven, or is it some other metric?

Thanks.

Last question first, yes, (indiscernible) GAAP net income breakeven.

Usage, we were flat on the quarter roughly -- 66 to 66 -- which was less than we expected.

We were looking for a seasonal increase.

I think the Olympics was one of the cost currents.

It's also true that amongst our heavy users, when we jacked the price, we saw our heaviest users leave -- a good thing for us, and maybe not for others.

And in terms of momentum during the quarter, no comment, except to say -- amplify my remarks, which were that our acquisition plan for the quarter was substantially on plan.

So we did not see softening as a result of competition, but we did see unexpectedly an increase in churn, which is why the ending sub number came in below the midpoint of the guidance.

And that's why your guidance for fourth quarter might be a little bit lower than it was before?

Correct.

Well, I would say that is among the reasons.

Okay, thanks.

Safa Rashtchy, Piper Jaffray.

Hi, guys.

First of all, I'm a little puzzled by the magnitude of the changes that you're implementing so suddenly.

I guess, Reed, you were suggesting that to a large degree, this has to do with your information that Amazon will be launching something soon.

Can you elaborate on that?

When do you expect Amazon to enter?

To what degree do you think they will be entering, because it does -- obviously, up here, it has been a big factor in your decision to launch these initiatives and spend heavily?

And I have a couple of follow-ups.

That's correct, Safa.

If not for Amazon, we would not be doing this magnitude of change at this juncture.

And because of Amazon, we view it as prudent to do these changes.

In terms of timing of Amazon's launch, we don't have specific information on that, but look forward to hearing about that from Amazon over the coming quarter.

You mentioned that next year, you plan to run breakeven, and I was assuming that your comments mean you will be spending heavily.

Could you comment on -- will you be spending strictly on customer acquisition, or will you be doing more branding?

How would you be spending the money that you will generate so that you will break even?

Well, first, a lot of it is to the lower price, if you are thinking relative to the P&L that you have in your model for us now for '05.

So at $18, essentially a lot of the money goes to with (ph) the consumer value, and then the balance of it goes, as you said, to customer acquisitions, so there's no big new expenses for next year.

And finally, could you, Reed, talk about cash flow?

I understand you will be GAAP breakeven.

What do you expect for your cash flow for next year?

We will take the majority of our free cash flow next year, which would have been quite significant, and we'll pile it back into acquisitions so it will (ph) be self-funding.

We ought to at a macro-level imagine that we are in investment mode to grow as rapidly as we can, the subscriber base and not look to us to throw off huge amounts of free cash flow.

But, now should you necessarily look for the business to be cash negative, unless along the way by way of example, we discover some enormous opportunity for automation savings that might cost unexpectedly 20 million.

And then for sure, you will see us reach for that automation savings and make that CapEx expenditure.

So as to Reed mentioned, we have quite a strong balance sheet, no debt, and not quite $170 million in cash.

Thank you.

Dennis MacAlpine, MacAlpine Associates LLC.

Thank you and welcome back, Barry, even though you haven't left yet.

You talked about the postponement of the British launch.

Can we also assume that the Canadian launch is also postponed?

Correct.

And, you've made a comment that you said you expect to exit the year next year with some number of subscribers, and I just missed the number.

Dennis, actually, it's over 4 million.

Over 4 million?

When I look at the numbers for the third quarter, you had a very good new trial subscriber number -- almost 600,000 -- about the same as the second quarter.

But the retention levels seemed to have gone down.

Is this because of the price increase, or it is there anything else coming into play in here?

And with the price reduction, do you expect that retention to go back up?

They were -- the price increase and competition both played a role in the increase in churn.

Competition contributed to the increase in churn above our expectations to the tune of about 30 basis points, and in the neighborhood of 100 basis points of churn possibly resulted from the price increase.

And when you look at the catalog, how much of your catalog -- of your library at this point, the DVD library, is catalog versus new release, and how much of each of those is rev share, as opposed to physical DVDs, or whatever we want to call that?

We don't break it out on a library basis.

In terms of rental activity, as in prior quarters, we were still split about one-third new release mix, two-thirds back catalog.

Okay.

And lastly, are you also going to cut back your spending on the Internet delivery launch?

Dennis, it's Reed.

No, there are no plans to cut that back.

We plan on launching that.

And again, in the past, we have said, and I'll emphasize today, that we expect it initially to have only modest consumer interest and it will grow in importance and interest year after year.

Thank you.

Youssef Squali, Jeffries & Co.

Thanks a lot, a couple of questions.

First, Reed, in terms of digital delivery, which you just said you will be launching in 2005, the only relationship now you have is the TiVo.

TiVo itself has only 2 million subscribers, and that hardly qualifies at nationwide coverage.

Can you just give us a little more color on what is the strategy there?

And related to that, the studio relationships are obviously a very important part of that.

By when should we expect to see announcements about relationships which ultimately will allow you to have a digital offering?

And then I have a follow-up.

Not until we launch, Youssef.

We would not actually have even announced the TiVo relationship.

But for the Newsweek leak and Mike Ramsey having to resign from our Board, which of course was a disclosure item, our general preference is to announce these things when they are available for consumers so that we take advantage of that press cycle.

So look for it in '05 when we launch.

And your next question was?

The next question was about the studio relationships.

Again, same thing.

I would say, we will announce those not incrementally, but when we launch the service.

So, last question to Barry.

How does the digital delivery impact your digital DVD library investment?

So, this quarter, it was around 22, 23 percent; that was up from last quarter.

I guess looking at it not for Q4 but looking at it a couple of years out, do you see that 20 to 25 percent still in place, or do you see as the digital mechanism gets into place, that should go down?

I believe that the downloading market will evolve with slow but steady progress enabled by the availability of low cost devices which are going to move that content from the Internet to the TV set.

We need to be on as many of those devices as we can be, so that will be a core strategy for us.

Those devices become relatively inexpensive, like the DVD player did, with three price points below 50 bucks, and found its way in the mass-market distribution.

It was five years from launch, the 50 percent household penetration.

So we could imagine that pace by (indiscernible) the availability of content in these boxes, digital downloading will take awhile.

I'm slow enough I think that we will be able to modulate up or down our purchasing of DVD as we've become delivery platform agnostic so that we do not risk inventory obsolescence of our DVDs.

Meaning we are going to see the growth coming long before it hits us and a large percentage of our subscriber base, even when we offer digital downloading, will continue to want to put something in the DVD player in their house, and that's likely to be ADVD (ph).

So for modeling purposes, still looking at 20 to 25 percent?

Yes, I think so, especially in a competitive environment.

Thanks a lot.

Heath Terry, CS First Boston.

I was hoping you could kind of give us a better idea of why you felt like, given how competitive, hypercompetitive this market is getting, why you felt like it was not worth going ahead and putting the flag in the ground in the UK, given the limited cash flow or cash flow investment that you would need to do that, at least judging from what you had said earlier.

And then I guess if you could also give us an idea of based on what you know, having seen this business at a couple of different price points and what has happened with usage, what you expect usage to be like as you capture more consumers at this $18 level?

On the UK, it's a tough call.

We had only a few million dollars invested (indiscernible) money to be spent was next year as you start to build the brand.

And when you launch to build a brand, you want to make sure that you can sustain that fight for multiple years.

And we realized that our spending of $20 to $32 million next year, that we would like to pull that back to the U.S., that our destiny we made by getting to 4, 10, 20 million subscribers in the U.S. so that we should conserve it of course was to focus, given the new competitive information.

Second, your question was on $18 -- do the usage characteristics change?

And we think that it may well.

It brings in a lot more light renters, and that can skew the average usage down.

How much that actually happens, we will be able to tell you a lot more about in Q1 and Q2 when we've actually seen it.

But it's certainly a plausible theory.

And then, Reed, if you could talk a little bit more about your decision to stay, kind of besides the competitive environment, what has changed from earlier this year to now?

And then, Barry, if you could also mention, I guess maybe talk about what you are expecting subscriber cost to do to the extent that you can in absolute dollar terms, now that you're going to this lower price point?

Not much has changed, except competition since January when I made my decision to move on.

I made my decision because I want to run my own show and that is not likely to happen here at Netflix.

On the other hand, there are very few challenges as exciting as the one we face, if in fact Amazon enters the marketplace.

And the opportunity to be a part of that and help grow this business, which whose growth I have been a part of for the last five years, with this team and with Reed, was an opportunity for the foreseeable future that I felt I needed to participate in.

So it was not for lack of opportunities (multiple speakers).

But someday, someone -- this is going to be epic and it will be part of the lure of Silicon Valley.

It has grown to 500 million in five years.

The second part of the question relates to SAC.

Of course, that's not nearly as interesting as the first answer.

We have a lot of flexibility, given our spending plan over the next 18 months, depending on what the market does, how price (indiscernible) demand is, how intense competition is, the swing up and down on SAC to drive growth.

One of the reasons we pulled back the metric is so we did not feel constrained to deliver a number to you.

If during the quarter, the dynamics change, then we wanted to hammer down on spending, we could.

There is every reason to believe that in the absence of an response from a competitor to our new price, that response rates will increase and growth will accelerate and word-of-mouth will accelerate and SAC will decline.

What happens with SAC ultimately depends on two things, I think -- what happens with word-of-mouth, and secondly, what the competitive response is.

Is it a full frontal strategic assault with spending and big investment, or is a Blue Nile kind of execution with low pricing and not much headway and a relatively poor Internet execution?

Okay, thanks.

Jim Friedland, SG Cowen.

Thanks.

Most of my questions have been answered, just one on online ad rates.

I just want to confirm that you said that they were relatively stable from Q2 to Q3.

And if you could comment on what you're seeing in online ad rates so far early in the fourth quarter?

Thanks.

Consistent with our Q2, Q3 up until now.

Sorry -- what was the last part?

Up till now.

So you asked at the beginning of this quarter to we haven't seen any material change.

Okay, thank you.

Jason Avilio, First Albany.

Hey, guys, thanks for taking my call.

I'm wondering if you could perhaps talk about customer acquisition strategy by channel.

Obviously, you started spending some more on TV advertising this quarter.

Wonder if you're going to accelerate that relative to online spend?

Secondly, Reed, perhaps you could address the 4 million subscriber number by the end of 2005?

In the absence of sort of information about pricing from Amazon, what gives you confidence that you could hit that metric?

Thanks.

On your first question, the advantage of having a diversified customer acquisition strategy where we have coupons in DVD boxes, we have TV advertising online, is that we can move back and forth between those segments, depending on what we're getting the best deals with working the best, where we have the best creative, etc..

So we continue to move between those.

As a consumer, you will notice that we have done more TV recently and we may continue to do that; but, again, only as long as it's more effective on a cost per acquisition than online or than doing (indiscernible) off-line.

So we will continue to move those.

Your second question was on not knowing what Amazon's pricing is, how can you be confident of 4 million?

I think the reason we get confident of 4 million is in all scenarios that we gave out of Amazon to entry.

They will gain some share, but we will still have enormous momentum.

And it's those sequence of events that leave us to feel comfortable on our warranting to use 4 million coming out of 2004.

Thanks.

Sorry, coming out of 2005.

Richard Ingrassia, Roth Capital Partners.

Thanks, good afternoon everybody.

Obviously, we have heard a lot of reasons why cancellation was higher in the quarter.

But anecdotally, you have also spoken before to conversion rates on the new trials and I think in the 90 percent range.

Did you pick up any noticeable reduction in conversion rates in the quarter?

That hasn't changed materially.

It's still around 90 percent.

Okay.

And, I just want to make sure I'm getting this right.

Obviously, this dramatic increase in costs that you are projecting in 2005, we could presume that the bulk of that is going to be in marketing as you push to compete?

Actually, Rich, we're not projecting that dramatic an increase in cost.

What is driving us to breakeven is lower revenue per subscriber moving from $22 to $18.

Okay, so primarily just a lower price than costs.

Could you give us a sense for how costs increase on the marketing side, or are we all in the right range now?

They will increase along with total acquisition.

But what we are explicitly doing is saying we are going to move around SAC in a fairly wide range in balance with the other numbers that we have so that we can deliver consistent revenue and breakeven earnings for next year.

And that's why we are looking for more flexibility in how we manage that number.

So that is why we are giving you those more general guidance.

Do you have a new perception for what a "natural rate" of churn might be?

The churn rate is definitely related to the price, it's related to the service levels and it's related to competition.

So I wouldn't think of it as a natural rate.

Moving from $22 to $18, we will see a reduction in churn, other things being equal.

And what we have to see is how we move forward with respect to competition and see where churn goes.

The other thing I would say in that respect is that churn is also a function of subscriber life.

And we've said on this call it is clearly our intention to accelerate the growth in our subscriber base, growth in revenues, put the hammer down on growth, and we have a substantial history track record of success as a management of providing rapid growth.

Implications for churn are, all things being equal, the churn rate will go up because younger subscribers churn at a slightly higher rate than older subscribers.

But I think the macro trends will be in the presence of lower price.

And absent of underpricing from competition, churn rates probably coming down.

And just one last thing.

Barry, did I hear you say that you have also increased the salvage value on a new or catalog or both?

We have changed it and we have reduced it.

Reduced --.

Reduced it.

And the macro trend is that we imagine when we said it originally that we would be selling a higher percentage of our purchased DVDs than we are because we're keeping them utilized and we're going so fast, we're not selling as many as we used to.

So, reduce salvage across the board?

As we imagined, yes.

Thanks.

(Operator Instructions).

Rick Legott (ph), Arbor Capital Management.

Good afternoon, guys.

When exactly did you make this decision, the change strategy?

The rumors on Amazon started to surface about two weeks ago.

And over the last two weeks, we have been confirming them.

So it's in the last two weeks, Rick.

Okay.

And their service will look and feel just like yours and Blockbuster's, presumably?

I don't have any specific information about that.

Approximately like is certainly a good presumption, I think.

Second question -- do you intend to change your DVD purchases as a percentage of revs up or down with this price change?

In other words, the content you are buying, vis-a-vis the subscribers you're adding -- will that change?

I don't think so.

I think if you want to be a player in this market, you're going to have to provide the same level of service, speed of delivery, depth of inventory, merchandising capability that we provide.

And it would be a strategic blunder, a tactical blunder I think, for us to detune the quality of the service at a point in time when we need barriers to entry.

So I don't think good quality of service will be sufficient to assure someone's ability to compete.

But without it, I don't think you stand a fighting chance.

But, you don't feel the need to have to increase purchases of content relative to what you have done in the past?

No.

We have been dialing it back a little bit.

The inventory experience on our site, including the new release experience on our Web site, is tremendous.

So, if we hold utilization flat, perhaps it will go down if you bring on marginal users.

If we hold it flat, you would expect gross margin to continue to be in line with the guidance you released earlier this month?

It would be in line with the guidance we released earlier this month if you held prices constant.

Well, of course.

Adjusting for that, where do we take gross margins in?

Yes, adjusting for that.

Well, you have to make your own usage assumptions in your model.

You said if we hold them flat.

Yes, and I said we're not guiding to gross margin.

Final question.

I thought I just heard someone ask a question about conversion of trialers.

Reed, did you say something about 90 percent -- what?

That is correct.

In the past, what we had said is approximately nine out of 10 free trials convert to paid.

Okay.

When I look at your numbers in the September quarter this year/last year, you added less net paying subscribers in this September quarter versus last year, correct?

Yes, slightly.

Yet, you trialed a lot more.

So what am I my missing about conversion rate?

You're looking at net paid, and it's the churn that's different.

So, churn last year I think was 5.2 percent.

This year, it's -- for Q3, it's 5.6.

So it's that higher churn that makes the difference there.

Okay, thank you.

Brian Bolan, Marquis Investment Research.

I was wondering if you guys have any idea how many cities you might share as distribution hubs with Amazons?

Amazon's distribution centers are not well located for overnight postal delivery.

They do regional centers.

So, for example, the West Coast is served out of Nevada.

So either they will use those regional centers and then have only two-day delivery to most of the major metropolitan areas, or they will develop a metropolitan distribution architecture, like Netflix and like Blockbuster.

Okay, thanks.

Among the reasons we thought they were not getting into this space was both the fact that they hadn't and because it's hard for them to leverage their existing infrastructure and compete effectively in our business.

With the stock and especially getting crushed here in after hours, do you think there is an opportunity that Amazon might just put an offer out there for you, as opposed to building up the centers on their own?

You would have to ask Amazon.

Right.

Thanks, guys.

Lanny Baker, Citigroup.

Two questions.

The merits of lifetime via the subscriber model are kind of weakened I guess by the -- when you're moving around your price, you're moving around your stack (ph).

In a dynamic market, it becomes a tricky way to look at it.

But I was wondering if there's any way to look through next year as of your breakeven profitability and discuss instead, when you roll in the lower price, the lower churn that you contemplate and whatever you're thinking happens to subscriber acquisition, what do you think the 18 percent reduction in price point does to the lifetime value of the subscriber?

And then secondly, I wonder if you could just go back on one question that was asked earlier about usage.

And I think, Reed, you said that maybe at $18 you'd bring in a more casual user, and that reduces the usage on average.

On the other hand, when you raised prices, I think Barry said in the quarter that chased away some of your higher usage subscribers, and that so when you raise prices, it seems to have lowered usage.

And you're saying now that when you lower prices, you think that's going to lower usage as well.

Can you just square those two?

Yes, Lanny.

On your first question, it was around -- well, what does going to $18 do to lifetime value?

And that depends upon churn.

If you compared $22 and 5.6 percent churn with $18, and -- but suppose that we got down to churn levels that we saw earlier this year, then you're looking at lifetime value that's quite attractive.

So of course, it's the interplay between the price and the churn.

A mistake would be to say to take the current churn by $18.

That would not really give you an apples-to-apples, but it would certainly give you an unfavorable lifetime value, but I don't think it's a fair comparison.

Second question on usage -- what Barry is referring to is that the most value seekers slightly differentially or heavy users -- in other words, people who moved to service.

And it is possible that as you said, in addition at $18, you open up the market to lighter renters.

Whoever is the lowest cost service will attract that fringe of heavy value seekers.

Lanny, as you know, we offer service at different price points.

And with respect to the decline in usage and the increased price, we didn't see it in our core program in the three out (ph), but we did see it in the eight-out program.

Just going back to the lifetime value question, that is helpful.

The pieces are obviously -- there are a lot of different pieces.

But in your own thinking about lifetime value, can you quantify what you expect to happen to the lifetime value subscribers, based on this change right now?

We will have a lot more information on that, Lanny, that is more speculation in a quarter or two after running at $18.

So I hesitate to quantify that for you.

What we are convinced that we can do and will do is to manage to breakeven, grow very rapidly.

And as soon as we have the kind of information that you're looking for and can make predictions about it in the presence of Amazon's competition, we will do so.

But short of knowing what Amazon's competition is, we don't want to say something and then have it turn out differently.

And we will manage those factors so that we end up at breakeven.

Okay, thanks.

Dennis McAlpine, MacAlpine Associates.

In your release, you implied that there was some cost associated with -- or at least SAC costs -- associated with non-U.S. domestic.

Can you talk about whether there are any residual subscribers and what the total cost was for the quarter?

There were no residual subscribers, Dennis.

We were operational, but in test mode.

The all-in cost in the quarter was in the neighborhood of $3 million -- sorry, excuse me, I misspoke -- he was handing me a note here -- a little less than $1 million in the quarter.

I'm expecting our all-in cost start to finish to be in the neighborhood of 5 million, maybe, a little less.

So you have another 4 million in the fourth quarter?

No, we were spending some small amounts early in the year, but the bulk of it will be in the fourth quarter in the neighborhood of 3 million.

But, it's all said and done.

Okay.

One of the things that Blockbuster's offering or has been offering in addition to a lower price, which you now have certainly countered, has been the two free rentals if you go into a store I guess one at a time.

Do you have any sense of the effect of that and whether that is a selling proposition that has been working?

It's a good strategy on Blockbuster's part.

They should leverage the asset they have at the stores to be an effective competitor.

So if what they do -- for some consumers, it's a big deal; for most consumers, they're thrilled to not to have to go to the store and deal with the due dates and late fees that those two free rentals involve.

So a good strategy on their part, but only applicable to a small part of the market.

And, given the expected entrance of Amazon, do you expect the other sleeping giant over there at Wal-Mart to do anything, or are they just going to sit and watch this one?

At this point and time, we've been competing successfully with Wal-Mart for two years now.

So I don't expect to see any significant change in their approached to the market.

Thank you.

Alban Mahabir (ph), Vintage Research.

Good afternoon.

Just one quick question.

I was wondering if you could help me understand why you decided to raise prices by $2, knowing that Blockbuster was coming to the market soon, but now decided to lower prices by $4 because of Amazon's entry in the near future?

Is Amazon really that much of a threat?

For those who have followed the Company over the last two years know that when asked about competition, we have often said Blockbuster will be like any other bricks and mortar company, getting some small percentage of the market but not be a significant threat.

And Amazon was the only company that had the e-commerce ethic, understood the customer base and that was a credible and significant threat.

So when we raised prices knowing Blockbuster would come in, we were not fearful of sustaining that premium against Blockbuster.

Amazon's entry, it's a surprise to many of us.

We had thought if they were going to enter, they would have entered in 2002 or 2003 as they've done in some other markets, now they are entering.

We are glad that we found out early.

We are taking significant, prudent actions to be able to prosper with Amazon's competition.

And in many ways, it's going to grow the market very significantly.

So it's a different course than we were expecting.

We were expecting the $22 high-margin, high marketing route to success.

Amazon's entry has convinced us that the more prudent and conservative strategy of lower margin, lower prices and faster growth, and we're executing on that.

And both of those keep us on this strategy that we have had, which is get many, many subscribers -- 5, 10, 20 million subscribers -- and be the key strategic asset for the evolution to downloading.

Thank you.

I would like to turn the conference back over to Mr. Hastings for closing comments.

Look, everyone, I know the Amazon entry is a bitter and surprising pill for those of you that are long in our stock.

I will say at $18, you know, the suppliers are thrilled, the consumers are thrilled.

This is going to be a very large market and we're going to execute very hard to make this back for our shareholders, including ourselves.

Thank you very much for being on the call.

That does conclude our conference, everyone.

We thank you for your participation.

You may disconnect.