Netflix Inc (NFLX) 0 Q0 法說會逐字稿

Good day everyone and welcome to today's Netflix fourth-quarter and year-end results conference call.

Today's call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to Ms. Erin Kozenczak (ph).

Please go ahead, ma'am.

Thank you and good afternoon.

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

I'm pleased to be joining you today.

For those on the call, I have not had an opportunity to speak with yet, I joined Netflix a few months ago as the Manager of Investor Relations, and I look forward to working with you all in the future, particularly during Deborah's maternity leave.

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

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

The earnings release, which includes a reconsolidation of all non-GAAP financial measures to GAAP, and this conference call are available at the Company's Investor Relations website at Netflix.com.

A rebroadcast of this call will be available at the Netflix website 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 filings 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.

Thank you and good afternoon, everyone.

Thank you for joining today's call.

There are three points I would like to cover which I will first summarize.

First, the market for online rentals is growing faster than we had believed likely.

Second, Blockbuster has been aggressive in pricing and promotions, but in two quarters since Blockbuster launched, we have added 517,000 net subscribers, which is comparable to what we believe Blockbuster has added.

We are both benefiting from the rapid growth of online rentals, and Netflix closed 2004 with over 2.6 million subscribers.

Third, our primary goals for 2005 are to reach 4 million subscribers and to return to sustained profitability.

Let's now look at each of these areas in more detail.

How large will the market for online rental be in a few years?

First, the DVD market is growing steadily, and the studios economic commitment to maintaining the DVD exclusive window for new films is deepening every quarter.

We expect DVDs, both standard-def and high-def, to continue to have an exclusive window against cable VOD for the rest of this decade at least.

Second, Internet commerce and broadband adoption are growing steadily and likely to continue to grow for the rest of this decade.

Third, online rental is a phenomenal value compared to store-based rental.

Online subscription rental is more than 25 percent cheaper than store-based subscription rental.

Imagine the market potential of cars.com if cars purchased online were 25 percent cheaper than at the local car dealer.

This efficiency in online rental is enabled by the fact that it takes over 500 video stores to serve the Los Angeles area for example.

Yet we have just one warehouse to serve the same Los Angeles area.

Because of the value Adams Media Research projects, there will be nearly 8 million online rental subscribers by the end of 2006.

Fourth, in the market we entered with local delivery five years ago our growth has continued to impress us.

Now over 9 percent of all households in the Oakland, San Jose, San Francisco Metropolitan market subscribe to Netflix.

Moreover, the growth rate has been approximately 50 percent year-over-year for the last two years.

Even if this growth rate tapers to 30 percent per year, which is likely, it would imply that in three years 20 percent of all households in the Bay Area would subscribe to Netflix.

Just as importantly, after we upgraded Seattle, New York, Dallas, etc. to local overnight delivery, the growth in these markets has paralleled the Bay Area's growth.

In terms of the total online rental market, a year ago we had 1.49 million subscribers.

Today between Blockbuster's forecast of .5 million and our 2.6 million, there are over 3 million online renters.

Thus, online rental is a $650 million market that is growing over 100 percent year-over-year, which makes it one of the fastest-growing large markets anywhere in the world.

In short 20 percent penetration rates are plausible, and someday 20 million households in the U.S. may be renting movies online.

Of course, a $650 million market that is doubling attracts serious competition.

In the last six months Blockbuster has thrown everything but the kitchen sink at us, and yet we have continued to grow and retain our customers at record rates.

In particular, Blockbuster was promoting their service in their stores to their 20 million store customers, is promoting their service online, is offering free store rentals for online subscribers, has opened 23 local warehouses and has flashed their prices twice in Q4.

How can it be then that our subscriber retention and growth were at record levels in Q4?

In part the answer is that this large and growing market appears to have room for multiple players.

And in part the answer is that online rental is all we do.

We have been doing it for over five years, and we do it better than anyone on the plant.

Because of our large subscriber base, we can invest more in service improvements than any competitor.

We have more overnight delivery and higher inventory availability than any competitor.

We have the most useful recommendation system anywhere, which uses the over 500 million movie ratings we have collected to help consumers sort through the 30,000 films we carried to find the 30 best for them.

We launched in Q4 our social networking Friends network, which allows consumers to share movie ratings and recommendations with their friends who are also Netflix subscribers.

We launched Profiles, which allows subscribers to set up accounts for spouses and children where each account gets its own queue and recommendation.

Finally, we expanded our family section, making it easier to find great movies for children of any age.

In summary, our service is superior, and it shows in our subscriber numbers and in our high customer satisfaction level where 95 percent of our members say they would recommend Netflix to a friend.

We believe it is likely but not certain that our satisfaction superiority will enable us to maintain our $18 price point and to reach our 4 million-subscriber goal for 2005.

One month after the latest Blockbuster price cut we remain on track for achieving our 4 million-subscriber goal.

One positive of Blockbuster's substantial investment has been market growth.

The other positive is that the incremental threat from an Amazon launch is less than it used to be.

Both Blockbuster and Amazon have about 20 million active customers, 6 billion in revenue and a strong brand.

While Amazon may be more formidable from a technology standpoint, Blockbuster is more motivated because they are defending a core franchise.

Given that Blockbuster's entry has grown the market substantially, you can expect that once Amazon enters the market will grow even faster.

Of course, the price cuts that Netflix and Blockbuster initiated last quarter may cause Amazon to reassess the financial returns from a major investment in our market, and perhaps their entry will be more cautious than it would have otherwise been.

We will find out when they launch domestically and we see if they open the dozens of Metropolitan warehouses that is now the minimum cost of serious entry.

A note of caution on competition.

This is a big market and a big prize.

It is hard to predict what Blockbuster and Amazon will do.

If they increase their promotional efforts substantially or cut prices even further, we will respond as necessary to maintain our leadership.

Should the competitors over invest or under price sufficiently to begin to compromise of our leadership, we would respond with lower prices, increased marketing or other measures to maintain our leadership.

This would delay our return to profitability.

No one should doubt our resolve to maintain our leadership in the market we invented or our financial ability to defend that market.

We believe we have the highest gross margin and the lowest operating costs of any competitor in our business because of the size and nature of our subscriber base, the strength of our brand, and our experience operating this business.

We do not intend to lose our leadership position.

It is too valuable to the future of DVD rentals in the near-term and to the Internet delivery of movies in the long-term.

In fact, one of the main reasons the online DVD rental space has become so competitive is that the major players also see it as the gateway to success in Internet delivery of movies.

Our long-term strategy is and always has been to exploit our service superiority, market leadership, and the long life of DVD; to gain size 10 or 20 million DVD subscribers and offer those subscribers the choice of DVD by mail delivery or Internet delivery on a movie-by-movie basis.

To that end, in addition to ending 2005 with 4 million subscribers, we plan to launch Internet delivery as a movie delivery option in 2005.

We expect this option to be of only modest consumer interest initially, primarily due to the DVD exclusive window on content, which will limit content availability.

Internet delivery, however, will grow in importance every year through this decade.

We will have more to say about this initiative, as this service is ready for consumer launch.

Our goals for 2005 are to reach 4 million subscribers and to return to sustained profitability.

While we are planning to lose money in Q1 of 2005 due to seasonally higher marketing spend, our plan is to make money in the last three quarters of the year.

Significant profitability comes in future years both as we grow gross profit faster than our fixed cost and as we reduce marketing from its historic 17 to 20 percent of revenue to 2 to 4 percent of revenue like Amazon, Blockbuster and Wal-Mart today.

For shareholders, 2004 was a brutal year due to the new competition from Blockbuster, the impending competition from Amazon, and the consequent price cuts.

We believe 2005 will be the year where the world sees that Netflix can and will maintain its leadership in the market it created and that Netflix will return to sustained profitability in 2005 and beyond.

Now I will turn it over to Barry before we take questions.

Welcome, everyone, and thank you, Reed. 2004 has been a significant and eventful year for us in many ways.

It was our first year of aggressive direct competition in the marketplace Netflix invented.

From both a performance and strategic perspective, 2004 was a great year for net flex.

Our performance as measured by our financial results and key metrics was extraordinary as we managed through a series of surprises involving usage, stack, pricing and competition.

We also believe that the results in 2004 have clarified the potential size of the market and the strength of our business model.

In my remarks today I will share my perspective on the competitive landscape.

Next, I will review our key performance metrics, and then I will discuss guidance and explain in more detail why we are confident about our future.

So let's begin with the competitive discussion with Blockbuster's entry in the online rental space in August.

It has been a serious effort and one we clearly underestimated, a mistake we do not intend to repeat.

We estimate that Blockbuster has invested about $100 million in the last six months.

They have invested in 23 distribution centers and competed aggressively on price.

They took price cuts -- one in October, followed by a steeper cut in late December when they priced their service at a loss leading $15 a month.

At the $15 price point based on our modeling, we expect their online business to lose money on every subscriber indefinitely unless they slash their marketing spending, which will slow their growth.

If we have to match Blockbuster's pricing to sustain our growth objectives, it is if we end up in a war of attrition, our operating losses will increase as well.

But I believe we are better positioned to survive the battle than Blockbuster.

Why?

Because we believe that the more aggressively they compete with us for market share and the lower they price their service, the faster they drain their stores of customers and the more money they lose online.

They have more debt than we do -- $1 billion more, thanks to the Viacom spinout -- and that debt has interests and principal payments and loan covenants to meet in 2005.

And they have large fixed expenses associating with operating their rental stores, which has steadily declining same-store sales and profit margins.

And that I think is Blockbuster's Achilles heel.

In other words, we believe declining sales same-store sales revenue; declining gross margins without late fees and increasing losses online will strain Blockbuster's ability to comply with its bank loan covenants.

If we are right, then aggressive price competition and margin erosion will end sometime this year.

2004 also saw continued competition from Wal-Mart and a weak entry by Amazon into the online rental business in the UK.

We continue to expect Amazon to roll out their U.S. version this year.

The aggressive entry of Blockbuster and the likely entry of Amazon has created a challenging competitive environment.

But we believe there is much less uncertainty than the market is reflecting in our stock price.

In fact, the events and results of 2004 have in our view significantly reduced uncertainty about the size of the online rental market and the value of our competitive advantages.

First, 2004 has clearly demonstrated the strength and potential of the online rental market.

It is large, growing, price elastic with room for a number of competitors.

We are and intend to remain the clear leader.

But there is room in this market for competitors to build successful businesses.

It is tempting sometimes to think that competition is a zero sum gain, but the market expansion in 2004 means there is room for more than one competitor.

Clearly pricing is an important element in maintaining our subscriber leadership, but it is not the only factor.

Innovation made Netflix the leader in this market and continued innovation with features like Friends and Profiles enabled us to deliver greater value to our subscribers.

Innovative features, together with great service and operational efficiencies, will sustain our market leadership.

Second, 2004 also demonstrated the strength of the Netflix business model, particularly in direct comparison with Blockbuster.

Blockbuster does not release performance metrics for its online business, but as you might imagine, we have analyzed their business closely, and based on our estimates, which while reasonable may be incorrect and assuming they hit their year-end subscriber goal of 500,000 subs from a starting point of 200,000 subscribers, those metrics would show how extraordinarily well our business performed in the fourth quarter.

Our U.S.

SAC of $36 compares to their estimated SAC of more than $50.

Our churn of 4.4 percent compares to their estimated churn of more than 13 percent.

Our gross margin of 45.5 percent compares to their estimated gross margin of less than 30 percent.

And our U.S. operating profit in Q3 and Q4 combined of $27 million compares to an estimated operating loss for Blockbuster's U.S. online business of more than $50 million as their $15 price point drains customers from the stores and cash from their bank account.

Investors who don't find my arguments on competition and market growth persuasive might think that the competition has been eating our lunch.

But that conclusion would be wrong.

Despite Blockbuster's frontal assault, our business performed extraordinarily well whether you look at quarterly or annual measures and whether you look at revenues, net income, SAC, churn or gross margin.

In January 2004 the high-end of full year guidance for revenue and GAAP net income was $475 million and $22 million respectively.

We finished the year with revenues of $506 million and GAAP net income of $21 million.

A very strong performance.

In our analysis, the presence of competition is helping to fuel awareness for online movie rental, and that is helping our business grow.

Let's look in more detail at some of the fourth quarter's key metrics.

We finished the year with 2.61 million subscribers, 76 percent growth from last year and 17 percent growth from Q3.

Despite competition, we grew faster on a quarterly and annual basis than we did one year ago without competition.

Fourth-quarter SAC for the U.S. business was $35.61, about $1.35 less than it was in the third quarter.

Rapid subscriber growth, increased brand awareness and the overall effectiveness of the channel mix contributed to our marketing effectiveness in the quarter.

Gross margin was 45.5 percent in the fourth quarter.

We outperformed our expectations primarily because of lower-than-expected usage.

This is the second consecutive quarter of lighter than expected usage, and it is a trend that has continued in the current quarter.

If this usage trend continues, it will represent a shift in a pattern of usage increases we encountered in the first quarters of 2003 and 2004.

Frankly, we are not entirely sure why usage is not following its historical pattern.

But our experience has taught us some things about usage patterns, and that experience suggests good news for gross margins in 2005.

On previous calls you have heard me tell you that on average disk usage starts at a high level and then declines during the first 12 months of a subscriber's life before flattening in month 12 and beyond.

Today about 35 percent of our subscribers or over 900,000 subscribers have been with us for a year or longer.

By way of comparison, that is nearly twice as many subscribers as Blockbuster hopes to end 2004 with.

At the same that usage declined, churn reached an all-time low in the fourth quarter of 4.4 percent, down from 5.6 percent in the prior quarter and 4.8 percent one year ago.

We saw significant improvements in churn across all classes of paying subs during the fourth quarter after we dropped our pricing to $18 from $22 on November 1st.

That drop was followed by a small increase in cancellation rates to year ago levels when Blockbuster dropped its price to $15.

Taken together, the usage and churn trends have significant cost implications for Netflix versus its competition.

They mean that Netflix should sustain lower usage and higher gross margins than our competition even at comparable price points as long as we sustain our subscriber lead, which is why maintaining subscriber leadership is fundamental to our business strategy.

Summarized, on the one hand you have outstanding business performance and on the other hand the low stock price.

Why the disconnect?

I believe the primary reason today is uncertainty about the competitive environment.

Well, what then does 2004 mean for competition in 2005?

While we cannot say for sure what the competitive environment will look at, our experience in 2004 gives us increased confidence that we will be the long-term winner in this space and strengthens our resolve to take the near-term actions that may become necessary to preserve our clear leadership.

Before I review our guidance for the first quarter and full year of 2005, it is important to note that our guidance is based on a number of assumptions.

One is that we are able to sustain our sub growth at current pricing levels.

We are also assuming that the usage levels we are seeing so far in the quarter sustain themselves through the remainder of the year with normal seasonal fluctuations quarter to quarter.

As Reed mentioned in his remarks, our primary focus in 2005 will be to sustain our subscriber growth.

If our assumptions about pricing and usage are wrong, which would be a change from our experience last quarter and this quarter, and competition slows our net sub growth, you can expect us to reevaluate our pricing and marketing spending or both to sustain our growth, and you can expect us to revise our guidance.

Our guidance also assumes that the market for online subscription rental grows to 5.5 to 6 million subscribers by year-end off a base of about 3.3 million in 2004, and that we account for 4 million of those subs or roughly 70 percent of the market by year-end 2005.

With the strong growth, Blockbuster could reach 1.5 million subs, while Wal-Mart and Amazon split the balance of the remaining subs.

Under this scenario, online growth could be 74 percent as compared to an estimated 12 percent decline in store-based video rental revenues last year, according to Adams Media Research.

Now with regards to 2005 guidance, last quarter we said we would manage the business to break even on a GAAP basis in 2005.

The midpoint of today's guidance projects a loss of 10 million for the full year.

What has changed primarily is our forecast for stock-based compensation, which increased by $6 million when we updated the volatility assumption in our Black-Scholes model.

And secondly, our forecast for marketing expense has grown because we expect to acquire more subscribers.

In Q1 we expect a net loss for GAAP purposes of $16 to $19 million as the full effect of our price dropped to $18, which went into effect mid-Q4 coupled with rapid subscriber growth (technical difficulty) better operating margins.

In past years subscribers have grown in a seasonal pattern that we expect to repeat itself in 2005.

The pattern is rapid sub growth in Q1, followed by two quarters of relatively slow growth in Q2 and Q3, followed by fast growth again in Q4.

As I have described on previous calls, because we expensed 100 percent of the cost of acquiring new subscribers at acquisition, marketing expense grows as a percent of revenue in periods when rapid -- excuse me, in periods of rapid growth and falls in periods of slower growth.

You see the impact of sub growth on GAAP profitability in each of the last two years when we posted losses in Q1, followed by three consecutive quarters of profitability.

We are expecting a repeat of this seasonal pattern of subscriber growth and profit and loss again this year, which means we expect to be GAAP profitable in the second, third and fourth quarter of 2005.

In summary we performed well in 2004 in the face of significant competition and beat our guidance for the full year.

Second, our market is large and growing, and we expect that growth to continue in 2005 at more than 70 percent.

And third, we will finish the year with 4 million subscribers and a return to profitability.

That concludes my prepared remarks, and now we will open the phones to questions.

(OPERATOR INSTRUCTIONS).

Gordon Hodge.

Thomas Weisel Partners.

Good afternoon.

I was just curious, Reed, I think when you started out you mentioned you are pretty confident that the VOD window will stay intact.

I don't know if that is more of a looking at the market and looking at the size of the DVD market and more of an intuitive sense, or is that actually based on some recent conversations with the studios?

I know that there is some question about MGM whether they might give Comcast some favorable VOD window treatment.

So I'm curious about that.

And then I am also curious on the pace of gross sub adds going into Q1, it sounds like even with Blockbuster at 14.99, it sounds like you guys are seeing very strong demand.

Is it similar to the strong demand you saw in gross subscriber additions before?

In terms of the DVD exclusive window, that is based both on economic analysis of the profitability that DVD sales primarily generate for the studios which is very substantial, which makes it very rationale for them to have a DVD exclusive window.

So this is not the case of some set of content owners being irrational about future technology development.

This is the case of the studios being rational about maximizing profits, which is to focus on DVD sales.

The joke that I hear most often from studio executives is that they found VOD, they love VOD, and VOD is a shelf full of DVDs and you can grab one at home anytime you want and watch it whenever you want.

In other words, that the real economic nirvana is DVD.

In regards to the purchase of MGM and Comcast involved in that, MGM has virtually no new releases.

They have a very large catalog.

And the DVD exclusive window, as I said in my remarks, applies to new films.

We will certainly see VOD with catalog films as we have in the past, and we will see more of that with MGM, which does have a great catalog.

The second question you asked is on the pace of gross adds, and yes, we set our subscriber guidance with the knowledge that the first 24 days of the quarter, and that is exactly where we expect to get to.

Lanny Baker.

Solomon Smith Barney.

I had a couple of questions.

Could you quantify any losses from the United Kingdom shutdown or any kind of disengagement or anything like that that might have been in the fourth quarter?

About $3 million, I think.

And was that 3 million operating or 3 million kind of disengagement?

Both.

Okay.

And then can you talk about the usage?

You said you don't really have any answer for it that you're confident of.

I thought if I remember correctly a quarter ago there was some speculation that maybe the Olympics or the election or something like that might have lowered usage.

Maybe another way to think about it is turn back to when usage was high and rising.

Was there anything going on differently then in terms of composition of sub growth?

Can you just add any more color on what you think the longer-term -- not only what you're seeing right now -- but if you were think out -- let's say this is 20 million households a few years from now, how many movies do you think people are taking?

Let me talk about -- let me give you some color on what we are seeing in terms of changes.

You made reference to the Olympics.

On the Q3 call, we said we had seen a softening of usage and we attributed that to the Olympics, and the softening occurred roughly coincides with the broadcast.

We were expecting year-over-year to see a decline Q3 to Q4 if historical patterns followed themselves, and we saw roughly exactly for the fraction of a disk, the same decline Q3 to Q4 in 2004 that we had seen in 2003.

So in retrospect that suggests to me that the decline we saw in usage in 2003 is something to do not just for the Olympics but a change in behavior on the part of subscribers, which continued into Q4 and 24/23 months to date, is continuing.

Now it is too soon to say for the first quarter what accounts for that decrease.

In Q4 we saw it roughly across all subscribers.

So a shift in behavior similar to the shift in behavior we saw one year ago in the first quarter.

We know it was not due to demographics.

It was not due to age of the subscriber base.

It was not due to any particular class of subscribers using more disks.

It seemed to be normally distributed across the base.

Is that helpful?

Yes, it is.

Lanny, this is Reed.

You asked the other part of the question, which is when do we expect the 20 million subscribers?

And the way to think about that is if they were big increases in past years probably associated with a rollout of next day delivery and now we are seeing some flattening, we may be at a saturation of what average consumers, the amount of time they are going to spend on movies, where the rate of increases slows, and by a year from now we can more accurately predict what does it look like at 20 million subscribers?

So we would probably want at least one more year to confirm that the year-over-year increases are continuing to decline as we approach a sort of social maximum of the amount of time that people are going to spend on movies.

Let me just pose one other quick question, and that is, can you quantify the amount of money that you're going to be investing in the online area?

Is the content cost dynamic there -- can you compare it to what the content cost dynamic looks today when you're either buying or revenue splitting the disks?

How do you think it will look when you have to file another disk?

What we have said before on standby is that we will spending 1 to 2 percent of revenue on our downloading initiatives.

And so for this year you know that is $7 to $14 million implied net income.

And then in terms of the content cost, you cannot really get a handle on what it is going to be at scale yet.

In other words, the deal terms that we will end up signing to get the initial content would likely be higher than the ones we have had after five years of being in the DVD business, and then follow the same curve that we have seen on DVD costs, which is after we have gotten bigger and more sophisticated we have gotten better deals.

So we imagined that we will see that.

Because there will be so low content because of the DVD exclusive window for download, I don't think it is going to affect the P&L substantially for a few years again because we will be mostly a DVD business as much as we want the Internet front to grow.

Heath Terry.

Credit Suisse First Boston.

Is there anything that you can tell us a little bit more on the timing schedule for your investments online, and also to the extent that there is anything else to say as far as your relationship with TiVo goes, and how that relationship and others that you might form with consumer device manufacturers or marketers might play out over the course of '05 and how important those are to you?

This is Reed here.

The spending is spread out through the year, so it is development spending.

So it is ongoing now and has been ongoing you know for at least a year.

In terms of the TiVo and other deals, our strategy is to announce those when they are ready for consumers as opposed to preannounce them.

So we will be talking about them again when they are ready for consumer launch.

Okay and then with Friends offering that you have got, can you give us an idea, realizing that it is pretty early on, what adoption has been like there?

Sure.

It has really been stunning.

It is a very viral thing.

For those of you on the call that have not used it, it allows friends to share recommendations and ratings.

You get invited by other friends, you except those invitations.

We launched it broadly two or three weeks ago, and it has just gone from 5000 friends in the system -- that is subscribers that have friends -- to 10,000 to 20,000 to 50,000 to over 100,000 the last time I checked a couple of days ago.

So it is doing very nicely, and we're very excited about it.

It is still in its first generation, but I think it has tremendous potential to redefine and expand the online movie proposition to be one that is not only about selecting movies, but also one that is heavily engaged with the social nature of movies, people talking about movies, watching what your friends, parents and siblings are watching, you know really evolving the nature of the Netflix experience in a very positive way.

Derek Brown.

Pacific Growth Equities.

Two questions actually.

The first is, can you maybe just walk us through your thought process in terms of your willingness to trade sub growth for profitability as the year progresses, kind of sort of the switch that you might pull, what would trigger you pulling that switch to move more toward subscriber growth mode versus profitability mode?

Then the other thing is, I'm trying to get Q1 net income to jive with some of your guidance, and I'm wondering if the wild-card really is on the stock-based compensation.

If so, can you give us some parameters around what that number might be for the quarter?

I will jump in and do the second part, and Reed will do the first.

We are expecting about $ 4 or $5 million, 4.9 million of the stock comp in Q1.

In terms of the trade-off that would get us to change price, our goals are for this year returning to profitability and getting to 4 million subscribers.

If we were to fall materially off of the path to 4 million subscribers, that is what would get us to contemplate either changing price or to increase marketing spend or otherwise to delay our return to profitability.

So as long as we are on track for 4 million as we are in the first 24 days of the quarter, we will maintain that price.

Does that answer it for you?

Yes, it does.

Thank you.

Safa Rashtchy.

Piper Jaffray.

Good afternoon.

A couple of questions.

First, could you try to give us a sense of contribution of each of the two factors in the market growth that you experienced or your sub growth I should say?

The price decrease obviously was very effective as you had noted the churn rate came down.

But you also mentioned that you believe Blockbuster's entry and the promotion increased the market significantly enough it has helped you as well.

Is there a way for you to try to at least broadly quantify how much of the growth you think came from price increase and decrease rather and how much from Blockbuster activity?

And then I have a follow-up.

That is a pretty abstract question I'm afraid, because the only way to answer it is to try to think through how big would we have grown if Blockbuster had not entered or how big would we have grown without a price increase you know and we can take some guesses.

But I would say, probably, you know more of the effect is on the price decrease than on Blockbuster, but again not having run the experiment, that is just intuition.

I have no particular data to be able to split those two effects apart.

Okay.

Then sticking with your price decrease issue, you obviously had seen major positive impact from it.

I'm most surprised that you seem to suggest you would not be necessarily contemplating further price decreases unless you had to for competitive reasons.

If price decrease is so effective and decreasing churn rates, increasing subs and, in fact, maybe lowering your SAC as well, why stop it here, and why do you feel confident that this is pretty much a good optimal level for you?

Well, as you would I'm sure agree, the long-term gain is about generating profit.

So you say the price increase has done us well and it has in terms of subscribers, but I think you would agree the price decrease that we have done so far has in the short-term not increased profits.

So we balance prices against profitability, and that is why we are focused and believe that we can get to 4 million subscribers at $18.

And in the 32 days that we have competed against the new Blockbuster price, that has backed up -- that data has backed up our intuition, and it is partially because the service is so strong, it is partially because our word-of-mouth is very good, so we have 2.6 million people telling their friends about the service, and partially because it is a very large market, and there appears to be room for several players because as far as I can tell Blockbuster is succeeding at their goals in terms of getting the 500,000 subscribers and we are succeeding at ours.

Anthony Diclemente.

Lehman Brothers.

My question is surrounding free cash flow.

I was wondering if you have a free cash flow expectation for 2005?

And then also, just more generally, as you look at your model, I was wondering if you could elaborate on timing of when you start to see that inflection point and where you start to see that critical mass of subscribers begin to flip the inflection point and we start to see some gratification on the free cash flow line?

And maybe within that, you can talk a little bit about the spending that you are anticipating, whether it is the buildout of the DVD inventory which comes from the investment line or investments in further service improvement?

We don't give guidance on free cash flow, and so I don't have a comment about '05.

In terms of reaching the inflection point in the business, I think the second question was -- the second part of the question was, when do we reach the inflection point in the business model such that free cash flow begins to accelerate?

Yes.

When growth slows.

Right.

As long as we are growing at 76 percent year-over-year, it is remarkable that we generate free cash flow at all.

And the other extreme is, if growth slows to 20 percent or 30 percent a year, we will be throwing off a ton of cash.

Okay.

Just one follow-up.

I was wondering if you could comment on high-definition DVD in the '05, '06 timeframe and how you think that impacts your business?

High-definition DVD, there is a format were -- that looks like it's going to happen between two camps.

They will both launch first version players in Q4 is the current market assessment.

I imagine both of those players will be fairly expensive, and then not many consumers will get them because they will be afraid that they got the wrong format.

Our view is that eventually the CE companies will figure out the difficult challenges to make one player that plays both formats, and that consumers will race to that manufacturer because then their future-proofed about whichever format eventually wins.

This is something that we saw in DVD writable that we have seen with SACD, and I think it is going to be into the electronics companies' court to figure it out.

And it is quite a challenge because they are different physical formats.

I don't know how long that will take.

In the meantime, what is happening is with the progressive scan DVD players, we have seen them become pretty standard in the market.

The pictures from Ford/ADP (ph) on standard-defi DVDs look great, and that is really the core of the market.

Jim Friedland.

SG Cowen.

Thanks.

Two questions.

The first is on DVD expenditures.

It looks like you guys have been growing extremely fast, and yet the expenditures on DVD has dropped pretty significantly in the quarter.

I'm wondering in terms of -- are you limiting usage?

What are your plans going into next year?

What should we be looking for?

And the second question is on the growth in Q4.

What percent of gross adds were from I guess what I would call win-backs, people who were previous customers who were paying $20 or $22 who you e-mailed or marketed to to say, hey, we are cheaper now.

Do you have any kind of way of gauging that?

Barry, let me address that DVD purchase question, and then you can address the rejoin question.

We acquired this from studios who are hot and supplement those purchases with that catalog.

In any given quarter, the mix between purchased DVDs and registered DVDs is in part a function of which of those studios' content is in demand because they have new releases in the home video marketplace.

In this quarter in particular in Q4, we saw a significant shift away from partners we purchased from towards partners we revshare from.

We actually had a very aggressive program acquiring content.

A heavy proportion of it was in revshare.

Okay and just quickly on that, Barry.

It seems as if you are about 20 percent of DVD purchases over revs this year and last year.

Is that sort of where you expect ballpark to be going forward?

We historically we've operated in a range of about 18 to 24 percent of rev.

It is a 24 range.

We're really maxed out.

That is when we were hammering purchases last year, doing some catch-up and trying to optimize the subscriber experience.

The recent quarter was down at 16 percent, and it will fluctuate within that range, again depending on who is hot and who is not.

Okay.

Thanks.

And the question about net additions.

It was fairly small.

I don't remember the exact number, but we did an e-mail campaign and we got a small bump in November.

But it is not material.

It is -- Barry is throwing me the sign that says it is about 18 percent, so, of new starts in Q4.

That percentage is not going up, and that has some -- encouraging when you think about how many subscribers we and our competition have to hit in order to grow the marketplace.

To date we have touched we estimate about 5.7 million unique users ever.

So roughly a 2-to-1 relationship with the number of subscribers.

And, Jim, you referred to limits on usage and you have written about it a little bit.

There are no limits on usage.

What we have said we do is, if we run out of inventory on a particular title that is a new hot release, we will give preference to a customer who has rented fewer movies from us.

So someone who is renting a lot of money gets a great deal in terms of the volume.

They may not get the new releases as quickly as a lighter user, and that is something that has been an operating procedure for three, four, five years.

Very long time.

Youssef Squali.

Jefferies & Co.

First, Barry, can you quantify usage for us or either percentage decline quarter-over-quarter or year-on-year?

No.

Okay.

Let me not be so glib.

We have been very detailed in our disclosures around usage in the past both in terms of absolute levels and the incremental changes, and I think for competitive reasons we're going to be less forthcoming about that.

You seem to be saying that there is acceleration and a decline in the rate of decline, is that correct?

I would not put it in those terms, but as compared with the prior year's increase, there is a significant departure from the pattern of increase that we have seen in the past.

It is not a decrease on an absolute basis.

It is a decrease in the growth rate of usage.

I see.

Okay, that is helpful.

Second, you seem to be signaling that a cut -- (inaudible) competitive landscape a cut in -- a price cut could be in the cards for 2005.

I'm trying to understand, what assuming Blockbuster stays at $15, what could prompt you to instigate a price decline?

Is it the entry of Amazon at a lower price?

Is it slowing subscriber growth?

Can you just elaborate on that a little bit?

So ultimately it is about us maintaining our growth path to 4 million subscribers.

Things that could at least potentially slow that down was if Blockbuster did a $200 million advertising campaign.

If Amazon came in at $12 for unlimited rentals.

If Blockbuster further cuts their price to $12.

None of these things we think make economic sense.

None of them do we think are likely, but we want to acknowledge that there are scenarios.

Because this is a big market, these are very motivated competitors, and it is a big prize that would cause us to protect our market share with a further price cut.

At this point, you know again 34 days after the last Blockbuster price cut, we don't see the need to do it.

But those are the kinds of scenarios that could change our mind.

Okay and lastly, on the gross margin being better than expected, how much of that was potentially due to the mix shift between revshare DVDs and owned DVDs as well?

Not at all.

Okay.

Thanks a lot.

Daniel Ernst.

Hudson Square Research.

Good afternoon.

Thanks for taking the call.

A couple of questions if I might.

The first, just an update and some specifics.

Last year at the Analyst Day you said that churn for subscribers has been with you for 12 months or more with under 4 percent.

I was wondering if you could give us an update on that?

Is it still around that number?

Has it gone down?

Has it gone up?

And then secondly, maybe an update on your long tail now that you have grown.

You are at 2.6, almost 3 million subscribers coming up soon.

You have launched a new initiative with the Friends and Profiles.

Are you still seeing the same kind of long tail you had before that roughly two-thirds of your rentals are coming from the back catalog?

Thanks.

Yes, the churn rate of long-term customers has continued to decline.

It is sub 3 percent now, and the characteristics of catalog and new release has stayed stable despite the very large growth in mainstream (inaudible) base.

And they are not so much reflections of the demographics we believe, they are reflections of the technology on their website, which finds the relevant films for each person in the 30,000 title catalog.

And if the technology, when the technology is successful at that, it creates a great consumer experience that is around -- at least substantially around catalog movies.

And that creates good economics and creates value for the consumer.

Just a follow-up on the long tail discussion.

Your are finding the same kind of ratio in San Francisco in affluent markets with high penetration as you are in newer maybe more suburban/exurban markets?

Correct.

We have not seen any material difference is in behavior between those markets.

Richard Ingrassia.

Roth Capital Partners.

Did I hear this right that you are controlling delivery time to your highest volume renters?

No.

What I said in response to a part of the question Jim asked is that there were no limits on usage, so the no being the relative word in your question.

But I said that high-volume users are light users' preference when we do run short.

Okay.

Fine.

I would like to understand a little bit about your customer data and if you have any kind of hard research from your subscribers.

I'm most interested in if they are telling you why they subscribe to start, and maybe why they cancel, and how much it is related to the new services that you obviously provide that are better than your competition, or how much it really is related to price?

You know, we do do a lot of research on it by asking questions when people sign up on a sample basis, asking them when they cancel, why.

But all of this is in any -- all the marketing literature well-documented to be fairly inaccurate and not precise.

It is indicators on what are possibilities.

For example, if we detect a sensitivity on customer support, it does not really mean that customer support is bad.

It means they checked that box.

And the only way to check that is then to take a sample of customers, say 10,000 customers, and give them superpriority for customer support, you know just the world's best Nordstrom level customer support, and then find out what happens to that subset of customers.

Do they actually retain better?

Do they tell more friends, etc.?

So we look at that, what you referred to as hard data, more as soft data because it is soft, and we use that along with our own intuition about what to test.

And then we only incorporate things that actually test out as superior experience and superior economics.

That was our final question for today's question-and-answer session.

At this time, I will turn the call back over to Mr. Reed Hastings for any closing remarks.

Thank you, ladies and gentlemen, for participating in the call, and we look forward to talking to you again in the quarter.

And that does conclude today's conference.

We thank you for your participation, and you may now disconnect your lines.