Netflix Inc (NFLX) 2005 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen.

Thank you for your patience in holding and welcome to today's Netflix first quarter results conference call.

Today's call is being recorded.

At this time for opening remarks and introductions, I'd like to turn the conference over to Miss Deborah Crawford, Director of Investor Relations.

Please go ahead, Miss Crawford.

Thank you, and good afternoon.

Welcome to Netflix's first quarter 2005 earnings call.

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

We released earnings for the first quarter at approximately 1:10 p.m.

Pacific Time.

The earning release, which includes a reconciliation of all non-GAAP financial measures to GAAP, and this conference call are available at the Company's investor relations website at www.netflix.com.

A rebroadcast of this call will be available at the Netflix website after 5:30 p.m.

Pacific Time today.

We will make forward-looking statements during this call regarding the Company's future performance.

Actual results may differ materially from these statements due to risks and uncertainties related to the business.

A detailed discussion of such risks and uncertainties is contained in our filing with the Securities and Exchange Commission, including our annual report on Form 10-K filed with the Commission on March 15th, 2005.

And now, over to Reed.

Thank you, Deborah, and thanks to all of you for joining us on this call.

We reported strong Q1 results and delivered meaningfully on the strategy we shared with you in January.

We ended the quarter with over 3 million subscribers, well on the way to our 4 million subscribers we are targeting for 2005, and maintained solid leadership position and ended the quarter with a substantially smaller loss than we had earlier guided to.

We're proud of our performance.

This -- the most impressive fact in the quarter, however, was how fast the whole market for online rental expanded.

Between Blockbuster and Netflix, over 3.75 million domestic households have switched to online rental.

That is up 94% from the 1.93 million households one year ago.

A year from now, Blockbuster expects to have 2 million subscribers, and we expect to be well over 4 million subscribers, leading to yet another year of stunning market growth for online rental.

Propelling this market growth are the inherent advantages of online rental, selection, convenience, and most important of all, value.

On selection, we now have over 40,000 titles, including an amazing variety of television content.

Whether your tastes are X games, the BBC, or Bollywood online rental is by far the best entertainment channel.

In terms of convenience, our free home delivery and our no due date subscription model make renting online much easier than dealing with video stores.

Finally, great value is the big driver of internet commerce generally.

Renting online is much lower cost than renting from stores because of the real estate savings and advantages of inventory pooling.

Whether it is our 9.99 for one-out unlimited program or 17.99 for our three-out plan, the value of online rental is compelling.

How large online rental eventually becomes is hard to say.

Our view is over 20 million domestic subscribers given the growth rates we see today.

Blockbuster recently estimated that 25% of the rental market would be online, which would be 2 billion in revenue or 10 plus million subscribers.

Adams Media Research estimates that by 2010, there will be over 15 million online rental subscribers.

Of course, if online rental gets big enough that it breaks the economic model of store-based rental then by travel we could see even higher penetration.

One of the key factors underlying our analysis of the market size are the studios’ views on video on demand.

At a recent NCTA cable conference, various studio heads, including those with substantial cable interests, all weighed in on the priority of DVD over VOD.

Bob Wright, head of NBC Universal said, quote, maybe five years from now VOD will develop into something, unquote.

Bob Iger, new head of Disney, quipped that Disney makes more money from DVD alone than all of Comcast.

The big entertainment story for the next five years will not be VOD, but instead high definition DVD.

The billions of potential profits to be generated over the next decade on high definition DVD are the big prize the studios are focused on.

Because of the DVD economic importance to studios, on line DVD rental will be a growth market for at least the next five years, and perhaps much longer.

While the online rental may be large, fast growing, and long lasting, Netflix shareholders need to know how profitable the market will be and what share will Netflix have.

In terms of profitability over the coming years, the key issue is the number of major competitors.

If there are only two major players, Blockbuster and Netflix, the profitability may be substantial like other two-firm entertainment markets.

If on the other hand Amazon, Wal-mart, Blockbuster and Netflix are all major competitors in online rental, then the profits would likely be small.

Blockbuster's entry is the first hard data the market has on the cost of becoming a major player in online rental, and I would think it is a discouraging example to potential entrance.

If Blockbuster meets their goals of 2 million subscribers and profitability one year from now, their total investment to reach breakeven will have been approximately $400 million.

And this is from Blockbuster, a company that has a great movie rental brand, deep rental operational experience, 20 million active store rental customers to market to, and is the second major entrant.

If there is a third major entrant, it will likely cost that new player even more than 400 million to reach breakeven.

So while the barriers to become a major player are not insurmountable, they are quite large and growing, which indicates that the likely case is online rental becomes a two-firm market over the coming years.

In terms of the other firm, Blockbuster is a formidable competitor.

They have deep conviction that online rental will be large and important.

They have been spending heavily.

Their pricing is aggressive, their in-store coupons creative, and their Super Bowl and March Madness advertising plentiful.

The headwind of their competitive efforts have driven up our SAC and our churn up modestly and made us work harder for every new subscriber, but we were tremendously pleased with our ability to achieve 3 million subscribers despite this competitive headwind.

In fact, despite Blockbuster aggressive pricing, in-store promotion and TV advertising, Netflix generated a record number of gross subscriber additions.

The last five years of hard work building a superior service has been paying off handsomely.

Current Netflix subscribers are great evangelists for our service.

In addition to a superior service, one contributor to our success in Q1 was our evolution from marketing a single price point to a family of price points.

Our testing of multiple programs at sign up started in Q4, and throughout Q1 we tuned these marketing efforts.

Importantly, our 9.99 one-out unlimited program has nearly identical churn and monthly contribution profit as our standard 17.99 program.

So from an earnings standpoint, we are agnostic as to which programs subscribers prefer.

You can see the effect of this lower revenue same profit approach by looking at the change for our year-end guidance, where we took down revenue but left subscribers and earnings intact.

As you might expect, our 17.99 three-out program has remained our most popular for new subscribers, even though our 9.99 and 11.99 programs are more frequently advertised.

Multiple price points are a natural evolution of our marketing efforts as we continue to mainstream our service.

To close, we believe online rental will be a very large and profitable market.

Over the last six months, we have consistently told you that we are making aggressive smart choices now to ensure substantial sustained profits in the future.

In particular, being the dominant firm in a large profitable two-firm market is a prize worth fighting for.

Our strategy for maintaining leadership in the years ahead is the same strategy that has won us market leadership to date.

We are focused exclusively on online rental, and we do it better than anyone on the planet.

Our selection is better than our competition.

Our overnight delivery more consistent, our website easier to use, and our customers are more satisfied.

I'll now turn the call over to Barry.

Thank you, Reed, for those remarks.

For the next ten minutes or so, I'd like to offer my perspective on the Q1 performance.

Then I'll share my thoughts on guidance for the rest of the year.

And then we'll open the phones for Q&A.

A month from now, after earnings season is over when you look back at first quarter results, I think one thing will be clear.

We had an amazing quarter.

Competition was fierce.

Blockbuster offered lower pricing, extended free trial offers to canceling subscribers, had expensive TV advertising on the Super Bowl and during March Madness; and despite Blockbuster's increased spending, we had great results, reaching the high end of our subscriber guidance and posting a 50% smaller net loss than our guidance for the quarter.

As many of you know, in August 2004 Blockbuster launched their online service, and in the three quarters that followed, our subscriber growth and financial performance reached the high end of our guidance.

Why?

Because we offer a better service.

Consumers have connected with our brand, and that connection is making the word Netflix a verb in today's pop culture.

So let's look at the Q1 numbers that made this a great quarter.

We finished Q1 with 3 million 18 thousand subscribers, a fast 56% growth from last year and 16% growth from Q4.

Despite competition, we had 945,000 gross sub ads in Q1, and that's a new record.

The previous record was set last quarter.

So that's back-to-back record quarters and staying power in the face of competition.

During the quarter, we began offering subscribers a choice of plans at sign up.

The majority of subscribers have chosen the 17.99 three-out unlimited usage program.

And we expect the 17.99 program to remain our most popular plan.

The new plan choices are a natural evolution of our marketing strategy as the marketplace extends beyond early adopters and into mainstream America.

We expect these new plans to increase our profit margins.

And I'll have more to say about that and their effect on ASP when I discuss our guidance.

First quarter SAC was $37.89, better than most analysts expected.

Rapid subscriber growth, strong brand awareness, and broad consumer appeal of our subscription plans increased our marketing effectiveness in the quarter.

Gross margin was 38.4%, also slightly better than we expected.

Why?

ASP was higher and content cost was lower than we expected at the start of the quarter.

And I'm pleased to report last quarter's trend of light disc usage continued again this quarter, as we expected.

Churn was 5% in the quarter, the second lowest quarterly churn percentage in the last four quarters and about in line with expectations.

Blockbuster's lower prices and TV advertising increased our churn from the record low we reported last quarter.

The GAAP net loss for the quarter was $8.8 million, much less than the 16 -- than our guidance -- the16 to $19 million loss.

The big contributors to this strong performance were gross margin, which I just discussed, and the lower-than-expected fulfillment and marketing expense which contributed about equally to the quarter's performance.

Last quarter we said competition would help define the online DVD rental market and showcase our strength in that market.

Q1 was an important step in that direction.

It's now clear to even the skeptics, I think, that this fast growing market has the potential to become quite large.

Perhaps as Reed suggested, as large as 20 million households.

Of course, there are two primary competitors today, Netflix and the other guy.

With aggressive pricing and heavy marketing spending, Blockbuster has grown rapidly.

In early March, Blockbuster said they'd spend $60 million in operating losses this quarter to grow their online business.

That's impressive spending, and about 10 times larger than our operating loss this quarter.

They also said they had 750,000 subscribers.

Now, that's impressive growth, but not as impressive as our growth.

The 945,000 gross subscriber additions we had in Q1 were the most in our history, and our second consecutive quarter of record additions.

So now we know that Blockbuster can invest in an operating loss that's ten times ours and grow quickly, and we also know that we can grow faster at one-tenth the operating loss, even with our higher prices and lower marketing spending.

That's because we do subscription rentals better and because doing it better matters.

And this is because the rental market is growing fast.

While competition hasn't slowed our ability to grow subscribers rapidly, we do think it's going to affect our financial performance this year, delaying our return to profitability by one quarter.

In Q1 we saw SAC and churn increase because of competition.

I'll talk more about the implications for the '05 financial performance in a moment when we talk about guidance.

Before I get to that guidance, I'd like to review the assumptions our guidance makes about competition.

First, until Blockbuster changes their online strategy by raising prices or cutting marketing spending, and there's no indication they plan to do either, we expect to remain locked in a tough battle for market share this year.

While we see no signs that they're cutting back, costs are clearly an increasing concern for them as they scale back other spending initiatives, lay off corporate staff, and battle the Icahn initiative.

But Icahn may not be Blockbuster's only problem this quarter.

Less than a year into a seven-year bank loan agreement, seven sell-side analysts covering Blockbuster forecast results that make it hard to understand how Blockbuster can possibly be in compliance with its bank loan covenants beginning this quarter, meaning Q2.

I'm talking about the fixed charge coverage ratio and the leverage ratio covenants in their publicly filed bank loan agreement.

If the analysts are right, then it's a good bet that Blockbuster's under-performing its operating plan because, after all, who plans to violate their loan covenants in the first year of a seven-year agreement?

So regardless of what happens with Icahn or the bank lenders, we may see additional cutbacks on spending soon that are performance related, but whether their business is weak or strong, our guidance assumes a tough competitive environment for the remainder of the year.

So what does that mean for Netflix going forward?

Last quarter I said our primary focus would be to reach 4 million subscribers by December 31.

Through Q1, our business is on track to reach this goal.

We expect Blockbuster to finish the year with about 1.5 million subscribers, and so far we think they're on track to reach that goal.

That would be a net sub gain for them of 1 million subscribers, about 400,000 fewer subs than we expect to add.

A moment ago I said competition was affecting our churn and subscriber acquisition costs.

Now I want to tell you what we're doing about it.

First, we're going to spend marketing dollars to replace the churn subs.

Second, we're going to increase marketing spending on a per-subscriber basis by taking SAC up, and third, we're going to offer subscribers a choice of plans at sign up.

We expect most consumers to take the 17.99 plan, but we'll also advertise several lower-priced plans.

This means ASP will fall, but we expect to hold the line on profits per sub.

This is an important point, so I want to emphasize it.

We expect higher gross margins from the lower priced plans.

So we expect to hold the line on profit dollars per sub.

In Q2, we expect a GAAP net loss of 2.2 to $7.2 million due to increased marketing spending, and we expect the business to return to profitability in Q3 and Q4 of this year.

In summary, we had a great quarter despite Blockbuster's lower price and expensive TV advertising, and despite their planned investment of $60 million in operating losses this quarter.

We think they grew fast, but we grew faster at one-tenth the loss.

Gross subscriber additions set a new record.

Again, net sub growth was the second highest in our history, and ending subs reached the high end of our guidance.

Revenue beat our guidance; the net loss of 8.8 million was much better than expectations.

We're on a roll, and that's my first point.

Second, the total markets for online subscribers continues to grow rapidly this year, and we expect all market participants to grow rapidly with it.

And third, we continue to expect that we'll reach 4 million subscribers by year end, the key strategic objective we laid out last quarter.

That concludes my remarks.

So now we'll turn the call back over to the operator so we can open the phone lines and answer your questions.

[OPERATOR INSTRUCTIONS].

Gordon Hodge, Thomas Weisel Partners.

Good afternoon.

Just a couple things.

The -- Barry, I missed your comment, you talked about disc usage.

I think you said it was lighter.

I may have misheard.

I just was curious about that.

And then I guess follow-up, I assume if the mix subscriber shifts to a little bit higher on the lower priced plans, obviously that would bring your disc usage down.

I'm just curious what sort of experience you're seeing so far on the low price plans.

A couple things, Gordon.

There was a lot of confusion on last quarter's call related to disc usage, so let me step back in time and remind people that last quarter we said we were expecting to see a seasonal increase year-over-year in disc usage, and that the increase we were seeing was running lighter than we were expecting.

And that appeared to be a continuation of a trend that had emerged early in the prior quarter.

So year-over-year, we are seeing it -- we did see an increase in Q1 but it was quite a bit lighter --

Oh, okay.

-- significantly lighter than the increase we had seen in prior years.

Think of it in terms of the core program, 17.99.

Got you.

And then a question for Reed.

I know there was some press out about Amazon thinking about partnering here, I'm just wondering if you could bear (ph) with us or maybe it's inappropriate, whether you've had any -- whether they've approached you at all or revisited the idea of working with you, or is that -- do you have anything -- any sense of what the competitive landscape might look like beyond Blockbuster?

As you would imagine, Gordon, I can't comment, on any possible discussions that we've had.

I'd point out that Amazon would be a great advertising vehicle for either us or for Blockbuster as is Yahoo, as is AOL, as is MSN.

They're all very substantial portals that are useful for either or both of us to be advertising on.

Great.

Thanks.

Heath Terry, CSFB.

Great.

I was wondering if you could just give us an idea in terms of what you think the lower priced option is -- or maybe if you could even give us an idea now that you've seen the differences in usage of your various price points of what the margin point from a gross standpoint would be on each one of those kind of break points in business?

Heath, we're not actually going to -- going to provide that level of detail.

I will say to amplify Reed's comments, that if you were to drop below the gross margin lines contribution profit -- dollars of profit, to get there, you would subtract fulfillment from gross profit.

We expect the profit dollars under the two plans to be very similar.

Okay.

And then in terms of -- and just even if you can't give us actual numbers, just kind of relative, you said that the 17.99 price point was the biggest part of your business right now.

Can you give us -- can you kind of quantify that for us a little bit in terms of how big it is relative to your other price points?

Well, in prior quarters I think we've said that it's something like 95, 94% of subs were at the 17.99 price point or higher.

We'd say in the -- for the recently completed quarter, the percentages are close to that.

Okay.

Of course, we're expecting it to move some on a -- in future quarters; and for competitive reasons, I think we are hesitant to discuss that in more detail.

Among the things we find attractive about this shift is this, the fewer DVDs you have at home, the more important it becomes for a company like us to ship you DVDs on time, to be in stock, to get them to your home quickly, and so it emphasizes, I think, a competitive advantage we have from a fulfillment perspective and also in terms of the depth of our inventory.

So it shifts the playing field a little bit in a way I think will be advantageous to us.

Great.

Thank you.

Anthony DiClemente, Lehman Brothers.

I apologize.

It looks like he has disconnected.

Safa Rashtchy, Piper Jaffray.

Hi, it's Safa Rashtchy.

Hi, guys.

Couple of questions.

First, could you tell us your observation as to how these new lower priced plans, not new -- but your success with them has come about?

In other words, in the past, I understand you were not promoting it, but the idea was that most people are happiest with the full plan of three and unlimited.

Is there a change in consumer behavior either because of just a growth in the demographics that's using the discs or because of competitive reasons, or is it simply because you're pushing it, or are there people who simply were downgrading from the full plan?

Safa, it's Reed here.

As you pointed out, we've had the 11.99 program for several years, but we didn't use it in sign up.

So the improvement in evolution in our technique is to offer multiple choices when consumers sign up.

And that's something that we started testing in Q4.

We developed more confidence in it in Q1, in terms of maximizing total contribution dollars from a given set of potential subscribers, and that's indeed what it's done.

So it's visible to all of you through the advertising on the lower price, and that's why we're bringing it up, but other -- we constantly improve our sign up pipeline and its effectiveness, and it's just another improvement in that, and really is just our time to test it and validate it is why it's come up now.

And do you have any sense if you have people who you might have lost otherwise who are now signing up for the lower price system?

I see.

Like a market expansion, in that way?

Right.

It's hard to detect in the presence of the shift in the competitive climate, so I think if it was a constant competitive environment, you might -- we might be able to more clearly measure some increase in addressable market.

Because the external world is shifting -- or shifted for us in Blockbuster's heavy advertising, I think some of that gets clouded where in principal it ought to be an expansion, but in practice it's just one more thing that we're doing.

Okay.

Great.

Thank you.

Jim Friedland, SG Cowen.

Thanks.

Just a first, quick housekeeping.

Can you give us an update on distribution center coverage, the number of distribution centers and the percentage of your users that can get overnight?

And then the second question is with a 10% postage rate coming up in Q1, how might that affect your pricing, especially with the new array of lower end plans?

Thanks.

Jim, I'll take that first part.

We've got 31 distribution centers open and it's a little less than 90% of our subscribers getting overnight delivery.

In terms of the postal rate increase, I'll pass that to Barry.

We have a number of cost reduction initiatives under way this year, Jim, which -- in our fulfillment operation enabled by scale, which we expect will more than offset increased costs related to the change in postal rates.

So I don't think it's going to affect us at all.

And, Jim, you referred to a 10%, but the latest feedback from the post office is that it would probably be less than that, depending on some various congressional actions between now and then, so the actual number is still in flux, too.

Okay.

Great.

Thank you for that.

Anthony DiClemente.

Hi, sorry I got disconnected there.

Just wondering -- you talked a little bit about what your guidance assumptions incorporate, you talked a little bit about the higher SAC.

I'm just curious as to the churn.

I mean, it seems as though it implies that your churn actually remains pretty steady year-over-year, if not coming down in the second half of the year.

Is that right?

And if not, maybe you can give us a little bit more of a sketch there on what churn might look like.

Thanks.

Yes, you don't want to think about it as year-over-year right now because last year in this period we had the price increase so your year-over-year amount will be thrown off a bit.

We haven't guided specifically to churn, but it's fair to say that if Blockbuster advertises as heavily as they have been in Q1, then you would probably expect in the neighborhood of the same churn that you saw in Q1 and Q2.

Okay.

Thank you.

[OPERATOR INSTRUCTIONS] Youssef Squali, Jeffries.

Yes.

Thank you very much.

Barry, I was wondering if you could just, once again, walk us through your analysis about kind of the unit economics or just how you were still planning on keeping the line on profitability.

With SAC going up, subscriber acquisition cost going up and your average selling price going down, I think what you said is that that will be done through increase in gross margin through -- for the lower price plan.

Can you just go through that again?

Yes.

Specifically what I said is I expect that the contribution profit per subscriber --

So that's before marketing?

-- Before marketing, to be the same.

And the delta there will all be coming from improvement in gross margins?

From both the improvement in gross margins and from a reduction in fulfillment cost --

Okay.

-- on a per subscriber basis with the lower price plans.

Why?

Well, you would expect that a one-out plan would have lower uses than a three-out plan on average over a month.

Right.

So if you're shipping fewer DVDs, you've got lower postage expense which gets reflected in the gross -- in the cost of revenues, or in the gross profit line -- the gross margin line; and you have fewer direct labor hours associated with shipping the DVDs, so you'll have lower fulfillment expense as well.

On your guidance, what kind of SAC assumptions have you baked by year end?

We're not guiding to SAC any longer.

What we said is that we would take it up slightly between now and year end, and how much we actually end up spending will, in part, be a function of how aggressively Blockbuster is marketing their competitive service and the price point at which they're marketing that service.

So if they continue -- so we are assuming that they continue down the path of aggressive marketing that they pursued in the first quarter.

Okay.

Thank you very much.

Gordon Hodge.

Yes, sorry.

Just a couple more.

One, capital expenditures were running up in the quarter, I guess they were comparable to the fourth quarter.

I'm just wondering should we expect that kind of spending going forward and maybe describe what it's on.

And then as you spent a little bit more on subscriber acquisition costs, are you -- I don't think we're sensing significant price increases in the marketplace, other than maybe on banner ads.

I'm just wondering are you planning new ad channels to -- are you stepping up TV?

Are you stepping up -- moving into radio?

Any new channels to pursue subscribers?

Thanks.

Why don't I take the CapEx piece, and Reed'll take the marketing expenditure piece.

CapEx on the quarter, I think, was 6 million and change -- 6.9 million and roughly flat with the prior quarter; and I expect that to come down by -- to an average of something in the neighborhood of maybe $5 million a quarter on a go-forward basis.

Okay.

Let's say in each of the next three quarters.

In terms of what it represented in the current year, primarily storage equipment, which we acquired in a year end deal at advantageous pricing that will support our growth in the coming year.

Gordon, on the marketing spending question, the SAC pressure a little bit in Q4 and now in Q1 and us saying potential SAC pressure throughout the year is really related to the competitive environment of Blockbuster spending heavily, as opposed to TV rates going up or online rates going up, and so that's why that is in there.

It's not any new channel, per se.

Okay.

Thanks.

Gordon, let me expand to on the CapEx if I might, anticipating a question that you haven't asked but I think will come up and that relates to the purchase of DVDs.

And that was up quite a bit in the quarter.

Yes.

We were going to ask that later.

Yes, Q over Q. Well, you might recall that we took a question about this last quarter, and the DVD purchasing appeared to be light and I said then it was because in the fourth quarter there was a shift from purchased to revshare discs, not as a result of a strategy shift, but because studios we revshare with were hot, and there was less demand for purchased DVDs.

That trend reversed itself by about 10 percentage points in terms of a percentage of discs purchased away from revshare towards purchase.

So last quarter we indicated that it'll fluctuate within a band, depending on who's hot and who's not.

And studios from whom we purchase discs were hot, plus we increased our purchases of back catalog as we significantly increased the number of titles we carry, so doesn't signal a long-term shift in the way that’s quarter to quarter.

Okay Thanks.

[OPERATOR INSTRUCTIONS].

Richard Ingrassia, Roth Capital Partners.

Thanks.

Good afternoon, everybody.

Hi, Rick.

Reed, I know we've spoken about earnings going positive in Q3 and Q4.

I'm wondering about where your thoughts are cash flow wise?

I mean, about 9 million in cash was burned in this quarter.

Obviously you can last years burning at that rate, but do you have a strategy and a timeframe for generating positive cash flow again?

This is Barry.

I'll jump in on that.

I expect it to be positive this quarter, meaning Q2.

Positive free cash flow in the current quarter.

Yes.

Okay.

And just to be clear on the gross margin comments, they were actually down almost 500 basis points year-over-year and 700 basis points quarter-over-quarter, so the improvements you're highlighting are really just with respect to guidance; is that clear?

Yes.

That's right.

And you remember the reason it's down, of course, is because we cut our price.

We went from 22 bucks to -- 18 bucks effective November 1, and part of that washed through last quarter, and all of that washed through this quarter.

Okay.

And on the distribution centers, I heard Reed say you're at 31.

Did you actually close any distribution centers in the quarter?

No.

We haven't closed any.

We continue to open them.

Here's a framework for thinking about it.

Perhaps this will be helpful.

We might open something like half a dozen a year.

So new hubs is actually less of a story than expansion of the existing hubs.

For instance in the most -- in 2004, we expanded twice as many hubs as we opened.

Many of them we doubled and tripled in size as we increased the size of our subscriber base, so as we get bigger, it creates opportunities for us to open hubs in markets that weren't previously economical to open hubs in.

But the majority of the growth in that infrastructure is coming in the hubs that have outgrown the space that we originally leased to support the sub base because the sub base is bigger.

Okay.

Got it.

And last one, there was -- the sequential change in deferred revs was down about a half million dollars versus 3 million or so in March of '04.

Can you just interpret that for us?

Yes.

Sure.

Delighted.

There are two effects.

First effect is on a Q over Q basis we had a big surge in the fourth quarter in gift certificates, and as those subscribers convert and become paying members, we've already seen the effect in deferred revenue in the prior quarter.

There was something like $3 million worth of what would have been deferred revenue that wasn't in the quarter, and the reason it's off trend with the prior year is because we had a significantly higher price a year ago than we have now, and so a new sub creates less in deferred revenue this year than they did a year ago.

Great.

Thank you.

Anthony DiClemente.

Hi, just one more question.

So it seems like the dynamic of what's happening in the second half of '05 is all sort of revolving around your strategic initiative of growing subscribers.

You're taking up your SAC a little bit.

You're introducing and emphasizing a family of a bit lower prices, and I just wonder, is there sort of a time, or is there as we look even further ahead long term that you shift your strategic thinking and you say to yourself, Okay, at what point do we want to start running this business for profitability?

Do we want to start really shifting our strategic focus?

At what point does that happen?

Does it happen at 5 million subscribers?

Does it happen at 6 million subscribers?

Or is this business, for the intermediate and perhaps the long term, going to remain focused entirely on subscriber growth?

Thank you.

Anthony, it's Reed.

I think the way to ask that question is for how long will we be spending 17 to 20% of revenue on marketing.

Because that's very high for an e-retailer or a retailer generally, Wal-mart, Best Buy, Amazon, Blockbuster, they're all at 1 to 3% of revenue in marketing.

And as our brand becomes more established, as we settle into 20 and 30% secular growth rates, we should be able to make considerable progress in terms of getting our percent of revenue and marketing down.

In the near term the overall dynamic is the new Blockbuster entry, and we're looking at the DVD market seeing that DVD is going to have an incredibly long life with high-def DVD with a studio focus on that; and that now is the time to really assert that leadership, to push through to 4 million subscribers, and through that to emerge with this two-firm market for the next several years.

And I think as that market stabilizes, we'll then see a return to substantial profitability for both of the players that you typically see in a large fast-growing long lasting two-firm market.

And, Reed, when do you think that happens?

I mean is that -- do you think that happens by the end of '05?

Do you think it's the end of '06?

Do you have a subscriber target in '06?

I'm just curious as to how you think this might play out in terms of the timing.

Well, I think some of that is competitively determined because to the degree that Blockbuster is on a continued hyperaggressive lose $60 million a quarter path, that necessitates a response in kind from us, which is what you're seeing both in the low pricing, heavy running for breakeven.

So somewhat it depends on your analysis of Blockbuster's ability and likelihood to continue to spend $60 million a quarter losses against us.

Presumably at some point, they are interested in profits also, and I think that's probably the trigger point that may be them backing off in marketing or it might be them raising prices, but at that point, I think we'll be able to both grow and generate a real profit.

Got you.

That makes sense.

Thank you.

And that will conclude today's question-and-answer session.

At this time, I'd like to turn the conference back over to Mr. Hastings for any additional or closing comments.

Thank all of you for joining us on this call, and we look forward to following up with you over the quarter.

Once again, that will conclude today's conference.

We do thank you for your participation and have a good afternoon.