Netflix Inc (NFLX) 2005 Q2 法說會逐字稿

Good day, everyone, and welcome to the Netflix second quarter 2005 conference call.

Today's call is being recorded and at this time for opening remarks and introduction, I'd like to turn the conference over to Deborah Crawford, Director of Investor Relations.

Please go ahead.

Thank you and good afternoon.

Welcome to Netflix's second 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 second quarter at approximately 1:10 p.m.

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 website at www.netflix.com.

A re-broadcast 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 those 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 & Exchange Commission, including our annual report on form 10-K filed with the Commission on March 15th, 2005.

And now, over to Reed.

Thanks, Deborah.

Today we announced excellent results for the second quarter on both the top and bottom lines.

We re-affirmed our 4 million subscriber goal for 2005, raised our net income guidance, and now expect to be profitable for the full year.

I think this performance speaks directly to the appeal of our service as well as the focus and competitive strength of our organization.

We continue to lead and grow a very large market.

Last quarter we talked about how the total on-line rental market had grown 93% from $1.93 million to 3.75 million subscribers year-over-year.

This quarter the market continued to grow at a remarkable pace, doubling from 2.1 million subscribers one year ago to approximately 4.2 million subscribers today for Netflix and Blockbuster combined.

A billion-dollar market with subscribers growing at 100% year-over-year is quite extraordinary.

Adams Media Research, now estimates that by 2010 there will be 15 million on-line rental subscribers, which suggests that we're still early in the growth cycle and the potential may be greater than any of us imagined.

This year, 90 million U.S. households will pay for either cable or satellite TV.

This means that there are 90 million households in the United States willing to pay for subscription entertainment, and that gives us a very large, addressable market.

The Oakland/San Jose/San Francisco Bay Area has now surpassed 10% of households subscribing to Netflix, and the rate of net ads in the Bay Area remains at record high levels.

Even in the Bay Area, we are still in the first part of the S curve of growth.

Other major markets across the U.S., which we upgraded to one-day delivery zones several years after the Bay Area, continue to follow the Bay Area growth trajectory, which gives us additional confidence that the on-line rental market is very large.

At some point the growth of on-line may push video stores to unprofitability, just as we've seen with local travel agencies.

They simply won't be able to efficiently offer what the consumer wants.

Once that process begins, it will help propel on-line rental to even greater household penetration numbers.

DVD household penetration continues to climb with major retailers only now dropping VHS.

DVD continues to be the major profit source for both film and television studios, and while DVD is huge, we believe there is yet another wave coming: High-definition DVD.

High-definition DVD is so important to the CE companies, the studios, and to the consumers of big-screen TVs that we are convinced there will be a technological or commercial solution to the current format disagreement.

The second wave of DVD, high-definition, will extend the dominance of packaged media for many years to come.

Finally, broadband internet and internet commerce are continuing to climb.

Verizon's new $15 DSL offering, for example, continues to drive broad band penetrations forward.

Growth in the DVD market, internet commerce and broadband growth, and most of all, the terrific value of on-line rental are the forces that have expanded the market in the last year from 2.1 to 4.2 million subscribers.

We continue to improve our consumer experience every quarter.

Today we are announcing that we now have 50,000 titles for consumers to choose from, up from 40,000 one quarter ago and 30,000 two quarters ago, as we continue to offer superior selection to our subscribers.

During the quarter, we opened four new distribution centers, in Florida, Iowa, Utah, and Tennessee, to continue to expand our one-day postal zone coverage, which is now approximately 90% of our subscribers.

We continue to improve our websites with content mouse-overs that allow subscribers to view greater details of every movie.

We rolled out enhancements to the Netflix recommendation systems, which increased the number of our subscribers who make active use of the system.

We made substantial improvements to our Netflix Friends feature, including a new and richer home page.

Today, approximately 10% of our subscribers are Netflix Friends participants, just six months from its launch.

Finally, we added previously-viewed DVD sales, which allow members to buy great DVDs for $9.99 with a quality guarantee, free shipping, and original studio packaging.

All told, our unrelenting focus on improving our service was recently recognized by an independent study of consumer satisfaction in which Netflix was rated No. 1 in all of internet retail, beating out highly-regarded companies like Amazon, LL Bean, and Apple Computer.

The benefits of these improvements to consumers are obvious, and the benefit to you as shareholders is falling churn, which means longer subscriber life-time.

Service quality and price are the two big drivers of churn.

In Q2, with the service improvements I've mentioned and our expansion to a family of price points, churn came down to 4.7%, our second lowest figure ever.

Our $9.99 program is resinating with consumers and the plan has the lowest churn of any program we have offered.

We continue to believe that low churn is ultimately the best indicator of the value and satisfaction perceptions of our subscribers and we will continue to work to drive churn down with aggressive pricing and great service levels.

Last quarter we said on-line rental was shaping up to be a two-player market, and that is indeed what is happening.

Although it's not material to today's results, Wal-Mart's decision to exit the on-line rental business and its partnership with Netflix clearly both confirmed and reinforces our leadership position, and as time goes by and our competitive position strengthens, Amazon's direct entry into the market seems both less formidable and less likely.

With our volume of one million shipments per day, we can make money at price points no new entrants can.

Any new competitor can have small losses and small results, such as Amazon's UK on-line rental business, or they can suffer huge losses in an attempt to get to scale quickly.

Speaking of Blockbuster, we are clearly taking the fight to them on all fronts.

We have 3.2 million subscribers; they claim to have 1 million.

In fact, our lead is now larger than it was a year ago, as we have added more net new subscribers than they did over the last year.

We are profitable; their on-line business is deeply in the red.

We delivered positive free cash flow; their free cash flow is negative.

We have no long-term debt; they have substantial debt.

Our churn is 4.7%; we believe theirs is over 7%.

In every dimension we are winning and continuing to extend our lead, and I can assure you that we remain vigilant on the competitive front.

Looking forward, we have begun to develop advertising sales to allow us to run at higher margins and lower consumer pricing than otherwise would be possible.

We expect to run advertising sales at break-even for the next several quarters while we build the staff and infrastructure to support a material contributor to our business.

Looking further ahead, we are on track to begin trials of our internet delivery initiative by the end of the year.

As I've said in the past, we expect downloading to attract only modest consumer interest initially, primarily due to the lack of content availability.

The content, rather than the technology, will be the gating factor, but in the meantime, of course, we'll keep growing our DVD subscriber base and we'll continue to invest 1 to 2% of revenues in downloading to ensure we're ready when content availability and pricing makes it compelling to consumers.

In conclusion, the market for on-line rentals just doubled from 2.1 to 4.2 million subscribers.

It is being driven by strong secular forces, has an addressable market of 90 million domestic households, and Netflix is the clear leader by all metrics-- total subs, net subs added, and profits.

Our service is superior and improving every quarter.

We are on track for 4 million subscribers and profitability for 2005.

As DVD matures, high-definition DVD is poised to drive the next wave of profits for the studios and Netflix.

We continue to make progress in our expansion into downloading of movies for the long-term.

We lead the market we invented, are starting to reap the rewards of that leadership, and are very well positioned for the future.

And now, I'll turn it over to Barry.

Reed, thank you.

Netflix was traded as a public company for 1161 days.

In that time, Reed and I have participated in 13 earnings calls and I don't think we've ever felt better about the business than we do today.

Before opening the phones to questions, I'll review our second quarter performance.

Next I'll talk about our guidance for the remainder of the year and then I'll discuss new revenue initiatives like add sales and new sales, as well as cost savings initiatives like automation and their financial impact on our business.

Q2 results marked our return to profitable growth.

Our ability to make smart decisions across the business enabled us to outperform our Q2 guidance.

All key metrics beat our expectations and contributed to the quarter's remarkable performance.

Subscriber growth was strong last quarter.

We marketed multiple subscription plans covering a range of price points and subscribers responded well.

The success of these plans plays an important role in our raised guidance for the balance of the year, as I'll explain in a moment.

Q2 sub growth was organic, predominantly from traditional acquisition sources and the contribution from Wal-Mart was inconsequential, which we predicted when we announced our agreement in May.

Churn was 4.7% last quarter, the second lowest reported churn rate in our history.

The most important factor contributing to the reduction in churn was the aging of our subscriber base.

I expect this to be a sustainable, long-term trend in the business.

SAC was $37.25 for the second quarter, down 2% from the first quarter and about $2 less per sub than we expected at the start of the second quarter.

In April I told you we planned to increase marketing spending on a per-subscriber basis by taking SAC up in Q2.

Now, obviously, that didn't happen.

We spent less in on-line and TV than we expected to.

We were too conservative in our assumptions about what things were going to cost and the yield from various initiatives.

So, SAC was lower than planned.

In hindsight, given our strong performance in Q2, we should have spent more on marketing and grown even faster.

Today we re-affirmed our year-end subscriber goal of 4 million.

To reach that goal, our subscriber base needs to grow by 25%, the same percentage increase we achieved last year from Q2 to Q4.

For 15 consecutive quarters, our sub base has grown by more than 50% on a year-over-year basis, despite competition from Wal-Mart and Blockbuster and in spite of last year's price increase.

Our sub growth in Q2 was 53% year-over-year.

If we maintain that same growth rate or better through year-end, like we have for 15 quarters, we'll reach 4 million subs in December, a goal few people thought achievable just two years ago.

If our churn rate continues to drop, as our subscriber base ages, and we think it will, the challenge of reaching 4 million subs grows easier to meet.

Each 50 basis-point drop in our churn rate is the equivalent of a 10-point increase in the growth rate of gross subscriber additions.

So by way of example, a drop in churn from 4.7 to 4.2% is equivalent to an increase in the growth rate in gross subscriber additions from 30% to 40% on a year-over-year basis.

Because our business metrics have improved and because the business is more profitable, beginning in Q3 we plan to increase marketing expense as a percent of revenue in Q3 and Q4 of this year by increasing SAC.

To avoid a repeat of last quarter's spending shortfall, we'll be more aggressive this quarter in spending our marketing budget.

Despite this planned increase in marketing spending, today we significantly raised our net income guidance for the third and fourth quarters of this year.

Last quarter we guided the GAAP net income of 1 to $6 million for the second half of 2005 and today we raised that guidance to 5.5 to $14 million.

The new guidance assumes lower usage and higher gross margins than our previous guidance.

The new subscriber plans we spoke about on last quarter's earnings call are performing strongly and lead us to expect a significant increase in gross margin by year end, which is reflected in our new guidance.

We also expect lower churn and lower levels of spending in G&A.

And lastly, in response to SEC guidance, [inaudible] 107, we expect lower stock compensation expense than we forecast in last quarter's full-year guidance.

New initiatives account for roughly 15% of net income in the second half of 2005.

These initiatives include selling previously-viewed DVDs on our website and add sales.

The profit potential from these initiatives may be significant in future years if we can grow them successfully this year.

Profits from these new initiatives in 2005 will be small, on the order of 1 to $2 million.

We're also pursuing cost reduction initiatives in our fulfillment operations through the use of automation, which we expect to reduce unit shipping costs in 2006.

These initiatives will increase CapEx spending.

In total, we'll invest about $8 million over the next two quarters on this initiative.

These unit costs-- [ No audio ] .

Please stand by.

Up 5%-- so in summary-- (indiscernible) two quarters ago we said the competition would help define the on-line DVD rental market and showcase our strength in that market.

The first quarter was an important first step in maintaining our leadership position.

We grew fast despite Blockbuster's aggressive pricing and heavy marketing spending.

The second quarter was an important second step towards solidifying our leadership position in the on-line subscription market.

We remained on track to achieve our goal of 4 million ending subscribers by year end.

We returned the business to profitability and we raised financial guidance for the remainder of the year to reflect the improving economics of our model.

Now, that concludes my prepared remarks and brings us to the Q-and-A part of the call.

So, Operator, we'll turn the call back over to you and take our first question, please.

Thank you. [OPERATOR INSTRUCTIONS] Our first question today comes from Gordon Hodge with Thomas Weisel Partners.

Yes, good afternoon.

Just a couple things.

One, your RPU was a little higher than expected.

Can you just talk about the mix of -- and it sounds like, based on your comments, Reed, that the 9.99 plan was well received.

So, can you give us a sense for how the mix of the pricing plans is shaking out in terms of all the various offers you have?

And then a question on usage, just if you could comment on how it trended, quarter-to-quarter and year-over-year?

Thanks.

Gordon, we're not going to break out the mix of plans for competitive reasons, but we'll say that RPU was slightly higher than we had expected in our forecast, but that broke our way in the quarter.

But having said that, consumers are responding enormously well to the new price points that we introduced, so we're very encouraged by that.

Let's see, part 2 of the question was with respect to usage.

We don't break that out any longer, as you know.

Sure.

In absolute levels, we're quite pleased with the trend.

On prior calls, you may recollect we identified an emerging trend of slowing usage which began at the time of the Olympics last year.

I think that trend has continued, but we also are benefiting enormously from the new success of the new plan.

The new plan.

Sure.

Okay, thank you.

And our next question will come from Anthony DiClemente with Lehman Brothers.

Hi, thank you.

It seems that on a per-capita basis, just if you look at SAC, it came in a little lower than our expectation.

I'm wondering if you could comment if you think that in terms of growth additions you've reached an inflection point in terms of word of mouth and maybe you think that just word of mouth and that mix of word of mouth versus a converted advertising-based growth addition is improving for you?

That's one question, and then I have a second question.

If you can talk a little bit, Reed, about that gating factor on the content and digital rights with respect to your DVR plan.

You know, can you elaborate, give us a little more color?

How are you proceeding with the studios in terms of getting digital rights for catalog titles over a set top box?

Thank you.

Sure, Anthony.

Your first question on SAC.

It was light because we were too conservative and Barry went through on some of the commitments that we made for TV, et cetera.

So I don't see any -- as Barry said, we are going to push that money into increased marketing spending in Q3 and Q4, and yet, because the underlying gross margins are so strong and the churn is so low, we're able to both increase marketing and deliver on the GAAP profitability.

What I will say is in the long-term, if you look at the Bay Area, our SAC is substantially lower from those scale effects.

That is, we've got so much word of mouth going on in the Bay Area, with its 10% subscriber base, that that helps us.

So it portends very well as we get the rest of the nation to 10% of households.

Second question you asked is about content.

You know, negotiations are never done until they're done, so we're continuing to work with the studios.

We continue to believe that it will be many years until downloading is a major part of the entertainment landscape.

It's not something that's going to happen in the next 60 or 90 days.

There may be some offerings, and there have been offerings, such as Movie Link, that are well run, and Cinema Now, but they generate very small amounts of revenue at this point because DVD is so dominant.

We see that continuing through the DVD wave and then through the high-definition wave.

So really, this investment in downloading is about what it will do for us three to five to eight years from now, when downloading starts to become a bigger business, and while that's difficult to acknowledge how long it's going to take, again, from a DVD perspective, we'll continue to grow our subscriber base rapidly between now and when downloading becomes large.

Great, thanks.

And we'll take our next question from Safa Rashtchy with Piper Jaffray.

Good afternoon.

Congratulations on a great quarter.

Thank you.

Couple of questions here.

First, going back to Gordon's question, can you give us some idea then, kind of how do we reconcile -- the two data points you gave was, one, that $9.99 price one was extremely attractive to your customers, and you stated that your RPU was higher than what you expected.

What contributed to that?

Should we continue to kind of look for RPU at the current levels or what are the current pricing trends?

And I have a follow-up.

I think RPU will decline slightly on a go-forward basis due to the mix change.

Okay.

And, Safa, what underlies part of our comment on the excellent response is that the churn is substantially lower on the $9.95 plan, so consumers, when we say we really love it, they love it.

It's reflected in the lower churn.

Okay.

And also, can you comment on the push of DVDs versus rental as well as on usage?

I understand that you don't want to give exact numbers, but could you give us some sense of directionally, whether it's up or down, and what kind of trend do you expect this year.

Would it be comparable to last year, for instance, or would the new price points on competition be different?

The overall trend on usage is down this year, and as compared with last year.

Some of that is mix change and some of it is not, and as regards content purchasing, it was roughly unchanged on a percentage basis of -- on a dollar cost basis from the prior quarter.

Okay.

Great, thank you.

Heath Terry, CSFB.

Thank you.

I was wondering if you could just talk a little bit more about the advertising initiative.

How are you going to handle ad sales?

Will you be hiring a dedicated ad sales force for the business?

Outside of the -- obviously, ads potentially on the site and on the mailers -- where else do you see an opportunity to expand into advertising and at what point do you think we start seeing it showing up in the numbers?

Well, our overarching strategy is to lay a foundation for success, and so we'll run that business at break-even for the foreseeable future, at least through year end.

And then in '06, if we have some traction in the marketplace as we begin to figure out the red card, we may begin to make some progress towards-- I expect we'll make progress towards profitability in that business.

As you know, the margins are likely to be quite high.

We will have a captive sales force, but we're talking about a small number of people in total.

As you know, we've hired a very talented executive, Peggy Fry, based in L.A. to run that business for us, and we'll add a few additional resources to support the sale of advertising to our target market initially, which is studios primarily, so that the things we advertise are complimentary to our core business and supportive of the brand.

And when should we first start seeing advertising on the site?

We'll let you know more about that the more progress we make.

Great.

Thank you.

And our next question will come from Dennis Alpine with Alpine Associates.

Thank you and good afternoon.

Would you talk a bit about Amazon?

It seems like they, you know, from what you've said that they have pretty much said that they're not-- or not said, but acted like -- they're not going into it.

If that's the case, why don't you slow down your push, or are you really now competing against Blockbuster?

Second, it appears from the buys that you made of DVDs that you went more towards rev share in the quarter.

Is that the case or did you just buy less?

And if you did that, how did you get up to 50,000 titles?

And then out of curiosity -- although you're doing very well at adding new gross subscribers, there still is over 500,000 a quarter that are dropping out.

What sort of reasons do you get from that and is there anything you can do to minimize the dropout rate?

Dennis, it's Reed.

I'll try to get those.

On Amazon, as I went through, they've launched in the UK, expanded to Germany, but seems to be a fairly tactical effort.

Most of the data on Amazon in the UK is that they're No. 4 in the market behind Video Island, Love Film, and Blockbuster.

So they seem to be more of a skim mode than a strategic focus, and the expansion to Germany's consistent with that.

In terms of rev share, again, no material change in the mix.

Obviously, when the rev share studio has a hot hand one quarter, that can move the numbers, but not strategically, sort of just tactically.

In terms of getting to 50,000 titles, we have always carried all the titles from the major studios, so what that represents is an expansion down into some of the smaller and smaller studios that do speciality, whether that's yoga DVDs or surfing DVDs -- there's a lot of speciality vendors.

So it represents the expansion into that.

And finally, you asked about churn.

We continue to work to reduce churn.

There's two big drivers of churn: One is price.

And you noticed that last year when we raised price, churn went up, and last year when we brought price down, churn went down substantially.

You've heard us talk that the $9.99 program has the lowest churn of any of the programs.

Again, price is a major value, is a major driver.

Second is the service quality.

We continue to work to improve the service.

All of the things that we've talked about on this call and that we've worked on for several years, and it's a low-- rather, it's a steady, persistent effort that slowly improves churn, and we believe our churn to be by far the best in the on-line rental industry, which gives us a key advantage in terms of average subscriber lifetime and average subscriber age.

Although your churn is low, you still lost almost 75% of the subscribers that tried the product.

Is there a dissatisfaction in something or is that all just the price that you're referring to?

It's typically that they're not watching movies.

So the main reason someone cancels is -- like when someone cancels HBO, it's not that they don't like HBO, it's that they just haven't watched something in a while and it's up to us to find relevant content for them and get them excited about DVDs again.

So it's not so much satisfaction issues around the service.

We continue to try to motivate them by finding highly relevant movies.

That really is the key.

And of course, the 500,000 number you quoted, in the abstract may sound large, but it's significantly better than with the percentage than in prior quarters, so we're continuing to get better at that, and as you point out, despite that churn, we're continuing to grow very rapidly.

And one last thing, the negative feeling that you have on downloading: would that change if the better product were made available and do you see that happening?

I don't feel negatively about it except on its availability in the short-term, so you know, we're very optimistic about it, and frankly, why we formed Netflix is to lead that sector.

It's just that we believe the studios will be reluctant to do broad licensing in the near-term on the most relevant content, and frankly, that makes some economic sense for them.

It's rational of them to be slow on that and to preserve the life of DVD, and the beautiful thing about our business model is whether downloading becomes big in two years or 15 years, we continue -- it's neutral to us.

We continue to grow the DVD side of the business.

So it gives us a unique platform to expand on when there is such uncertainty about the studios' licensing.

Dennis, this is Barry.

I just want to supplement Reed's response on churn.

Some of the mirror image of churn is something we refer to as a re-join rate, which are customers who have left and come back.

And gradually over time as we've improved the service and broadened the number of price points we offer, we've seen an increase in that rate and in the last quarter it was at the historical high, which is about 50% higher than it was a year ago at this time.

Good!

Thank you.

Our next question comes from Jim Friedland with SG Cowen.

Thanks.

Actually, a quick follow-up on that re-join rate, Barry, that you said 50% up from where it was a year ago.

I believe in the past you've noted that that 10% and I just want to see.

Are you saying it's 15%?

And then on G&A costs, we've seen costs come down for the last few quarters in a row.

Have you pretty much squeezed out what you can squeeze out and will now grow off that base or is there still more you can do in terms of cutting costs?

Thanks.

The re-join rate is closer to 20 than 15.

With respect to G&A, over time I think we could probably find some additional efficiencies of scale as revenues grow.

Okay, great.

Thanks.

I just want to add, the re-join rate does move seasonally, so it's conceivable that in future quarters we may see a drop from 19, although -- 19, 20, but there's nothing unusual that happened in the current quarter that would have contributed to a spike.

Okay, thanks.

Our next question comes from Youssef Squali, Jefferies & Company.

Yes.

Thank you very much.

Two questions.

First, the growth in your growth ads is low, relative to historical trends, up about 21%.

The mid-point of your guidance entails some 229,000 subs in Q3 and 525 in Q4.

Can you talk about the assumptions about pricing in competition-year guidance?

Is it fair to assume that it's stable?

As a related question, Q1, you talked about SAC 37 to 39, so are we to assume that that range still stands, but you'll probably be hitting the high end?

Then I have one additional question.

Youssef, on the -- we haven't given guidance on SAC, so the 37 to 39 is not guidance, and what we're focused on is growing fast, hitting the 4 million, and delivering on GAAP profitability for the year, and even then, it's our rising gross margins and our falling churn that allow that combination to work, to get both the growth and the profits.

I think you're asking a modeling question, and we're going have to deal with it on 101 sessions, so let me just hit it here.

That would be a very conservative spend level.

We have said in the past consistently that there are three key variables that we manage simultaneously in order to fine-tune the financial performance of the business: One is churn; one is gross margin; and the other is SAC, and we are clearly performing very strongly with respect to gross margin and SAC -- excuse me, and churn, and that gives us the financial flexibility to be more aggressive on the marketing front than we have been.

So among the reasons we're confident about our ability to accelerate the growth rate is because we're going to increase our marketing spending.

We're going to increase our marketing spending because we can afford to, and that's the right decision to make for the business because each incremental subscriber is profitable and adds to the enterprise value, and the sooner we build that sub base, then the sooner we're going to see some of the scale economies in terms of profitability on a go-forward basis.

On the CapEx discussion that you gave before, could you just go over it one time?

I think you were talking about an 8 million additional market -- or CapEx spend total for the year?

Did you give a total number?

And then what kind of an improvement in fulfillment costs do you see next year?

I guess last quarter you did 10.4% of revenues.

How low can that go?

I'll deal with the "how low can it go" question on the next call, when I think we'll be prepared to talk about our guidance for '06.

I said about CapEx was that we expected to invest in the neighborhood of 8 million bucks between now and year end in automation equipment and begin to drive down some of those fulfillment costs.

So that would be incremental to the numbers I gave you last quarter and last quarter I said we spent -- we expected to spend about $5 million a quarter through year end.

Okay, thanks a lot.

And we'll go now to Jason Avilio with First Albany.

Hey, guys.

Good job on the quarter.

I apologize, first off, if I get ask a redundant question.

I've been taken off-line, I've been hopping back and forth between a couple of calls.

Barry, I think you mentioned earlier that you expect gross margins to increase significantly.

I'm wondering if maybe you could quantify for us how high they could go in the back half of the year?

And then secondly, maybe if you could help us understand the different gross margin characteristics between what I would consider your core plan, the $18 price point and the newer plans, particularly the $9.99 price point?

Thanks.

Last quarter when we spoke with you about the introduction of the new price points, we said that we expected the contribution margin on those plans, which is gross profit, less fulfillment expense on a dollar basis to be roughly equivalent across the plans, and so we were optimistic about our ability to continue to drive profitability even as ASP was dropping.

And that's as much color commentary as we've given on those new plans, and we have elected not to give gross margin guidance.

So I know it would be helpful if I did for modeling purposes, but we're going to remain silent on that.

And so you'll have to, you'll have to adjust your assumptions for SAC and gross margin to land within the range of guidance that we've given.

Thank you.

And we'll go now to Imran Khan with J.P. Morgan.

A couple of questions.

Barry, you talked about -- your attributed the decline in churn rate, one of the reasons is aging subscriber base.

I was wondering if you could talk a little bit about if a subscriber stays with you for a year or so, what is the churn rate growth?

And secondly, you launched a new television advertisement.

I was wondering if your marketing expenses, in terms of on-line versus off-line mix, has shifted?

Thanks.

I'll let Reed deal with the marketing/spending shift piece of the question.

In terms of the one-year churn rate for our customers, it would take three DVDs a month.

We have said in the past that that subscriber, once they've reached the one-year mark, churns add an average monthly rate of about 2.5%, 2.5 to 3%, and that remains the rate today.

In terms of the mix, every other month or so we're No. 1 internet advertiser in terms of our impressions on the entire internet, and you know, we're around top 100 in terms of television advertising.

So I certainly see that as we grow, that imbalance would tend to correct itself, we would spend incrementally more on television, and that would grow faster than the growth rate of our on-line spending, simply because we are so high already on on-line relative to other on-line advertisers.

Okay.

Can I ask a follow-up question?

In terms of your pricing.

I was just trying to understand in terms of your raising prices, is it just predicated upon the competitive pricing or now as you have the second lowest churn rate in the history and are moving towards formula and subscriber, is there a threshold from those metrics that might re-think you to raising prices for your subscribers?

Thank you.

Well, I think it's a profit to acceleration question, primarily.

Let's first and foremost take stock of the fact that the business model at current prices is working just fine, thank you, witness the results for the quarter and our guidance over the next few quarters.

And among the things we've learned in the last 18 months is that the marketplace appears to be price-elastic, and it would appear that at current prices we have an ability to grow the business faster, bigger, than any of us thought possible a couple of years ago, and it may be that maintaining prices at current levels will in the fullness of time enable us to grow a bigger and more profitable business than would be the decision to raise prices in the short-term.

Now, I often get the question in the context of Blockbuster pricing.

What happens if or when they raise price?

And as you know, I've said repeatedly, I think the only way they get their business to profitability is if they raise price.

So from my narrow point of view, as a spread sheet modeling exercise, the question is when and not if.

So if and when they raise price, what will we do?

And what we said at the J.P.

Morgan call, when we announced the Wal-Mart deal and took the same question, was we will watch.

We will watch and see what happens to the rate of growth in our business and the other key metrics in our business.

We'll take stock and we'll make a decision then.

But there are only two levers to pull: One is marketing spending and one is pricing, and it's more likely than not that we would pull the marketing spending lever long before we pull the pricing lever because of what we've learned about price elasticity.

Great.

Thank you very much.

Our next question comes from Frank Gristina with Avondale Partners.

Thanks, guys.

One more question on churn, as if there haven't been enough, but is there also seasonality?

Is your churn normally higher in the June quarter?

And it shrank in spite of that seasonal trend?

I think the way to think about seasonality is it's linked to member age.

So subscribers who are brand new for their first several months are really evaluating the service in a way, and churn is higher in that period.

The longer a subscriber is with us, the lower the churn of that class of subscriber.

So yes, there's seasonality because there's seasonality in growth.

So it's not linked to seasonality of the movie business or other aspects, but we have more young subscribers around the Christmas DVD rush and our big growth acceleration in Q4 and Q1, which can drive churn up, relatively speaking, in those periods.

Historically, we saw some in Q4 and Q1 as an artifact of the formula we used to calculate it.

Less and less as the business grows larger.

We still see some seasonality from a growth perspective, meaning growth subscriber additions, and Q2 tends seasonally to be the slowest quarter of new subscribers, or at least it has been historically.

And then in terms of the 50,000 titles -- so, you've added 10,000 titles and I think you mentioned some smaller studios, but are you adding any significant number of TV series or made-for-TV content?

And if so, is that in part responsible for favorable utilization trends?

So, if people rent those, do they tend to keep them low longer and slow utilization long-term?

The next 10,000, or the 10,000 titles we got from 40 to 50,000 and are not generally TV titles.

TV titles tend to come from large studios, you know, they're part of Paramount's television division and they come through our agreements with Paramount, as an example.

So the rise in TV, which has been substantial, we've disclosed in the past that it's over 10% of our rental turns now, is a great trend for us, because as you point out, it's a great way to watch serialized content and you get generally three to four hours of content on one DVD, which means the consumers keep any one DVD slightly longer.

Whether that's what's responsible for the leveling off on usage, I don't think it's material.

There's no easy way to identify the separate cause from it, but certainly the rise of TV on DVD becoming such a large profit source for the television studios, is part of the big story, which is that DVD is a dominant form for the studios for the next several years, not only on film, but also for TV.

Thank you.

Mario Cibelli with Marathon Partners.

I don't know if you've done this lately, but I think last year you talked about how many of your subscribers are older than 12 months.

Would you care to share that number now?

No.

Oh, come on! (Laughter).

Thanks.

That's it.

More than in the past. (Laughter).

And we'll go next to Richard Ingrassia with Ross Capital Partners.

Thanks.

Good afternoon, guys.

Obviously, the $9.99 subscribers are more profitable than your subs in the core plan.

Would you say -- I mean, is it primarily because they churn less or is it because they're coming on primarily without the free two-week trial?

It's really a self-selection, Rich, because what's happening is subscribers who are pretty light movie users gravitate to the light program.

So they don't watch that many movies.

They're very casual, whereas people who are film buffs gravitate towards the three-out, $18 program.

So I think it's a bit more of a selection bias than the program is doing one thing or the other.

As a financial modeling, it does help us because the $9.99 is higher margin because it's lower usage.

Okay.

And then just finally about the guidance.

Obviously, the range is still fairly wide, and has been changing pretty dramatically, quarter to quarter.

What sorts of things can change in your business or are changing in your business that might give you more confidence in your guidance going forward?

Well, the big drivers, from a modeling standpoint, could be usage, but I don't think that will be a contributing factor.

Usage because it drives gross margin.

Mix: I don't think that's likely to be a big driver.

You've got to get the marketing money spent, and we need to get the conversion rates on trials that we're optimistic we'll get.

In spite of our underspending last quarter, we had pretty good results.

And if we were to underspend again this quarter, that has a big impact on the bottom line because we're talking about a lot of subs.

We have made the commitment emotionally to be more aggressive in the way we commit marketing monies, and so I'm fairly confident that we'll get that done this quarter.

There are a few other items that drive the bottom-line number up or down a million bucks in G&A and [inaudible] a few other line items that are tough to fine-tune.

Mostly our objective is to never miss on the bottom line because it's absolute death, and the revenue numbers are large enough now and the net income numbers are still relatively small enough that you can get pretty big swings for very small changes and key variables for the modeling exercise.

And the big, I think, change, over the last six months or perhaps nine months is of the competitive climate, and six months ago it was hard for us to predict with any precision the effect of Blockbuster's SuperBowl advertising and pricing, and I think now we have the perception that they've given it everything they've got from a balance sheet perspective, and that we've got them contained and that we are, with our higher net sub ads and continued growth, increasingly confident of the future because we've seen what they've got and it isn't enough.

Having said that, we're assuming that they continue to hang out at their current price points, so we're not envisioning in our forecast any kind of structural shift from a competitive standpoint, up or down.

That would have bearing on our results.

Okay, so in other words, by settling in now competitively for the long haul and having some flexibility in the marketing, we can expect that you'll spend towards the mid-point of guidance?

Yes, our strategy is to try to end -- just try to finish in or around the mid-point of guidance.

We've not planned the guide down [inaudible].

Both on subs and on earnings.

Okay.

Thank you.

And we'll take our next question from Derek Brown with Pacific Growth Equity.

Thanks.

I have two questions.

The first is, with respect to usage, do you get the sense that you are bumping up against sort of the natural ceiling for individual usage?

And then the second question relates to postal rate changes that are either talked about or expected, and just better understand what your position is around that and when you would expect it to hit in '06?

On usage, it's not so much that it's the natural rate for any one subscriber, although that may be out there.

I think it's mostly as we expand the base towards more casual renters with a variety of price points, that helps on overall usage quite a bit.

And then, on postage rates, and you should be modeling a 2-cent increase each way.

So a 4-cent per turn increase.

If a bill which is before the House, HR-22, passes, it goes to the Senate, it's passed and it's signed by the President this calendar year, then the likely case is that 4-cent increase would not happen; it would be pushed off until at least 2007.

Has to do with pension fund accounting, et cetera, and the odds are sort of 50/50 that this relief for the post office will go through all those stages and be signed this year.

So the conservative thing to do is model the $0.04.

That's what we're doing.

And you said that you've thought, at least you've said in the past, you've thought you could work on some operational things that would help mitigate that expense, or did I not hear that correctly?

No, you heard that correctly.

Okay, thank you.

And we'll go now to Anthony DiClemente with Lehman Brothers.

Yes, hi, I just had one follow-up.

So you commented on the different drivers of usage.

The part of usage declines that were not driven by conversion to the new plan: do you think that any of that has to do with weak title flow?

And I know that the majority of the units that are ordered by your consumers are catalog titles, but do you think that any of these just has to do with weak title flow?

Thanks.

Well, I don't think so, because it appears to me to have been a trend, that as I said earlier in Q & A, began to emerge at the time of the Summer Olympics a year ago, and we clearly saw it present in the first quarter when, historically, we had seen a big year-over-year increase and we didn't see nearly that big an increase.

It was an increase, but nothing on the order of what we had seen in the prior two years and we continue to see the trend coming down, so it may be that we have a different kind of consumer or the consumer behavior as they've grown more accustomed to DVD usage in the home is changing.

We'll know more over time, but it appears to be a structural shift and not a short-term trend.

Does that answer your question, Anthony?

Yes.

Thanks, Barry.

And at this time that would conclude today's question and answer session.

I'd like to turn the conference back to Mr. Reed Hastings for any closing remarks.

Thank you, everyone.

Nine months ago, mid-October earnings call, we took strong action in terms of reducing our price.

There's been considerable anxiety about that externally.

Obviously, our stock price was down considerably.

We continue to believe it was the right thing to do, and at that point we said that we would be 4 million and break-even this calendar year, and I think there was a general show-me perspective, which is fair, and I think we feel great about coming forward at this point in confirming 4 million and break-even.

We're on target for that.

So I want to thank everyone for their support and with that, we look forward to talking to you on the next call.

Thank you for your participation on today's conference call.

You may disconnect at this time.