Netflix Inc (NFLX) 2005 Q3 法說會逐字稿

Good day, everyone, and welcome to the Netflix third quarter 2005 earnings 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. Deborah Crawford, Director of Investor Relations.

Please go ahead, ma'am.

Thank you and good afternoon.

Welcome to Netflix third 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 third quarter at approximately 1:05 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 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 15, 2005.

And now, over to Reed.

Thanks, Deborah.

Good afternoon, everyone, and thank you for joining us.

Our performance in Q3 provides a clear view of the power and potential of the Netflix model.

We've combined strong subscriber acquisition with cost leadership resulting in large growth and healthy earnings.

We have made huge progress over the past year since cutting prices.

Our churn has dropped from 5.6% one year ago to 4.3% last quarter, a new record.

Our subscriber acquisition cost has dropped from $38.18 to $35.69.

Net adds have nearly tripled from a year ago, growing from 136,000 to 396,000.

Ending subscribers are up from 2.2 million a year ago to 3.6 million today.

Our competitors are weakened or gone.

And our earnings, while not as strong as one year ago, are positive and are above the high end of our guidance.

Because of our momentum, we feel very comfortable about delivering 50 to 60 million in pretax GAAP net income in 2006.

And 50% pretax earnings growth for several years after that.

At the heart of our success is a superior business model and an intense focus on the consumer experience.

Our large scale and deep personalization technology enable us to provide the studio a large new revenue stream, to provide investors substantial and growing earnings, and to provide consumers an unrivaled movie rental experience.

Our scale and technology allow us to make money at price points no competitor can sustainably match.

Dell and Southwest are two similar examples, both of which capture 100% of their industry profit.

Let's talk about Q3 results in some more detail.

We launched our subscription service six years ago.

And over the last six years, our churn has steadily declined, except for our $2 price increase and Blockbuster's Super Bowl advertising binge promoting its temporary $15 price.

This quarter we continued our long-term trend of churn reduction which results from our improving service, more aggressive price points, weakening competition, and our customer base aging.

At some point, this churn reduction trend will flow, but already, at low 4% churn we have a terrific economic model.

In addition to the drop in churn, our gross subscriber additions were strong in the quarter.

The big drivers were strong word of mouth, our variety of pricing options, and well executed advertising.

One factor to keep in mind, however, is that in Q3 last year we were at a $22 price point with light gross adds, which provided us this quarter with a relatively easy comparable period.

In Q4 last year we cut price and we saw a large growth spurt.

So we will have a more challenging comparable period this Q4.

In terms of total marketing spend, and subscriber acquisition cost, we have in all past quarters had a fluid total marketing budget and managed internally to a specific average quarterly SAC.

When we had room to take up total marketing spending, and still hit the specific SAC target we did so.

Sometimes negatively impacting that quarter's earnings.

Last quarter, we moved to managing to a fixed total marketing budget each quarter, and letting SAC float up or down.

Our first quarter on this more traditional model was quite a success in terms of delivering great growth and strong earnings.

Our fixed marketing budget will make SAC somewhat more fluid than in the past.

SAC may well rise in Q4, but the fixed marketing spend model has the overriding virtue of stable expenses and more predictable earnings.

Barry will talk more about this in a few minutes.

Combining falling churn and increasing gross additions, net adds is the best indicator of our growth.

As I mentioned, we had 396,000 net adds last quarter.

This acceleration in growth is very exciting to be nearly 4 million subscribers and to have net adds still accelerating implies the market for on-line rental is extremely large.

Finally, we drove a nice increase in gross margin in Q3.

This is partially due to the increased acceptance of our lower priced programs which have higher margins than our standard program, and partially due to efficiency from our personalization efforts, merchandising catalog movies, more effectively than ever.

One of the reasons our last year has been so successful is the market's elasticity in response to our price cuts one year ago.

And to our offering of lower priced one and two out plans this year.

So naturally we want to test this elasticity further as we continue to realize cost efficiencies in the business.

As we said at our analyst conference last month, we expect to run a number of pricing tests over the next six months to determine if, at lower prices we can deliver faster subscriber growth, lower SAC, lower churn, higher competitive barriers, and still deliver on our earnings commitment.

Obviously, if there's enough elasticity to make additional price cuts work, this would increase the economic pressure on video stores, and the additional store closures would further increase Netflix growth for many years ahead.

This positive feedback loop between Netflix growth and video store closures is the tipping point for on-line rental.

Now let me turn from Netflix to the broader movie industry.

Where there continues to be consternation about falling theatrical revenues.

One view is that this is a temporary lull in compelling theatrical releases that may soon be remedied.

Supporting data is the lulls in some prior years that have proven to only be temporary.

A contrary view is that the low cost of large screen televisions is, family by family, changing American movie watching habits.

For less than $1,000 today, you can buy a 52-inch RCA hi-definition television from Wal-Mart.

If home theater is the growth engine of the future, then we will see more studio heads join Disney's Bob Iger's call for DVDs to be released earlier, which has the potential to grow the DVD market substantially.

The other big potential growth factor in the DVD market is high definition DVD.

In the past three months, the battle over hi-def DVD has changed from a stalemate to one favoring Blue Ray.

We are agnostic.

We do expect the launch of high definition DVD to happen next year, and that this will be the beginning of another 10 to 20-year product cycle that will extend our leadership for many years.

As we have said before, there is minimal inventory obsolescence risk for Netflix because the conversion of the 80 million existing standard-def DVD households in America will be steady but gradual like DVD over VHS.

While DVD and hi-definition DVD show great promise, the near term for downloading is not so bright.

TV channels, such as NBC, Starz, and TNT, have been paying large sums for many years to have and maintain exclusive access to many studio films.

Because of this, Movielink and Comcast, despite impressive technology and management, have so far been unable to license most of the 50,000 titles available on DVD.

The same holds true for Apple, which recently launched their video iPod with essentially no studio movie.

Of course, we face the same obstacles as Movielink, Comcast, and Apple, in terms of licensing for downloading.

As such, we are going to hold off on the launch of our movie downloading service.

We will continue to enhance our technology and infrastructure, and we will be ready to quickly launch when the content climate begins to thaw and it becomes possible to deliver a compelling consumer experience.

How long will it take, and who will help us get there?

Interestingly, while you might think of Comcast, Movielink, and Apple as our potential competitors, they are, for now, our allies.

We all four want broad, nonexclusive licensing of movies, as with music today.

Our shared opponent are the TV channels who pay large sums to get multiyear exclusive access to studio films.

In a music context, imagine if Clear Channel, or XM, had paid big money to get five years of exclusive rights to all Warner music, and that the entire Warner catalog was then not available for legal downloading.

That is the current movie situation, which is why no one has been able to license the 50,000 DVD titles for downloading.

This will shift, over time, as those exclusive contracts are renegotiated and Netflix and its allies can collectively deliver more profits to the studios than the exclusive TV channels.

When the content climate does shift, we will have broad camp content for downloading and the next generation of movie delivery will begin in earnest.

Whether this happens in 2 quarters or 20 quarters is hard to say.

In the near term fortunately, DVD is king.

Netflix continues to grow rapidly, and we prepare for the emergence of downloading in the future.

As we grow towards our 20 million subscriber goal, we are comforted by the reality that the bigger we are when the content logjam breaks, the more likely we are to be one of the leading companies in the downloading space.

Speaking of 20 million subscribers, I'm often asked why we feel confident about such an enormous number.

There are three parts to the answer.

Part one is that the markets that we upgraded to overnight delivery in 2002 and 2003, such as Boston, Atlanta, and Dallas, continue to follow the Bay area growth trajectory.

Part two is that in the Bay area, over 11% of households now subscribe to Netflix and net adds are still accelerating.

Part three is the tipping point.

We think that once on-line gets big enough, video store economics fall apart, and stores start closing, driving more people to try on-line rental.

We are just seeing the beginning of the tipping point in the Bay area with more and more video store closures.

These three factors are what give us confidence that 20 million Netflix subscribers is very achievable in the 2010 to 2012 time frame.

And we are committed to achieving it while delivering on our earnings guidance.

At this point, I'll turn the call over to Barry, and I look forward to taking your questions.

Thanks, Reed.

On last quarter's earnings call, I said we were feeling pretty good about our business.

And you saw us raise our net income guidance for 2005.

Then at our analyst day in early September, we talked at length about our first mover advantages and the momentum we were seeing in the business which caused us to raise our guidance in late September for third quarter subs and net income before net settlement expense.

And today we announced results that outperformed our revised net income guidance for Q3 and continue to trend I commented on last quarter as key metrics like subscriber growth, gross margin, SAC, churn, and net income all beat our initial expectations.

As Reed mentioned, our momentum continues to build, which gives us the confidence to increase our guidance for Q4, 2005 and for next year.

Because Reed has already reviewed the highlights of our third quarter performance, my comments today will focus primarily on our guidance for Q4 and 2006, and I'll close with a discussion of our financial expectations through 2006 for new initiatives like ad sales and the sale of previously viewed DVDs.

But first, I want to amplify Reed's comments on SAC.

Three months ago, I told you we would increase our marketing spending in Q3 as a percent of revenue and, in fact, we increased marketing spending about 300 basis points from 16% of revenue in Q2 to nearly 19% in Q3.

I also told you we expected to increase SAC above the $37 we spent in Q2.

In fact just the opposite happened.

As we increased our marketing spending, subscriber growth accelerated faster than we expected, and SAC dropped almost $2 in the third quarter to $35.69.

Its lowest level in five quarters.

And about $4 lower than we forecast in early April.

So the obvious question here is what will SAC be going forward.

For Q4 and for 2006 we're planning on a fixed marketing budget.

And as I'll indicate in my guidance discussion, given this level of spending, our planning assumes that SAC rises in the fourth quarter of 2005 and in 2006, but if we're wrong and growth accelerates, as it did in Q3, we'll see lower SAC than we're expecting and more sub growth.

Either way, we expect to deliver the earnings we have guided to by managing the amount of our marketing spending.

For the fourth quarter, our revised guidance is for GAAP net income of 4 to $7.5 million, up from our previous guidance of 1 to $6 million.

For 2006, we're raising our guidance for pretax income to a range of 50 to 60 million from our previous guidance of 50 million.

I'm emphasizing our income guidance because our plan is to deliver the maximum growth consistent with our profit objective.

The new guidance assumes higher revenues and higher gross margins.

It also assumes that we spend a fixed dollar amount on marketing in Q4 and next year, and that SAC increases in both periods.

Of course, as Q2 and Q3 demonstrate, it's entirely possible that SAC could land below our expectations, and if SAC runs lower than forecast, ending subs will beat our guidance.

And if SAC runs true to forecast, we'll meet our subscriber goals for the quarter.

But either way, we plan to cap our marketing spending just like we did in Q3 and meet our earnings guidance.

Our focus on achieving maximum growth consistent with our income goals also means that if we get ahead on earnings, we'll invest the incremental profit back into the business to drive additional growth.

As our third quarter results make clear, this is a business in which scale delivers significant cost and strategic advantages, so growth remains an important objective for us.

Today's earnings release raises our Q4 guidance to 4 to 4.2 million subscribers, and revenue in the range of 191 to $196 million.

For 2006, we expect to end the year with at least 5.65 million subscribers, and at least 940 million in revenue, and with 50 to 60 million in pretax income.

Think of the sub and the revenue guidance as the bottom of our range.

On a pro forma basis, if the Company were fully taxed in 2006, GAAP net income would be in the range of 29 to $35 million.

As a reminder, because of NOLs, Netflix doesn't pay taxes currently.

But I expect we'll become taxable, for GAAP purposes, sometime in 2006, and possibly as early as Q4 of this year, but that seems unlikely.

We expect the same seasonal patterns of high marketing spending and fast subscriber growth in Q1 of next year that we saw in 2004 and 2005.

This means we expect to increase marketing spending as a percent of revenue in Q1 which will pressure profit margins in the quarter, and we may post a net loss for GAAP purposes in Q1 because of our rapid growth, like we did in Q1 of '05 and in Q1 of '04.

Built into our forecast is the postal rate increase of $0.37 to $0.39 in January of 2006 for first-class postage, which is a $0.04 impact for Netflix on every round trip DVD shipment.

Scale economy is in our business and the automation initiatives I discussed last quarter will more than offset the increased postal expense.

I'll close with a few words about two new initiatives at Netflix.

Selling previously viewed DVDs on our website, and ad sales.

Both initiatives will remain small through year end while we complete consumer research, although both will become more visible to Netflix investors and subscribers during the fourth quarter.

Revenues from the combined initiatives in 2006 will be in the broad range of 8 to $16 million and neither initiative will be a material contributor to increased profitability next year.

For the foreseeable future, the primary engine for growth and profitability will continue to be our core DVD subscription rental business.

In summary, three-quarters ago, we said the competition would help define the on-line DVD rental market, and showcase our strengths in this market.

The first quarter showed we could maintain our leadership position.

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

The second quarter helped solidify our leadership position in the on-line subscription market.

We remained on track to achieve our goal of four million 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.

The third quarter extended our leadership position enabling us to raise guidance again, for ending subscribers in net income, which showcases the themes we highlighted in September at our analyst day meeting.

Namely, that scale drives profitability, margin expansion, and competitive advantage.

That concludes my prepared remarks and brings us to the Q&A part of the call.

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

[OPERATOR INSTRUCTIONS] We'll have our first question from Gordon Hodge, Thomas Weisel Partners.

Good afternoon.

Just a couple of things.

One, it looked as though, based on the high level of free trials in the quarter, that a lot of the sub adds may have come towards the end of the quarter, and that would be consistent with the fact that you raised guidance at the very end of the quarter rather than at your analyst day.

I'm wondering if you could comment on that or was the decline in ARPU, was that more related to a mix issue with the lower price plans in there?

And then also the disk purchases look rather low in the quarter.

At least low relative to the other quarters this year.

You've got much higher users now.

I'm just wondering if you're enjoying some economies there, or is it just sort of a one-off situation in the quarter?

Thanks.

Hi, Gordon.

It's Barry.

Thanks for the questions.

I heard three of them.

One about the timing of sub growth, one about ARPU, and one about content purchasing.

Yes.

Did I get that right?

Yes.

Well, with respect to sub growth we had quite a bit of momentum coming into the end of the quarter and you see that in part in our earnings release in the mix of free versus paid subscribers.

The update in the guidance was as much about the settlement as it was about an update on the business, but since we were updating people about the settlement, we felt compelled to give you the full picture.

With respect to ARPU, it has declined and that reflects the continued popularity of the lower priced plans.

Which are also contributing to the improvement in gross margin in part as Reed mentioned.

Then lastly, you're right, disk purchasing was down in the quarter by quite a bit.

It was about 13% of revenues.

We'll see a slight -- which is low historically, as you know, we've been in the high teens.

We'll see a slight increase probably next quarter by a couple hundred basis points maybe, something in, let's call it the mid teens, 15, 16% range.

So the personalization software that we've been developing and integrated into the website has been working quite well for us, as Reed mentioned, that is contributing to the decline in purchasing and to increased margins.

So some of that is sustainable it sounds like, in terms of the lower purchasing.

Well, it's extending into Q4 below historical levels, and we'll see after that.

Terrific.

Then just, I guess, I didn't really ask the question very well, on the subscriber adds, did you notice an appreciable change when Blockbuster took prices up in terms of an acceleration in the adds of subscribers and is that continuing into Q4?

It would appear that it is but.

Gordon, there's no question that the Blockbuster price increase helped, but there was no inflection point in the quarter.

For example, the price that they actually did -- the week that they actually increased prices.

So it's as much also helped by their lack of marketing and general weakening state which affects their service level, it affects the marketing and it affects the pricing.

So it's -- all of those factors combined make for a weakened competitor and for a stronger competitive environment for Netflix.

Terrific.

Thanks.

And we'll have our next question from Glen Reid, Bear Stearns.

Yes, hi.

Just quickly following up on the -- on sort of the ARPU question, is it still the case, or maybe you could kind of elaborate more just on the dollar contribution or the gross profit contribution, between your -- say your 9.99 plan and your 17.99 plan.

Are they still roughly equivalent?

Is that really the case?

And I guess the second thing, there's been some talk here, in the last few days about a Blockbuster-Amazon partnership that's sort of been going around.

I'd love to get your thoughts on that in terms of how it might affect your business.

Thanks.

Glen, it's Reed.

I'll do the second part and let Barry do the first part.

Yes, we've heard the same rumors but then we've been hearing them for nine months.

So I don't think there's anything really different happening there, and I think what we've shown is Blockbuster spent about $300 million trying to compete against us, and we've held together and, in fact, accelerated our business, returning a substantial profitability, looking at great profit streams next year, so it would have to be another $300 million investment to knock us off our momentum in some slight way.

At smaller levels we wouldn't feel it.

So we look at it and say very unlikely to see -- again, the key thing is not whether there's a partnership or advertising.

It's whether there's another round of $300 million of investment, and we would look at that and say it's fairly unlikely, that we're just too far ahead for them to be willing or able to do that.

So would that mean that you wouldn't necessarily feel compelled then also to revisit your sort of marketing spending caps that you've kind of laid out?

Well, let me separate it again in the two cases.

One case, which is Blockbuster can do anything they want.

If they're not able to spend another $300 million, there's almost no chance that they will make an impact against us.

Sure.

If, for some reason, they've got another 300 million to invest, either through partnership or anything else, and they choose to invest it on on-line we think it's highly unlikely, given the poor return on their current investment, but that would ratchet up the competitive environment and we would have to respond in a variety of ways.

So that always stands out there.

I think a very low percentage chance because they've already spent 300 million, they're in a weak state.

We've accelerated where our distance between them in terms of total adds has grown over the last year.

So that kind of double down thing is always possible but extremely unlikely.

Okay.

Barry, the ARPU question.

I think the question was about the comparability between the plans around contribution margin, which is gross margin less the fulfillment cost.

And we had previously said they were roughly equivalent, and we still like -- what I'll say about it today is, we like the economics quite a bit.

You can see the increased profitability in the plans reflected in the increasing gross margin of the business.

Yes.

Okay.

Thank you.

It's not as specific as you'd like, I know, but I think directionally it answers your question.

Sure, thanks.

We'll have our next question from Heath Terry, CS First Boston.

Great.

Actually, I was just wondering if you could go maybe a little bit more in-depth on what you are feeling these days about the possibility of any kind of new entrant into the space, specifically Amazon, especially as you're looking at what they ure doing in Europe?

And then also if could you talk with -- strategy evolving here around your -- the launch of your video download service and certainly I understand the thought process behind that.

As you look at potential investments for growth, does international and possibly revisiting some of the plans that you had previously about international make any sense from where you sit?

Sure, Heath.

If Amazon's DVD rental service in the U.K. were a roaring success and taking the country by storm, I think everyone would be more concerned about their likelihood of entering in the U.S.

Given what we know about Amazon's DVD rental service in the U.K., that it's appreciably behind Video Island and Love Film and behind Blockbuster in the U.K., there's number four in the market, the prospect of Amazon expanding that relatively unsuccessful initiative is fairly small because they're a very thoughtful, rational player.

So always possible.

Don't see anything that indicates it's likely, again because they're in the market.

If they were motivated enough they would have entered earlier this year and a small entry like they've done in the U.K. where they're still number four a year later would be inconsequential to us.

Next you asked about downloading.

Anything specific?

I could go through what I said on the script, but we tried to give a good explanation there, which is, the TV channels have a lot of the content locked up exclusively.

That's why Comcast, Movielink, Apple, and us don't have much content.

That will shift over time, and it's unfortunate, and the consoling factor is that the larger we get, the bigger profit base and the bigger subscriber base we have when that content eventually is available for licensing, and when it is, it will be available to everybody just like music is.

Got you.

Did that get your question?

No, can you hear me?

Yes.

No, actually what I was asking about on the -- when I mentioned downloading was less actually about downloading but with your decision not to do downloading.

Like I said, I completely understand the strategy there, or to hold off on downloading until it makes more sense for you.

Does that put you in a position to maybe revisit some of the international expansion plans that you had previously -- does that make sense from where you sit at this point?

We'll continue to invest in downloading as appropriate, but obviously lighter than we would if we had launched.

In terms of international, it's something that we look at from time to time, and the way that we approach it is, is the core business profitable enough that we can afford the investment in international and still deliver on our 50 to 60 million earnings guidance for next year and the 50% growth thereafter.

So we look at it as it's -- international is one way for it -- to do growth, another way is invest in marketing in the U.S.

We trade those off against each other.

So nothing imminent, but it is something that we continue to look at.

You want to add anything to that, Barry?

We don't feel like we're missing any opportunities internationally, as we watch by way of example the U.K. market develop.

It's developing slowly.

The economic proposition appears to be challenging, and there are some small and -- competitors who are capital constrained who are battling each other to a draw at the moment, it seems.

And the U.S. is growing so fast that we look at it and say 20 million subscribers in the next five years, let's concentrate on the U.S. for the most part, and grab the 20 million, and serve them.

Got you.

Thank you.

We'll have our next question from Safa Rashtchy, Piper Jaffray.

Hi, this is Paul Beaver for Safa.

What is driving the increase in SAC?

Is it word of mouth as penetration increases?

Or is the sharing movie queues with friends?

Can you give us a little bit more color on the decrease in SAC?

Sure.

Well, SAC has stayed amazingly stable over the last two years between 35 and $38.

So in the middle of the big Blockbuster storm, it only moved up to $38.

So the macro look at SAC has been enormously stable.

It's more efficient than down this quarter to do with effectiveness of our program, the weakening competitive environment, continued improving execution in scale.

One of the things that we shared in our analyst day is that if you look in our more developed markets, such as the Bay area.

It's not that SAC has skyrocketed as we've got into deeper penetrations, it's that SAC is actually less.

So as we grow we're getting scale economies and in the Bay area we estimate our SAC between 25 and $35 per subscriber.

In other words, appreciably less than the national average.

So that portends very well for us as we get to those kind of 10% penetration levels across the nation.

Thank you.

Reed just made a great case for why it is that we should be forecasting a lower SAC and we're not, so let me try to at least articulate our thinking so that you won't walk away from the call imagining that we've sandbagged our plan here, which really isn't our intent.

In each of the last two quarters we have expected SAC to come in higher and depart from the trend.

We have spent aggressively and made, what, in retrospect have proven to be relatively conservative assumptions about response rates on some of the spending we have done.

I think from a planning perspective, that's the right approach, because in the alternative, if we fall behind, and we overshoot on SAC, there's no way to meet the plan numbers.

We'll get crushed.

So that's the approach we took the last two quarters.

We're going to continue to take that approach as we begin to bring some new advertising vehicles more heavily into the mix, and until we've got a consistent history that shows we should be more agressive and our assumptions about response rates will continue to be relatively conservative.

The reason that we've changed our approach on the guidance for '06 by way of not giving you a range, just giving you a point estimate below which we will not fall, which I characterize as the bottom of the range, is because our goal is to spend the marketing dollars and we may very well be more productive in terms of yields from a SAC perspective in which case subs will be considerably higher than we have been forecasting, and that's just fine but you should have the comfort of knowing that we'll be in that 50 to $60 million range for income on a pretax basis next year regardless of what happens from a growth perspective.

And, of course, historically that hasn't been the case.

If we overshot on subscriber growth, because we were managing to a SAC number, we have, I'll say, overshot from marketing spending and it came out of the bottom line.

Thank you.

We'll have our next question from Youssef Squali, Jefferies.

Yes, thank you.

Hi, Barry, hi, Reed.

A few questions.

First, I'm just trying to understand why the switch to this fixed market and budget strategy at a time when your competitor is weaker and when you can grow fastest, why has the focus changed to profitability?

Well, we said fixed marketing, not small marketing, so if you look at our report you'll see that we spent about 33 million in marketing up from low 20s in Q2.

So don't interpret as we're backing off at all.

We're pushing the growth lever hard, but we're doing it in a way where we can feel very dependable in terms of delivering our earnings.

Yes.

It's been in a range of -- as a percent of revenue, about 15% on the low side I think, and 24% on the high side in the Q1 time frame when sub growth has really been rocking.

The latest quarter we were 19%.

I think you can expect to see us sitting in the 19 to 20% range.

So we feel like we've put the hammer down on spending and we have taken advantage of all of the scale economies in the business that have contributed to increased profitability.

I think we made this argument last quarter, and invested it in incremental marketing.

So we share the same view that you do, which is that this is an opportune time to pursue growth in the presence of a weakened competitor, and we are.

Will you be playing with promotional discounts or introduce lower prices, say, for instance, $7.99 as a plan?

Well, we may test a number of different things, Youssef, and we'll give you an update if any of them work and that we can be confident of their success.

But -- of course, it would be smart for us to test many different things.

Okay.

Lastly, I guess, Barry, in you guys pushing back the download service, would you still be spending 1 to 2% of your revenues on R&D as you've said before?

Well, if we don't spend it on downloading, we're going to reinvest it in incremental subscriber growth and marketing, provided, of course, that the marginal acquisition cost per subscriber still works within the framework of our economic model, and I think it will.

So if it's not going into downloading we'll reinvest into marketing and we'll drive for faster growth.

Now, one more word about this investment of marketing and faster growth.

Over the long run, I think we will have a more valuable enterprise on a net present value basis.

Since each sub is profitable over their life the sooner we bring in a sub, the more valuable the enterprise is going to be, and the faster we'll drive bigger profits if not in the current quarter then in the next couple of years.

So it's good for the business and I think it's good for investors.

Makes sense.

Thanks a lot.

We'll have our next question from Dennis McAlpine, McAlpine and Associates.

Thank you and good afternoon.

A couple of clarifications.

Could you say what that postage assumption was for next year?

Was it 37 to 39?

Yes, $0.02 each way, Dennis, so the disk goes out and back, so two plus two, $0.04.

Okay.

And then when you talked about the purchasing being down, I think you said 14% or so, did you increase the rev share, and what do you see happening to rev share going forward, particularly as you go into hi-def DVD?

Dennis, there's a slight increase in rev share but it, again, it really just depends on which studios have the hot films of the quarter and are we in the share with them as opposed to any strategic evolution.

And then in terms of high-def DVD, none of that has been worked out.

So it may be more rev share or it may be less rev share and we'll get a chance to talk with the studios about it as their plans firm up around the pricing of hi-def.

And as you know, but perhaps not all of the investors do, the expected time is middle to late next year in terms of the launching of the first movie following on the launch of PlayStation 3, and potentially of HD-DVD, depending on the format for it.

I want to -- I think I heard -- I want to make a correction.

I think I heard Reed say that rev share was up slightly.

Rev share was actually down in the quarter.

So with our content costs across the board, were actually important contributors to increased profitability because of some of the things we're doing from a personalization standpoint on the website.

Can you update us on where you are with the TiVo arrangement given would you are talking about, downloading, does that mean that that's done and over with or is that proceeding, or what's happening there?

Yes, Dennis.

There's no work going on right now.

We love those guys, and we just don't have any content.

So there's not really any point of doing anything at this point.

One last thing.

You were willing to put Wal-Mart out of its misery by taking over its operation.

Would you consider doing the same thing for Blockbuster?

I think there would be potential to significant FTC issues there.

So it's not clear that we would be able to even if we desired to.

So for now it works very well for us because by having them in the market creates a lot of press, we grow the market category, and we've done very well since they've been in.

So it may be in our interest to actually have them stay as a relatively not strong balance sheet and be in the business in a small way.

So we're not particularly eager for anything to change over there.

Very good.

Thank you.

We'll have our next question from Jim Friedland, SG Cowen.

Thanks.

First, a quick question on the tax rate assuming you have to start booking taxes even though they're noncash.

If you exclude the stock-based comp impact should we just use a 40% rate?

And then the second question is on usage.

On a like for like basis have you seen any different usage patterns with the lower price plans and is usage still continuing to sort of be flattish to slightly down on the core three DVD plan?

Thanks.

Jim, with respect to the tax rate I'd use a 42% number.

Overall, usage has come down significantly, not on a normalized basis, which reflects the shift in plan mix.

Historically Q3 has been a heavier period of usage than either Q2 or Q4 on a normalized basis.

And the last thing I'll say about usage, this doesn't answer your question directly, but tells you roughly how we're feeling about the level.

Usage in the quarter was almost exactly, within 100th of a disk where we expected it to be.

And we're liking the current usage levels.

Okay.

That helps.

Thanks.

We'll have our next question from Doug Ernst, Hudson Research.

Good afternoon.

It's actually, Daniel Ernst, but thanks for taking the call.

Two questions if I might.

Could you give us an estimate what you think cash flow is for 2006 based on your assumptions for beginning to pay taxes during the year?

And then, secondly, kind of looking at your guidance for the year in subs and also for your longer term goal of 20 million, if I look back over the last five years or so you've touched 8, 9 million homes already, kept 3.6 million of them.

Are you seeing in your gross homes that you touched, two, three years ago, two, three quarters ago they are coming back and trying the service?

Or are you getting your growth from new subscribers?

Thanks.

Daniel, it's Reed.

I'll take the second part and leave the first part for Barry.

We're seeing the growth all around of people who come back to the service and new people, and so, for example, in the San Francisco Bay area, we've continued to see net adds, so if you're looking at gross adds and then churn and trying to figure out total people touched, but ultimately what drives the P&L is net adds.

So we put a lot of focus on watching trends in that.

And in the Bay area -- well, nationally, we've seen an acceleration in net adds.

I talked about it nearly tripling from a year ago in terms of net adds.

In the Bay area we're still seeing an acceleration of net adds.

And if you think of the S curve of growth in terms of trying to understand at what point will we saturate, we're still on the first half of that S curve where net adds is still accelerating.

Obviously that won't go on forever.

Eventually net adds will stop increasing and we'll continue to grow but at a constant rate.

Like DirecTV, which grows by about 1.5 million a year of net subs over the last ten years.

So again, our net adds are still accelerating, so we still haven't even hit the halfway mark in the S curve of growth and even in the Bay area where we're 11% of households, the net add rate is still growing.

So that's what gives us the confidence in talking about those very large numbers such as 20 million subscribers in the 2010 to 2012 period.

I'll let Barry handle the free cash flow questions.

The question was is there guidance we could give about free cash flow in '06 and what if any would be the impact of taxes.

We don't provide free cash flow guidance for '06.

And the answer to the second part of the question is there will be no impact on free cash flow from taxes.

It's entirely a GAAP accounting issue.

At some point we'll make the determination that it's likely that the business will consume on a go forward basis the roughly $125 million in NOLs that we expect to finish the year with at a 42% tax rate.

That will translate into a -- something like if we booked it up all at one time, a $53 million one-time gain that will get run through the P&L.

Then for accounting purposes we appear to be a fully taxed entity, and so it will affect the GAAP net income number we report, but for as far as the IRS is concerned, we'll continue to consume that $125 million NOL even after the business becomes profitable for tax purposes, and that will happen at a different time than it does for GAAP purposes, primarily because of the treatment that has to do with the stock option expensing.

Okay.

Understood.

But without giving me the cash flow guidance could you give me a range of CapEx for '06?

No, we don't give CapEx guidance, either, sorry.

Okay.

Thanks.

We'll have our next question from Frank Gristina, Avondale Partners.

Thanks.

Just two questions.

I apologize if you answered this one already but the phone was a little choppy.

In terms of utilization did you give a stat as to whether or not it was up or down year-over-year?

Utilization of--?

Disk usage.

Oh, thank you.

Sorry.

Was it -- did you give the stat as to whether or not it changed year-over-year?

It's down year-over-year.

And in the past you've sometimes given a percentage.

Can you give us a ballpark there?

No.

Okay.

Then the other question is, with regards to the cash flow it seems like you had an atypical decrease in accounts payable, and I was just curious what that was?

That's historically risen.

If you could give us some color there.

Yes, we think about the combination of AP and accrued expense and AP was down quite a bit in the current quarter.

It's primarily related to a decrease in content purchasing.

Okay.

Thanks very much.

Sure.

We'll have a follow-up question from Gordon Hodge, Thomas Weisel Partners.

Yes, sorry, but here's one on the whole notion of tipping the stores.

I'm curious if you think you're pretty close to doing so and if so would that cause you to be really aggressive, at least on a short-term basis, I guess to test that hypothesis that you can do it?

And would you then be able to cut prices, for instance, or be aggressive in a particular regional area, would that be the -- kind of the way you would think about a test of the--?

No, Gordon, it's, remember that the stores have five and ten-year leases, so you can't get short-term, let's run aggressive pricing for summer and change the flavor of the market.

So it's really of a long-term trend and what we're seeing in the Bay area, video stores closing and a number of Blockbuster's closing so that's a positive trend for us.

But again, it would play out over five years because as those leases come up they just get non renewed.

They can't get out of the leases.

So that's the real constraint, and meanwhile they're losing money because of low sales in those stores where there's high penetration.

So by continuing to drive our penetration up, we continue to lower their efficiency in the stores and you see that in the earnings about competitors or lack thereof, and I think that would be a continued trend going forward as we grow.

So this isn't a sharp change in tact on your part in terms of tinkering with prices more?

It's more gradual?

That's correct.

Really, the price what we've seen is the elasticity is substantial but we'll only do the price if the elasticity is enough that we end up at the same or better place from an earnings point of view.

Great.

Thank you.

We'll have our next question from Derek Brown, Pacific Growth Equities.

Thank you.

My question kind of relates to the -- how you guys anticipate the mix of subs coming in by the various price plan.

I mean, based on kind of the general framework you guys are giving for '06 it seems like there's quite a bit coming in at the lower end, and I'm wondering if that's by design or by accident or people rotating from current price plans downstream at all?

Well, we're pretty agnostic in terms of the different price plans.

What we do want to do is get subscribers on the plan that makes sense for their profile because then they're more likely to stay with us.

And that's part of why our retention has been improving, churn dropping is we're doing a better job of getting someone who's a very casual movie person to be on the $9.99 program and someone who is a very heavy-duty movie person to be on our $24 four-out program.

So when you match the right program with the person they're much more likely to stay with you for a long time.

And as we've mentioned before, the gross profit dollars, per plan is pretty similar across the plans which allows us to be agnostic.

So we really don't try to, for example, we have a free trial for all of the plans.

If we wanted to steer people we could have our free trial just on one or two of the plans.

What we found is that on balance it works better to let people choose the plan that makes sense for their life, so other than the revenue artifact, if you take it down to the gross profit line you get much more stable.

Great.

Thank you.

Started to say it in a slightly different way, on a revenue per disk basis we really like what we're seeing in the business.

We'll have a follow-up question from Glen Reid, Bear Stearns.

Hi.

Thanks.

Just again real quick on the tax issues, just so I'm clear.

So there is no cash tax impact, it's really a GAAP tax, and we should be modeling 42% starting when?

Yes, I think 42% is as good an assumption as any other, and yes, it is not a tax issue, it's a bookkeeping issue for GAAP purposes.

The timing is uncertain.

I think the bid and the ask is somewhere between the fourth quarter of this year, which I think is probably unlikely, but within the realm of possibility, and then the outer limits I would say the third quarter of next year, assuming that we're operating the bottom line along the lines of our forecast.

Okay.

So it's about us developing and conveying to our auditors and us collectively reaching the conclusion that there's more than a reasonable likelihood that we will be able to utilize in future periods the NOLs that we've accumulated.

Okay.

And then one other question, just back to the marketing issue.

Have you guys sort of found any particular marketing, whether it's TV, Internet that's become more effective, less effective, and how do you think you'll sort of proceed with your marketing strategy based on what you've seen in terms of effectiveness?

Well, we're getting better and better as we get bigger in terms of our on-line buying, in terms of our TV buying, print, radio, direct mail, all of the vehicles that we use, and any channel can work depending on its price.

So by having multiple channels we're able to be a very diversified mix, so if pricing drops in one area, we'll tend to pour a little more money into it.

If pricing rises in another area we'll shift money out of it.

And in that way we have a very flexible and diversified platform for our acquisition spending.

Okay.

Thanks.

And we will eel have our final question from Youssef Squali with Jefferies.

Actually, my question has been answered.

So thanks a lot.

Great.

Well, thank you to everybody on the call.

And look forward to talking with you in another quarter.

That does conclude today's conference call.

You may disconnect at this time.

We do appreciate your participation.