Netflix Inc (NFLX) 2006 Q1 法說會逐字稿

Good day, everyone, and welcome to the Netflix first-quarter 2006 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 Deborah Crawford, Director of Investor Relations.

Thank you and good afternoon.

Welcome to Netflix first-quarter 2006 earnings call.

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

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

The earnings release, which includes a reconciliation of all non-GAAP financial measures to GAAP in 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 PM Pacific time today.

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

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

A detailed discussion of such risks and uncertainties is contained in our filing with the Securities and Exchange Commission including our annual report on Form 10-K filed with the Commission on March 16, 2006.

Now over to Reed.

Thank you, Deborah, and welcome, everyone.

At Netflix, our overarching objectives are to extend and accelerate our subscriber growth momentum while meeting our quarterly and annual profit goals by continuing to deliver an extraordinary customer experience.

I'm pleased to report that the first quarter of 2006 represented another strong step forward in the pursuit of these objectives with excellent performance in all of the key measures of our business.

We generated $4.4 million of GAAP net income, the first time in our history that we have delivered a profit in the high-growth first quarter.

We grew our subscriber growth base from 4.18 million to 4.86 million, an all-time record increase of nearly 700,000 net new subscribers in a single quarter.

Our customer satisfaction was outstanding and we have the lowest Q1 churn in our history.

This performance together with developments in the broader marketplace has strengthened our confidence in achieving our goal of 20 million subscribers in the 2010 to 2012 timeframe and 50% annual earnings growth for the next three to four years starting with $30 million to $35 million of GAAP net income we intend to deliver this year.

Let's talk about the most significant aspects of our strong Q1 performance.

First we continued our outstanding customer satisfaction levels in Q1.

We were number one in customer sat across all of e-commerce as measured by independent consumer studies not commissioned by Netflix and it shows, as we have the lowest Q1 churn in our history.

The first quarter tends to run seasonally higher in churn than other quarters because of the post-holiday surge in free trial subscribers, which is included as always in our churn calculation.

A year ago we saw 5.0% churn.

This year we were down to 4.1%, a year-over-year reduction of almost 20% and our second lowest level in history.

Our shipment speed and our new release availability are at amazing levels and it shows in our following churn.

We expect to see churn continue to fall this year as we improve our service even more as our large and growing subscriber base continues to mature and as our lower-cost, lower churn plan continued to be popular.

Second, in Q1 we were able to invest $53 million in marketing, up from $37 million a year ago and yet generate $4 million plus in GAAP net income, compared to a loss of $9 million one year ago.

In other words our scale now allows us to ramp up our subscriber acquisition engine and also generate profit.

Our only regret in the quarter is that we did not spend $2 million more in marketing delivering even higher subscriber growth and have our earnings come within rather than above our guidance range.

Recall that with our strong subscriber lifetime value well in excess of our SAC that each incremental subscriber acquired now represents both more profits in the future and more subscribers in the future from word-of-mouth, thus the high strategic priority we put on growth within the context of meeting our profit guidance.

Third, our marketing investment remained efficient and productive.

Each quarter we spend as much on marketing as we can afford and whether our subscriber acquisition cost is $35 or $45 has only marginal effect given the strong lifetime value of a Netflix subscriber.

The efficiency of our marketing investment is partially due to our marketing expertise and partially due to our high customer satisfaction generating word-of-mouth subscribers.

We generated nearly 700,000 net additions in a single quarter, an all-time record for Netflix and the second consecutive quarter of record subscriber additions.

For the calendar year, we are now on track for 2.1 million net adds, taking us from 4.2 million to 6.3 million.

For purposes of comparison, in 2004 we had 1.1 million net adds.

In 2005 we accelerated to 1.6 million and this year as I said we expect to have 2.1 million net additions.

Interestingly in our most penetrated markets our SAC is lower and our rate of net addition continues to climb.

For example, as the San Francisco Bay area reached 13% household penetration in Q1, we generated more net adds there than ever before.

What we are observing is that through strong word-of-mouth, high penetration levels in a market generate even higher penetration in that market.

In fact in several high digital communities such as Menlo Park, California, we are now running at 22% household penetration and we see no signs of saturation even at those high penetration levels.

And these high penetration communities are not limited to California.

Jamaica Plain in Boston is ringing in at over 19% of households subscribing to Netflix and climbing every quarter.

Moreover the rest of the country is following the adoption trajectory of these leading communities quite nicely.

We are reaching subscriber milestones much more quickly than anyone expected, ourselves included.

In 2002 with less than 1 million subscribers we hit the goal of reaching 5 million subs in 27 to 29.

We will cross the 5 million threshold this quarter, one to three years earlier than we forecast in 2002.

We are now focused on our path to 20 million subscribers in 2010 to 2012.

Now let's talk about the broader industry and competition.

To begin, we see a slow down likely in DVD sales this year as avid buyers become more aware of the onset of high-definition DVD but do not yet own a high def DVD player.

We have seen this phenomenon in the video game market, where transitions to a new generation hardware platform caused a 10% to 25% drop in software sales for the year preceding the launch of a new platform.

Fortunately DVD rental is unlikely in our opinion to be affected by the tick up in DVD collecting.

In the long-term, we believe the success of high-definition DVD will grow studio DVD revenue and the film market generally as well as reconfirm the consumer’s love of the DVD format, and so we will do everything we can to help high-definition succeed.

In Q2, both HD-DVD and Blu-ray are soft launching in preparation for a larger retail push in Q4.

We believe Microsoft sees studio support of HD-DVD as very important to their game format battle with Sony.

We also believe that Xbox and Vista will support HD-DVD more directly with every one of their product updates.

Therefore since neither Sony nor Microsoft will concede nor win in this format war for at least several years, there will be a protracted competition which will hurt the adoption of high-definition DVD despite everyone's best intentions to avoid a format war.

There is however a practical solution.

If all studios were to embrace both formats agnostically, consumers would be reasonably comfortable buying either format and presumably making their purchase decisions based on hardware price and features.

Studios have supported VHS and DVD for years, so supporting two formats is not something new.

While two formats is not ideal, it is better than consumers delaying adoption of all high-definition formats while we wait for either Sony or Microsoft and Toshiba to blink.

As we previously announced, Netflix will carry both high-definition formats as titles are released and high-definition access is free to Netflix subscribers for now.

And last week we started mailing high-definition DVDs to our early subscribers.

High-definition DVD is here today.

It is our hope that the studios will consider support for both high def formats and therefore make consumer adoption of either format safe.

Warner Bros. and Paramount have already started the movement towards agnostic support of both high def formats.

Also on the studio front, Q1 saw the emergence of a new competitor to DVD sales, namely download to own offered in the DVD window.

This recent relaunch of the movie link service is very nicely implemented technologically.

The new release pricing is generally $20 to $25 and does not include DVD burn rights.

We believe this demonstrates the importance the studios attach to maintaining or increasing DVD sales price points and the unlikelihood that the movie equivalent of the $0.99 song download will be offered in the next few years by the studios.

The most visible downloading service today is Movie Link, owned by the major movie studios.

If you look at its web traffic over the past two years, you can see it has remained fairly flat.

While the next big wave is going to be high-definition DVD, someday Internet delivery will be important and we are continuing to invest in our technology.

We talked on the last call and in subsequent investor presentations about the Internet and content challenges that prevent large near-term movie downloading adoption.

We will not repeat them here, but we do believe we're making significant progress in our download efforts.

By the end of this year, we will communicate a clear timeframe for launching the additional option of the Internet delivery for Netflix subscribers.

Finally on the competitive front, in Q1 Blockbuster stepped up advertising for their online service and we estimate they added 200,000 net subscribers from 1.2 million to 1.4 million.

This compares as I mentioned earlier to our nearly 700,000 net adds in the quarter and means that nearly 900,000 households in total moved from store renting to online rentals in the quarter.

Our primary focus remains as before enhancing our superior service and continuing to outdistance our online competitor in terms of net additions.

The fact is however that our biggest competition remains local video stores and the fundamentals in that market continue to weaken.

As video stores close, more and more consumers go online for their movie rentals and our available market grows and the store based economic model weakens, leaving us closer to the tipping point when the video store chains begin mass closures.

In conclusion and for all the reasons I have outlined, we are measurably more confident than we have ever been in our ability to deliver $30 million to $35 million in GAAP net income this year and 50% earnings growth for many years ahead.

Thank you for listening and at this point I will turn the call over to Barry.

Thank you, Reed, and good afternoon everyone.

We continue to see strong momentum in our business, as we did last quarter and the quarter before that and the quarter before that.

Once again we exceeded our subscriber goals and profit expectations and for the second time this year, we raised our year-end subscriber guidance to reflect the acceleration we see in our business.

Last quarter I told you that we believe our ability to lead the future of digital downloading begins with our ability to grow a large and profitable DVD subscription business even larger.

In the first quarter, we continued to make strong progress toward our long-term goals of reaching 20 million subscribers by 2010 to 2012 and growing GAAP net income by 50% year-over-year off a base of $30 million to the $35 million in 2006.

By way of reminder, this is a fully taxed number.

My remarks today will focus on four areas.

First I'll discuss the quarter's performance.

Next I will discuss the accounting changes we made in our financial statements with the filing of our Form 10-K and the impact of these changes on the current quarter.

Then I'll talk about our upwardly revised subscriber and revenue guidance for the full year of 2006.

And finally, I will conclude my remarks by talking about our price testing and patent infringement lawsuit against Blockbuster.

At our analyst day last September I showed a slide labeled "scale drives profitability" and I made the point that the business is scaling and margins are expanding with scale.

Our Q1 results illustrate that trend.

In particular there are four aspect of our business I would like to highlight in talking about our Q1 performance.

Net income, subscriber acquisition costs, which I will refer to as SAC for the balance of my remarks today, gross margin and free cash flow.

Let's take them one at a time.

First net income.

For the first time in our history, Netflix was profitable in the first quarter of the fiscal year.

GAAP net income of $4.4 million exceeded the high end of our earnings guidance, which ranged from a loss of $1.5 million to a profit of $2.5 million.

Historically and again this year, subscribers grew rapidly in Q1.

In past years this rapid growth was accompanied by an increase in marketing spending.

In prior years the increased marketing spending contributed to a net loss in the quarter.

That was not the case this year.

We realized the benefits of scale and produced a profit despite the increase in marketing spending.

With perfect forecasting and execution, we would have landed earnings within the range of our guidance and invested all of the surplus earnings in more marketing and faster subscriber growth.

But our expense forecasting was not precise enough to better manage the trade-offs between subscriber growth and profit and we overshot our earnings target by about $2 million at the expense of faster subscriber growth.

Lower SAC also contributed to the quarter's outperformance.

Despite the fact that growth subscriber additions reached an all-time high in Q1, our second consecutive quarter of record gross additions, SAC was down this quarter.

I think it is worth noting that increased marketing spending by Blockbuster online had no apparent effect on our ability to beat the Q1 growth and profit objectives we established for Netflix.

On the Q4 earnings call, I told you we would maintain SAC at about $40 in order to drive rapid subscriber growth as long as profit margins and churn remained healthy.

We began the quarter expecting to see SAC at Q4 levels, but our marketing acquisition programs across multiple acquisition channels were more productive than we forecasted them to be.

We expect SAC to return to Q4 levels this quarter and remain there plus or minus 10% for the second half of the year, depending partially on how aggressively we can invest and still meet our earnings guidance.

Now let's discuss gross margin.

In January I told you we expected gross margin to decline in Q1 as we absorbed the cost of a postal rate increase and a seasonal increase in disk usage.

The postal increase became effective in January and margins declined as we predicted.

Usage also increased seasonally as we expected and was the principal contributor to the decline in gross margin from Q4 levels.

Last year, gross margin improved during the calendar year.

We expect this secular trend to continue this year.

As some of you know, we changed the way we define gross margin with the filing of last year's Form 10-K.

I will talk more about this change in a moment.

The final point I want to make about last quarter's performance relates to free cash flow.

Free cash flow of $11.7 million was significantly higher than we expected, as it was in Q4.

Last quarter I told you we expected free cash flow to turn negative in Q1 before turning positive again for the remainder of the year.

There were two primary contributing factors to the quarter's strong cash flow performance.

First we had higher revenues and higher profit than was forecasted; and second and more importantly, certain DVD purchases and marketing spending came later in the quarter than we anticipated, which grew our payables and raised our free cash flow this quarter.

That late Q1 spending will hit cash flow in Q2, so the net effect across both quarters will be a wash.

The overall level of content purchasing in Q1 was about 20% of revenue in line with expectations and was not a contributing factor to the stronger than expected free cash flow in the quarter.

Now I would like to briefly review the accounting changes we made in our 10-K filing in March and their effect on our Q1 results.

We made two changes in the presentations of our financials in the 10-K filing, which you see reflected in the results we reported today.

First, we reclassified fulfillment expense in the cost of revenues.

Gross margin declined as a result of this change, but the underlying economics of the business were unchanged.

Second, we moved revenues from the sale of previously viewed content out of total revenues and the cost of content out of cost of revenues and presented them on a net basis with other operating expenses.

This change produced reported revenues in Q1 by about $2.5 million.

Without this change, we would have reported revenue of $226.6 million and beaten the high-end of our revenue guidance for the quarter.

The guidance was issued before we made the accounting change and we made these changes at the suggestion of the SEC.

Now I would like to comment on our 2006 full-year guidance.

As I mentioned in my opening remarks, we continue to see strong momentum in the business today and expect strong performance in Q2 and for the remainder of the year.

This momentum is reflected in the 400,000 increase in the low end of our subscriber forecast to 6.3 million subscribers and in the $30 million increase in the low end of our revenue guidance to $990 million.

However, we did not raise our earnings guidance even though we've beaten the high-end in each of the last two quarters.

To explain why earnings guidance did not increase, let's remember what we said last quarter and earlier in my comments today.

If we are running ahead of our full year's earnings guidance, we intend to invest in higher marketing spending to drive faster subscriber growth.

That is because as we have said consistently for some time now, we are focused on growing as fast as we can within the parameters of our earnings objectives in order to reach 20 million subscribers and position the Company to lead the expansion into digital downloading.

We would raise our full-year guidance for earnings only in the unlikely event we could not deploy the excess earnings at a marginal SAC that worked within the constraints of our economic model.

You saw us make these trade-offs between earnings and growth in today's guidance increase.

Before upwardly revising our subscriber guidance today, our forecast models had pretax earnings were running ahead of our $50 million to $60 million pretax guidance for the full year 2006.

Today's revised guidance redeploys those additional earnings to grow the business faster by acquiring additional subscribers, which increases the value of our business by accelerating future profitability.

In closing, I would like to say a final word about price testing and the patent infringement lawsuit we recently filed against Blockbuster.

On the subject of price testing, we continue to test various pricing scenarios, in search of models that generate more subscribers on the same 50% annual earnings growth that we see today.

Because price testing isn't visible on our website, questions about our pricing strategy have been top of mind for investors.

We continue to monitor our test results and have made no decisions yet about new price points and plans.

Today's upward revision in guidance assumes no change in pricing and no new plan introductions.

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As I said last quarter if the test results convince us we can introduce new plans which enable us to grow faster and still meet our earnings guidance, we will launch those new plans and upwardly revise our subscriber guidance while we reaffirm our earnings guidance.

A few weeks ago the U.S.

Patent Office issued Netflix an additional patent and that day we filed suit against Blockbuster.

The estimated cost of prosecuting this lawsuit are included in our guidance.

The new patent is a continuation of the business method patent that was issued in June 2003.

These patents among other things, cover our subscription rental service.

Suits like this typically take several years to litigate but the value can be significant if we prevail.

Of course Blockbuster says the suit is without merit and of course we think Netflix has a strong case, the cost of which represents a small, prudent, high leverage investment on our part.

Having said that, we remain focused on enhancing our superior service and continuing to outdistance our competitors in terms of subscriber growth.

In summary, Q1 was another quarter of record results for Netflix.

Our second consecutive quarter of record subscriber growth and record revenue; our second lowest churn ever; record high Q1 earnings; and record high Q1 free cash flow.

Last year our business outperformed our expectations and we raised guidance a total of four times.

So far this year we have raised our subscriber and revenue guidance twice to reflect the acceleration we see in our business, which is why I began my remarks today by saying we continue to see strong momentum and expect strong performance in Q2 and for the remainder of the year.

That concludes my prepared remarks and now we'll open the phones to questions.

(OPERATOR INSTRUCTIONS) Gordon Hodge, Thomas Weisel Partners.

It's Lloyd in for Gordon.

I was just wondering if you could comment a little bit on the mix of the $17.99 subs versus the lower-priced subs and talk a little bit about the usage trends you're seeing in those two different subscriber sets?

It's Reed, Lloyd.

We don't break out the different plans, so we are successful in matching subscribers to the plan that makes sense for them and usage has been on plan and as we expected in both of those categories.

Okay, thank you.

Derek Brown, Pacific Growth Equities.

I've got a question about content acquisition and the strategy around that.

Certainly have been a little more news related to you guys getting into the exclusive content business and I am wondering your thoughts on that and your expectations for that going forward?

Sure.

It's Reed.

They are fairly modest at this point.

We have got a team that is working on it.

We have been acquiring some small titles over the past couple of years but it is fairly modest today, has the potential to grow into something interesting as we grow from 5 million subscribers to 20 million.

And that is why we're investing in the confidence, getting her hands around it at a small scale today because of its potential value when we have a 20 million subscriber platform.

Great, thank you.

Heath Terry, Credit Suisse First Boston.

You mentioned that you felt like Blockbuster had added a couple hundred thousand subscribers this quarter.

Can you also comment, you guys always seem to have a pretty good view into what's going on there as to how many more subscribers you feel like they need before they hit breakeven in that business or how close to that they are and if you could also -- go-ahead, sorry.

Sorry, they've got a call coming up in a couple of days and I think that question is better posed to them.

Okay, great.

Then if you could also talk to us a little bit on what you expect to the extent that there is any what you expect seasonality to look like over the next couple of quarters both in regards to the subscriber acquisition costs that you gave or subscriber acquisition costs that you gave as well as they churn side of things.

I tell you what, roughly like last year I don't see anything that is likely to be materially different.

So Q1 tends to be the largest in total subs because of all the new subs, the highest in churn.

And so it should roughly follow last year's pattern.

Okay, great.

Thanks.

Glen Reid, Bear Stearns.

Just real quick, you talked about, Barry, I guess the subscriber acquisition costs in the quarter dropped down like $38.50 roughly and I guess you had mentioned that you'd gotten better response from some of your marketing initiatives.

Maybe you could kind of detail for us or a little bit more color on what sort of marketing channels you maybe try to exploit more this quarter and which ones you maybe found were more successful than others?

Just kind of maybe help us out with what was going on there?

Thanks.

We are actually using all channels all the time with no particular emphasis on any one.

The marketing budget has become quite large, so there was no particular emphasis on any one channel.

I don't have any particular color for you and on a go-forward basis; we expect to utilize all of the channels fully.

Okay.

I guess maybe anecdotally I'd been hearing and had seen towards the end of the quarter a bit more advertising on television.

Would it be fair to say that you guys watch the spot markets and depending on how your subs are trending will sort of be a little bit more tactical and try to exploit some of those opportunities?

It has less to do with how subs are tracking than it has to do with the cost of the acquisition and opportunities that Leslie and her team are seeing in the marketplace.

Yes, it is true if we see opportunities and we have money to spend, we will go spend it and if there are not opportunities, we won't.

That is true not only amongst TV as you're referring to but between TV, direct-mail, radio, online, wherever we see a bargain that our marketing team tends to push money in that direction.

Okay, then I guess one last thing.

You had said the subscriber acquisition costs will sort of get back to that fourth-quarter level of about $40 plus or minus 10%, so that is pretty consistent over the balance of the year, you expect call it $40, $42 SAC?

We don't guide specifically to SAC and whether we land at $38 or $42 is not a matter of great concern to us as we plan out the business.

The reason -- we had articulated the reason clearly which is to say that whether it is $38 or $42 has got almost next to nothing to do with the lifetime value of its subscriber.

It informs us a lot about our ability to make the earnings guidance we've given, that we care about the absolute level of spending, but less about the marginal cost.

Got you, thanks.

Provided that it works within the microeconomic model that we have set up.

Sure.

Okay, thank you.

Safa Rashtchy, Piper Jaffray.

Great quarter.

A couple of questions.

As you mentioned, Reed or Barry, you mentioned you're still testing prices.

Can you give us some qualitative color on what you're finding out?

Are people still continuing to demand lower and lower prices?

Is there some stability in the price levels?

What can we learn from the experiments you have had on pricing?

It seems like you left the door open for further price reductions.

Then I have a follow-up.

Sure, it's Reed.

We are continuing to test -- you characterized it as what consumers are demanding, but it is not really that dynamic.

We have the best value in the market already.

What we are finding is that when we push price down that we see an elastic response of more subscribers and lower churn and the question is does it pay for itself?

So in direction, it is very positive and the question is as we balance out those factors, do we find any models that generate the same earnings stream that we're looking at today with more subscribers, in which case we would tend to adopt that.

It may be through all the testing that we conclude that the current family of price points is the optimal family of price points.

And we wouldn't normally talk about this in advance except that price testing is so visible and so sensitive with investors and we want everyone to know what we're doing.

But again it may be that we conclude we've got the optimal portfolio now.

It may be that we find one where we are able to keep our earnings guidance and upwardly revise our subscriber guidance.

Okay.

Second can you comment on what you're seeing in terms of margins from the lower-based price brackets?

In the past you had said that somewhat surprisingly at least to some people those actually had high margins because of the lower usage.

I understand seasonally this quarter is different but still within different price points you have a way of comparing them.

Are you still seeing that dynamic or are margins not better anymore with the lower price points?

We still like what we're seeing, Safa, and you can see that in the increased momentum in the business.

Okay, one last question then.

Can you give us an update on your plans for the national expansion especially in the UK?

In the UK, as you might have heard, is the two venture backed independent private firms that lead DVD rentals that is LOVEFiLM and Video Island agreed to merge, so that will happen.

They will have about 65%, 70% of the UK market and we do not have any near-term plans in international.

But the U.S. market is just so large and growing so fast that we're focused here for now.

Okay, great.

Thanks.

Tony Wible, Citigroup.

Quick question is how much of the optimism in your guidance is relating to improving rental industry trends that we're just starting to now see over the past seven weeks and what looks to be like a strong box office over the summer?

None.

None.

So presumably there would be upside from their taking into account the 10% swing in rental industry?

No, our business isn't very hits driven and I think it is much less dependent on box office than the store based models because it is so much less dependent on new release.

We are about helping people find good movies which is not the same as helping people find new release movies.

And the mix of new and back catalog is practically unchanged today from the mix when we went public in May 2002.

What is the percentage from new release?

About one-third of movies are new releases and it has been pretty consistent the last four or five years.

And a proved point to Barry's point is last year when other video chains were saying that their sales were off because the movie or the rental industry etc., we upwardly revised our subscriber guidance.

So it shows you that we are unaffected on the downside, which presumably means we are unaffected on the upside in terms of these swings of theatrical releases.

Great.

One last question is on the gross margin.

Not I guess under the new method with fulfillment costs included but just looking at the content costs, is there a way to kind of pinpoint what you would say is the long-term potential for that margin if we just kind of looked at some of the traditional in-store businesses?

You've had kind of a 70% gross margin.

What would you say has been a long-term view on where the margin is going to head from here?

I would not say.

We have not given a long-term guidance on it and we don't have a comment on it.

Okay, thank you.

Youssef Squali, Jefferies & Company.

This is (indiscernible) for Youssef Squali.

Great quarter.

Just a quick question on the free subs as a percentage of the trial subs, why are they declining sequentially?

Is it because the commercial paper was higher or free subscribers was just less this quarter?

I think it is a seasonal artifact.

At the end of the first quarter -- sorry, end of the fourth quarter there are quite a few subs who sign up in the post-holiday rush and those subscribers tend to roll off in the first couple of weeks of the first quarter.

I see.

And then a follow-up on the [access] program.

How is that progressing?

Can you add any color on that?

Good.

We've been actively selling ads on mailers for some time.

That business is progressing well and we have been testing putting ads online on a targeted basis and those tests are progressing well.

So we are quite pleased.

Thank you.

Daniel Ernst, Hudson Square Research.

Just looking again at the guidance, this quarter you underspent on marketing yet overdelivered on sub growth, so presumably your ad spending was more effective than you anticipated.

But yet you are raising your sub target but not the earnings target.

Are you assuming the effectiveness of your ad spending is reduced in the coming quarters or is it just a degree of conservatism that the [color for your guidance here]?

Thanks.

In the first quarter we actually increased during the quarter our marketing spending as compared with our plan at the beginning of the quarter and we increased again in Q2 slightly our marketing spending during the quarter.

So it is true that on a per acquired subscriber basis, the cost was down a little bit, but in absolute dollars the marketing spending is up, enabled by the overall profitability of the business.

Right, but if you do the math on that, you still had a slightly lower SAC or SAC roughly in line.

So if we continue that trend I guess I just have trouble coming to an EBIT level as low as you suggest given the sub growth and given the relatively nominal declines you have seen in ARPU.

Given your current economic model and the topline numbers and what we know about your effectiveness in ad spending it just sort of seems hard to come to those numbers.

Again I think you didn't actually give us the answer we want to hear but if you could help us understand the guidance a little better relative to how effective you have been in the last couple of quarters?

Let's see, we have increased our marketing spending going forward as compared with our plans at the beginning of the year.

As in past quarters we have a fairly conservative assumption about the rate at which we're going to acquire subs, meaning SAC.

If that rate proves to be even enormously conservative, then earnings will run ahead of our forecast or as the year unfolds, we will recapture those earnings and reinvest them at more marketing dollars and drive the subs growth even faster.

And with perfect execution, that would be our preferred outcome.

Okay, thanks a lot.

Doug Anmuth, Lehman Brothers.

Reed, I just wanted to clarify the comment you made about the fact that you'd communicate the product on the digital side by the end of the year.

I'm just curious if that is more a function why the timing is sort of at the end of the year?

Is that more a function of what's happening in the market?

Is there anything in particular from a competitive standpoint that is sort of forcing that type of timeframe?

Or is it more just a product development thing from your end?

Thank you.

It is mostly product development on our end as opposed to anything external.

It is still going to be many years until this is a large market, but by the end of the year we will be able to announce the timeframes of our subscribers being able to get downloaded content from Netflix.

Okay, thank you.

Jim Friedland, Cowen & Co.

Most of my questions have been answered, so just a quick question on drilldown on usage.

So, Reed, in terms of the three DVD products you've noted in the past that the usage trends have been improving.

So on a like-for-like basis, your three DVD customers in Q1 versus your three DVD customers in Q1 of last year -- flat, up, or down?

Can you give us any additional color?

Jim, it's Barry.

Down slightly.

Okay, and then one other quick question on the tax rate.

Are you still targeting an effective rate of 41%?

Yes, roughly.

It could be 42, could be 41.

Okay, great.

Thanks.

That concludes today's question-and-answer session.

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

Thank you operator, and thanks to all of you for participating on the call.

I look forward to talking to you over the quarter.

That does conclude today's conference.

Thank you for your participation.

You may disconnect at this time.