Netflix Inc (NFLX) 2007 Q1 法說會逐字稿

Good day and welcome to the Netflix first quarter 2007 earnings conference call.

Today's call is being recorded.

At this time for opening remarks and introductions, I'd like to turn the call over to Ms.

Deborah Crawford, Director of Investor Relations.

Please go ahead, Ma'am.

Thank you and good morning.

Welcome to Netflix first quarter 2007 earnings call.

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

We released earnings for the first quarter at approximately 5 AM 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 6:30 AM Pacific time today.

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

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

A detailed discussion of such risks and uncertainties is contained in our filings with the Securities and Exchange Commission including our annual report on Form 10-K filed with the Commission on February 28, 2007.

And now I'd like to turn the call over to Reed.

Thank you, Deborah, and welcome, everyone.

I will start with issues that are on everyone's mind.

Our performance in the first quarter, our growth and earnings projections for the balance of the year and the change in our competitive climate.

Then I will provide you an update on our success in online video.

In Q1 we added approximately 500,000 net subscribers growing from 6.3 million to 6.8 million subscribers; and we delivered $0.14 of EPS.

Both were within the guidance ranges we outlined in January but in the lower half of those ranges.

Our earnings were our highest-ever Q1 earnings and more than double Q1 a year ago.

Our churn was pretty much as we expected in Q1 and our incremental losses from Q4 were only five people in 1000 per month.

Mostly the battle is for new subscribers.

Clearly the big change from last year is the emergence of Blockbuster as an aggressive online player enjoying strong subscriber growth.

The key for them has been their new online program induced in Q4 where for every online rental they allow one free store-based rental.

For subscribers who live near a Blockbuster store this can be twice as many DVD rentals as online only, creating significant operating margin pressures for Blockbuster as their online business grows.

Obviously when you quite literally give away the store you are going to see both share growth and market growth.

Blockbuster's share of gross additions has rapidly grown to slightly over half of online DVD rentals; and the overall online business has exploded from about 6 million subscribers one year ago today to approximately 10 million subscribers today.

Our thesis, that online DVD rental would become very large, appears more and more credible.

Our thesis that most subscribers would choose Netflix seems more open to question.

At least for now.

If we thought the proposition of giving away one free store rental for every online rental while maintaining price parity was an economically viable proposition, we would be concerned about our long-term leadership and would take appropriate steps.

But we're confident Blockbuster's online offering is not economically viable at current prices.

What makes us confident in this view of Blockbuster's economics is that, for the last nine years, we have been working to make our operations more efficient and our costs lower.

In Q1 with nearly 7 million subscribers and over $300 million in quarterly revenue our operating margin was only 4%.

From everything we can observe, Blockbuster is materially less efficient than we are and then you add in a free store rental for every online rental and, well, you are looking at some serious operating losses.

So to us it is not a question if Blockbuster will raise their online prices but only when and how muchl and when they do, it will reset the competitive calculus as well as increase their profit.

If online is going to be as big as we think, then there should be room for two profitable firms.

Despite the likelihood of a Blockbuster price hike at some point we of course have no sense of when or how large it might be.

So in updating guidance for the year we have to assume there is no price hike this year.

Given that, we are maintaining our EPS guidance for approximately $0.80 for the year and cutting our ending subscriber guidance to $7.3 million to $7.8 million.

If there is a positive change in the pricing environment, we would expect to upwardly revise our subscriber guidance after that.

Giving -- growing our earnings steadily and letting our marketing investment float is a strategy we first outlined two years ago and continue to use today.

Our marketing spend will still be aggressive, nearly 20% of revenue and larger than last year.

In the past, we have talked about 50% annual earnings growth and 20 million Netflix subscribers by 2012.

To state the obvious, if Blockbuster stays on the tolerate losses for growth model long enough, these earnings growth and subscriber goals would become unattainable.

We will have to see how the year plays out before we can offer any thoughtful update on these goals.

In the meantime, we are charging forward in our competitive differentiation as the world's best online rental service.

We are continuing to improve our service levels and reduce our cost.

Our website and, in particular, our movie recommendations have continued to improve and are getting even more usage by our subscribers.

We offer an amazing 75,000 unique DVD titles for rent and now we offer all subscribers online video included free in their subscription.

Turning to the terrific progress we've made in Q1 on our online video efforts, we had thought it would take us six months to get online video fully rolled out to our nearly seven million members but we completed the rollout in less than three months.

Since launch approximately 90 days ago we have increased the number of TV shows and movies from 1000 to over 2000 and we think we can be at 5000 by year-end.

The response to our offering has been very positive with the New York Times calling it "deliciously immediate", "incredibly economical" and because it introduces movie surfing impressively "convention shattering".

The consumer response has been even more positive and just during our rollout phase, we have delivered over one million movie and TV show streams to our members.

Of course the big opportunity for Netflix online video arrives when we can deliver content to the television without requiring a laptop or media center PC as an intermediary device.

We are working hard with various partners to make this a reality in 2008.

To remind everyone, we see three likely segments in online video emerging.

One is advertising supported free content of which YouTube is the leader today and this segments is akin to free ad-supported television.

The second segment is download digital file ownership in which Apple is the leader today and this segment is akin to $15 DVD ownership.

The third segment is online subscription viewing, which is akin to video rental and pay television.

This is the online segment we are leading.

As big and important as online is for movies, for at least the next ten years we think that a hybrid DVD online subscription service will be the winning offering.

We have, for example, 75,000 titles on DVD and it may take a full decade for all of those to get cleared for online.

Plus there is the window issue where DVD gets great advantages, which is another reason we think a hybrid service is critical for at least the next ten years.

We intend to continue to be the leading subscription service and hybrid DVD online is our key advantage.

In summary, building a great business requires a strong team, endurance and good strategy.

We have those three and we remain focused on building a growing profitable business.

Now I'll turn the call over to Barry.

Thank you, Reed, and good morning, everyone.

I would like to begin today with several comments about our Q1 performance.

And then I will talk about our guidance for Q2 and our revised guidance for the remainder of the year and, lastly, I'm going to discuss the stock by that program we announced today after which we will open the phones to questions.

Operating results for Q1 were somewhat mixed.

(inaudible) subscribers of 6.8 million grew 40% year-over-year which was strong but not as strong as we were projecting at the start of the quarter.

GAAP net income grew 124% and was the largest Q1 profit in our history, but was not as large as we were projecting at the start of the quarter.

For the first time in our 20 quarters of reporting as a public company, we announced quarterly results in the low end of our guidance range for subscribers, revenue, net income and EPS.

Our goal is to land at the midpoint of guidance.

That has been true since we took the Company public in 2002.

Given our track record of performance versus guidance Q1 results were disappointing to us.

As I mentioned a moment ago, we ended the first quarter with nearly 6.8 million subscribers.

Subscriber growth was limited by the effectiveness of Blockbuster's Total Access program.

That subscriber growth is driven by gross subscriber additions and churn.

Our gross subscriber additions were up 10% year-over-year, about 150,000 less than we forecast at beginning of the quarter and about 400,000 less than 1.9 million gross subscriber additions we estimate Blockbuster added with their Total Access program.

As Reed mentioned, we believe Blockbuster is growing quickly because Total Access is very aggressively priced.

That pricing strategy is driving rapid growth in their share of the online rental business.

We heard a lot about Blockbuster's sub growth on their Q4 earnings call but not much about the cost of operating the Total Access program.

I expect they will start talking about those costs on their Q1 call and I expect those costs will imply that the larger Blockbuster's online business grows the more money they will lose at current price points.

We believe Blockbuster will have to raise prices to sustain the total access program.

That belief informs our own competitive strategy and the trade-offs we are willing to make between growth and earnings.

In the last six months, you have heard me say that if forced to choose between earnings and subscriber growth, we would choose earnings.

You see those choices reflected in our revised full year guidance, which I will talk more about in a moment.

Churn was about in line with our expectations in the quarter.

On last quarters call we said we expected a 60 basis point increase in churn in response to Blockbuster's total access pricing.

At 4.4% in Q1, churn was 10 basis points better than we expected.

In the current competitive environment, we expect churn to remain elevated on a year-over-year basis for the remainder of the year.

As we mentioned in last quarter's call, we expect that gap to narrow through the remainder of the year.

Q1 net income of $9.9 million fell below the midpoint of guidance for two principal reasons.

Revenue were shy of expectations and content expenses were somewhat higher than expected for the quarter.

The revenue shortfall was related in equal parts to subscriber growth and lower-than-expected ASP.

In terms of key metrics, gross margin of 36.1% was 230 basis points higher than it was a year ago, reflecting a 4% year-over-year growth in revenue per paid disk shipment.

This growth in revenue per paid disk shipment is tied to the popularity of our lower priced plans.

On a quarter-over-quarter basis, gross margin declined as expected by 280 basis points due to a seasonal increase in DVD usage in Q1.

Content cost for Internet delivered video were also expensed to cost of revenue in Q1 which further pressured gross margin.

For the quarter, gross margin landed about where we expected.

By way of a reminder gross margin will decline again in the second quarter as we absorb the cost of the postal rate increase, which becomes effective in May.

In Q1 SAC reached an all-time high of approximately $47.

Even though the year-over-year growth in marketing spending slowed in the quarter as compared with Q3 and Q4 of last year.

In past quarters we've told you to expect an increase in SAC when marketing spending accelerates and a decrease in SAC when marketing spending decelerates.

So I want to explain why that pattern changed this quarter and what it means for the rest of the year.

In a slightly oversimplified view of subscriber acquisition we acquired subscribers in one of two ways -- either from a paid advertisement or for free because somebody heard about the service from a friend and decided to join NetFlex, based on that word of mouth recommendation.

SAC was up in Q1 because word-of-mouth subscriber growth was weak and we don't expect this organic growth to strengthen again, unless Blockbuster raises prices for total access which means that for the remainder of 2007, we expect higher SAC than we saw a year ago.

Before concluding my remarks about Q1 performance, I'd like to comment on free cash flow for the quarter, which was negative $18 million dollars down from a positive $22 million in Q4 and a positive $12 million in Q1 2006.

Several factors contributed to the large swing in cash flow in the quarter, including a decline of cash from operating activities as a result of a reduction in the average days payable for accounts payable and accrued expenses, and a reduction in deferred revenue as gift subscriptions sold in Q4 were redeemed in Q1.

In addition, we saw an increase in acquisitions of both our content library including both DVDs and Internet video license fees and fixed assets.

For the full year, I expect free cash flow to exceed GAAP net income like it did last year.

Today's earnings release includes guidance for Q2 and an update to guidance for the full year.

The full year guidance lowers the midpoint of the range for ending subscribers by 8% and lowers the midpoint of the range for revenue by 3%.

Our guidance for GAAP net income remains unchanged at $55 million to $60 million.

The new lower guidance for subscriber growth and revenue reflects our best assessment of the competitive impact of Blockbuster's total access program on our growth.

Our guidance assumes that Blockbuster holds the line on current pricing through year end.

If they raise prices before year end we would expect to grow faster.

For Q1 -- excuse me -- for Q2 which is normally a period of seasonally slow growth we are forecasting gross subscriber additions and subscriber churn to be roughly equal for essentially no net subscriber growth in Q2.

With this slower subscriber growth we expect sequential net income growth of 52% to the midpoint of guidance of $15 million.

Earlier in my remarks, I said we valued earnings more than subscriber growth and I want to explain why.

If we could grow subscribers faster by spending more to acquire the marginal new subscriber, we would lose money on each new subscriber like Blockbuster does with total access.

Which means there's no there there in pursuing subscriber growth at the expense of subscriber lifetime value.

Because the bogger your subscriber base grows the more money you lose.

So we are content to grow more slowly but profitably while we wait for Blockbuster to rationalize their pricing, at which point we expect our growth to accelerate.

Today's earnings release announced a program to buy back $100 million in NetFlex stock.

We expect to complete that program by year-end.

At the time of our secondary offering a year ago, we said we plan to accumulate cash to position the Company to successfully license digital downloading rights for Internet delivered content.

Today we think that licensing this content will require less upfront cash than we envisioned a year ago, which allows us to put that cash to more productive use.

We expect to have about $500 million in cash by year end without the buyback program.

And of course we have no debt.

So $100 million or 20% of predicted year end cash is a conservative but meaningful amount of money with which to begin our first-ever stock buyback program.

In summary, we have record first quarter profit but fell about 10% short of our profit expectations for the quarter.

Our subscriber growth has slowed and our acquisition cost has increased because Blockbuster is aggressively pricing Total Access.

At current pricing levels, we believe Blockbuster loses money on each Total Access subscriber.

We don't believe that's sustainable.

And so we expect them to raise prices and if they raise prices, we expect our growth to accelerate as the subscriber value proposition shifts back in our competitive favor.

But until they raise prices, we think the wise course is to grow more slowly but profitably.

That includes my prepared remarks and now, operator, if we could open the phone lines, we will take our first question.

(OPERATOR INSTRUCTIONS) Tony Wible from Citigroup.

I was wondering what your thoughts are on pricing for your sales, considering that you are alluding to Blockbuster having a difficult time sustaining price levels?

Is there any thought on changing pricing in NetFlex?

It's something we always look at.

We are constantly testing.

It remains one of the various tools that we may use, but what I think is more likely to happen is for Blockbuster -- they have indicated that they are looking at the price increase, doing some testing on it and that we have a situation where we have two profitable (inaudible) growing in the market.

So I think that's the more likely outcome at this point.

But we continue to test and look at the price cut option.

With your commentary about getting content to the TV set by 2008 or in 2008, can you provide a little bit more framework about qualitatively how you are hoping to achieve that?

No.

I really I can't at this point for competitive reasons mostly.

So we announced when we started online video that we wanted to get it to every Internet-connected screen over time from the cellphone to the laptop to the plasma screen in the living room.

So there is a variety of partnerships that we are working on and we hope to have a ready amount of content, the subscriber interest and those relationships in place in 2008.

[Doug Imnest].

Can you talk a little bit about how the fragmentation of online ad inventory has altered your marketing spend?

If you have been able to do any better in terms of nonpremium inventory?

And then, secondly, around digital cost, can you give us a sense for -- is the at least $40 million for the year, is that number still intact?

And is there a way to break down the digital spend in 1Q?

Thank you.

Let me take the digital cost piece of it and Reed will take the precedent of defragmentation and online advertising.

I expect we will be fully spent with respect to the guidance we gave about full year digital content and related costs.

It will be north of $40 million.

We will fully spend in the quarter.

We had at least 100 basis points of [ED-related] costs in round numbers in Q1.

I don't think we will break it out beyond that.

And then we haven't seen any material changes in online advertising environment in the last three months.

Jim Friedland.

Just a question on, first, on the ARPU.

It looks like it's holding steady.

Do you feel like you have reached a steady state in terms of the distribution between the multiple DVD plans?

Second question relates to the PP&E up in Q1 and tech and [dev] spending.

I'm assuming that is all related to the online initiatives in terms of video on demand.

Can you talk a little bit about how tech and dev and PG&E might play out over the next couple of years as you build out the online product and the download product?

Let me begin with the ARPU piece of the question.

I don't think we have reached equilibrium yet but you are right.

It didn't move much in the quarter.

What?

Sort of $0.07.

Kind of from $15.73 to $15.66 something like that.

But I am expecting it to continue to move a little bit.

As the mix of a buy price point amongst subscribers moves towards the average mix of what is called the installed base.

The second question I think related to tech and dev and you're probably observing that on the present of revenue basis tech and dev was up slightly 30 basis points kind of on the quarter, and has been moving up since the third quarter.

But that trend will probably continue as we make additional progress in the Internet delivery video content area, although we are keeping an eye on the bottom line and of course trying to find the right level of spending relative to profit in the biz so that we maintain the overall profit integrity of the business as we try to sca;e out the Internet video opportunity.

Then with respect to PP&E we did have some front-loaded costs associated with bringing data centers online to support the distribution of content; and so I don't think that was scale at quite the same rate on a go-forward basis.

[Bill Pasquali].

Couple of questions.

You spent about $68, $69 million in acquisition of DVD library.

That's about 80% more than what you spent last year.

Your revenues year on year are up 36%.

Is the delta there primarily due to the -- your increased spend on the digital download?

And if not are we seeing any kind of scale in just the pure DVD library spend versus the core business?

Right.

We spent 68 versus 30 Q1 on a year-over-year basis and as a percent of revenue which is a metric we sometimes used (inaudible).

As a framework for overall spending we were about 22% versus 13% and we (multiple speakers).

Q1 -- in Q1 did you spend, of last year was it 30 or 45?

It was roughly 30.

Okay.

Sorry about that then.

Consistent with my comments on last quarter's call, there has been a shift in the mix of DVD purchasing from rev share towards purchased and easy that reflected in the -- from the DVD purchasing mix.

And that is primarily the overall driver.

Notwithstanding the mix change we have been able to expand the gross margin and on a year-over-year basis seeing reductions in content cost.

Let's say, on a per disk shipped basis.

So we like the way the economics are playing out for the business.

It has changed slightly the cash flow attributes.

But we have been able to utilize the content that we've purchased effectively and expand margins.

Right.

And what's basic to your '07 guidance in terms of gross margin and churn?

Well, we don't guide to either as you know.

But I guess, basically, you are talking about Q2 see in -- I think you just said a slight decline in gross margins driven by the postal increase.

So is a fair to assume that Q2 should a low watermark?

Again, we don't guide.

Barton Crockett from J.P.

Morgan.

Barry, I wanted to ask you a question about Blockbuster Online which used to be very key to your outlook for the year.

You have in the past kind of forecasted what you think their online business is losing.

Much to their chagrin.

Yes, much to their chagrin.

I was wondering if you could update us there now if they don't raise rates?

And what, maybe, just some sense of what the key assumptions are there and the level of certainty on those assumptions?

That would be one question.

The other question would be the $40 million investment this year on online video, can you tell us how much of that showed up in the first quarter and where it hit in terms of the expensive lines?

And then as we look to '08 should we assume that that $40 million number goes up as you ramp up the direct to TV initiative?

Thank you.

So let's begin with the answer to the Blockbuster question.

I want to try to keep this the Netflix call notwithstanding the fact that we've emphasized the importance of Blockbusters overall pricing strategy.

They have an upcoming call on May second and I'm sure they will shed light on the success of their models.

Our internal forecast for their online business has been growing slightly faster than we had them growing a quarter ago; and because of the operating, the pressure on margins created by subscriber growth, we now project into them losing more money than we are projecting from last quarter's call when I said I thought they would lose something in the neighborhood of $150 million to $200 million.

This calender year I think the losses will be north of 200 million.

So the faster they grow the more money they lose.

That is the good news and the bad news at current pricing levels, we think.

Now how accurate is our -- are our insights about their business?

It depends entirely on how accurate our assumptions are in two dimensions.

One relates to usage under the Total Access program, both online and in-store.

And then secondly, how much ancillary revenue if any is being generated by subscribers -- online subscribers who travel to the store to exchange DVDs.

We think the answer to the second question is not much and I think Blockbuster is forecasting something like $3.

And with respect to usage I think the good news and the bad news is that Total Access customers really like the service based on our research and use it a lot.

They use it a lot to mention of the business model is where I think real economic pressure is created.

On Blockbuster's website they say they're offering $42 in value at an $18 cost.

Well that is great for subscribers and bad for shareholders.

Now, with respect to our ED content cost, I am going to frustrate you and say we are not going to break out on a quarterly basis how much we are actually spending on ED.

We will say that ED-related costs showed up for the first time in the cost of revenues as we had launched the service across the entire subscriber base.

There are some component cost that are showing up in tech and dev as well.

In general there are three categories of cost.

One is content.

That is the largest bucket.

Those costs are showing up in the cost of revenue, in cost of revenues in the P&L.

Second bucket there are all the encoding-related costs.

Creating the digital files.

And then, thirdly, there's a bunch of engineering work to support the current embodiment of the product and the future embodiment of the product that we are not yet -- we are not preannouncing and not yet willing to talk about publicly.

Heath Terry from Credit Suisse.

Not to draw this back into the Blockbuster conversation, but when you look at what they are spending, when you make your own assumptions around the cost associated with their business, is there a timeline that you can kind of put on them reaching the breaking point and raising prices?

Or what you feel like at least the way your model and your guidance is, a timeline around that?

That would be a great question for them on their call.

We are assuming that they stay the course this year.

And when you look at the increase in subscriber acquisition cost, to what extent is that your advertising becoming less effective in the presence of the massive spend on the part of Blockbuster versus the cost of advertising units going higher?

It's almost all the former of the competitive impact.

And I would tell you it is also to reiterate my remarks about SAC it's about the mix of folks who come in for free and the folks you acquire you pay to acquire.

Gordon Hodge from Thomas Weisel.

Couple of questions.

One, Reed, I was wondering if you could give us your perspective on the HBO Universal renewal, their output.

I'm wondering if you had a chance to discuss that possibility of getting involved there with Universal and what that might mean going forward in terms of your electronic distribution rights, subscription rights?

Then Barry I think you mentioned you thought you'd have $500 million in cash by the end of the year without the buyback.

I'm curious that would imply about $100 million of free cash over the next three quarters.

Is that something -- did I hear that correctly?

I will do the cash piece and then, Reed will answer.

You know I said roughly $500 million.

I didn't mean to imply specifically that it would be $100 million.

I was just rounding up.

Then for those of you on the call who don't follow the pay television market that closely, last week HBO and Universal announced an extension of their business relationship from 2011 to 2016 involving exclusive access for Universal films with HBO.

So it's a continuation of the pay television exclusive window system.

There is always a chance Gordon that we find a way to work with universal and HBO in a way that makes us all more money but at this point they're focused on their businesses and of course HBO is quite a large business.

Can put a lot of money upfront.

And this whole exclusive rights issue is one of the many things that prevent online video from being as big as it might otherwise be and extends the life and importance of DVD in this medium because the rights are all chopped up in these pockets.

And in this example it is a pocket that's of Universal pictures content, that is now licensed exclusively for the next 10 years until 2016.

So again these are all the things that continue to keep DVD such an important part of the overall movie ecosystem.

Daniel Ernst.

Hudson Square.

Two questions if I might, both on the online side.

One kind of Micro maybe after 90 days you can share with us a little bit of color on the gross margin differential of delivering the digital version versus delivering the physical movie.

Taking aside the cost of the onetime cost I assume that digitized a single movie and get that of a running but just the ongoing cost?

Then secondly, more broadly speaking on competition and your positioning in the digital domain, there's a lot of different people trying this from yourselves to Apple to Amazon and Sony has got Internet TV that they are talking about.

XBOX and (inaudible) stuff, maybe all those things are partners for you, but interesting about your business today is that you stand alone.

You don't necessarily need those partners to deliver a movie for you.

You've got the post office.

They are completely indiscriminate.

In the digital world there's a lot of bigger players that want a piece of this pie.

And I wanted to see where you think you differentiate yourselves in that digital world longer-term?

Sure.

Well, you asked about gross margin.

What we will find is delivery will cost much less than it does over postal; and that content will cost more partially because of all those different players trying to get into the space and bidding up content costs.

So you'll see some trade-offs there with content costs increasing and delivery costs shrinking.

In terms of long-term competitive structure, again, I will bring it back to my comments on the different segments of the market.

While Apple is a very strong player, they are focused on this digital file ownership model which makes a lot of sense given that that has been so successful for them in music.

It's a nice extension of the iPod.

They have great advantages in that.

Then there is the ad-supported market which will probably be the largest of the three segments.

Obviously YouTube is out there in front.

You know Juiced and Yahoo!

and a lot of others are coming after that.

The content providers themselves, like NBC.com and ESPN.com, want a piece of that.

So I think you'll see a huge market there and then there is the subscription and video rental and pay TV segment, which is where we are focused on.

For now there is not that much focus on that segment by the other players and we are clearly the leader.

And it is going to be up to us to continue to build and differentiate.

Your second question or aspect of it was about with all these big companies and not having uniform access like the post office.

Our fundamental view with the Internet is going to get to the television in an open manner.

If it turns out that the only way to get to the television is to go through someone's pipe that has an exclusive access, well, of course they are going to tax everybody severely.

And that wouldn't generate a very open or more profitable market.

We think that is not likely to happen.

We think that the traditions and the technology underlying the Internet are going to mean that there's broad amounts of bandwidth to television in America over the next 10 years, and that it is going to be pretty open access which leads to a lot of great possibilities for independent services such as Netflix.

(technical difficulties) you brought up the idea of the access through the pipe.

I mean, obviously, cable TV operators truly want to sell video on demand and subscription video and they've invested billions in putting together the pipe that gets you there.

So are we talking about this is a regulatory issue that you assume you'll be able to have open access through that pipe?

And I think I would compare that to experiences of (inaudible) experiences of kind of telecom guys like (inaudible) Vonage and having to leverage miles to pipe to give that's -- their differentiated service to customers?

Yes, we do think it will be open access.

That is what it has been historically.

That is what it is today.

Economically, remember that when various people sell Internet access such as cable companies, you know they are charging $20 to $40 a month and they have no content fees associated with that.

So selling Internet access especially big bandwidth Internet access is a great business for those companies also.

So we look at it and say they will make a lot of money and they will -- their customers want content not just from Netflix.

They want content from YouTube and 100 other video sources also.

And this open architecture is part of why we were able to deliver over a million streams of entertainment content to our subscribers just during our rollout period, which you know where we only had partial availability.

So I think we will see some -- just a great traction on that option over the next coming years.

[Maurice McKenzie] from [Signa] Hill.

Couple of questions.

The first relates to your facility automation plan.

Can you just give us an update on where you are?

What percentage of plant has been automated?

If there was any spending in the CapEx line this quarter?

And then also the potential margin benefit going forward?

The second question is really on the Watch Now program and it relates to utilization.

What percentage of your subscriber base had access in the first quarter and what their overall utilization of their available hours look like?

Sure.

On the automation don't think of -- it's not a one shot.

A distribution center is not automated and then it becomes automated.

There's various steps.

A dozen or so that our distribution centers go through and it's automating one step at a time and rolling those out.

So it's much more continuous and steady.

Yes, there was automation spending both in Q4 and in Q1 as part of PP&E.

And then your second question?

The second question or the third part of that is from the ongoing improvements and facility automation, what margin impact you think that could have in future years, meaning what's the return on this current investment?

Fairly modest.

I mean we've been on the -- we've been reducing our cost substantially over the last couple of years.

So there is not a lot of low-hanging fruit there.

If we are able to offset the postal increases that come down the pipe we feel great.

So nothing dramatic there.

Then you asked about online videos.

A percent of the subs -- all of our subs have access to online video.

Over the quarter, it was gradually rolled out so maybe call it a kind of weighted average of a third or a half of the subs at any point in time.

And utilization among those subs of the available hours that they had?

It's kind of early to give any color on that, specifically.

We are still learning a lot as we grow the content.

Everything feels good about the approach that we've taken.

All the kind of key points of what we are doing has been validated and then, of course, the big opportunity comes as we can deliver directly to the television.

Brian Pitz from Banc of America.

Just two real quick ones.

Any update on the endeavors to improve your recommendation engines and then secondly we note some of your recent announcements with respect to a potential involving relationship with Microsoft, including Silverlight like video player technology?

Can you comment on longer-term potential plans on how your relationship may grow with Microsoft, especially in the context of a more competitive environment with Blockbuster, Apple, Time Warner, Wal-Mart and others?

Sure.

On the Microsoft front, and maybe you asked because Mike got appointed to the Board of Directors on Microsoft, but those are two very disconnected things.

I personally don't have anything to do with the Silverlight aspects of -- looks to be great technology and our guys are doing some stuff with them and that's great.

But I wouldn't view it as like the key to our future.

In some way they are a great partner, but it is not at the core of what we do.

You know, they are playing in the platform basis at a very different space than we do.

And they are sending updates on the recommendation engines?

Steady progress.

You know, we have got our Netflix Prize contest out there that we have continued to see every month, more and more progress toward someone winning the Grand Prize.

The current leader is a Hungarian mathematician; and we've got contestants in 124 countries that are trying to win the price and to improve the algorithms.

So we are waiting until someone wins the Grand Prize; and then we will see about incorporating all of those improvements.

Due to time restraints, we will no longer be able to continue with Q&A so at this time for closing remarks, I would like to turn the call back over to Mr.

Reed Hastings.

Please go ahead.

Thank you, everyone.

To close, I will just reflect on something that I said in the beginning of the call which is what's really astounding is the total growth in this market.

Four quarters ago, we were about 4.8.

Blockbuster about 1.24 for 6 million total subscribers.

And in just one year we have gone as a total market from 6 million to 10 million subscribers.

There's not many markets that grow at speed, at that size.

So I think everyone should feel very good about the total online rental subscriber base and look forward to giving you an update nexs quarter.

Thank you.

This concludes today's conference.

We appreciate your participation and have a nice day.