Netflix Inc (NFLX) 2007 Q2 法說會逐字稿

Good day, everyone, and welcome to the Netflix second quarter 2007 earnings conference call.

Today's call is being recorded.

And at this time, for opening remarks and introductions, I'd like to turn the program over to Ms.

Deborah Crawford, Director of Investor Relations.

Please go ahead, ma'am.

Thank you, and good afternoon.

Welcome to Netflix second quarter 2007 earnings call.

Before turning the call over to Reed Hastings, the company's Cofounder and CEO, I'll dispense with a customary language and comment about the webcast for this earnings call.

We released earnings for the second quarter at approximately 1:05 PM pacific time.

This earnings release which includes a reconciliation of all nonGAAP financial measures to GAAP and this conference call are available at the company's investor relations website at www.netflix.com.

A rebroadcast of the call will be available at the Netflix website after 3:30 PM pacific time today.

We'll 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 & Exchange Commission, including our annual report on Form K -- 10K filed with the commission on February 28, 2007.

And now I would like to turn the call over to Reed.

Thank you, Deborah.

And welcome to everyone.

In the second quarter, Netflix exceeded our profit forecast and delivered one of our most profitable quarters ever.

The seasonality in our business means that the second quarter is typically our most profitable and slowest growing quarter of the year.

In the past, slow growth meant a 5% to 10% sequential increase in subscribers.

This quarter, due to increased competition, it meant a 1% decline in subscribers.

We expect to return to positive sequential growth in the second half, even assuming no relief from the competitive environment due to higher seasonal growth in the second half of the year compared to the second quarter.

Partially due to the battle with our competition, the on-line rental segment as a whole is growing quite remarkably.

In the year between mid 2005 and mid 2006, on-line rental expanded by a healthy 2.5 million net additions.

But in the most recent 12 months, from mid '06 to mid '07, on-line additions accelerated to approximately 3.7 million subscribers.

As internet commerce continues to mainstream and as video stores close, the prospects for on-line rental to add over 4 million net new subscribers over the next year are strong.

If on-line rental stays on that 4 million per year track for three years, that would be more than 20 million on-line subscribers by mid 2010.

If on-line rental achieves these subscriber levels, then the mass closures of the largely fixed-cost video stores will help make on-line rental even more pervasive.

Within just a few years, much of the DVD rental market will likely be on-line rental.

And despite alternatives to DVD rental, such as video on demand and DVD sales, domestic DVD rental from Blockbuster, Movie Gallery and Netflix combined grew from Q1 '06 to Q1 '07, the last published quarter.

In other words, on-line rental growth more than made up for shrinking store rental revenue.

Consumers are not shifting away from DVD rental.

But they are shifting from store-based DVD rental to on-line DVD rental.

Consumers are choosing on-line DVD rental in ever greater numbers due to its superior value, convenience and selection.

And the on-line one distribution center per region model is significantly more efficient than the one video store per neighborhood model.

This year Blockbuster realized the criticality of on-line rental and changed its strategy to dramatically increase investment in on-line rental by giving away one free store rental for every on-line rental.

By literally giving away the store, they have gained on-line subscribers at the cost of big financial losses.

Earlier this year, we thought Blockbuster might sustain these steep losses for only a quarter or two as they did in 2005.

So we maintained our profit goals and trimmed our subscriber expectations for the year.

At this point, however, we believe it is prudent for us to assume that Blockbuster stays in the on-line growth-over-profits mode as long as they can, and, therefore, we're adapting our competitive posture, by shifting some profits to defend our share.

If this assumption turns out to be too conservative, that should be upside for us.

As we look at how to grow our business, most efficiently, we make trade-offs between service levels, marketing levels and price levels.

For example, we are opening 10 or so new distribution centers this year, because we find improving service levels with faster delivery is a relatively efficient means of subscriber growth and retention.

Similarly, we are frequently testing lower price points to see if there is enough elasticity to pay for the price cuts.

Last month, in June, we became convinced that we could cut the price of our two out unlimited program by $1, and it would substantially pay itself back through increased retention in increased organic growth, allowing us to spend less in marketing.

We're very pleased with the results of that two out price cut.

And we're now extending that reduction to our one out and three out customers.

At lower prices, we'll spend less acquiring subscribers than we otherwise would have because of the increased attractiveness of our lower priced programs.

In other words, marketing reductions largely funds these price cuts.

Our strategy evolution is shifting some profits into growth investments.

For as long as our competitor runs their on-line service at a considerable loss.

The tactics of our increased growth investments are higher service levels, lower pricing and slightly less marketing, because we believe that is the most efficient combination for Netflix at this point.

Despite the shift of some profits into growth, our full-year subscriber guidance is down slightly, but not by as much as it otherwise would have been.

We have shifted some profits into growth, but are attempting to avoid the trap of overreacting.

At some point, our competitor will likely desire at least a modest profit on their on-line service.

And we expect Netflix to enjoy greater growth and profitability at that time.

The market is large enough that there is room for two large, growing and profitable on-line businesses.

The reason the current competition is so intense is the opportunity is quite large as consumers switch from store rental to on-line rental.

Over the long-term, we think our advantages as an innovative internet company filled with great talent and fueled by outstanding customer satisfaction are enormous.

Couple that with the strength of our balance sheet and we believe Netflix is well-positioned to compete effectively and to emerge from the current battle strong, growing and profitable.

Part of this optimism stems from the progress we're making in on-line video, which will grow slowly but steadily over the next 5 to 10 years.

Usage tracking by compete.com already shows us as the leading on-line movie service by a wide margin.

And our ability to combine on-line DVD rental and on-line video into one service gives us a significant competitive advantage.

We are generating more on-line video viewing every month.

The next big step, delivering Netflix on-line video to the television, we expect to come together next year with a number of partners and we'll have more to say about that next year.

One subscription service with two delivery methods is, we believe, the path to long-term leadership and profits.

At this point, I'll turn the call over to Barry to give you some more color on our results.

Thank you, Reed.

And good afternoon, everyone.

My prepared remarks will comment on our financial performance for Q2 and our earnings guidance for the remainder of the year.

I'll also share some preliminary thoughts about guidance for 2008, after which I will conclude my remarks with a status update on the $100 million stock buyback program we announced last quarter.

As Reed mentioned, last quarter's results were mixed.

Subscribers were in the low end of our guidance range and ending subs actually declined for the first time in our history, which was disappointing.

The good news is that slower subscriber growth was accompanied by lower marketing spending, which resulted in near record high net income.

Significantly above the high end of our guidance for the quarter.

Revenue for Q2 was in the low end of the range of our guidance.

This resulted from the sequential decline in ending subscribers.

ASP continued to decline as we expected, reflecting the popularity of our lower-priced plans.

As in prior quarters, the three out, $17.99 a month program was our most popular offering.

We expect ASP to continue to decline for the foreseeable future, until the mix of new subscribers and existing subscribers reaches equilibrium.

I'll explain why this shift is driving expansion of our gross margin in a moment.

Excuse me.

As we forecast on last quarter's earnings call, our gross margin declined sequentially in Q2.

The primary reasons for that decline were one, the 2% increase in the first class mail rate we absorbed in May, and two, increasing costs related to our watch now on-line video feature, which we rolled out to our entire subscriber base during the quarter.

With the growing popularity of our on-line video feature, we expect these costs to increase over the next two quarters, and reduce gross margins further as Netflix subscribers enjoy the immediacy of internet-delivered video.

The on-line video costs are another example of the investment spending we talked about to drive increased value for Netflix subscribers.

But our gross margin for the quarter was, in fact, better than we expected, because fulfillment and on-line video costs were less than we expected.

And that brings us back to my earlier mention of the decline in ASP and the positive impact on our gross margin.

Overall, ASP declined about 3% sequentially in Q2.

But that 3% decline was accompanied by a 6% increase in the revenue we earned on every paid disk shipment in the quarter which means profit margins are expanding with the decline in ASP, assisted by the seasonal decline in disk shipments and the growth of our lower priced plans.

Net income of $26 million grew 50% year over year and was 71% above the midpoint of our guidance for Q2.

The majority of the outperformance were about 60% was due to slower subgrowth and lower marketing expense which accompanied that slower growth, as well as the stronger than expected gross margin.

The remainder of the outperformance were about 40% was due to our patent infringement litigation settlement with Blockbuster.

This was a one-time payment with no ongoing stream of license fees.

The marketing group maintained their spending discipline again this past quarter, spending up to the marginal lifetime value of a subscriber to grow our business, which maximizes our total profit.

To put the impact of our marketing spending in perspective, let's remember that with flat revenue of approximately $305 million in each of the last two quarters, we more than doubled net income from $10 million to $26 million, as we reduced marketing spending sequentially by $27 million or 1/3.

Free cash flow in the quarter of $6.5 million was modestly positive after last quarter's negative free cash flow of $18 million, but would have been nearly breakeven without the Blockbuster settlement.

The principal contributors to the improvement in cash flow were the $16 million sequential increase in net income, plus a decrease in prepaid expenses, combined with a reduction in both fixed asset and DVD purchases.

Like last year, we expect comparatively strong cash flow in the second half of the year.

Today's earnings release introduces guidance for Q3 and Q4.

Our guidance includes a downward revision in ending subscribers and net income for 2007.

This was the second consecutive quarter in which Blockbuster's willingness to lose money on its Total Access program slowed our subgrowth.

Because we think they operate Total Access at a 5% to 10% growth margin, the more subs they get the more money they lose after deducting -- deducting marketing and fixed expenses.

Last quarter, I estimated their on-line business would lose more than $200 million this year.

If they continue to operate their on-line business this way, we'll continue to operate in a challenging, competitive environment.

As Reed mentioned, we're assuming Blockbuster continues on its current path.

That means we expect continued pressure on our ability to grow our sub base profitably.

So, while we were pleased with this quarter's near record net income, we're also feeling pressure to arrest the shift in market share and reaccelerate subgrowth.

The increased investment in growth relative to profits that Reed spoke about today is another positive if modest step toward slowing the shift in market share.

On last quarter's earnings call, Reed told you that we needed to see an acceleration in our subscriber growth as compared with current trends to reach 20 million subs by 2012.

And without an acceleration in subscriber growth and profit, we can't deliver the 50% annual earnings growth we once targeted for the business.

In 2008, by way of example, we may see a decline in net income on a year-over-year basis.

Two important assumptions underlie our expectations for 2008 the first is that the current competitive environment remains unchanged, and the second assumption that we significantly increase our investment spending and internet delivered video.

As Reed indicated, we expect to debut internet delivery to the TV next year.

And that will involve increased investment primarily in content, if an increasing numbers of Netflix subscribers choose internet delivery.

Last quarter, we announced a program to buy back $100 million of Netflix stock.

To date, we have purchased 1.4 million shares at a cost of approximately $30 million.

If the business performs as we expect over the next few quarters, we'll complete the buyback program by year end and finish the year with more than $350 million in cash and no debt on our balance sheet.

In summary, Q2 was our first quarter of declining subs and our first quarter with more than $25 million of net income, excluding the realization that the preferred tax asset in Q4 of 2005.

The business model is performing well from a P&L perspective, but our growth has slowed in this rapidly growing on-line rental market.

With Blockbuster losing more than $200 million a year to grow its on-line business, we're unable to grow subscribes as fast as we would like to and maintain strong profit growth.

And so, we're gradually investing more resources to drive growth at the expense of profit.

That's the goal of the increased investment in growth Reed spoke about earlier.

To change the growth trajectory of our business by changing the competitive value proposition of our service.

Last quarter, I told you we valued profit more than growth.

We saw that emphasis play itself out in last quarter's results.

The profit growth outpaced subgrowth to such an extent last quarter that we think the pendulum swung too far.

And our guidance for the remainder of 2007 reflects our decision to compete more aggressively for new subscriber growth than we did last quarter.

When Blockbuster decides to operate its on-line business profitably, our financial results will improve also.

But until that time, both subgrowth and earnings will remain under pressure.

That concludes my prepared remarks, and now we'll open the phone lines to answer your questions.

Thank you.

The question-and-answer session will be conducted electronically.

(OPERATOR INSTRUCTIONS) And we'll pause momentarily.

Our first question will come from Barton Crockett with JPMorgan.

Okay.

Great.

Thank you very much for taking the question.

I wanted to ask, I guess, one thing I guess following up on the sort of -- [key] information from 2008.

I take it at this point you're giving us some qualitative information saying you may see stepped up investment in the internet video and some of the competitive environment is unchanged.

But you're not providing EPS guidance at this point for 2008, specifically.

But I was wondering if you could provide us any qualitative sense with your baseline view is whether '08 is higher or lower than what you're seeing for '07.

That would be the first question.

Well, I don't see it being any higher than current year and there is a possibility it will be lower and mostly what I see when I look across the southside research are forecasts for increases on a year-over-year basis.

And I'm trying to signal I think that's -- we're really optimistic given the level of investment in growth we have planned to make in the business.

Okay.

Alrighty.

And then second thing I was wondering about is, if we go through the changes in the guidance, it looks like the reduction to the back half after backing in the level of beat versus the second quarter and what you've printed here, something in the range of reduction of I guess in the $0.20 to $0.33 range.

What is the principal driver of that?

Is it the price reduction or is it lower subs than you had anticipated?

In other words, how much of it is competitive versus a change in your pricing plan?

There's some of both, primarily related to pricing.

Okay.

And then the final thing, and then I'll jump off here.

Blockbuster said in their presentations to lenders they've done some survey work that says that 60% of video renters, DVD renters, want a combination of store and on-line.

20% want store only.

20% want the on-line subscription only.

Since their numbers are out there, I was wondering if you guys have any counterpoint to that, any research you've done which either supports or contradicts what Blockbuster is putting out there?

Barton, it's Reed.

Consumers want a value and if you give away a lot of free store rentals, I'm sure they respond positively to that as we've seen in the numbers.

And I think really the issue is Blockbuster is willing to lose a lot of money to grow their share.

And that makes it a tougher climate for us.

And they could do that by, for example, having on-line only and cutting the price in half, or they could do that with $200 million of marketing, or they could do it with free store rentals.

How they do it is not that relevant.

What's relevant is that they're willing to subsidize the business to a great degree because they feel that it is a wise course for them.

So, again, it is the -- I think it has become clearer that on-line rental is going to become the dominant form of rental.

And we're seeing a share scramble and it look like they think they were a little behind and so they got to invest a lot to catch up.

But presumably, they'll be interested in profits in that business over time also.

Okay.

Alright.

I've asked enough questions.

Thank you, guys, very much.

Our next question will come from Doug Anmuth from Lehman Brothers.

Please go ahead.

Thank you.

It seems like you think that you can shift the competitive landscape at least by some degree by lowering prices and then next year shifting more into digital.

So digital is obviously a big part of the story in terms of the spending.

But can you talk about what you're seeing so far in terms of churn rates or customer satisfaction with your instant viewing users?

Then can you also talk about the impact you've seen so far of the BBI mail only product?

Thank you.

Sure, I'll take those in reverse order.

In terms of the BBI mail only, they don't promote that.

They promote integration with the store and we compete with Total Access.

I doubt many people -- many consumers know that they have a mail-only program.

So, I don't think that's a relevant competitive point for us.

Second, you stated that the $1 price cut will make a difference now in the overtime instant viewing.

The $1 price cut is one tactic.

The other tactics that we're doing are improving the service levels throughout the business and those all get traded off against each other as ways to efficiently grow.

So, I wouldn't put as much emphasis on the price cut as opposed to really again at the strategy level, what we're doing is shifting some profits over to be more competitive and some of that is going into price cuts.

Some of that is going into service levels.

And then in terms of the retention impact in instant viewing, what we certainly believe is that more people use Netflix, whether that's DVD or instant viewing, the more they perceive they're getting a value.

And that those are the things that drive retention.

And on-line viewing, because of the lack of mailing the disk, is inherently a lot more efficient way to deliver movies.

So, we're pushing into that to harvest those increased deficiencies, but it is still at a relatively small volume again being on the PC only.

So, we'll know more about it next year as we're getting closer to television access.

Are there any further questions?

No.

You can go ahead.

Thank you.

We'll move next to Youssef Squali with Jefferies & Co.

Thank you very much.

Barry, I was wondering if you could qualitatively comment on your '08 revenue.

I think Q3, we're going see the first sequential decline in revenues and you're guiding for similar trend in Q4.

How are you looking at '08 versus '07?

Hi, Youssef, I don't have any additional comments to make on '08.

It's -- we haven't begun our planning process yet.

I can say I know enough about the business to have concluded that the street forecast I've seen look excessively optimistic.

We'll talk about '08 on our fourth quarter call, probably, if we follow last year's pattern and not have more to say about it before then.

Okay.

And then the trend in your ARPU seems to indicate a pretty aggressive drop, I think in Q2 it was around $15.24.

In Q3, at the midpoints, it is in the mid $14, and then it drops below $14.

Are you baking in another price drop or just the mix shift toward lower priced plans?

Just mix shift.

As we move towards equilibrium, the mix of new customers becomes the same as -- or nearly the same as the mix of the installed base.

Okay.

My last question for Reed.

Reed, I was wondering why did you decide to settle the patent with BBI if you believed that your patent was strong enough to prevent them from continuing to expand their business?

Going to hurt you in the short term at least?

In any settlement, it is because the fact that they appear to both sides indicate that a settlement makes sense.

So it made sense to us given the facts present at the time.

And presumably it made sense to Blockbuster.

That's why we're able to find mutual ground.

And now we're both focused on growing the on-line rental market as fast as we both can.

Okay.

Thank you.

And we move now to Mike Olson with Piper Jaffray.

Had a couple of questions on the on-line initiative for download.

Basically, it seems like one of the biggest issues for on-line services is figuring out how to solve the last 10-feet problem in that you kind of alluded to it.

Can you give us anymore flavor as far as how you're kind of looking at this and what are some of the potential options for you to solve that problem?

Well, you're absolutely right that it is one of the biggest issues holding back the entire industry and we'll come forth with a variety of solutions next year.

But it is going to be a slow evolution.

This internet to the television isn't going to happen in one or two years, which is why we think on-line video grows slowly over the next 5 and 10 years for movies.

It is because of the adoption cycle to get to the television won't be overnight.

And if there is a slow adoption like that, steady over 5 or 10 years, it very much favors an incumbent such as ourselves that can make the investments and hybridize the program that is putting on-line and DVD together.

Okay.

That makes sense.

And then just one question similar.

As far as, right now I guess on the competitive front, the focus is on Blockbuster.

But in download, Apple is probably going to be one of your bigger competitives.

Can you just talk about how you feel your position relative to Apple and what would be your thoughts if Apple has a movie rental service on iTunes at some point?\

Sure.

Today there are three segments of on-line video.

There is an advertising supported segment we think will be quite large that is led by companies like YouTube and BC.com and a variety of sites.

And then there's DVD purchasing, or rather movie purchasing, which is what Apple has been focusing on a $10 to $15 price point.

Amazon's in that space.

That makes sense as extensions to their businesses.

And then there is a third segment around rental that we're the clear leader in it at this point.

And so, that's how I see the segmentation.

To the degree you asked does Apple go with a transactional rental, that basically becomes a reimplementation of cable video on demand and hard to see how and why it gets traction, because it is like video on demand except you've got to buy an additional box for it.

But it doesn't offer anything beyond what you get on cable video on demand.

So that's not particularly concerning.

Remember, the DVD rental has always competed successfully against DVD sales, video on demand, etc.

So it's a pretty large market, about $40 billion in the U.S., including the theatrical side.

So there is a lot of room there for a number of approaches.

Thanks.

And then just one question for Barry.

Any thoughts on tax rate for the next few quarters or are we going to stick at 41% or so?

Nominally, yes.

Taxes will be less than half of that, but the nominal tax rate will be about 41%.

Okay.

That's it for me.

Thank you.

Tony Wible with Citi.

Your line is open.

Please go ahead.

Hi.

You guys talked about making some smaller changes to your marketing expenditures.

What are you thinking about that on a seasonal basis?

Would it still make sense to ramp up marketing a little bit more in peak seasonal time periods?

Tony, sure, yes.

Marketing spending will follow seasonality to a degree.

That definitely makes sense.

Okay.

And I know it is still a little early for the high def format, but which percentage of your disk shipped now are high definition.

And what does that cost typically run versus the the standard definition disk?

Unfortunately, high def is still pretty small for us.

On number maybe it's 1% or something.

That's true industry-wide.

It is relative because of the small adoption.

And we would like high def to be a big success.

We're doing everything we can, that the studio dual adopts both formats.

We think that's the right decision for the studio to support both formats, get the perception of the war over.

From a cost point of view, postage handling, all of that's identical, content cost is a little bit higher right now, but that's because it is so early adopter.

So, I don't think it is going to be any higher once this becomes a mainstream format, but right now, I'm going to estimate that it runs maybe 10% higher per unit.

Last question.

Have your thoughts on international changed at all in light of the competitive environment in the U.S., I guess heightening, and seeing Blockbuster pulling more away from the international environment?

Well, I agree that Blockbuster's pulling away from the international environment, but it hasn't changed our perspective on it.

And certainly, our primary focus is growing the DVD subscriber base and the expansion into on-line video.

And those ripe for on-line video are very much country specific.

Great.

Thank you.

We go next to Heath Terry with Credit Suisse.

Please go ahead, sir.

Thank you.

I was just wondering, you mentioned several times Blockbuster losing money on their offering.

Based on the intelligence that you have, can you give us an idea of what you feel like they're losing either on a per customer basis or in a total basis, and how long, just again from your perspective, you think they're going to be able to keep that up.

Well, they have an earnings call Thursday, Heath.

And so there will be a timely opportunity to pose that question to them.

They don't actually disclose that information.

So, we make an educated, informed guess from what the models that we keep of their business that we hope gives us insight into the competitive environment.

And we have said consistently this year that in total we expect the on-line business to lose north of $200 million chased by subscriber growth.

So, if they end the year just south of $5 million, it could be as high as $230 million, if they're tracking closer to $4.5 million in their subs, it will be less.

Now, as I said in my remarks, that I thought the -- I estimate that the gross margin on their on-line business including the cost of the in-store fulfillment for Total Access and less fulfillment cost, which is how we account for our on-line business is running in the 5% to 10% range.

And I think they ran at a negative gross margin in Q1.

They're making some slight improvements, that really their need is to be more structural changes in the value proposition to then convert the business to a moneymaker.

Heath, we have the information to be able to estimate bottoms-up cost.

From an outside point of view, you can take their store revenue and apply the gross margin that Movie Gallery generates.

It's been pretty consistent.

It is what store rental runs at.

And from that, you can back into some top down numbers.

Great.

Thank you very much.

Our next question comes from Gordon Hodge with Thomas Weisel Partners.

Yes.

Good afternoon.

Just wanted to dig in a little bit.

And I may have missed a little bit of your comments, Barry, or didn't understand it well enough on gross margin because you handily beat our estimate there again in the quarter.

And I'm curious about a couple of things.

One, I think you mentioned that seasonally, usage was down which we would expect, but I'm wondering if you're losing -- if you can sense whether your you're losing high usage customers to Total Access, if that's the dynamic that seems to be playing out.

And then also just wondering if maybe you could just review -- maybe go over it again just why you're able to absorb the postal increase and generate the margins that you are.

Well, the gross margin was more or less in line with our expectations.

Clearly, we continue to make good progress as we have for many years in lowering on a per disk shipped basis, cost for fulfillment and content-related cost which is driven by effective merchandising on the site, which contributes to the long tail.

We also benefited from some slightly lower credit card fees in the quarter.

MasterCard revised our rate.

Okay.

And those were the primary contributors, plus the seasonal change in usage, which we eluded to.

I don't have any particular sight, nor do I think that there is a shift that's occuring with respect to hot users, frequent users of DVD.

To the extent that they're going to shift away from us and toward Total Access program, that's already taken place.

Alright.

Terrific.

Another question if you don't mind.

Just on the marketing spending decision trade-off versus the decision to cut prices.

It sounds like you saw some nice elasticity or some consumer response to the $13.99 price cut, or the move to $13.99, I should say And I assume the same was true at $4.99.

Yet your guidance would suggest you aren't expecting a lot of elasticity in reaction to the price cut here today.

Is the idea here just strategically to put pressure on Blockbuster throughout the year with this price cut with the view that maybe if you get some relief next year and maybe you entertain an ability to raise the price later on?

It is Reed, Gordon.

It is certainly not designed to put pressure on Blockbuster.

They've got plenty of pressure on them.

It is designed to be more attractive to consumers.

So, the brand and the category were very unknown four or five years ago.

Yep.

And so a much heavier investment in marketing was necessary.

If you think from a high level in a big, competitive battle, where they're investing heavily in advertising on-line rental, we are -- we can sort of split the load in terms of the awareness of the category.

There is over 10 million on-line renters today.

They're telling their friends about it.

There's all of these things that says the market -- you all need to more compete on value and less on promotion.

I think that's the evolution that you're beginning to see.

Again that the market is now 10 million total subscribers.

So our actions are driven by how to grow our business as we're going through this competitive storm.

Because, again, we and I think our competitor realized that on-line rental absolutely has the potential to be 20 million in three years and maybe quite a bit bigger beyond that.

So we're doing the big share jockeying right now.

Gordon, this is Barry, and I would also add with respect of elasticity, it's helpful to remind yourself that decreasing significantly the marketing spending in order to offset some of the cost of the price decrease, and if we weren't doing that and could effectively deploy those moneys, you would see a different forecast for sub growth than you're seeing.

Yep.

Okay.

That makes sense.

Thanks.

Our next question will come from Maurice Mckenzie with Signal Hill Your line is open.

Thank you for taking the question.

I just have one.

Can you discuss other elements of the competitive environment such as Redbox and the cable MSOs during the quarter, whether or not those had impact on overall sub growth?

Sure.

It's Reed here.

Let's take them separately.

Redbox, DVDPlay, and The New [Release] I think are the three companies that are leading the kiosk business with these $1 a day rental in supermarkets, primarily.

And from what we can tell by their public small base, they're growing nicely, they're all new release focus and will be an increasing pressure on video stores.

And they're directly competitive with video stores, but not terribly competitive with ours, because we're much more catalog oriented within the system.

But they're still pretty small, so in the background, but take the significant pressure over the next three years, mostly due to negatively impact stores which of course has a positive impact for us.

Then you mentioned cable, video on demand.

Not much changing in that space.

There is a movie or two that's coming (inaudible) to DVD, but across the year, that's not much of a change.

And again, I mentioned that if you sum up Movie Gallery's, Blockbusters' and our rental revenue on a domestic basis, that it has actually grown from Q1 '06 to Q1 '07.

So despite all of those various competitors, the consumers are sticking with DVD rental.

Reed, just as a followup, are there any alliances that are particularly interesting to you, those that may expand your reach or penetration?

I would say that our competitive view is that we should forecast forward in the on-line video, so if you see us doing various partnerships, we would be more inclined to do that in the area of which -- we're an internet company.

We look forward on these things rather than trying to go tit-for-tat with Blockbuster on more their core area being store logistics.

Today, stores are probably more relevant to most consumers than on-line video, partially because it's (inaudible) to the laptop.

But stores are going to be less relevant over the next few years, and on-line video's going to be more relevant every year over the next five years.

So we've got a great balance sheet.

We're investing in on-line video.

We're moving forward.

And that's the way we look at the world.

Reed, thank you very much.

We go now to Jim Friedland with Cowen and Company.

Thanks.

First on free cash flow.

The guidance you said getting to $350 million in cash by year end implies that you have decent free cash flow in the second half.

So the first question is based on the new strategy, especially looking into '08, it sounds like you think you can continue to operate the business by generating free cash flow.

The second question is on the expenses relating to the on-line video business and watch now.

You said you get to 5,000 titles by year end and in the -- in Q2, the tech and dev spending went up pretty significantly sequentially.

I know you don't want to give us guidance on stuff like that, but as we think about costs going into next year, what are going to be -- what's the primary driver in terms of increased expenses?

Is it going to be the goal to get to 10,000 movies by year end and that's going to be the primary driver, or is it something in tech and dev?

And then what specifically in tech and dev is driving that ramp?

Thanks.

Well, the question to answer one, free cash flow positive in 2008 is, yes, we think we can operate the business with positive free cash flow.

Answer to the second question related to tech and dev spending is there were some one-time fees which we incurred this quarter, and I expect the absolute level of spending to decline as compared with the second quarter in Q3 and Q4.

The apparent ramp in spending will not be the ramp gone forward.

And on the availability of titles for watch now, again at 5,000 at year end, as you look out to '08, is there -- is the restriction in getting those titles up to say 10,000 a limit that the studios are putting out there because those are -- you're getting the titles that are available, or is it more you're just trying to grow it systematically so you don't kill the P&L?

It's Reed here.

Adding titles doesn't particularly cost us.

It is the actual viewing.

So, the more people watch, the more we owe the studios, which is fair and appropriate.

So, the big drivers would be if we had 500 really great titles, like we've had seasons of "The Office," the U.S.

version of "The Office," that have been very popular.

So, those drive up costs, but also increase satisfaction.

So, our costs again are related to how much -- how successful we are promoting on-line video, and there is only very small costs, things like encoding, some fixed contract stuff, to the per title count.

Okay.

That's helpful.

Thanks.

And we'll go now to Barton Crockett with JPMorgan.

Great.

I wanted to come back with a followup.

I was wondering -- there's been some commentary about a level of price that Blockbuster might contemplate if they were to charge more for the in-store feature.

Particularly, I think Antioco said at their annual shareholder meeting that, hypothetically, there could be a situation where they could raise their rates $2 for that.

Our model is assuming a $3 price hike in the fourth quarter, at least at this point.

What is your sense of the impact that would have on the Blockbuster -- the interest in the Total Access versus Netflix?

Do you think that would be -- at that level of price, $2 to $3 where people are maybe taking four or five disks out of the store right now.

But a $2 or $3 price hike for that , would that help you a lot or not?

Have you done any work -- I was wondering if you could share some light on

Yes, it's Reed, here.

Every dollar makes a difference.

$3 makes more of a difference than $2.

$5 makes more of a difference than $4.

So, it is pretty continuous.

There is no big inflection points across there.

And if they choose to do a price increase, that will rebalance the relative share growth to a degree, but they may choose not to.

I mean it's anybody's guess at this point on how they look at the world.

I think you can see the significance of their commitment in their P&L in the last two quarters, because they see that the consumers are voting for on-line rental and they need to [have some touch up there].

Okay, great.

And just on the guidance here for the back half.

Can you give us some sense.

I mean the churn is up year to year here in the second quarter.

Are you assuming there is a comparable kind of year-to-year growth in churn in the back half?

We're assuming that the same seasonal pattern applies as last year.

So, by way of example in the current quarter, churn was 4.6% up 20 basis points sequentially and it was up 20 basis points sequentially a year ago.

But this year was about 30 basis points higher than it was last year.

So, we are feeling the effects of competition, like we said we would.

And we did anticipate that the effects of competition would diminish slowly over time.

And that is still our view.

Now, we'll have to see how today's announcement plays itself out in the market place in the form of churn.

Okay.

Great.

Then also, the final question here.

What is the patent payment you got from Blockbuster.

What line did that fall into on the income statement this quarter?

That was broken out separately in the release.

I'm quickly thumbing through the P&L.

Bear with me a moment.

and I'll point you toward it.

Was that an interest in, oh, here it is again in legal settlement.

I see it.

Yes.

Operating expenses, the last line, before total operating expenses.

I'm sorry.

Thank you very much.

Sure.

Okay, bye.

We go now to Daniel Ernst, Hudson Square Research.

Good evening.

Thanks for taking the call.

Three questions, if I might.

First, G&A is up around 34%, it looks like year on year.

Can talk about where the resources are being focused and is there a potential here to reverse that trend?

And then two questions on the on-line market.

Where are you now with -- if you looked at the on-line -- the watch now subscribers ex the male component of their service.

Where would the gross margins come?

You're following given usage and what it costs you to deliver technology and then I guess rev share back to studio and then romance that longer term, where do you see the economics of the digital delivery going?

Is it more like rev share and less like DVD acquisition, or can you give me some color on what the economics of -- in all digital demand might look?

Thanks.

Well, in terms of G&A, the trend is up in part related to some legal spending in the quarter.

If litigation diminishes going forward, we'll see December [lease] there.

We have expanded our investment in content group which is rolled up into G&A, and there has been some increased investment in systems related to the finance staff.

I expect those to be relatively flat on a go-forward basis.

In terms of on-line watch now related stuff, we'll kick that over to Reed.

The cost per movie delivers are less on-line as you would imagine.

And the good part is the studio gets the dominant part of the revenue -- the cost instead of splitting between the studio and the post office.

So studios are happy with it, because it increases their percentage of the pie.

Consumers are happy with it, because it is a mediate and because it costs less per movie to deliver.

You asked about sort of the pricing structure and the margin structure in that market.

And I think the market's just too immature to tell.

Pricing is often competitively determined.

It is one of the big reasons we're investing in the DVD subscriber base, because we think the magic combination for leadership and profits is combining DVD rental with on-line video and getting out of the pure commodities space of the on-line video players.

Thanks.

Very helpful.

Any further questions, Mr.

Ernst?

No.

Okay.

We'll go now to Brian Pitz, Banc of America Securities.

Please go ahead, sir.

Great.

Thanks.

Can you give us some details on your marketing spending in the quarter?

Maybe your off-line versus on-line mix, as well as any color on the mix of on-line spending by type in terms of keywords, CPM, CPA?

And then I've got a quick followup.

Yes, Brian, for competitive reasons, I'll defer -- we move between all of those categories based upon what we perceive as the relative efficiency of those in the deals that we get, so it is fairly fluid.

And it is relatively useful for proprietary knowledge for us.

Okay.

And then just a quick one on -- you mentioned mail cost and the quarter up about 2%.

First class mail, we know the postage, I think it was on May 14th, increased.

Is the 2% because of the timing of the increase mid quarter?

And can you talk about, going forward, how we should think about the increased cost of mail on a full quarter basis?

Thanks.

Well, on a per disk ship basis, it's about $0.04 to $0.02 each way.

We don't actually break out the cost of postage and packaging.

I don't have any comments except to say we'll pick up a full quarter's worth in Q3 and we picked up a partial quarter in Q2.

Great.

Thank you.

And that concludes today's question-and-answer session.

At this time, I would like to turn the program back to Mr.

Hastings for any closing remarks.

Thanks, operator.

So, everyone, our revised guidance, of course, is based on the assumption that Blockbuster doesn't change course at all over the foreseeable future.

And we don't know if that is too conservative or not.

But we thought it is the most prudent assumption.

What we can certainly see is that consumers are not turning away from DVD rental, but they are definitely switching from store-based rental to on-line rental, and that's apparent to all of the players in the market.

So, it is likely to be a fairly intense competitive battle here, as people play for that big market over the next couple of years.

So, with that, I would like to thank you for participating, and look forward to talking to you again in a quarter.

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

You may disconnect at this time.