Netflix Inc (NFLX) 2007 Q3 法說會逐字稿

Good day everyone.

Welcome to the Netflix third 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 Deborah Crawford, Vice President of Investor Relations.

Please go ahead, ma'am.

Thank you, and good afternoon.

Welcome to Netflix third quarter 2007 earnings call.

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

We released earnings for the third quarter at approximately 1:05 p.m.

Pacific time.

The earnings release, which includes a reconciliation of all non-GAAP financial measures to GAAP and this conference call are available at the Company's Investor Relations website at www.netflix.com.

A rebroadcast of this call will be available at the Netflix website after 3:30 p.m.

Pacific time today.

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

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

A detailed discussion of such risks and uncertainties is contained in our 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 over the call to Reed.

Thank you, Deborah.

Welcome everyone.

As you read today, our results in Q3 were very strong in comparison to expectations, and we substantially exceeded our guidance in subscribers, revenue and earnings.

In addition, we've raised our guidance for Q4 as described in our press release.

In short, it was a great quarter.

As you know, in recent quarters our growth has been impacted by Blockbuster Online's strategy of selling dollars for $0.85.

It's not a viable long-term strategy.

Our competitor now appears to have de-emphasized their online business in favor of generating profits and focusing on improving their stores.

While our results in Q3 were significantly above our expectations, we are mindful that they were about the same as Q3 one year ago.

Earnings, gross additions and churn were on par with last year's Q3 while net additions were 40% less than last year since we were churning from a bigger base this Q3.

We're much happier today than 90 days ago.

But we're still not where we'd like to be in terms of subscriber growth.

However, I'm pleased in the first three quarters of this year, we've already generated more net income than in the whole of 2006.

Internally, we debate how our business would have performed in Q3 without our June and July price cuts and there's no consensus.

What is clear, however, is that even after the price cuts, we are an Internet retailer with over 30% gross margins and growing profits.

Compared to other Internet retailers, our new pricing is still quite healthy in terms of gross margins.

The advantage of lower prices to our business is reduced churn and lower SAC.

Our Q3 churn reduction was as our price cut models predicted and most of it was due to our lower prices rather than the change in competitive climate.

The reduction in SAC, however, we think was from a mix of lower prices, more efficient spend and competitors' lighter marketing.

As we look ahead, we are focused on continuing to deepen the competitive modes around our DVD rental offering.

By continuing to improve our service and being aggressive on value we are confident of remaining the leader in online DVD rental regardless of what the competitive landscape holds, and to be the primary beneficiary as more and more consumers move their spending and time online.

In addition to prospering and online DVD rental we're expanding in online video quite nicely.

In the past, we've announced various milestones, such as reaching 10 million views in our desire to provide you with some sense of how subscribers were reacting to to the option of watching content instantly on their PCs.

As the number of viewers and views continues to grow, this information becomes more sensitive for competitive reasons and going forward we will no longer release it.

At a high level, our strategy is to build a very large DVD rental subscriber base and to bundle in the ability to watch those movies online.

If a consumer in America is into the Internet and movies, the chances are good they're going to be a Netflix DVD rental subscriber.

Additionally, since a good deal of content will be available only on DVD for some years, a hybrid offering like ours is differentially compelling to consumers in comparison with any online only offering.

Our goals in online video over the coming years are threefold.

One, to expand the content we offer online.

Two, to make it inexpensive and easy for consumers to view that content on the television, and, three, to understand what the financial model for the hybrid service will be in the long-term.

On the content side, we are working steadily year after year to increase the amount of movies and TV shows we have available online.

It took 10 years to get most content available on DVD, and it may take that long again to get most content online.

We are pleased with our progress to date and are licensing more content every quarter.

In terms of enabling the viewing of online content on the television screen, we are exploring a variety of options including Internet connected high definition DVD players, Internet connected game consoles and dedicated Internet set tops with a variety of partners trying to understand the best ways to provide inexpensive viewing of online content on the television.

In the meantime, laptop computers are, for the younger generation, one of the primary ways video of all sorts is being enjoyed and our online viewing is up dramatically quarter-over-quarter.

While we are not yet in a position to provide investors the long-term financial model behind the hybrid service, we do want to reassure you that we plan no large scale changes to our cash flows next year with say big hardware subsidies.

Ten years ago we formed Netflix and eight years ago we launched our subscription service.

Our ambition has always been to emerge as one of the world's leading Internet movie firms with a profit stream that will significantly exceed that of our initial DVD business.

It took several years for us to turn our DVD rental business profitable, and our online video expansion may take just as long.

We now have more resources, bigger competitors and a much bigger prize to earn.

Since the opportunity for online video, however, will emerge slowly rather than suddenly, we believe we can generate increasing profits for the business as a whole while we expand into online video.

To close, I want to thank everyone who continued to see the value in owning Netflix over the last nine months.

The competition was more aggressive than we had imagined likely.

I'm proud that we chose to stick to the basics by steadily improving value and service quality for our subscribers, and we emerged stronger than ever.

It's reasonable to expect that our stock price could continue to experience slings, but we will continue as we have been to focus on steadily build on a Company whose competitive strengths position us to grow subscribers and profits year after year.

And now over to Barry.

Thanks, Reed.

And good afternoon everyone.

As you know from today's earnings release and Reed's comments, Q3 results exceeded our expectations.

Three weeks into the fourth quarter we remain encouraged by our results quarter-to-date, which is reflected in our upward revision in Q4 guidance for subscribers, revenue, net income, and EPS.

Changes in the competitive environment were an important catalyst for the quarter's performance.

So I'll begin my remarks by talking about the implications of competition for subscriber growth.

Next, I'll discuss our third quarter results, our updated guidance for Q4, and provide a few comments on 2008.

Then I'll close my remarks with an update on the status of the stock buyback program we announced on the Q1 earnings call.

Last quarter, I said we expected to operate in a challenging competitive environment for the remainder of 2007 and into 2008.

Ninety days later we see a different picture.

The question is how could things have changed so quickly?

Two factors contributing to this shift.

First, as we discussed on last quarter's call, we stepped up our investment in growth by lowering prices in order to increase our share of new subscribers and reaccelerate our subgrowth.

And, second, Blockbuster's new management team shifted strategy to emphasize profit in addition to same store sales growth, a significant change in direction from the prior management team.

These two changes, and to a lesser degree, the effects of a seasonally strong quarter, restored our subgrowth and lifted our ending subscribers above the high end of our guidance.

Financial results for Q3 exceeded our expectations across all key financial metrics.

The highlights I'll focus on today include revenue, gross margin, subscriber acquisition cost, and free cash flow.

Revenues were above the high end of guidance fueled by subscriber growth and retention improvements.

RPU declined again this quarter by about 4% sequentially and 10% on a year-over-year basis which was inline with our expectations following the price cut last quarter.

In spite of the price cut, we earned the same revenue per paid disc shipment in Q3 as we did one year ago which shows that the economics of lower-priced plans are working.

Gross margin of 33.9% outperformed our expectations for the quarter.

Lower content cost was the primary driver of this outperformance, along with some benefit from lower fulfillment cost.

Although margins exceeded our expectations in the quarter, they were still down sequentially and year-over-year as expected.

Increased spending on Internet delivered video content and the price cut were the primary contributors to the sequential decline in gross margin.

This trend will continue in Q4 as the full impact of lower prices cycles through the P&L and we continue to invest in Internet delivered video content.

In my opening remarks, I pointed to the changed competitive environment and the reacceleration of our subscriber growth.

Faster subscriber growth in Q3 was accompanied by significantly lower marketing spending, which was a managed outcome.

Subscriber acquisition cost of $37.91 was the lowest it's been in eight quarters and total marketing expense decreased by $10.2 million, or 17% on a year-over-year basis.

Last quarter we committed ourselves to funding most of the cost of the price decrease with reductions in marketing spending, and this quarter you saw that strategy at work in lower subscriber acquisition cost.

My final comments on our financial performance for the quarter relate to free cash flow of $36 million which increased from $6.5 million in Q2 continuing a trend that emerged last quarter and a seasonal pattern that dates back to our days as a private Company.

This increase was driven primarily by a seasonal decrease in content acquisition and an increase in our accounts payable.

I began my remarks today by commenting on our raised guidance for Q4.

Faster subscriber growth driven by our Q3 price cuts as well as changes in the competitive climate explains our expectations for faster growth.

At the same time, the lower marketing spending associated with the price cuts should contribute to increased profitability.

Given our outperformance in Q3, and our increased guidance for Q4, I'd like to comment briefly on our expectations for 2008 profitability.

Last quarter, I said we may see a decline in 2008 net income on a year-over-year basis.

Given our third quarter performance, that view now seems overly pessimistic.

Today, it wouldn't surprise me to see net income flat to slightly up in 2008 on a year-over-year basis.

Let me explain why I think that's plausible.

Two important assumptions underly our expectations for 2008.

First, we expect the current competitive environment to remain unchanged.

And, second, we expect to significantly increase our investment spending in Internet delivered video.

As Reed mentioned last quarter, we expect to debut Internet delivery to the TV next year.

That will involve increased investment in content, as we expand our library of titles and more Netflix subscribers choose Internet delivery.

Before closing, I'd like to update you on the status of the stock buyback program we announced six months ago.

Last quarter we purchased 2.1 million shares at an average cost of $17.17 per share.

Since inception, we've purchased 3.4 million shares at a total cost of approximately $65.7 million.

Whether we continue to buy shares back in the current quarter depends on where the stock trades during the quarter.

In summary, last quarter's price cut, which was funded in part by a reduction in marketing spending and a favorable shift in the competitive environment, led the strong outperformance across all key metrics in the third quarter.

We believe the overall category of online DVD rental will continue growing.

Our business model continues to perform well.

We're pleased with our Internet delivered video progress and believe our hybrid distribution strategy, by mail, and across the Internet gives us a long-term, sustainable competitive advantage.

We remain focused on accomplishing the strategic initiatives Reed outlined in his remarks today.

We look forward to updating you again in January on our Q4 call.

That concludes my prepared remarks.

Thank you for joining us today.

Now we look forward to answering your questions.

Thank you, Mr.

McCarthy.

(OPERATOR INSTRUCTIONS) We'll pause for a moment to give everyone a chance to signal.

We'll take our first question from Gordon Hodge with Thomas Weisel.

Yes.

Thanks.

Terrific quarter.

Just a couple questions.

It sounds, it sounds like, again, the gross margin very strong.

I'm just curious if you could go a little bit more into it, I think your capital expenditures on discs was also, at least below our expectations.

Is the source of that primarily usage or are you getting meaningful turns on discs that are fully amortized and/or are you seeing any change in the mix, either rev share, towards rev share discs or alternatively catalog versus new releases?

Thanks.

As I said in my comments, Gordon, seasonally we see a decline in Q3 purchasing and that explains the reason for the decline that we reported.

Is that, is that, is that a seasonal decline in the need to purchase or is that just something to do with the calendar as it relates to studios?

Studios primarily, studio release.

Okay, got it, and then just anything on catalog versus new release, and rev share versus purchased?

Yes, nothing new in the quarter related to catalog versus purchased new release and as it relates to rev share versus purchased, we've, over the last several quarters, we've leaned slightly more towards purchased than rev share.

Okay, terrific.

And then any comments as to what you think the impact of Movie Gallery's' bankruptcy filing might do for you?

Thanks.

Gordon, it's Reed.

Any time video stores close, it's got to help us.

You'd have to imagine, though, that the first 1,000 or so Movie Gallery stores that close are the ones that are right across the street from a Blockbuster.

It's probably reasonable to think they're more likely to cross the street than suddenly come online.

If there are ever isolated rural stores that close, then the only option is online so -- there's a second wave that will be more helpful to us.

I think the first wave will be mostly helpful to other video stores in the neighborhood.

Perfect, thank you.

We'll take our next question from Jim Friedland with Cowen & Co.

Thanks, some questions on the P&L.

Sequentially, looking at the tech and dev spending, G&A and also PP&E, you're sequentially down G over Q.

I just wanted to get an idea some of the drivers and the question behind that is in terms of the ramp of the watch instantly feature, are some of the expenses already pre-loaded so as we go into next year, the need to increase, for example, tech and dev or PP&E is not as great?

Thanks.

In the tech and dev line, Jim, last quarter we capitalized, we expensed, we took some one-time expenses that were non-recurring so that explains the sequential decline.

The G&A line, which also declined sequentially, probably driven by litigation expense.

Also, non-recurring.

And PP&E, which has declined for the last couple of quarters?

It fluctuates seasonally.

We tend to, to the extent we're going to buy CapEx, it tends to be a year-end phenomenon for us when vendors are anxious to cut deals to make sales quotas.

Okay, and then the last part of that question is thinking about your necessary expenses for watched instantly as you look at game players, DVRs, et cetera, is there any need to accelerate the tech and dev spending or in terms of the percentage of revenues going into '08, should there be any meaningful change there?

It's Reed, Jim, we'll continue to grow our investment on an absolute business, reasonably consistent with our history over the last couple years.

So there's no big change in that history.

Some of that's deployed against instant watching.

Some of that is deployed against making the core DVD rental service better.

Okay, great, thanks a lot.

We'll take our next question from Youssef Squali with Jefferies.

Thank you very much.

Reed, some time back you had talked about reaching 20 million subs by 2010, I think, 2012.

The competitive landscape kind of toughened up a little bit, so are you focused a little less on that and more on bottom line.

The competitive landscape seems to have improved quite dramatically in the last three months.

Can you kind of tell us where you stand directionally, a choice between raising prices and trying to maximize profits, versus just keeping prices down and just dramatically increase subscriber growth to maybe going back to the initial philosophy?

Is, can you just update us on that?

And is a price increase potentially on the table considering how favorable the competitive landscape is?

Youssef, it's a balance for us of both growth and subscribers on DVD rental.

Earnings, and our investments in online video, and so, if we do our job well we'll be able to pull off increases in all three of those.

So we've never looked at it as, for example, the 20 million that it was, the 20 million at any cost .

It was 20 million consistent with some very nice earnings growth along the way.

In terms of the 20 million, it will probably take us a couple quarters to get a feel for what's the likely trajectory going forward.

In terms of a price increase, it could always happen, so could price cuts.

We continue to actually test more price cuts and looking for the elasticity in the same way that we always have.

So prices and value is an effective tool for us to use on both sides of

Okay, and then you've invested a lot in customer care, I guess.

You seem to be seeing that as a strategic advantage.

Any way to quantify the benefit in churn from that move and what other side benefits do you realize from having that asset?

There's no precise way of quantifying it in terms of churn because we don't have a control set of customers that didn't get the high quality customer support, so it's more our judgment that this is a worthy investment and it pays itself off in a positive brand reputation, which helps the word of mouth and helps us grow.

I would point out, we're getting some great press about it, it's not particularly material in the total P&L.

It's a good thing, but if you calculate the cost of 200 or 300 hourly employees, it's not a big investment or a big driver of our P&L.

Okay, helpful, thanks a lot.

We'll take our next question from Doug Anmuth with Lehman Brothers.

Thank you.

Barry, you were talking about SAC and noting how it's the lowest it's been in two years, can you provide color on how the marketing spend trended throughout the quarter.

I'm sort of wondering why maybe you didn't even spend more in marketing to take advantage of the more favorable environment at least during the back half of 3Q?

Secondly, can you also talk about the composition of new adds and how that may differ from where it was a year ago, for example, in terms of whether you think these are new customers coming online or whether they are more so coming from a competitor?

Thank you.

Well, let's see, Doug, as it relates to the trend during the quarter, no comment.

As it relates to the composition versus a year ago, I think all we'll say is that the trended growth in rejoins continues.

We've seen a gradual increase over time that remains true today.

We are seeing fewer folks leave for other online services, but it's not an hugely significant shift.

As it relates to why we didn't spend more in the quarter on marketing, I would remind you that last quarter our message was there are lots of different ways to invest in growth.

One way is through additional marketing.

Another means is with price reductions.

And last quarter, we made the decision to throw our weight behind price reductions and we committed at the time that we would pay for it in, significantly pay for it with reductions in marketing spending.

So nothing we saw during the quarter convinced us that we should depart from the strategy that we had articulated for you on last quarter's call.

Okay, and can you also comment on your Bay area penetration?

16.9%.

Great, thank you.

Yes.

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

Okay, great.

Thanks a lot.

Congratulations on a great quarter.

I wanted to ask you a question about the gross addition trend which was down 1% year-over-year here.

The net additions down 50%.

If you trend that out for a couple of years that puts you at a point where basically you're not growing subscribers a couple years out.

Clearly, I don't think you guys see that, so I'm wondering what keeps the long-term trend of subscribers going?

Do you pick up gross additions over the next couple years, or does the churn rate improve?

That's the first question there.

Barton, it's Reed.

A little bit of both.

We're seeing, if you map out how do you grow to our goals over the next couple years, it will require both reduction in churn and an increase in the gross adds.

So it's why we pointed out that in fact, although we significantly exceeded where we thought we'd be for Q3 on a year-over-year basis, we're only half recovered where we were one year ago.

We still have some work to do.

Okay, [all righty], and the other things in terms of the investment in online.

I know you guys talked about a $40 million spend this year.

I want to be clear, in the past you suggested you'd spend more than that next year, is that still what you're suggesting and if so, if you could give us some sense of what that spend gets you?

We did say that we expect to increase our spending next year.

That's all we've said.

We said we'd talk more about our online strategy and plans in January on the Q4 call.

Okay.

So if you'll be patient, we'll have more to say then.

Okay, all right.

But, again, the flat to slightly up earnings includes more spend on online next year?

That's correct.

I don't think you could get your model to work without increasing your assumption for online spending.

Okay, and then the final thing, you may not be willing to go this far, but is the increase in online spending is that of a recurring nature or is that a one time thing that hurts you in '08, but isn't likely to be there in subsequent years?

Barton, it's Reed.

There's very little of our online spending that's one time in nature.

You can always call something one time, but it almost always turns into, as you're growing and you have new competitors in the future to be essentially an ongoing investment.

Okay, great.

We're definitely planning for success.

Okay, great.

Okay, good.

Thanks a lot, guys.

I appreciate it

We'll go next to Tony Wible with Citigroup.

Good afternoon.

I had a couple questions on the SAC.

Barry, if you could, how do you anticipate the SAC changing with seasonality, and then also if we were to see a revamped marketing push by Blockbuster, is there a way of kind of quantifying tit-for-tat how that would affect the earnings model?

Well, very hard to answer the second question in the abstract.

One of the big drivers of SAC is growth from word of mouth.

People who have heard about the service from friends and decide that you're the place they want to, you're the brand they want to associate and they walk in the door essentially for free.

That drives down your average cost per acquired sub.

In terms of overall spending, SAC is very much a managed outcome.

We begin each quarter with a fixed dollar amount in mind and Leslie and her team manage the business to deliver that level of spending.

We will periodically reassess, during the quarter, reassess the amount of money we plan to spend with respect to our forecast for profitability during the quarter.

But given that we're still in the process of paying for the price cuts that we implemented, it's not likely we're going to double down our marketing spending.

Got it.

Given that the cuts you've made have clearly kind of netted into a benefit based on your results this quarter, would you not consider just lowering pricing then on a go-forward basis?

It's Reed, Tony, as I said earlier on the call, we're definitely testing additional price cuts and lower prices to see is there enough elasticity such that with reduced marketing we end up with greater profits and greater subscribers after the price cut.

So something we look at and potentially price increases also, depending again on that same elasticity.

So we look at both.

And, Reed, I appreciated your comments during the call about the potential for one of the channels to get to the TV being a box that you would not carry subsidies on that box.

Can you elaborate a little bit more on what you meant about that?

Are we talking about partnering with a third party or how would that box work relative to the other models?

You know, we'll fill you in more, I think, on our next quarter's call.

The main thing I wanted to get across is that we weren't contemplating any radical moves on the cash flows.

You can put that one to rest.

It still gives us a lot of flexibility in how to operate and how to be effective.

We'll be able to give you a fuller update a quarter from now.

Great, thank you

We'll take our next question from Brian Pitz with Banc of America.

Thanks.

You mentioned the increase in investment spending in Internet video next year.

Just to be more specific in terms of content, can you give us a sense between longer tail content projects versus not so long-tail and really comment on the competition that may result from other studios potentially chasing the longer-tail content?

And then a second question, sort of a follow-up from another question that was asked, can you really give us a sense for how much may have been spent year-to-date on Internet video projects so we just can model things thoughtfully going forward?

Thanks.

Brian, Barry.

I understand why you're asking, and I don't mean to be difficult in saying we have no comment at this time.

But we have no further comment at this time and we'll, to the extent we have more to say, we'll say it on the Q4 call in January.

Great, thanks.

And we'll take our next question from Heath Terry with Credit Suisse.

Great.

Thank you.

I was wondering if you could give us an update on what kind of penetration you're seeing for the Watch Now service and to what extent you've been able to meet your goals in terms of expanding the availability of the product offering there?

Heath, it's Reed.

We've been very pleased with the Watch Now service.

We announced, of course, 10 million views as of about six weeks ago.

We've seen very nice and broad usage, and there's a whole demographic of people that are very comfortable watching movies, whether those are DVDs or online video on their laptop.

There's a high end base which has the plasma TV in the den, and then there's another group or another segment of consumers that are really pretty laptop centric and they have been getting significant value from our service.

So we're very pleased with the progress there.

Is there a penetration number you can talk about?

20%?

25%?

No, again, same as Barry referred to.

For competitive reasons, we're going to be a little quieter going forward.

Okay.

We'll give you a qualitative update on where it's trending, but it's been very successful for us.

And we're very excited by it.

Have you got any feel for, been able to get any feel from those that have adopted it?

Are they changing their, their by-mail rental habits?

Are they still consuming the same number of discs by mail and just Watch Now on top of it, or is this actually a replacement for them?

We'll be able to get a feel for that over the next probably two years in terms of how our gross margin evolves, to see how much substitution there is.

In the best case, there's enough substitution that we're able to maintain pricing and maintain gross margins, but we don't have enough evidence to believe in that.

It's more of a desire at this point.

I'd point out that without a control set, i.e., a large set of subscribers that didn't have online, it's really hard to tell mixed in with the seasonality and the other factors going on.

Is it because of online video or is it because of fewer big hit movies this Q3 than in the past?

Okay, great, thank you.

And we'll take our next question from Gordon Hodge with Thomas Weisel.

Yes, just a follow-up, just on the fact that you had a 1% decline in gross subscriber additions, given the fact you didn't change your pricing until July and,, I think, Blockbuster took the foot off the gas in marketing sometime in July or early August, my guess is your trend in gross subscriber adds is stepped up considerably so that you're actually pacing up into Q4, or maybe you can, if you can't comment on that, maybe you can comment on the gross subscriber adds, August and September, would be great?

Thanks.

I think you see in our increased guidance for Q4 how we feel about the net of those trends and we're very excited about those.

Obviously, we're not guiding explicitly to growth adds, but we're making some real progress by continuing to focus on great execution.

It's probably fair to say that you're up in September, you were up in September and August?

You know, I didn't confirm or disconfirm that for you, Gordon.

Okay.

Sorry about that.

Don't worry.

Thanks.

That does conclude today's question-and-answer session.

At this time, I'll turn the call back over to you, Mr.

Reed, for any enclosing remarks.

Thank you, everyone.

Look forward to talking to you again in the quarter.

Thank you.

That does conclude today's conference.

Thank you for your participation.

You may disconnect at this time.