Netflix - Earnings Call - Q1 2011

Transcript

Speaker 2

Good day, everyone, and welcome to the Netflix First Quarter 2011 Earnings Q&A session. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to Ellie Mertz, Vice President of Finance and Investor Relations. Please go ahead.

Speaker 3

Thank you, and good afternoon. Welcome to the Netflix First Quarter 2011 Earnings Q&A session. We announced our financial results for the first quarter at approximately 1:05 P.M. Pacific Time today. The shareholder letter and the Q1 financial results and the webcast of this Q&A session are all available at the company's Investor Relations website at ir.netflix.com. As is our standard practice, this call will consist solely of Q&A, and we are going to conduct the Q&A via email. Please email your questions to [email protected]. We may make forward-looking statements during this call regarding the company's future performance. Actual results may differ materially from these statements due to risks and uncertainties related to the business. A detailed discussion of such risks and uncertainties is contained in our filing for the Securities and Exchange Commission, including our annual report on Form 10-K filed with the Commission on February 18, 2011.

A rebroadcast of this Q&A session will be available at the Netflix website after 6:00 P.M. Pacific Time today. Now, let's move directly to questions. We've organized the questions by topic this time, and we'll start with content questions. Here we go. As you acquire digital content rights, what level of competition are you seeing during the negotiations?

Speaker 1

There's a substantial level of competition, as you would expect, not only amongst the online players but against cable networks and sometimes in partnership with cable networks in a window sharing. Content owners want to get the best price for their content, as you would expect, and they're pretty sophisticated about making sure they've got all the possible offers on the table.

Speaker 3

A related question: How much risk is there that Amazon will outbid Netflix for digital rights to STARZ content?

Speaker 1

I'm not sure that Amazon specifically is a different risk. I would say, in general, STARZ, like any other content provider, wants to get the most money for their content. The STARZ deal is non-exclusive today, so it could be across a range of providers. It could be a single, but I don't think I'd particularly single out Amazon as a risk factor relative to, say, Google+ or DISH or anybody else.

Speaker 3

Okay. In the past, Reed has commented that shutting down Red Envelope and Netflix's lack of interest in producing content or licensing previously unreleased content was a bet on creativity and was outside of Netflix's circle of competence. How can you reconcile these previous remarks with the recent move to invest in the House of Cards series?

Speaker 1

There is a slight shift there, which is we're willing to try a little bit more riskier work than we've done with a little bit of our budget, and then we're going to see how it goes. It's sort of how we approach international when we tried Canada first before getting too committed. Our theory is that with serialized content, we may be able to build an audience very effectively because with on demand, you can get back to the first episode as momentum around the series builds. I don't know if it's anything we'd bet the farm on, but we're certainly willing to try it with a small percent of the budget in House of Cards and in two or three other smaller ones that we would look for. If we're successful with it, then we would expand our circle of competence a little bit more, a little bit more. We'll take it step by step and year by year.

Speaker 0

Just to add to that, this is David. In the House of Cards deal, it was a pre-packaged deal that came to us. We weren't out there looking for creative talent or directors or a script. It's a small nuance, but it was an important one for us in the fact that we weren't having to manage the larger part of the creative process.

Speaker 3

An additional question on House of Cards. Are you seeking to buy domestic or global rights to House of Cards? Is your intent to keep House of Cards exclusive to Netflix? After presenting the series on Netflix, will you look to sell subsequent rights to other cable or broadcast networks or online services?

Speaker 1

House of Cards doesn't start until the fall of next year, so it'll be a couple of years out before we're faced with both decisions. We've licensed it for multiple territories.

Speaker 3

Okay. Prep speculation puts your spend on Mad Men at nearly $1 million per episode, which seems to be lower than recent syndication deals for procedurals but higher than deals for some other low-profile serialized series. Why did you decide to pay for exclusivity? Should we think of your Mad Men deal as typical of some other TV deals you may be doing going forward, or was this a unique case?

Speaker 1

We don't comment on the specific deal terms of any of our deals.

Speaker 3

Can you share any data that supports your view that putting a previous season on Netflix grows audience for a current season of a show? Wouldn't Netflix also diminish sales of prior-season DVDs?

Speaker 1

What we've seen as an example with Spartacus is we've seen something even more aggressive, which is we have current season with Spartacus. That's a STARZ original that's been very successful, and now it's one of the highest-rated shows on cable despite the fact, or maybe because of the fact, that it's also on Netflix. I think in general, it's opened our eyes to the fact that more and more awareness of a given show sometimes creates more viewing on both cable or MVPD and on Netflix.

Speaker 3

Given the size of your subscriber base, is it getting easier to negotiate content deals, or is there still a level of animosity with some content owners that must be worked through?

Speaker 1

I don't think there's any animosity. It's only a question of is our check big enough? As we get a larger subscriber base, that becomes easier to write bigger checks. It's very respectful, I would say, across the board.

Speaker 3

Moving to the topic of international. In terms of international expansion and content acquisition in non-U.S. markets, what type of expenditures do you anticipate making for locally relevant content, and how might deals with foreign outlets differ from domestic deals?

Speaker 1

We're not sure of how much local content will be important for Netflix. With Canada, we've got a fair amount of Canadian content, and it's quite successful for us. In our new territories, we'll also license some local content, and then we'll feel our way along as we see what our subscribers are viewing and what they enjoy.

Speaker 0

I'd say that there's an opportunity here outside the U.S. in some markets with respect to some local content. There might not be a secondary market or a third or fourth sort of channel for the content owner. To the extent that we might be the only syndicated buyer in the market, it's going to work well for us in terms of the economics.

Speaker 3

Will new geographies take priority over the U.S. as you build out content, or should we continue to expect the U.S. to see the bulk of the spending?

Speaker 1

I think you should think about them as separate. We'll run the U.S. around 14% operating margin and spend on content in accordance with that. In international, we'll spend as we see appropriate to launch the service, where we've obviously got spending ahead of revenue, and then as rapidly as possible within eight quarters in our target model, get each territory to be a positive operating margin. In Canada, we've been very successful, and we intend to be at break-even on an operating contribution basis within four quarters of launch, which is, I think, Q3 and really quite extraordinary. That's probably too high a bar for every international territory, but eight quarters feels good.

Speaker 3

On the topic of Canada, can you provide a little color on how the ISP bandwidth caps in Canada have impacted consumer behavior? What percentage of your Canadian customers are using the new "managed video quality" tool and watching lower-quality video? Also, do you believe ISPs in the U.S. or other countries are thinking of capping bandwidth in a similar strict fashion?

Speaker 1

We don't have any indication that in the U.S., low, call it below 100 GB data caps are going to become a significant offering. In Canada, we switched to default, so virtually everybody is on our low data usage, slightly lower video quality plan. It is helping both directly in terms of the usage and indirectly in terms of the general fear of usage charges. It's a mitigator. I'm not sure I would call it a solution. It helps. I think the right solution over time is that Canadians enjoy great uncapped internet like the rest of the developed world.

Speaker 3

A related question: How have usage patterns in Canada performed relative to your expectation, given the various bandwidth caps? What drove the more modest subscriber growth performance relative to your expectation?

Speaker 1

I think what drove the overshoot on the forecast is just we don't have any seasonal data. The growth was very consistent throughout the quarter, and we're really happy with it, and it's a pretty small percentage, but we just don't have multiple years of year-on-year data. In terms of the caps, they play a role, but they played a role from inception. The caps are not something that were new this quarter. The caps have been in effect for a year or more in Canada.

Speaker 0

Just to add to that, we achieved 8% of broadband household penetration in Canada in seven months. It took us six years in the U.S. to get there. Just so that you're not feeling like we're sort of trying to make ourselves feel better on the forecast in this, we're happy about the business. We think we've got a great business going in Canada, and we're excited about going forward.

Speaker 3

Another related question: Your shareholder letter mentioned the seasonality curve in Canada. Can you elaborate on this comment? Is your initial sense that the market's similar to other colder regions where subscriber growth is more tepid in the warm months?

Speaker 1

A year and a half from now, after we've gone through, the initial seasonality is masked by the launch, and so you really can't get a clean read till at least a year from now about the beginnings of the seasonality effect.

Speaker 3

Is it reasonable to assume that Netflix could enter as many as two international markets or more per year, starting in 2012?

Speaker 1

If we continue to see the kind of success that we've seen in Canada, we think it would be very smart for us to move at least that fast, yes.

Speaker 3

You noted a high probability of success in our second international market, driving early content commitments for a third market. What are the data points that you focus on to define success prior to launching in a market?

Speaker 1

The reason that we feel a high degree of confidence is how well Canada has done, how well our licensing has gone for content in our second international market, and our qualitative focus group work on the reactions in that market for our service. Those are all very healthy indicators that we'll enjoy success.

Speaker 0

Those qualitative factors have a lot to do with how much that content is going to cost us relative to where we think we could price it and the consumers' willingness to pay based on their other entertainment alternatives. We've grown more, I think, confident over the last year given where we think those economics are going to work out.

Speaker 3

Moving to the topic of subscribers and subscriber metrics. Do you think we get tiered pricing for multi-user households from Netflix by year-end? In that case, how big an addressable market is it?

Speaker 0

The individual subscriber market is a two to three or a few year, I think is how we characterized it in the last investor letter. We haven't changed our point of view. This is a gradual evolution. It's not going to be an immediate 90 or 180-day thing for Netflix. I think pricing is certainly part of that evolution, changes to the interface are part of that evolution, changes to how we, if and when we enforce concurrent stream limits, either per device or by account. There are lots of things for us to figure out and tease out. We wouldn't want to alienate the subscriber or the consumer as we go through those, and I think that we'll evolve to those over the next couple of years.

Speaker 3

Can you share any details on Facebook integration that you are working on? What would be the primary objective of the same? Enhance your recommendation engine, drive engagement, or acquire subscribers?

Speaker 1

It's better for us to share those details when we launch that, so I'll defer to that.

Speaker 3

Are you starting to see DVD subscribers trade down from multi-app subscriptions?

Speaker 0

I don't think so. In fact, what we said before is that basically downward migration and upward migration are canceling each other, and that's what we continue to see. With respect to the price change, we saw behavior that was more linked to the immediate announcement than to the credit card change, meaning when a subscriber actually got the change to the price on their bill, there wasn't as much activity as when they were notified of the change.

Speaker 3

Related to the price increase, was the price increase a contributor to the increase in churn, or was it more of a normal seasonal pattern?

Speaker 0

Normal seasonal pattern. It's also a factor of the tremendous growth we saw in Q1. If you followed our company for a long time, you'll note that when we grow quickly, our churn goes up because the retention rates of early subscribers are lower than those subscribers that have been around for 12 or more months, and we continue to see that.

Speaker 3

Another question on churn. Can you comment some on the churn rates for streaming-only customers in the U.S.? Is it above or below the average? Do you expect a decline over time as customers are maybe testing out the service today?

Speaker 1

What we said is streaming-only has a higher churn rate. It's easier to get in and out of, so it's the same as we said last quarter.

Speaker 0

Yes. We've said before that the streaming-only plan actually crossed over the DVD-only. Retention for streaming-only subscribers is actually at higher rates than DVD-only subscribers. It's going to be slightly lower than hybrid, but it's better.

Speaker 3

A final question on churn. It still seems like the overall churn rate for the company is still high relative to other MVPD companies and causes you to respend stacked dollars on customers who have already been Netflix subscribers in the past. If the customer satisfaction is very high on your streaming products, shouldn't your churn materially decline over the next 18 months in the U.S.?

Speaker 1

Given how stable churn has been the last two years, it'd be hard to think why it should suddenly decline in the next 18 months. The question refers to us like other MVPD, and MVPD is a much different service. It's premises-based, it's more expensive, and it's more considered an essential service. It's really just quite different in all those dimensions. We have a low subscriber acquisition cost, and we have higher churn, and people do test out the service, come back, go out, go in, and that's fine because our overall growth, our net ads, are continuing to increase.

Speaker 3

Moving to the topic of stack, why did the domestic stack rise so much quarter-over-quarter? Which should be the right base level going forward? Q4's $10.87 or Q1's $14.38?

Speaker 0

There's nothing to say as a right base level going forward, but what we said in last quarter's investor letter, and we reiterate in this investor letter, is that we identified the fact that we would have additional money. We would love to spend it on streaming content because of the complexity of those contracts. There's more lead time required, and therefore we put the money into marketing. The higher stack sequentially from Q4 to Q1 is somewhat of an artifact of additional marketing dollars we spend up to the efficient point in Q1, and we'll continue to make that trade-off going forward. What we said in the investor letter, just to remind folks, is that we're going to raise streaming costs. We plan to do that. We're going to continue to do that. You should see marketing as a percentage of revenue somewhat modified relative to Q1.

Speaker 3

As subscribers have grown due to streaming, how have the demographics of the Netflix subscriber changed? Is the demographic in Canada comparable to the U.S.?

Speaker 1

Yeah, there's no material differences there.

Speaker 3

Can we get U.S. and S.F.A. area household penetration?

Speaker 0

We've gotten this question before, and I'll respond by saying that the penetration in the U.S. is 21%. You can calculate that for yourself by looking at the 22.8 million U.S. subscribers and taking it over roughly 110 million households. The reason that people ask us this is we've given out Bay Area before because when we launched the DVD service back in 1999, we started in the Bay Area, and we had thought at the time that the Bay Area would be a good proxy for the rest of the country. We've come and evolved that notion to believe that that's not necessarily the case, especially with a streaming product that we've launched nationally. In terms of penetration, it's 21% U.S.

Speaker 3

Your letter to shareholders mentions that you expect DVD shipments to decline slightly year-over-year. In the past, Netflix has announced various milestones in DVD shipments, such as the 1 billion February 2007 and the 2 billion April 2009 disk ships. When did Netflix ship the 3 billion disks? Are there other notable DVD milestones?

Speaker 1

Our focus is really on streaming at this point, so I don't anticipate that we would have or would make those kinds of announcements.

Speaker 3

Moving to the topic of competition. Can you speak to the competitive landscape and how a series is competitive today versus, say, a year ago, especially with Amazon's free video streaming offering and with DISH streaming HBO's content and STARZ channels for free?

Speaker 1

A big market attracts a lot of competition. I think it's pretty clear to everyone that online video is a big opportunity. There'll be a number of substantial competitors. If DISH launches something under the Blockbuster brand, that'll be the newest entrant. Clearly, Google and Amazon may or may not have been having success, but they haven't held us back at all, which you would expect in a growing market, because in Q1 domestically, our net ads were up over 90%, so we feel great about that.

Speaker 3

You mentioned DISH is a competitor. Could you elaborate? Blockbuster is currently a VOD product, white labeling Sonic Technology. Do you expect that to change?

Speaker 1

You know, we really don't know what DISH is up to, but presumably they paid a couple hundred million for Blockbuster, not for its technology but for its brand. It's a well-known brand, and they would do that. It would be consistent to do that if they had plans to launch a service with a fair amount of content and a fair amount of marketing such that it would make sense to pay $300 million to be able to use the Blockbuster brand.

Speaker 3

One more question on competition. How do you look at HBO and HBO GO as a competitive product as it prepares to expand across the many platforms Netflix currently occupies?

Speaker 1

HBO GO is an implementation of TV Everywhere. A consumer can't subscribe to HBO GO directly, and so it really doesn't compete today. I would say the overall effort that TV Everywhere is making is how to improve MVPD, and one aspect of that is HBO Online. For example, in the Comcast implementation, you don't use HBO GO, the user interface. You use the Xfinity user interface. I think you'll see different implementations, and the only, you know, the competitive threat to take out of that for us is TV Everywhere.

Speaker 3

Moving on to questions about the financials. In response to a question post-last quarter regarding the significant increase in AP, the company indicated that "largely payments are short timing at the end of the quarter that could reverse themselves in Q1." Can the company indicate why this did not reverse in Q1 and instead AP increased further?

Speaker 0

I was responding to the sequential increase in AP last quarter. I answered it somewhat narrowly in saying that the two contracts that drove that AP increase were going to reverse themselves out in Q2, and they did. In addition to that, we signed a bunch of new content deals that we discussed in the investor letter, and to the extent that those deals were within a year with identified titles, it drove the AP up. Let me answer this in a general sense. Cash payments for content increased $130 million year-over-year versus a $110 million year-over-year increase in the expense associated with that content. To the extent that we've talked about close matching of our payment terms with our expense, we're continuing to execute on that. We ran a little bit ahead in Q1.

In terms of the sequential increase, the cash out the door for content was roughly in line with the expense increase. I think you should see the accounts payable and the associated long-term accrued payable line increase with our continued investment in streaming content. I don't think you'll see it increase at quite the same rate, say, going forward as you saw in the last couple of quarters, but it will go up.

Speaker 3

Can you explain the large sequential and year-over-year drop in acquisitions for the DVD content library?

Speaker 0

I'm sorry, repeat that one more time.

Speaker 1

I can handle it. There's a mix there. When we do a rev share title, most of the expense, essentially all of it, does not go through that line. That can be a shift towards rev share from purchasing DVDs.

Speaker 3

On the streaming side, are storage and encoding costs typically fixed or variable, and are they significant relative to content delivery costs?

Speaker 1

They're not significant.

Speaker 0

They're not significant.

Speaker 3

What drove the G&A increase in the quarter, and what are your expectations going forward?

Speaker 0

Mostly headcount. There was some increase related to stock comp expense due to employees taking more equity compensation versus cash compensation, but mostly a headcount increase.

Speaker 3

Why is fulfillment cost still growing? Do you expect it to slow as DVD shipments decline?

Speaker 0

Fulfillment cost as a percent of revenue is actually declining. The absolute fulfillment cost is growing because we shipped more in the quarter. We have more subscribers that have more credit card expense associated with them, with their revenue. As a percent of revenue, it's actually been declining over the last six quarters or so.

Speaker 3

Next question. If you are a growth company, why are you dividending cash out to shareholders rather than reinvesting it back into the business?

Speaker 1

We're generating cash flow, and we anticipate continuing to generate cash flow.

Speaker 0

I think we're doing both. I think we're trying to draw a fine distinction between being a pure company that invests everything we possibly have into growth and also returning some to shareholders. I think it's consistent with the strategy that we've had for quite some time of trying to draw both, to do both, be a growth company and also make sure that we're not setting up a false promise to return earnings down the road.

Speaker 3

Let's turn to a handful of miscellaneous questions. When will we start seeing Netflix streaming on Android devices? Will future versions of Android solve the DRM issues that prevent making Netflix widely available on the platform?

Speaker 1

We're working hard on Android. I don't have any news at this call. It's a big priority for us, and stay tuned.

Speaker 3

Device partnerships have been a significant component of building out the footprint of streaming subs symmetrically, and it seems that it could be used as a valuable tool in building out the international footprint. To what extent will your U.S. device partnerships be applicable internationally, or what will it take to build out a similar ecosystem of devices?

Speaker 1

We very much expect to work with our CE partners around the world, and certainly in Canada, we've already done that with specific Canadian implementations across all of our major CE partners. There are now many, many devices in the Canadian market, and that's a good blueprint for what we'll be doing going forward.

Speaker 3

In the press release, you say TV shows and feature films are consumed in equal volumes. Is that true domestically and in Canada?

Speaker 1

It's approximately true in both, yes.

Speaker 3

Moving to a marketing question. Given what is likely to be a very lucrative upfront process for both broadcast and cable networks come this May and June, do you see paying what is rumored to possibly be as high as low-teen price hikes for the network ad inventory for marketing purposes, or will you just bypass network television spending and gear your marketing spend more towards lower CPM alternatives such as outdoor radio?

Speaker 1

We always try to market the most efficiently we can, and sometimes if one channel, say outdoor or online or print or a network, were to increase in cost, it would get less of our total dollars. It's a big, broad mix of which the two primary components for us are online and television, not necessarily network, but cable often.

Speaker 3

Great. Okay, that's the last question for today. We'd like to thank everyone for your time, and we look forward to speaking with you again next quarter.

Speaker 1

Thanks, everyone.

Speaker 0

Thanks. You too.

Speaker 2

Thank you, ladies and gentlemen. This does conclude today's program. Thank you for your participation.