Good day, ladies and gentlemen, and welcome to the Netflix Second Quarter 2011 Earnings Q&A Session Conference Call. During today's call, all phone participants will be in a listen-only mode. If anyone requires operator assistance during the call, please press star, then zero, on your touch-tone telephone. As a reminder, today's conference call is being recorded. Now, I would like to pass the call over to Ellie Mertz, Vice President of Finance and Investor Relations.
Thank you, and good afternoon. Welcome to the Netflix Second Quarter 2011 Earnings Q&A Session. I am joined here by Reed Hastings, CEO, and David Wells, CFO. We announce our financial results for the second quarter at approximately 1:05 P.M. Pacific Time today. The shareholder letter and the Q2 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 ir@netflix.com. 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 filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K filed with the Commission on February 18th, 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. Similar to last quarter, we have organized the questions by topic as we've received them via email this afternoon. We'll start with questions about the pricing changes we announced just two weeks ago. How are you feeling about the price increase two weeks since announcing it? Do you expect for some of the subscribers turning off with the pricing increase that they will return later once they try other alternatives?
This is Reed. Like any customer-driven organization, we feel bad about having customers upset with us. We feel great about the amazing new content we're going to be able to license in the fourth quarter and next year, which will further propel our growth and our subscriber satisfaction. The price change takes effect upon each subscriber's renewal in September, so we don't have a full-range view of it. From what we've seen, we've been very pleased at the effects, and we're feeling great about the decision, as tough as it is, and it's going to allow us to have just fantastic streaming content going forward.
Let me follow up on that. While still early, could you help us understand the initial effects of the subscription plan pricing change? The net effect on subscriber growth, churn, and ARPU.
Because of the timing, we announced it at the very beginning of a quarter. We'll see the negative effects of it in Q3. That is, the elevated churn and lower revenue growth than we would otherwise have. The price increase takes effect essentially mid-September on average, so we get a little bit of benefit at the end of the quarter, and then the real benefit comes in the following quarters, Q4 and beyond. In terms of tracking where we are and our expectations, we're feeling very good.
Can you tell us what percentage of subscribers have canceled the service? Have you seen subscribers migrate more towards the unlimited streaming plans or towards the DVD plans, or are they opting for both?
We are making estimates for the end of the quarter. That is what is in our guidance. We will see over time what the split is. We feel great when you think about it with our DVD service at $7.99. It is an incredible value. It is the lowest priced offer in the marketplace. It is the best service levels in the marketplace. If a customer wants a DVD rental by mail, we are definitely the place to go. In terms of streaming, we have gained increasing confidence over the last two years about the viability and strength of a pure streaming plan. We gained some confidence when we launched in Canada, and that blew away our expectations of the response.
We gained some confidence when we led on our non-member homepage with streaming only, and as we put in our shareholder letter in Q2, about 75% of subscribers chose streaming only. In other words, even though DVD was only $2 more, 75% stuck with streaming only. With this pricing change, we are going to be able to strengthen that streaming plan with more content. That is why we feel good about it.
I'd say just to add on to that, our guidance in the letter shows people the strength of the offerings in the sense that we do feel that most people are taking the hybrid offering. A lot of those hybrid subscribers are staying on both plans, and that's implied in both the guidance and the diagram that we put into the letter.
A follow-up question on timing. Why did you implement the recent pricing changes now when subscriber growth is near the highest you've ever had? Why not wait until you are further into your penetration curve?
I think the reason we felt confident about doing it now is the strength of streaming-only. Really, we got convinced that we can thrive on streaming-only, and with the great new content we were going to be able to get with this pricing change, the best timing was now.
Why did you decide to push through such a large pricing increase with a smaller, less disruptive one?
You know, we didn't approach it as what percent price increase should one do. I think if we had, we probably wouldn't have gone to 60%. I can understand the question. We really approached it on that we should separate the businesses and the plans because streaming-only was going to become a global offering, and we wanted to really focus on that global streaming offering. DVD is an incredible U.S.-based plan that's very profitable, it's very large, and we wanted it to be able to be successful and to have a group that was going to focus on it. The pricing change somewhat was an outcome of that.
Why lower the price on DVD only? As subs shift to streaming, the economics of the remaining DVD business would appear to be working against you. Is there a lot less infrastructure for less subs?
We didn't lower the price on DVD only. We never had a DVD only plan. The perception of lowering might come from the combination plan, which was $9.99, and it was the only way to get DVD. For someone who's very rural and doesn't have broadband, they were essentially paying that extra $2 for streaming and not being able to access it. We felt great about making a low-priced, aggressively low-priced $7.99 DVD plan, and that was the right plan to carry forward on our DVD side.
Could you explain in more detail the thought process and drivers behind separating the DVD-only business, the start of DVD-only marketing again, and looking to improve the service after several quarters of effectively putting that part of your service back of mind?
One of the aspects that we wanted to get is that the DVD can last a long time as a successful service and generate lots of satisfaction and lots of profits if we give it a platform to succeed on. It is true that we haven't marketed it much in the last couple of years, but by now having it as a division within Netflix, we've got a way to measure the P&L, and we think it'll be a smart investment in its growth and sustainability. Whether its growth is probably maybe a bit overstated, that would be an aggressive case, at least that it will shrink slowly as opposed to rapidly with a little bit of investment. We'll figure that out over the next couple of quarters.
We have always talked about the DVD side of our business in a spectrum of emphasis and focus. Rather than being pushed to the extremes, what we've said is that we've focused on streaming, we've proved it out, we've had two to three quarters of tremendous growth, and now it's the right time to go back and look at how easy it is to find the DVD service, how easy it is for those subscribers to find what interests them. That is what I think this is, a step in that progression.
Does the separation of streaming and DVD plans set the stage for the acquisition of streaming content on a per-subscriber basis?
No, there's no connection between those issues.
Can you please give us a little bit more color on your Q3 guidance? I was hoping to hear your thoughts on U.S. subscribers. Are you expecting significant cancellations with the new price plan? Are we close to the peak number of subscribers Netflix reasonably hopes to attain in the U.S.?
I think we've answered most of that question in the sense that we've provided pretty clear guidance, in addition to providing some streaming versus DVD subscriber guidance. I don't think there's any implication that we're nearing the peak in that, and I think that we're expecting Q3 to be a quarter where we have subscribers choosing where they want to land, and then Q4 we expect a return to growth as the comments in the letter indicate.
Netflix prides itself on customer service. Did the call volume after the price change surprise you at all? Calls were actually being disconnected instantaneously. What about the social media reaction? Was the noise level in line or higher than you expected?
Believe it or not, the noise level was actually less than we expected given a 60% price increase for some subscribers. We knew what we were getting into. We tried to be as straightforward as we could, and that has worked out very well for us. In terms of the customer support line, it was a very short amount of time that it exceeded our capacity there, and now our service levels have returned to our normal great service levels.
How does separating your DVD and streaming business impact your relationships with the studios? Do you expect the content partnerships to be negotiated separately in the future? What kind of impact does that have?
The content acquisition has mostly been separated for a while. That is, movie studios mostly have different divisions between DVD and streaming, and the television studios very much have been different for a while. We don't see any significant effect coming out of the separation of the plans.
Let's move to questions about content. Could the company please address what proportion of total streaming content is obtained under revenue sharing agreements, along with color as to what types of titles are usually obtained under such arrangements, and how the economics of revenue sharing compares to the company's other content purchasing agreements?
For streaming content, we buy like our industry and pay television and network TV buys and cable networks, which is you have to commit upfront, and you have to pay a fixed amount per time period, typically per year, for access to that content on your network. That is the industry in which we compete, and we buy in that way. There is not revenue sharing in the DVD style model. Of course, on DVD we have some revenue sharing, and that's as it always has been.
Sony Pictures films are still down from the Netflix service. Could you go directly to Sony and Disney for streaming content, or is the Sony Stars agreement exclusive until 2016-2017?
The Starz agreement and that industry, for example, HBO Go, also are exclusive. It is working through Starz. That is our preferred option.
In the shareholder letter, you noted that streaming content deals are, quote, "being recognized as assets on our balance sheets," as the content becomes available to streaming customers. How, if at all, does this affect the former $1.6 billion of commitments related to streaming content license agreements that do not meet the content library recognition criteria? Is this how those commitments move on to the balance sheet? In that case, how are the assets matched on the liability side of the equation?
It is a pretty long question, but in general, that is how the staging area for content contracts works as they move into what we call in window or available for streaming. When they do that, depending on the payment terms on the matching side, there will be cash out for a quarter of payment, the quarter of expense associated with that, and then to the extent that there are short-term liabilities, it will move into accounts payable. That is one of the reasons that we discussed that in the letter. If they are longer than a year, it will increase the other accrued liabilities. At this point, I will take those questions and refer you to our IR website. There is a pretty detailed treatment of our content accounting, and it should walk you through exactly what happens under each scenario.
Could the company please address, one, what is the total content obligations as reflected in the contractual obligations footnote of the 10-Q outstanding as of 6/30/2011? What amount of content obligations are due within the next 12 months?
Sure, this will follow in the next few days as we file the Q, but right now there's $2.44 billion in that contractual obligations versus $1.84 billion in last quarter as of 3/30, and roughly a quarter or about $625 million of those are related to short term.
Do you find that demand for streaming titles fades after their streaming debut, or does the demand remain constant over the life of the content's availability?
It's very title specific. We're very excited about launching Mad Men in a few days and being the exclusive subscription provider of that content. What we expect to see is a burst of activity, then it'll slow a little bit, and there'll be another burst as Season 5 goes live on television. Consumers want to go back to Seasons 1 through 4 to get into the story, so it gets built by that outside promotion. There are a lot of patterns in that way. In general, we've been very pleased with the kind of continuous viewing that we've seen when we license content, that it doesn't die right away and in fact has a great life.
Bloomberg and other outlets have said Netflix is in discussions with DreamWorks Animation for a streaming deal. Can you comment on those reports or generally on the potential to take away studio output deals from HBO and other premium services? Should we see a potential deal with DreamWorks as a potential hedge on the risk of not renewing with Starz and thus losing access to Disney's family movies?
We're always in talks with all of the different providers in terms of licensing more content, but we're not going to comment on them in advance. If we conclude a deal, we would typically announce it and go forward on that basis.
We're going to move now to questions on our international expansion. A lot of us on the sell side thought that the Latin American rollout would maybe be just one or two countries at first, followed by an additional one to two countries six months later after you've climbed the learning curve. Instead, it's 43 countries simultaneously. What's your reaction to the notion that you guys are biting off more than you can chew? Why not focus on the largest countries first? Why spread marketing dollars so widely?
I think that's driven by internally some balance between moving too fast and too slow. You could make the argument that we should just focus on Brazil, say, and learn some lessons there before expanding to the rest of Latin America. You could make the argument, no, we should go even faster, and we should do Asia and Europe and South America all at the same time. We ended up in the middle of doing Latin America at all countries at the same time. Our primary focus is on the larger countries in terms of where we spend on the marketing, but most of the content deals are Latin America-wide. It's inefficient to arbitrarily not allow the service to be in certain countries when we've essentially paid for the content for those countries anyway. That's where we get to.
We're definitely focused most of our time and effort on the major countries.
Can you offer us a little color on your progress with signing local content? What will be the local versus American content mix available to consumers in these new countries? Have you been able to secure such local language programming at reasonable rates?
As we get closer to launch, we'll have more content to announce. Obviously, in Latin America, there's lots of watching of sports, which we're not going to be carrying. There's lots of watching of Hollywood films, which we'll have, and there's lots of viewing of telenovelas. We'll have a very nice complement of telenovelas for launch.
What level of streaming content is necessary to launch markets in Latin America? Do you believe it to be more or less than Canada, either from a dollar or title perspective?
We are going to launch with much more content than we did proportionally in Canada, and that's because we're more confident of the outcome, which is part of what we learned in Canada. We started Canada pretty cautiously and then quickly built up the content, and we have more confidence. We are starting even stronger in relative terms in Latin America than we did in Canada.
Your guidance for international subscribers seems to suggest that you expect slower subscriber growth in Latin America compared to what happened in Canada. Do you expect adoption rates in Latin America similar to what you experienced in Canada?
No, that would be too aggressive. Canada is consistently rich as opposed to pockets of wealth, and Canada is broader in broadband, has more broadband penetration per capita, and it also has more video game consoles per capita. On a per capita basis, it'll be slower than Canada. On a per broadband household, it'll still be slower because of payment methods and because of video game consoles. We are very optimistic about what we can create and what will happen in Latin America.
The only thing I'd add to that is Reed mentioned the major reasons. There's a small brand halo effect in Canada that we don't have down in Latin America, as you would imagine. We're building a brand that is largely unknown down in Latin America, so there's a little bit of an effect there in terms of the speed.
Moving to questions specifically about Canada. What feedback have you gotten from Canadian subscribers about the data plans? Has the subscriber growth number been materially affected by the data plans?
We don't think that the subscriber growth number is materially affected by the data plans post our shift a few months ago to default people to the lower data plan, which is a very efficient use of data. The primary things that we're learning in Canada is that it operates from a seasonality basis, a little bit like Alaska, which is that summertime is great, people are outdoors and watching less content, and wintertime is cold and dark, and people watch a lot of content. In the U.S., we see more seasonality in Maine and in Alaska than we do, for example, in the rest of the country. Canada's operating consistent with that increased seasonality.
Based on that, how would you expect that ads in Canada to trend year- over- year in, say, Q3 and Q4?
In Q3 we had a large pent-up launch, and it will be difficult for us to match that comp. I wouldn't add anything other to the guidance that we've already provided in terms of international subs.
All right, moving to questions about competition. How has Amazon's deal for CBS content changed the landscape for acquiring content? How specifically will Netflix change its strategy, if at all?
It hasn't changed. That deal hasn't changed our perspective. Our brand is strong and focused, and that's what we're continuing to invest in and improve. We haven't been able to detect any effect from the Amazon Prime bundling.
What most concerns you about competitive streaming services? Have you seen much traction for Amazon service or HBO Go that is creating a compelling alternative experience for Netflix subscribers?
We haven't seen anything that's an alternative service. HBO Go's very impressive application, it doesn't have any of the content that we have, and we don't have any of the content that it has. It comes back to my metaphor of baseball and football competing for some of the same dollars and time, but really different offerings.
All right, let's move to questions about subscriber metrics. As it relates to the current churn rate, could you please provide some numbers on what percent or number of your current customers are repeat customers, meaning they have had the service in the past, canceled, and then signed back up?
What we've said in the past is it's about a third in terms of a rejoin rate. Obviously, the price changes have had a small effect on that, and we're sort of waiting for the trend to revert to a new level. I would say that the effect on the rejoin rate was not more than 20% in terms of that trend.
As we prepare for Netflix to provide less information about subscriber growth and churn, it would be helpful to understand the retention levels for customers based on their tenure with Netflix. Do you see different rates of retention or churn for customers depending on how long they have subscribed to the service? Are longer tenured subscribers retained at a higher or lower rate than the subscribers who have used the service for a year or less?
All subscriber services have the aspect that the longer a subscriber has been with that service as a class, they're pre-selected to either be comfortable with a value proposition, and churn declines with age continuously. I'm sure that's the same on all subscription services, and it's certainly true for Netflix. Mostly what we focus on is net ads. It's very easy to get distracted by SAC and churn in our experience, and we focus on how is our net ad growth compared to following a prior year period and compared to other aspects of the service.
Is there a material difference in churn between streaming-only customers and a streaming plus DVD hybrid customer?
Yes, as we've said before, the streaming-onlys have a higher churn. It's less of a commitment than those who have taken DVDs, and the DVDs are at home in that way. It is also easier to sign up because you can use the service 10 minutes later as opposed to waiting for the DVD. You get easier to sign up, more cancels. If you look at the net ads, they're very positive. We just want a lot of people to try Netflix. If they don't currently have the budget to keep it, that's okay. They will over time. We're really fine with lots of people trying Netflix and being exposed to that.
Let's move to questions about the financial results. You had a large sequential spend increase in tech and dev and G&A, while historically you have had very moderate moves from Q1 to Q2 in these expense lines. What specific new investments are you making, and will these expenses continue to grow at a similar pace going forward?
I'll take them separately. Tech and dev is generally headcount growth associated with both our domestic and our international investments. There's some partner spending in there as well, but it's mostly dominated by headcount. As a percent of revenue, it didn't actually grow, it grew sequentially. In terms of percent of revenues, it's still about 7% of revenue. I would expect that line to continue to track as we invest further in terms of percent of revenues. In terms of G&A, that should scale more slowly, but we did have a $5 million commercial settlement charge in the quarter. It was a one-time charge that you normally wouldn't see in the quarter.
Given your relatively modest cash position relative to the size of checks you're writing for content and the success you were having with that content investment, what is the rationale of buying back stock? Given the multiple you get for subs, wouldn't you generate more value by investing in adding subs versus buybacks?
We think about that slightly differently in the sense that our marketing expense is not constrained by how much cash we have in the bank. Our marketing expense is constrained by two things. One, how much marginal cost or marginal subscriber acquisition cost we'll have to lay out to acquire that subscriber, and can we do that at a profitable level? The second constraint on our marketing expense is basically our earnings targets that we set forth. We have three legs basically of investment. One is our streaming content investment, one is our marketing, and one is our earnings target, basically putting money towards back to investors. Setting the 14% operating margin, domestic operating margin target, allows us to set basically a content spend and a marketing spend. How we think about cash relative to the buyback is independent of how much we spend on marketing.
I'd say how we approach the buyback is what could we do with that cash as an alternative use? Should we hold it as an insurance policy, or should we return it to shareholders? A buyback is the most efficient way to do that.
In Q4 2011, you say that growth in net subs will resume. Is it fair to assume that the improved year-over-year trend is driven by a return in cancellation rates to normal levels? In other words, you see the price change as stimulating only a one-quarter hiccup in cancellation rates.
Yes, basically. What's happening is in Q3, there's an increase in cancellation because of the price increase announcement and in taking effect. In Q4, we expect the more typical year-over-year trend of net ads growth to return.
You had guided that Q2 2011 gross margins would step down versus the first quarter, and it didn't happen. You are essentially saying the same thing for the second half of 2011 versus the first half. Why should we believe you? Have you already signed online content deals that would cause a gross margin step down in the second half of the year, or would you need to sign new deals to hit your guidance for a step down?
We have to sign new deals to get there. We believe that we will find that content on the right terms, and that's why we're saying that. It is definitely possible that it will be like in the past where we underspend slightly on the content side. We definitely want the flexibility to be able to spend to that and thus our statements.
As we think about 2012, how should we think about your domestic operating margin target? In 2010, it was around 12% +. In 2011, it is 14%. You have exceeded it in two quarters in a row. Should we consider the 14% operating income target a long-term target or a near-term target?
I think you should consider that a target that we're comfortable with for 2011. As the year progresses and as we know more about how our DVD division does and our streaming offerings do, we'll probably look to raise that target going forward slightly. It's all relative to our international investments and our domestic investments, both DVD and streaming.
I would say that's been a multi-year pattern. We were at 10% three or four years ago. You see our value system in terms of allocating profits and growth, and as we continue to grow, also increasing the operating margins.
At maturity, is there any reason to think that the margins in the U.S. and international streaming businesses will be materially different?
I think the operating margins are really most closely linked to the competitiveness in the market. If in a given country we've got five big direct competitors, I would expect the operating margins in that territory to be less than in another market where we have a fewer number of significant competitors. It really depends ultimately on the number of competitors. That's what drives the operating margins.
Question on the balance sheet. What happened to current payables and other non-current liabilities? They exploded during the quarter.
I think I addressed that earlier, but basically as we have these large, multi-year content streaming agreements come into window or available for streaming, they're recognized as an asset. They come on into the content library, and depending on the payment terms, there's associated accounts payable increases or other accrued, which in the case it's just longer than a year in terms of the payable.
All right, moving to a handful of miscellaneous questions. There have been several service disruptions to the instant-watch service over the past quarter. Could you please characterize the nature of these disruptions and indicate what can be done or has been done to reduce or eliminate them going forward?
We are working very hard and expanding our systems to be able to handle the growth and capacity, and we think we are making great improvements in those, and we are very focused on improving that.
Can you explain the domestic Facebook issue? Consumers are already sharing a lot of broadcast and cable network viewing data on Facebook and Twitter. Why should Netflix be viewed differently as long as it opts in?
Unfortunately, Judge Bork, when he went for Supreme Court nomination, some enterprising reporter got his video rental records from a local video store. In the next few days, Congress passed an Act, perhaps propelled by every Congressman's fear of their own video rental records being released. It passed so quickly that it was fairly poorly drafted, and it's very ambiguous what happens and who it applies to. Does it only apply to people who rent DVDs, or is it more broad than that? Does it apply? Can a consumer get permission? It's that ambiguity that leads us to want to seek this clarification, and that's why it's different.
Does Netflix still plan to launch the family plans, or is this something that you're still thinking about?
We don't have any specific plans to launch family plans. We do have an interest, as we said, over the next few years in figuring out individual accounts and making Netflix feel more personal to the individual. We've got a couple of building blocks in that, including the Facebook integration. That is not going to happen in the very short term, but it's consistent with what we said before, which is something we're working on over the next few years.
All right, moving to the final topic, DVD. Overall, does DVD become more or less of a priority now that the service has been decoupled from streaming? Will the DVD business start to decline faster than anticipated? Any color here would be appreciated.
It'll become less important to those people at Netflix working on streaming and much more important to those people in the dedicated DVD division. That's the purpose of putting it in a separate group so that they can focus on that. In terms of the long-term decline rate, it's hard to know. If you look at the music industry starting in 2000, then it was around 10% per year, so that might be a proxy. It is hard to know. What we do know is that we're going to maximize whatever opportunity is there. That's why we've got a dedicated group who actually have come up with some pretty neat ideas for how to improve the DVD service, which will be, and those improvements will roll out in Q4.
What will the key performance metrics be for the standalone DVD business? Will there be an increased focus on near-term profit and cash flow as opposed to subscriber growth?
I don't think there'll be an increased focus. That part of our business will still be revenue, operating profit, specifically operating profit, and trying to maintain or grow that profit if they can. I wouldn't characterize it as an increased focus. I'd say it's about the same as we've had before.
You mentioned that you'll begin marketing the DVD business again in the fall. Is this incremental set cost on top of the streaming service cost, or do you feel that the streaming service is established enough to pull back somewhat on your spending there?
It's not really either. We're focused on backing the DVD service, and then we'll see what happens. We'll see how effective that marketing spend is and learn and adjust from there. What we wanted to do is make clear that we think DVD has a longer and bigger life than many people otherwise think, and that we're prepared to do some investment to see that thesis through.
Can you tell us what type of improvements we can expect from the streaming division going forward?
No, we'll be announcing those in Q4.
Final question. Will you now be breaking out streaming and DVD segments separately in your financials to give us a better understanding of the transformation, or does this replace the domestic and international segments?
I think we addressed that in the letter, but just as a repeat, what you'll see from us is in Q4, by Q4, we will have enough information so that we're looking at our business in the different segments. In the January filings, you'll see a segment oriented around DVD and a segment around streaming. We've also provided additional information in our guidance this quarter for Q3, and you'll see that again in October for Q4.
Okay, that's the last question for today. We'd like to thank everyone for your time, and we look forward to speaking to you again next quarter.
Ladies and gentlemen, thank you for joining today's conference. This does conclude the program, and you may now disconnect.