How Netflix Maintains Growth

The Motley Fool: Let me start off. Despite Blockbuster's (NYSE:BBI) aggressive ways, Netflix (NASDAQ:NFLX) still closed out the quarter with nearly 400,000 more members than it began with. With its churn rate at historic lows, it seems as if there is loyalty, even in the middle of a pricing war. Is this market's potential for growth so explosive that even with Blockbuster nipping on its heels that Netflix can deliver superior shareholder returns?

Reed Hastings: Over the long term, I am confident of the shareholder returns because over the long term, it follows revenue and earnings. In terms of the short term, that is harder to predict for all of us. We are focused on achieving 4 million subscribers and over $700 million in revenue. We will have a $10 million GAAP loss for the year, which is really Q1, with a seasonally high marketing expense being GAAP-negative, about $17 million, and then the rest of the years, Q2, three, and four shifting into profit generation.

The strategic goal, as I said on the call, is to maintain our growth at this very aggressive pace, going from 2.6 million subscribers that we are at now to over 4 million subscribers. We do think the market is big enough that we think Blockbuster is being successful with their online service, that they are at their forecast 500,000 subscribers, and that they will continue to grow also.

The Motley Fool: Earnings doubled this past quarter, though through the month of November, subscribers had their monthly rates marked down by roughly four bucks. Can you color in a bit of the company's performance within the actual quarter, as in, was the company profitable for the month of December?

Reed Hastings: I can't give you monthly figures. The key factor, as you point out, we were profitable in Q4, and despite Blockbuster's pretty significant advertising efforts, despite the two price cuts in a quarter that they did. And fundamentally, our service works substantially better than theirs in terms of overnight delivery. We have over 30 local warehouses that provide overnight delivery to our subscribers and in terms of how easy it is to find movies.

The challenge in movie finding is there are 30,000 titles available, and the consumer wants to find 30 movies to put on their queue that they want to watch in the next few months, and boiling down the 30,000 to the right 30 is quite hard for consumers. Our recommendation system, which is powered by the over 500 million movie ratings we have collected over the past five years, is able to do a uniquely compelling job at helping consumers find the best 30 of the 30,000.

The Motley Fool: Your company, it's projecting a loss of $0.25 to $0.30 a share in the current quarter yet is looking to post a profit over the balance of the last nine months of the year. What do you see changing as 2005 wears on to provide that kind of shift toward profitability?

Reed Hastings: Many DVD players are sold during the Christmas holiday period. We take up our marketing expense in Q1 to take advantage of all those new DVD owners, so if you look back in 2004, 2003, 2002, we have increased marketing from roughly 17% to 24% of revenue in those past years. We are doing a similar increase this Q1, so it is purely a seasonal pattern that has been well-established.

The Motley Fool: Netflix closed out the quarter with nearly $3 a share in cash. Amazon (NASDAQ:AMZN) is waiting in the wings after launching its DVD rental service in the U.K. One of the arguments favoring Amazon and online rentals is that its customer acquisition costs would be low, given the fact that there are so many consumers on the site, especially after it acquired the popular IMDB.com movie information site. Would Netflix consider buying popular movie sites like Rottentomatoes.com or the Hollywood Stock Exchange to drive down its cost of acquiring new subscribers?

Reed Hastings: I think the best way for Netflix is to buy advertising at those sites, such as Rotten Tomatoes, and not to buy advertising vehicles simply because the P&L treatment might be slightly more favorable. We will always be buying advertising from a wide range of online, radio, TV, and we don't feel the need to go buy a TV station, and similarly, we don't feel the need to buy good advertisers such as Rotten Tomatoes.

The Motley Fool: You lowered your monthly dues aggressively once you heard that Amazon was thinking of entering the market. If you heard that Blockbuster was about to launch video game rentals by mail, would that force you to make a decision to enter that market to compete, or would you wait and see how the service stands up for Blockbuster first?

Reed Hastings: Well, we will typically watch the competitive environment develop. In the Amazon case, we felt that we were confident enough of their entry that we felt it was appropriate to change our pricing proactively, but typically we will wait and see exactly what the competitor is doing and take our time about responding.

Stay tuned for Part 2 tomorrow.

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Mac Greer is radio producer for the Motley Fool Radio Team. Rick Munarriz is a member of David Gardner's Rule Breakers analytical team, seeking out the next great growth stock early in its stage of defiance.