David and Tom Gardner recently interviewed Netflix (Nasdaq: NFLX) CEO Reed Hastings on The Motley Fool Radio Show on NPR. This is the first of four parts.

TMF: Reed Hastings is the CEO of Netflix. He joins us from Los Angeles, Calif. Reed, welcome back to The Motley Fool Radio Show.

Hastings: Thank you.

TMF: You just reported a third-quarter profit that exceeded expectations. You ended the quarter with 1.29 million subscribers. That is a 74% increase from last year. Your stock now trades at around $50 a share, Reed, compared to $12 a share when our show last had you on in January, what is going on?

Hastings: Well, we have continued to grow our subscriber base. First quarter we were up 75%, second quarter we are up 75% year over year, and now third quarter we are up 75% year over year. It has just been tremendous growth and it is driven from, I think, a great service that customers want to tell their friends about, one of these amazing word-of-mouth phenomena. 

TMF: So your third-quarter report is just out. What is the highlight and, importantly, what is the lowlight in your opinion of your third quarter earnings?

Hastings: Well, the highlight is we had record revenues, $72 million. We had GAAP net income of $3.3 million; about three times what we expected. Our monthly churn has decreased from 7.2% to 6% and now in Q3 hit a record low of 5.2%. So those are the big highlights.

Lowlights, I am stretching for that one. We did not issue guidance for 2004. We will do that in January.

TMF: Explain for our listeners what a "churn rate" is and why it is important that yours has been falling.

Hastings: Sure. The churn rate is how many subscribers quit in a given month. Our service is $20 a month and there is no commitment. It is easy to get in and out of. What we do is sometimes consumers will leave the service for a few months, similar to how people treat HBO. They might turn it off for a few months and then come back to it. The rate at which they leave is the churn and that is, again, about 5% per month now.

TMF: We are looking over the numbers, Reed. At your present rate, we estimate you will churn out of about 900,000 customers by year's end. You begin here with about 850,000 customers, which I guess begs the question: How long is your median customer maintaining his Netflix membership?

Hastings: The mean customer life is roughly one divided by the churn, so that is about 20 months at this point, 19 point something. I am not sure on the median, but it would probably be pretty close. I don't think there would be anything skewed there. So what we have done is really extend the customer life by reducing the churn. Many of the people who leave the service come back to it. So they are not leaving because they are unhappy with it. They are just turning it off and to be most straightforward, we report that as churn, even though they say that they are going to be coming back.

TMF: To the extent that there is any tradition in the world of DVD rentals, I will say for many people it is a pretty impulsive act. They walk down to their video store. They check out some of the aisles. They spend more time than they wanted to looking, and they end up renting something and then taking it home. Now with Netflix, customers wait to get the movie in the mail. So does getting people to rent from Netflix involve changing consumer behavior from here?

Hastings: It does. It is one of the great challenges of Netflix marketing. It is a consumer behavior change. It is why our best marketing program ever has been our free trial to let any consumer try Netflix for free. What we find is once they have tried it, they realize, "Oh, I get to keep three movies at home at any point. I don't have any late fees or due dates." So then Friday night comes and it actually feels more spontaneous because they can just pick up one of the DVDs from the top of the TV and watch it. But until someone tries it, that's a bit of an abstract concept. So we have really invested heavily in this free-trial notion. The way you can see that working is nine out of 10 people who try our service for free become paying subscribers.

TMF: Reed, the U.S. isn't the only country with a well-developed postal infrastructure. Will Netflix expand internationally, and if so, when?

Hastings: Sure. It is absolutely something we are looking at. What we realize, though, is that we will do about $270 million of revenue this year in the U.S. That is only about 3% of the domestic video rental market. It is about a $10 billion market. We are really at a very small penetration here in the U.S., and we may be as well served in focusing domestically for a little while, continuing to build that share, get to our 5 million subscribers/billion dollars of revenue goal and then expand at that point. So we are debating that back and forth.

Tomorrow: Will Netflix expand beyond movies?

Netflix was David Gardner's June 2003 pick for Motley Fool Stock Advisor and has returned about 137% to date.