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Netflix Q2 In Line, EPS Strong, Stock Soars (NFLX)

reed-hastings.jpgA solid Q2 for Netflix, meeting the Street's sales expectations and beating profit expectations by a few cents. Third quarter outlook looks a bit light -- both revenue and EPS are below consensus, but the company expects margins to increase despite more investment in digital content. Meanwhile, Netflix (NFLX) raised its full-year EPS guidance, now 2 cents above consensus. The company's depressed shares jumped 7.7% in morning trading to $28.79.

On the conference call, Netflix management said it continues to invest in new content for its Internet movie streaming service, which is now up to 12,000 titles, but declined to offer any usage metrics or trends.

Regarding the economy, Netflix says it hasn't seen any material changes in its business, and that there's no real changes regarding where subscribers are coming from. "We appear to be substantially unaffected by this significant economic negative climate," said CEO Reed Hastings. And while marketing costs were at long-time low, Netflix says it's not paying lower CPMs for Internet advertising -- the "outside advertising climate... hasn't shifted materially for us," Hastings said.

Up next: Netflix says it'll start testing price hikes for Blu-ray content. More on that in a separate post, which we'll link to. Also: More places to stream Netflix online content. The company's exclusive deal with Microsoft (MSFT) to stream Netflix movies to Xbox 360s kicks off this fall. Sales of its Roku streaming box are "strong," but management declined to comment on one report that said almost 100,000 had been sold so far. In addition to its partnership with LG, Netflix has one more streaming partner announcement to make to fill out the four it promised.

Key Metrics:

Revenue: $337.6 million, vs. $337.6 million consensus, $334 million to $339 million guidance; up 11% y/y
EPS: $0.42, vs. $0.40 consensus, $0.33 to $0.42 guidance
Subscribers: 8.41 million, vs. 8.3 million to 8.5 million guidance, 8.5 million Jefferies est., 8.44 million Lehman est.

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Guidance:

Q3 Revenue: $343 million to $348 million, $345.5 million midpoint, vs. $347.1 million consensus
Q3 EPS: $0.26 to $0.34, $0.30 midpoint, vs. $0.31 consensus
Q3 Subscribers: 8.675 million to 8.875 million, 8.78 million midpoint, vs. 8.93 million Jefferies, 8.85 million Lehman
2008 Revenue: $1.364 billion to $1.379 billion, tightened from $1.35 billion to $1.39 billion. Midpoint $1.37 billion, virtually unchanged, vs. $1.37 billion consensus
2008 EPS: $1.19 to $1.31
, increased from $1.16 to $1.29, midpoint $1.25 vs. $1.23 consensus

LIVE Conference Call Notes:

8:30 Waiting for call to begin.

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8:31 Call is beginning. Standard disclaimers. Going to take questions by email -- positive feedback from last quarter, when that happened by accident. Wacky!

8:33 Reed: Lowest-ever SAC, profits at top end of guidance, ending subs above midpoint of guidance. Significant progress in streaming with Roku, Xbox deals, continued growth of content.

8:34 Think DVD by mail will continue to grow for 5-10 years. Don't plan to enter pay-per-view or ad-supported streaming segments. Both of those will likely be substantial, but our subscription segment will also be large. In order to succeed, we need it to be easy and inexpensive for consumers to watch Internet video. Goal is to have it integrated into lots of devices.

8:36 Talking about Roku box. "Huge hit," "strong sales," "great subscriber satisfaction." In the future, Roku boxes will support other Internet content and migrate from being Netflix-only player to general Internet video player. LG partnership will be discussed in more detail "soon." With MSFT's fall update, NFLX members will be able to stream Netflix movies to their TVs if they're also Xbox Live Gold members. That's probably going to be our only exclusive deal in any segment. (Sorry, PS3 users!) Haven't figured out how it will drive Live Gold sales, NFLX subs, console sales. As we both learn more, will use that information to determine extent of promotional activity. In best case, substantial promotion in 2009 will make sense for both parties.

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8:39 Over last 18 months, grown number of choices to over 12,000 from 2,000. Continue to increase content; investment already included in guidance.

8:39 Blockbuster still active; we assume they'll still be. Kiosks should accelerate store closures. DVD franchise still very strong with mainstream consumers. Think DVD by mail and DVD rental kiosks will take share from stores in long-term. To close, our goal is to materially expand subs, EPS, etc. Making "excellent progress" toward goal. Barry joins to talk about Q2 results.

8:41 Gross margins 10 bps higher than Q1, as expected. Small increase in content spending offset by equally small decline in fulfullment and shipping/packaging. Expect gross margin to be up slightly in Q3 and Q4 despite investment in streaming content.

8:43 Marketing expense down 11% to $40.1 million, yet gross subscriber additions continue to grow. Primary contributor to increase in operating income.

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8:45 Don't expect hyper growth FCF rates of 100%+ to continue. But 35-45% y/y at end of year seems possible. EPS raised due to lower average share count. Growth rates to slow after price drop comps go away. But growth accelerated y/y in Q2 over Q1.

8:46 We didn't buy back stock because of MSFT announcement, but if we could have, we would have. Q&A to begin.

8:47 What drove down SAC? Lower ad pricing? Greater consumer interest? Reed: Not outside advertising climate, which hasn't shifted materially for us. Spending less marketing as percentage of revenue. Better competitive climate. Made a big investment in lower prices; think of it as a marketing investment, though it's not reflected in SAC.

8:48 Next year optimistic that cross-promotions will be good for us. Unable to make RedEnvelope work. Don't comment on usage.

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8:49 Why not push marketing for more subs? Balance of earnings vs. growth. Certainly good argument to push more growth, at end of day think it's better to stick to earnings targets. Gives us substantial room for growth, but it is a very attractive opportunity.

8:50 More competitive now that Amazon streaming? AMZN ppv streaming nicely implemented. But mainly ppv new-release content. But you really need a bunch of content; not just that. Not trying to block them, don't know of them trying to block us. Really different markets. Any color on digital usage? Haven't given any color on specific trends; too early to tell, and don't have a control group that doens't have instant watching. Very encouraged by usage; "significant, growing numbers" but no specifics.

8:52 Potential pricing changes for Blu-ray or streaming? Will be testing Blu-ray price increases very shortly. Depending on test results of those, will move forward. Any potential to get back to 33-34% GM? What is keeping ceiling on? Barry: Expect GM a bit higher next quarter, which is a change from Q1 expectations. Expect it to be up in Q4 from now, but not as strong in Q3. How high can they go? If GM rose to 35-36%, would not necessarily mean that business is more profitable. Relationship we've explored between customer satisfaction and GM; inversely related. Customer drives SAT and retention. Sometimes business is more profitable with lower gross margin.

8:55 Are we doing better or worse because of economy? No real changes where subs are coming from. No material change. Substantially uneffected by economic climate. Blu-ray low single digits; has promise if player prices fall significantly.

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8:57 Not commenting on how long Xbox exclusivity is. Why was content library on balance sheet down so much q/q? Spent less on new content and relatively weak new release box office. Buy some content outright, rev share some with studios. Sometimes there's switching from capex vs. p&l perspective based on which studio is hot, and rev. share.

8:59 No meaningful cost savings from closing of RedEnvelope. Roku near 100,000? Not giving any comment on number of Roku sold. Early adopters not typical.

9:01 Any comment on traction you are expecting from Netflix? Yes, a step function. Think we're well prepared for that in terms of load, financials; all built into guidance. Haven't given number of streams anymore.

9:02 Why AMZN library so big and NFLX so small? No good answer yet. Something we'll look at when we get to use Amazon. Obviously YouTube has 400 million titles; have to think of weight. The way we look at it is providing enough content that people are excited about staying a NFLX sub. Current title count much lower than AMZN's suggested.

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9:05 Bay Area penetration 18.8%, rest of country 7.2% at the end of Q2. MSFT felt that 1 million of its subs are NFLX subs. Don't have access to MSFT userbase, so unable to do survey. Whatever current numbers are, more interested to think about potential as MSFT upsells Live Gold subscription. Excited more about future overlap.

9:07 Framework of digital content deals? Purposely vague in responding to that question. Content deals in some respects are similar to DVD; some revenue sharing, some payment. From P&L, if service were to grow at twice the rate of adoption expecting, obvious concern is that P&L would get away from us. Mindful of that in negotiations.

9:08 No material change in rev share climate.

9:10 BBI MovieLink is PPV, competes with Amazon and Apple... imagine they've done a good job. Another ppv service, and that's fine, just not in our segment.

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9:12 Call concludes.

See Also:
Netflix Shuts Down Indie Film Unit
Netflix's Streaming Movie Budget: $70 Million This Year
Netflix's Next Step: More, Better Streaming Movies

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Disclosure: Mathias Döpfner, CEO of Business Insider's parent company, Axel Springer, is a Netflix board member.

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