Netflix Presents at Lehman Brothers Small Cap Conference

By Davis Freeberg

This post should not be construed as financial advice. Davis Freeberg is both a shareholder and current customer of Netflix.

Barry McCarthy, the Chief Financial Officer of Netflix gave one of the best investor presentations I've ever heard at the Lehman Small Cap conference earlier today. If you've never listened to a conference call or an investor presentation, this is the one to catch. In the call, he made a strong argument for why Netflix will make it to 20 million subscribers by 2010 - 2012.

During the presentation he gave great statistics about past growth and indicated that they believe they will hit 4 - 4.2 million subscribers by the end of this year. He also said that "our objective through the end of next year is to finish with at least 5.65 Million Subscribers." An amazing accomplishment considering that they had less then 2.6 million subscribers a year ago.

He pointed out that a key driver to their growth will be the superiority of their website design and proprietary algorithms. In the presentation he points out that "among online retail businesses we have been rated the best website on the internet and as we grow, our objective is to become an iconic brand." He sees brand loyalty, strong customer satisfaction and personalization as being key components to their growth.

The personalization of their site is really what makes their service so unique. At this point Netflix has now collected over 1 billion ratings for moves. They use these ratings to make recommendations of longtail content for their consumers.

"we help you find movies you've never heard of. By the way of example there were 554 movies released theatrically last year and I bet most of us can't name 20. A lot of those movies you would enjoy, if you knew that they existed. If you don't know that they existed then they might as well have not been invented. Our goal is create demand for content and own the gross margins associated with owning demand."

He later goes on to compare this approach with Blockbuster.

"Historically Blockbuster has reported that about 90% of the movies they rent are new theatrical releases. They do a great job of fulfilling demand, created by the studios who spend $4 billion per year marketing new theatrical releases and the studios own the gross margins associated with creating that demand . . . Now they have a slightly different mix online. A couple of quarters ago they said that about 70% of what they rent online is new releases and about 30% is back catalog. That's not true in our business and it's never been true in our business. The day we came public and in the most recent quarter about 30% of what we rent is new releases and about 70% is back catalog and it's not because we have a different subscriber. It's because we create demand for content and we help you find great movies that you'll really like, we do it algorithmically and we do it with recommendations and ratings."

You can argue that the concept of the longtail is merely theoretically or that it's nothing more then a fad, but to me this is proof that the longtail is not only relevant, but will revolutionize Media as we know it today. I don't believe that I have ever rented a new release from Netflix, simply because there are currently 216 movies in my queue that are highly relevant to my interests. I want to see all of the movies very badly and only on a very rare occasion have I wanted to see a movie as soon as it's released to DVD.

While their rental mix has not changed their demographics certainly have. In the call he said that when they went public 80% of their customers were high income, educated males. Today 54% of their subscribers are women and 40% of their customers didn't go to college.

Later in the presentation he talked a lot about the upcoming High definition DVD's that are coming out.

"As many know there's been a format war. Two formats have been proposed as a successor to DVD, one sponsored by Warner primarily and one sponsored by Sony. Warner is HDDvd and Sony is Blu-Ray. I think it's pretty clear that Blu-Ray has won. Even Warner has agreed to license and to release technology to Blu-Ray, only Universal hasn't made a commitment at this point, so I think the format wars are a thing of the past and I think it's going to be Blu-Ray. I think the content will get priced at a 20% premium. I think it's going to roll out slowly over time."

If the content does get priced at a premium this will benefit Netflix tremendously because it will extend the life of their current inventory dramatically.

The two biggest bombshells during the presentation were the possibilities of lower prices and the inclusion of advertising on their website. While both of these issues are still in an experimental phase, it's clear that the company is continuing to experiment with the business model that they have created.

"Along the way we are going to test lower prices, some of you may already be in a test cell, if you're not a subscriber and you've recently come to the site and you may have seen some initial testing of lower prices. The reason why we're testing it is because we think that the market is price elastic. We want to get bigger, the bigger we get I think the more video stores we put out of business."

If they decrease prices, they don't expect it to impact their gross profits because they expect to reduce marketing expenses to offset the loss of profits.

On the advertising front McCarthy pointed out that they are currently test marketing ads to different "cells" and are trying to gauge it's impact on churn. While as an investor I think the idea of creating alternative revenue streams is great the thought of paying to look at banner ads does not sit well with me as a consumer. One thing that I really enjoyed about Netflix when Netflix took over for Walmart was that they gave me an opportunity to opt out of the Walmart ads on the site. My question to them would be that given that you have great personalization tools, why not create an advertising model where consumers can choose to opt out of ads if it bothers them? This way Netflix could have their cake without it impacting churn or customer satisfaction.

While these conferences are rarely exciting and compelling, I felt that this was a very impressive overview of what Netflix has accomplished to date and a great layout of their strategies going forward. I highly recommend listening to the entire call for anyone who is interested in their company.

*Update - Mike K at Hackingnetflix has a review of a similar presentation that Barry McCarthy gave to Pacific Growth Equities last week, as well as the new test prices.