Netflix Inc (NFLX) — Q4 2016 Earnings Call Transcript

Welcome to the Netflix Q4 2016 Earnings Call. I am David Wells, the CFO. Joining me today from the company is Reed Hastings, our CEO, and Ted Sarandos, our Chief Content Officer. Interviewing us on today's call is Doug Mitchelson from UBS and Scott Devitt from Stifel Nicolaus. A cautionary note that we will be making forward-looking statements; actual results may vary. Scott, I think you have the first question, so over to Scott.

Yes, thanks, David. First question for Reed. Just an outstanding quarter, both domestically and internationally, relative to expectation from a subscriber standpoint. And there is so much focus on international given the opportunity there to grow the business, as well as the way you've built out the international business with some more mature markets that you've been in for quite some time. Some newer markets like France and Germany that are starting to kick in, and the 130 that were added at the beginning of 2016. So, I was wondering if you could frame, potentially, the over-performance in the quarter and where you saw strength regionally.

You describe it as over-performance in the quarter, but if you look at it on a longer-term basis, like over the last couple of years, it smooths it out. So, we are seeing some lumpiness in the quarters depending on when we launched certain content, but the big picture is remarkably steady. We have a huge quarter like Q4; this quarter it’s a little bit less, so think of it really as this big adoption of Internet TV. It's somewhat influenced by the content in the short term. Then you asked about the international expansion, which has been remarkably steady. If you don't look at it by the quarter but by the year, what we're seeing in Latin America is steady growth, Europe as a whole has been really picking up momentum for us, and in Asia, we're just getting started.

And then secondly, possibly for David, you got the first quarter U.S. contribution margin above the longer-term target. Understanding that there is lumpiness in that and you're going to continue to invest in the business. Is there any update on that longer-term target in terms of the contribution margin for the U.S. market?

No, no Scott, as you correctly asked me, there's two pieces. One is the U.S. contribution margin pops up in the first quarter, and we're indicating that we're going to continue to reinvest. On the international line, we actually broke through into profitability for our consolidated international segment, and we will continue to invest and take that back down through the year. So, I think that we don't talk about long-term targets other than an operating margin target. We had mentioned before that we would produce meaningful operating profit in 2017 and beyond, so we fleshed that out a little bit for you, the investor, now targeting a 7% operating margin for this year with steady growth afterward. We don't think anything structural is at hand in terms of our international businesses. It really depends on the competitiveness of each market, but we think we can continue to grow overall profitability. So, we'll grow operating profit by continuing to grow U.S. margin and also reduce international losses with respect to adding on more investment. Long-term, we'll reduce those losses and grow international margin, but we haven’t provided a specific target.

Thank you.

I think on the fourth quarter results, I'm curious; in the U.S., what content specifically drove the strong performance relative to budgets?

Well, we had some pretty powerful releases in Q4. Particularly shows like Luke Cage, Narcos, and the new series of Narcos that travel really well around the world. We know that they are exciting for consumers of television in America, but it has been fantastic to see how these shows are adopted around the world.

Yes, Doug, I would just add to that that you're now seeing the benefit of Netflix having its third, fourth year of original slates. As Ted mentioned, Narcos season two comes out, but we've got new seasons as well. You're getting the benefit of shows that might take hold in their second or third season, but some new shows as well, like Stranger Things, which did well for us in the third quarter and continued to be popular through the fourth quarter.

And a nice upside surprise is something like Gilmore Girls, where you think it would be incredibly domestic in its popularity, but we found it to be incredibly internationally popular as well, particularly performing well in Europe.

And this might seem relatively obvious given the comments so far that content drives subscriber growth, but in terms of your ability to measure how content drives subscribers, and you talked last quarter about including new content into your subscriber growth guidance. Given the strong result this quarter, is it tangible title-by-title? Are you making an overall estimate based on spending or number of releases?

Think of it as a cumulative effect. Very few people will join Netflix just because of a single title. But there's a tipping point: if we have one more title that has great excitement, you're hearing a lot about, that triggers you to finally sign up for Netflix. So, it's a cumulative effect of all of these, and you can see some frontloading, but the basic demand creation is increasing as people get more comfortable and more aware of the idea of Internet television, where you don't get the commercial interruptions and you can watch when and where you want. So those are the big drivers. The things that capture the demand are really these big launches that we're doing with particular title franchises.

Just to feed off Doug's question, there is commentary in the letter regarding content being a driver for subscribers in the second half of 2017. Is that just looking at the slate in that period as a driver for the business, or is there something else to that comment?

You should look at it that we have multiple seasons of our shows, and we see that the audience continues to build cumulatively; therefore, the excitement for the upcoming season builds as well. In Q2 of this year, we have new seasons of many of our very popular shows like Orange Is The New Black, Kimmy Schmidt, Bloodline, Sense8, Master of None, and we think that they should have a pretty nice impact on our subscriber growth as well.

Yes, and Doug, if I - and Scott, if I can knit these comments together: Reed's comments, Ted's comments, and your questions. There's a difference between the baseline demand, as Reed said. The transition to Internet TV and the overwhelming convenience of it. We talk a lot about whether we hit above what we expected based on some of how these shows perform. If they are new shows, they don’t tend to draw new subscribers in as great of numbers as some of our existing shows. In the first quarter, we have some great new shows performing well, but they don't tend to draw numbers like House of Cards did last year; it was a surprise for us with Making a Murderer as well. So, I think the great shows coming in the back half of the year, more of them being second season, tend to draw in more subscribers because they are better-known shows.

Second, third, fourth, and this season even.

And sorry to be so myopic around the more near-term subs, but one final question on that for me. There was a comment in terms of potentially being a pull-forward in subscribers into Q4 as part of the explanation for the 1Q sub guidance. Can you flesh that out a bit and what gives you that type of visibility?

Sure. Reed or I could do that, but I'll take a stab at it. What we saw in 2016 around un-grandfathering our price change was a lot of lumpiness in our subscribers in terms of - we grew strongly in the first quarter, second and third more modestly, and then built into the fourth quarter. What we found was many rejoins coming back, so yes, there was a reaction to the price, but we got many of those subscribers back. In the fourth quarter, we got many of them back that may have come in the first quarter; we may have seen some of those folks in the first quarter. We tend to look less at a specific quarter's performance; instead, we look over a six, nine, or twelve-month period in terms of what is the real trend here, not focusing too much on any specific quarter because they seem to bleed in terms of folks joining in a quarter when they would have joined the former quarter.

Got it. Thank you.

Two more questions from me on near-term subscribers. First, Reed, you said that Europe is really picking up, and I think when you launched those markets, you indicated it would take some time for them to work. Latin America now that's happening, but investors are still wondering: is there something specific that you have done differently or done recently that's driving improvements, particularly in Germany and France?

No, there's no specific pricing or marketing tactic. It's the cumulative effect of show after show being in the market; just the steady work that we've done. This is what we also saw in Latin America; there was no step function, just steady discipline of staying on our game with great shows, great movies, and enjoyment continues to increase. There's slightly incrementally more partners that we have, but there's no real step function. It's really the continued buildup of momentum.

Yes, we're seeing that as we're adding more and more global shows, it's raising all boats across the world.

And I think we talked about acquisition a lot in near-term. When you think about churn management, I think investors are curious: did X1 integration have any impact in the quarter? Did other bundling deals throughout the world have any influence? As you think about churn trends, is there anything noticeable for investors' assessment, and how should we think about that on an ongoing basis?

All the partnership deals we really believe in, and that's why we're doing more of them. You can see we've had performance in international and in domestic. It wasn't just a Comcast story, in which case it would have been domestic only. It's fundamentally a story of the broad acceptance of Internet TV and the content. On the margin, those partnership deals are good for customers, good for us, and good for the partner.

The cable set-top box deals - I think John Malone was quoted recently at Lionsgate Analyst Day as saying that you had approached some operators in terms of being bundled into service where carriers would cover. Just interested in terms of the accuracy of the statement, is that something you are interested in and what do you think the benefit of that would be?

We wouldn’t want to speculate on future deals. In general around the world, we've done extremely well focusing on our service as a discrete service, $7.99 a month, and incredible content. We're just going to keep pounding that drum as we expand around the world and also here in the U.S.

The X1 interface, which is outstanding by the way, we have it in our house, are there - I assume there is interest in doing more integrations like that. Is there any reason, other than simply being able to cut those deals, technology restrictions with other providers limiting your ability to do deals?

Yes, X1 is a very advanced set-top, so not all MSOs in the U.S. have such advanced technology, so they can't do Internet apps or can't do Netflix. X1 is very strong in that way, so are dish receivers; we're able to operate on ones that are relatively modern and have other IT apps as well.

Reed, I think you've had an advantage just because of the technology investment you've made over time. The scale that you have deployed; any concerns longer term, as more and more of your competitors bundle into the same aggregating platforms like X1, that you could lose a bit of a technology edge, with consumers accessing your content all through the same interface?

When the consumer finds in the Comcast UI some Netflix show, they click on that and it opens the Netflix app. The consumer enjoys the show, and we control after the show the post-play experience, which guides them into another show. We look at it as an entry ramp onto our application, and we feel that our application is the best way to enjoy Netflix content, but that doesn’t mean there shouldn't be easy entry ramps from interfaces like a Comcast user interface, as that's very effective for customers.

I was circling back to some of the subscriber issues, and I'm curious about any learnings now that the global rollout is a full year behind you. Looking back, is there anything that has been far different than expected, and when can we expect the next round of launches in newer markets like Poland and Turkey?

We'll continue with more Poland and Turkey-like launches this year with several countries. It will just be a steady process we go through. We really liked what we saw once we localized Poland and Turkey in terms of increased viewing and increased membership growth. We'll keep on that pattern. From a near-term subscriber standpoint, it’s a background influence compared to major established markets in Europe, Latin America, and North America. Of course, over time they should be quite substantial, but they are longer-term plays.

And Doug, from a financial standpoint, just keep in mind that when we talk about investments in international, content is the big piece of that. Localization is relatively modest compared to the content.

Ted, I think the last time you spoke publicly on this topic; you were producing local language content in 10 different countries. I was wondering if you could talk about the successes or challenges of that, and if that was tied to original content. More broadly, local language in newer markets as well as marketing campaigns, which were identified in 2016 as something that needed to be put in place to get some of the newer markets to begin to progress.

So far, we've been really happy with the success of our local language productions in France, Mexico, and Brazil. As I mentioned last time, we've rolled it out to Germany, Spain, and Italy. We're deep in production; we're entering into a couple of new productions in Asia. What we find is it creates a lot of excitement for Netflix in the market because it’s a really elevated form of television relative to what else is available. We're thrilled to be working with local storytellers and producers to make that content. More importantly, making it available around the world has been a huge differentiator for us. When I mentioned earlier about Gilmore Girls being popular globally, at the same time we launched a great little science fiction show called 3%, a local Portuguese language show we shot in Brazil. It was enormously popular in Brazil and played to millions of subscribers around the world, including the U.S. It's been a great way to find new global storytellers and make Netflix feel more local in those countries.

I think you also quoted as saying that 1,000 hours of content in 2017 seemed pretty conservative. Can you speak to that in terms of - was local language a contributor to that, but also across genres and geographies? What is going to be the makeup of those 1,000 hours?

I'd like to focus you less on the 1,000 hours and more on the quality of those 1,000 hours. About half of the most searched-for shows on television around the world this year were Netflix Original shows, and that's something we're really proud of. It's a lot of volume, but it's also a ton of quality that consumers are falling in love with. We still have 42 Original launches planned for the rest of this quarter, including shows like Santa Clarita Diet with Drew Barrymore and Timothy Olyphant, and the second season of Love, as well as Iron Fist, our latest Marvel series launching this quarter.

Shifting over to strategies, I’m just curious, reflecting back on the last year, where you had said your price increases flowing through from the un-grandfathering. Reed, David, did you learn anything about the pricing power of Netflix? What should investors expect regarding your pricing strategies in 2017 and beyond?

You should expect us to continue to invest in the consumer experience, making the content incredible, and we don't have any plans for any near-term changes. So, I would just suggest continuing to expect us to expand the membership base at these terrific rates.

I also think Doug, in terms of nothing has changed in our long-term view of our belief in our ability to continue to add great value and slowly and steadily assume that value over time. I don't think anything has changed in that respect.

One of the questions we get from investors is, 'Why focus on earnings at all with Netflix?' I mean shareholders have clearly rewarded you for subscriber growth and revenue growth; while Ted is ramping content pretty aggressively, I'm sure he is always asking for more money. Why the philosophy around trying to balance growth with delivering earnings?

Yes, we don't really believe in hockey-stick businesses, like suddenly we’ll turn significantly profitable at 200 million members. We think it's much smarter to grow into that bit by bit. So, expect us to modestly increase operating income and operating margins as we have from 4% to 7% and continue to grow into that as we scale. We'll keep an eye on the investment levels that are necessary to protect the advantages we have.

The only thing I'd add is that there's a little bit of scarcity that goes a long way in terms of efficiency, and we need to make sure that we continue to focus on quality.

Ted, how did The Crown do? Did it seem like it would perform well in the U.K.? How did it perform in the U.S. and other regions?

We're incredibly proud of it, both for the reasons you just mentioned. It's been incredibly popular globally; there's enormous interest in the royal family around the world. So, in the U.K., it was really celebrated as something that only the BBC could do just a couple of years ago and is really loved in the U.K. and in the U.S., but also even in countries throughout Asia and Europe where people just love that story. More importantly, they loved how it was told, and we were thrilled that it won a Golden Globe for Best Drama; it was our first Best Drama Award there. We're excited and deep into season two now and eager to tell the rest of the story.

Great. Thank you. And Reed, in the test market, I think you are going to be approaching 50 million U.S. paying subscribers at the end of the first quarter. There's over 100 million households in the U.S. that subscribe to cable and satellite. The price point and the value proposition, it does seem like there is no reason why, over time, with broadband speeds, you should be able to address all households. When you look at the next 50 million in the U.S., where do you see the friction points limiting you right now to getting to those numbers faster?

I think it's really about the fusion of society as more and more people use Netflix. We have better and better shows, and as more of them come in, you just get the word of mouth, which is how you grow from nearly 50 million to 60 million and hopefully continue. In terms of getting to a full 1:1 tie ratio with today's cable that includes a lot of sports, which we don't have and don't plan for. You want to wait a little bit. Looking back four or five years, it has been pretty steady growth overall, following this formula of just improving value, improving content, and improving service, like adding our offline viewing. We're creating a big wave of customer joy through video merchandising, allowing customers to choose content based on what they see. We're continuing to innovate on multiple fronts to make it a better experience.

I have two questions for David just on some financial commentary. In the letter, I think you guided for 7% margin for full year 2017. It would be helpful for investors to understand the outlook for some of the cost categories. When you look at G&A, tech and development, and marketing, could you give us a sense of the dynamics for each of those this year?

Sure, Doug, we updated our long-term letter a bit in this respect. Think about $6 billion in content, $1 billion in tech and dev, and somewhere around $1 billion in G&A to round out the operating profit expense lines, and that should help get you there.

That works. Also, notable free cash flow burn of $2 billion for this quarter was a bit higher than I believe you suggested a few months ago. So, what's changed?

Well, I think what we mentioned in the October letter was that free cash flow might be similar to Q3; it was more than that. We do think it's going to come down this quarter in Q1, but we wanted to give an indication that it's pretty lumpy right now. My team has said we don't focus on trying to optimize a single quarter; we're looking across four and eight quarters. We think the run rate is around $500 million right now per quarter as we continue to expand content. It's not too different from 2016; we moved up to $1.7 billion in 2016, so we're indicating it might be around $2 billion this year. What you'll find is we will organically fund more and more of our own content expansion with the growth of our operating profit; so as we transition over the next few years, our debt will be about content expansion and then transition to optimizing cost of capital.

I think you mentioned at one point that, if content is available, you would be willing to take on more leverage or adopt a strategy versus letting it go because it fits into the P&L currently. With where you are now with the $2 billion drag versus when content spend might normalize, is there visibility on when the business will become self-funding based on the current trajectory?

We haven't provided that guidance, Scott. It depends on how much we want to continue to expand content and the business growth itself. We're a little bit guarded in providing specifics because of interdependencies. What I think - back to Doug's earlier question, part of the reason our working capital needs have gone up a bit is because we're owning more of our content. That’s a good thing for investors and shareholders; we control more of the rights and advantages as a platform with an increasing number of global subscribers. The step-up from years past to the $2 billion we're discussing this year includes more owned content and increasingly more content categories.

As investors begin to look at the U.S. market as a template for the rest of the world, can you discuss what could lead to a similar margin profile in markets outside the U.S. versus higher or lower depending on churn?

Sure. I'll pitch it to Reed and say something, then Reed can follow on. Generally, overall, I would say there's nothing fundamental. We can look to get margins equal or better in some places than the U.S. So you think about an average across the globe, it's somewhat determined by competitiveness and the cost of that content. The more we can grow and spread the cost of popular content that's engaging for a large audience, the more advantage and scale we have there.

That's perfect, David. Our North Star is providing incredible value to consumers because, upon that, we can build a very large and very profitable franchise. But it starts with an amazing value for consumers, which encompasses a great service and amazing content behind it.

Two questions for Ted. Anything new regarding ROIs on your investment in content? You look at acquired versus originals; are the lines starting to cross in any way? Are you willing to give us an update on hours consumed? Globally, we haven’t had that number from you in a while.

Stay tuned for those numbers. We don't have anything to report today, but I'll tell you that as David mentioned, while it is a bit more cash consumptive, owning our own content and including our original productions has many big scale advantages to the business. The most meaningful one is removing the studio markup and overhead on those productions, allowing us to put more on the screen, own the IP as we expand into multiple seasons, and having control over the windows. We lean into both original programming and owned original programming, but we're still active buyers of second-window content from our studio partners. We're increasingly co-producing programming with networks and studios around the world. We'll take one country and premiere the show globally at the same time, which takes off some of that risk while enhancing our partnerships with those networks and studios. There's more value in owning the IP and creating new content. If we need to have great programming for our members, we will also go out and buy content elsewhere to enhance what we are doing.

Any suggestions regarding emphasis moving forward? There's still a feeling that this could use more movie content. You've made huge investments on the comedy side; do you want to talk about that? Are there particular genres that we should expect you to focus on going forward?

You could look at those comedy investments as a good example of taking a category that we primarily bought second window from others and produced original programming. The rest of this quarter, we're launching stand-up shows from Amy Schumer, Dave Chappelle, Trevor Noah, Jim Norton, and other top names in comedy. We're also bringing in more unscripted programming, launching shows this quarter like Ultimate Beastmaster and Abstract. We used to license this type of content in second window, and now we're finding it valuable to produce originally for Netflix.

Scott, Doug, I think we have time for maybe one final question from either one of you or one each.

I'll go first. The question I had is, squeezing the net neutrality edits, it was commented in the letter, but we could assume that the new administration is set to roll back net neutrality. What are the implications for Netflix?

I think we addressed that in the letter. I don't have anything to add.

I think from my end, my last question: we're just curious about your ultimate vision at this point. We're turning the new calendar year. You previously mentioned the desire to satisfy consumers by giving them all the television shows they want for $25. What's your ultimate vision at this point for the service?

You never want to characterize something as an ultimate vision because when you get there, there's always more to achieve. Taking it year by year, we’re growing around the world. We're thrilled with our global expansion, ex-China. We're focused on all the different Asia markets and building our content production capability in Europe. Think of us as continuing to iterate on the basic cycle of more content and better products, combining it into a great service with a great price. Hopefully, we can attract many more people to join Netflix, and that fuels the whole cycle. We're just going to continue to repeat this cycle; we have a long way to go. When you think about how many movies and TV shows we don’t have, we want to think about the fantastic range of content that we need. We're ambitious about what we can do, especially around the world. In the next six weeks, we’re having a blast spreading and evangelizing this vision of Internet TV, where customers control what they watch and get incredible quality content. We hope to land this quarter in 99 million subscribers, which will be quite an achievement. Thank you very much for your support, and I look forward to talking to you again next quarter.