Netflix NFLX

1
Netflix (NFLX)

• MII Presentation
• September 10, 2002

2
Service

• Maintain a list, 8 recommended
• CinaMatch Netflix will send the highest on your
  list when received
• Average user has rated 145 titles
• Maintains 25 title list
• 2-4 day first class delivery from 10
  distribution centers
• All DVDs come with a return envelope
• One month free trial
• 19.95 per month for 3 DVDs
• Not late fees

3
Customers

• Carol Duncan, a 57-year-old postal carrier who
  lives in rural Dillwyn, Va., 70 miles west of
  Richmond, said she has little use for the
  recommendations. She finds Netflixs long lists
  of "ancient movies" -- to her, anything that's
  not a new release -- especially annoying.
  Duncan and her husband also wish Netflix would
  deliver movies faster. While the service can be
  speedy in urban areas (Netflix opened 10 regional
  distribution centers this year), Duncan says
  delivery to Dillwyn hasn't improved since the
  Gaithersburg facility opened. While she's
  entitled to three titles at once, often she has
  none or only one. "I want to get my money's
  worth if I'm paying 20 a month," she said.
  "Otherwise my husband and I will just watch
  pay-per-view movies on our DirecTV system."

4
Customers

• Martin Kane, a trade show manager in Bowie, said
  he and his wife generally get their replacements
  within two or three days of returning one.
  Occasionally they have to wait for their top
  choice. "We have been waiting for a while for
  'All the President's Men,' " he said. "That
  apparently is a hot rental for older movies."

5
DVD Market

• 35M players sold to date penetrating 1/3 of US
  households
• Rapid year-over-year growth
• Prices from 200-500 have fallen to 100 level
• Netflix still must change the way people rent
  movies. Rather than go to the video store on
  Friday night, they must build a library ahead of
  time and hope they have the right DVD on movie
  night.

6
Management

• Reed Hastings
• His epiphany came in 1997. He had just sold his
  software company, Pure Atria, to Rational
  Software, and after returning a late copy of
  "Apollo 13," he garnered a 40 fee. There had to
  be a better way.
• "We weren't particularly attracted by the
  dot-com phenomena but "We're certainly attracted
  by people that we trust-- like Reed." - Mike
  Schuh, General Partner with Foundation Capital.
• President of California state board of education

7
Equity

• Market Cap
• 285.4M
• Lock-up Period 11/18/2002
• Short Interest
• 46.7
• Float
• 5.5M
• Institutional
• 10.27M
• Outstanding
• 22M
• Options
• 11M

8
Competition

• Retail

Mail
Online
9
Indirect Competition

• Cable providers like AOL and Comcast
• Direct broadcast satellite providers like
  DirectTV and EchoStar
• HBO, Showtime, and other premium networks

10
VOD

• 5-15 years away from mass commercial use
• There will be a little bit of "buffering" and
  then the movie begins playing.
• Movies currently offered at 700k bit rate
• Harry Potter 3.99
• To download a feature length film, it will take
  anywhere from 1-4 hours with even the fastest
  Internet connection 550MB
• "From Microsoft's perspective, digital
  entertainment and digital media are important
  catalysts for driving the next big cycle of PC
  upgrades, and The challenge for Microsoft is to
  convince content creators their intellectual
  property won't be pirated - Directions on
  Microsoft analyst Matt Rosoff

11
Blockbuster

• Cash 230M
• Market cap 4.26B
• Q2 Revenue 1.27B
• 48-52M active accounts
• 8,000 stores
• 64 of US within 10 minutes of store
• Co-branded DIRECTV pay-per-view

12
Rental Market

• 10 of Blockbusters revenues come from late fees
• Peak time is 30-90 days after a release
• Netflix still must change the way people rent
  movies. Rather than go to the video store on
  Friday night, they must build a library ahead of
  time and hope they have the right DVD on movie
  night.

13
Blockbusters Reply

• "One of the things we are actually going to be
  testing in our stores in the not-too-distant
  future is a prepaid mailer," "We don't know
  whether there is going to be a huge demand for
  that product." - Blockbuster CEO John Antioco,
  July 24
• Blockbuster last week lengthened its standard
  rental window for all rentals except new releases
  by two days, to seven
• DVD Freedom Pass
• 10 week rental card and free DVD for 24.99

14
Q2 Financials

• Revenues 35.6M
• Gross profit 18.3M
• Operating loss (2.5)M
• Stock-based compensation not included (2.7)M
• Net loss (5.2)M
• Cash short-term 91.7M
• Current assets current liabilities 64.9

15
Financial Trends

• High fixed-cost structure will increase DVDs,
  Infrastructure, up front fees for DVD licensing
• Gross margins expected to fall 3
• Subscriber acquisition 34 up from 25
• 10 new 3,000 square feet distribution centers
  will impact income
• Q3 Revenue Guidance 37-40
• Q4 Revenue Guidance41-44

16
Concerns

• Churn 6.7 declining
• Churn calculation is misleading
• Operating cash flow
• Does not include amortization of DVDs
• Growing 12,000 DVD database
• Capitalized, cant sell, rental window is 30-90
  days
• DVD market is growing
• Increased availability will make it easier for
  consumers to rent/buy at retail locations
• Longs agree that the current business model is
  not sustainable in the long-run
• Q What happens if a movie gets lost in the
  mail?A There is no cost to you. Just report it
  as "lost" in the "Shipping Problems" section of
  the Your Account page.
• If Netflix thinks having a Wal-Mart or
  Blockbuster in the industry will help them, they
  are nuts President of DVD rental company

17
Interviews with Reed

• CNBC May 23, 2002
• MACCALLUM When do you expect to be profitable,
  Mr. Hastings? HASTINGS We don't have any
  projections on that. MACCALLUM All right. I'm
  sorry. Can you tell me that again? I didn't hear
  your answer. HASTINGS We don't have any
  projections on profitability. MACCALLUM All
  right, no projections. Thank you very much and
  good of you to spend sometime with us. Appreciate
  it. HASTINGS Thank you very much.
• Biz Buzz January 25, 2001
• PILGRIM All this seed money, how many
  subscriptions do you need to break even? You're
  not breaking even quite yet, are you? HASTINGS
  No, it's true. Like many Internet businesses,
  we're not yet profitable, but we have acquired
  over 300,000 subscribers that are active
  subscribers today. And we break even at 500,000.
  So, you know, we're not there yet but we're over
  halfway there.

18
Churn

• The key thing with the service is, as you said,
  you get to try it. It sounds great, but it also
  sounds kind of strange, I mean, to rent the
  movies by mail. And, what we encourage people to
  do is try NetFlix for free. Anyone can go to the
  web site and try it for free. Get a bunch of
  movies on us. And, what we've found, nine out of
  ten people stay a paying subscriber. Reed
  Hastings Money markets June 24, 2002
• (603,000 236,000 670,000)/(603,000
  236,000)/3 6.7 per month Q2 Financials
• OR 20.1 per quarter, 24 assuming 9/10 stay
• Q2 Trial subscribers down 24
• The business is dependant on having more than a
  quarter of the current subscriber base as trial
  members in order to replace lost ones on a
  continual basis
• 90-95 of customers who leave will not come back
  again

19
Negative Trends

• Targeted areas away from retail locations are
  less likely to have Internet and DVD and will
  have to wait longer for delivery
• Growing customers increases number of hit titles
  necessary to maintain customer service
• Saturation Most likely consumers were targeted
  in initial marketing waves
• NetFlixs success speeds up their competitors
  interest in their model
• Net distribution centers will generate more
  fulfillment expenses, geographic issues, high
  expectations, and more rentals per month
• DVD sales provide cheap used DVDs currently
  around 9.99 including shipping

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Conclusion

• Business model is not sustainable
• Competitive threats
• Pressure on VOD technology developers
• Increased costs to sustaining growth will impact
  this years financials
• DVD presence is increasing at retail locations
• A large amount of shares will hit the market
  after the lockup period from employees and
  investors

21
Risks

• Best Buy is helping acquire subscribers
• Revenue and subscribers are growing
• Potential acquisition candidate
• Forecasting profitability before stock based
  compensation expense in 2003
• Service works
• Some advertising is linked to performance
• High capital need to grow verses competitors
• Penetration of 3.2 in local area

22
Questions?

• End of Show