NetFlix 2004 Annual Report Download - page 29

increase in churn may signal a deterioration in the quality of our service, or it may signal an unfavorable
behavioral change in the mix of new subscribers. Lower churn means higher customer retention, faster
revenue growth and lower marketing expenses as a percent of revenues for any given level of subscriber
acquisition.
•Subscriber Acquisition Cost: Subscriber acquisition cost is defined as total marketing expense divided
by total gross subscriber additions. Management reviews this metric closely to evaluate how effective
our marketing programs are in acquiring new subscribers on an economical basis.
•Gross Margin: Management reviews gross margin in conjunction with churn and subscriber
acquisition cost to target a desired operating margin. For example, movie rentals per average paying
subscriber may increase, which depresses our gross margin. However, increased movie rentals per
average paying subscriber may result in higher subscriber satisfaction, which reduces churn and
increases word-of-mouth advertising about our service. As a result, marketing expense may fall as a
percentage of revenues and operating margins rise, offsetting the impact of a reduction in gross margin.
We can also make trade-offs between our DVD library investments which have an inverse relationship
with churn and subscriber acquisition cost. For example, an increase in our DVD library investments
may improve customer satisfaction and lower churn, and hence increase the number of new subscribers
acquired via word-of-mouth. This in turn may allow us to accelerate our subscriber growth for a given
level of marketing spending.
Please see “Results of Operations” below for further discussion on these key business metrics.
Recent Developments and Initiatives
We continue to experience aggressive direct competition from Blockbuster. In particular, Blockbuster cut its
standard subscription price twice during the last quarter of 2004 and currently has a price $3 below our standard
price. In addition, Blockbuster has begun television advertising of its online offering. We also anticipate that
other entrants, such as Amazon.com, will offer competing services, either directly or in conjunction with others.
Despite this dynamic competitive landscape, we do not intend to lose our leadership position. While we aim to
maintain domestic market leadership in the face of aggressive competition, there can be no assurance that we will
be able to compete effectively. If we are unable to successfully or profitably compete with current and new
competitors, our business will be adversely affected and we may not be able to increase or maintain market share,
revenues or profitability.
We continue to invest resources to develop solutions for downloading movies to consumers. Our core
strategy has been and remains to grow a large DVD subscription business; however, as technology and
infrastructure develop to allow effective and convenient delivery of movies over the Internet, we intend to offer
our subscribers the choice under one subscription of receiving their movies on DVD or by downloading,
whichever they prefer. Although our solutions may be well in advance of meaningful demand for downloading
services and we expect only modest consumer interest for the near term, we believe the demand for this
technology will grow steadily over the next ten years.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally
accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and
liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in our consolidated
financial statements and accompanying notes. The Securities and Exchange Commission has defined a
company’s critical accounting policies as the ones that are most important to the portrayal of a company’s
financial condition and results of operations, and which require a company to make its most difficult and
subjective judgments. Based on this definition, we have identified the critical accounting policies and judgments
addressed below. Although we believe that our estimates, assumptions and judgments are reasonable, they are
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