Netflix, Inc. — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014; interim financial statements are unaudited. Netflix operates Domestic Streaming, International Streaming and Domestic DVD businesses, earning revenue primarily from monthly membership fees.
Financial performance
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $1.340B | $1.069B | $2.610B | $2.093B |
| Operating income | $129.6M | $57.1M | $227.2M | $88.9M |
| Net income | $71.0M | $29.5M | $124.1M | $32.2M |
| Diluted EPS | $1.15 | $0.49 | $2.02 | $0.53 |
| Operating cash flow | $56.0M | $33.9M | $92.4M | $21.7M |
| Free cash flow (non-GAAP) | $16.3M | $12.9M | $24.7M | $(28.6)M |
Q2 revenue rose 25%, operating income 127% and net income 141% year over year. Operating margin was approximately 9.7%, versus 5.3% in Q2 2013; net margin was approximately 5.3%, versus 2.8%. Management attributed revenue growth primarily to domestic and international streaming membership growth; higher content licensing costs partly offset the revenue increase.
At June 30, cash and cash equivalents were $1.214B and short-term investments were $500.1M, totaling $1.714B in cash and short-term investments. Long-term debt was $900M: $500M of 5.375% notes due 2021 and $400M of 5.750% notes due 2024. Total liabilities were $4.716B. Netflix issued the $400M 2024 notes in February 2014.
Segments and changes versus prior year
- Domestic Streaming: Q2 revenue increased 25% to $838.2M; contribution profit was $227.3M and contribution margin 27%, up from 23%. Members reached 36.2M, up 22% year over year.
- International Streaming: Q2 revenue increased 85% to $307.5M; contribution loss narrowed to $15.3M from $65.8M. Members reached 13.8M, up 78% year over year.
- Domestic DVD: Q2 revenue fell 16% to $194.7M as paid members declined 16% to 6.2M. Contribution profit was $92.8M, with a 48% margin.
- Streaming content amortization was $656.0M in Q2, versus $528.0M a year earlier. Content library, net, rose to $4.135B from $3.797B at year-end 2013.
- Six-month interest expense increased to $23.4M from $14.3M, principally reflecting higher outstanding interest-bearing debt. The six-month 2013 comparison included a $25.1M loss on extinguishment of debt; there was no such charge in 2014.
Outlook, risks and unusual items
- Netflix planned to launch in Germany, Austria, Switzerland, France, Belgium and Luxembourg in Q3 2014. Management expected continued significant spending on streaming licenses, original content and international expansion. The filing provides no specific financial guidance for future periods.
- In Q2, the most popular domestic streaming plan for new members increased from $7.99 to $8.99 per month; existing members were to retain the $7.99 price for two years if they remained members. A new $7.99 single-device, standard-definition plan was introduced. Similar pricing and plan changes were rolled out internationally.
- Streaming content obligations totaled $7.728B, including $4.5B not recorded on the balance sheet because the related titles were not yet available or otherwise did not meet recognition criteria. Obligations for unknown future titles are expected to be significant but are not quantified.
- Management cautioned that content payment timing can exceed expense recognition and affect liquidity. It also noted that financing for expansion or content investment may not be available on acceptable terms, or at all.
- Netflix was negotiating with performing rights organizations over music and other performance rights; outcomes could differ materially from estimates. The company also disclosed shareholder securities and derivative litigation; management considered potential losses reasonably possible but could not estimate a loss range.
- The effective tax rate was 39% in Q2 and 40% for the first half, higher than comparable 2013 rates partly because the federal R&D tax credit had expired. Gross unrecognized tax benefits were $78.6M; IRS and California examinations and appeals were ongoing, and changes within 12 months were reasonably possible but not estimable.
Investor verification priorities
- Track paid-member growth, average revenue per paying member and retention following the price and plan changes.
- Assess international contribution losses, planned European launches and the cost of building local content and marketing.
- Compare content cash payments with amortization and operating cash flow; review the scale and timing of the $7.728B content commitments, including unrecorded obligations.
- Monitor debt service, liquidity needs and the possibility of additional financing as content and expansion investment increases.
- Follow the performing-rights negotiations, shareholder litigation and tax examinations for potential financial effects.