Netflix, Inc. — Q3 2011 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2011. Unaudited consolidated results; amounts below are in U.S. dollars. Netflix operates Domestic and International segments, offering streaming subscriptions internationally and streaming and DVD-by-mail services domestically.
Financial performance
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Revenue | $821.8 million | $553.2 million | $2,329.0 million | $1,566.7 million |
| Operating income | $96.8 million | $69.5 million | $314.2 million | $205.2 million |
| Net income | $62.5 million | $38.0 million | $190.9 million | $113.8 million |
| Diluted EPS | $1.16 | $0.70 | $3.53 | $2.09 |
| Operating margin | 11.8% | 12.6% | 13.5% | 13.1% |
| Net margin | 7.6% | 6.9% | 8.2% | 7.3% |
| Operating cash flow | $49.5 million | $42.2 million | $252.2 million | $179.7 million |
| Free cash flow, non-GAAP | $13.8 million | $7.8 million | $152.6 million | $79.6 million |
Q3 revenue grew 48.6% year over year, while operating income grew 39.3%. Subscription cost rose 61.4% year over year, largely from streaming content licenses, and increased to 57.4% of revenue from 52.9%. Domestic average monthly revenue per paying subscriber fell 4.6% to $11.56, reflecting growth in lower-priced plans. Q3 operating income and net income declined 15.9% and 8.4%, respectively, from Q2 2011.
Liquidity, debt, and commitments
- At September 30, cash and cash equivalents were $159.2 million and short-term investments were $206.6 million. Current assets were $1.190 billion and current liabilities $968.0 million.
- Long-term debt was $200 million: 8.50% senior notes due November 2017. Netflix reported compliance with debt covenants.
- Net content library was $1.276 billion, up from $362.0 million at December 31, 2010. Accounts payable increased to $750.1 million, including $653.6 million for streaming content.
- Streaming content obligations totaled approximately $3.459 billion, including $740.8 million due within one year. Total listed contractual obligations were $4.117 billion. Certain title commitments with unspecified quantities or variable pricing were excluded and expected to be significant.
- Q3 free cash flow was $48.7 million below net income, primarily because payments for streaming and DVD content exceeded related expense. The company repurchased $199.7 million of stock in the first nine months; $41.0 million remained authorized, but management said it did not expect further repurchases in the foreseeable future.
Material changes and operating developments
- Netflix separated domestic DVD-by-mail and streaming plans in July 2011, raising prices for customers who previously subscribed to both. The company later withdrew its plan to rebrand DVD service as Qwikster and split the websites.
- Management said customer reaction to the pricing and service announcements was very negative. Domestic churn rose to 6.3% in Q3 from 4.2% in Q2 and 3.8% a year earlier. Domestic net subscribers fell by 805,000; international additions of 513,000 left total net additions at negative 292,000. Ending subscribers were 25.269 million, down from 25.561 million at Q2-end.
- Domestic Q3 revenue was $799.2 million and segment contribution profit was $219.4 million. International revenue was $22.7 million and contribution loss was $23.3 million, compared with a $2.7 million loss a year earlier.
- International streaming expanded to Latin America and the Caribbean in September 2011. Netflix planned to launch in the UK and Ireland in Q1 2012 and then pause entry into new international markets.
Outlook, risks, and unusual items
- Management expected consolidated revenue to remain relatively flat until positive net subscriber additions resume, as cancellations and migration to lower-priced plans are partly offset by international revenue growth.
- Netflix anticipated significant International contribution losses in 2011 and 2012, consolidated net losses in 2012, and negative operating cash flow and free cash flow in future periods. Management said available funds were expected to meet cash needs for the foreseeable future, while noting additional financing might be needed or chosen and might not be available on acceptable terms.
- Management expected substantial, increasing investment in streaming content. The scale and timing of contractual content payments, including obligations not recorded as balance-sheet liabilities, create liquidity and cash-flow risks.
- Q3’s 33.3% effective tax rate included a $3.5 million discrete tax benefit from the expiration of the statute of limitations for earlier tax years. The company had $26.3 million of gross unrecognized tax benefits and $1.8 million of accrued interest and penalties; IRS and California examinations were ongoing.
- Pending matters included patent and antitrust litigation; management said potential losses in several cases were reasonably possible but not reasonably estimable. The Alcatel-Lucent case was dismissed with prejudice in September 2011.
Important facts for investors to verify
- Whether subscriber trends, domestic churn, and brand response improved after the pricing and service changes.
- Whether international subscriber growth can support content investment and reduce segment losses, particularly after the planned UK and Ireland launch.
- The cash-payment schedule and flexibility of streaming-content commitments, including significant excluded or variable-price arrangements.
- Actual free cash flow and liquidity needs relative to management’s forecast of 2012 losses and potential negative operating cash flow.
- Developments in tax examinations and litigation, and any resulting changes to estimated liabilities or cash requirements.