Netflix, Inc. — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. Unaudited consolidated results; comparisons are with the corresponding 2013 periods. Netflix reported three segments: Domestic streaming, International streaming and Domestic DVD.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Revenue | $1.409B | $1.106B | $4.020B | $3.199B |
| Operating income | $110.4M | $57.1M | $337.6M | $146.1M |
| Net income | $59.3M | $31.8M | $183.4M | $64.0M |
| Diluted EPS | $0.96 | $0.52 | $2.97 | $1.06 |
| Operating cash flow | $(37.4)M | $34.7M | $54.9M | $56.4M |
| Non-GAAP free cash flow | $(73.7)M | $7.1M | $(49.0)M | $(21.5)M |
Q3 revenue rose 27%, operating income 93% and net income 86% year over year. Revenue growth reflected streaming membership growth in the U.S. and internationally; higher content costs partly offset that growth. Q3 operating margin was approximately 7.8%, versus 5.2% a year earlier.
- Liquidity: Cash and cash equivalents were $1.183B and short-term investments $483.6M at quarter-end, totaling $1.667B, versus $1.200B at December 31, 2013.
- Debt: Long-term debt was $900M, comprising $500M of 5.375% senior notes due 2021 and $400M of 5.750% notes due 2024. The company reported covenant compliance. Q3 interest expense was $13.5M.
- Content investment: Net content library was $4.639B, up from $3.797B at year-end 2013. Q3 streaming content additions were $1.202B; amortization of the content library was $704.4M.
Segment performance and changes
- Domestic streaming: Revenue was $877.2M, up 25%; contribution profit was $250.9M and contribution margin 29%, versus 24% a year earlier. Ending members were 37.2M, including 36.3M paid members. Average monthly revenue per paying member was $8.20, up 3%.
- International streaming: Revenue was $345.7M, up 89%; contribution loss narrowed to $30.9M from $74.3M, with contribution margin improving to -9% from -41%. Ending members were 15.8M, including 14.4M paid members. The company launched in Germany, Austria, Switzerland, France, Belgium and Luxembourg in September 2014.
- Domestic DVD: Revenue declined 16% to $186.6M as paid members fell 16% to 5.9M. Contribution profit was $89.4M and contribution margin remained 48%.
In Q2 2014, Netflix raised the price for new U.S. members choosing its popular two-screen HD plan from $7.99 to $8.99 monthly, while grandfathering existing members at $7.99 for two years if they remain members. It also introduced a $7.99 single-screen standard-definition plan. The filing says similar pricing and plan changes were rolled out internationally.
Outlook, risks and unusual items
- Management expects Domestic streaming contribution margins to grow by an average of 200 basis points per year beginning “some time next year.” This is a margin target, not overall earnings guidance.
- Management expects free cash flow to be materially below net income while investments rise, particularly in original content, and says future periods may have negative free cash flow. It cites content payment timing, marketing and international expansion as important cash demands.
- Streaming content obligations totaled $8.857B, up from $7.252B at year-end 2013; $5.3B was not on the balance sheet because it did not yet meet asset-recognition criteria. The company says additional obligations for unknown future titles are expected to be significant but cannot yet be estimated.
- Content obligations include $3.574B due within one year. The filing attributes the increase mainly to commitments for European market launches and exclusive and original programming. Performing-rights-organization licensing negotiations remain uncertain and may produce amounts materially different from management’s estimates.
- Gross unrecognized tax benefits were $83.1M, with $4.6M of accrued interest and penalties. IRS and California examinations and proposed assessments relating primarily to R&D credits are ongoing; management could not estimate a range of potential changes in unrecognized tax benefits over the next 12 months.
- Shareholder securities and derivative lawsuits remain pending or under appeal. Management considers potential losses reasonably possible but says amounts or ranges are not reasonably estimable. Other litigation was not considered material at the filing date.
- The company issued $400M of 5.750% senior notes in February 2014. No debt-extinguishment loss was recorded in 2014; the 2013 comparison includes a $25.1M loss from redeeming older notes.
- Management reported no material change in previously disclosed risk factors or market-risk exposure. Disclosure controls were assessed as effective. The company was evaluating a new revenue-recognition standard and did not expect a material impact.
Investor verification priorities
- Track free cash flow against net income and the timing of content cash payments, not just reported content expense.
- Monitor the growth and payment schedule of the $8.9B content commitment total, including obligations for titles not yet estimable.
- Assess whether international membership growth and improving contribution losses continue as new markets and content investments scale.
- Verify the effect of pricing changes on paid-member growth, churn and average revenue per paying member.
- Follow tax examinations, legal proceedings and the potential effect of any resulting assessments or settlements.