Netflix, Inc. — Q3 2010 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2010. Unaudited consolidated results; dollar figures below are in millions unless noted. Netflix reported more than 16 million subscribers and operated a subscription streaming and, in the U.S., DVD-by-mail service. It launched streaming-only service in Canada during the quarter.
Financial performance
| Metric | Q3 2010 | Q3 2009 | 9M 2010 | 9M 2009 |
|---|---|---|---|---|
| Revenue | $553.2 | $423.1 | $1,566.7 | $1,225.7 |
| Gross profit / margin | $208.8 / 37.7% | $147.8 / 34.9% | $600.1 / 38.3% | $421.9 / 34.4% |
| Operating income / margin | $69.5 / 12.6% | $49.3 / 11.6% | $205.2 / 13.1% | $138.6 / 11.3% |
| Net income | $38.0 | $30.1 | $113.8 | $84.9 |
| Diluted EPS | $0.70 | $0.52 | $2.09 | $1.43 |
| Operating cash flow | $42.2 | $78.3 | $179.7 | $219.2 |
| Non-GAAP free cash flow | $7.8 | $25.5 | $79.6 | $66.9 |
Q3 revenue rose 30.7% year over year, driven primarily by 43.5% growth in average paying subscribers; average monthly revenue per paying subscriber fell 8.9% to $12.12 as lower-priced plans grew. Ending subscribers were 16.933 million, including 15.863 million paid and 1.070 million free subscribers. Churn was 3.8%, compared with 4.4% a year earlier. Subscriber acquisition cost declined 26.2% year over year to $19.81.
Q3 net income increased 26.0% year over year but fell 12.8% sequentially from Q2; diluted EPS was $0.70 versus $0.80 in Q2. Gross margin rose year over year but declined from 39.4% in Q2, reflecting increased streaming-content investment. Nine-month operating cash flow fell 18.0% year over year; management attributed the reduction principally to higher streaming-content acquisition and licensing spending.
Liquidity, debt and capital allocation
- At September 30, cash and cash equivalents were $113.1 million and short-term investments were $143.7 million. Current assets totaled $492.2 million and current liabilities $312.1 million.
- Long-term debt was $200 million: 8.50% senior notes due November 2017. The company reported compliance with debt covenants. Interest expense was $4.9 million in Q3, up from $0.7 million a year earlier, principally reflecting the notes.
- Q3 investing cash flow was a $5.6 million use; financing cash flow was a $30.8 million use. The company repurchased 530,000 shares for approximately $59 million during Q3. About $240.6 million remained under its $300 million authorization through 2012.
Outlook, risks and unusual items
- No specific numerical earnings or revenue guidance is provided in the supplied filing text. Management expected average revenue per paying subscriber to keep declining while lower-priced plans gained share, and said a possible U.S. streaming-only plan could change pricing and affect revenue and that metric.
- Management expected to continue increasing content-library investment, particularly for streaming. It cautioned that content spending outpacing revenue growth could reduce gross margin and affect liquidity. It nevertheless expected operating cash flow and available funds to meet cash needs for the foreseeable future, while noting additional financing could be required or chosen.
- Contractual obligations totaled $1.917 billion, including $1.409 billion of content obligations, of which $547.6 million was due within one year. Separately, the company disclosed $1.181 billion of streaming-content license commitments that did not meet asset-recognition criteria. Some future theatrical-title license fees were unquantifiable but expected to be significant; potential additional studio-title commitments were up to $21.6 million.
- Music royalty negotiations with performing rights organizations remained unresolved. Netflix reduced its estimated royalty accrual by $3.5 million in Q3; negotiations or related litigation could produce materially different outcomes from its estimates.
- Pending matters included patent-infringement claims and DVD-rental antitrust litigation. Management considered potential losses reasonably possible but not probable for the described claims and generally could not estimate a loss range; no amounts were accrued. Wal-Mart reported a settlement of federal antitrust cases, but preliminary court approval had not yet been sought. A separate Parallel Networks case was dismissed without payment.
- The company identified international expansion risks following its Canada launch, including regulatory, tax, currency, privacy, content-localization, competition and broadband-access risks. Q3 also included a write-down of certain deferred tax assets that contributed to a higher effective tax rate, and a $32.6 million write-off of fully depreciated property and equipment no longer in existence.
Most important facts for investors to verify
- Whether subscriber growth can continue while average monthly revenue per paying subscriber declines and free subscribers increase.
- How streaming-content commitments and future licensing costs affect cash flow, margins and the timing of payments.
- Whether operating cash flow recovers as content investment expands, given lower Q3 and nine-month cash generation year over year.
- Developments in royalty negotiations, patent claims and antitrust litigation, including any changes to loss estimates or accruals.
- Progress and costs of Canadian and prospective international operations, including execution against the risks disclosed.