Netflix, Inc. — Q3 2012 Form 10-Q
Reporting period: Quarter ended September 30, 2012; interim financial statements are unaudited. Netflix operates Domestic Streaming, International Streaming and Domestic DVD subscription services.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Change |
|---|---|---|---|
| Revenue | $905.1 million | $821.8 million | +10% |
| Gross profit | $242.5 million | $285.2 million | −15% |
| Operating income | $16.1 million | $96.8 million | −83% |
| Net income | $7.7 million | $62.5 million | −88% |
| Diluted EPS | $0.13 | $1.16 | −89% |
| Operating cash flow | $0.2 million | $49.5 million | Down $49.4 million |
| Free cash flow (non-GAAP) | −$20.5 million | $13.8 million | Down $34.2 million |
For the first nine months of 2012, revenue rose 14% to $2.664 billion, while operating income fell to $30.4 million from $314.2 million and net income fell to $9.3 million from $190.9 million. Nine-month free cash flow was −$7.1 million, versus $152.6 million in 2011. Q3 operating margin was approximately 2%, compared with 12% a year earlier; cost of revenues increased to 73% of revenue from 65%.
Segments and subscriber trends
- Domestic Streaming: Q3 revenue of $556.0 million and contribution profit of $90.9 million; contribution margin was 16%. Paid subscriptions ended the quarter at 23.8 million, up from 22.7 million at June 30.
- International Streaming: Q3 revenue of $77.7 million and contribution loss of $92.4 million, versus a $23.3 million loss in the prior-year quarter. Paid subscriptions were 3.7 million, up from 3.0 million at June 30. Netflix launched in Norway, Denmark, Sweden and Finland in October 2012.
- Domestic DVD: Q3 revenue of $271.3 million and contribution profit of $130.6 million; subscriptions fell 7% from June 30 to 8.6 million total subscriptions.
- Consolidated paid unique subscribers reached 29.9 million, compared with 23.8 million a year earlier. Domestic revenue growth was partly offset by lower average revenue per unique paying subscriber, associated with streaming’s popularity and fewer customers taking both streaming and DVD plans.
Liquidity, debt and commitments
Cash and cash equivalents were $370.3 million and short-term investments were $428.1 million at September 30, 2012, totaling $798.4 million, approximately unchanged from year-end 2011. Current assets were $2.225 billion and current liabilities $1.598 billion. Total liabilities were $3.092 billion.
Debt principal totaled $400 million: $200 million of 8.50% senior notes due 2017 and $200 million of zero-coupon senior convertible notes due 2018, issued to related-party funds. The company reported covenant compliance. Streaming content obligations totaled $4.973 billion, including $2.7 billion not recorded on the balance sheet because the related content did not yet qualify for asset recognition. Total contractual obligations were $5.722 billion. The company cautioned that variable and contingent content commitments may make the disclosed amounts an incomplete indicator of future cash outflows.
Management outlook, risks and unusual items
- Management expected modest sequential revenue growth in future quarters, driven by streaming subscriptions and partly offset by declining DVD subscriptions.
- Netflix anticipated significant International Streaming contribution losses during 2012 and into 2013. Management expected content and marketing investment to moderate relative to revenue over time, supporting domestic streaming margin expansion.
- Management warned that international expansion and original programming would pressure cash flow. Original programming was expected to require more upfront cash payments beginning in Q4 2012 and increasing in 2013. Available funds were expected to cover foreseeable needs, but additional financing could be required or chosen.
- Q3 cash flow was pressured by content payments exceeding expense, property and equipment payments, and reductions in certain payables and accruals. The company cited Open Connect equipment spending as a driver of higher capital spending versus Q2.
- Three shareholder class-action suits were consolidated; management considered a loss reasonably possible but could not estimate an amount or range. Shareholder derivative suits were also pending, with potential loss likewise not estimable. Netflix was under IRS examination for 2008–2011 and California examination for 2006–2007; the company said unrecognized tax benefits could change significantly within 12 months, but could not estimate the range.
- The effective tax rate was 35.8% for Q3 2012 versus 33.3% in Q3 2011; the increase primarily reflected expiration of the federal R&D tax credit and a prior-year discrete tax benefit.
Most important facts for investors to verify
- Whether streaming subscriber growth and pricing trends can offset continued DVD subscriber declines and lower domestic revenue per subscriber.
- Whether International Streaming losses and content and marketing costs narrow as new markets mature.
- The timing and cash impact of original programming commitments, content-license payments and the $4.973 billion disclosed streaming obligations, including unrecorded and contingent amounts.
- Whether operating cash flow and free cash flow recover after sharply weakening in 2012, and whether additional financing becomes necessary.
- Developments in shareholder litigation, tax examinations and any related exposure, which the filing does not quantify.