Netflix, Inc. — Q2 2016 Form 10-Q
Business context and reporting period. Unaudited results cover the quarter and six months ended June 30, 2016, compared with the same 2015 periods. Netflix operates Domestic Streaming, International Streaming and Domestic DVD; streaming membership growth and global content investment are central to its strategy.
Financial performance and key metrics
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Revenue | $2,105.2 million | $1,644.7 million | $4,062.9 million | $3,217.8 million |
| Operating income | $70.4 million | $74.8 million | $119.8 million | $172.3 million |
| Net income | $40.8 million | $26.3 million | $68.4 million | $50.0 million |
| Diluted EPS | $0.09 | $0.06 | $0.16 | $0.12 |
| Net cash used in operations | $226.3 million | $181.3 million | $454.9 million | $308.7 million |
| Non-GAAP free cash flow | $(254.1) million | $(229.3) million | $(514.7) million | $(392.4) million |
Q2 operating margin was approximately 3.3% (4.6% prior year); net margin was approximately 1.9% (1.6% prior year). For the first half, operating margin was approximately 3.0% (5.4% prior year) and net margin approximately 1.7% (1.6% prior year). Revenue growth was 28% for Q2 and 26% for the first half.
- Memberships: Global streaming memberships reached 83.2 million, up 27% year over year. Q2 average monthly revenue per paying streaming member was $8.32, up 3%.
- Segments, Q2: Domestic Streaming revenue was $1,208.3 million and contribution margin 34%; International Streaming revenue was $758.2 million and contribution margin negative 9%; Domestic DVD revenue was $138.7 million and contribution margin 51%. International contribution loss was $69.2 million.
- Liquidity and debt: Cash and cash equivalents were $1,390.9 million and short-term investments $443.3 million at June 30. Long-term debt, net of issuance costs, was $2,373.1 million. The company reported total current assets of $5,386.9 million and current liabilities of $4,051.8 million; it was in compliance with debt covenants.
- Content investment: Net content assets were $9,092.2 million, up from $7,218.8 million at year-end 2015. Streaming content amortization was $1,195.4 million in Q2 and $2,274.3 million in the first half.
Material changes versus prior periods
- Revenue growth was primarily driven by international expansion and increased streaming memberships, with pricing and plan mix also lifting average monthly revenue per paying member.
- Operating income declined in Q2 despite higher revenue, principally because of greater content expense and headcount to support international expansion. Technology and development and general and administrative expenses also increased materially.
- Net income increased partly because of favorable foreign-exchange results and a lower effective tax rate. Q2 included a $14.0 million foreign-exchange gain; the first half included a $38.2 million gain. Effective tax rates were 20% for Q2 and 25% for the first half, down from 35% and 37%, respectively, primarily following reinstatement of the federal R&D credit.
- Operating cash use and negative free cash flow worsened as cash payments for streaming content exceeded content amortization. First-half cash used for streaming content additions was $4,108.4 million, compared with $2,916.9 million in the prior-year period.
- Domestic DVD memberships continued to decline: 4.5 million at quarter-end, down 15% year over year. International streaming memberships were up 55% year over year.
Outlook, risks and unusual items
- Netflix expected to complete the phase-out of grandfathered pricing in the second half of 2016. It projected average monthly revenue per paying membership by Q4 2016 to increase 10%–20% year over year, while warning that cancellations, plan downgrades or adverse media reaction could affect membership and revenue.
- The company retained a 40% Domestic Streaming contribution-margin target for 2020. International expansion and content spending continued to pressure international contribution results.
- Management expected available funds and operating cash flows to cover cash needs for at least 12 months, but said it was likely to raise additional capital to fund content investment. It warned future free cash flow could remain negative, including after achieving material global profitability, and financing may not be available on acceptable terms.
- Streaming content obligations totaled $13.2 billion, including $7.3 billion not yet recognized on the balance sheet. The contractual-obligations discussion separately estimates an additional $3–$5 billion of unknown-title commitments over the next three years; these are not included in the stated contractual-obligations total and actual amounts may differ.
- Foreign-exchange exposure is material; the company does not hedge currency exposures with derivatives. Management estimated first-half international revenue would have been about $119 million higher at prior-year exchange rates.
- Management identified uncertainty in estimates for content amortization and tax positions. Gross unrecognized tax benefits were $22.4 million; the company could not estimate the timing of payments for most of the balance.
- A federal securities class action was affirmed dismissed with prejudice by the Ninth Circuit in April 2016. A related derivative action remained stayed; management considered a loss reasonably possible but could not reasonably estimate a loss range.
- Disclosure controls were assessed as effective, and the filing reported no material change in internal control over financial reporting or material change to previously disclosed risk factors.
Important facts for investors to verify
- Whether membership growth and the expected grandfathered-price migration translate into the projected revenue-per-member increase without elevated churn.
- How content cash payments, content amortization and the $13.2 billion of disclosed obligations evolve, including unknown-title commitments.
- Whether domestic margin improvement can continue while international expansion remains contribution-loss-making.
- Funding needs, potential additional debt or equity issuance, and the sustainability of liquidity given persistent negative free cash flow.
- The effects of foreign-exchange movements and tax-audit outcomes on reported earnings and cash flows.