Business context and reporting period
Netflix, Inc. filed this unaudited Form 10-Q for the quarter ended June 30, 2013. The company operates Domestic streaming, International streaming and Domestic DVD businesses, funded primarily by monthly membership fees. Management’s strategy is to grow streaming domestically and internationally while shifting investment from DVD to streaming content and marketing.
Financial performance and liquidity
Amounts are in millions of dollars except per-share data, percentages and member counts.
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Revenue | $1,069.4 | $889.2 | $2,093.3 | $1,759.0 |
| Operating income | $57.1 | $16.2 | $88.9 | $14.2 |
| Net income | $29.5 | $6.2 | $32.2 | $1.6 |
| Diluted EPS | $0.49 | $0.11 | $0.53 | $0.03 |
| Operating cash flow | $33.9 | $19.4 | $21.7 | $38.5 |
| Free cash flow (non-GAAP) | $12.9 | $11.2 | $(28.6) | $13.3 |
- Q2 revenue increased 20% year over year; operating income rose 254% and net income rose 378%. Revenue growth reflected domestic and international streaming membership gains. Q2 net income also benefited from not repeating the $25.1 million debt-extinguishment loss recorded in Q1 2013.
- At June 30, cash and cash equivalents were $370.7 million and short-term investments were $709.4 million, totaling $1.08 billion. Total current assets were $2.57 billion versus current liabilities of $1.67 billion.
- Long-term debt was $500 million. Netflix issued $500 million of 5.375% senior notes due 2021, used part of the proceeds to redeem $200 million of 8.50% notes, and converted $200 million of zero-coupon convertible notes into common shares in April.
- Streaming content obligations totaled $6.37 billion, including $4.0 billion not recorded on the balance sheet because the related titles or fees did not yet meet asset-recognition criteria. Some additional contingent or variable-title commitments were excluded and expected to be significant.
Material changes and segment trends
- Domestic streaming: Q2 revenue was $671.1 million, up 26% year over year; quarter-end members were 29.8 million, including 28.6 million paid members. Contribution profit was $151.3 million and margin increased to 23% from 16%, as revenue grew faster than content spending.
- International streaming: Q2 revenue was $165.9 million, up 155%; quarter-end members were 7.7 million, including 7.0 million paid members. Contribution loss narrowed to $65.8 million from $89.4 million, but the segment remained loss-making.
- Domestic DVD: Q2 revenue fell 20% to $232.4 million as average paid memberships declined 20%. Contribution profit was $108.6 million and margin was 47%. Quarter-end members were 7.5 million.
- Content amortization and licensing investment increased with streaming growth. Total net content library rose to $3.05 billion from $2.87 billion at year-end 2012.
- For the first half, free cash flow was negative $28.6 million, mainly reflecting content cash payments exceeding content expense. Q2 free cash flow was positive $12.9 million; management said content payments remain the most significant use of cash and can fluctuate.
Outlook, risks and unusual items
- Management expected domestic streaming memberships to continue growing and anticipated domestic contribution-margin expansion over time as content and marketing investment grows more slowly than revenue. Second-quarter net additions were seasonally low.
- Netflix planned to launch in the Netherlands in Q3 2013. Management expected international contribution loss to increase in Q3, reflecting launch costs and content investment planned to grow slightly ahead of revenue.
- Management expected DVD memberships to continue declining and anticipated maintaining DVD margins around first-half 2013 levels through the full year.
- For 2013, Original-content cash outflows were expected to be less than 10% of total streaming-content payments. Originals and earlier-window content may require larger upfront payments, affecting liquidity and operating cash flow.
- Management believed available funds and remaining note proceeds would meet foreseeable cash needs, but said additional financing might be required or chosen; financing may be unavailable or dilute shareholders. $57.8 million of cash was held by foreign subsidiaries and could incur tax upon repatriation to the U.S.
- Other risks include negotiations with performing-rights organizations, which could lead to litigation or restrictions on certain music; the outcome and potential costs were uncertain. Shareholder securities and derivative suits remained pending; possible losses were considered reasonably possible but not estimable. IRS and California tax examinations were ongoing, and the possible adjustment to unrecognized tax benefits could not be estimated.
- The $25.1 million Q1 debt-extinguishment loss included the make-whole premium and write-off of issuance costs. The effective tax rate was affected by the retroactive reinstatement of the federal R&D credit, including a $3.1 million benefit recognized in Q1.
Important facts for investors to verify
- Whether domestic streaming growth and margin expansion continue while content costs rise.
- The pace and eventual profitability of international expansion, including the Netherlands launch and future content commitments.
- The size, timing and cash-flow effects of content obligations, including commitments excluded from the disclosed contractual-obligations total.
- Whether declining DVD memberships affect cash generation or segment margins more than management expects.
- Developments in shareholder litigation, music-rights negotiations and tax examinations, including any material change in estimated exposure.
Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. The filing stated that risk factors had not materially changed from the 2012 Form 10-K.