Netflix, Inc. — Q2 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. Financial statements are unaudited. Amounts below are in U.S. dollars; financial figures are in millions unless stated otherwise.
Business context and key metrics
Netflix operates Domestic Streaming, International Streaming and Domestic DVD segments. Its strategy is to grow streaming domestically and internationally; domestic customers must purchase separate plans to receive streaming and DVDs. The 2011 pricing and plan changes prompted significant cancellations. At quarter-end, Netflix reported 30.1 million total unique subscribers (28.3 million paid) and 30.1 million total subscriptions across its services.
Financial performance
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Revenue | $889.2 | $788.6 | $1,759.0 | $1,507.2 |
| Gross profit | $245.7 | $298.6 | $491.6 | $579.0 |
| Operating income | $16.2 | $115.1 | $14.2 | $217.4 |
| Net income | $6.2 | $68.2 | $1.6 | $128.4 |
| Diluted EPS | $0.11 | $1.26 | $0.03 | $2.37 |
| Operating cash flow | $19.7 | $86.4 | $38.8 | $202.7 |
| Free cash flow (non-GAAP) | $11.2 | $59.5 | $13.3 | $138.8 |
Q2 revenue rose 13% year over year, but cost of revenue increased 31%; gross margin fell to about 28% from 38%. Operating income declined 86% and net income 91%. For the first half, revenue grew 17%, while operating income and net income fell sharply. Content acquisition and licensing drove the cost increase, partly offset by lower DVD delivery costs.
Q2 segment contribution: Domestic Streaming revenue was $532.7 million and contribution profit $83.2 million; International Streaming revenue was $65.0 million and contribution loss $89.4 million; Domestic DVD revenue was $291.5 million and contribution profit $133.8 million. These segment comparisons require care because the 2011 domestic streaming and DVD businesses were reported together.
Liquidity, debt and obligations
At June 30, cash and cash equivalents were $402.3 million and short-term investments were $411.1 million, totaling $813.3 million. Total assets were $3.48 billion and current liabilities $1.50 billion. Long-term debt comprised $200 million of 8.50% senior notes due 2017 and $200 million of zero-coupon convertible notes due 2018; the company reported compliance with debt covenants.
Streaming content obligations totaled $5.02 billion, including $2.03 billion of recorded content liabilities and approximately $3.0 billion not yet recognized as balance-sheet assets or liabilities. The filing cautions that commitments for titles with unspecified quantities or variable pricing are excluded and could be significant.
Outlook, risks and unusual items
- Management expected modest sequential revenue growth, driven by streaming growth and partly offset by declining DVD subscriptions. It expected seasonally higher net subscription additions in Q3 and Q4.
- Management anticipated significant International Streaming contribution losses in 2012 and planned another market launch in Q4. Content and marketing investment, including original programming, could cause future consolidated losses and negative operating cash flow or cash use for 2012.
- Q2 consolidated revenue increased 2% sequentially; net income improved from a $4.6 million Q1 loss to $6.2 million, mainly due to lower marketing expense. Management said future free cash flow could be pressured by international expansion and original-content investment.
- Three shareholder securities class actions were consolidated; management considered a loss reasonably possible but could not estimate an amount or range. Related derivative suits were also pending, with no consolidated complaint yet filed as of the report.
- The company was under IRS examination for 2008–2010 and California examination for 2006–2007; the possible change in unrecognized tax benefits over the next 12 months could not be estimated. Management reported effective disclosure controls and no material change in internal control over financial reporting.
Most important facts for investors to verify
- Whether streaming subscriber growth and revenue can offset continuing DVD subscription declines and lower revenue per domestic subscriber.
- Whether content amortization, cash payment timing and the $5.02 billion of disclosed streaming obligations permit sustainable margins and cash generation.
- The pace and cost of international expansion and original-content investment, including their impact on losses and 2012 cash use.
- Developments in the shareholder litigation and tax examinations, for which potential outcomes or amounts were not estimable.
- Interpretation of free cash flow: it is a company-defined non-GAAP measure and excludes purchases, maturities and sales of short-term investments.