Netflix, Inc. — Q3 2015 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2015; unaudited. Netflix reported three segments: Domestic Streaming, International Streaming, and Domestic DVD. Unless stated otherwise, financial amounts below are in millions of U.S. dollars.
Financial performance
| Metric | Q3 2015 | Q3 2014 | Change |
|---|---|---|---|
| Revenue | $1,738.4 | $1,409.4 | +23% |
| Operating income | $73.6 | $110.4 | -33% |
| Net income | $29.4 | $59.3 | -50% |
| Diluted EPS | $0.07 | $0.14 | Lower by $0.07 |
| Operating margin | 4.2% | 7.8% | Down 3.6 percentage points |
| Net margin | 1.7% | 4.2% | Down 2.5 percentage points |
For the first nine months, revenue rose 23% to $4,956.2 million, while operating income fell 27% to $245.9 million and net income fell 57% to $79.5 million. Diluted EPS was $0.18 versus $0.42.
Cash flow, liquidity, and debt
- Q3 operating cash flow was negative $196.0 million and free cash flow, a company-defined non-GAAP measure, was negative $252.0 million; prior-year Q3 free cash flow was negative $73.7 million. For the first nine months, operating cash flow was negative $504.7 million and free cash flow was negative $644.4 million, versus positive operating cash flow of $54.9 million and negative free cash flow of $49.0 million in 2014.
- Management attributed the cash use chiefly to content payments exceeding content expense: $326.7 million in Q3 and $859.0 million year to date. Content additions were $4,194.5 million in the first nine months.
- At September 30, cash and cash equivalents were $2,115.4 million and short-term investments were $494.2 million, totaling $2,609.6 million. Long-term debt was $2,400.0 million, up from $900.0 million at year-end 2014 following $1,500.0 million of debt issuance in 2015. The company reported compliance with debt covenants.
- Total streaming content obligations were $10.4 billion, including $5.8 billion not recorded on the balance sheet. Netflix said unknown future-title commitments were expected to be significant and estimated they could total approximately $3 billion to $5 billion over the next three years; those estimates are excluded from the stated obligations table.
Segments and changes versus prior year
- Domestic Streaming: Q3 revenue grew 21% to $1,064.0 million; contribution profit rose 37% to $344.2 million and contribution margin improved to 32% from 29%. End-period memberships were 43.2 million. Growth reflected paid-member gains and higher average revenue per paying member.
- International Streaming: Q3 revenue increased 50% to $516.9 million, but contribution loss widened to $67.6 million from $30.9 million; contribution margin declined to negative 13% from negative 9%. End-period memberships were 26.0 million. Average monthly revenue per paying member fell 10% to $7.56, primarily due to currency movements and higher European VAT, partly offset by pricing and plan mix.
- Domestic DVD: Q3 revenue declined 16% to $157.5 million as paid memberships fell 16% to 5.0 million. Contribution profit declined 11% to $79.7 million; contribution margin was 51% versus 48%.
- Consolidated revenue growth did not translate into profit growth: higher content, marketing, technology and administrative spending, international expansion, and higher interest expense contributed to lower earnings. Q3 interest expense increased to $35.3 million from $13.5 million.
Outlook, commentary, risks, and unusual items
- Management’s stated strategy was to grow global streaming within consolidated net income and segment contribution targets. It expected significant further investment in international expansion and streaming content, particularly original content, and anticipated launching in Spain, Portugal, and Italy in October 2015. The filing does not provide a numerical consolidated earnings or revenue forecast.
- Netflix launched in Japan in Q3. It cited more than 69 million global streaming memberships across over 50 countries. A U.S. two-screen HD plan price increase from $8.99 to $9.99 took effect in October 2015; existing members were grandfathered for one year.
- Foreign exchange was a material risk: management estimated that first-nine-month 2015 international revenue would have been about $225 million higher and international contribution loss about $84 million lower at prior-year exchange rates. The company does not hedge foreign currency exposures and reported a $32.0 million year-to-date foreign exchange loss.
- A Q3 change in the amortization method for certain content, reflecting revised viewing-pattern estimates, increased cost of revenue by $12.8 million and reduced net income by $8.0 million for both the quarter and nine-month period; diluted and basic EPS each decreased by $0.02.
- The company reported a $33.6 million foreign-currency translation loss in other comprehensive income for the first nine months, including a $21.8 million cumulative adjustment related to changing the functional currency of certain European entities to the euro.
- Netflix reported tentative IRS and California tax settlements expected to be finalized within 12 months; the possible range of adjustments to unrecognized tax benefits was not estimable. Shareholder securities and derivative litigation remained pending; management considered possible losses reasonably possible but not reasonably estimable.
Important facts for investors to verify
- Whether streaming membership growth and U.S. pricing changes improve revenue and margins enough to offset content and operating-cost growth.
- How international contribution losses, foreign exchange effects, and expansion spending develop, including after the planned European launches.
- Content cash-payment timing, the $10.4 billion disclosed streaming obligations, and the additional estimated $3 billion to $5 billion of unknown future-title commitments.
- Funding needs and debt costs in light of negative free cash flow, $2.4 billion of debt, and management’s stated possibility that additional financing may be needed.
- Final outcomes and financial effects of the tax settlements, content-rights negotiations, and pending legal matters.