Netflix, Inc. — Q1 2014 Form 10-Q
Business context and period: Unaudited results for the three months ended March 31, 2014, compared with Q1 2013; balance-sheet comparisons are against December 31, 2013. Netflix reported Domestic Streaming, International Streaming and Domestic DVD segments. Membership fees are its primary revenue source.
Key financial metrics
| Metric | Q1 2014 | Q1 2013 |
|---|---|---|
| Revenue | $1,270.1 million | $1,024.0 million |
| Operating income | $97.6 million | $31.8 million |
| Net income | $53.1 million | $2.7 million |
| Diluted EPS | $0.86 | $0.05 |
| Operating cash flow | $36.4 million | $(12.3) million |
| Free cash flow (non-GAAP) | $8.4 million | $(41.5) million |
- Revenue grew 24%; operating income rose 207% and net income increased substantially from the prior-year quarter. Operating margin was approximately 7.7%, versus 3.1%.
- Cash and cash equivalents plus short-term investments totaled $1.668 billion at quarter-end, up from $1.200 billion at year-end. Net cash provided by investing activities was $57.6 million, largely reflecting net sales and maturities of short-term investments; financing cash flow was $458.2 million, principally from the new notes issuance.
- Long-term debt was $900 million: $500 million of 5.375% notes due 2021 and $400 million of 5.750% notes due 2024. Interest expense was $10.1 million. Current liabilities were $2.264 billion; total liabilities were $4.570 billion.
- Net content library was $3.951 billion. Streaming content obligations totaled $7.123 billion, including $3.1 billion due within one year; $4.0 billion was not recorded on the balance sheet because recognition criteria had not yet been met.
- Segment contribution: Domestic Streaming $201.3 million (25% margin); International Streaming loss of $35.0 million; Domestic DVD $97.5 million (48% margin).
Material changes versus Q1 2013
- Growth was driven by streaming membership expansion. Domestic Streaming revenue rose 25%, with ending members up 22% to 35.7 million; International Streaming revenue rose 88%, with ending members up 78% to 12.7 million.
- Domestic Streaming contribution margin improved to 25% from 21%. International contribution losses narrowed to $35.0 million from $76.9 million, but the segment remained loss-making as Netflix invested in content and market growth.
- Domestic DVD revenue declined 16% to $204.4 million, and ending members fell 17% to 6.7 million.
- Higher content licensing costs partly offset revenue growth. Streaming content amortization increased to $600.7 million from $485.7 million. Q1 2013 also included a $25.1 million debt-extinguishment loss and a tax benefit related to the federal R&D credit, affecting the comparison of net income and effective tax rates.
Outlook, risks and unusual items
- Management expected to raise monthly streaming prices by $1–$2, depending on country, for new members in Q2 2014; existing members were expected to retain current pricing for a “generous time period.” This was an expectation, not a quantified earnings forecast.
- Management expected substantial European expansion in the second half of 2014 and a substantial increase in 2014 original-content investment. Content and international growth may require significant upfront cash and could pressure liquidity; additional financing might not be available on acceptable terms or at all.
- Management cited content licensing and delivery, marketing and payroll as key cash uses. Free cash flow was $44.7 million below net income, primarily because content cash payments exceeded content expense by $110.6 million, partly offset by stock-based compensation and favorable working-capital effects.
- Unknown future-title obligations under some content agreements are not fully estimable and are expected to be significant. Music and performance-rights licensing negotiations could produce costs materially different from management’s estimates.
- Tax authorities were examining U.S. federal returns for 2008–2011 and California returns for 2006–2007, including proposed assessments relating primarily to R&D credits. Gross unrecognized tax benefits were $73.4 million; the company said the possible range of adjustment could not be estimated.
- Shareholder securities-litigation plaintiffs appealed dismissal; derivative litigation was stayed. Management considered a potential loss reasonably possible but said the amount or range was not estimable. The filing reported no material change in previously disclosed risk factors.
Important facts for investors to verify
- Whether subscriber growth, retention and pricing changes support continued revenue growth, particularly as domestic DVD membership declines.
- Whether International Streaming can reduce contribution losses as expansion and content investment continue.
- The cash-payment timing and economics of the $7.123 billion in disclosed streaming content obligations, plus significant unquantified future-title commitments.
- Liquidity and financing needs relative to content spending, international expansion and debt service; distinguish operating performance from cash flow and debt-issuance proceeds.
- Outcomes of tax examinations and litigation, and any resulting changes to tax liabilities, contingencies or reported earnings.