Netflix, Inc. — Q2 2018 Form 10-Q
Business context and period: Unaudited results for the quarter and six months ended June 30, 2018, compared with the same 2017 periods. Netflix earns primarily from monthly streaming memberships, with Domestic streaming, International streaming and Domestic DVD segments. It reported more than 130 million streaming memberships across over 190 countries.
Financial and operating performance
- Q2 revenue: $3.907 billion, up 40% year over year. International streaming supplied 49% of revenue, versus 42% a year earlier.
- Q2 profit: Operating income was $462 million, up from $128 million; operating margin rose to 11.8% from 4.6%. Net income was $384 million versus $66 million; diluted EPS was $0.85 versus $0.15.
- Six-month results: Revenue was $7.608 billion, up 40%; operating income was $909 million versus $385 million; net income was $674 million versus $244 million. Diluted EPS was $1.50 versus $0.55.
- Memberships and pricing: Global streaming memberships at quarter-end were 130.1 million, up 25%. Global average monthly revenue per paying streaming membership was $10.45, up 13%. Q2 Domestic and International streaming memberships were 57.4 million and 72.8 million, respectively; Domestic DVD memberships were 3.0 million.
- Segment contribution margins: Q2 Domestic streaming was 39% (37% in 2017); International streaming was 16% (negative 1%); Domestic DVD was 57% (54%). International streaming contribution profit improved to $298 million from a $13 million loss.
- Cash flow: Q2 operating cash flow was negative $518 million and company-defined free cash flow (non-GAAP) was negative $559 million, versus negative $535 million and negative $608 million, respectively. For six months, operating cash flow was negative $755 million and free cash flow negative $845 million, compared with negative $878 million and negative $1.031 billion.
- Liquidity and debt: June 30 cash and cash equivalents were $3.906 billion; cash, cash equivalents and restricted cash totaled $3.914 billion. Long-term debt, net of issuance costs, was $8.342 billion, up from $6.499 billion at year-end 2017. Netflix issued $1.9 billion of notes in April. Its $500 million revolving credit facility was undrawn, and the company reported covenant compliance.
- Content investment: Net content assets were $17.1 billion. Streaming content asset additions were $6.020 billion in the first half, while streaming content amortization was $3.567 billion.
Material changes and management commentary
- Growth was driven by more paid streaming memberships, price increases and a shift toward higher-priced plans. International streaming revenue rose 65% in Q2, compared with 26% Domestic streaming growth.
- Management attributed higher operating income to revenue growth, partly offset by greater content spending and headcount. Marketing also increased substantially, particularly in Domestic streaming.
- Q2 net income benefited from foreign-exchange gains, primarily from remeasurement of euro-denominated notes; higher debt increased interest expense. The company reported a $58.1 million foreign-exchange gain for the first half, versus a loss in the prior-year period.
- Management expects to continue significantly increasing global streaming content investment, especially originals, and anticipates negative free cash flow for many years. It said operating cash flow, available funds and financing sources should meet cash needs for at least the next 12 months; it expects to continue using debt markets for financing needs.
- Management stated that DVD memberships are declining and expects the decline to continue. It also expects plan prices may increase from time to time. No specific forward financial guidance is provided in the supplied filing text.
Risks, contingencies and unusual items
- Content commitments: Streaming content obligations totaled $18.4 billion, including $8.1 billion due within one year; $10.3 billion was not yet recognized on the balance sheet. Management also estimated significant commitments for unknown future titles, potentially $3 billion to $5 billion over the next three years, mostly payable after the next 12 months. Total contractual obligations shown were $31.9 billion.
- Foreign exchange: Currency movements affect international revenue, contribution profit and reported earnings. Netflix said first-half international revenue would have been about $179 million lower at prior-year exchange rates and does not hedge foreign-currency exposure with derivatives.
- Liquidity and financing: Content production requires substantial upfront cash, and free cash flow remains negative. Access to future financing depends on operating performance and capital-market conditions and may not be available on acceptable terms.
- Taxes and legal matters: The company had $56.1 million of gross unrecognized tax benefits; current U.S., California and U.K. tax examinations could change that balance, with the potential range of adjustments not estimable. Netflix disclosed ordinary-course litigation and indemnification obligations but reported no material accrual for indemnifications.
- The filing reported no material change to previously disclosed risk factors and no material change in internal control over financial reporting. The effective tax rate was 10% for Q2 2018, versus a tax benefit and negative 370% rate in Q2 2017, reflecting differing tax items and U.S. tax reform effects.
Important facts for investors to verify
- Whether membership growth, retention and average revenue per paying member can sustain revenue growth, particularly as Q2 Domestic net additions fell to 674,000 from 1.067 million.
- How content spending and the $18.4 billion of disclosed obligations—including uncertain future-title commitments—will affect cash needs and free cash flow.
- Whether the company can fund ongoing investment through cash generation and debt markets while managing its $8.3 billion carrying-value debt balance and related interest expense.
- How foreign-exchange movements, tax examinations and remaining tax accounting work may affect reported earnings and cash flows.