Netflix, Inc. — Q1 2012 Form 10-Q
Reporting period: Three months ended March 31, 2012. Financial statements are unaudited. Unless otherwise noted, dollar amounts are in millions.
Business context
Netflix operates Domestic streaming, International streaming, and Domestic DVD subscription services. Its stated strategy is to grow streaming domestically and internationally while managing consolidated profitability and segment contribution. The 2011 U.S. separation of DVD and streaming plans continued to affect subscriber mix and revenue comparisons.
Financial and operating results
- Revenue: $869.8, up 21.0% from $718.6 in Q1 2011, but down 0.7% sequentially from Q4 2011. Domestic revenue was $826.4 and international revenue was $43.4. Domestic growth reflected more paying subscribers, partly offset by a 3.2% decline in average monthly revenue per unique paying subscriber; international revenue rose with market launches.
- Profitability: Gross profit was $245.9, with a 28.3% gross margin versus 39.0% a year earlier. Operating loss was $1.9, compared with operating income of $102.2; operating margin was negative 0.2% versus 14.2%. Net loss was $4.6, or $0.08 per diluted share, versus net income of $60.2, or $1.11 per diluted share. Net margin was negative 0.5% versus 8.4%.
- Costs: Cost of revenue rose 42.4% to $623.9, faster than revenue, largely due to higher streaming content acquisition and licensing expense. Marketing increased 30.3% to $135.9, and technology and development increased 62.7% to $82.8.
- Segment contribution: Domestic streaming contributed $66.5; International streaming recorded a loss of $102.7; Domestic DVD contributed $146.1. These amounts are before other operating expenses. Segment definitions changed in Q4 2011, limiting direct comparison with Q1 2011 segment data.
- Subscribers: Paid unique subscribers were 27.083 million at quarter-end, and total unique subscribers were 29.139 million. Domestic streaming subscriptions increased 8% sequentially; international streaming subscriptions increased 65%. Domestic DVD subscriptions declined 10% sequentially.
- Cash flow: Operating cash flow was $19.1, down from $116.3 in Q1 2011. Capital expenditures and DVD library acquisitions contributed to reported free cash flow of $2.1, versus $79.3 a year earlier. Free cash flow is a company-defined non-GAAP measure.
- Liquidity: Cash and cash equivalents were $396.0 and short-term investments were $408.5, totaling $804.5. Current assets were $2,058.7 and current liabilities were $1,446.7. Cash declined $112.1 during the quarter.
- Debt and content obligations: Debt totaled $400.0: $200.0 of zero-coupon convertible notes due 2018 and $200.0 of 8.50% senior notes due 2017. Total content liabilities on the balance sheet were $2,072.0. Separately, disclosed streaming content obligations were $3,684.1; the filing says significant variable or otherwise unquantified commitments are excluded.
Changes and management outlook
- Revenue grew year over year, but content and operating costs rose more quickly, turning prior-year operating and net profits into losses.
- Management expected seasonally low net subscription additions in Q2, with additions increasing in Q3 and Q4. It expected modest sequential revenue growth, driven by streaming growth and partly offset by DVD declines.
- Management expected the consolidated net loss to decline in Q2 and said Netflix might be at or near consolidated net income. It anticipated continued International streaming losses, further expansion of domestic streaming contribution margin, and a new international market launch in Q4 2012.
- Management warned that international expansion and original-content investment could depress free cash flow and that Netflix might use cash during 2012. It said available funds were expected to cover foreseeable needs, while noting additional financing might be required or chosen and might not be available on acceptable terms.
Risks, contingencies and unusual items
- Three purported shareholder class actions and five derivative suits alleged, among other matters, misleading disclosures or breaches of fiduciary duty. Management considered loss reasonably possible but could not reasonably estimate an amount or range.
- Streaming content commitments, including excluded commitments with uncertain titles or pricing, create substantial future cash requirements. Ongoing negotiations with some performing rights organizations could produce outcomes materially different from management estimates.
- The company was under IRS examinations for 2008 and 2009 and California examinations for 2006 and 2007. Gross unrecognized tax benefits were $29.5, with $23.3 potentially benefiting earnings if recognized; the timing and outcome of examinations were uncertain.
- The $200.0 convertible notes were issued to funds whose general partner had a representative on Netflix’s board, making the issuance a related-party transaction. The filing reported compliance with debt covenants.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It reported no material changes to previously disclosed risk factors.
Important facts for investors to verify
- Whether streaming subscriber growth and revenue per subscriber can offset continued DVD declines.
- Whether domestic streaming margin expansion and the projected improvement in Q2 profitability materialize, while International losses continue.
- The cash-flow impact of content payments, original programming, and the $3.684 billion of disclosed streaming obligations, including significant commitments excluded from that figure.
- Progress and potential financial exposure from shareholder litigation, tax examinations, and performing-rights negotiations.
- Liquidity and financing needs if content investment and international expansion result in further cash use or operating losses.