10-Q 1 nflx-093012x10qxdoc.htm FORM 10-Q NFLX-09.30.12-10Q-DOC
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012
OR

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                  to                 
Commission File Number: 000-49802
 
Netflix, Inc.
(Exact name of Registrant as specified in its charter)
 
Delaware
77-0467272
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
100 Winchester Circle, Los Gatos, California 95032
(Address and zip code of principal executive offices)
(408) 540-3700
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No   o  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
ý
 
Accelerated filer
o
Non-accelerated filer
o
(Do not check if a smaller reporting company)
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).    Yes  o    No  ý
As of September 30, 2012, there were 55,545,531 shares of the registrant’s common stock, par value $0.001, outstanding.




Table of Contents
 
 
 
Page
 
Part I. Financial Information
 
Item 1.
Consolidated Financial Statements
 
 
 
Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2012 and 2011
 
 
 
Item 2.
Item 3.
Item 4.
 
Part II. Other Information
Item 1.
Item 1A.
Item 6.
 
 


2


NETFLIX, INC.

Consolidated Statements of Operations
(unaudited)
(in thousands, except per share data)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Revenues
$
905,089

 
$
821,839

 
$
2,664,043

 
$
2,329,002

Cost of revenues:
 
 
 
 
 
 
 
Subscription
602,165

 
471,823

 
1,749,816

 
1,277,018

Fulfillment expenses
60,473

 
64,794

 
180,183

 
187,728

Total cost of revenues
662,638

 
536,617

 
1,929,999

 
1,464,746

Gross profit
242,451

 
285,222

 
734,044

 
864,256

Operating expenses:
 
 
 
 
 
 
 
Marketing
113,233

 
89,108

 
367,357

 
288,350

Technology and development
82,521

 
69,480

 
246,869

 
178,250

General and administrative
30,562

 
29,792

 
89,464

 
83,460

Total operating expenses
226,316

 
188,380

 
703,690

 
550,060

Operating income
16,135

 
96,842

 
30,354

 
314,196

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(4,990
)
 
(4,915
)
 
(14,970
)
 
(15,083
)
Interest and other income (expense)
801

 
1,696

 
192

 
3,574

Income before income taxes
11,946

 
93,623

 
15,576

 
302,687

Provision for income taxes
4,271

 
31,163

 
6,321

 
111,780

Net income
$
7,675

 
$
62,460

 
$
9,255

 
$
190,907

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.14

 
$
1.19

 
$
0.17

 
$
3.63

Diluted
$
0.13

 
$
1.16

 
$
0.16

 
$
3.53

Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
55,541

 
52,569

 
55,508

 
52,599

Diluted
58,729

 
53,870

 
58,829

 
54,008

See accompanying notes to the consolidated financial statements.


3



NETFLIX, INC.
Consolidated Statements of Comprehensive Income
(unaudited)
(in thousands)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Net income
$
7,675

 
$
62,460

 
$
9,255

 
$
190,907

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments 
1,084

 

 
1,128

 

Change in unrealized gains on available-for-sale securities
1,565

 
(213
)
 
1,908

 
172

Other comprehensive income (loss) before tax 
2,649

 
(213
)
 
3,036

 
172

Income tax expense related to items of other comprehensive income 
(604
)
 
(83
)
 
(736
)
 
(334
)
Other comprehensive income (loss), net of tax
2,045

 
(296
)
 
2,300

 
(162
)
Comprehensive income
$
9,720

 
$
62,164

 
$
11,555

 
$
190,745























See accompanying notes to the consolidated financial statements.


4


NETFLIX, INC.
Consolidated Balance Sheets
(in thousands, except share and par value data)

 
As of
   
September 30,
2012
 
December 31,
2011
 
(unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
370,298

 
$
508,053

Short-term investments
428,057

 
289,758

Current content library, net
1,335,769

 
919,709

Prepaid content
33,152

 
56,007

Other current assets
57,742

 
57,330

Total current assets
2,225,018

 
1,830,857

Non-current content library, net
1,366,566

 
1,046,934

Property and equipment, net
133,603

 
136,353

Other non-current assets
83,646

 
55,052

Total assets
$
3,808,833

 
$
3,069,196

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Content liabilities
$
1,280,885

 
$
935,036

Accounts payable
91,511

 
86,992

Accrued expenses
70,681

 
54,231

Deferred revenue
155,146

 
148,796

Total current liabilities
1,598,223

 
1,225,055

Non-current content liabilities
1,030,979

 
739,628

Long-term debt
200,000

 
200,000

Long-term debt due to related party
200,000

 
200,000

Other non-current liabilities
62,791

 
61,703

Total liabilities
3,091,993

 
2,426,386

Commitments and contingencies (Note 8)


 


Stockholders’ equity:
 
 
 
Common stock, $0.001 par value; 160,000,000 shares authorized at September 30, 2012 and December 31, 2011; 55,545,531 and 55,398,615 issued and outstanding at September 30, 2012 and December 31, 2011, respectively
56

 
55

Additional paid-in capital
281,593

 
219,119

Accumulated other comprehensive income, net
3,006

 
706

Retained earnings
432,185

 
422,930

Total stockholders’ equity
716,840

 
642,810

Total liabilities and stockholders’ equity
$
3,808,833

 
$
3,069,196

See accompanying notes to the consolidated financial statements.
 

5


NETFLIX, INC.

Consolidated Statements of Cash Flows
(unaudited)
(in thousands)
   
Three Months Ended
 
Nine Months Ended
   
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
7,675

 
$
62,460

 
$
9,255

 
$
190,907

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 

 

Additions to streaming content library
(744,714
)
 
(539,285
)
 
(1,883,859
)
 
(1,344,187
)
Change in streaming content liabilities
274,196

 
313,781

 
631,802

 
819,909

Amortization of streaming content library
410,947

 
187,446

 
1,126,680

 
417,849

Amortization of DVD content library
13,132

 
23,000

 
49,482

 
73,990

Depreciation and amortization of property, equipment and intangibles
11,128

 
11,913

 
33,506

 
31,921

Stock-based compensation expense
18,472

 
15,705

 
56,254

 
43,505

Excess tax benefits from stock-based compensation
(111
)
 
(11,761
)
 
(4,173
)
 
(45,283
)
Other non-cash items
(2,078
)
 
(1,745
)
 
(5,176
)
 
(3,472
)
Deferred taxes
(15,606
)
 
(5,281
)
 
(26,449
)
 
(14,190
)
Changes in operating assets and liabilities:
 
 
 
 

 

Prepaid content
15,358

 
(17,335
)
 
22,855

 
(14,928
)
Other current assets
(3,476
)
 
(8,578
)
 
188

 
4,935

Accounts payable
(6,652
)
 
(7,052
)
 
(7,807
)
 
3,949

Accrued expenses
15,294

 
23,489

 
23,931

 
59,241

Deferred revenue
2,356

 
13,992

 
6,350

 
33,746

Other non-current assets and liabilities
4,229

 
(11,218
)
 
6,112

 
(5,646
)
Net cash provided by operating activities
150

 
49,531

 
38,951

 
252,246

Cash flows from investing activities:
 
 
 
 
 
 
 
Acquisitions of DVD content library
(8,586
)
 
(20,826
)
 
(30,126
)
 
(62,010
)
Purchases of short-term investments
(67,779
)
 
(7,673
)
 
(430,549
)
 
(100,536
)
Proceeds from sale of short-term investments
52,172

 
37

 
272,680

 
31,508

Proceeds from maturities of short-term investments
2,695

 
1,805

 
23,685

 
18,440

Purchases of property and equipment
(13,883
)
 
(14,080
)
 
(22,293
)
 
(39,026
)
Other assets
1,857

 
(844
)
 
6,323

 
1,419

Net cash used in investing activities
(33,524
)
 
(41,581
)
 
(180,280
)
 
(150,205
)
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from issuance of common stock upon exercise of options
318

 
4,409

 
2,066

 
18,589

Financing costs

 

 
(759
)
 

Repurchases of common stock

 
(39,602
)
 

 
(199,666
)
Excess tax benefits from stock-based compensation
111

 
11,761

 
4,173

 
45,283

Principal payments of lease financing obligations
(587
)
 
(526
)
 
(1,723
)
 
(1,547
)
Net cash provided by (used in) financing activities
(158
)
 
(23,958
)
 
3,757

 
(137,341
)
Effect of exchange rate changes on cash and cash equivalents
1,579

 

 
(183
)
 

Net decrease in cash and cash equivalents
(31,953
)
 
(16,008
)
 
(137,755
)
 
(35,300
)
Cash and cash equivalents, beginning of period
402,251

 
175,207

 
508,053

 
194,499

Cash and cash equivalents, end of period
$
370,298

 
$
159,199

 
$
370,298

 
$
159,199

See accompanying notes to the consolidated financial statements.

6


NETFLIX, INC.
Notes to Consolidated Financial Statements
(unaudited)

1. Basis of Presentation and Summary of Significant Accounting Policies
The accompanying consolidated interim financial statements of Netflix, Inc. and its wholly owned subsidiaries (the “Company”) have been prepared in conformity with accounting principles generally accepted in the United States (“U.S.”) and are consistent in all material respects with those applied in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (the “SEC”) on February 10, 2012. The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. Significant items subject to such estimates and assumptions include: the amortization policy of the Company’s content library; the valuation of stock-based compensation; and the recognition and measurement of income tax assets and liabilities. The Company bases its estimates on historical experience and on various other assumptions that the Company believes to be reasonable under the circumstances. The actual results experienced by the Company may differ from management’s estimates.
The interim financial information is unaudited, but reflects all normal recurring adjustments that are, in the opinion of management, necessary to fairly present the information set forth herein. The interim financial statements should be read in conjunction with the audited financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Interim results are not necessarily indicative of the results for a full year.
The Company is organized into three operating segments: Domestic streaming, International streaming and Domestic DVD. Substantially all of the Company’s revenues are generated in the U.S., and substantially all of the Company’s long-lived tangible assets are held in the U.S. The Company’s revenues are derived from monthly subscription fees.
Certain prior period amounts have been reclassified to conform to current period presentation. These reclassifications did not impact total assets, total liabilities, stockholders’ equity, results of operations or cash flows.
There have been no material changes in the Company’s significant accounting policies as compared to the significant accounting policies described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

2. Earnings Per Share

Basic earnings per share is computed using the weighted-average number of outstanding shares of common stock during the period. Diluted earnings per share is computed using the weighted-average number of outstanding shares of common stock and, when dilutive, potential outstanding shares of common stock during the period. Potential common shares consist of shares issuable upon the assumed conversion of the Company’s Senior Convertible Notes and incremental shares issuable upon the assumed exercise of stock options. The computation of earnings per share is as follows:


7


 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
 
(in thousands, except per share data)
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
7,675

 
$
62,460

 
$
9,255

 
$
190,907

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
55,541

 
52,569

 
55,508

 
52,599

Basic earnings per share
$
0.14

 
$
1.19

 
$
0.17

 
$
3.63

 
 
 
 
 
 
 
 
Diluted earnings per share:
 
 
 
 
 
 
 
Net income
$
7,675

 
$
62,460

 
$
9,255

 
$
190,907

Convertible Notes interest expense, net of tax
49

 

 
146

 

Numerator for diluted earnings per share
$
7,724

 
$
62,460

 
$
9,401

 
$
190,907

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
55,541

 
52,569

 
55,508

 
52,599

Convertible notes shares
2,331

 

 
2,331

 

Employee stock options
857

 
1,301

 
990

 
1,409

Weighted-average number of shares
58,729

 
53,870

 
58,829

 
54,008

Diluted earnings per share
$
0.13

 
$
1.16

 
$
0.16

 
$
3.53


Employee stock options with exercise prices greater than the average market price of the common stock were excluded from the diluted calculation as their inclusion would have been anti-dilutive. The following table summarizes the potential common shares excluded from the diluted calculation:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
 
(in thousands)
Employee stock options
1,782

 
189

 
1,199

 
76



3. Cash, Cash Equivalents, Short-Term Investments and Fair Value Measurement
The Company’s investment policy is consistent with the definition of available-for-sale securities. The Company does not buy and hold securities principally for the purpose of selling them in the near future. The Company’s policy is focused on the preservation of capital, liquidity and return. From time to time, the Company may sell certain securities but the objectives are generally not to generate profits on short-term differences in price. The following table summarizes, by major security type, the Company’s assets that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy:
 

8


 
As of
 
September 30, 2012
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
331,902

 
$

 
$

 
$
331,902

Level 1 securities (1):
 
 
 
 
 
 
 
Money market funds
7,618

 

 

 
7,618

Level 2 securities (2):
 
 
 
 
 
 
 
Corporate debt securities
139,064

 
1,709

 
(3
)
 
140,770

Government and agency securities
202,466

 
339

 

 
202,805

Asset and mortgage-backed securities
119,179

 
991

 
(40
)
 
120,130

 
$
800,229

 
$
3,039

 
$
(43
)
 
$
803,225

Less: Restricted cash (1)
 
 
 
 
 
 
(4,870
)
Total cash, cash equivalents and short-term investments
 
 
 
 
 
 
$
798,355

 
 
As of
 
December 31, 2011
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
388,941

 
$

 
$

 
$
388,941

Level 1 securities (3):
 
 
 
 
 
 
 
Money market funds
123,608

 

 

 
123,608

Level 2 securities (4):
 
 
 
 
 
 
 
Corporate debt securities
112,264

 
603

 
(214
)
 
112,653

Government and agency securities
175,464

 
694

 
(56
)
 
176,102

Asset and mortgage-backed securities
941

 
62

 

 
1,003

 
$
801,218

 
$
1,359

 
$
(270
)
 
$
802,307

Less: Restricted cash (3)
 
 
 
 
 
 
(4,496
)
Total cash, cash equivalents and short-term investments
 
 
 
 
 
 
$
797,811

(1)
Includes $2.7 million classified in cash and cash equivalents and $4.9 million of restricted cash classified in other non-current assets.
(2)
Includes $35.6 million classified in cash and cash equivalents and $428.1 million included in short-term investments in the Company’s consolidated balance sheets.
(3)
Includes $119.1 million classified in cash and cash equivalents and $4.5 million of restricted cash classified in other current assets and non-current assets.
(4)
Included in short-term investments.

Fair value is a market-based measurement that should be determined based on the assumptions that market participants would use in pricing an asset or liability. The hierarchy level assigned to each security in the Company’s available-for-sale portfolio and cash equivalents is based on its assessment of the transparency and reliability of the inputs used in the valuation of such instrument at the measurement date. The fair value of available-for-sale securities and cash equivalents included in the Level 1 category is based on quoted prices that are readily and regularly available in an active market. The fair value of cash equivalents and available-for-sale securities included in the Level 2 category is based on observable inputs, such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. These values were obtained from an independent pricing service and were evaluated using pricing models that vary by asset class and may incorporate available trade, bid and other market information and price quotes from well-established independent pricing vendors and broker-dealers. The Company's procedures include controls to ensure that appropriate fair values are recorded, such as comparing prices obtained from multiple independent sources. See Note 5 to the consolidated financial statements for further information regarding the fair value of the Company’s Senior Convertible Notes and Senior Notes.

Because the Company does not intend to sell the investments that are in an unrealized loss position and it is not likely that the Company will be required to sell any investments before recovery of their amortized cost basis, the Company does not consider those investments with an unrealized loss to be other-than-temporarily impaired at September 30, 2012. There were no material other-than-temporary impairments or

9


credit losses related to available-for-sale securities in the three or nine months ended September 30, 2012 and 2011. In addition, there were no material gross realized gains or losses in the three or nine months ended September 30, 2012 and 2011.
The estimated fair value of short-term investments by contractual maturity as of September 30, 2012 is as follows:
 
 
(in thousands)
Due within one year
$
17,011

Due after one year and through 5 years
364,929

Due after 5 years and through 10 years
7,091

Due after 10 years
39,026

Total short-term investments
$
428,057


4. Balance Sheet Components
Content Library
Content library consisted of the following:
 
 
As of
 
September 30, 2012
 
December 31, 2011
 
Streaming
 
DVD
 
Total
 
Streaming
 
DVD
 
Total
 
(in thousands)
Total content library, gross
$
4,021,055

 
$
525,634

 
$
4,546,689

 
$
2,552,284

 
$
599,155

 
$
3,151,439

Accumulated amortization
(1,343,859
)
 
(500,495
)
 
(1,844,354
)
 
(632,270
)
 
(552,526
)
 
(1,184,796
)
Total content library, net
2,677,196

 
25,139

 
2,702,335

 
1,920,014

 
46,629

 
1,966,643

Current content library, net
1,335,769

 

 
1,335,769

 
919,709

 

 
919,709

Non-current content library, net
$
1,341,427

 
$
25,139

 
$
1,366,566

 
$
1,000,305

 
$
46,629

 
$
1,046,934


Content Liabilities
Content liabilities consisted of the following:
 
 
As of
 
September 30, 2012
 
December 31, 2011
 
Streaming
 
DVD 
 
Total
 
Streaming
 
DVD
 
Total
 
(in thousands)
Content liabilities
$
1,260,999

 
$
19,886

 
$
1,280,885

 
$
915,796

 
$
19,240

 
$
935,036

Non-current content liabilities
1,026,227

 
4,752

 
1,030,979

 
739,628

 

 
739,628

Total content liabilities
$
2,287,226

 
$
24,638

 
$
2,311,864

 
$
1,655,424

 
$
19,240

 
$
1,674,664


The Company typically enters into multi-year streaming content licenses with studios and other distributors that may result in an increase in the streaming content library and a corresponding increase in streaming content liabilities. The payment terms for these streaming license fees may extend over the term of the license agreement, which typically ranges from six months to five years. In the nine months ended September 30, 2012, streaming content liabilities increased $631.8 million, as compared to a higher increase in streaming content library, net, of $757.2 million due to payments exceeding amortization of the streaming content library.
Property and Equipment, Net
Property and equipment and accumulated depreciation consisted of the following:


10


 
 
 
As of
 
 
 
September 30,
2012
 
December 31,
2011
 
 
 
(in thousands)
Computer equipment
 
3 years
$
79,851

 
$
67,090

Operations and other equipment
 
5 years
100,226

 
100,306

Software
 
3 years
38,450

 
35,356

Furniture and fixtures
 
3 years
17,014

 
17,310

Buildings
 
30 years
40,681

 
40,681

Leasehold improvements
 
Over life of lease
43,168

 
44,473

Capital work-in-progress
 
 
10,443

 
822

Property and equipment, gross
 
 
329,833

 
306,038

Less: Accumulated depreciation
 
 
(196,230
)
 
(169,685
)
Property and equipment, net
 
 
$
133,603

 
$
136,353



5. Long-term Debt
Senior Convertible Notes

As of September 30, 2012, the Company had $200.0 million aggregate principal amount of zero coupon senior convertible notes due on December 1, 2018 (the “Convertible Notes”) outstanding. The Convertible Notes were issued in a private placement offering to TCV VII, L.P., TCV VII(A), L.P. and TCV Member Fund, L.P. A general partner of these funds also serves on the Company’s board of directors, and as such, the issuance of the notes was considered a related party transaction. At any time following May 28, 2012, the Company may elect to cause the conversion of the Convertible Notes into shares of the Company’s common stock when specified conditions are satisfied, including that the daily volume weighted average price of the Company’s common stock is equal or greater than $111.54 for at least 50 trading days during a 65 trading day period prior to the conversion date. The Convertible Notes include, among other terms and conditions, limitations on the Company’s ability to pay cash dividends or to repurchase shares of its common stock, subject to specified exceptions. At September 30, 2012 and December 31, 2011, the Company was in compliance with these covenants.
Based on quoted market prices of the Company’s publicly traded debt, the fair value of the Convertible Notes as of September 30, 2012 and December 31, 2011 was approximately $213.0 million and $206.5 million, respectively.
Senior Notes
As of September 30, 2012, the Company also had $200.0 million aggregate principal amount of 8.50% senior notes due November 15, 2017 (the “8.50% Notes”) outstanding. Interest on the 8.50% Notes is payable semi-annually at a rate of 8.50% per annum on May 15 and November 15 of each year.
On or after November 15, 2013, the Company may redeem the 8.50% Notes in whole or in part at specified prices ranging from 104.25% to 100% of the principal plus accrued interest. The 8.50% Notes include, among other terms and conditions, limitations on the Company’s ability to create, incur, assume or be liable for indebtedness (other than specified types of permitted indebtedness); dispose of assets outside the ordinary course (subject to specified exceptions); acquire, merge or consolidate with or into another person or entity (other than specified types of permitted acquisitions); create, incur or allow any lien on any of its property or assign any right to receive income (except for specified permitted liens); make investments (other than specified types of investments); or pay dividends, make distributions, or purchase or redeem the Company’s equity interests (each subject to specified exceptions). At September 30, 2012 and December 31, 2011, the Company was in compliance with these covenants.
Based on quoted market prices, the fair value of the 8.50% Notes as of September 30, 2012 and December 31, 2011 was approximately $213.0 million and $206.5 million, respectively.

6. Stockholders’ Equity
Stock Option Plan
In June 2011, the Company adopted the 2011 Stock Plan. The 2011 Stock Plan provides for the grant of incentive stock options to employees and for the grant of non-statutory stock options, stock appreciation rights, restricted stock and restricted stock units to employees, directors and consultants. As of September 30, 2012, 4.5 million shares were reserved for future grants under the 2011 Stock Plan.
In February 2002, the Company adopted the 2002 Stock Plan, which was amended and restated in May 2006. The 2002 Stock Plan provides for the grant of incentive stock options to employees and for the grant of non-statutory stock options and stock purchase rights to

11


employees, directors and consultants. In the first quarter of 2012, 1.2 million shares reserved for future grants under the 2002 Stock Plan expired.
A summary of the activity related to the Company’s stock option plans during the nine months ended September 30, 2012 is as follows:
 
 
 
 
Options Outstanding
 
 
 
 
 
Shares
Available
for Grant
 
Number of
Shares
 
Weighted-
Average
Exercise Price
 
Weighted-Average
Remaining
Contractual Term
(in Years)
 
Aggregate
Intrinsic Value
(in Thousands)
Balances as of December 31, 2011
7,013,508

 
2,957,754

 
$
66.59

 
 
 
 
Granted
(1,321,197
)
 
1,321,197

 
75.95

 
 
 
 
Exercised

 
(146,916
)
 
14.06

 
 
 
 
Canceled
48

 
(48
)
 
35.95

 
 
 
 
Expired
(1,160,721
)
 

 

 
 
 
 
Balances as of September 30, 2012
4,531,638

 
4,131,987

 
71.45

 
6.97
 
$
50,057

Vested and exercisable at September 30, 2012
 
 
4,131,987

 
71.45

 
6.97
 
$
50,057


The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the third quarter of 2012 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on September 30, 2012. This amount changes based on the fair market value of the Company’s common stock. Total intrinsic value of options exercised for the three months ended September 30, 2012 and 2011 was $0.4 million and $32.2 million, respectively. Total intrinsic value of options exercised for the nine months ended September 30, 2012 and 2011 was $13.2 million and $125.6 million, respectively.
Cash received from option exercises for the three months ended September 30, 2012 and 2011 was $0.3 million and $4.4 million, respectively. Cash received from option exercises for the nine months ended September 30, 2012 and 2011 was $2.1 million and $18.6 million, respectively.
Stock Option Expense

Vested stock options granted before June 30, 2004 can be exercised up to three months following termination of employment. Vested stock options granted after June 30, 2004 and before January 1, 2007 can be exercised up to one year following termination of employment. Vested stock options granted after January 2007 will remain exercisable for the full ten year contractual term regardless of employment status. The following table summarizes the assumptions used to value stock option grants using the lattice-binomial model:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Dividend yield
%
 
%
 
%
 
%
Expected volatility
60
%
 
52
%
 
60% - 65%

 
51% - 52%

Risk-free interest rate
1.61
%
 
2.98
%
 
1.61 - 2.01%

 
2.98-3.42%

Suboptimal exercise factor
2.27 - 3.64

 
2.26 - 3.63

 
2.26 - 3.65

 
2.17-3.63


The Company bifurcates its option grants into two employee groupings (executive and non-executive) based on exercise behavior and considers several factors in determining the estimate of expected term for each group, including the historical option exercise behavior, the terms and vesting periods of the options granted.

The weighted-average fair value of employee stock options granted during the three months ended September 30, 2012 and 2011 was $32.57 and $137.90 per share, respectively. The weighted-average fair value of employee stock options granted during the nine months ended September 30, 2012 and 2011 was $42.58 and $127.41 per share, respectively.

The following table summarizes stock-based compensation expense, net of tax, related to stock option plans which was allocated as follows:
 

12


 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
 
(in thousands)
Fulfillment expenses
$
103

 
$
206

 
$
260

 
$
1,446

Marketing
690

 
1,539

 
2,911

 
4,273

Technology and development
10,510

 
7,522

 
31,550

 
19,819

General and administrative
7,169

 
6,438

 
21,533

 
17,967

Stock-based compensation expense before income taxes
18,472

 
15,705

 
56,254

 
43,505

Income tax benefit
(7,128
)
 
(5,228
)
 
(21,709
)
 
(16,066
)
Stock-based compensation after income taxes
$
11,344

 
$
10,477

 
$
34,545

 
$
27,439


Stock Repurchases

Under the Company’s current stock repurchase plan, announced on June 11, 2010, the Company is authorized to repurchase up to $300.0 million of its common stock through the end of 2012. The Company did not repurchase stock during the nine months ended September 30, 2012. As of September 30, 2012, $41.0 million of this authorization remained. The timing and actual number of shares repurchased is at management’s discretion and will depend on various factors including price, corporate and regulatory requirements, debt covenant requirements, alternative investment opportunities and other market conditions.

7. Income Taxes

The effective tax rates for the three months ended September 30, 2012 and 2011 were 35.8% and 33.3%, respectively. The effective tax rates for the nine months ended September 30, 2012 and 2011 were 40.6% and 36.9%, respectively. These rates differed from the federal statutory rate due primarily to state taxes which were partially offset by the California R&D tax credit. The increase in the Company's effective tax rates for the three and nine months ended September 30, 2012 as compared to the three and nine months ended September 30, 2011 was primarily attributable to the expiration of the Federal R&D tax credit on December 31, 2011 and the expiration of the statute of limitations for years 1997 through 2007, resulting in a discrete benefit of $3.5 million in the third quarter of 2011.
 
As of December 31, 2011, the Company had $28.1 million of gross unrecognized tax benefits. During the nine months ended September 30, 2012, the Company had an increase in gross unrecognized tax benefits of approximately $1.1 million. The gross unrecognized tax benefits, if recognized by the Company, will result in a reduction of approximately $23.0 million to the provision for income taxes thereby favorably impacting the Company’s effective tax rate. The Company’s unrecognized tax benefits are classified as “Other non-current liabilities” on the Consolidated Balance Sheets. The Company includes interest and penalties related to unrecognized tax benefits within the "Provision for income taxes" on the Consolidated Statements of Operations. As of September 30, 2012, the total amount of gross interest and penalties accrued was $2.8 million, and is classified as “Other non-current liabilities” on the Consolidated Balance Sheets.
Deferred tax assets include $8.4 million and $10.0 million classified as “Other current assets” and $55.7 million and $28.3 million classified as “Other non-current assets” on the Consolidated Balance Sheets as of September 30, 2012 and December 31, 2011, respectively. In evaluating its ability to realize the net deferred tax assets, the Company considered all available positive and negative evidence, including its past operating results and the forecast of future market growth, forecasted earnings, future taxable income, and prudent and feasible tax planning strategies. As of September 30, 2012 and December 31, 2011, it was considered more likely than not that substantially all deferred tax assets would be realized, and no significant valuation allowance was recorded.
Income tax benefits attributable to the exercise of employee stock options of $0.1 million and $11.6 million, during the three months ended September 30, 2012 and 2011, respectively, were recorded directly to "Additional paid-in capital" on the Consolidated Balance Sheets. Income tax benefits attributable to the exercise of employee stock options of $4.2 million and $45.0 million, during the nine months ended September 30, 2012 and 2011, respectively, were recorded directly to "Additional paid-in capital" on the Consolidated Balance Sheets.

The Company files U.S. federal, state and foreign tax returns. The Company is currently under examination by the IRS for the years 2008 through 2011.  The Company is currently under examination by the state of California for the years 2006 and 2007. The years 1997 through 2005, as well as 2008 through 2011, remain subject to examination by the state of California. Given the potential outcome of the current examinations, as well as the impact of the current examination on the potential expiration of the statute of limitations, it is reasonably possible that the balance of unrecognized tax benefits could significantly change within the next twelve months. However, at this time, an estimate of the range of reasonably possible adjustments to the balance of unrecognized tax benefits cannot be made.


8. Commitments and Contingencies

13



Streaming Content

The Company had $5.0 billion and $4.8 billion of obligations at September 30, 2012 and December 31, 2011, respectively, including agreements to acquire and license streaming content that represent current or long-term liabilities or that are not reflected on the Consolidated Balance Sheets because they do not meet content library asset recognition criteria. The license agreements that are not reflected on the Consolidated Balance Sheets do not meet content library asset recognition criteria because either the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to subscribers.

For those agreements with variable terms, the Company does not estimate what the total obligation may be beyond any minimum quantities and/or pricing as of the reporting date. For those agreements that include renewal provisions that are solely at the option of the content provider, the Company includes the commitments associated with the renewal period to the extent such commitments are fixed or a minimum amount is specified.
The Company has entered into certain license agreements that include an unspecified or a maximum number of titles that the Company may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether the Company will receive access to these titles or what the ultimate price per title will be. Accordingly, such amounts are not reflected in the commitments described below. However such amounts are expected to be significant and the expected timing of payments could range from less than one year to more than five years.

The expected timing of payments for these agreements to acquire and license streaming content that represent current or long-term liabilities as well as obligations not reflected on the consolidated balance sheet is as follows:
 
 
As of 
 
 
September 30,
2012
 
December 31,
2011
 
 
(in thousands)
 
Less than one year
$
2,088,881

 
$
1,713,445

(1)
Due after one year and through 3 years
2,391,629

 
2,384,373

 
Due after 3 years and through 5 years
433,549

 
650,480

 
Due after 5 years
58,968

 
74,696

 
Total streaming content obligations
$
4,973,027

 
$
4,822,994

 

(1) Prior period amounts have been presented to conform to the current period presentation which includes the streaming portion of current "Content liabilities" reflected on the Consolidated Balance Sheets. Note that total streaming content obligations remain unchanged with this presentation. Specifically, payments for streaming content obligations expected to be made in less than one year as of September 30, 2012 and December 31, 2011, as shown above, include $1.3 billion and $0.9 billion, respectively, of current "Content liabilities" reflected on the Consolidated Balance Sheets.
The Company has licenses with certain performing rights organizations (“PRO”), and is currently involved in negotiations with other PROs, that hold certain rights to musical compositions used in connection with streaming content. For the latter, the Company accrues for estimated royalties that are due to PROs and adjusts these accruals based on any changes in estimates. These amounts are included in the Company's streaming content obligations. While the Company anticipates finalizing these negotiations, the outcome of these negotiations is uncertain. The results of any negotiation may be materially different from management’s estimates.

Legal Proceedings
From time to time, in the normal course of its operations, the Company is a party to litigation matters and claims, including claims relating to employee relations, business practices and patent infringement. Litigation can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict and the Company’s view of these matters may change in the future as the litigation and events related thereto unfold. The Company expenses legal fees as incurred. The Company records a provision for contingent losses when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. An unfavorable outcome to any legal matter, if material, could have an adverse effect on the Company’s operations or its financial position, liquidity or results of operations.
On January 13, 2012, the first of three purported shareholder class action lawsuits was filed in the United States District Court for the Northern District of California against the Company and certain of its officers and directors. Two additional purported shareholder class action lawsuits were filed in the same court on January 27, 2012 and February 29, 2012, respectively, alleging substantially similar claims. These lawsuits have been consolidated and the Court has selected lead plaintiffs. Lead plaintiffs filed a consolidated complaint on June 26, 2012. The

14


consolidated complaint alleges violations of the federal securities laws and seeks unspecified compensatory damages and other relief on behalf of a class of purchasers of the Company's common stock between October 20, 2010 and October 24, 2011. The complaint alleges among other things, that the Company issued materially false and misleading statements regarding the Company’s business practices and violated accounting rules concerning segment reporting, which led to artificially inflated stock prices. Management has determined a potential loss is reasonably possible however, based on its current knowledge, management does not believe that the amount of such possible loss or a range of potential loss is reasonably estimable.
On November 23, 2011, the first of six purported shareholder derivative suits was filed in the Superior Court of California, Santa Clara County, against the Company and certain of its officers and directors. Five additional purported shareholder derivative suits were subsequently filed: two in the Superior Court of California, Santa Clara County on February 9, 2012 and May 2, 2012; and three in the United States District Court for the Northern District of California on February 13, 2012, February 24, 2012 and April 2, 2012. The purported shareholder derivative suits filed in the Northern District of California have been voluntarily dismissed. On July 5, 2012, the purported shareholder derivative suits filed in Santa Clara County were consolidated and lead counsel was appointed. A consolidated complaint has not yet been filed. The original complaints alleged, among other things, that the Company’s officers and directors breached their fiduciary duties, wasted valuable corporate assets, and were unjustly enriched as a result of causing the Company to buy back stock at artificially inflated prices to the detriment of the Company and its shareholders. Additionally, certain of the original complaints contained allegations regarding false and misleading statements surrounding the Company’s business practices and its contracts with content providers. Management has determined a potential loss is reasonably possible however, based on its current knowledge, management does not believe that the amount of such possible loss or a range of potential loss is reasonably estimable.
The Company is involved in other litigation matters not listed above but does not consider the matters to be material either individually or in the aggregate at this time. The Company’s view of the matters not listed may change in the future as the litigation and events related thereto unfold.

Indemnification
In the ordinary course of business, the Company has entered into contractual arrangements under which it has agreed to provide indemnification of varying scope and terms to business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the Company’s breach of such agreements and out of intellectual property infringement claims made by third parties. In these circumstances, payment may be conditional on the other party making a claim pursuant to the procedures specified in the particular contract.
The Company’s obligations under these agreements may be limited in terms of time or amount, and in some instances, the Company may have recourse against third-parties for certain payments. In addition, the Company has entered into indemnification agreements with its directors and certain of its officers that will require it, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. The terms of such obligations vary.
It is not possible to make a reasonable estimate of the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement. No amount has been accrued in the accompanying financial statements with respect to these indemnification obligations.

9. Segment Information
Beginning in the fourth quarter of 2011, the Company has three operating segments: Domestic streaming, International streaming and Domestic DVD. Segment information is presented along the same lines that the Company’s chief operating decision maker reviews the operating results in assessing performance and allocating resources. The Company’s chief operating decision maker reviews revenue and contribution profit (loss) for each of the reportable segments. Contribution profit (loss) is defined as revenues less cost of revenues and marketing expenses.
Revenues and the related credit card fees are attributed to the operating segment based on the nature of the underlying subscription (DVD or streaming) and the geographic region from which the subscription originates. Cost of revenues are primarily attributed to the operating segment based on the amounts directly incurred by the segment to obtain content and deliver it to the specific region. Allocations of certain corporate costs related to customer service are included in the total cost of revenues within each operating segment. Marketing is primarily comprised of advertising expenses which are generally included in the segment in which the expenditures are directly incurred. Marketing also includes an allocation of the cost of revenues incurred by that segment related to free trials.
There are no internal revenue transactions between the Company’s reportable segments. The Company's chief operating decision maker does not review an allocation of assets by reportable segment. The Domestic and International streaming segments derive revenue from monthly subscription services consisting solely of streaming content. The Domestic DVD segment derives revenue from monthly subscription services consisting solely of DVDs-by-mail.
Between the fourth quarter of 2010 and the third quarter of 2011, the Company had two operating segments: Domestic and International. During this time, the Company’s domestic streaming service and DVDs-by-mail operations were combined. Subscribers in the U.S. were able to receive both streaming services and DVDs under a single hybrid plan. Accordingly, revenues were generated and marketing expenses were

15


incurred in connection with the subscription offerings as a whole. Therefore, it is impracticable to allocate revenues or marketing expenses or present discrete segment information for the Domestic streaming and Domestic DVD segments for periods prior to the fourth quarter of 2011.
In the third quarter of 2011, the Company made certain changes to its domestic pricing and plan structure which require subscribers who wish to receive both streaming services and DVDs-by-mail to have two separate subscription plans. Following this change, beginning in the fourth quarter of 2011, the Company was able to generate discrete financial information for its Domestic streaming and Domestic DVD operations and began reporting this information to the chief operating decision maker for review.
 The following tables represent segment information for the quarter ended September 30, 2012:
 
 
As of/ Three months ended September 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total subscriptions at end of period (1)
25,101

 
4,311

 
8,606

 

Revenues
$
556,027

 
$
77,744

 
$
271,318

 
$
905,089

Cost of revenues and marketing expense
465,079

 
170,121

 
140,671

 
775,871

Contribution profit (loss)
$
90,948

 
$
(92,377
)
 
$
130,647

 
$
129,218

Other operating expenses
 
 
 
 
 
 
113,083

Operating income
 
 
 
 
 
 
16,135

Other income (expense)
 
 
 
 
 
 
(4,189
)
Provision for income taxes
 
 
 
 
 
 
4,271

Net income
 
 
 
 
 
 
$
7,675

 
As of/ Nine months ended September 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total subscriptions at end of period (1)
25,101

 
4,311

 
8,606

 

Revenues
$
1,595,397

 
$
186,142

 
$
882,504

 
$
2,664,043

Cost of revenues and marketing expense
1,354,769

 
470,629

 
471,958

 
2,297,356

Contribution profit (loss)
$
240,628

 
$
(284,487
)
 
$
410,546

 
$
366,687

Other operating expenses
 
 
 
 
 
 
336,333

Operating income
 
 
 
 
 
 
30,354

Other income (expense)
 
 
 
 
 
 
(14,778
)
Provision for income taxes
 
 
 
 
 
 
6,321

Net income
 
 
 
 
 
 
$
9,255


The following tables represent the Company’s segment information for the quarter ended September 30, 2011:
 

16


 
As of/ Three months ended September 30, 2011
 
Domestic
 
International
 
Consolidated
 
(in thousands)
Total unique subscribers at end of period (2)
23,789

 
1,480

 
25,269

Revenues
$
799,152

 
$
22,687

 
$
821,839

Cost of revenues and marketing expense
579,720

 
46,005

 
625,725

Contribution profit (loss)
$
219,432

 
$
(23,318
)
 
$
196,114

Other operating expenses
 
 
 
 
99,272

Operating income
 
 
 
 
96,842

Other income (expense)
 
 
 
 
(3,219
)
Provision for income taxes
 
 
 
 
31,163

Net income
 
 
 
 
$
62,460



 
As of/ Nine months ended September 30, 2011
 
Domestic
 
International
 
Consolidated
 
(in thousands)
Total unique subscribers at end of period (2)
23,789

 
1,480

 
25,269

Revenues
$
2,275,140

 
$
53,862

 
$
2,329,002

Cost of revenues and marketing expense
1,655,828

 
97,268

 
1,753,096

Contribution profit (loss)
$
619,312

 
$
(43,406
)
 
$
575,906

Other operating expenses
 
 
 
 
261,710

Operating income
 
 
 
 
314,196

Other income (expense)
 
 
 
 
(11,509
)
Provision for income taxes
 
 
 
 
111,780

Net income
 
 
 
 
$
190,907




(1) A subscription is defined as the right to receive either the Netflix streaming service or Netflix DVD service. In connection with the Company's subscription services, the Company offers free-trial memberships to new and certain rejoining members. A method of payment is required to be provided even during the free-trial period for the membership to be defined as a subscription and included in the above metrics. Total unique subscribers and total subscriptions include those subscribers who are on a free-trial. Paid unique subscribers and paid subscriptions exclude free trial memberships. A subscription would cease to be reflected in the above metrics as of the effective cancellation date. Voluntary cancellations become effective at the end of the monthly subscription period, while involuntary cancellation of the service, as a result of a failed method of payment, becomes effective immediately.

(2) For purposes of determining the number of unique subscribers, domestic subscribers who have elected both a DVD and a streaming subscription plan are considered a single unique subscriber.

17


Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These forward-looking statements include, but are not limited to statements regarding: our core strategy, contribution profit (losses) and margins both domestically and internationally, consolidated revenues, DVD and streaming subscription trends, investments in our international segment, cash use in connection with content acquisitions and international expansion, investments in content and marketing, consolidated revenue, content payments and expense, free cash flow and available funds, deferred tax assets, stock repurchases and future contractual obligations. These forward-looking statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those included in forward-looking statements. These forward-looking statements can be identified by our use of words such as "anticipate", "expect", "will", "may" and derivations thereof. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (“SEC”) on February 10, 2012, in particular the risk factors discussed under the heading “Risk Factors” in Part I, Item IA.

We assume no obligation to revise or publicly release any revision to any forward-looking statements contained in this Quarterly Report on Form 10-Q, unless required by law.

Overview

We are the world’s leading Internet subscription service for enjoying TV shows and movies. Our subscribers can instantly watch as many TV shows and movies as they want, streamed over the Internet to their TVs, computers and mobile devices. Additionally, in the U.S., our subscribers can receive standard definition DVDs, and their high definition successor, Blu-ray discs (collectively referred to as “DVD”), delivered quickly to their homes.

Our core strategy is to grow our streaming subscription business domestically and globally. We are continuously improving the customer experience, with a focus on expanding our streaming content, enhancing our user interface and extending our streaming service to even more Internet-connected devices, while staying within the parameters of our consolidated net income (loss) and operating segment contribution profit (loss) targets. Contribution profit (loss) is defined as revenue less cost of revenues and marketing expenses.

We are a pioneer in the Internet delivery of TV shows and movies, launching our streaming service in 2007. Since this launch, we have developed an ecosystem of Internet-connected devices and have licensed increasing amounts of content that enable consumers to enjoy TV shows and movies directly on their TVs, computers and mobile devices. As a result of these efforts, we have experienced growing consumer acceptance of and interest in the delivery of TV shows and movies directly over the Internet. We believe that the DVD portion of our domestic service will be a fading differentiator to our streaming success. Historically, our acquisition of new subscriptions has been seasonal with the first and fourth quarters representing our strongest net subscription additions and our second quarter representing the lowest net subscription additions in a calendar year.

Prior to July 2011, in the U.S., our streaming and DVDs-by-mail operations were combined and subscribers could receive both streaming content and DVDs under a single “hybrid” plan. In July 2011, we introduced DVD only plans and separated the combined plans, making it necessary for subscribers who wish to receive both streaming services and DVDs-by-mail to have two separate subscription plans. This resulted in a price increase for our members who were taking a hybrid plan. We made a subsequent announcement during the third quarter of 2011 concerning the rebranding of our DVDs-by-mail service and the separation of the DVDs-by-mail and streaming websites. The consumer reaction to the price change, and to a lesser degree, the branding announcement, was very negative leading to significant customer cancellations. We subsequently retracted our plans to rebrand our DVDs-by-mail service and separate the DVDs-by-mail and streaming websites.

In September 2010, we began international operations by offering our streaming service in Canada. In September 2011, we expanded our streaming service to Latin America. In January 2012, we launched our streaming service in the United Kingdom ("U.K.") and Ireland. In October 2012, we launched our streaming service in Norway, Denmark, Sweden and Finland. We anticipate significant contribution losses in the International streaming segment in 2012 and extending into 2013.
 
As a result of the changes to our pricing and plan structure, we no longer offer a single subscription plan including both DVDs-by-mail and streaming in the U.S. Domestic subscribers who wish to receive DVDs-by-mail and watch streaming content must elect both a DVDs-by-mail subscription plan and a streaming subscription plan. Accordingly, beginning with the third quarter of 2011, management views the number of paid subscriptions as the key driver of revenues. The following metrics reflect these changes.


18


 
As of /Three Months Ended,
Subscription Metrics:
September 30,
2012
 
June 30,
2012
 
September 30,
2011
 
(in thousands)
Domestic streaming (1):
 
 
 
 
 
Net additions
1,163

 
528

 
 
Paid subscriptions at end of period
23,801

 
22,686

 
 
Total subscriptions at end of period
25,101

 
23,938

 
 
International streaming (1):
 
 
 
 
 
Net additions
687

 
559

 
513

Paid subscriptions at end of period
3,689

 
3,024

 
989

Total subscriptions at end of period
4,311

 
3,624

 
1,480

Domestic DVD (1):
 
 
 
 
 
Net losses
(634
)
 
(849
)
 
 
Paid subscriptions at end of period
8,465

 
9,145

 
 
Total subscriptions at end of period
8,606

 
9,240

 
 
Consolidated (2):
 
 
 
 
 
Net unique subscriber additions during period
1,700

 
979

 
(292
)
Paid unique subscribers at end of period
29,892

 
28,254

 
23,832

Total unique subscribers at end of period
31,818

 
30,118

 
25,269


(1)
A subscription is defined as the right to receive either the Netflix streaming service or Netflix DVD service. In connection with our subscription services, we offer free-trial memberships to new and certain rejoining members. A method of payment is required to be provided even during the free-trial period for the membership to be defined as a subscription and included in the above metrics. Total unique subscribers and total subscriptions include those subscribers who are on a free-trial. Paid unique subscribers and paid subscriptions exclude free trial memberships. A subscription would cease to be reflected in the above metrics as of the effective cancellation date. Voluntary cancellations become effective at the end of the monthly subscription period, while involuntary cancellation of the service, as a result of a failed method of payment, becomes effective immediately.
(2)
For purposes of determining the number of unique subscribers, domestic subscribers who have elected both a DVD and a streaming subscription plan are considered a single unique subscriber.

The following represents our consolidated performance highlights:
 
Three Months Ended
 
Change
 
September 30,
2012
 
June 30,
2012
 
September 30,
2011
 
Q3'12 vs. Q2'12
 
Q3'12 vs. Q3'11
 
(in thousands, except per share data)
 
 
 
 
Revenues
$
905,089

 
$
889,163

 
$
821,839

 
2
 %
 
10
 %
Operating income
16,135

 
16,154

 
96,842

 
 %
 
(83
)%
Net income
7,675

 
6,164

 
62,460

 
25
 %
 
(88
)%
Diluted earnings per share
0.13

 
0.11

 
1.16

 
18
 %
 
(89
)%
Free cash flow (3)
(20,462
)
 
11,168

 
13,781

 
NM

 
NM

 
(3)
See “Liquidity and Capital Resources” for a definition of “free cash flow” and a reconciliation of “net cash provided by operating activities” to “free cash flow.”

Consolidated revenues, operating income and net income for the third quarter of 2012 were relatively flat as compared to the second quarter of 2012. We expect consolidated revenues to increase at a modest pace sequentially in future quarters driven by the growth in global streaming subscriptions and partially offset by a decline in domestic DVD subscriptions. Investments in streaming content and marketing to support new international markets may result in future consolidated net losses.
Free cash flow for the three months ended September 30, 2012 decreased $31.6 million as compared to the three months ended June 30, 2012 to negative $20.5 million. Significant uses of cash in the quarter were cash payments for content (in excess of the expense), cash payments for property and equipment (in excess of depreciation expense) primarily related to equipment for our Open Connect content delivery

19


program and reductions in miscellaneous accounts payable and accrued expenses. These uses of cash were partially offset by net income excluding the impact of non-cash stock compensation. The excess content payments over expense will continue to fluctuate over time based on new content licenses domestically and internationally and in particular may increase as a result of the timing of payments for original programming. Our movement into original programming will require more up-front cash payments than our typical licensing agreements, beginning in the fourth quarter of 2012 and increasing in 2013. We expect that free cash flow in future periods will be negatively impacted by investments in new international markets and in original content.
Segment Overview
The following tables set forth, for the periods presented, financial information for each of our reportable segments including revenues from subscriptions and contribution profit (loss) which is the measure of profitability used by our chief operating decision maker.
 
Three months ended September 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Revenues
$
556,027

 
$
77,744

 
$
271,318

 
$
905,089

Cost of revenues and marketing expense
465,079

 
170,121

 
140,671

 
775,871

Contribution profit (loss)
$
90,948

 
$
(92,377
)
 
$
130,647

 
$
129,218


 
Three months ended June 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Revenues
$
532,705

 
$
64,973

 
$
291,485

 
$
889,163

Cost of revenues and marketing expense
449,533

 
154,400

 
157,719

 
761,652

Contribution profit (loss)
$
83,172

 
$
(89,427
)
 
$
133,766

 
$
127,511


 
Three months ended September 30, 2011 (1)
 
Domestic
 
International
 
Consolidated
 
(in thousands)
Revenues
$
799,152

 
$
22,687

 
$
821,839

Cost of revenues and marketing expense
579,720

 
46,005

 
625,725

Contribution profit (loss)
$
219,432

 
$
(23,318
)
 
$
196,114

(1)
Presented using our segment reporting prior to the fourth quarter of 2011. Prior to the fourth quarter of 2011, our domestic streaming service and DVDs-by-mail operations were combined.

Our core strategy is to grow a streaming subscription business domestically and globally. As we grow our streaming subscription segments, we have shifted spending away from the Domestic DVD segment to invest more in streaming content and marketing our streaming services. Content acquisition and licensing expenses are higher as a percentage of revenues for the Domestic and International Streaming segments as compared to the Domestic DVD segment. Content delivery expenses and fulfillment expenses tend to be lower for the streaming business. Marketing costs for the streaming business are higher as a percentage of revenues given our focus on building consumer awareness of the streaming offerings. Marketing costs are immaterial for the Domestic DVD segment. As a result of our focus on growing the streaming segments, contribution margins for the Domestic and International Streaming segments are lower than for our Domestic DVD segment. Also impacting the Domestic streaming segment was the loss of subscribers resulting from the consumer reaction to the pricing and plan changes made in the third quarter of 2011. We expect that the investments in content and marketing associated with the streaming service segments will slow relative to revenue to allow for contribution margin expansion over time. Streaming content rights are generally specific to a geographic region and accordingly our international expansion will require us to obtain additional streaming content licenses to support new global markets.
Our Domestic Streaming segment had a contribution margin of 16% for the third quarter of 2012. We expect further contribution margin expansion as investments in domestic content and marketing grow slower than domestic streaming revenue. Average number of paying domestic streaming subscriptions for the three months ending September 30, 2012 increased 4% from the prior quarter, driving the increase in Domestic streaming revenues. Content acquisition and licensing expense for our Domestic streaming segment represent the vast majority of expenses for this segment and increased 5% quarter over quarter. Marketing decreased by 7% due to reduced spending in TV and Radio

20


advertising partially offset by an increase in online and direct-mail advertising. Content delivery and fulfillment expenses were immaterial for this period for the Domestic streaming segment.
Our International Streaming segment does not benefit from the established subscriber base that exists for the Domestic Streaming segment. As a result of having to build a member base from zero, investments in streaming content and marketing for our International segment are larger initially relative to revenues, in particular as new territories are launched. Marketing expenses incurred by our International streaming segment have been significant and will fluctuate dependent upon the number of International territories in which our streaming service is offered and the timing of the launch of new territories. Typically for a specific territory, marketing expenses represent a larger percentage of total expenses at launch. The contribution losses for our International segment have been significant and we expect will continue to be significant as we expand globally. Our International streaming segment had a contribution loss of $92.4 million for the third quarter of 2012 compared to a contribution loss of $89.4 million for the second quarter of 2012 due to increased investments in our content library to drive more membership growth and viewing. International streaming subscriptions increased 19% from June 30, 2012 to September 30, 2012, and the number of average paid subscriptions increased even more at 24% from the second to third quarters of 2012 due to conversion of free trial members. The increase in average paid subscriptions was the driver of the increase in International streaming revenues in the third quarter of 2012 as compared to the second quarter of 2012. International streaming subscriptions account for 15% of total streaming subscriptions at the end of the third quarter. The increase in revenues was partially offset by increases in content acquisition and licensing expenses of 14%. Content acquisition and licensing expense for our International streaming segment represent the vast majority of costs of revenues. Content delivery and fulfillment expenses were immaterial for this period and are not a material contributor to the contribution loss in our International segment.
The Domestic DVD segment had a small increase in contribution margin to 48% compared to 46% in the second quarter of 2012 due to a lower revenue mix in content utilization subject to revenue sharing agreements. Given that our core strategy is to grow a streaming subscription business both domestically and internationally, we do not expect future investments in DVD content, technology or marketing to be material. Current and future expenses for the Domestic DVD segment are primarily variable in nature such as shipping and packaging associated with delivery of DVDs-by-mail. As a result, contribution margins for the Domestic DVD segment are expected to increase slightly for the remainder of the year, while DVD subscription declines continue to moderate. DVD subscriptions as of September 30, 2012 decreased 7% from June 30, 2012, due to cancellations during the quarter, resulting in a 7% decrease in Domestic DVD revenues.

Consolidated Results of Operations
The following table sets forth, for the periods presented, the line items on our Consolidated Statements of Operations as a percentage of total revenues.
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012
 
June 30,
2012
 
September 30,
2011
 
September 30,
2012
 
September 30,
2011
Revenues
100
 %
 
100
 %
 
100
 %
 
100
 %
 
100
%
Cost of revenues:
 
 
 
 
 
 
 
 
 
Subscription
66
 %
 
65
 %
 
57
 %
 
66
 %
 
55
%
Fulfillment expenses
7
 %
 
7
 %
 
8
 %
 
7
 %
 
8
%
Total cost of revenues
73
 %
 
72
 %
 
65
 %
 
73
 %
 
63
%
Operating expenses:
 
 
 
 
 
 
 
 
 
Marketing
13
 %
 
13
 %
 
11
 %
 
14
 %
 
12
%
Technology and development
9
 %
 
9
 %
 
8
 %
 
9
 %
 
8
%
General and administrative
3
 %
 
4
 %
 
4
 %
 
3
 %
 
4
%
Total operating expenses
25
 %
 
26
 %
 
23
 %
 
26
 %
 
24
%
Operating income
2
 %
 
2
 %
 
12
 %
 
1
 %
 
13
%
Other income (expense):
 
 
 
 
 
 
 
 
 
Interest expense
(1
)%
 
(1
)%
 
 %
 
(1
)%
 
%
Interest and other income (expense)
 %
 
 %
 
 %
 
 %
 
%
Income before income taxes
1
 %
 
1
 %
 
12
 %
 
 %
 
13
%
Provision for income taxes
 %
 
 %
 
4
 %
 
 %
 
5
%
Net income
1
 %
 
1
 %
 
8
 %
 
 %
 
8
%
 
Revenues
We derive our revenues from monthly subscription fees and recognize subscription revenues ratably over each subscriber’s monthly subscription period. We currently generate substantially all of our revenues in the U.S.

21


In the Domestic streaming segment, we derive revenues from services consisting solely of streaming content offered through a subscription plan priced at $7.99 per month. In the Domestic DVD segment, we derive revenues from our DVDs-by-mail subscription services. The price per plan for DVDs-by-mail varies from $4.99 to $43.99 per month based on the number of DVDs that a subscriber may have out at any given point. Customers electing access to high definition Blu-ray discs in addition to standard definition DVDs pay a surcharge ranging from $2 to $4 per month for our most popular plans.
In July 2011, in the U.S., we introduced DVD only plans and separated DVDs-by-mail and streaming making it necessary for subscribers who opt to receive both streaming and DVDs-by-mail to have two separate subscription plans. As subscribers were able to receive both streaming and DVDs-by-mail under a single hybrid plan prior to the fourth quarter of 2011, it is impracticable to allocate revenues to the Domestic streaming and Domestic DVD segments prior to the fourth quarter of 2011.
In the International streaming segment, we derive revenues from services consisting solely of streaming content offered through a subscription plan priced at approximately the equivalent of USD7.99 per month. In September 2010, we began international operations in Canada. We expanded to Latin America in September 2011 and the U.K. and Ireland in January 2012. In October 2012, we launched our streaming service in Norway, Denmark, Sweden and Finland.

Three months ended September 30, 2012 as compared to the three months ended September 30, 2011
 
 
Three Months Ended
 
Change
 
September 30,
2012
 
September 30,
2011
 
Q3'12 vs. Q3'11
 
(in thousands, except percentages)
Revenues (1)
$
905,089

 
$
821,839

 
10
%
Domestic
827,345

 
799,152

 
4
%
International
77,744

 
22,687

 
243
%
(1)
Presented using our segment reporting prior to the fourth quarter of 2011. The Domestic segment consists of both our domestic streaming service and DVDs-by-mail as prior to the fourth quarter of 2011, our domestic streaming service and DVDs-by-mail operations were combined.
The $83.3 million increase in our consolidated revenues was due to the $28.2 million increase in domestic revenues and a $55.1 million increase in international revenues. Domestic revenues increased 4% as a result of the 12% growth in the domestic average number of unique paying subscribers driven by new streaming subscriptions. This increase was offset in part by a 7% decline in domestic average monthly revenue per unique paying subscriber, resulting from the popularity of the streaming subscription service and a decline in the percentage of unique paying subscribers electing both a streaming and a DVD subscription.
International revenues increased by $55.1 million primarily due to our launch in Latin America in September 2011 and our launch in the U.K. and Ireland in January 2012.
Nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011
 
 
Nine Months Ended
 
Change
 
September 30,
2012
 
September 30,
2011
 
YTD'12 vs. YTD'11
 
(in thousands, except percentages)
Revenues (2)
$
2,664,043

 
$
2,329,002

 
14
%
Domestic
2,477,901

 
2,275,140

 
9
%
International
186,142

 
53,862

 
246
%

(2)
Presented using our segment reporting prior to the fourth quarter of 2011. Prior to the fourth quarter of 2011, our domestic streaming service and DVDs-by-mail operations were combined.

The $335.0 million increase in our consolidated revenues was due to the $202.8 million increase in domestic revenues and $132.3 million increase in international revenues. Domestic revenues increased 9% as a result of the 14% growth in the domestic average number of unique paying subscribers driven by new streaming subscriptions. This increase was offset in part by a 5% decline in domestic average monthly

22


revenue per unique paying subscriber, resulting from the popularity of the streaming subscription service and a decline in the percentage of unique paying subscribers electing both a streaming and a DVD subscription.
International revenues increased by $132.3 million primarily due to our launch in Latin America in September 2011 and our launch in the U.K. and Ireland in January 2012.
Three months ended September 30, 2012 as compared to the three months ended June 30, 2012
 
Three Months Ended
 
Change
 
September 30,
2012
 
June 30,
2012
 
Q3'12 vs. Q2'12
 
(in thousands, except percentages)
Revenues
$
905,089

 
$
889,163

 
2
 %
Domestic streaming
556,027

 
532,705

 
4
 %
International streaming
77,744

 
64,973

 
20
 %
 Domestic DVD
271,318

 
291,485

 
(7
)%
The $15.9 million increase in our consolidated revenues was due to the $23.3 million increase in Domestic streaming revenues and the $12.8 million increase in International streaming revenues. Domestic streaming revenues increased 4% as a result of the growth in the average number of paying streaming subscriptions. International streaming revenues increased 20% as a result of the growth in the average number of paying international streaming subscriptions resulting from continued subscription growth across all international regions. These increases in streaming revenues were offset by a $20.2 million decrease in Domestic DVD revenue due to an 8% decrease in the average number of paying DVD subscriptions.
We expect streaming subscriptions both domestically and internationally to continue to grow and DVD subscription declines to continue to moderate. As a result, we expect consolidated revenues to increase at a modest pace sequentially in future quarters.

Cost of Revenues

Cost of revenues consists of expenses related to the acquisition and licensing of content, content delivery expenses and fulfillment expenses. Costs related to free-trial periods are allocated to marketing expenses.

Content acquisition and licensing expenses consist primarily of amortization of streaming content licenses, which may or may not be recognized in the streaming content library, amortization of DVD content library and revenue sharing expenses. We obtain content through streaming content license agreements, DVD direct purchases and DVD revenue sharing agreements with studios, distributors and other suppliers. Content agreements are made in the ordinary course of business and our business is not substantially dependent on any particular agreement.

Content delivery expenses consist primarily of the postage costs to mail DVDs to and from our paying subscribers and the packaging and label costs for the mailers. We utilize both our own and third-party content delivery networks to help us efficiently stream content in high volume to our subscribers over the Internet. Content delivery expenses therefore also include equipment costs related to our own streaming content delivery networks ("Open Connect") and all third party costs associated with delivering streaming content over the Internet.

Fulfillment expenses represent those expenses incurred in content processing including operating and staffing our DVD shipping centers, as well as receiving, encoding, inspecting and warehousing our content library. Fulfillment expenses also include operating and staffing our customer service centers and credit card fees.

Three months ended September 30, 2012 as compared to the three months ended September 30, 2011

 
Three Months Ended
 
Change
 
September 30,
2012
 
September 30,
2011
 
Q3'12 vs. Q3'11
 
(in thousands, except percentages)
Total cost of revenues
$
662,638

 
$
536,617

 
23
%
As a percentage of revenues
73
%
 
65
%
 
 


23


The $126.0 million increase in cost of revenues was primarily due to the following factors:
Content acquisition and licensing expenses increased by $171.2 million. This increase was primarily due to a 26% increase in the Domestic segment. Additionally, the launches in Latin America and the U.K. and Ireland have contributed to a 14% increase in our content expenses in the International segment. The increases in both Domestic and International content acquisition expense are due to the continued investments in existing and new streaming content available for viewing to our subscribers.
Content delivery expenses decreased $40.8 million primarily due to a 43% decrease in the number of DVDs mailed for paid subscriptions. The decrease in the number of DVDs mailed was driven by the decrease in the average number of paid DVD subscriptions. Costs associated with our use of our own and third-party streaming content delivery networks increased 37% but were not a significant contributor to the total variance in content delivery expense.
Nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011

 
Nine Months Ended
 
Change
 
September 30,
2012
 
September 30,
2011
 
YTD'12 vs. YTD'11
 
(in thousands, except percentages)
Total cost of revenues
$
1,929,999

 
$
1,464,746

 
32
%
As a percentage of revenues
73
%
 
63
%
 
 

The $465.3 million increase in cost of revenues was primarily due to the following factors:
 
Content acquisition and licensing expenses increased by $608.9 million. This increase was primarily due to a 44% increase in the Domestic segment. Additionally, the launches in Latin America and the U.K. and Ireland have contributed to an increase in our content expenses in the International segment. The increases in both Domestic and International content acquisition expense were due to the continued investments in existing and new streaming content available for viewing to our subscribers.
Content delivery expenses decreased $136.1 million primarily due to a 43% decrease in the number of DVDs mailed for paid subscriptions. The decrease in the number of DVDs mailed was driven by the decrease in the average paid DVD subscriptions. Costs associated with our use of our own and third-party streaming content delivery networks increased 41% but were not a significant contributor to the total variance in content delivery expense.
Three months ended September 30, 2012 as compared to the three months ended June 30, 2012

 
Three Months Ended
 
Change
 
September 30,
2012
 
June 30,
2012
 
Q3'12 vs. Q2'12
 
(in thousands, except percentages)
Total cost of revenues
$
662,638

 
$
643,428

 
3
%
As a percentage of revenues
73
%
 
72
%
 
 

The $19.2 million increase in cost of revenues was primarily due a $20.1 million increase in content acquisition and licensing expenses. This increase was attributable to a 14% increase in the International segment due to an increase in streaming content titles available in our International locations and to the 5% increase in the Domestic streaming segment due to the continued investments in existing and new streaming content available for viewing to our domestic subscribers. These increases were offset by a decrease in the Domestic DVD segment of 18%.


Marketing
Marketing expenses consist primarily of advertising expenses and also include payments made to our affiliates and consumer electronics partners and payroll related expenses. Advertising expenses include promotional activities such as television and online advertising as well as allocated costs of revenues relating to free trial periods. Payments to our affiliates and consumer electronics partners may be in the form of a fixed-fee or may be a revenue sharing payment.

Three months ended September 30, 2012 as compared to the three months ended September 30, 2011
 

24


 
Three Months Ended
 
Change
 
September 30,
2012
 
September 30,
2011
 
Q3'12 vs. Q3'11
 
(in thousands, except percentages)
Marketing
$
113,233

 
$
89,108

 
27
%
As a percentage of revenues
13
%
 
11
%
 
 
 
The $24.1 million increase in marketing expenses was primarily due to a $25.0 million increase in marketing program spending primarily in online advertising. International marketing expenses increased by 166% as expenses were higher in the third quarter of 2012 to support the marketing of our service in Latin America and U.K. and Ireland. Domestic marketing expenses decreased by 6%.
Nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011
 
 
Nine Months Ended
 
Change
 
September 30,
2012
 
September 30,
2011
 
YTD'12 vs. YTD'11
 
(in thousands, except percentages)
Marketing
$
367,357

 
$
288,350

 
27
%
As a percentage of revenues
14
%
 
12
%
 
 
 
The $79.0 million increase in marketing expenses was primarily due to an $85.8 million increase in marketing program spending primarily in online and television advertising. International marketing expenses increased by 220% as expenses were higher in the nine months ended September 30, 2012 to support the launch of our service in the U.K. and Ireland and continued marketing in Latin America and Canada. Domestic marketing expenses decreased by 9%.
Three months ended September 30, 2012 as compared to the three months ended June 30, 2012
 
 
Three Months Ended
 
Change
 
September 30,
2012
 
June 30,
2012
 
Q3'12 vs. Q2'12
 
(in thousands, except percentages)
Marketing
$
113,233

 
$
118,224

 
(4
)%
As a percentage of revenues
13
%
 
13
%
 
 
 
The $5.0 million decrease in marketing expenses was primarily due to a $5.5 million decrease in domestic marketing program spending primarily in television advertising partially offset by increases in online and direct-mail advertising. Marketing expenses in our International streaming segment were relatively flat.


Technology and Development