10-Q 1 nflx-09301310qdoc.htm 10-Q NFLX-09.30.13-10Q-DOC
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
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  x    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  x    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
x
 
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  x
As of September 30, 2013, there were 59,257,798 shares of the registrant’s common stock, par value $0.001, outstanding.




Table of Contents
 


2


NETFLIX, INC.

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2013
 
September 30,
2012
 
September 30,
2013
 
September 30,
2012
Revenues
$
1,105,999

 
$
905,089

 
$
3,199,332

 
$
2,664,043

Cost of revenues
791,019

 
662,638

 
2,271,407

 
1,929,999

Marketing
116,109

 
108,448

 
367,044

 
352,340

Technology and development
95,540

 
82,521

 
280,641

 
246,869

General and administrative
46,211

 
35,347

 
134,181

 
104,481

Operating income
57,120

 
16,135

 
146,059

 
30,354

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(7,436
)
 
(4,990
)
 
(21,704
)
 
(14,970
)
Interest and other income (expense)
(193
)
 
801

 
(2,156
)
 
192

Loss on extinguishment of debt

 

 
(25,129
)
 

Income before income taxes
49,491

 
11,946

 
97,070

 
15,576

Provision for income taxes
17,669

 
4,271

 
33,088

 
6,321

Net income
$
31,822

 
$
7,675

 
$
63,982

 
$
9,255

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.54

 
$
0.14

 
$
1.11

 
$
0.17

Diluted
$
0.52

 
$
0.13

 
$
1.06

 
$
0.16

Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
59,108

 
55,541

 
57,769

 
55,508

Diluted
60,990

 
58,729

 
60,578

 
58,829












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,
2013
 
September 30,
2012
 
September 30,
2013
 
September 30,
2012
Net income
$
31,822

 
$
7,675

 
$
63,982

 
$
9,255

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments 
2,409

 
1,084

 
150

 
1,128

Change in unrealized gains (losses) on available-for-sale securities, net of tax of $515, $604, $(936), and $736, respectively
825

 
961

 
(1,499
)
 
1,172

Total other comprehensive income (loss)
3,234

 
2,045

 
(1,349
)
 
2,300

Comprehensive income
$
35,056

 
$
9,720

 
$
62,633

 
$
11,555






















See accompanying notes to the consolidated financial statements.

4


NETFLIX, INC.

Consolidated Statements of Cash Flows
(unaudited)
(in thousands)
   
Three Months Ended
 
Nine Months Ended
   
September 30,
2013
 
September 30,
2012
 
September 30,
2013
 
September 30,
2012
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
31,822

 
$
7,675

 
$
63,982

 
$
9,255

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 
 
 
 
 
Additions to streaming content library
(878,314
)
 
(744,714
)
 
(2,063,709
)
 
(1,883,859
)
Change in streaming content liabilities
310,191

 
274,196

 
327,175

 
631,802

Amortization of streaming content library
553,394

 
410,947

 
1,549,384

 
1,126,680

Amortization of DVD content library
17,546

 
13,132

 
53,492

 
49,482

Depreciation and amortization of property, equipment and intangibles
11,452

 
11,128

 
35,529

 
33,506

Stock-based compensation expense
18,477

 
18,472

 
54,178

 
56,254

Excess tax benefits from stock-based compensation
(20,492
)
 
(111
)
 
(52,475
)
 
(4,173
)
Other non-cash items
1,994

 
(2,078
)
 
4,932

 
(5,176
)
Loss on extinguishment of debt

 

 
25,129

 

Deferred taxes
(2,424
)
 
(15,606
)
 
(11,212
)
 
(26,449
)
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
Prepaid content
1,542

 
15,358

 
29,407

 
22,855

Other current assets
8,378

 
(3,476
)
 
8,548

 
188

Accounts payable
(5,877
)
 
(9,727
)
 
6,004

 
(11,167
)
Accrued expenses
(11,451
)
 
15,294

 
(5,089
)
 
23,931

Deferred revenue
9,252

 
2,356

 
26,351

 
6,350

Other non-current assets and liabilities
(10,797
)
 
4,229

 
4,760

 
6,112

Net cash provided by (used in) operating activities
34,693

 
(2,925
)
 
56,386

 
35,591

Cash flows from investing activities:
 
 
 
 
 
 
 
Acquisitions of DVD content library
(15,471
)
 
(8,586
)
 
(50,687
)
 
(30,126
)
Purchases of property and equipment
(10,828
)
 
(10,808
)
 
(31,034
)
 
(18,933
)
Other assets
(1,329
)
 
1,857

 
3,808

 
6,323

Purchases of short-term investments
(116,116
)
 
(67,779
)
 
(497,789
)
 
(430,549
)
Proceeds from sale of short-term investments
81,185

 
52,172

 
196,392

 
272,680

Proceeds from maturities of short-term investments
48,890

 
2,695

 
58,720

 
23,685

Net cash used in investing activities
(13,669
)
 
(30,449
)
 
(320,590
)
 
(176,920
)
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from issuance of common stock
25,561

 
318

 
93,553

 
2,066

Proceeds from issuance of debt

 

 
500,000

 

Issuance costs

 

 
(9,414
)
 
(759
)
Redemption of debt

 

 
(219,362
)
 

Excess tax benefits from stock-based compensation
20,492

 
111

 
52,475

 
4,173

Principal payments of lease financing obligations
(258
)
 
(587
)
 
(916
)
 
(1,723
)
Net cash provided by (used in) financing activities
45,795

 
(158
)
 
416,336

 
3,757

Effect of exchange rate changes on cash and cash equivalents
1,559

 
1,579

 
(3,367
)
 
(183
)
Net increase (decrease) in cash and cash equivalents
68,378

 
(31,953
)
 
148,765

 
(137,755
)
Cash and cash equivalents, beginning of period
370,678

 
402,251

 
290,291

 
508,053

Cash and cash equivalents, end of period
$
439,056

 
$
370,298

 
$
439,056

 
$
370,298

See accompanying notes to the consolidated financial statements.

5


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

 
As of
   
September 30,
2013
 
December 31,
2012
 
(unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
439,056

 
$
290,291

Short-term investments
695,931

 
457,787

Current content library, net
1,577,514

 
1,368,162

Prepaid content
30,522

 
59,929

Other current assets
106,255

 
64,622

Total current assets
2,849,278

 
2,240,791

Non-current content library, net
1,808,387

 
1,506,008

Property and equipment, net
127,263

 
131,681

Other non-current assets
116,397

 
89,410

Total assets
$
4,901,325

 
$
3,967,890

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Current content liabilities
$
1,591,981

 
$
1,366,847

Accounts payable
100,899

 
86,468

Accrued expenses
46,433

 
53,139

Deferred revenue
195,823

 
169,472

Total current liabilities
1,935,136

 
1,675,926

Non-current content liabilities
1,179,055

 
1,076,622

Long-term debt
500,000

 
200,000

Long-term debt due to related party

 
200,000

Other non-current liabilities
82,764

 
70,669

Total liabilities
3,696,955

 
3,223,217

Commitments and contingencies (Note 10)


 


Stockholders’ equity:
 
 
 
Common stock, $0.001 par value; 160,000,000 shares authorized at September 30, 2013 and December 31, 2012; 59,257,798 and 55,587,167 issued and outstanding at September 30, 2013 and December 31, 2012, respectively
59

 
56

Additional paid-in capital
698,677

 
301,616

Accumulated other comprehensive income
1,570

 
2,919

Retained earnings
504,064

 
440,082

Total stockholders’ equity
1,204,370

 
744,673

Total liabilities and stockholders’ equity
$
4,901,325

 
$
3,967,890

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, 2012 filed with the Securities and Exchange Commission (the “SEC”) on February 1, 2013. 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 for the streaming content library; the recognition and measurement of income tax assets and liabilities; and the valuation of stock-based compensation. The Company bases its estimates on historical experience and on various other assumptions that the Company believes to be reasonable under the circumstances. On a regular basis, we evaluate our assumptions, judgments and estimates. Actual results may differ from these 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, 2012. 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. The Company’s revenues are derived from monthly membership fees.
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, 2012.


2. Reclassifications and Changes in Estimates
Certain prior period amounts have been reclassified to conform to the current period presentation in the Consolidated Statements of Operations. Payroll and related expenses of $4.8 million and $15.0 million for the three and nine months ended September 30, 2012, respectively, associated with corporate marketing personnel, previously classified in "Marketing" on the Consolidated Statements of Operations, have been reclassified as "General and administrative." Historically these costs were substantially recorded in the Domestic streaming segment and impacted segment contribution profit. Management and the Company's chief operating decision maker consider such employee costs to be global corporate costs rather than marketing costs directly attributable to the segment and as such are not indicative of any given segment's performance. Accordingly, such costs have been reclassified as "General and administrative" expenses which are not a component of contribution profit. There was no impact to operating income in any period.
Certain prior period amounts in the Consolidated Statements of Cash Flows have been revised to correctly present changes in accounts payable related to purchases of fixed assets. For the three and nine months ended September 30, 2012, a $3.1 million and $3.4 million increase in accounts payable has been reclassified from purchases of fixed assets in "Net cash used in investing activities" to changes in accounts payable in "Net cash provided by (used in) operating activities." There was no impact to the Consolidated Statements of Operations or Consolidated Balance Sheets.
The Company had a change in estimate that is reflected in the consolidated financial statements for the three months ended September 30, 2013. When the Company started with original content, the Company did not have specific data about viewing patterns over time for content that premieres on Netflix. Based on experience with other similar television series and initial estimates of viewing patterns, the Company amortized this type of content on a straight-line basis over the shorter of four years or the license period. If a subsequent season is added, the remaining amortization period is extended by a year. Current estimates of viewing patterns indicate that viewing in the first few months is significantly higher, relative to the remaining amortization period, than previously estimated. As a result, in the third quarter of 2013, the Company began amortizing this type of content on an accelerated basis over the amortization period. The effect of this change in estimate was a $20.2 million decrease in contribution profit for the Domestic streaming segment and a $6.5 million increase in contribution loss for the International streaming segment for the three and nine months ended September 30, 2013. The effect to operating income and net income is a decrease of $26.7 million and $16.7 million, respectively, for the three and nine months ended September 30, 2013. The effect to basic earnings per share and diluted earnings per share was a decrease of $0.28 and $0.27, respectively, for the three months ended September 30, 2013 and a decrease of $0.29 and $0.27, respectively for the nine months ended September 30, 2013. The effect of this change in estimate relates primarily to titles that first premiered on Netflix in the first and second quarters of 2013.


7








3. 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 common shares outstanding during the period. Potential common shares consist of shares issuable upon the assumed conversion of the Company’s Senior Convertible Notes (prior to the conversion of such notes) and incremental shares issuable upon the assumed exercise of stock options. The computation of earnings per share is as follows:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2013
 
September 30,
2012
 
September 30,
2013
 
September 30,
2012
 
(in thousands, except per share data)
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
31,822

 
$
7,675

 
$
63,982

 
$
9,255

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
59,108

 
55,541

 
57,769

 
55,508

Basic earnings per share
$
0.54

 
$
0.14

 
$
1.11

 
$
0.17

 
 
 
 
 
 
 
 
Diluted earnings per share:
 
 
 
 
 
 
 
Net income
$
31,822

 
$
7,675

 
$
63,982

 
$
9,255

Senior Convertible Notes interest expense, net of tax

 
49

 
49

 
146

Numerator for diluted earnings per share
$
31,822

 
$
7,724

 
$
64,031

 
$
9,401

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
59,108

 
55,541

 
57,769

 
55,508

Senior Convertible Notes shares

 
2,331

 
956

 
2,331

Employee stock options
1,882

 
857

 
1,853

 
990

Weighted-average number of shares
60,990

 
58,729

 
60,578

 
58,829

Diluted earnings per share
$
0.52

 
$
0.13

 
$
1.06

 
$
0.16


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,
2013
 
September 30,
2012
 
September 30,
2013
 
September 30,
2012
 
(in thousands)
Employee stock options
12

 
1,782

 
260

 
1,199


4. Short-term Investments
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, 2013
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
420,235

 
$

 
$

 
$
420,235

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
24,024

 

 

 
24,024

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
324,422

 
975

 
(788
)
 
324,609

Government and agency securities
163,610

 
352

 
(18
)
 
163,944

Asset and mortgage-backed securities
207,852

 
288

 
(762
)
 
207,378

Total (1)
$
1,140,143

 
$
1,615

 
$
(1,568
)
 
$
1,140,190

 
As of December 31, 2012
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
284,661

 
$

 
$

 
$
284,661

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
10,500

 

 

 
10,500

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
150,322

 
1,605

 
(32
)
 
151,895

Government and agency securities
166,643

 
285

 

 
166,928

Asset and mortgage-backed securities
138,340

 
750

 
(125
)
 
138,965

Total (2)
$
750,466

 
$
2,640

 
$
(157
)
 
$
752,949

(1)
Includes $439.1 million that is included in cash and cash equivalents, $695.9 million included in short-term investments and $5.2 million of restricted cash that is included in other non-current assets related to workers compensation deposits.
(2)
Includes $290.3 million that is included in cash and cash equivalents, $457.8 million included in short-term investments and $4.8 million of restricted cash that is included in other non-current assets related to workers compensation deposits.

Fair value is a market-based measurement that is 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 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 6 to the consolidated financial statements for further information regarding the fair value of the Company’s debt instruments.
Because the Company does not intend to sell the investments that are in a material 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, 2013. There were no investments in a material unrealized loss position as of September 30, 2013 or December 31, 2012, respectively. There were no material other-than-temporary impairments or credit losses related to available-for-sale securities in the three and nine months ended September 30, 2013 and 2012. In addition, there were no material gross realized gains or losses in the three and nine months ended September 30, 2013 and 2012.

9


The estimated fair value of short-term investments by contractual maturity as of September 30, 2013 is as follows:
 
 
(in thousands)
Due within one year
$
128,506

Due after one year and through 5 years
519,446

Due after 5 years and through 10 years
4,015

Due after 10 years
43,964

Total short-term investments
$
695,931


5. Balance Sheet Components
Content Library
Content library consisted of the following:
 
 
As of
 
September 30,
2013
 
December 31,
2012
 
(in thousands)
Total content library, gross
$
5,951,485

 
$
5,001,524

Accumulated amortization
(2,565,584
)
 
(2,127,354
)
Total content library, net
3,385,901

 
2,874,170

Current content library, net
1,577,514

 
1,368,162

Non-current content library, net
$
1,808,387

 
$
1,506,008


Property and Equipment, Net
Property and equipment and accumulated depreciation consisted of the following:

 
 
 
As of
 
 
 
September 30,
2013
 
December 31,
2012
 
 
 
(in thousands)
Computer equipment
 
3 years
$
87,967

 
$
84,193

Operations and other equipment
 
5 years
98,539

 
100,207

Software
 
3 years
39,242

 
39,073

Furniture and fixtures
 
3 years
20,594

 
18,208

Building
 
30 years
40,681

 
40,681

Leasehold improvements
 
Over life of lease
49,681

 
45,393

Capital work-in-progress
 
 
7,715

 
8,282

Property and equipment, gross
 
 
344,419

 
336,037

Less: Accumulated depreciation
 
 
(217,156
)
 
(204,356
)
Property and equipment, net
 
 
$
127,263

 
$
131,681


6. Long-term Debt
Senior Convertible Notes
In November 2011, the Company issued $200.0 million aggregate principal amount of zero coupon Senior Convertible Notes due on December 1, 2018 (the “Convertible Notes”) 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 could have elected to cause the conversion of the Convertible Notes into shares of the Company’s common stock when specified conditions were satisfied, including that the daily volume weighted average price of the Company’s common stock was equal to or greater than $111.54 for at least 50 trading days during a 65 trading day period prior to the conversion date.

10


In April 2013, after all specified conditions were satisfied, the Company elected to cause the conversion of all outstanding Convertible Notes with an aggregate principal amount of $200.0 million in accordance with the terms of the Indenture governing such notes. Pursuant to this conversion, the Company issued 2.3 million shares of common stock to the holders of the Convertible Notes at a conversion ratio of 11.6553. The fair market value of one share of common stock on the date of conversion was $216.99 per share.
Senior Notes
In February 2013, the Company issued $500.0 million aggregate principal amount of 5.375% Senior Notes due 2021 (the "5.375% Notes"). The 5.375% Notes were issued at par and are senior unsecured obligations of the Company. Interest is payable semi-annually at a rate of 5.375% per annum on February 1 and August 1 of each year, commencing on August 1, 2013. The 5.375% Notes are repayable in whole or in part upon the occurrence of a change of control, at the option of the holders, at a purchase price in cash equal to 101% of the principal plus accrued interest. The Company may redeem the 5.375% Notes prior to maturity in whole or in part at an amount equal to the principal amount thereof plus accrued and unpaid interest plus a make-whole payment equivalent to the present value of the remaining interest payments through maturity.
The 5.375% Notes include, among other terms and conditions, limitations on the Company's ability to create, incur or allow certain liens; enter into sale and lease-back transactions; create, assume, incur or guarantee additional indebtedness of the Company's subsidiaries; and consolidate or merge with, or convey, transfer or lease all or substantially all of the Company's and its subsidiaries assets, to another person. At September 30, 2013 the Company was in compliance with these covenants.
In the first quarter of 2013, the Company used $224.5 million of the net proceeds of the 5.375% Notes to redeem the outstanding $200.0 million aggregate principal amount of 8.50% Senior Notes due 2017 (the “8.50% Notes”) and pursuant to the make-whole provision in the Indenture governing the 8.50% Notes, paid a $19.4 million premium and $5.1 million of accrued and unpaid interest. The Company recognized a loss on extinguishment of debt of $25.1 million related to redemption of the 8.50% Notes which included the write off of unamortized debt issuance costs of $4.2 million.
Based on quoted market prices in less active markets (a Level 2 input for this financial instrument), the fair value of the 5.375% Notes as of September 30, 2013 was approximately $496.3 million.

7. Stockholders’ Equity
In April 2013, the Company issued 2.3 million shares of common stock in connection with the conversion of the Convertible Notes. See Note 6 to the consolidated financial statements for further details.
Preferred Stock
In 2012, the Company designated 1,000,000 shares of its preferred stock with par value of $0.001 per share as Series A Participating Preferred Stock. The remaining 9,000,000 shares of preferred stock with par value of $0.001 remain undesignated. None of the preferred shares were issued and outstanding at September 30, 2013 or December 31, 2012.
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, 2013, 3.5 million shares were reserved for future grants under the 2011 Stock Plan.
A summary of the activities related to the Company’s stock option plans 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, 2012
4,049,037

 
4,572,952

 
$
71.33

 
 
 
 
Granted
(541,378
)
 
541,378

 
184.71

 
 
 
 
Exercised


 
(1,339,571
)
 
69.84

 
 
 
 
Balances as of September 30, 2013
3,507,659

 
3,774,759

 
88.12

 
6.37
 
$
834,555

Vested and exercisable at September 30, 2013
 
 
3,774,759

 
88.12

 
6.37
 
$
834,555



11


The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the third quarter of 2013 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, 2013. This amount changes based on the fair market value of the Company’s common stock. The total intrinsic value of options exercised for the three months ended September 30, 2013 and 2012 was $64.5 million and $0.4 million, respectively. The total intrinsic value of options exercised for the nine months ended September 30, 2013 and 2012 was $182.8 million and $13.2 million, respectively.
Cash received from option exercises for the three months ended September 30, 2013 and 2012 was $25.6 million and $0.3 million, respectively. Cash received from option exercises for the nine months ended September 30, 2013 and 2012 was $93.6 million and $2.1 million, respectively.
Stock-Based Compensation
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 on or after January 1, 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,
2013
 
September 30,
2012
 
September 30,
2013
 
September 30,
2012
Dividend yield
%
 
%
 
%
 
%
Expected volatility
51
%
 
60
%
 
51% - 54%

 
60% - 65%

Risk-free interest rate
2.55
%
 
1.61
%
 
1.87% - 2.55%

 
1.61% - 2.01%

Suboptimal exercise factor
2.43 - 3.79

 
2.27 - 3.64

 
2.33 - 3.79

 
2.26 - 3.65


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, 2013 and 2012 was $136.78 and $32.57 per share, respectively. The weighted-average fair value of employee stock options granted during the nine months ended September 30, 2013 and 2012 was $100.08 and $42.58 per share, respectively.
Stock-based compensation expense related to stock option plans was $18.5 million for each of the three months ended September 30, 2013 and 2012. Stock-based compensation expense related to stock option plans was $54.2 million and $56.3 million for the nine months ended September 30, 2013 and 2012, respectively. The total income tax benefit recognized in the income statement related to stock option plans was $7.1 million for each of the three months ended September 30, 2013 and 2012. The total income tax benefit recognized in the income statement related to stock option plans was $20.8 million and $21.7 million for the nine months ended September 30, 2013 and 2012, respectively.


8. Accumulated Other Comprehensive Income

The following tables summarize the changes in accumulated balances of other comprehensive income (loss), net of tax for the three and nine months ended September 30, 2013:
 
Foreign currency
 
Change in unrealized gains on available for sale securities
 
Total
 
(in thousands)
Balance as of June 30, 2013
$
(878
)
 
$
(786
)
 
$
(1,664
)
Other comprehensive income before reclassifications
2,409

 
340

 
2,749

Amounts reclassified from accumulated other comprehensive income

 
485

 
485

Net increase in other comprehensive income
2,409

 
825

 
3,234

Balance as of September 30, 2013
$
1,531

 
$
39

 
$
1,570



12


 
Foreign currency
 
Change in unrealized gains on available for sale securities
 
Total
 
(in thousands)
Balance as of December 31, 2012
$
1,381

 
$
1,538

 
$
2,919

Other comprehensive income before reclassifications
150

 
(2,023
)
 
(1,873
)
Amounts reclassified from accumulated other comprehensive income

 
524

 
524

Net increase (decrease) in other comprehensive income
150

 
(1,499
)
 
(1,349
)
Balance as of September 30, 2013
$
1,531

 
$
39

 
$
1,570



All amounts reclassified from accumulated other comprehensive income were related to gains (losses) on available-for-sale securities. These reclassifications impacted "Interest and other income (expense)" on the Consolidated Statements of Operations.


9. Income Taxes
The effective tax rates for each of the three months ended September 30, 2013 and 2012 was 36%. The effective tax rates for the nine months ended September 30, 2013 and 2012 were 34% and 41%, respectively. These rates differed from the federal statutory rate primarily due to the Federal and California R&D tax credits partially offset by state taxes and nondeductible expenses. The decrease in the Company's effective tax rate for the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012 was primarily due to the retroactive reinstatement of the 2012 Federal R&D credit in January 2013.

On January 2, 2013, the American Taxpayer Relief Act of 2012 (H.R. 8) was signed into law which retroactively extended the Federal R&D credit from January 1, 2012 through December 31, 2013. As a result, the Company recognized the retroactive benefit of the 2012 Federal R&D credit of approximately $3.1 million as a discrete item in the first quarter of 2013, the period in which the legislation was enacted.
Gross unrecognized tax benefits were $59.7 million and $43.3 million as of September 30, 2013 and December 31, 2012, respectively. The gross unrecognized tax benefits, if recognized by the Company, will result in a reduction of approximately $50.1 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, 2013, the total amount of gross interest and penalties accrued was $3.7 million, and is classified as “Other non-current liabilities” on the Consolidated Balance Sheets.
Deferred tax assets include $11.4 million and $11.0 million classified as “Other current assets” and $68.6 million and $56.9 million classified as “Other non-current assets” on the Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012, 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, 2013 and December 31, 2012, 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 $19.7 million and $0.1 million, during the three months ended September 30, 2013 and 2012, 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 $51.1 million and $4.2 million, during the nine months ended September 30, 2013 and 2012, 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 year 2012 remains subject to examination by the IRS. The Company is also 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.


10. Commitments and Contingencies


13


Streaming Content

The Company had $6.5 billion and $5.6 billion of obligations at September 30, 2013 and December 31, 2012, respectively, including agreements to 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 the content library asset recognition criteria. The license agreements that are not reflected on the Consolidated Balance Sheets do not meet the 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 members.
For those agreements with variable terms, the Company does not estimate the total obligation 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 license streaming content that represent current or long-term liabilities as well as obligations not reflected on the Consolidated Balance Sheets is as follows:
 
 
As of 
 
September 30,
2013
 
December 31,
2012
 
(in thousands)
Less than one year
$
2,766,597

 
$
2,299,562

Due after one year and through 3 years
2,829,201

 
2,715,294

Due after 3 years and through 5 years
803,942

 
540,346

Due after 5 years
105,611

 
78,483

Total streaming content obligations
$
6,505,351

 
$
5,633,685



The Company has licenses with certain performing rights organizations (“PROs”), and is currently involved in negotiations with other PROs, that hold certain rights to music "publicly performed" in connection with streaming content into various territories. The Company accrues for estimated royalties that are expected to be due to PROs and adjusts these accruals based on any changes in estimates. These amounts are included in "Current content liabilities" on the Company's Consolidated Balance Sheets. If the Company is unable to reach mutually acceptable terms with the PROs, it could become involved in litigation and/or could be enjoined from delivering certain musical compositions, which could adversely impact the Company. Additionally, pending and ongoing litigation between certain PROs and other third parties in various territories could impact the Company's negotiations with PROs. The results of these negotiations are uncertain and 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 alleging substantially similar claims. These lawsuits were consolidated into In re Netflix, Inc., Securities Litigation, Case No. 3:12-cv-00225-SC, and the Court selected lead plaintiffs. Lead plaintiffs filed a consolidated complaint which alleged violations of the federal securities laws on June 26, 2012. The Court dismissed the consolidated complaint with leave to amend on February 13, 2013. Lead plaintiffs filed a first amended consolidated complaint on March 22, 2013. The Court dismissed the first amended consolidated complaint with prejudice on August 20, 2013, and judgment was entered on September 27, 2013.

14


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 into In re Netflix, Inc. Shareholder Derivative Litigation, Case No. 1-12-cv-218399, and lead counsel was appointed. A consolidated complaint was filed December 4, 2012, with plaintiffs seeking compensatory damages and other relief. The consolidated complaint alleges, among other things, that certain of the Company's current and former officers and directors breached their fiduciary duties, issued false and misleading statements primarily regarding the Company's streaming business, violated accounting rules concerning segment reporting, violated provisions of the California Corporations Code, and wasted corporate assets. The consolidated complaint further alleges that the defendants caused the Company to buy back stock at artificially inflated prices to the detriment of the Company and its shareholders while contemporaneously selling personally held Company stock. The Company filed a demurrer to the consolidated complaint and a motion to stay the litigation on February 4, 2013 and on June 21, 2013, the Court granted the motion to stay the litigation. 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 consolidated financial statements with respect to these indemnification obligations.

11. Segment Information
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 revenues and contribution profit (loss) for each of the reportable segments. Contribution profit (loss) is defined as revenues less cost of revenues and marketing expenses directly incurred by the segment.
The Domestic and International streaming segments derive revenues from monthly membership services consisting solely of streaming content. The Domestic DVD segment derives revenues from monthly membership services consisting solely of DVD-by-mail. Revenues and the related credit card fees are attributed to the operating segment based on the nature of the underlying membership (DVD or streaming) and the geographic region from which the membership originates. There are no internal revenue transactions between the Company’s reporting segments.
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. Marketing expenses are primarily comprised of advertising expenses which are generally included in the segment in which the expenditures are directly incurred.
As of September 30, 2013, the Company had $4.7 million in long-lived tangible assets located internationally and $122.6 million in long-lived tangible assets located in the United States. As of December 31, 2012, the Company had $4.0 million in long-lived tangible assets located internationally and $127.7 million in long-lived tangible assets located in the United States.

15


The following tables represent segment information for the quarter ended September 30, 2013 and 2012:
 
 
As of/ Three months ended September 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
31,092

 
9,188

 
7,148

 

Revenues
$
701,083

 
$
183,051

 
$
221,865

 
$
1,105,999

Cost of revenues
470,631

 
207,989

 
112,399

 
791,019

Marketing
63,971

 
49,359

 
2,779

 
116,109

Contribution profit (loss)
$
166,481

 
$
(74,297
)
 
$
106,687

 
$
198,871

Other operating expenses
 
 
 
 
 
 
141,751

Operating income
 
 
 
 
 
 
57,120

Other income (expense)
 
 
 
 
 
 
(7,629
)
Provision for income taxes
 
 
 
 
 
 
17,669

Net income
 
 
 
 
 
 
$
31,822


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

 
4,311

 
8,606

 

Revenues
$
556,027

 
$
77,744

 
$
271,318

 
$
905,089

Cost of revenues
399,124

 
124,379

 
139,135

 
662,638

Marketing
61,197

 
45,742

 
1,509

 
108,448

Contribution profit (loss)
$
95,706

 
$
(92,377
)
 
$
130,674

 
$
134,003

Other operating expenses
 
 
 
 
 
 
117,868

Operating income
 
 
 
 
 
 
16,135

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

Net income
 
 
 
 
 
 
$
7,675

The following table represents the amortization of the content library:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
Three months ended September 30,
(in thousands)
2013
$
363,787

 
$
189,607

 
$
17,546

 
$
570,940

2012
$
296,234

 
$
114,713

 
$
13,132

 
$
424,079








16



The following tables represent segment information for the nine months ended September 30, 2013 and 2012:
 
As of/ Nine months ended September 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
31,092

 
9,188

 
7,148

 

Revenues
$
2,010,821

 
$
490,972

 
$
697,539

 
$
3,199,332

Cost of revenues
1,356,610

 
555,898

 
358,899

 
2,271,407

Marketing
205,066

 
152,124

 
9,854

 
367,044

Contribution profit (loss)
$
449,145

 
$
(217,050
)
 
$
328,786

 
$
560,881

Other operating expenses
 
 
 
 
 
 
414,822

Operating income
 
 
 
 
 
 
146,059

Other income (expense)
 
 
 
 
 
 
(48,989
)
Provision for income taxes
 
 
 
 
 
 
33,088

Net income
 
 
 
 
 
 
$
63,982

 
As of/ Nine months ended September 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members 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
1,138,474

 
324,332

 
467,193

 
1,929,999

Marketing
201,334

 
146,297

 
4,709

 
352,340

Contribution profit (loss)
$
255,589

 
$
(284,487
)
 
$
410,602

 
$
381,704

Other operating expenses
 
 
 
 
 
 
351,350

Operating income
 
 
 
 
 
 
30,354

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

Net income
 
 
 
 
 
 
$
9,255

The following table represents the amortization of the content library:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
Nine months ended September 30,
(in thousands)
2013
$
1,043,976

 
$
505,408

 
$
53,492

 
$
1,602,876

2012
$
826,254

 
$
300,426

 
$
49,482

 
$
1,176,162

The following table represents total content library, net:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
As of September 30, 2013
$
2,643,433

 
$
715,962

 
$
26,506

 
$
3,385,901

As of December 31, 2012
$
2,317,070

 
$
527,235

 
$
29,865

 
$
2,874,170




17



(1)
A membership (also referred to as a subscription) is defined as the right to receive either the Netflix streaming service or Netflix DVD service. In connection with these services, the Company offers free-trial memberships to new and certain rejoining members. For inclusion in the definition of a member in the above metrics, a method of payment is required to be provided even during the free-trial period. Total members therefore include those who are on a free-trial and have provided a method of payment. A membership would be canceled and cease to be reflected in the above metrics as of the effective cancellation date. Voluntary cancellations become effective at the end of the monthly membership period, while involuntary cancellation of the service, as a result of a failed method of payment, becomes effective immediately.


18



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, DVD and streaming member trends, cash use in connection with content acquisitions and international expansion, investments in content, including expanding investments in original content, content payments and expense, investments in marketing, free and operating cash flow and available funds, deferred tax assets, accessing and obtaining additional capital 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, 2012 filed with the Securities and Exchange Commission (“SEC”) on February 1, 2013, 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.

Investors and others should note that we announce material financial information to our investors using our investor relations website (http://ir.netflix.com), SEC filings, press releases, public conference calls and webcasts. We use these channels, as well as social media, to communicate with our subscribers and the public about our company, our services and other issues. It is possible that the information we post on social media could be deemed to be material information. Therefore, we encourage investors, the media, and others interested in our company to review the information we post on the U.S. social media channels listed on our investor relations website.

Overview
We are the world’s leading Internet television network with over 40 million streaming members in 41 countries enjoying more than one billion hours of TV shows and movies per month, including Netflix original series. Our members can watch as much as they want, anytime, anywhere, on nearly any Internet-connected screen. Additionally, in the United States ("U.S."), our members can receive standard definition DVDs, and their high definition successor, Blu-ray discs (collectively referred to as “DVD”), delivered quickly to their homes.
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 for 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. Historically, our acquisition of new members has been seasonal with the first and fourth quarters representing our strongest net member additions and our second quarter representing the lowest net member additions in a calendar year.
Our core strategy is to grow a streaming membership business domestically and internationally. We are continuously improving the member experience, with a focus on the quality of our streaming content mix, enhancing our user interface and improving the user experience on Internet-connected devices, while staying within the parameters of our consolidated net income and operating segment contribution profit targets. As we grow our streaming segments, we have shifted spending away from the Domestic DVD segment to invest more in streaming content and marketing for our streaming services.

We define contribution profit as revenues less cost of revenues and marketing expenses. We believe this is an important measure of our operating segment performance as it represents each segment's performance before discrete global corporate costs.

For the Domestic and International streaming segments, content licensing expenses, which include the amortization of the streaming content library and other expenses associated with the licensing of streaming content, represent the vast majority of cost of revenues. 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 international markets. Other cost of revenues such as content delivery expenses, customer service and payment processing fees tend to be lower as a percentage of total cost of revenues as compared to content licensing expenses. We utilize both our own and third-party content delivery networks to help us efficiently stream a high volume of content to our members over the Internet. Content delivery expenses, therefore, also include equipment costs related to our streaming content delivery network ("Open Connect") and all third-party costs associated with delivering streaming content over the Internet. Cost of revenues in the Domestic DVD segment consists primarily of content delivery, expenses related to the acquisition of content, including amortization of DVD content library and revenue sharing expenses, and other expenses associated with our DVD processing and customer service centers.

19


Content delivery expenses for the Domestic DVD segment consist of the postage costs to mail DVDs to and from our paying members and the packaging and label costs for the mailers.

For the Domestic and International streaming segments, marketing expenses consist primarily of advertising expenses and payments made to our affiliates and consumer electronics partners. 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 device partners may be in the form of a fixed fee or may be a revenue sharing payment. Marketing costs are primarily incurred by our Domestic and International streaming segments 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. We expect that the investments in content and marketing associated with the Domestic streaming segment will slow relative to revenues to allow for contribution margin expansion over time, and we have grown contribution margin from 12% when we first began separately reporting Domestic streaming results in the fourth quarter of 2011 to 24% in the third quarter of 2013. Investments in content and marketing associated with the International streaming segment will continue to fluctuate dependent upon the number of International territories in which our streaming service is offered and the timing of the launch of new territories.

Results of Operations
The following represents our consolidated performance highlights:
 
Three Months Ended
 
Change
 
September 30,
2013
 
June 30,
2013
 
September 30,
2012
 
Q3'13 vs. Q2'13
 
Q3'13 vs. Q3'12
 
(in thousands)
 
 
 
 
Revenues
$
1,105,999

 
$
1,069,372

 
$
905,089

 
3
%
 
22
%
Operating income
57,120

 
57,117

 
16,135

 
%
 
254
%
Net income
31,822

 
29,471

 
7,675

 
8
%
 
315
%

Consolidated revenues for the three months ended September 30, 2013 increased $200.9 million as compared to the three months ended September 30, 2012 and $36.6 million as compared to the three months ended June 30, 2013 due to growth in streaming members, both internationally and domestically. This increase in revenues was partially offset by an increase in the cost of revenues due to continued investments in existing and new streaming content and a change in estimate related to amortization of certain content.

When we started with original content, we did not have specific data about viewing patterns over time for content that premieres on Netflix. Based on our experience with other similar television series and our initial estimates of viewing patterns, we amortized content that premiered on our service on a straight-line basis over the shorter of four years or the license period. If a subsequent season is added, we extend the remaining amortization period by a year. Current estimates of viewing patterns indicate that viewing in the first few months is significantly higher, relative to the rest of the amortization period, than previously estimated. As a result, in the third quarter of 2013, we began amortizing this type of content on an accelerated basis over the amortization period. The effect of this change in estimate was a $20.2 million decrease in contribution profit for the Domestic streaming segment and a $6.5 million increase in contribution loss for the International streaming segment for the three and nine months ended September 30, 2013. The effect to operating income and net income is a decrease of $26.7 million and $16.7 million, respectively, for the three and nine months ended September 30, 2013. The effect to basic earnings per share and diluted earnings per share was a decrease of $0.28 and $0.27, respectively, for the three months ended September 30, 2013 and a decrease of $0.29 and $0.27, respectively for the nine months ended September 30, 2013. The effect of this change in estimate relates primarily to titles that first premiered on Netflix in the first and second quarters of 2013.


20


Domestic Streaming Segment
Three months ended September 30, 2013 as compared to the three months ended September 30, 2012
 
 
As of/ Three Months Ended
 
Change
 
 
September 30,
2013
 
September 30,
2012
 
Q3'13 vs. Q3'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
1,285

 
1,163

 
10
%
Members at end of period
 
31,092

 
25,101

 
24
%
Paid members at end of period
 
29,925

 
23,801

 
26
%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
701,083

 
$
556,027

 
26
%
Cost of revenues
 
470,631

 
399,124

 
18
%
Marketing
 
63,971

 
61,197

 
5
%
Contribution profit
 
166,481

 
95,706

 
74
%
Contribution margin
 
24
%
 
17
%
 
 



In the Domestic streaming segment, we derive revenues from services consisting solely of streaming content offered through a membership plan priced primarily at $7.99 per month. The $145.1 million increase in our domestic streaming revenues was due to the 26% growth in the average number of paid memberships.
The $71.5 million increase in domestic streaming cost of revenues was primarily due to the $58.3 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content as well as the impact of revised amortization (detailed above) for content premiering on Netflix. In addition, content delivery expenses increased by $5.2 million and other costs, such as payment processing fees and customer service call centers, increased $8.0 million due to our growing member base.
Marketing expenses increased $2.8 million primarily due to an increase in advertising, partially offset by a decrease in payments made to our affiliates.
Our Domestic streaming segment had a contribution margin of 24% for the three months ended September 30, 2013, which increased as compared to the contribution margin of 17% for the three months ended September 30, 2012, as a result of growing memberships and revenue faster than content spending.
Nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012
 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2013
 
September 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
3,946

 
3,430

 
15
%
Members at end of period
 
31,092

 
25,101

 
24
%
Paid members at end of period
 
29,925

 
23,801

 
26
%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
2,010,821

 
$
1,595,397

 
26
%
Cost of revenues
 
1,356,610

 
1,138,474

 
19
%
Marketing
 
205,066

 
201,334

 
2
%
Contribution profit
 
449,145

 
255,589

 
76
%
Contribution margin
 
22
%
 
16
%
 
 


21



The $415.4 million increase in our domestic streaming revenues was due to the 26% growth in the average number of paid memberships.
The $218.1 million increase in domestic streaming cost of revenues was primarily due to the $173.3 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content as well as the impact of revised amortization (detailed above) for content premiering on Netflix. In addition, content delivery expenses increased by $20.6 million and other costs, such as payment processing fees and customer service call centers, increased $24.2 million due to our growing member base.
Our Domestic streaming segment had a contribution margin of 22% for the nine months ended September 30, 2013, which increased as compared to the contribution margin of 16% for the nine months ended September 30, 2012, as a result of growing memberships and revenue faster than content spending.
Three months ended September 30, 2013 as compared to the three months ended June 30, 2013
 
 
As of /Three Months Ended
 
Change
 
 
September 30,
2013
 
June 30,
2013
 
Q3'13 vs. Q2'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
1,285

 
633

 
103
 %
Members at end of period
 
31,092

 
29,807

 
4
 %
Paid members at end of period
 
29,925

 
28,624

 
5
 %
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
701,083

 
$
671,089

 
4
 %
Cost of revenues
 
470,631

 
449,473

 
5
 %
Marketing
 
63,971

 
70,302

 
(9
)%
Contribution profit
 
166,481

 
151,314

 
10
 %
Contribution margin
 
24
%
 
23
%
 
 

The $30.0 million increase in our domestic streaming revenues was due to the 4% growth in the average number of paid memberships. We expect domestic streaming memberships to continue to grow.
The $21.2 million increase in domestic streaming cost of revenues was primarily due to the $19.9 million increase in content licensing expenses. This increase was primarily attributable to the impact of revised amortization (detailed above) for content premiering on Netflix. Other costs increased $1.3 million primarily due to an increase in payment processing fees and costs associated with customer service call centers due to our growing member base.
Marketing expenses decreased $6.3 million primarily due to a decrease in advertising.
Our Domestic streaming segment had a contribution margin of 24% for the three months ended September 30, 2013, which increased as compared to the contribution margin of 23% for the three months ended June 30, 2013, as a result of growing memberships and revenue coupled with a decrease in growth in marketing. We expect that contribution margin for the Domestic streaming segment in the fourth quarter of 2013 will be roughly flat as compared to the third quarter of 2013 but will increase as compared to the fourth quarter of 2012.


22


International Streaming Segment
Three months ended September 30, 2013 as compared to the three months ended September 30, 2012
 
 
As of /Three Months Ended
 
Change
 
 
September 30,
2013
 
September 30,
2012
 
Q3'13 vs. Q3'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
1,441

 
687

 
110
 %
Members at end of period
 
9,188

 
4,311

 
113
 %
Paid members at end of period
 
8,084

 
3,689

 
119
 %
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
183,051

 
$
77,744

 
135
 %
Cost of revenues
 
207,989

 
124,379

 
67
 %
Marketing
 
49,359

 
45,742

 
8
 %
Contribution loss
 
(74,297
)
 
(92,377
)
 
(20
)%

In the International streaming segment, we derive revenues from services consisting of streaming content offered through a membership plan priced at the equivalent of USD $7 to $14 per month. We launched our streaming service in Canada in September 2010 and have continuously expanded our services internationally with launches in Latin America in September 2011, the U.K. and Ireland in January 2012, Finland, Denmark, Sweden and Norway in October 2012 and most recently the Netherlands in September 2013.
The $105.3 million increase in our international revenues was primarily due to the 125% growth in the average number of paid international memberships. International streaming memberships account for 23% of total streaming memberships as of September 30, 2013 as compared to 15% as of September 30, 2012. We expect international streaming memberships to continue to grow.
The $83.6 million increase in international cost of revenues was primarily due to a $77.2 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content, including content to support the launch of our service in the Nordics and the Netherlands, as well as the impact of revised amortization (detailed above) for content premiering on Netflix. Other costs increased $6.4 million due to an increase in content delivery expenses, payment processing fees, and costs associated with our customer service call centers, all driven by our growing member base.
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. International marketing expenses for the three months ended September 30, 2013 increased $3.6 million as compared to the three months ended September 30, 2012 due to our expansion in the Nordic regions and the Netherlands, offset partially by a decrease in spending in other territories.
Our International streaming segment had a contribution loss of $74.3 million for the three months ended September 30, 2013, which decreased as compared to the contribution loss of $92.4 million for the three months ended September 30, 2012, as a result of growing memberships and revenues faster than content spending.

23


Nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012
 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2013
 
September 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
3,067

 
2,453

 
25
 %
Members at end of period
 
9,188

 
4,311

 
113
 %
Paid members at end of period
 
8,084

 
3,689

 
119
 %
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
490,972

 
$
186,142

 
164
 %
Cost of revenues
 
555,898

 
324,332

 
71
 %
Marketing
 
152,124

 
146,297

 
4
 %
Contribution loss
 
(217,050
)
 
(284,487
)
 
(24
)%

The $304.8 million increase in our international revenues was primarily due to the 148% growth in the average number of paid international memberships.
The $231.6 million increase in international cost of revenues was primarily due to a $211.8 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content including content to support the launch of our service in the Nordics and the Netherlands. Other costs increased $19.8 million due to an increase in content delivery expenses, payment processing fees, and costs associated with our customer service call centers, all driven by our growing member base.
International marketing expenses for the nine months ended September 30, 2013 increased $5.8 million as compared to the nine months ended September 30, 2012 due to our expansion in the Nordic regions and the Netherlands offset partially by a decrease in spending in other territories.
Our International streaming segment had a contribution loss of $217.1 million for the nine months ended September 30, 2013, which decreased as compared to the contribution loss of $284.5 million for the nine months ended September 30, 2012, as a result of growing memberships and revenues faster than content spending.
Three months ended September 30, 2013 as compared to the three months ended June 30, 2013
 
 
As of /Three Months Ended
 
Change
 
 
September 30,
2013
 
June 30,
2013
 
Q3'13 vs. Q2'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
1,441

 
605

 
138
%
Members at end of period
 
9,188

 
7,747

 
19
%
Paid members at end of period
 
8,084

 
7,014

 
15
%
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
183,051

 
$
165,902

 
10
%
Cost of revenues
 
207,989

 
182,885

 
14
%
Marketing
 
49,359

 
48,850

 
1
%
Contribution loss
 
(74,297
)
 
(65,833
)
 
13
%
The $17.1 million increase in our international revenues was primarily due to the 13% growth in the average number of paid international memberships.

The $25.1 million increase in international cost of revenues was primarily due to a $23.6 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content, including content to

24


support the launch of our service in the Netherlands, as well as the impact of revised amortization (detailed above) for content premiering on Netflix.
International marketing expenses were relatively flat, primarily due to an increase in marketing spend for the launch of the Netherlands offset by a decrease in spending in other territories.
International contribution losses increased $8.5 million sequentially, due to an increase in content spending as compared to the growth in revenues. Our International streaming segment does not benefit from the established member base that exists for the Domestic segments. As a result of having to build a member base from zero, investments in streaming content and marketing programs for our International segment are larger initially relative to revenues, in particular as new territories are launched. The contribution losses for our International segment have been significant due to investments in streaming content and marketing programs to drive membership growth and viewing in our international markets.
Domestic DVD Segment
Three months ended September 30, 2013 as compared to the three months ended September 30, 2012
 
 
As of/ Three Months Ended
 
Change
 
 
September 30,
2013
 
September 30,
2012
 
Q3'13 vs. Q3'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(360
)
 
(634
)
 
(43
)%
Members at end of period
 
7,148

 
8,606

 
(17
)%
Paid members at end of period
 
7,014

 
8,465

 
(17
)%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
221,865

 
$
271,318

 
(18
)%
Cost of revenues
 
112,399

 
139,135

 
(19
)%
Marketing
 
2,779

 
1,509

 
84
 %
Contribution profit
 
106,687

 
130,674

 
(18
)%
Contribution margin
 
48
%
 
48
%
 
 

In the Domestic DVD segment, we derive revenues from our DVD-by-mail membership services. The price per plan for DVD-by-mail varies from $4.99 to $43.99 per month according to the plan chosen by the member. DVD-by-mail plans differ by the number of DVDs that a member 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.
The $49.5 million decrease in our domestic DVD revenues was due to an 18% decrease in the average number of paid memberships.
The $26.7 million decrease in domestic DVD cost of revenues was primarily due to a $13.0 million decrease in content acquisition expenses and a $9.4 million decrease in content delivery expenses resulting from an 18% decrease in the number of DVDs mailed to paying members. The decrease in shipments was driven by a decline in the number of DVD memberships.
Our Domestic DVD segment had a contribution margin of 48% for the three months ended September 30, 2013, and is flat as compared to the three months ended September 30, 2012.
Nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012

25


 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2013
 
September 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(1,076
)
 
(2,559
)
 
(58
)%
Members at end of period
 
7,148

 
8,606

 
(17
)%
Paid members at end of period
 
7,014

 
8,465

 
(17
)%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
697,539

 
$
882,504

 
(21
)%
Cost of revenues
 
358,899

 
467,193

 
(23
)%
Marketing
 
9,854

 
4,709

 
109
 %
Contribution profit
 
328,786

 
410,602

 
(20
)%
Contribution margin
 
47
%
 
47
%
 
 


The $185.0 million decrease in our domestic DVD revenues was primarily due to a 21% decrease in the average number of paid memberships.
The $108.3 million decrease in domestic DVD cost of revenues was primarily due to a $55.9 million decrease in content acquisition expenses and a $38.9 million decrease in content delivery expenses resulting from a 21% decrease in the number of DVDs mailed to paying members. The decrease in shipments was driven by a decline in the number of DVD memberships. Other costs, primarily those associated with content processing and customer service center expenses, decreased $13.5 million primarily due to a decrease in hub operation expenses resulting from the decline in DVD shipments.
Our Domestic DVD segment had a contribution margin of 47% for the nine months ended September 30, 2013, and is flat as compared to the nine months ended September 30, 2012.
Three months ended September 30, 2013 as compared to the three months ended June 30, 2013
 
 
As of /Three Months Ended
 
Change
 
 
September 30,
2013
 
June 30,
2013
 
Q3'13 vs. Q2'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(360
)
 
(475
)
 
(24
)%
Members at end of period
 
7,148

 
7,508

 
(5
)%
Paid members at end of period
 
7,014

 
7,369

 
(5
)%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
221,865

 
$
232,381

 
(5
)%
Cost of revenues
 
112,399

 
121,167

 
(7
)%
Marketing
 
2,779

 
2,608

 
7
 %
Contribution profit
 
106,687

 
108,606

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