10-Q 1 nflx-63014x10qxdoc.htm 10-Q NFLX-6.30.14-10Q-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 June 30, 2014
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: 001-35727
 
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 June 30, 2014, there were 60,091,015 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
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Revenues
$
1,340,407

 
$
1,069,372

 
$
2,610,496

 
$
2,093,333

Cost of revenues
914,848

 
760,674

 
1,784,034

 
1,497,626

Marketing
120,763

 
114,611

 
257,861

 
233,697

Technology and development
115,182

 
93,126

 
225,492

 
185,101

General and administrative
60,014

 
43,844

 
115,914

 
87,970

Operating income
129,600

 
57,117

 
227,195

 
88,939

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(13,328
)
 
(7,528
)
 
(23,380
)
 
(14,268
)
Interest and other income (expense)
1,100

 
(2,940
)
 
2,501

 
(1,963
)
Loss on extinguishment of debt

 

 

 
(25,129
)
Income before income taxes
117,372

 
46,649

 
206,316

 
47,579

Provision for income taxes
46,354

 
17,178

 
82,183

 
15,419

Net income
$
71,018

 
$
29,471

 
$
124,133

 
$
32,160

Earnings per share:
 
 
 
 
 
 
 
Basic
$
1.18

 
$
0.51

 
$
2.07

 
$
0.56

Diluted
$
1.15

 
$
0.49

 
$
2.02

 
$
0.53

Weighted-average common shares outstanding:
 
 
 
 
 
 
 
Basic
59,996

 
58,192

 
59,907

 
57,089

Diluted
61,634

 
60,590

 
61,592

 
60,369













See accompanying notes to the consolidated financial statements.

3


NETFLIX, INC.
Consolidated Statements of Comprehensive Income
(unaudited)
(in thousands)
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Net income
$
71,018

 
$
29,471

 
$
124,133

 
$
32,160

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments 
1,918

 
30

 
2,379

 
(2,259
)
Change in unrealized gains (losses) on available-for-sale securities, net of tax of $51, $(1,239), $342, and $(1,451), respectively
81

 
(1,985
)
 
548

 
(2,324
)
Total other comprehensive income (loss)
1,999

 
(1,955
)
 
2,927

 
(4,583
)
Comprehensive income
$
73,017

 
$
27,516

 
$
127,060

 
$
27,577

























See accompanying notes to the consolidated financial statements.

4


NETFLIX, INC.

Consolidated Statements of Cash Flows
(unaudited)
(in thousands)
   
Three Months Ended
 
Six Months Ended
   
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
71,018

 
$
29,471

 
$
124,133

 
$
32,160

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 
 
Additions to streaming content library
(813,314
)
 
(593,454
)
 
(1,562,713
)
 
(1,185,395
)
Change in streaming content liabilities
78,359

 
7,284

 
120,603

 
16,984

Amortization of streaming content library
639,037

 
510,250

 
1,239,772

 
995,990

Amortization of DVD content library
16,923

 
17,709

 
33,044

 
35,946

Depreciation and amortization of property, equipment and intangibles
12,977

 
12,026

 
25,359

 
24,077

Stock-based compensation expense
29,285

 
17,955

 
55,110

 
35,701

Excess tax benefits from stock-based compensation
(14,628
)
 
(20,368
)
 
(47,360
)
 
(31,983
)
Other non-cash items
3,251

 
1,188

 
5,447

 
2,938

Loss on extinguishment of debt

 

 

 
25,129

Deferred taxes
(16,569
)
 
(2,040
)
 
(29,672
)
 
(8,788
)
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
Other current assets
(20,685
)
 
33,762

 
14,381

 
28,035

Accounts payable
(3,086
)
 
(5,138
)
 
19,726

 
11,881

Accrued expenses
59,008

 
10,494

 
58,566

 
6,362

Deferred revenue
11,315

 
7,693

 
25,563

 
17,099

Other non-current assets and liabilities
3,133

 
7,111

 
10,424

 
15,557

Net cash provided by operating activities
56,024

 
33,943

 
92,383

 
21,693

Cash flows from investing activities:
 
 
 
 
 
 
 
Acquisition of DVD content library
(20,981
)
 
(14,023
)
 
(35,895
)
 
(35,216
)
Purchases of property and equipment
(19,869
)
 
(8,088
)
 
(33,203
)
 
(20,206
)
Other assets
1,129

 
1,087

 
1,424

 
5,137

Purchases of short-term investments
(170,908
)
 
(146,050
)
 
(231,454
)
 
(381,673
)
Proceeds from sale of short-term investments
89,662

 
33,979

 
232,710

 
115,207

Proceeds from maturities of short-term investments
92,014

 
5,410

 
95,104

 
9,830

Net cash (used in) provided by investing activities
(28,953
)
 
(127,685
)
 
28,686

 
(306,921
)
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from issuance of common stock
14,469

 
28,846

 
46,917

 
67,992

Proceeds from issuance of debt

 

 
400,000

 
500,000

Issuance costs
(353
)
 

 
(7,080
)
 
(9,414
)
Redemption of debt

 

 

 
(219,362
)
Excess tax benefits from stock-based compensation
14,628

 
20,368

 
47,360

 
31,983

Principal payments of lease financing obligations
(271
)
 
(255
)
 
(538
)
 
(658
)
Net cash provided by financing activities
28,473

 
48,959

 
486,659

 
370,541

Effect of exchange rate changes on cash and cash equivalents
1,250

 
(2,590
)
 
1,551

 
(4,926
)
Net increase (decrease) in cash and cash equivalents
56,794

 
(47,373
)
 
609,279

 
80,387

Cash and cash equivalents, beginning of period
1,157,450

 
418,051

 
604,965

 
290,291

Cash and cash equivalents, end of period
$
1,214,244

 
$
370,678

 
$
1,214,244

 
$
370,678


See accompanying notes to the consolidated financial statements.

5


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

 
As of
   
June 30,
2014
 
December 31,
2013
 
(unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,214,244

 
$
604,965

Short-term investments
500,121

 
595,440

Current content library, net
1,786,341

 
1,706,421

Other current assets
167,674

 
151,937

Total current assets
3,668,380

 
3,058,763

Non-current content library, net
2,348,796

 
2,091,071

Property and equipment, net
141,715

 
133,605

Other non-current assets
166,931

 
129,124

Total assets
$
6,325,822

 
$
5,412,563

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Current content liabilities
$
1,858,020

 
$
1,775,983

Accounts payable
137,226

 
108,435

Accrued expenses
98,548

 
54,018

Deferred revenue
241,330

 
215,767

Total current liabilities
2,335,124

 
2,154,203

Non-current content liabilities
1,390,770

 
1,345,590

Long-term debt
900,000

 
500,000

Other non-current liabilities
90,223

 
79,209

Total liabilities
4,716,117

 
4,079,002

Commitments and contingencies (Note 10)


 


Stockholders’ equity:
 
 
 
Common stock, $0.001 par value; 160,000,000 shares authorized at June 30, 2014 and December 31, 2013; 60,091,015 and 59,607,001 issued and outstanding at June 30, 2014 and December 31, 2013, respectively
60

 
60

Additional paid-in capital
926,525

 
777,441

Accumulated other comprehensive income
6,502

 
3,575

Retained earnings
676,618

 
552,485

Total stockholders’ equity
1,609,705

 
1,333,561

Total liabilities and stockholders’ equity
$
6,325,822

 
$
5,412,563





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, 2013 filed with the Securities and Exchange Commission (the “SEC”) on February 3, 2014. 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, the Company evaluates the 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, 2013. 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. A majority of the Company’s revenues are generated in the United States, and substantially all of the Company’s long-lived tangible assets are held in the United States. 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, 2013.
In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update ("ASU") 2014-09, Revenue from Contracts with Customers (Topic 606) which amended the existing accounting standards for revenue recognition. ASU 2014-09 establishes principles for recognizing revenue upon the transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. It is effective for annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. The amendments may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of initial application. The Company is currently in the process of evaluating the impact of adoption of the ASU on its consolidated financial statements, but does not expect the impact to be material.

2. Reclassifications
Certain prior year amounts have been reclassified to conform to the current year presentation in the consolidated financial statements.
Costs of revenues in the amount of $7.1 million and $17.2 million for the three and six months ended June 30, 2013, respectively, related to free-trial periods that were previously allocated to “Marketing” on the Consolidated Statements of Operations have been reallocated to “Cost of revenues”. There was no impact to contribution profit or net income in any period presented and there was no impact to the Consolidated Balance Sheets or Consolidated Statements of Cash Flows.

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 in April 2013) and incremental shares issuable upon the assumed exercise of stock options. The computation of earnings per share is as follows:

7


 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
 
(in thousands, except per share data)
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
71,018

 
$
29,471

 
$
124,133

 
$
32,160

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
59,996

 
58,192

 
59,907

 
57,089

Basic earnings per share
$
1.18

 
$
0.51

 
$
2.07

 
$
0.56

 
 
 
 
 
 
 
 
Diluted earnings per share:
 
 
 
 
 
 
 
Net income
$
71,018

 
$
29,471

 
$
124,133

 
$
32,160

Senior Convertible Notes interest expense, net of tax

 

 

 
49

Numerator for diluted earnings per share
$
71,018

 
$
29,471

 
$
124,133

 
$
32,209

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
59,996

 
58,192

 
59,907

 
57,089

Senior Convertible Notes shares

 
564

 

 
1,442

Employee stock options
1,638

 
1,834

 
1,685

 
1,838

Weighted-average number of shares
61,634

 
60,590

 
61,592

 
60,369

Diluted earnings per share
$
1.15

 
$
0.49

 
$
2.02

 
$
0.53


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
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
 
(in thousands)
Employee stock options
99

 
318

 
70

 
384



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 tables summarize, 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 June 30, 2014
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
1,113,853

 
$

 
$

 
$
1,113,853

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
106,094

 

 

 
106,094

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
309,328

 
1,266

 
(17
)
 
310,577

Government securities
163,871

 
311

 
(1
)
 
164,181

Asset backed securities
1,534

 
1

 

 
1,535

Certificate of deposits and commercial paper
23,828

 

 

 
23,828

Total (1)
$
1,718,508

 
$
1,578

 
$
(18
)
 
$
1,720,068


 
As of December 31, 2013
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
483,959

 
$

 
$

 
$
483,959

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
126,208

 

 

 
126,208

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
316,465

 
1,245

 
(654
)
 
317,056

Government securities
143,812

 
287

 
(18
)
 
144,081

Asset and mortgage-backed securities
93,118

 
229

 
(418
)
 
92,929

Certificate of deposits
23,425

 

 

 
23,425

Agency securities
17,951

 

 
(2
)
 
17,949

Total (2)
$
1,204,938

 
$
1,761

 
$
(1,092
)
 
$
1,205,607


(1)
Includes $1,214.2 million that is included in cash and cash equivalents, $500.1 million included in short-term investments and $5.7 million of restricted cash that is included in other non-current assets related to workers compensation deposits.
(2)
Includes $605.0 million that is included in cash and cash equivalents, $595.4 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.

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.

There were no investments in a material unrealized loss position as of June 30, 2014 or December 31, 2013. There were no material other-than-temporary impairments or credit losses related to available-for-sale securities in the three and six months ended June 30, 2014 and 2013. In addition, there were no material gross realized gains or losses in the three and six months ended June 30, 2014 and 2013.

9


The estimated fair value of short-term investments by contractual maturity as of June 30, 2014 is as follows:
 
(in thousands)
Due within one year
$
134,965

Due after one year and through 5 years
365,156

Total short-term investments
$
500,121



5. Balance Sheet Components
Content Library
Content library consisted of the following:
 
 
As of
 
June 30,
2014
 
December 31,
2013
 
(in thousands)
Total content library, gross
$
7,347,867

 
$
6,474,688

Accumulated amortization
(3,212,730
)
 
(2,677,196
)
Total content library, net
4,135,137

 
3,797,492

Current content library, net
1,786,341

 
1,706,421

Non-current content library, net
$
2,348,796

 
$
2,091,071


Property and Equipment, Net
Property and equipment and accumulated depreciation consisted of the following:
 
 
 
As of
 
 
 
June 30,
2014
 
December 31,
2013
 
 
 
(in thousands)
Computer equipment
 
3 years
$
125,264

 
$
102,867

Operations and other equipment
 
5 years
94,109

 
96,361

Software
 
3 years
36,249

 
36,439

Furniture and fixtures
 
3 years
24,010

 
21,011

Building
 
30 years
40,681

 
40,681

Leasehold improvements
 
Over life of lease
54,343

 
51,194

Capital work-in-progress
 
 
12,149

 
8,643

Property and equipment, gross
 
 
386,805

 
357,196

Less: Accumulated depreciation
 
 
(245,090
)
 
(223,591
)
Property and equipment, net
 
 
$
141,715

 
$
133,605



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.
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

10


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.
5.375% 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 June 30, 2014 and December 31, 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 June 30, 2014 and December 31, 2013 was approximately $523.8 million and $506.3 million, respectively.
5.750% Senior Notes

In February 2014, the Company issued $400.0 million aggregate principal amount of 5.750% Senior Notes due 2024 (the "5.750% Notes"). The 5.750% Notes were issued at par and are senior unsecured obligations of the Company. Interest is payable semi-annually at a rate of 5.750% per annum on March 1 and September 1 of each year, commencing on September 1, 2014. The 5.750% 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 5.750% 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 5.750% 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 June 30, 2014 the Company was in compliance with these covenants.
Based on quoted market prices in less active markets (a Level 2 input for this financial instrument), the fair value of the 5.750% Notes as of June 30, 2014 was approximately $418.0 million.


7. 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 June 30, 2014, 3.1 million shares were reserved for future grants under the 2011 Stock Plan.

11


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, 2013
3,406,317

 
3,526,898

 
$
95.25

 
 
 
 
Granted
(265,146
)
 
265,146

 
387.16

 
 
 
 
Exercised


 
(484,014
)
 
96.93

 
 
 
 
Balances as of June 30, 2014
3,141,171

 
3,308,030

 
118.40

 
5.94
 
$
1,066,052

Vested and exercisable at June 30, 2014
 
 
3,308,030

 
118.40

 
5.94
 
$
1,066,052


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 second quarter of 2014 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 June 30, 2014. 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 June 30, 2014 and 2013 was $46.2 million and $68.3 million, respectively. The total intrinsic value of options exercised for the six months ended June 30, 2014 and 2013 was $147.7 million and $118.3 million, respectively.
Cash received from option exercises for the three months ended June 30, 2014 and 2013 was $14.5 million and $28.8 million, respectively. Cash received from option exercises for the six months ended June 30, 2014 and 2013 was $46.9 million and $68.0 million, respectively.
Stock-Based Compensation
The following table summarizes the assumptions used to value stock option grants using the lattice-binomial model:
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
June 30,
2013
 
June 30,
2014
 
June 30,
2013
Dividend yield
%
 
%
 
%
 
%
Expected volatility
45
%
 
53
%
 
45% - 48%

 
 53% - 54%

Risk-free interest rate
2.66
%
 
1.88
%
 
2.66% - 2.83%

 
1.87% - 1.88%

Suboptimal exercise factor
2.66 - 4.20

 
2.39 - 3.61

 
2.66 - 4.20

 
2.33 - 3.61


The Company bifurcates its option grants into two employee groupings (executive and non-executive) and considers several factors, including the historical option exercise behavior, the contractual terms and vesting periods of the options granted, in determining the suboptimal exercise factor.
The weighted-average fair value of employee stock options granted during the three months ended June 30, 2014 and 2013 was $196.93 and $110.67 per share, respectively. The weighted-average fair value of employee stock options granted during the six months ended June 30, 2014 and 2013 was $207.85 and $87.87 per share, respectively.
Stock-based compensation expense related to stock option plans was $29.3 million and $18.0 million for the three months ended June 30, 2014 and 2013, respectively. Stock-based compensation expense related to stock option plans was $55.1 million and $35.7 million for the six months ended June 30, 2014 and 2013, respectively. The total income tax benefit recognized in the income statement related to stock option plans was $11.2 million and $6.9 million for the three months ended June 30, 2014 and 2013, respectively. The total income tax benefit recognized in the income statement related to stock option plans was $21.1 million and $13.7 million for the six months ended June 30, 2014 and 2013, respectively.


8. Accumulated Other Comprehensive Income

The following tables summarize the changes in accumulated balances of other comprehensive income, net of tax for the three and six months ended June 30, 2014:

12


 
Foreign currency
 
Change in unrealized gains on available-for-sale securities
 
Total
 
(in thousands)
Balance as of March 31, 2014
$
3,614

 
$
889

 
$
4,503

Other comprehensive income before reclassifications
1,918

 
151

 
2,069

Amounts reclassified from accumulated other comprehensive income

 
(70
)
 
(70
)
Net increase in other comprehensive income
1,918

 
81

 
1,999

Balance as of June 30, 2014
$
5,532

 
$
970

 
$
6,502


 
Foreign currency
 
Change in unrealized gains on available-for-sale securities
 
Total
 
(in thousands)
Balance as of December 31, 2013
$
3,153

 
$
422

 
$
3,575

Other comprehensive income before reclassifications
2,379

 
798

 
3,177

Amounts reclassified from accumulated other comprehensive income

 
(250
)
 
(250
)
Net increase in other comprehensive income
2,379

 
548

 
2,927

Balance as of June 30, 2014
$
5,532

 
$
970

 
$
6,502


All amounts reclassified from accumulated other comprehensive income were related to gains 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 the three months ended June 30, 2014 and 2013 were 39% and 37%, respectively. The effective tax rates for the six months ended June 30, 2014 and 2013 were 40% and 32%, respectively. The effective tax rates for the three and six months ended June 30, 2014 differed from the federal statutory rate primarily due to state taxes, foreign taxes and nondeductible expenses. The effective tax rates for the three and six months ended June 30, 2013 differed from the federal statutory rate primarily due to state taxes, foreign taxes and nondeductible expenses offset by a discrete benefit recorded for Federal R&D credit. 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.
The increase in our effective tax rates for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013 was primarily attributable to the expiration of the Federal R&D tax credit on December 31, 2013. The increase in our effective tax rates for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013 was primarily attributable to the expiration of the Federal R&D tax credit on December 31, 2013 and from the discrete item recorded in the first quarter of 2013 related to the retroactive benefit of the 2012 Federal R&D credit.
Gross unrecognized tax benefits were $78.6 million and $68.2 million as of June 30, 2014 and December 31, 2013, respectively. The gross unrecognized tax benefits, if recognized by the Company, will result in a reduction of approximately $65.4 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 June 30, 2014, the total amount of gross interest and penalties accrued was $4.4 million, and is classified as “Other non-current liabilities” on the Consolidated Balance Sheets.
Deferred tax assets include $19.0 million and $21.5 million classified as “Other current assets” and $100.9 million and $69.1 million classified as “Other non-current assets” on the Consolidated Balance Sheets as of June 30, 2014 and December 31, 2013, 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 June 30, 2014 and December 31, 2013, 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 $14.6 million and $20.2 million, during the three months ended June 30, 2014 and 2013, 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 $47.1 million and $31.5 million, during the six months ended June 30, 2014 and 2013, respectively, were recorded directly to "Additional paid-in capital" on the Consolidated Balance Sheets.

13


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 IRS has completed its Field Exam of the 2008 and 2009 federal tax returns and has issued a Revenue Agent Report with a proposed assessment primarily related to the Company's R&D Credits claimed in those years. The Company has filed a protest against the proposed assessment and is currently in the midst of the IRS Appeals process. The IRS Field Exam of the 2010 and 2011 federal tax returns is in process. The 2012 federal tax return 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. California has completed its Field Exam of the 2006 and 2007 California tax returns and has issued a Notice of Proposed Assessment primarily related to our R&D Credits claimed in those years. The Company has filed a protest against the proposed assessment and is currently awaiting the commencement of the Protest process with the Franchise Tax Board. The years 1997 through 2005, as well as 2008 through 2012, remain subject to examination by the state of California.
The Company is currently not under examination in any foreign jurisdiction. The years 2011 through 2013 remain subject to examination by foreign jurisdictions.
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

Streaming Content
At June 30, 2014, the Company had $7.7 billion of obligations comprised of $1.8 billion included in "Current content liabilities" and $1.4 billion of "Non-current content liabilities" on the Consolidated Balance Sheets and $4.5 billion of obligations that are not reflected on the Consolidated Balance Sheets.
At December 31, 2013, the Company had $7.3 billion of obligations comprised of $1.8 billion included in "Current content liabilities" and $1.3 billion of "Non-current content liabilities" on the Consolidated Balance Sheets and $4.2 billion of obligations that are not reflected on the Consolidated Balance Sheets.
The expected timing of payments for these streaming content obligations is as follows:
 
As of 
 
June 30,
2014
 
December 31,
2013
 
(in thousands)
Less than one year
$
3,304,367

 
$
2,972,325

Due after one year and through 3 years
3,732,380

 
3,266,907

Due after 3 years and through 5 years
653,408

 
929,645

Due after 5 years
37,895

 
83,284

Total streaming content obligations
$
7,728,050

 
$
7,252,161


A streaming content obligation is incurred at the time the Company enters into a license agreement to obtain future titles. Once a title becomes available, a content liability is generally recorded on the Consolidated Balance Sheets. Certain agreements include the obligation to license rights for unknown future titles, the ultimate quantity and / or fees for which are not yet determinable as of the reporting date. Because the amount is not reasonably estimable, the Company does not include any estimated obligation for these future titles beyond the known minimum amount. However, the unknown obligations are expected to be significant and the expected timing of payments could range from less than one year to more than five years.
The Company has entered into certain licenses with performing rights organizations ("PROs"), and is currently involved in negotiations with other PROs, that hold certain rights to music and other entertainment works "publicly performed" in connection with streaming content into various territories. Accruals for estimated license fees are recorded and then adjusted based on any change in estimates. These amounts are included in the streaming content obligations. 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 subject 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

14


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. On June 26, 2012, lead plaintiffs filed a consolidated complaint which alleged violations of the federal securities laws. 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. Lead plaintiffs filed a motion to alter or amend the judgment and requested leave to file a second amended complaint on October 25, 2013. On January 17, 2014, the Court denied that motion. On February 18, 2014, plaintiffs appealed that decision to the Unites States Court of Appeals for the Ninth Circuit. 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 into In re Netflix, Inc. Shareholder Derivative Litigation, Case No. 1-12-cv-218399, and lead counsel was appointed. A consolidated complaint was filed on 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 derivative litigation in favor of the related federal securities class action on February 4, 2013. On June 21, 2013, the Court granted the motion to stay the derivative litigation pending resolution of the related federal securities class action. 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 fees for services consisting solely of streaming content. The Domestic DVD segment derives revenues from monthly membership fees for services consisting solely of DVD-by-

15


mail. Revenues and the related payment card fees are attributed to the operating segment based on the nature of the underlying membership (streaming or DVD) 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.
The Company's long-lived tangible assets were located as follows:
 
As of
 
June 30,
2014
 
December 31,
2013
 
(in thousands)
United States
$
133,451

 
$
126,455

International
8,264

 
7,150

The following tables represent segment information for the quarter ended June 30, 2014:
 
 
As of/ Three months ended June 30, 2014
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
36,244

 
13,801

 
6,261

 

Revenues
$
838,225

 
$
307,461

 
$
194,721

 
$
1,340,407

Cost of revenues
546,223

 
266,697

 
101,928

 
914,848

Marketing
64,727

 
56,036

 

 
120,763

Contribution profit (loss)
$
227,275

 
$
(15,272
)
 
$
92,793

 
$
304,796

Other operating expenses
 
 
 
 
 
 
175,196

Operating income
 
 
 
 
 
 
129,600

Other income (expense)
 
 
 
 
 
 
(12,228
)
Provision for income taxes
 
 
 
 
 
 
46,354

Net income
 
 
 
 
 
 
$
71,018

 
As of/ Six months ended June 30, 2014
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
36,244

 
13,801

 
6,261

 

Revenues
$
1,636,842

 
$
574,579

 
$
399,075

 
$
2,610,496

Cost of revenues
1,063,317

 
511,964

 
208,753

 
1,784,034

Marketing
144,985

 
112,876

 

 
257,861

Contribution profit (loss)
$
428,540

 
$
(50,261
)
 
$
190,322

 
$
568,601

Other operating expenses
 
 
 
 
 
 
341,406

Operating income
 
 
 
 
 
 
227,195

Other income (expense)
 
 
 
 
 
 
(20,879
)
Provision for income taxes
 
 
 
 
 
 
82,183

Net income
 
 
 
 
 
 
$
124,133




16


The following tables represent segment information for the quarter ended June 30, 2013:
 
As of/ Three months ended June 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
29,807

 
7,747

 
7,508

 

Revenues
$
671,089

 
$
165,902

 
$
232,381

 
$
1,069,372

Cost of revenues
452,598

 
184,400

 
123,676

 
760,674

Marketing
67,177

 
47,335

 
99

 
114,611

Contribution profit (loss)
$
151,314

 
$
(65,833
)
 
$
108,606

 
$
194,087

Other operating expenses
 
 
 
 
 
 
136,970

Operating income
 
 
 
 
 
 
57,117

Other income (expense)
 
 
 
 
 
 
(10,468
)
Provision for income taxes
 
 
 
 
 
 
17,178

Net income
 
 
 
 
 
 
$
29,471

 
As of/ Six months ended June 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
29,807

 
7,747

 
7,508

 

Revenues
$
1,309,738

 
$
307,921

 
$
475,674

 
$
2,093,333

Cost of revenues
892,932

 
351,292

 
253,402

 
1,497,626

Marketing
134,142

 
99,382

 
173

 
233,697

Contribution profit (loss)
$
282,664

 
$
(142,753
)
 
$
222,099

 
$
362,010

Other operating expenses
 
 
 
 
 
 
273,071

Operating income
 
 
 
 
 
 
88,939

Other income (expense)
 
 
 
 
 
 
(41,360
)
Provision for income taxes
 
 
 
 
 
 
15,419

Net income
 
 
 
 
 
 
$
32,160


The following table represents the amortization of the content library:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
Three months ended June 30,
(in thousands)
2014
$
409,896

 
$
229,141

 
$
16,923

 
$
655,960

2013
344,441

 
165,809

 
17,709

 
527,959

Six months ended June 30,
 
 
 
 
 
 
 
2014
796,211

 
443,561

 
33,044

 
1,272,816

2013
680,189

 
315,801

 
35,946

 
1,031,936

The following table represents total content library, net:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
As of June 30, 2014
$
3,196,275

 
$
914,239

 
$
24,623

 
$
4,135,137

As of December 31, 2013
2,973,023

 
804,690

 
19,779

 
3,797,492


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. Memberships are assigned to territories based on the geographic location used at time of sign up as determined by the Company's internal systems, which utilize industry standard geo-location technology. 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; the impact of new accounting standards; investments in content, including original content; international expansion and investments related thereto; cash use in connection with content acquisitions and licensing and international expansion; deferred tax assets; pricing; 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, 2013 filed with the Securities and Exchange Commission (“SEC”) on February 3, 2014, 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 members 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 United States ("U.S.") social media channels listed on our investor relations website.

Overview
We are the world’s leading Internet television network with more than 50 million streaming members in over 40 countries enjoying more than two billion hours of TV shows and movies per month, including original series. Our members can watch as much as they want, anytime, anywhere, on nearly any Internet-connected screen. Members can play, pause and resume watching, all without commercials or commitments. Additionally, in the U.S., our members can receive DVDs 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 our streaming subscription business domestically and internationally. We are continuously improving our members' experience - expanding our streaming content, with a focus on programming an overall mix of content that delights our customers, 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 and operating segment contribution profit (loss) targets.

Results of Operations

The following represents our consolidated performance highlights:
 
Three Months Ended
 
Change
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
(in thousands, except percentages)
Revenues
$
1,340,407

 
$
1,069,372

 
25
%
Operating income
129,600

 
57,117

 
127
%
Net income
71,018

 
29,471

 
141
%


In the second quarter of 2014, we increased the domestic streaming membership fee from $7.99 to $8.99 per month for new members who choose our most popular streaming plan, which includes access to high definition quality streaming on two screens concurrently. Current members will be grandfathered in at $7.99 per month for this plan for two years, as long as they remain a member. We also introduced a new membership plan priced at $7.99 per month which offers standard definition quality streaming on a single device at a time. In the second quarter of 2013, we introduced membership plans priced at $11.99 per month under which members can stream content on up to four devices concurrently. Internationally, we rolled out similar changes in pricing and plan offerings.


19


Consolidated revenues for the three months ended June 30, 2014 increased $271.0 million as compared to the three months ended June 30, 2013 due to growth in streaming members, both internationally and domestically. Operating income and net income increased $72.5 million and $41.5 million, respectively, due to the increase in revenues, partially offset by the increase in the cost of revenues due to increased content licensing expenses relating to our existing and new streaming content.

The following represents the key elements to our segment results of operations:

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 and acquisition 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 consist 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. Content delivery expenses for the Domestic DVD segment consist of the postage costs to mail DVDs to and from our 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. Payments to our affiliates and device partners include fixed fee and /or revenue sharing payments. Marketing expenses are primarily incurred by our Domestic and International streaming segments given our focus on building consumer awareness of the streaming offerings. 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. Marketing expenses are immaterial for the Domestic DVD segment.

We have demonstrated our ability to grow contribution margin as evidenced by the increase in contribution margin from 12% when we first began separately reporting Domestic streaming results in the fourth quarter of 2011 to 27% in the second quarter of 2014. 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. 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.

As we grow our streaming segments, we continue to shift spending away from the Domestic DVD segment to invest more in streaming content and marketing for our streaming services.


20


Domestic Streaming Segment
Three months ended June 30, 2014 as compared to the three months ended June 30, 2013
 
 
As of/ Three Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
570

 
633

 
(10
)%
Members at end of period
 
36,244

 
29,807

 
22
 %
Paid members at end of period
 
35,085

 
28,624

 
23
 %
Average monthly revenue per paying member
 
$
8.04

 
$
7.91

 
2
 %
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
838,225

 
$
671,089

 
25
 %
Cost of revenues
 
546,223

 
452,598

 
21
 %
Marketing
 
64,727

 
67,177

 
(4
)%
Contribution profit
 
227,275

 
151,314

 
50
 %
Contribution margin
 
27
%
 
23
%
 
 

In the Domestic streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan. The $167.1 million increase in our domestic streaming revenues was primarily due to the 23% growth in the average number of paid memberships as well as to the 2% increase in average monthly revenue per paying member resulting from our price increase and introduction of higher priced plans. Our two screen high definition plan continues to be the most popular plan choice for new members.
The $93.6 million increase in domestic streaming cost of revenues was primarily due to the $67.2 million increase in content licensing expenses relating to our existing and new streaming content, including more exclusive and original programming. In addition, content delivery expenses increased by $17.3 million and other costs, such as payment processing fees and customer service call centers, increased $9.1 million due to our growing member base.
Marketing expenses decreased $2.5 million primarily due to a decrease in advertising partially offset by an increase in public relations expenses.
Our Domestic streaming segment had a contribution margin of 27% for the three months ended June 30, 2014, 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 faster than content and marketing spending.

Six months ended June 30, 2014 as compared to the six months ended June 30, 2013
 
 
As of/ Six Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
YTD'14 vs. YTD'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
2,824

 
2,661

 
6
%
Members at end of period
 
36,244

 
29,807

 
22
%
Paid members at end of period
 
35,085

 
28,624

 
23
%
Average monthly revenue per paying member
 
$
8.05

 
$
7.94

 
1
%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
1,636,842

 
$
1,309,738

 
25
%
Cost of revenues
 
1,063,317

 
892,932

 
19
%
Marketing
 
144,985

 
134,142

 
8
%
Contribution profit
 
428,540

 
282,664

 
52
%
Contribution margin
 
26
%
 
22
%
 
 

21



The $327.1 million increase in our domestic streaming revenues was due to the 23% growth in the average number of paid memberships as well as to the 1% increase in the average monthly revenue per paying member resulting from our price increase and introduction of higher priced plan.
The $170.4 million increase in domestic streaming cost of revenues was primarily due to the $117.5 million increase in content licensing expenses relating to our existing and new streaming content, including more exclusive and original programming. In addition, content delivery expenses increased by $32.4 million and other costs, such as payment processing fees and customer service call centers, increased $20.5 million due to our growing member base.
Marketing expenses increased $10.8 million primarily due to an increase in advertising and public relations spending.
Our Domestic streaming segment had a contribution margin of 26% for the six months ended June 30, 2014, which increased as compared to the contribution margin of 22% for the six months ended June 30, 2013, as a result of growing memberships and revenue faster than content and marketing spending.

International Streaming Segment
Three months ended June 30, 2014 as compared to the three months ended June 30, 2013
 
 
As of /Three Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
1,118

 
605

 
85
 %
Members at end of period
 
13,801

 
7,747

 
78
 %
Paid members at end of period
 
12,907

 
7,014

 
84
 %
Average monthly revenue per paying member
 
$
8.31

 
$
8.29

 
 %
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
307,461

 
$
165,902

 
85
 %
Cost of revenues
 
266,697

 
184,400

 
45
 %
Marketing
 
56,036

 
47,335

 
18
 %
Contribution loss
 
(15,272
)
 
(65,833
)
 
(77
)%
Contribution margin
 
(5
)%
 
(40
)%
 



In the International streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan. 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 the Netherlands in September 2013. We plan to continue to expand our services internationally and expect to launch in Germany, Austria, Switzerland, France, Belgium and Luxembourg in the third quarter of 2014.
The $141.6 million increase in our international revenues was primarily due to the 85% growth in the average number of paid international memberships. Average paid international streaming memberships account for 26% of total average paid streaming memberships as of June 30, 2014, as compared to 19% of total average paid streaming memberships as of June 30, 2013.
The $82.3 million increase in international cost of revenues was primarily due to a $67.5 million increase in content licensing expenses relating to our existing and new streaming content, including more exclusive and original programming. Other costs increased $14.8 million primarily due to increases in our content delivery expenses, costs associated with our customer service call centers and payment processing fees, all driven by our growing member base.
International marketing expenses for the three months ended June 30, 2014 increased $8.7 million as compared to the three months ended June 30, 2013 mainly due to expenses for territories launched in the last twelve months, as well as increased marketing spend in the U.K. and Ireland.
International contribution losses improved $50.6 million for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, as a result of growing memberships and revenues faster than content and marketing spending. 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,

22


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.
Six months ended June 30, 2014 as compared to the six months ended June 30, 2013
 
 
As of /Six Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
YTD'14 vs. YTD'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
2,871

 
1,626

 
77
 %
Members at end of period
 
13,801

 
7,747

 
78
 %
Paid members at end of period
 
12,907

 
7,014

 
84
 %
Average monthly revenue per paying member
 
$
8.30

 
$
8.35

 
(1
)%
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
574,579

 
$
307,921

 
87
 %
Cost of revenues
 
511,964

 
351,292

 
46
 %
Marketing
 
112,876

 
99,382

 
14
 %
Contribution loss
 
(50,261
)
 
(142,753
)
 
(65
)%
Contribution margin
 
(9
)%
 
(46
)%
 



The $266.7 million increase in our international revenues was primarily due to the 88% growth in the average number of paid international memberships. The increase in average monthly revenue per paying member resulting from our price increase was offset by the impact of unfavorable changes in foreign exchange rates.
The $160.7 million increase in international cost of revenues was primarily due to a $135.2 million increase in content licensing expenses relating to our existing and new streaming content, including more exclusive and original programming. Other costs increased $25.5 million primarily due to increases in our content delivery expenses, costs associated with our customer service call centers and payment processing fees, all driven by our growing member base.
International marketing expenses for the six months ended June 30, 2014 increased $13.5 million as compared to the six months ended June 30, 2013 mainly due to expenses for territories launched in the last twelve months, as well as increased marketing spend in the U.K. and Ireland.
International contribution losses improved $92.5 million for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, as a result of growing memberships and revenues faster than content and marketing spending.
Domestic DVD Segment
Three months ended June 30, 2014 as compared to the three months ended June 30, 2013
 
 
As of/ Three Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(391
)
 
(475
)
 
(18
)%
Members at end of period
 
6,261

 
7,508

 
(17
)%
Paid members at end of period
 
6,167

 
7,369

 
(16
)%
Average monthly revenue per paying member
 
$
10.24

 
$
10.19

 
 %
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
194,721

 
$
232,381

 
(16
)%
Cost of revenues
 
101,928

 
123,676

 
(18
)%
Marketing
 

 
99

 
(100
)%
Contribution profit
 
92,793

 
108,606

 
(15
)%
Contribution margin
 
48
%
 
47
%
 
 


23


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. Members 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 $37.7 million decrease in our domestic DVD revenues was due to a 17% decrease in the average number of paid memberships.
The $21.7 million decrease in domestic DVD cost of revenues was primarily due to a $6.0 million decrease in content acquisition expenses and a $10.1 million decrease in content delivery expenses resulting from a 21% decrease in the number of DVDs mailed to members. The decrease in shipments was driven by a decline in the number of DVD memberships coupled with a decrease in usage by these members. Other costs, primarily those associated with content processing and customer service center expenses, decreased $5.6 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 48% for the three months ended June 30, 2014, and was relatively flat as compared to the three months ended June 30, 2013.

Six months ended June 30, 2014 as compared to the six months ended June 30, 2013
 
 
As of/ Six Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
YTD'14 vs. YTD'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(669
)
 
(716
)
 
(7
)%
Members at end of period
 
6,261

 
7,508

 
(17
)%
Paid members at end of period
 
6,167

 
7,369

 
(16
)%
Average monthly revenue per paying member
 
$
10.25

 
$
10.21

 
 %
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
399,075

 
$
475,674

 
(16
)%
Cost of revenues
 
208,753

 
253,402

 
(18
)%
Marketing
 

 
173

 
(100
)%
Contribution profit
 
190,322

 
222,099

 
(14
)%
Contribution margin
 
48
%
 
47
%
 
 

The $76.6 million decrease in our domestic DVD revenues was due to a 17% decrease in the average number of paid memberships.
The $44.6 million decrease in domestic DVD cost of revenues was primarily due to a $10.8 million decrease in content acquisition expenses and a $22.6 million decrease in content delivery expenses resulting from a 21% decrease in the number of DVDs mailed to members. The decrease in shipments was driven by a decline in the number of DVD memberships coupled with a decrease in usage by these members. Other costs, primarily those associated with content processing and customer service center expenses, decreased $11.2 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 48% for the six months ended June 30, 2014, and was relatively flat as compared to the six months ended June 30, 2013.


Consolidated Operating Expenses
Technology and Development
Technology and development expenses consist of payroll and related costs incurred in making improvements to our service offerings, including testing, maintaining and modifying our user interface, our recommendation, merchandising and content delivery technology, as well as our telecommunications systems and infrastructures. Technology and development expenses also include costs associated with computer hardware and software.
Three months ended June 30, 2014 as compared to the three months ended June 30, 2013
 

24


 
Three Months Ended
 
Change
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
(in thousands, except percentages)
Technology and development
$
115,182

 
$
93,126

 
24
%
As a percentage of revenues
9
%
 
9
%
 
 

The $22.1 million increase in technology and development expenses was primarily due to a $20.2 million increase in personnel-related costs including stock-based compensation expense resulting from a 10% growth in average headcount supporting continued improvements in our streaming service and our international expansion, coupled with an increase in average employee compensation.

Six months ended June 30, 2014 as compared to the six months ended June 30, 2013
 
 
Six Months Ended
 
Change
 
June 30,
2014
 
June 30,
2013
 
YTD'14 vs. YTD'13
 
(in thousands, except percentages)
Technology and development
$
225,492

 
$
185,101

 
22
%
As a percentage of revenues
9
%
 
9
%
 
 

The $40.4 million increase in technology and development expenses was primarily due to a $39.6 million increase in personnel-related costs including stock-based compensation expense resulting from a 9% growth in average headcount supporting continued improvements in our streaming service and our international expansion, coupled with an increase in average employee compensation.

General and Administrative
General and administrative expenses consist of payroll and related expenses for corporate personnel, as well as professional fees and other general corporate expenses. General and administrative expenses also include the gain on disposal of DVDs.
Three months ended June 30, 2014 as compared to the three months ended June 30, 2013

 
Three Months Ended
 
Change
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
(in thousands, except percentages)
General and administrative
$
60,014

 
$
43,844

 
37
%
As a percentage of revenues
4
%
 
4
%
 
 

General and administrative expenses increased $16.2 million primarily due to a $13.9 million increase in personnel related costs including stock-based compensation expense resulting from a 34% increase in average headcount to support our growth, coupled with an increase in average employee compensation.

Six months ended June 30, 2014 as compared to the six months ended June 30, 2013

 
Six Months Ended
 
Change
 
June 30,
2014
 
June 30,
2013
 
YTD'14 vs. YTD'13
 
(in thousands, except percentages)
General and administrative
$
115,914

 
$
87,970

 
32
%
As a percentage of revenues
4
%
 
4
%
 
 

General and administrative expenses increased $27.9 million primarily due to a $27.6 million increase in personnel related costs including stock-based compensation expense resulting from a 33% increase in average headcount to support our growth, coupled with an increase in average employee compensation.


25


Interest Expense
Interest expense consists primarily of the interest associated with our outstanding long-term debt obligations, including the amortization of debt issuance costs, as well as interest on our lease financing obligations.
Three months ended June 30, 2014 as compared to the three months ended June 30, 2013
 
 
 
Three Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
 
(in thousands, except percentages)
Interest expense
 
$
(13,328
)
 
$
(7,528
)
 
77
%
As a percentage of revenues
 
1
%
 
1
%
 
 

Six months ended June 30, 2014 as compared to the six months ended June 30, 2013
 
 
 
Six Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
YTD'14 vs. YTD'13
 
 
(in thousands, except percentages)
Interest expense
 
$
(23,380
)
 
$
(14,268
)
 
64
%
As a percentage of revenues
 
1
%
 
1
%
 
 

Interest expense for the three and six months ended June 30, 2014 consisted primarily of $12.5 million of interest accrued per quarter on our notes. The increase in interest expense for the three and six months ended June 30, 2014 as compared the three and six months ended June 30, 2013 was due to the higher aggregate principal of interest bearing notes outstanding.
Interest and Other Income (Expense)
Interest and other income (expense) consists primarily of interest earned on cash, cash equivalents and short-term investments and foreign exchange gains and losses on foreign currency denominated balances.
Three months ended June 30, 2014 as compared to the three months ended June 30, 2013
 
 
 
Three Months Ended
 
Change
 
 
June 30,
2014
 
June 30,
2013
 
Q2'14 vs. Q2'13
 
 
(in thousands, except percentages)
Interest and other income (expense)
 
$
1,100

 
$
(2,940