10-Q 1 nflx-93016x10qxdoc.htm FORM 10-Q Document

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, 2016
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 September 30, 2016, there were 429,145,023 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,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Revenues
$
2,290,188

 
$
1,738,355

 
$
6,353,128

 
$
4,956,178

Cost of revenues
1,532,844

 
1,173,958

 
4,375,482

 
3,342,111

Marketing
282,043

 
208,102

 
706,082

 
599,919

Technology and development
216,099

 
171,762

 
626,907

 
469,929

General and administrative
153,166

 
110,892

 
418,798

 
298,287

Operating income
106,036

 
73,641

 
225,859

 
245,932

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(35,536
)
 
(35,333
)
 
(106,528
)
 
(97,287
)
Interest and other income (expense)
8,627

 
3,930

 
50,907

 
(27,491
)
Income before income taxes
79,127

 
42,238

 
170,238

 
121,154

Provision for income taxes
27,610

 
12,806

 
50,308

 
41,691

Net income
$
51,517

 
$
29,432

 
$
119,930

 
$
79,463

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.12

 
$
0.07

 
$
0.28

 
$
0.19

Diluted
$
0.12

 
$
0.07

 
$
0.27

 
$
0.18

Weighted-average common shares outstanding:
 
 
 
 
 
 
 
Basic
428,937

 
426,869

 
428,514

 
425,289

Diluted
438,389

 
437,606

 
438,180

 
435,849













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,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Net income
$
51,517

 
$
29,432

 
$
119,930

 
$
79,463

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments 
2,357

 
302

 
5,453

 
(33,628
)
Change in unrealized gains (losses) on available-for-sale securities, net of tax of $(412), $(45), $810 and $113, respectively
(676
)
 
(72
)
 
1,325

 
184

Total other comprehensive income (loss)
1,681

 
230

 
6,778

 
(33,444
)
Comprehensive income
$
53,198

 
$
29,662

 
$
126,708

 
$
46,019

























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,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
51,517

 
$
29,432

 
$
119,930

 
$
79,463

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
 
 
 
 
Additions to streaming content assets
(2,442,080
)
 
(1,304,466
)
 
(6,550,445
)
 
(4,221,326
)
Change in streaming content liabilities
529,885

 
104,684

 
1,674,125

 
922,163

Amortization of streaming content assets
1,224,108

 
871,403

 
3,457,990

 
2,443,521

Amortization of DVD content assets
19,284

 
18,589

 
59,746

 
60,587

Depreciation and amortization of property, equipment and intangibles
14,410

 
16,047

 
43,339

 
46,795

Stock-based compensation expense
43,495

 
32,834

 
130,029

 
88,865

Excess tax benefits from stock-based compensation
(12,762
)
 
(37,726
)
 
(37,401
)
 
(106,154
)
Other non-cash items
9,682

 
10,866

 
31,479

 
23,854

Deferred taxes
14,338

 
(29,417
)
 
(20,141
)
 
(70,691
)
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
Other current assets
10,250

 
66,695

 
48,649

 
81,448

Accounts payable
27,810

 
6,762

 
16,707

 
2,584

Accrued expenses
28,957

 
10,883

 
72,288

 
88,429

Deferred revenue
30,230

 
27,985

 
80,485

 
55,153

Other non-current assets and liabilities
(11,065
)
 
(20,540
)
 
(43,604
)
 
615

Net cash used in operating activities
(461,941
)
 
(195,969
)
 
(916,824
)
 
(504,694
)
Cash flows from investing activities:
 
 
 
 
 
 
 
Acquisition of DVD content assets
(17,249
)
 
(14,467
)
 
(58,380
)
 
(57,159
)
Purchases of property and equipment
(27,366
)
 
(37,820
)
 
(46,605
)
 
(78,394
)
Change in other assets
125

 
(3,760
)
 
676

 
(4,174
)
Purchases of short-term investments
(128,136
)
 
(66,444
)
 
(181,590
)
 
(225,333
)
Proceeds from sale of short-term investments
171,747

 
43,887

 
198,687

 
144,247

Proceeds from maturities of short-term investments
24,855

 
31,125

 
112,555

 
82,182

Net cash provided by (used in) investing activities
23,976

 
(47,479
)
 
25,343

 
(138,631
)
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from issuance of common stock
3,819

 
35,089

 
11,587

 
69,809

Proceeds from issuance of debt

 

 

 
1,500,000

Issuance costs

 

 

 
(17,629
)
Excess tax benefits from stock-based compensation
12,762

 
37,726

 
37,401

 
106,154

Other financing activities
58

 
(61
)
 
170

 
(599
)
Net cash provided by financing activities
16,639

 
72,754

 
49,158

 
1,657,735

Effect of exchange rate changes on cash and cash equivalents
(441
)
 
(7,741
)
 
2,151

 
(12,581
)
Net (decrease) increase in cash and cash equivalents
(421,767
)
 
(178,435
)
 
(840,172
)
 
1,001,829

Cash and cash equivalents, beginning of period
1,390,925

 
2,293,872

 
1,809,330

 
1,113,608

Cash and cash equivalents, end of period
$
969,158

 
$
2,115,437

 
$
969,158

 
$
2,115,437

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,
2016
 
December 31,
2015
 
(unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
969,158

 
$
1,809,330

Short-term investments
374,098

 
501,385

Current content assets, net
3,632,399

 
2,905,998

Other current assets
218,238

 
215,127

Total current assets
5,193,893

 
5,431,840

Non-current content assets, net
6,677,674

 
4,312,817

Property and equipment, net
191,876

 
173,412

Other non-current assets
283,895

 
284,802

Total assets
$
12,347,338

 
$
10,202,871

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Current content liabilities
$
3,497,214

 
$
2,789,023

Accounts payable
285,753

 
253,491

Accrued expenses
201,232

 
140,389

Deferred revenue
427,206

 
346,721

Total current liabilities
4,411,405

 
3,529,624

Non-current content liabilities
2,975,189

 
2,026,360

Long-term debt
2,373,966

 
2,371,362

Other non-current liabilities
57,812

 
52,099

Total liabilities
9,818,372

 
7,979,445

Commitments and contingencies (Note 6)


 


Stockholders’ equity:
 
 
 
Common stock, $0.001 par value; 4,990,000,000 shares authorized at September 30, 2016 and December 31, 2015; 429,145,023 and 427,940,440 issued and outstanding at September 30, 2016 and December 31, 2015, respectively
1,503,641

 
1,324,809

Accumulated other comprehensive loss
(36,530
)
 
(43,308
)
Retained earnings
1,061,855

 
941,925

Total stockholders’ equity
2,528,966

 
2,223,426

Total liabilities and stockholders’ equity
$
12,347,338

 
$
10,202,871





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, 2015 filed with the Securities and Exchange Commission (the “SEC”) on January 28, 2016. 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 streaming content asset amortization policy; 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, 2015. Interim results are not necessarily indicative of the results for a full year.
The Company has three reportable segments: Domestic streaming, International streaming and Domestic DVD, all of which derive revenue from monthly membership fees. See Note 10 for further detail on the Company's segments.
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, 2015.
Certain prior year amounts on the Consolidated Statements of Cash Flow have been reclassified to conform to the current year presentation. Specifically, the Company reclassified prepaid content from "Other current assets" on the Consolidated Balance Sheets to "Current content assets, net". The impact of reclassification on the cash flow resulted in a decrease in "Other current assets" and "Additions to streaming content assets" of $4.5 million in the three months ended September 30, 2015, and an increase in "Other current assets" and "Additions to streaming content assets" of $26.8 million for the nine months ended September 30, 2015.
In the third quarter of 2016, the Company changed the amortization method of certain types of content given changes in estimated viewing patterns of this content. The effect of this change in estimate on operating income, net income and basic and diluted earnings per share was not material for the three and nine months ended September 30, 2016.
In May 2014, the Financial Accounting Standards Board ("FASB") 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. In July 2015, the FASB deferred the effective date for annual reporting periods beginning after December 15, 2017 (including interim reporting periods within those periods). Early adoption is permitted to the original effective date for annual reporting periods beginning after December 15, 2016 (including interim reporting periods within those periods). The amendments may be applied retrospectively to each prior period (full retrospective) or retrospectively with the cumulative effect recognized as of the date of initial application (modified retrospective). The Company will adopt ASU 2014-09 in the first quarter of 2018 and apply the full retrospective approach. The Company does not expect the impact on its consolidated financial statements to be material.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) in order to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet for those leases classified as operating leases under previous GAAP. ASU 2016-02 requires that a lessee should recognize a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term on the balance sheet. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018 (including interim periods within those periods) using a modified retrospective approach and early adoption is permitted. The Company will adopt ASU 2016-02 in the first quarter of 2019 and is currently in the process of evaluating the impact of adoption of the ASU on its consolidated financial statements.
In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which amends Accounting Standards Codification ("ASC") Topic 718, Compensation – Stock Compensation.  ASU 2016-09 simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years and early adoption is permitted. The Company will adopt ASU 2016-09 in the first quarter of 2017 and is currently in the process of evaluating the impact of adoption of the ASU on its consolidated financial statements.


7


2. Earnings Per Share

Basic earnings per share is computed using the weighted-average number of outstanding shares of common stock during the period. Diluted earnings per share is computed using the weighted-average number of outstanding shares of common stock and, when dilutive, potential common shares outstanding during the period. Potential common shares consist of 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,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
 
(in thousands, except per share data)
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
51,517

 
$
29,432

 
$
119,930

 
$
79,463

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
428,937

 
426,869

 
428,514

 
425,289

Basic earnings per share
$
0.12

 
$
0.07

 
$
0.28

 
$
0.19

 
 
 
 
 
 
 
 
Diluted earnings per share:
 
 
 
 
 
 
 
Net income
$
51,517

 
$
29,432

 
$
119,930

 
$
79,463

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
428,937

 
426,869

 
428,514

 
425,289

Employee stock options
9,452

 
10,737

 
9,666

 
10,560

Weighted-average number of shares
438,389

 
437,606

 
438,180

 
435,849

Diluted earnings per share
$
0.12

 
$
0.07

 
$
0.27

 
$
0.18


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,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
 
(in thousands)
Employee stock options
2,559

 
130

 
1,942

 
668




8


3. 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 investment 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, the category using the fair value hierarchy and where they are classified on the Consolidated Balance Sheets:
 
As of September 30, 2016
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
Cash and cash equivalents
 
Short-term investments
 
Non-current assets (1)
 
(in thousands)
Cash
$
920,513

 
$

 
$

 
$
920,513

 
$
917,936

 
$

 
$
2,577

Level 1 securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
52,737

 

 

 
52,737

 
51,222

 

 
1,515

Level 2 securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
220,826

 
770

 
(68
)
 
221,528

 

 
221,528

 

Government securities
110,860

 
159

 

 
111,019

 

 
111,019

 

Certificates of deposit/commercial paper
9,817

 

 

 
9,817

 
 
 
9,817

 
 
Agency securities
31,770

 
4

 
(40
)
 
31,734

 

 
31,734

 

Total
$
1,346,523

 
$
933

 
$
(108
)
 
$
1,347,348

 
$
969,158

 
$
374,098

 
$
4,092


 
As of December 31, 2015
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
Cash and cash equivalents
 
Short-term investments
 
Non-current assets (1)
 
(in thousands)
Cash
$
1,708,220

 
$

 
$

 
$
1,708,220

 
$
1,706,592

 
$

 
$
1,628

Level 1 securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
107,199

 

 

 
107,199

 
102,738

 

 
4,461

Level 2 securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
240,867

 
154

 
(409
)
 
240,612

 

 
240,612

 

Government securities
235,252

 

 
(1,046
)
 
234,206

 

 
234,206

 

Agency securities
26,576

 

 
(9
)
 
26,567

 

 
26,567

 

Total
$
2,318,114

 
$
154

 
$
(1,464
)
 
$
2,316,804

 
$
1,809,330

 
$
501,385

 
$
6,089


(1) Primarily restricted cash that is related to workers compensation deposits and letter of credit agreements.

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 5 to the consolidated financial statements for further information regarding the fair value of the Company’s senior notes.
The Company does not intend to sell the investments that are in an unrealized loss position and it is not likely that the Company will be required to sell any investments before recovery of their amortized cost basis. As such, the Company does not consider those investments with an unrealized loss to be other-than-temporarily impaired at September 30, 2016 or December 31, 2015, 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, 2016 and 2015, respectively. In addition, there were no material gross realized gains or losses in the three and nine months ended September 30, 2016 and 2015, respectively.

9


The estimated fair value of short-term investments by contractual maturity as of September 30, 2016 is as follows:
 
(in thousands)
Due within one year
$
80,355

Due after one year and through five years
293,743

Total short-term investments
$
374,098



4. Balance Sheet Components
Content Assets
Content assets consisted of the following:
 
As of
 
September 30,
2016
 
December 31,
2015
 
(in thousands)
Licensed content, net
$
9,248,120

 
$
6,827,119

 
 
 
 
Produced content, net


 


Released, less amortization
194,621

 
61,515

In production
802,552

 
279,013

In development
40,154

 
24,651

 
1,037,327

 
365,179

DVD, net
24,626

 
26,517

Total
$
10,310,073

 
$
7,218,815

 
 
 
 
Current content assets, net
$
3,632,399

 
$
2,905,998

Non-current content assets, net
$
6,677,674

 
$
4,312,817

Produced content is included in "Non-current content assets, net" on the Consolidated Balance Sheets. Certain original content, such as House of Cards, is licensed and therefore not included in produced content. Of the produced content that has been released, approximately 28% and 82%, is expected to be amortized over the next twelve and thirty-six months, respectively. The amount of accrued participations and residuals to be paid during the next twelve months is not material.
Property and Equipment, Net
Property and equipment and accumulated depreciation consisted of the following:
 
 
As of
 
 
 
 
September 30,
2016
 
December 31,
2015
 
Estimated Useful Lives

 
 
(in thousands)
 
 
Information technology assets
 
$
206,957

 
$
194,054

 
3 years
Furniture and fixtures
 
32,255

 
30,914

 
3 years
Building
 
40,681

 
40,681

 
30 years
Leasehold improvements
 
108,820

 
107,793

 
Over life of lease
DVD operations equipment
 
76,248

 
88,471

 
5 years
Capital work-in-progress
 
40,997

 
8,845

 

Property and equipment, gross
 
505,958

 
470,758

 
 
Less: Accumulated depreciation
 
(314,082
)
 
(297,346
)
 
 
Property and equipment, net
 
$
191,876

 
$
173,412

 
 

The increase in capital work-in-progress is primarily related to leasehold improvements for the Company's expanded headquarters in Los Gatos, California and the Company's new office space in Los Angeles, California.

10


5. Long-term Debt

As of September 30, 2016, the Company had aggregate outstanding long-term debt of $2,374.0 million, net of $26.0 million of issuance costs, with varying maturities (the "Notes"). Each of the Notes were issued at par and are senior unsecured obligations of the Company. Interest is payable semi-annually at fixed rates.

The following table provides a summary of the Company's Notes and the fair values based on quoted market prices in less active markets as of September 30, 2016 and December 31, 2015:
 
 
 
 
 
 
 
 
 
Level 2 Fair Value as of
 
Principal Amount at Par
 
Issuance Date
 
Maturity
 
Interest Due Dates
 
September 30, 2016
 
December 31, 2015
 
(in millions)
 
 
 
 
 
 
 
(in millions)
5.50% Senior Notes
$
700.0

 
February 2015
 
2022
 
April 15 and October 15
 
$
756.9

 
$
717.5

5.875% Senior Notes
800.0

 
February 2015
 
2025
 
April 15 and October 15
 
866.0

 
820.0

5.750% Senior Notes
400.0

 
February 2014
 
2024
 
March 1 and September 1
 
432.0

 
411.0

5.375% Senior Notes
500.0

 
February 2013
 
2021
 
February 1 and August 1
 
548.8

 
525.0


Each of the 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 Notes prior to maturity in whole or in part at an amount equal to the principal amount thereof plus accrued and unpaid interest and an applicable premium. The 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 certain 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. As of September 30, 2016 and December 31, 2015, the Company was in compliance with all related covenants.


6. Commitments and Contingencies

Streaming Content
As of September 30, 2016, the Company had $14.4 billion of obligations comprised of $3.5 billion included in "Current content liabilities" and $3.0 billion of "Non-current content liabilities" on the Consolidated Balance Sheets and $7.9 billion of obligations that are not reflected on the Consolidated Balance Sheets as they did not then meet the criteria for recognition.
As of December 31, 2015, the Company had $10.9 billion of obligations comprised of $2.8 billion included in "Current content liabilities" and $2.0 billion of "Non-current content liabilities" on the Consolidated Balance Sheets and $6.1 billion of obligations that are not reflected on the Consolidated Balance Sheets as they did not then meet the criteria for recognition.
The expected timing of payments for these streaming content obligations is as follows:
 
As of 
 
September 30,
2016
 
December 31,
2015
 
(in thousands)
Less than one year
$
5,895,205

 
$
4,703,172

Due after one year and through three years
6,770,007

 
5,249,147

Due after three years and through five years
1,489,933

 
891,864

Due after five years
197,900

 
58,048

Total streaming content obligations
$
14,353,045

 
$
10,902,231



11


Content obligations include amounts related to the acquisition, licensing and production of content. Obligations that are in non U.S. dollar currencies are translated to the U.S. dollar at period end rates. A content obligation for the production of original content includes non-cancellable commitments under creative talent and employment agreements. A content obligation for the acquisition and licensing of content is incurred at the time the Company enters into an 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. Traditional film output deals, like the U.S. output deal with Disney, or certain TV series license agreements where the number of seasons to be aired is unknown, are examples of such license agreements. 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.
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 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, lead plaintiffs appealed that decision to the United States Court of Appeals for the Ninth Circuit; oral argument occurred on March 17, 2016. On April 11, 2016, the Ninth Circuit panel affirmed the dismissal of the suit with prejudice. 
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. On August 29, 2016, by stipulation of the parties, the consolidated complaint was dismissed by the Court.

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

12


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.


7. Stockholders’ Equity

Stock Split
In March 2015, the Company's Board of Directors adopted an amendment to the Company's Certificate of Incorporation, to increase the number of shares of capital stock the Company is authorized to issue from 170,000,000 (160,000,000 shares of common stock and 10,000,000 shares of preferred stock), par value $0.001, to 5,000,000,000 (4,990,000,000 shares of common stock and 10,000,000 shares of preferred stock), par value $0.001. This amendment to the Company's certificate of incorporation was approved by the Company's stockholders at the 2015 Annual Meeting held on June 9, 2015.
On June 23, 2015, the Company's Board of Directors declared a seven-for-one stock split in the form of a stock dividend that was paid on July 14, 2015 to all shareholders of record as of July 2, 2015.
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, 2016, 14.1 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
(per share)
 
Weighted-Average Remaining
Contractual Term
(in years)
 
Aggregate
Intrinsic Value
(in thousands)
Balances as of December 31, 2015
16,845,316

 
20,995,756

 
$
32.39

 
 
 
 
Granted
(2,721,013
)
 
2,721,013

 
98.45

 
 
 
 
Exercised

 
(1,204,583
)
 
9.59

 
 
 
 
Balances as of September 30, 2016
14,124,303

 
22,512,186

 
$
41.59

 
6.2
 
$
1,300,444

Vested and exercisable as of September 30, 2016
 
 
22,512,186

 
$
41.59

 
6.2
 
$
1,300,444


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 2016 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 the last trading day of the third quarter of 2016. This amount changes based on the fair market value of the Company’s common stock.
A summary of the amounts related to option exercises, is as follows:
 
Three Months Ended
Nine Months Ended
 
September 30,
2016
September 30,
2015
 
September 30,
2016
September 30,
2015
 
(in thousands)
Total intrinsic value of options exercised
$
35,443

$
118,259

 
$
104,168

$
313,880

Cash received from options exercised
$
3,819

$
35,089

 
$
11,587

$
69,809


13


Stock-based Compensation
The following table summarizes the assumptions used to value stock option grants using the lattice-binomial model and the valuation data:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2016
 
September 30,
2015
 
September 30,
2016
 
September 30,
2015
Dividend yield
%
 
%
 
%
 
%
Expected volatility
41
%
 
45
%
 
41% - 50%

 
36% - 45%

Risk-free interest rate
1.57
%
 
2.29
%
 
1.57% - 2.04%

 
2.03% - 2.29%

Suboptimal exercise factor
2.48

 
2.48

 
2.48

 
2.47 - 2.48

Weighted-average fair value (per share)
$
44.68

 
$
50.58

 
$
47.79

 
$
34.64

Total stock-based compensation expense (in thousands)
$
43,495

 
$
32,834

 
$
130,029

 
$
88,865

Total income tax impact on provision (in thousands)
$
16,294

 
$
12,365

 
$
48,828

 
$
33,553


The Company considers several factors in determining the suboptimal exercise factor, including the historical and estimated option exercise behavior.
The Company calculates expected volatility based solely on implied volatility. The Company believes that implied volatility of publicly traded options in its common stock is more reflective of market conditions, and given consistently high trade volumes of the options, can reasonably be expected to be a better indicator of expected volatility than historical volatility of its common stock.
In valuing shares issued under the Company’s employee stock option plans, the Company bases the risk-free interest rate on U.S. Treasury zero-coupon issues with terms similar to the contractual term of the options. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option valuation model. The Company does not use a post-vesting termination rate as options are fully vested upon grant date.


8. Accumulated Other Comprehensive Loss

The following table summarizes the changes in the accumulated balance of other comprehensive income (loss), net of tax, for the three and nine months ended September 30, 2016:

 
Foreign currency
 
Change in unrealized gains on available-for-sale securities
 
Total
 
(in thousands)
Balance as of June 30, 2016
$
(39,406
)
 
$
1,195

 
$
(38,211
)
Other comprehensive income (loss) before reclassifications
2,357

 
(676
)
 
1,681

Net decrease (increase) in other comprehensive loss
2,357

 
(676
)
 
1,681

Balance as of September 30, 2016
$
(37,049
)

$
519


$
(36,530
)
 
Foreign currency
 
Change in unrealized gains on available-for-sale securities
 
Total
 
(in thousands)
Balance as of December 31, 2015
$
(42,502
)
 
$
(806
)
 
$
(43,308
)
Other comprehensive income before reclassifications
5,453

 
1,325

 
6,778

Net decrease in other comprehensive loss
5,453

 
1,325

 
6,778

Balance as of September 30, 2016
$
(37,049
)
 
$
519

 
$
(36,530
)
The amounts reclassified from accumulated other comprehensive loss were immaterial for the three and nine months ended September 30, 2016.



14


9. Income Taxes
The effective tax rates for the three months ended September 30, 2016 and 2015 were 35% and 30%, respectively. The effective tax rates for the nine months ended September 30, 2016 and 2015 were 30% and 34%, respectively. The effective tax rate for the nine months ended September 30, 2016 differed from the Federal statutory rate primarily due to Federal and California research and development ("R&D") credits partially offset by state taxes, foreign taxes and non-deductible expenses. The effective tax rate for the three and nine months ended September 30, 2015 differed from the Federal statutory rate primarily due to the California R&D credit partially offset by state taxes, foreign taxes and non-deductible expenses. The increase in effective tax rate for the three months ended September 30, 2016 as compared to the same period in 2015 was due primarily to increased operating results for the three months ended September 30, 2016. The decrease in effective tax rate for the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015 was primarily attributable to the permanent reinstatement of the Federal R&D credit in the fourth quarter of 2015.
Gross unrecognized tax benefits were $16.5 million and $17.1 million as of September 30, 2016 and December 31, 2015, respectively. The gross unrecognized tax benefits, if recognized by the Company, will result in a reduction of approximately $13.7 million to the provision for income taxes thereby favorably impacting the Company’s effective tax rate. As of September 30, 2016, the Company had identified gross unrecognized tax benefits of $16.5 million, of which $1.6 million was classified as “Other non-current liabilities” and $14.9 million as a reduction to deferred tax assets which was classified as "Other non-current assets" in 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 and “Other non-current liabilities” in the Consolidated Balance Sheets. Interest and penalties included in the Company’s “Provision for income taxes” were not material in any of the periods presented.
Deferred tax assets include $200.0 million and $180.6 million classified as “Other non-current assets” on the Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015, 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, 2016 and December 31, 2015, it was considered more likely than not that all deferred tax assets would be realized.
Income tax benefits attributable to the exercise of employee stock options are recorded in additional paid-in-capital. These benefits amounted to $12.6 million and $37.7 million, during the three months ended September 30, 2016 and 2015, respectively, and amounted to $37.2 million and $105.6 million, during the nine months ended September 30, 2016 and 2015, respectively.
The Company files U.S. Federal, state and foreign tax returns. The Company is currently under examination by the IRS for 2014 and 2015. The 2008 through 2015 state tax returns are subject to examination by state tax authorities. The Company has no significant foreign jurisdiction audits underway, and 2011 through 2015 remain subject to examination by foreign tax authorities. Given the potential outcome of the current examinations as well as the impact of the current examinations 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. At this time, an estimate of the range of reasonably possible adjustments to the balance of unrecognized tax benefits cannot be made.


10. Segment Information
The Company has three reportable segments: Domestic streaming, International streaming and Domestic DVD. Segment information is presented in the same manner that the Company’s chief operating decision maker ("CODM") reviews the operating results in assessing performance and allocating resources. The Company’s CODM 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 incurred by the segment. The Company has aggregated the results of the International operating segments into one reportable segment because these operating segments share similar long-term economic and other qualitative characteristics.
The Domestic streaming segment derives revenues from monthly membership fees for services consisting solely of streaming content to members in the United States. The International streaming segment derives revenues from monthly membership fees for services consisting solely of streaming content to members outside the United States. The Domestic DVD segment derives revenues from monthly membership fees for services consisting solely of DVD-by-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 segments.
The vast majority of the cost of revenues relate to content expenses, which include the amortization of streaming content assets and other costs associated with the licensing and acquisition of streaming content. In connection with the Company's global expansion, content acquired, licensed, and produced increasingly includes global rights. The Company allocates this content between the International and Domestic streaming segments based on estimated fair market value. Content expenses for each streaming segment thus include both expenses directly incurred by the segment as well as an allocation of expenses incurred for global rights. Other costs of revenues such as delivery costs are primarily attributed to the operating segment based on amounts directly incurred by the segment. Marketing expenses consist primarily of advertising expenses and payments made to device partners which are generally included in the segment in which the expenditures are directly incurred.

15


The Company's long-lived tangible assets were located as follows:
 
As of
 
September 30,
2016
 
December 31,
2015
 
(in thousands)
United States
$
176,271

 
$
159,566

International
15,605

 
13,846

The following table represents segment information for the three and nine months ended September 30, 2016:
 
 
As of/ Three Months Ended September 30, 2016
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total memberships at end of period (1)
47,497

 
39,246

 
4,273

 

Revenues
$
1,304,333

 
$
853,480

 
$
132,375

 
$
2,290,188

Cost of revenues
720,658

 
748,515

 
63,671

 
1,532,844

Marketing
108,495

 
173,548

 

 
282,043

Contribution profit (loss)
$
475,180

 
$
(68,583
)
 
$
68,704

 
$
475,301

Other operating expenses
 
 
 
 
 
 
369,265

Operating income
 
 
 
 
 
 
106,036

Other income (expense)
 
 
 
 
 
 
(26,909
)
Provision for income taxes
 
 
 
 
 
 
27,610

Net income
 
 
 
 
 
 
$
51,517

 
As of/ Nine Months Ended September 30, 2016
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total memberships at end of period (1)
47,497

 
39,246

 
4,273

 

Revenues
$
3,673,845

 
$
2,263,429

 
$
415,854

 
$
6,353,128

Cost of revenues
2,094,310

 
2,076,576

 
204,596

 
4,375,482

Marketing
277,243

 
428,839

 

 
706,082

Contribution profit (loss)
$
1,302,292

 
$
(241,986
)
 
$
211,258

 
$
1,271,564

Other operating expenses
 
 
 
 
 
 
1,045,705

Operating income
 
 
 
 
 
 
225,859

Other income (expense)
 
 
 
 
 
 
(55,621
)
Provision for income taxes
 
 
 
 
 
 
50,308

Net income
 
 
 
 
 
 
$
119,930



16


The following table represents segment information for the three and nine months ended September 30, 2015:
 
As of/ Three Months Ended September 30, 2015
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total memberships at end of period (1)
43,181

 
25,987

 
5,060

 

Revenues
$
1,063,961

 
$
516,870

 
$
157,524

 
$
1,738,355

Cost of revenues
644,914

 
451,251

 
77,793

 
1,173,958

Marketing
74,835

 
133,267

 

 
208,102

Contribution profit (loss)
$
344,212

 
$
(67,648
)
 
$
79,731

 
$
356,295

Other operating expenses
 
 
 
 
 
 
282,654

Operating income
 
 
 
 
 
 
73,641

Other income (expense)
 
 
 
 
 
 
(31,403
)
Provision for income taxes
 
 
 
 
 
 
12,806

Net income
 
 
 
 
 
 
$
29,432

 
As of/ Nine Months Ended September 30, 2015
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total memberships at end of period (1)
43,181

 
25,987

 
5,060

 

Revenues
$
3,074,406

 
$
1,387,030

 
$
494,742

 
$
4,956,178

Cost of revenues
1,840,134

 
1,249,495

 
252,482

 
3,342,111

Marketing
237,813

 
362,106

 

 
599,919

Contribution profit (loss)
$
996,459

 
$
(224,571
)
 
$
242,260

 
$
1,014,148

Other operating expenses
 
 
 
 
 
 
768,216

Operating income
 
 
 
 
 
 
245,932

Other income (expense)
 
 
 
 
 
 
(124,778
)
Provision for income taxes
 
 
 
 
 
 
41,691

Net income
 
 
 
 
 
 
$
79,463

The following table represents the amortization of content assets:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Three months ended September 30,
 
 
 
 
 
 
 
2016
$
597,039

 
$
627,069

 
$
19,284

 
$
1,243,392

2015
493,025

 
378,378

 
18,589

 
889,992

Nine months ended September 30,
 
 
 
 
 
 
 
2016
1,709,168

 
1,748,822

 
59,746

 
3,517,736

2015
1,387,242

 
1,056,279

 
60,587

 
2,504,108


(1)
A membership (also referred to as a subscription or a member) is defined as the right to receive Netflix service following sign-up and a method of payment being provided. 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. Total members include those who are on a free-trial as long as a method of payment has been provided. A membership is canceled and ceases to be reflected in the above metrics as of the effective cancellation date. Voluntary cancellations become effective at the end of the prepaid membership period, while involuntary cancellation of the service, as a result of a failed method of payment, becomes effective immediately except in limited circumstances where a short grace period is offered to ensure the streaming service is not interrupted for members who are impacted by payment processing delays by the Company's banks or integrated payment partners. The number of members in a grace period at any given point is not material.



17




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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These forward-looking statements include, but are not limited to statements regarding: our core strategy; the impact of, and the Company’s response to, new accounting standards; content amortization, pricing changes, including their impact on paid memberships and average monthly revenue per paying membership; dividends; impact of foreign currency and exchange rate fluctuations; investments in marketing and content, including original content; cash use in connection with the acquisition, licensing and production of content; contribution margin and free cash flow expectations; unrecognized tax benefits; deferred tax assets; tax settlements; accessing and obtaining additional capital; accounting treatment for changes related to content assets; and future contractual obligations, including unknown streaming content 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. 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, 2015 filed with the Securities and Exchange Commission (“SEC”) on January 28, 2016, 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 Web site (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 Web site.

Overview
We are the world’s leading Internet television network with over 86 million streaming members in over 190 countries enjoying more than 125 million hours of TV shows and movies per day, including original series, documentaries and feature films. 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 screens and have added increasing amounts of content that enable consumers to enjoy TV shows and movies directly on their Internet-connected screens. 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, the first and fourth quarters (October through March) represent our greatest membership growth across our Domestic and International streaming segments and the fewest membership losses in our Domestic DVD segment.
Our core strategy is to grow our streaming membership business globally within the parameters of our consolidated net income and operating segment contribution profit (loss) targets. We are continuously improving our members' experience by expanding our streaming content with a focus on a programming mix of content that delights our members. In addition, we are perpetually enhancing our user interface and extending our streaming service to more Internet-connected screens.

Results of Operations

The following represents our consolidated performance highlights:
 
As of/ Three Months Ended
 
Change
 
September 30,
2016
 
September 30,
2015
 
Q3'16 vs. Q3'15
 
(in thousands, except revenue per membership and percentages)

Global streaming memberships at end of period
86,743

 
69,168

 
25
%
Global streaming average monthly revenue per paying membership
$
8.82

 
$
8.19

 
8
%
Revenues
2,290,188

 
1,738,355

 
32
%
Operating income
106,036

 
73,641

 
44
%
Net income
51,517

 
29,432

 
75
%


18


Consolidated revenues for the three months ended September 30, 2016 increased $551.8 million as compared to the three months ended September 30, 2015 due to growth in global streaming paying memberships, primarily in our international memberships reflecting our expansion and focus on Netflix as a global Internet TV network. In addition, the average monthly revenue per paying streaming membership increased due to price changes and plan mix. The increase in operating income and net income for the three months ended September 30, 2016 as compared to the same period in 2015 was due primarily to increased revenues partially offset by increased content expenses as we continue to acquire, license and produce content, including more Netflix originals, as well as increased headcount costs to support continued improvements in our streaming service and our international expansion.

We offer three types of streaming membership plans. In the U.S. our "basic" plan is priced at $7.99 per month and includes access to standard definition quality streaming on a single screen at a time. Our "standard" plan is our most popular streaming plan and is priced at $9.99 per month and includes access to high definition quality streaming on two screens concurrently. Our "premium" plan is priced at $11.99 per month and includes access to high definition and ultra-high definition quality content on four screens concurrently. Internationally, the membership plans are structured similarly to the U.S. and range in price from the U.S. dollar equivalent of approximately $5.00 per month to $18.00 per month.
We expect that from time to time the prices of our membership plans in each country may change. For instance, in May 2014, in the U.S., we increased the price of our standard plan from $7.99 per month to $8.99 per month with existing memberships grandfathered for a two year period. In October 2015, in the U.S., we increased the price of this same standard plan from $8.99 per month to $9.99 per month with existing memberships grandfathered for a one year period. In the second quarter of 2016, we began to phase out the grandfathered pricing, giving members the option of electing the basic streaming plan at $7.99 per month, continuing on the standard streaming plan at the higher price of $9.99 per month, or electing the premium plan at $11.99 per month. We will complete the phase out of grandfathered pricing through the remainder of 2016. Most of our members under grandfathered pricing are in the U.S. However, the same approach and pricing structures are applied internationally.

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

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

For the Domestic and International streaming segments, content expenses, which include the amortization of the streaming content assets and other expenses associated with the licensing and acquisition of streaming content, represent the vast majority of cost of revenues. Streaming content rights were generally obtained for our current geographic regions. As we expand internationally, we obtained additional rights for new geographies. With our global expansion, we now aspire to obtain global rights for our content. We allocate this content between the Domestic and International streaming segments based on estimated fair market value. Other cost of revenues such as streaming delivery expenses, customer service and payment processing fees, including those we pay to our integrated payment partners, tend to be lower as a percentage of total cost of revenues. We have built our own global content delivery network ("Open Connect") to help us efficiently stream a high volume of content to our members over the Internet. Streaming delivery expenses, therefore, include equipment costs related to Open Connect and all third-party costs, such as cloud computing costs, associated with delivering streaming content over the Internet. Cost of revenues in the Domestic DVD segment consist primarily of delivery expenses, content expenses, including amortization of DVD content assets and revenue sharing expenses, and other expenses associated with our DVD processing and customer service centers. 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 device partners. Advertising expenses include promotional activities such as digital and television advertising. Payments to our device partners include fixed fee and/or revenue sharing payments. Marketing expenses are incurred by our Domestic and International streaming segments given our focus on building consumer awareness of the streaming offerings, and in particular our original content. Marketing expenses incurred by our International streaming segment have been significant and fluctuate dependent upon the number of international territories in which our streaming service is offered and the timing of the launch of new territories.

We have demonstrated our ability to grow domestic streaming contribution margin as evidenced by the increase in contribution margin from 12% in the fourth quarter of 2011 to 36% in the third quarter of 2016. 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.



19


Domestic Streaming Segment
Three months ended September 30, 2016 as compared to the three months ended September 30, 2015
 
 
As of/ Three Months Ended
 
Change
 
 
September 30,
2016
 
September 30,
2015
 
Q3'16 vs. Q3'15
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
368

 
881

 
(513
)
 
(58
)%
Memberships at end of period
 
47,497

 
43,181

 
4,316

 
10
 %
Paid memberships at end of period
 
46,479

 
42,068

 
4,411

 
10
 %
Average monthly revenue per paying membership
 
$
9.40

 
$
8.53

 
$
0.87

 
10
 %
 
 
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
 
 
Revenues
 
$
1,304,333

 
$
1,063,961

 
$
240,372

 
23
 %
Cost of revenues
 
720,658

 
644,914

 
75,744

 
12
 %
Marketing
 
108,495

 
74,835

 
33,660

 
45
 %
Contribution profit
 
475,180

 
344,212

 
130,968

 
38
 %
Contribution margin
 
36
%
 
32
%
 
 
 
 

In the Domestic streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content to our members in the United States. The 23% increase in our domestic streaming revenues was primarily due to an 11% growth in the average number of paid memberships, as well as a 10% increase in the average monthly revenue per paying membership, resulting from our price changes and plan mix. Our standard plan continues to be the most popular plan choice for new memberships.
In the second quarter of 2016, we began to phase out grandfathered pricing and will complete this in the fourth quarter of 2016. As of September 30, 2016, less than a quarter of our paying members in the United States remained under a grandfathered price plan. Cancellations by members whose grandfathered pricing expired have not been material and we expect this trend to continue. While the expiration of this grandfathered pricing may moderate near term membership growth, we believe the overall impact of the expiration of grandfathered pricing will be an increase in revenue.
If we experience higher than expected cancellations of service by members whose grandfathered pricing is expiring or if these members elect the lower priced plan in greater numbers than we expect, average monthly revenue per paying membership and revenues may differ from our expectations.
The increase in domestic streaming cost of revenues was primarily due to a $78.6 million increase in content expenses relating to our existing and new streaming content, including more exclusive and original programming.
Domestic marketing expenses increased primarily due to increased advertising and public relations spending, as well as increased payments to our device partners.
Our Domestic streaming segment had a contribution margin of 36% for the three months ended September 30, 2016, which increased as compared to the contribution margin of 32% for the three months ended September 30, 2015 due to growth in paid memberships and revenue which continued to outpace content spending. Our 2020 domestic streaming contribution margin target remains at 40%.

20



Nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015
 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2016
 
September 30,
2015
 
YTD'16 vs. YTD'15
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
2,759

 
4,067

 
(1,308
)
 
(32
)%
Memberships at end of period
 
47,497

 
43,181

 
4,316

 
10
 %
Paid memberships at end of period
 
46,479

 
42,068

 
4,411

 
10
 %
Average monthly revenue per paying membership
 
$
8.96

 
$
8.45

 
$
0.51

 
6
 %
 
 
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
 
 
Revenues
 
$
3,673,845

 
$
3,074,406

 
$
599,439

 
19
 %
Cost of revenues
 
2,094,310

 
1,840,134

 
254,176

 
14
 %
Marketing
 
277,243

 
237,813

 
39,430

 
17
 %
Contribution profit
 
1,302,292

 
996,459

 
305,833

 
31
 %
Contribution margin
 
35
%
 
32
%
 
 
 
 
The increase in our domestic streaming revenues was primarily due to a 13% growth in the average number of paid memberships as well as the 6% increase in average monthly revenue per paying membership resulting from our price changes and plan mix.
The increase in domestic streaming cost of revenues was primarily due to a $222.3 million increase in content expenses relating to our existing and new streaming content, including more exclusive and original programming. Other costs increased $31.9 million primarily due to increases in our streaming delivery expenses, costs associated with our customer service call centers and payment processing fees, all driven by our growing member base.
Domestic marketing expenses increased primarily due to increased advertising and public relations spending, as well as increased payments to our device partners.
Our Domestic streaming segment had a contribution margin of 35% for the nine months ended September 30, 2016, which increased as compared to the contribution margin of 32% for the nine months ended September 30, 2015 due to growth in paid memberships and revenue which outpaced content and marketing spending.
International Streaming Segment
Three months ended September 30, 2016 as compared to the three months ended September 30, 2015
 
 
As of /Three Months Ended
 
Change
 
 
September 30,
2016
 
September 30,
2015
 
Q3'16 vs. Q3'15
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
3,198

 
2,736

 
462

 
17
 %
Memberships at end of period
 
39,246

 
25,987

 
13,259

 
51
 %
Paid memberships at end of period
 
36,799

 
23,951

 
12,848

 
54
 %
Average monthly revenue per paying membership
 
$
8.05

 
$
7.56

 
$
0.49

 
6
 %
 
 
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
 
 
Revenues
 
$
853,480

 
$
516,870

 
$
336,610

 
65
 %
Cost of revenues
 
748,515

 
451,251

 
297,264

 
66
 %
Marketing
 
173,548

 
133,267

 
40,281

 
30
 %
Contribution loss
 
(68,583
)
 
(67,648
)
 
(935
)
 
(1
)%
Contribution margin
 
(8
)%
 
(13
)%
 
 
 



In the International streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content to our members outside the United States. We launched our streaming service in Canada in September 2010 and have expanded our services internationally as shown below.

21




timelineupdateda02.jpg
The increase in our international revenues was due to a 55% increase in the average number of paid international memberships, in addition to a 6% increase in the average monthly revenue per paying membership. The increase in the average monthly revenue per paying membership was due to price changes and plan mix offset partially by unfavorable fluctuations in foreign exchange rates. We estimate that international revenues in the third quarter of 2016 would have been approximately $34.9 million higher if foreign exchange rates had remained consistent with the foreign exchange rates from the third quarter of 2015. If foreign currency exchange rates fluctuate more than expected, revenues and average revenue per paying membership may differ from our expectations. Average paid international streaming memberships accounted for 43% of global average paid streaming memberships for the three months ended September 30, 2016, as compared to 35% of global average paid streaming memberships for the same period in 2015.
While the expiration of grandfathered pricing may moderate near term membership growth, we believe the overall impact of the expiration of grandfathered pricing will be an increase in revenue. If we experience higher than expected cancellations of service by members whose grandfathered pricing is expiring or if these members elect the lower priced plan in greater numbers than we expect, our paid memberships, average monthly revenue per paying membership and revenue may differ from our expectations.
The increase in international cost of revenues was primarily due to a $264.6 million increase in content expenses relating to our existing and new streaming content, including more exclusive and original programming. Other costs increased $32.7 million primarily due to increases in our streaming 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 September 30, 2016 increased as compared to the three months ended September 30, 2015 mainly due to expenses for territories launched in the last twelve months.
International contribution losses were relatively flat for the three months ended September 30, 2016 as compared to the three months ended September 30, 2015.

22



Nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015
 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2016
 
September 30,
2015
 
YTD'16 vs. YTD'15
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
9,222

 
7,710

 
1,512

 
20
 %
Memberships at end of period
 
39,246

 
25,987

 
13,259

 
51
 %
Paid memberships at end of period
 
36,799

 
23,951

 
12,848

 
54
 %
Average monthly revenue per paying membership
 
$
7.70

 
$
7.54

 
$
0.16

 
2
 %
 
 
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
 
 
Revenues
 
$
2,263,429

 
$
1,387,030

 
$
876,399

 
63
 %
Cost of revenues
 
2,076,576

 
1,249,495

 
827,081

 
66
 %
Marketing
 
428,839

 
362,106

 
66,733

 
18
 %
Contribution loss
 
(241,986
)
 
(224,571
)
 
(17,415
)
 
(8
)%
Contribution margin
 
(11
)%
 
(16
)%
 
 
 
 
The increase in our international revenues was due to the 60% growth in our average number of paid international memberships, in addition to a 2% increase in our average monthly revenue per paying membership. The increase in the average monthly revenue per paying membership was due to price changes and plan mix, partially offset by unfavorable fluctuations in foreign exchange rates. We estimate that international revenues in the nine months ended September 30, 2016 would have been approximately $153.6 million higher if foreign exchange rates had remained consistent with the foreign exchange rates for the nine months ended September 30, 2015.
The increase in international cost of revenues was primarily due to a $726.3 million increase in content expenses relating to our existing and new streaming content, including more exclusive and original programming. Other costs increased $100.8 million primarily due to increases in our streaming delivery expenses, costs associated with our customer service call centers and payment processing fees, all driven by our growing member base, partially offset by decreases resulting from exchange rate fluctuations.
International marketing expenses for the nine months ended September 30, 2016 increased mainly due to expenses for territories launched in the last twelve months.
International contribution losses grew for the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015, due to increased spending for our international expansion and the impact of foreign currency exchange rate fluctuations.
Domestic DVD Segment
Three months ended September 30, 2016 as compared to the three months ended September 30, 2015
 
 
As of/ Three Months Ended
 
Change
 
 
September 30,
2016
 
September 30,
2015
 
Q3'16 vs. Q3'15
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net losses
 
(257
)
 
(254
)
 
(3
)
 
(1
)%
Memberships at end of period
 
4,273

 
5,060

 
(787
)
 
(16
)%
Paid memberships at end of period
 
4,194

 
4,971

 
(777
)
 
(16
)%
Average monthly revenue per paying membership
 
$
10.23

 
$
10.31

 
$
(0.08
)
 
(1
)%
 
 
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
 
 
Revenues
 
$
132,375

 
$
157,524

 
$
(25,149
)
 
(16
)%
Cost of revenues
 
63,671

 
77,793

 
(14,122
)
 
(18
)%
Contribution profit
 
68,704

 
79,731

 
(11,027
)
 
(14
)%
Contribution margin
 
52
%
 
51
%
 
 
 
 

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 $15.99 per month according to the plan chosen by the member. DVD-by-mail plans differ by the number of DVDs that a

23


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 decrease in our domestic DVD revenues was due to a 15% decrease in the average number of paid memberships.
The decrease in domestic DVD cost of revenues was primarily due to a $9.3 million decrease in delivery expenses resulting from a 19% decrease in the number of DVDs mailed to members. The decrease in shipments was driven by a decline in the number of DVD memberships and reduced usage by those members. Other costs, primarily those associated with processing and customer service expenses, decreased $3.5 million primarily due to a decrease in hub operation expenses resulting from the decline in DVD shipments.
Our Domestic DVD segment contribution margin was relatively flat for the three months ended September 30, 2016, as compared to the three months ended September 30, 2015.

Nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015
 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2016
 
September 30,
2015
 
YTD'16 vs. YTD'15
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net losses
 
(631
)
 
(707
)
 
76

 
11
 %
Memberships at end of period
 
4,273

 
5,060

 
(787
)
 
(16
)%