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

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

Overview

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

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

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

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

In September 2010, we began international operations by offering our streaming service in Canada. In September 2011, we expanded our streaming service to Latin America and the Caribbean. In January 2012, we launched our streaming service in the United Kingdom ("U.K.") and Ireland. We anticipate significant contribution losses in the International streaming segment in 2012. We anticipate expanding our International operations to another market in the fourth quarter of 2012.

As a result of the changes to our pricing and plan structure, we no longer offer a single subscription plan including both DVDs-by-mail and streaming in the U.S. Domestic subscribers who wish to receive DVDs-by-mail and watch streaming content must elect both a DVDs-by-mail subscription plan and a streaming subscription plan. Accordingly, beginning with the third quarter of 2011, management views the number of paid subscriptions as the key driver of revenues. The following metrics reflect these changes.

                                                       As of /Three Months Ended,
                                                   June 30,      March 31,    June 30,
Subscription Metrics (1):                            2012           2012        2011
                                                             (in thousands)
Domestic streaming:
Net additions                                          528          1,739
Paid subscriptions at end of period                 22,686         22,022
Total subscriptions at end of period                23,938         23,410
International streaming:
Net additions                                          559          1,207          164
Paid subscriptions at end of period                  3,024          2,409          857
Total subscriptions at end of period                 3,624          3,065          967
Domestic DVD:
Net losses                                            (849 )       (1,076 )
Paid subscriptions at end of period                  9,145          9,958
Total subscriptions at end of period                 9,240         10,089
Consolidated:
Net unique subscriber additions during period (2)      979          2,886        1,961
Paid unique subscribers at end of period (2)        28,254         27,083       24,120
Total unique subscribers at end of period (2)       30,118         29,139       25,561

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

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

The following represents our consolidated performance highlights:

                                                 Three Months Ended                             Change
                                       June 30,         March 31,      June 30,      Q2'12 vs.
                                         2012             2012           2011          Q1'12      Q2'12 vs. Q2'11
                                        (in thousands, except per share data)
Revenues                            $     889,163     $   869,791     $ 788,610          2 %             13  %
Operating income (loss)                    16,154          (1,935 )     115,114         NM              (86 )%
Net income (loss)                           6,164          (4,584 )      68,214         NM              (91 )%
Diluted earnings per share                   0.11           (0.08 )        1.26         NM              (91 )%
Free cash flow (3)                         11,168           2,149        59,545        420 %            (81 )%

(3) See "Liquidity and Capital Resources" for a definition of "free cash flow" and a reconciliation of "net cash provided by operating activities" to "free cash flow." Consolidated revenues for the second quarter of 2012 were relatively flat as compared to the first quarter of 2012 while consolidated net income increased by $10.7 million from a first quarter consolidated net loss of $4.6 million to a consolidated net income of $6.2 million. The increase is primarily due to lower marketing expenses both domestically and internationally. We expect consolidated revenues to increase at a modest pace sequentially in future quarters driven by the growth in global streaming subscriptions and partially offset by a decline in domestic DVD subscriptions. Investments in streaming content and marketing to support new international markets, including the launch planned in the fourth quarter of 2012, may result in future consolidated net losses.

Free cash flow for the three months ended June 30, 2012 increased $9.0 million as compared to the three months ended March 31, 2012 to $11.2 million. Free cash flow of $11.2 million was slightly higher than our consolidated net income of $6.2 million and improved quarter-over-quarter largely because of the sequential improvement in net income. Significant sources of cash flow in the quarter (relative to net income) were non-cash stock compensation, depreciation expense in excess of property and equipment purchases, and miscellaneous increases to accounts payable and accrued expenses, which more than offset cash payments for content (in excess of the expense) and our bi-annual cash payment for interest on our notes. The excess streaming and DVD content payments over expense will continue to fluctuate over time based on new content licenses domestically and internationally and in particular may increase as a result of higher up-front cash requirements for original content. We expect that free cash flow in future periods will be negatively impacted by investments in new International markets and in original content and that we may use cash for the year ended December 31, 2012.
Segment Overview
The following tables set forth, for the periods presented, financial information for each of our reportable segments including revenues from subscriptions and contribution profit (loss) which is the measure of profitability used by our chief operating decision maker. The information contained in the tables below should be read in conjunction with the consolidated financial statements, notes to the consolidated financial statements and the entirety of this Management's Discussion and Analysis of Financial Condition and Results of Operations.