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NFLX > SEC Filings for NFLX > Form 10-K on 3-Feb-2014All Recent SEC Filings

Show all filings for NETFLIX INC

Form 10-K for NETFLIX INC


3-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview
We are the world's leading Internet television network with more than 44 million streaming members in over 40 countries enjoying more than one 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 United States ("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 (loss) and operating segment contribution profit (loss) targets.

Results of Operations
The following represents our consolidated performance highlights:

                                          Year Ended December 31,                           Change
                                   2013            2012            2011         2013 vs. 2012     2012 vs. 2011
                                              (in thousands)
Revenues                       $ 4,374,562     $ 3,609,282     $ 3,204,577             21 %            13  %
Operating income                   228,347          49,992         376,068            357 %           (87 )%
Net income                         112,403          17,152         226,126            555 %           (92 )%
Free cash flow (1)                 (16,300 )       (58,151 )       186,550             72 %            NM

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

Consolidated revenues for 2013 increased as compared to prior years due to growth in international and domestic streaming memberships. Operating income and net income increased as compared to prior year by $178.4 million and $95.3 million, respectively, due to the increase in revenue, partially offset by an increase in the cost of revenues due to continued investments in existing and new streaming content.
Free cash flow was $128.7 million lower than net income for the year ended December 31, 2013. The excess of net income over free cash flow has increased from $75.3 million and $39.6 million in the years ended December 31, 2012 and 2011, respectively. The increases are primarily the result of increased investments in original content or content that is licensed in an earlier window through an output arrangement which will typically, depending upon the terms, require more up-front cash payments relative to the expense.

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 of streaming content, represent the vast


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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 are lower as a percentage of total cost of revenues as compared to content licensing expenses. We utilize both our own and third-party content delivery networks to help us efficiently stream a high volume of content to our members over the Internet. Content delivery expenses, therefore, also include equipment costs related to our streaming content delivery network ("Open Connect") and all third-party costs associated with delivering streaming content over the Internet. Cost of revenues in the Domestic DVD segment consists primarily of content delivery, expenses related to the acquisition of content, including amortization of DVD content library and revenue sharing expenses, and other expenses associated with our DVD processing and customer service centers. Content delivery expenses for the Domestic DVD segment consist of the postage costs to mail DVDs to and from our paying members and the packaging and label costs for the mailers.

For the Domestic and International streaming segments, marketing expenses consist primarily of advertising expenses and payments made to our affiliates and consumer electronics partners. Advertising expenses include promotional activities such as television and online advertising. Payments to our affiliates and device partners include fixed fee and /or revenue sharing payments. Marketing costs 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 costs 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 23% in the fourth quarter of 2013. 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.

2013 Segment Results

Domestic Streaming Segment
                                   As of/ Year Ended December 31,          Change
                                       2013                2012         2013 vs. 2012
                                          (in thousands, except percentages)
Members:
Net additions                             6,274              5,475            15 %
Members at end of period                 33,420             27,146            23 %
Paid members at end of period            31,712             25,471            25 %

Contribution profit:
Revenues                        $     2,751,375       $  2,184,868            26 %
Cost of revenues                      1,849,154          1,558,864            19 %
Marketing                               279,454            256,995             9 %
Contribution profit                     622,767            369,009            69 %
Contribution margin                          23 %               17 %

In the Domestic streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan. Our Domestic streaming membership plans are priced primarily at $7.99 per month. In 2013, we introduced membership plans priced at $11.99 per month under which members can stream content on up to four devices concurrently. New member additions and revenue related to $11.99 membership plans were not material for the year ended December 31, 2013. The $566.5 million increase in our domestic streaming revenues was due to the 26% growth in the average number of paid memberships.


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The $290.3 million increase in domestic streaming cost of revenues was primarily due to the $226.3 million increase in content licensing expenses resulting from continued investments in existing and new streaming content including more exclusive and original programming. In addition, content delivery expenses increased by $31.0 million and other costs, such as payment processing fees and customer service call centers, increased $33.0 million due to our growing member base.
Marketing expenses increased $22.5 million primarily due to an increase in advertising partially offset by a decrease in payments to affiliates in the U.S. Our Domestic streaming segment had a contribution margin of 23% for the year ended December 31, 2013, which increased as compared to the contribution margin of 17% for the year ended December 31, 2012, as a result of growing memberships and revenue faster than content and marketing spending.

International Streaming Segment
                                   As of/ Year Ended December 31,           Change
                                      2013                 2012          2013 vs. 2012
                                          (in thousands, except percentages)
Members:
Net additions                           4,809                4,263             13  %
Members at end of period               10,930                6,121             79  %
Paid members at end of period           9,722                4,892             99  %

Contribution loss:
Revenues                        $     712,390        $     287,542            148  %
Cost of revenues                      774,753              475,570             63  %
Marketing                             211,969              201,115              5  %
Contribution loss                    (274,332 )           (389,143 )          (30 )%
Contribution margin                       (39 )%              (135 )%

In the International streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan priced at the equivalent of USD $7 to $14 per month. We launched our streaming service in Canada in September 2010 and have continuously expanded our services internationally with launches in Latin America in September 2011, the U.K. and Ireland in January 2012, Finland, Denmark, Sweden and Norway in October 2012 and most recently the Netherlands in September 2013. We plan to continue to expand our services internationally and expect a substantial European expansion in 2014.
The $424.8 million increase in our international revenues was primarily due to the 134% growth in the average number of paid international memberships. International streaming memberships account for 25% of total streaming memberships at the end of 2013.
The $299.2 million increase in international cost of revenues was primarily due to a $272.0 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content including content to support the launch of our service in the Nordics (launched in the fourth quarter of 2012) and the Netherlands (launched in the third quarter of 2013). Other costs increased $27.2 million 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 year ended December 31, 2013 increased $10.9 million as compared to the year ended December 31, 2012 due to our expansion in the Nordics and the Netherlands offset partially by a decrease in spending in other territories.
International contribution losses improved $114.8 million year over year, 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, 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.


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Domestic DVD Segment
                                    As of/ Year Ended December 31,           Change
                                      2013                 2012           2013 vs. 2012
                                           (in thousands, except percentages)
Members:
Net losses                             (1,294 )               (2,941 )         (56 )%
Members at end of period                6,930                  8,224           (16 )%
Paid members at end of period           6,765                  8,049           (16 )%

Contribution profit:
Revenues                        $     910,797       $      1,136,872           (20 )%
Cost of revenues                      459,349                591,432           (22 )%
Marketing                              12,466                  7,290            71  %
Contribution profit                   438,982                538,150           (18 )%
Contribution margin                        48 %                   47 %

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 $226.1 million decrease in our domestic DVD revenues was due to a 20% decrease in the average number of paid memberships.
The $132.1 million decrease in domestic DVD cost of revenues was primarily due to a $63.2 million decrease in content acquisition expenses and a $47.7 million decrease in content delivery expenses resulting from a 21% decrease in the number of DVDs mailed to paying members. The decrease in shipments was driven by a decline in the number of DVD memberships. Other costs, primarily those associated with content processing and customer service center expenses, decreased $21.2 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 year ended December 31, 2013, and was relatively flat as compared to the year ended December 31, 2012.


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2012 Segment Results

Domestic Segments
                                   As of /Year Ended December 31,         Change
                                       2012               2011         2012 vs. 2011
                                         (in thousands, except percentages)
Members:
Domestic Streaming
Members at end of period                 27,146            21,671            25  %
Paid members at end of period            25,471            20,153            26  %

Domestic DVD
Members at end of period                  8,224            11,165           (26 )%
Paid members at end of period             8,049            11,039           (27 )%

Unique Domestic
Net additions                             4,973             4,894             2  %
Members at end of period                 29,368            24,395            20  %
Paid members at end of period            27,613            22,858            21  %

Contribution Profit:
Revenues                        $     3,321,740       $ 3,121,727             6  %
Cost of revenues                      2,150,296         1,932,419            11  %
Marketing                               264,285           302,752           (13 )%
Contribution profit                     907,159           886,556             2  %
Contribution margin                          27 %              28 %

Prior to July 2011, in the U.S., our streaming and DVDs-by-mail operations were combined and members 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 members who wish to receive both streaming services and DVDs-by-mail to have two separate membership plans. As members were able to receive both streaming and DVDs-by-mail under a single hybrid plan prior to the fourth quarter of 2011, it is impracticable to allocate revenues and expenses to the Domestic streaming and Domestic DVD segments prior to the fourth quarter of 2011.
The $200.0 million increase in our domestic revenues in 2012 as compared to 2011 was primarily due to the 15% growth in the domestic average number of unique paying members driven by new streaming memberships. This increase was offset in part by an 8% decline in domestic average monthly revenue per unique paying member, resulting from the decline in DVD memberships.
The $217.9 million increase in domestic cost of revenues in 2012 as compared to 2011 was primarily due to a $397.7 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content. Content delivery expenses decreased by $162.0 million primarily due to a 41% decrease in the number of DVDs mailed to paying members driven by a decline in the number of DVD memberships. Other costs associated with content processing and customer service center expenses decreased by $13.9 million primarily due to a decrease in hub operation expenses resulting from the declines in DVD shipments, offset partially by increases in customer service center expenses to support our growth in domestic memberships. Marketing expenses decreased $38.5 million in 2012 as compared to 2011 primarily due to a decrease in marketing program spending in television, radio and direct mail advertising partially offset by increases in online advertising. The Domestic segment had a contribution margin of 27% for the year ended December 31, 2012, and is relatively flat as compared to December 31, 2011.


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International Streaming Segment
                                   As of /Year Ended December 31,           Change
                                       2012                2011          2012 vs. 2011
                                          (in thousands, except percentages)
Members:
Net additions                             4,263               1,349             216 %
Members at end of period                  6,121               1,858             229 %
Paid members at end of period             4,892               1,447             238 %

Contribution profit:
Revenues                        $       287,542       $      82,850             247 %
Cost of revenues                        475,570             107,482             342 %
Marketing                               201,115              78,517             156 %
Contribution loss                      (389,143 )          (103,149 )           277 %

The $204.7 million increase in our international revenues in 2012 as compared to 2011 was primarily due to the 260% growth in the international average number of unique paying members driven by a full year of service offering in Latin America as well as our launches in the U.K. and Ireland and Nordic regions. International streaming memberships account for 18% of total streaming memberships at the end of 2012.
International cost of revenues increased by $368.1 million in 2012 as compared to 2011 primarily due to a $347.5 million increase in content licensing costs resulting from the continued investments in streaming content available for viewing in Canada and Latin America and to support our launches in the U.K. and Ireland and Nordic regions.
International marketing expenses increased $122.6 million in 2012 as compared to 2011 primarily due to increases in marketing program spending online and in television and radio advertising to support our launches in the U.K. and Ireland and Nordic regions.

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.

                                 Year Ended December 31,          Change
                                   2013            2012        2013 vs. 2012
                                    (in thousands, except percentages)
Technology and development    $    378,769      $ 329,008            15 %
As a percentage of revenues              9 %            9 %

The $49.8 million increase in technology and development expenses was primarily the result of a $42.8 million increase in personnel-related costs. These increases are primarily due to increases in employee compensation as well as an 8% growth in average headcount supporting continued improvements in our streaming service and international expansion.

                                 Year Ended December 31,           Change
                                   2012            2011       2012 vs. 2011
                                     (in thousands, except percentages)
Technology and development    $    329,008      $ 259,033             27 %
As a percentage of revenues              9 %            8 %

The $70.0 million increase in technology and development expenses was primarily the result of a $63.4 million increase in personnel-related costs, including a $12.7 million increase in stock-based compensation. These increases are primarily due to a 35% growth in average headcount supporting continued improvements in our streaming service and international expansion.


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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.
                                 Year Ended December 31,          Change
                                   2013            2012        2013 vs. 2012
                                    (in thousands, except percentages)
General and administrative    $    180,301      $ 139,016            30 %
As a percentage of revenues              4 %            4 %

General and administrative expenses increased $41.3 million primarily due to a $22.0 million increase in personnel related costs resulting from a 31% increase in average headcount to support our growth. In addition, expenses related to the use of outside and professional services, taxes and insurance increased $8.9 million. The increase in expenses was further impacted by an $8.0 million decrease in the gain on the disposal of DVDs.

                                 Year Ended December 31,           Change
                                   2012            2011        2012 vs. 2011
                                     (in thousands, except percentages)
General and administrative    $    139,016      $ 148,306           (6 )%
As a percentage of revenues              4 %            5 %

The $9.3 million decrease in general and administrative expenses was primarily attributable to a $9.0 million expense in 2011 related to the settlement of a legal claim related to our compliance with the Video Privacy Protection Act, a $5.8 million increase in the gain on sale of previously viewed DVDs, and an $8.6 million decrease in miscellaneous expenses related to the use of outside and professional services, taxes, insurance costs and to costs associated with various legal claims against us. These decreases were partially offset by an increase in personnel-related costs of $14.1 million attributed to an 8% increase in average headcount.
Interest Expense
Interest expense consists primarily of the interest associated with outstanding long-term debt obligations, including the amortization of debt issuance costs, as well as interest on our lease financing obligations.

                                 Year Ended December 31,          Change
                                   2013            2012        2013 vs. 2012
                                    (in thousands, except percentages)
Interest expense              $    (29,142 )    $ (19,986 )          46 %
As a percentage of revenues              1 %            1 %

Interest expense for the year ended December 31, 2013 consists primarily of $26.1 million of interest on our notes. The increase in interest expense for the year ended December 31, 2013 as compared the year ended December 31, 2012 is due to the higher aggregate principal of interest bearing notes outstanding, partially offset by the lower interest rate.

                                 Year Ended December 31,           Change
                                   2012            2011       2012 vs. 2011
                                     (in thousands, except percentages)
Interest expense              $    (19,986 )    $ (20,025 )       -  %
As a percentage of revenues              1 %            1 %

Interest expense was relatively flat as compared to the prior year. Interest expense in 2012 consists primarily of $17.0 million of interest due on our 8.50% Notes.

Interest and Other Income (Expense)
Interest and other income (expense) consists primarily of interest earned on
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