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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2003

OR

For the transition period from                  to                 

Commission File Number: 000-49802

Netflix, Inc.

(Exact name of Registrant as specified in its charter)

970 University Avenue, Los Gatos, California 95032

(Address and zip code of principal executive offices)

(408) 399-3700

(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  ¨.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act).    YES   x     NO  ¨.

As of July 23, 2003, there were 24,004,351 shares of the registrant’s common stock, par value $0.001, outstanding.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Index to Financial Statements

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Netflix, Inc.

Statements of Operations

(unaudited)

(in thousands, except per share data)

See accompanying notes to financial statements.

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Netflix, Inc.

Balance Sheets

(unaudited)

(in thousands, except share and par value data)

See accompanying notes to financial statements.

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Netflix, Inc.

Statements of Cash Flows

(unaudited)

(in thousands)

See accompanying notes to financial statements.

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Netflix, Inc.

Notes to Financial Statements

(in thousands, except per share data)

Basis of Presentation

The accompanying financial statements of Netflix, Inc. (the “Company”) as of June 30, 2003 and for the three and six months ended June 30, 2002 and 2003 are unaudited and, in the opinion of management, include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the balance sheets, results of operations and cash flows for the periods presented. These financial statements should be read in conjunction with the audited financial statements and related notes included in the Company’s 2002 annual report on Form 10-K as filed with the Securities and Exchange Commission on March 31, 2003. Operating results for the three and six months ended June 30, 2003 may not be indicative of results for any future periods.

During the second quarter of 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standard (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of FASB Statement No. 123, and restated all prior periods presented to reflect the compensation costs that would have been recognized had the fair value recognition provisions of SFAS No. 123 been applied to all awards granted to employees. Please refer to the “Stock-Based Compensation” section below for further discussion.

Description of Business

The Company was incorporated on August 29, 1997 (inception) and began operations on April 14, 1998. The Company is an online subscriptions-based digital video disc (“DVD”) rental service, providing subscribers with access to a comprehensive library of titles. For $19.95 a month, subscribers can rent as many DVDs as they want, with three movies out at a time, and keep them for as long as they like. There are no due dates and no late fees. DVDs are delivered directly to the subscriber’s address by first-class mail from distribution centers throughout the United States. The Company can reach more than half of its subscribers with generally next-day service. The Company also provides background information on DVD releases, including critic reviews, member reviews and ratings, and personalized movie recommendations.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Fair Value of Financial Instruments

The fair value of the Company’s cash, accounts payable, accrued expenses, and borrowings approximates their carrying value due to their short maturity or fixed-rate structure.

Cash and Cash Equivalents

The Company considers highly liquid instruments with original maturities of three months or less, at the date of purchase, to be cash equivalents. The Company’s cash and cash equivalents are principally on deposit in short-term asset management accounts at two large financial institutions.

Short-Term Investments

Short-term investments generally mature between three months and five years from the purchase date. The Company has the ability to convert these short-term investments into cash at anytime without penalty. All short-term investments are classified as available-for-sale and are recorded at market value using the specific identification method. Unrealized gains (losses) are reflected in other comprehensive income (loss) and accumulated other comprehensive income (loss).

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Netflix, Inc.

Notes to Financial Statements—Continued

(in thousands, except per share data)

All short-term investments are invested in the Vanguard Short-Term Bond Index Fund – Admiral Shares (the “Fund”). The target index for the Fund, the Lehman Brothers 1-5 Year Government/Corporate Bond Index, is comprised of U.S. Treasury and agency securities and investment-grade corporate bonds with maturities between one and five years. As of June 30, 2003, the cost, unrealized gains and fair market value of the Company’s short-term investments were $43,765, $1,331 and $45,096, respectively.

Capitalized Software Costs

The Company capitalizes costs related to developing or obtaining internal-use software. Capitalization of costs begins after the conceptual formulation stage has been completed. Capitalized software costs are included in property and equipment and amortized over the estimated useful life of the software, generally one year.

DVD Library

The Company acquires DVDs from studios and distributors either via direct purchase or subject to revenue sharing agreements. These revenue sharing agreements enable the Company to obtain DVDs at a lower up front cost than under traditional purchase arrangements. The Company shares a percentage of the actual net revenues generated by the use of each particular title with the studios over a fixed period of time, which is typically 12 months for each DVD title (hereinafter referred to as the “title term”). At the end of the title term, the Company has the option of either returning the DVD title to the studio or purchasing the title.

The Company amortizes the cost, less salvage value, of its DVD library on a “sum-of-the-months” accelerated basis over one year.

Under certain revenue sharing agreements, the Company remits an upfront payment to acquire titles from the studios. This payment includes a contractually specified initial fixed license fee that is capitalized and amortized in accordance with the Company’s DVD library amortization policy. Some payments also include a contractually specified prepayment of future revenue sharing obligations that is classified as prepaid revenue sharing expense and is charged to expense as future revenue sharing obligations are incurred.

Several studios permit the Company to sell used DVDs upon the expiration of the title term. For those DVDs that the Company estimates it will sell at the end of the title term, a salvage value of $2.00 per DVD is provided. For those DVDs that the Company does not expect to sell, no salvage value is provided. As of December 31, 2002 and June 30, 2003, the salvage values of $929 and $1,332, respectively, were included in DVD library in the accompanying financial statements.

DVD library and accumulated amortization consisted of the following:

Intangible Assets

During 2000, in connection with revenue sharing agreements with three studios, the Company agreed to issue each studio an equity interest equal to 1.204% of the Company’s fully diluted equity securities outstanding in the form of Series F Non-Voting Convertible Preferred Stock (“Series F Preferred Stock”). In 2001, in connection with revenue sharing agreements with two additional studios, the Company agreed to issue each studio an equity interest equal to 1.204% of the Company’s fully diluted equity securities outstanding in the form of Series F Preferred Stock.

The Company’s obligation to maintain the studios’ equity interests at 6.02% of the Company’s fully diluted equity securities outstanding terminated immediately prior to its initial public offering. The studios’ Series F Preferred Stock automatically converted into 1,596 shares of common stock upon the closing of the Company’s initial public offering.

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Netflix, Inc.

Notes to Financial Statements—Continued

(in thousands, except per share data)

The Company measured the original issuances and any subsequent adjustments using the fair value of the securities at the issuance and any subsequent adjustment dates. The fair value was recorded as an intangible asset and is amortized to cost of subscription revenues ratably over the three to five-year terms of the agreements.

During 2001, in connection with a strategic marketing alliance agreement, the Company issued 416 shares of Series F Preferred Stock. These shares automatically converted into 139 shares of common stock upon the closing of the Company’s initial public offering. Under the agreement, the strategic partner has committed to provide, on a best-efforts basis, a stipulated number of impressions to a co-branded website and the Company’s website over a period of 24 months. In addition, the Company is allowed to use the partner’s trademark and logo in marketing the Company’s subscription services. The Company recognized the fair value of these instruments as an intangible asset with a corresponding credit to additional paid-in capital. The intangible asset is amortized on a straight-line basis to marketing expense over the two-year term of the strategic marketing alliance.

Intangible assets and accumulated amortization consisted of the following:

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation. Depreciation is calculated using the straight-line method over the shorter of the estimated useful lives of the respective assets, generally up to three years, or the lease term, if applicable.

Revenue Recognition

Subscription revenues are recognized ratably during each subscriber’s monthly subscription period. Refunds to customers are recorded as a reduction of revenues or deferred revenue, as appropriate. Revenues from sales of DVDs are recorded upon shipment.

Cost of Revenues

Cost of subscription revenues consists of revenue sharing costs, amortization of the DVD library, amortization of intangible assets related to equity instruments issued to studios, and postage and packaging costs related to DVDs provided to paying subscribers. Cost of DVD sales includes the salvage value of used DVDs that have been sold. Revenue sharing expense is recorded as DVDs subject to revenue sharing agreements are shipped to subscribers.

Fulfillment

Fulfillment costs represent those costs incurred in operating and staffing the Company’s fulfillment and customer service centers, including costs attributable to receiving, inspecting, and warehousing the Company’s DVD library. Fulfillment costs also include credit card fees.

Technology and Development

Technology and development costs consist of payroll and related costs incurred related to testing, maintaining, and modifying the Company’s website, recommendation software, and other internal-use software systems. Technology and development costs also include depreciation on the computer hardware and capitalized software the Company uses to run its website and store data.

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Netflix, Inc.

Notes to Financial Statements—Continued

(in thousands, except per share data)

Marketing

Marketing consists of payroll and related costs, advertising, public relations, payments to marketing affiliates who drive subscriber traffic to the Company’s website, and other costs related to promotional activities including revenue-sharing payments, postage and packaging, and DVD library amortization related to free trial periods. The Company expenses these costs as incurred.

Stock-Based Compensation

Prior to the second quarter of 2003, the Company accounted for its stock-based employee compensation plans using the intrinsic-value method of accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Deferred stock-based compensation expense was recorded if, on the date of grant, the current market value of the underlying stock exceeded the exercise price. Deferred compensation resulting from repriced options was calculated pursuant to Financial Accounting Standard Board (“FASB”) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation.

During the second quarter of 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, for stock-based employee compensation. The Company elected to apply the retroactive restatement method under SFAS No. 148 and all prior periods presented have been restated to reflect the compensation costs that would have been recognized had the fair value recognition provisions of SFAS No. 123 been applied to all awards granted to employees.

The following table presents a reconciliation of previously reported net loss to restated net loss for the first quarter of 2003 and the four quarters of 2002:

Income Taxes

The Company accounts for income taxes using the asset and liability method. Deferred income taxes are recognized by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits for which future realization is uncertain.

Net Income (Loss) Per Share

Basic net income (loss) per share is computed using the weighted-average number of outstanding shares of common stock, excluding common stock subject to repurchase, during the period. Diluted net income (loss) 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 exercise of stock options and warrants to purchase common stock using the treasury stock method.

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Netflix, Inc.

Notes to Financial Statements—Continued

(in thousands, except per share data)

The following table sets forth the computation of basic and diluted net income (loss) per share:

For the three and six months ended June 30, 2003, warrants and employee stock options with exercise prices greater than the average market price of the common shares were excluded from the diluted calculation as their inclusion would have been anti-dilutive. For the three and six months ended June 30, 2002, all warrants and employee stock options have been excluded from the diluted calculation because the Company was in a net loss position.

The following table summarizes the items excluded from the diluted calculation:

Comprehensive Income (Loss)

The Company’s comprehensive income (loss) consists of net income (loss) and unrealized gains (losses) on available-for-sale investments. The balances in accumulated other comprehensive income consist of accumulated net unrealized gains on available-for-sale investments.

The components of comprehensive income (loss) are as follows:

Segment Reporting

The Company is an online subscriptions-based DVD rental service and is organized in a single operating segment for purposes of making operating decisions and assessing performance in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. The Company’s Chief Executive Officer, who is the chief operating decision maker as defined in SFAS No. 131, evaluates performance, makes operating decisions, and allocates resources based on financial data consistent with the presentation in the accompanying financial statements.

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Netflix, Inc.

Notes to Financial Statements—Continued

(in thousands, except per share data)

Recently Issued Accounting Standards

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue 02-16, Accounting by a Reseller for Cash Consideration Received from a Vendor, addressing the accounting of cash consideration received by a customer from a vendor, including vendor rebates and refunds. The consensus states that consideration received should be presumed to be a reduction of the prices of the vendor’s products or services and should therefore be shown as a reduction of cost of sales in the income statement of the customer. The presumption could be overcome if the vendor receives an identifiable benefit in exchange for the consideration or the consideration represents a reimbursement of a specific incremental identifiable cost incurred by the customer in selling the vendor’s product or service. If one of these conditions is met, the cash consideration should be characterized as a reduction of those costs in the income statement of the customer. The consensus also concludes that if rebates or refunds can be reasonably estimated, such rebates or refunds should be recognized as a reduction of the cost of sales based on a systematic and rational allocation of the consideration to be received relative to the transactions that mark the progress of the customer towards earning the rebate or refund. The provisions of this consensus are not expected to have a material effect on the Company’s financial position or operating results.

In November 2002, the EITF reached a consensus on Issue 00-21, Revenue Arrangements with Multiple Deliverables, addressing how to account for arrangements that involve the delivery or performance of multiple products, services, and/or rights to use assets. Revenue arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the arrangement meet the following criteria: (1) the delivered item has value to the customer on a standalone basis; (2) there is objective and reliable evidence of the fair value of undelivered items; and (3) delivery of any undelivered item is probable. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values, with the amount allocated to the delivered item being limited to the amount that is not contingent on the delivery of additional items or meeting other specified performance conditions. The final consensus will be applicable to agreements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. The provisions of this consensus are not expected to have a material effect on the Company’s financial position or operating results.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003. For public enterprises with a variable interest in a variable interest entity created before February 1, 2003, the Interpretation is applied to the enterprise no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003. The application of this Interpretation is not expected to have a material effect on the Company’s financial statements.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is generally effective for derivative instruments, including derivative instruments embedded in certain contracts, entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The Company does not expect the adoption of SFAS No. 149 to have a material impact on its operating results or financial condition.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, which provides guidance for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company does not expect the adoption of SFAS No. 150 to have a material impact on its operating results or financial condition.

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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 certain forward-looking statements within the meaning of the federal securities laws, including statements regarding our subscriber growth, cost of subscription revenues, gross margin, fulfillment, technology and development, marketing, and general and administrative expenses, as well as subscriber acquisition cost and churn for the third quarter of 2003. These statements are subject to risks and uncertainties that could cause actual results and events to differ, including: our ability to manage our growth, in particular managing our subscriber acquisition cost as well as the mix between revenue sharing titles and titles not subject to revenue sharing that are delivered to our subscribers; our ability to attract new subscribers and retain existing subscribers; competition; fluctuations in subscriber usage of our service, consumer spending on DVD players, DVDs and related products; deterioration of the United States economy or conditions specific to online commerce or the filmed entertainment industry; conditions that affect our delivery through the United States Postal Service, including increases in postage; increases in the costs of acquiring DVDs; and widespread consumer adoption of different modes of viewing in-home filmed entertainment. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included as part of our annual report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003.

We undertake no obligation to revise or publicly release the results of any revision to any forward-looking statements contained in this quarterly report on Form 10-Q, or to explain why actual results differ.

Overview

We are the largest online entertainment subscription service in the United States providing more than 1,147,000 subscribers access to a comprehensive library of more than 15,000 movie, television, and other filmed entertainment titles. Our standard subscription plan allows subscribers to have three titles out at the same time with no due dates, late fees or shipping charges for $19.95 per month. Subscribers can view as many titles as they want in a month. Subscribers select titles at our website (www.netflix.com) aided by our proprietary recommendation service, receive them on DVD by first-class mail and return them to us at their convenience using our prepaid mailers. Once a title has been returned, we mail the next available title in a subscriber’s queue. For a more detailed discussion of our business and the risks and uncertainties associated with it, please refer to our annual report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003.

Critical Accounting Policy

The preparation of financial statements in conformity with generally accepted accounting principles requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the financial statements and accompanying notes. The Securities and Exchange Commission has defined a company’s critical accounting policies as the policies that are most important to the portrayal of a company’s financial condition and results of operations and which require a company to make its most difficult and subjective judgments. Based on this definition, we have identified the critical accounting policy below. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.

Amortization of DVD Library

We acquire DVDs from studios and distributors either through direct purchase or pursuant to revenue sharing agreements. These revenue sharing agreements enable us to obtain DVDs at a lower up-front cost than under traditional purchase arrangements. We share a percentage of the actual net revenues generated by the use of the DVDs associated with each particular title with the studios over a fixed period of time, which is generally 12 months for each title. At the end of the revenue sharing period for each title, we have the option of either returning the DVDs associated with the title to the studio or purchasing some or all of those DVDs.

We amortize the cost, less salvage value, of our DVD library on a “sum-of-the-months” accelerated basis over one year.

Under our revenue sharing agreements, we remit an upfront payment to acquire DVDs from the studios. This payment includes a contractually specified initial fixed license fee that is capitalized. Certain of these payments also include a contractually specified prepayment of future revenue sharing obligations that is classified as prepaid revenue sharing expense and is expensed as revenue sharing obligations are incurred. The initial fixed license fee is amortized on a “sum-of-the-months” accelerated basis over one year.

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We believe the use of an accelerated method is appropriate because we normally experience heavy initial demand for a title, which subsides once initial demand has been satisfied.

Results of Operations

The following table sets forth, for the periods presented, the line items in our statements of operations as a percentage of total revenues. The information contained in the table below should be read in conjunction with the Financial Statements, Notes to Financial Statements, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this quarterly report on Form 10-Q.

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Three and Six Months Ended June 30, 2003 Compared to Three and Six Months Ended June 30, 2002

Revenues

We derive substantially all our revenues from monthly subscription fees and recognize subscription revenues ratably during each subscriber’s monthly subscription period. From time to time, we generate revenues from the sale of excess DVDs and recognize revenues from the sale of used DVDs when the DVDs are shipped. We generate all our revenues from the United States.

The growth in our subscription revenues was primarily driven by an increase in the average number of paying subscribers, which went up 76.4% and 81.3% for the three and six months ended June 30, 2003, respectively. We believe the increase in the number of subscribers was caused by the continuing consumer adoption of DVD players, increased consumer awareness of our service, our high levels of subscriber satisfaction, and continuing improvements in our service. We expect to end the third quarter of 2003 with total subscribers of 1,240,000 to 1,290,000, an increase of 8.1% to 12.5% from the level as of June 30, 2003.

Cost of Revenues, Gross Profit and Gross Margin

Cost of Revenues:

Cost of subscription revenues consists of revenue sharing costs, amortization of our DVD library, amortization of intangible assets related to equity investments issued to certain studios, and postage and packaging related to shipping titles to paying subscribers. Costs related to free trial subscribers are allocated to marketing expenses. Cost of DVD sales includes salvage value and revenue sharing costs for used DVDs sold.

The increase in cost of subscription revenues was attributable primarily to the following factors:

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Amortization of intangibles remained mostly unchanged for the three and six months ended June 30, 2003 from the same prior-year periods.

We anticipate cost of subscription revenues will increase in absolute dollars in the third quarter of 2003 as the number of average paying subscribers continues to grow.

Gross Profit and Gross Margin: