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EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 - NETFLIX INCnflx311q315.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 - NETFLIX INCnflx312q315.htm
EX-32.1 - CERTIFICATIONS OF CEO AND CFO PURSUANT TO SECTION 906 - NETFLIX INCnflx321q315.htm

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, 2015
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, 2015, there were 427,388,288 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,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Revenues
$
1,738,355

 
$
1,409,432

 
$
4,956,178

 
$
4,019,928

Cost of revenues
1,173,958

 
954,394

 
3,342,111

 
2,738,428

Marketing
208,102

 
145,654

 
599,919

 
403,515

Technology and development
171,762

 
120,953

 
469,929

 
346,445

General and administrative
110,892

 
78,024

 
298,287

 
193,938

Operating income
73,641

 
110,407

 
245,932

 
337,602

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(35,333
)
 
(13,486
)
 
(97,287
)
 
(36,866
)
Interest and other income (expense)
3,930

 
616

 
(27,491
)
 
3,117

Income before income taxes
42,238

 
97,537

 
121,154

 
303,853

Provision for income taxes
12,806

 
38,242

 
41,691

 
120,425

Net income
$
29,432

 
$
59,295

 
$
79,463

 
$
183,428

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.07

 
$
0.14

 
$
0.19

 
$
0.44

Diluted
$
0.07

 
$
0.14

 
$
0.18

 
$
0.42

Weighted-average common shares outstanding:
 
 
 
 
 
 
 
Basic
426,869

 
421,194

 
425,289

 
419,972

Diluted
437,606

 
432,742

 
435,849

 
431,683













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,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Net income
$
29,432

 
$
59,295

 
$
79,463

 
$
183,428

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments 
302

 
(4,354
)
 
(33,628
)
 
(1,975
)
Change in unrealized gains on available-for-sale securities, net of tax of $(45), $(313), $113 and $28, respectively
(72
)
 
(503
)
 
184

 
45

Total other comprehensive income (loss)
230

 
(4,857
)
 
(33,444
)
 
(1,930
)
Comprehensive income
$
29,662

 
$
54,438

 
$
46,019

 
$
181,498

























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,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
29,432

 
$
59,295

 
$
79,463

 
$
183,428

Adjustments to reconcile net income to net cash (used in) provided by operating activities:
 
 
 
 
 
 
 
Additions to streaming content library
(1,308,943
)
 
(1,202,484
)
 
(4,194,545
)
 
(2,765,197
)
Change in streaming content liabilities
104,684

 
346,752

 
922,163

 
467,355

Amortization of streaming content library
871,403

 
686,154

 
2,443,521

 
1,925,926

Amortization of DVD content library
18,589

 
18,269

 
60,587

 
51,313

Depreciation and amortization of property, equipment and intangibles
16,047

 
14,357

 
46,795

 
39,716

Stock-based compensation expense
32,834

 
29,878

 
88,865

 
84,988

Excess tax benefits from stock-based compensation
(37,726
)
 
(21,060
)
 
(106,154
)
 
(68,420
)
Other non-cash items
10,866

 
3,360

 
23,854

 
8,807

Deferred taxes
(29,417
)
 
(7,892
)
 
(70,691
)
 
(37,564
)
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
Other current assets
71,172

 
12,960

 
54,667

 
27,341

Accounts payable
6,762

 
13,003

 
2,584

 
32,729

Accrued expenses
10,883

 
(6,980
)
 
88,429

 
51,586

Deferred revenue
27,985

 
11,626

 
55,153

 
37,189

Other non-current assets and liabilities
(20,540
)
 
5,323

 
615

 
15,747

Net cash (used in) provided by operating activities
(195,969
)
 
(37,439
)
 
(504,694
)
 
54,944

Cash flows from investing activities:
 
 
 
 
 
 
 
Acquisition of DVD content library
(14,467
)
 
(15,530
)
 
(57,159
)
 
(51,425
)
Purchases of property and equipment
(37,820
)
 
(21,032
)
 
(78,394
)
 
(54,235
)
Other assets
(3,760
)
 
341

 
(4,174
)
 
1,765

Purchases of short-term investments
(66,444
)
 
(123,883
)
 
(225,333
)
 
(355,337
)
Proceeds from sale of short-term investments
43,887

 
107,568

 
144,247

 
340,278

Proceeds from maturities of short-term investments
31,125

 
32,125

 
82,182

 
127,229

Net cash (used in) provided by investing activities
(47,479
)
 
(20,411
)
 
(138,631
)
 
8,275

Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from issuance of common stock
35,089

 
9,877

 
69,809

 
56,794

Proceeds from issuance of debt

 

 
1,500,000

 
400,000

Issuance costs

 

 
(17,629
)
 
(7,080
)
Excess tax benefits from stock-based compensation
37,726

 
21,060

 
106,154

 
68,420

Principal payments of lease financing obligations
(61
)
 
(275
)
 
(599
)
 
(813
)
Net cash provided by financing activities
72,754

 
30,662

 
1,657,735

 
517,321

Effect of exchange rate changes on cash and cash equivalents
(7,741
)
 
(3,839
)
 
(12,581
)
 
(2,288
)
Net (decrease) increase in cash and cash equivalents
(178,435
)
 
(31,027
)
 
1,001,829

 
578,252

Cash and cash equivalents, beginning of period
2,293,872

 
1,214,244

 
1,113,608

 
604,965

Cash and cash equivalents, end of period
$
2,115,437

 
$
1,183,217

 
$
2,115,437

 
$
1,183,217

Supplemental disclosure of non-cash investing activities:
 
 
 
 
 
 
 
(Decrease) increase in accounts payable related to purchases of property and equipment
$
(9,790
)
 
$
(1,362
)
 
$
2,362

 
$
4,431

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,
2015
 
December 31,
2014
 
(unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
2,115,437

 
$
1,113,608

Short-term investments
494,205

 
494,888

Current content library, net
2,695,184

 
2,125,702

Other current assets
264,887

 
206,271

Total current assets
5,569,713

 
3,940,469

Non-current content library, net
3,891,790

 
2,773,326

Property and equipment, net
181,268

 
149,875

Other non-current assets
273,496

 
192,981

Total assets
$
9,916,267

 
$
7,056,651

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Current content liabilities
$
2,622,964

 
$
2,117,241

Accounts payable
209,365

 
201,581

Accrued expenses
179,350

 
69,746

Deferred revenue
329,739

 
274,586

Total current liabilities
3,341,418

 
2,663,154

Non-current content liabilities
1,966,854

 
1,575,832

Long-term debt
2,400,000

 
900,000

Other non-current liabilities
40,677

 
59,957

Total liabilities
7,748,949

 
5,198,943

Commitments and contingencies (Note 9)


 


Stockholders’ equity:
 
 
 
Common stock, $0.001 par value; 4,990,000,000 and 160,000,000 shares authorized at September 30, 2015 and December 31, 2014, respectively; 427,388,288 and 422,910,887 issued and outstanding at September 30, 2015 and December 31, 2014, respectively
1,306,461

 
1,042,870

Accumulated other comprehensive loss
(37,890
)
 
(4,446
)
Retained earnings
898,747

 
819,284

Total stockholders’ equity
2,167,318

 
1,857,708

Total liabilities and stockholders’ equity
$
9,916,267

 
$
7,056,651





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, 2014 filed with the Securities and Exchange Commission (the “SEC”) on January 29, 2015. 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 library 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, 2014. 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. The majority of the Company’s revenues are generated in the United States, and substantially all of the Company’s long-lived tangible assets are held in the United States. The Company’s revenues are derived from monthly membership fees.
There have been no material changes in the Company’s significant accounting policies as compared to the significant accounting policies described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.
Prior to January 1, 2015, the functional currency of certain of the Company's European entities was the British pound. The Company changed the functional currency of these entities to the euro effective January 1, 2015 following the redomiciliation of the European headquarters and the launch of the Netflix service in several significant European countries. The change in functional currency was applied prospectively from January 1, 2015. Monetary assets and liabilities have been remeasured to the euro at current exchange rates. Non-monetary assets and liabilities have been remeasured to the euro using the exchange rate effective for the period in which the balance arose. As a result of this change of functional currency, the Company recorded a $21.8 million cumulative translation adjustment included in other comprehensive loss for the nine months ended September 30, 2015.
On July 14, 2015, the Company completed a seven-for-one stock split in the form of a stock dividend. References made to outstanding shares or per share amounts in the accompanying consolidated financial statements and applicable disclosures have been retroactively adjusted to reflect this seven-for-one stock split. The number of authorized shares as reflected on the Consolidated Balance Sheets was not affected by the stock split and accordingly has not been adjusted. See Notes 2 and 6 for additional information.
In the third quarter of 2015, the Company changed the amortization method of certain content given changes in estimated viewing patterns of this content. The effect of this change in estimate was a $12.8 million decrease in operating income and an $8.0 million decrease in net income for the three and nine month periods ended September 30, 2015. The effect on both basic earnings per share and diluted earnings per share was a decrease of $0.02, for the three and nine months ended September 30, 2015.
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 of December 15, 2016 (including interim reporting periods within those periods). The amendments may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of initial application. The Company is currently in the process of evaluating the impact of adoption of the ASU on its consolidated financial statements, but does not expect the impact to be material.
In April 2015, the FASB issued ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs which changes the presentation of debt issuance costs in financial statements. ASU 2015-03 requires an entity to present such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs will continue to be reported as interest expense. It is effective for annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company will adopt ASU 2015-03 on January 1, 2016, at which time the Company will retrospectively reclassify approximately $30 million of debt issuance costs associated with the Company's long-term debt from other non-current assets to long-term debt.

7


In April 2015, the FASB issued ASU 2015-05, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement, which provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for a cloud computing arrangement as a service contract. The Company has elected to early adopt the ASU in the third quarter of 2015 and will apply the guidance prospectively to all future arrangements. The impact of the adoption of the ASU was not material to the Company's consolidated financial statements.


2. Earnings Per Share
In June 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 Split").
Outstanding share and per-share amounts disclosed as of September 30, 2015 and for all other comparative periods provided have been retroactively adjusted to reflect the effects of the Stock Split. 
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, as adjusted to reflect the effects of the Stock Split, are as follows:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
 
(in thousands, except per share data)
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
29,432

 
$
59,295

 
$
79,463

 
$
183,428

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
426,869

 
421,194

 
425,289

 
419,972

Basic earnings per share
$
0.07

 
$
0.14

 
$
0.19

 
$
0.44

 
 
 
 
 
 
 
 
Diluted earnings per share:
 
 
 
 
 
 
 
Net income
$
29,432

 
$
59,295

 
$
79,463

 
$
183,428

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
426,869

 
421,194

 
425,289

 
419,972

Employee stock options
10,737

 
11,548

 
10,560

 
11,711

Weighted-average number of shares
437,606

 
432,742

 
435,849

 
431,683

Diluted earnings per share
$
0.07

 
$
0.14

 
$
0.18

 
$
0.42


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, as adjusted to reflect the effects of the Stock Split:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
 
(in thousands)
Employee stock options
130

 
371

 
668

 
448




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 preservation of capital, liquidity and return. From time to time, the Company may sell certain securities but the objectives are generally not to generate profits on short-term differences in price. The following tables summarize, by major security type, the Company’s assets that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy and where they are classified on the Consolidated Balance Sheets:
 
As of September 30, 2015
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
2,008,627

 
$

 
$

 
$
2,008,627

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
115,316

 

 

 
115,316

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
251,192

 
406

 
(467
)
 
251,131

Government securities
212,256

 
599

 
(9
)
 
212,846

Certificate of deposits
3,600

 

 

 
3,600

Agency securities
26,599

 
29

 

 
26,628

Total
$
2,617,590

 
$
1,034

 
$
(476
)
 
$
2,618,148


 
As of December 31, 2014
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
1,007,543

 
$

 
$

 
$
1,007,543

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
111,759

 

 

 
111,759

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
295,500

 
432

 
(199
)
 
295,733

Government securities
168,749

 
120

 
(95
)
 
168,774

Asset and mortgage-backed securities
112

 

 

 
112

Certificate of deposits
3,600

 

 

 
3,600

Agency securities
26,665

 
5

 
(1
)
 
26,669

Total
$
1,613,928

 
$
557

 
$
(295
)
 
$
1,614,190


 
As of
 
September 30, 2015
 
December 31, 2014
 
(in thousands)
Cash and cash equivalents
$
2,115,437

 
$
1,113,608

Short-term investments
494,205

 
494,888

Other non-current assets (1)
8,506

 
5,694

Total
$
2,618,148

 
$
1,614,190


(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

9


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 debt instruments.

There were no investments in a material unrealized loss position as of September 30, 2015 or December 31, 2014. There were no material other-than-temporary impairments or credit losses related to available-for-sale securities in the three or nine months ended September 30, 2015 and 2014. In addition, there were no material gross realized gains or losses in the three or nine months ended September 30, 2015 and 2014.
The estimated fair value of short-term investments by contractual maturity as of September 30, 2015 is as follows:
 
(in thousands)
Due within one year
$
155,330

Due after one year and through five years
338,875

Total short-term investments
$
494,205



4. Balance Sheet Components
Content Library
Content library consisted of the following:
 
As of
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
Total content library, gross
$
11,133,463

 
$
8,497,403

Accumulated amortization
(4,546,489
)
 
(3,598,375
)
Total content library, net
6,586,974

 
4,899,028

Current content library, net
2,695,184

 
2,125,702

Non-current content library, net
$
3,891,790

 
$
2,773,326


Content library includes costs capitalized for licensed streaming content, production of original content and DVD content.
Property and Equipment, Net
Property and equipment and accumulated depreciation consisted of the following:
 
 
As of
 
 
 
 
September 30,
2015
 
December 31,
2014
 
Estimated Useful Lives

 
 
(in thousands)
 
 
Information technology assets
 
$
190,929

 
$
189,274

 
3 years
Furniture and fixtures
 
35,967

 
25,758

 
3 years
Building
 
40,681

 
40,681

 
30 years
Leasehold improvements
 
103,113

 
57,339

 
Over life of lease
DVD operations equipment
 
89,132

 
89,144

 
5 years
Capital work-in-progress
 
12,483

 
12,495

 

Property and equipment, gross
 
472,305

 
414,691

 
 
Less: Accumulated depreciation
 
(291,037
)
 
(264,816
)
 
 
Property and equipment, net
 
$
181,268

 
$
149,875

 
 

Leasehold improvements as of September 30, 2015 includes $44.3 million for the expansion of the Company's headquarters that were placed into service during the quarter ended September 30, 2015.


10



5. Long-term Debt

As of September 30, 2015, the Company had aggregate outstanding principal of $2.4 billion in long-term notes 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 long-term debt as of September 30, 2015 and December 31, 2014:
 
 
 
 
 
 
 
 
 
Level 2 Fair Value (1) as of
 
Principal Amount at Par
 
Issuance Date
 
Maturity
 
Interest Due Dates
 
September 30,
2015
 
December 31, 2014
 
(in millions)
 
 
 
 
 
 
 
(in millions)
5.375% Senior Notes
$
500.0

 
February 2013
 
2021
 
February 1 and August 1
 
$
518.8

 
$
520.0

5.750% Senior Notes
400.0

 
February 2014
 
2024
 
March 1 and September 1
 
408.0

 
416.0

5.50% Senior Notes (2)
700.0

 
February 2015
 
2022
 
April 15 and October 15
 
707.0

 

5.875% Senior Notes (2)
800.0

 
February 2015
 
2025
 
April 15 and October 15
 
822.0

 


(1) Based on quoted market prices in less active markets.
(2)
The net proceeds to the Company for the 5.50% and 5.875% Senior Notes issued in the first quarter of 2015 were an aggregate $1,482.4 million. Debt issuance costs of $17.6 million were recorded in "Other non-current assets" on the Consolidated Balance Sheets and are amortized over the term of the notes as "Interest expense" on the Consolidated Statements of Operations.

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, 2015 and December 31, 2014, the Company was in compliance with all related covenants.


6. 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. Outstanding share and per-share amounts disclosed as of September 30, 2015 and for all other comparative periods presented have been retroactively adjusted to reflect the effects of the Stock Split. 
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, 2015, 17.5 million shares were reserved for future grants under the 2011 Stock Plan.

11


A summary of the activities related to the Company’s stock option plans, as adjusted for the Stock Split, 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, 2014
20,025,208

 
22,845,417

 
$
21.65

 
 
 
 
Granted
(2,565,445
)
 
2,565,445

 
75.55

 
 
 
 
Exercised


 
(4,477,401
)
 
15.45

 
 
 
 
Balances as of September 30, 2015
17,459,763

 
20,933,461

 
$
29.58

 
6.32
 
$
1,544,838

Vested and exercisable as of September 30, 2015
 
 
20,933,461

 
$
29.58

 
6.32
 
$
1,544,838


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 2015 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 2015. 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,
2015
September 30,
2014
 
September 30,
2015
September 30,
2014
 
(in thousands)
Total intrinsic value of options exercised
$
118,259

$
60,337

 
$
313,880

$
208,057

Cash received from options exercised
$
35,089

$
9,877

 
$
69,809

$
56,794

Stock-based Compensation
The following table summarizes the assumptions used to value stock option grants using the lattice-binomial model and the valuation data, as adjusted for the Stock Split:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2015
 
September 30,
2014
 
September 30,
2015
 
September 30,
2014
Dividend yield
%
 
%
 
%
 
%
Expected volatility
45
%
 
43
%
 
36% - 45%

 
 43% - 48%

Risk-free interest rate
2.29
%
 
2.52
%
 
2.03% - 2.29%

 
2.52% - 2.83%

Suboptimal exercise factor
2.48

 
2.68 - 4.57

 
2.47 -2.48

 
2.66 - 4.57

Valuation data:
 
 
 
 
 
 
 
Weighted-average fair value (per share)
$
50.58

 
$
33.85

 
$
34.64

 
$
31.03

Total stock-based compensation expense (in thousands)
$
32,834

 
$
29,878

 
$
88,865

 
$
84,988

Total income tax benefit related to stock options (in thousands)
$
12,365

 
$
11,438

 
$
33,553

 
$
32,562


The Company considers several factors in determining the suboptimal exercise factor, including the historical and estimated option exercise behavior and the employee groupings. Prior to January 1, 2015, the Company bifurcated its option grants into two employee groupings (executive and non-executive) to determine the suboptimal exercise factor. Beginning on January 1, 2015, the Company began aggregating employee groupings for its determination of the suboptimal exercise factor as the previous bifurcation into two groupings did not have a material impact on the fair value of the options granted.
Prior to January 1, 2015, the Company's computation of expected volatility was based on a blend of historical volatility of its common stock and implied volatility of tradable forward call options to purchase shares of its common stock, as low trade volume of its tradable forward call options prior to 2011 precluded sole reliance on implied volatility. Beginning on January 1, 2015, expected volatility is 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

12


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.


7. Accumulated Other Comprehensive Loss

The following table summarizes the changes in the accumulated balance of other comprehensive loss, net of tax, for the three and nine months ended September 30, 2015:
 
Foreign currency
 
Change in unrealized gains on available-for-sale securities
 
Total
 
(in thousands)
Balance as of June 30, 2015
$
(38,545
)
 
$
425

 
$
(38,120
)
Other comprehensive (loss) income before reclassifications
302

 
(59
)
 
243

Amounts reclassified from accumulated other comprehensive loss

 
(13
)
 
(13
)
Net increase (decrease) in other comprehensive (loss) income
302

 
(72
)
 
230

Balance as of September 30, 2015
$
(38,243
)
 
$
353

 
$
(37,890
)

 
Foreign currency
 
Change in unrealized gains on available-for-sale securities
 
Total
 
(in thousands)
Balance as of December 31, 2014
$
(4,615
)
 
$
169

 
$
(4,446
)
Other comprehensive (loss) income before reclassifications
(33,628
)
 
374

 
(33,254
)
Amounts reclassified from accumulated other comprehensive loss

 
(190
)
 
(190
)
Net increase (decrease) in other comprehensive (loss) income
(33,628
)
 
184

 
(33,444
)
Balance as of September 30, 2015
$
(38,243
)
 
$
353

 
$
(37,890
)
As discussed in Note 1, other comprehensive loss for the nine months ended September 30, 2015 includes the impact of the change in functional currency for certain of the Company's European entities.
All amounts reclassified from accumulated other comprehensive loss were related to realized gains on available-for-sale securities. These reclassifications impacted "Interest and other income (expense)" on the Consolidated Statements of Operations.


8. Income Taxes
The effective tax rates for the three months ended September 30, 2015 and 2014 were 30% and 39%, respectively. The effective tax rates for the nine months ended September 30, 2015 and 2014 were 34% and 40%, respectively. The effective tax rates for the three and nine months ended September 30, 2015 and 2014 differed from the federal statutory rate primarily due to state taxes, foreign taxes and non-deductible expenses, partially offset by the California R&D credit.
The decrease in the Company's effective tax rates for the three and nine months ended September 30, 2015 as compared to the three and nine months ended September 30, 2014 was primarily attributable to lower tax reserves on uncertain tax positions following an IRS Appeals settlement in the fourth quarter of 2014.
Gross unrecognized tax benefits were $41.1 million and $34.8 million as of September 30, 2015 and December 31, 2014, respectively. The gross unrecognized tax benefits, if recognized by the Company, will result in a reduction of approximately $33.7 million to the provision for income taxes thereby favorably impacting the Company’s effective tax rate. The Company’s unrecognized tax benefits are primarily classified as “Accrued expenses” on the Consolidated Balance Sheets as of September 30, 2015. The Company includes interest and penalties related to unrecognized tax benefits within the "Provision for income taxes" on the Consolidated Statements of Operations. As of September 30, 2015, the total amount of gross interest and penalties accrued was $0.5 million, and is primarily classified as “Accrued expenses” on the Consolidated Balance Sheets.
Deferred tax assets include $20.2 million and $13.4 million classified as “Other current assets” and $170.7 million and $106.9 million classified as “Other non-current assets” on the Consolidated Balance Sheets as of September 30, 2015 and December 31, 2014, 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

13


planning strategies. As of September 30, 2015 and December 31, 2014, 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 $37.7 million and $21.0 million, during the three months ended September 30, 2015 and 2014, respectively and $105.6 million and $68.1 million, during the nine months ended September 30, 2015 and 2014, respectively.
The Company files U.S. federal, state and foreign tax returns. The Company is currently under examination by the IRS for the years 2010 through 2013. During the third quarter ending September 30, 2015, the Company reached a tentative settlement with the IRS and expects to reach a final settlement within the next twelve months, at which time the tax reserves on the related uncertain tax position will be adjusted. The Company has reclassified the tax reserves related to these years from "Other non-current liabilities" to "Accrued expenses" on the Consolidated Balance Sheets. The year 2014 remains subject to examination by the IRS.
The Company is also currently under examination by the state of California for the years 2006 and 2007. The state of California has completed its Field Exam and has issued a Notice of Proposed Assessment primarily related to the Company's R&D Credits claimed in those years. The Company has filed a protest against the proposed assessment. During the third quarter ending September 30, 2015, the Company has reached a tentative settlement with the Franchise Tax Board for tax years 1997 - 2007 and expects to reach a final settlement within the next twelve months, at which time the tax reserves on the related uncertain tax position will be adjusted. The Company has reclassified the tax reserves related to these years from "Other non-current liabilities" to Accrued expenses" on the Consolidated Balance Sheets. The years 2008 through 2013 remain subject to examination by the state of California.
The Company has no significant foreign jurisdiction audits underway. The years 2011 through 2014 remain subject to examination by foreign jurisdictions. Given the potential outcome of the current examinations, as well as the impact of the current examination on the potential expiration of the statute of limitations, it is reasonably possible that the balance of unrecognized tax benefits could significantly change within the next twelve months. However, at this time, an estimate of the range of reasonably possible adjustments to the balance of unrecognized tax benefits cannot be made.


9. Commitments and Contingencies

Streaming Content
As of September 30, 2015, the Company had $10.4 billion of obligations comprised of $2.6 billion included in "Current content liabilities" and $2.0 billion of "Non-current content liabilities" on the Consolidated Balance Sheets and $5.8 billion of obligations that are not reflected on the Consolidated Balance Sheets.
As of December 31, 2014, the Company had $9.5 billion of obligations comprised of $2.1 billion included in "Current content liabilities" and $1.6 billion of "Non-current content liabilities" on the Consolidated Balance Sheets and $5.8 billion of obligations that are not reflected on the Consolidated Balance Sheets.
The expected timing of payments for these streaming content obligations is as follows:
 
As of 
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
Less than one year
$
4,535,209

 
$
3,747,648

Due after one year and through three years
4,888,130

 
4,495,103

Due after three years and through five years
908,111

 
1,164,308

Due after five years
46,768

 
44,053

Total streaming content obligations
$
10,378,218

 
$
9,451,112


A streaming content obligation 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. The Company does not include any estimated obligation for these future titles beyond the known minimum amount. However, the unknown obligations are expected to be significant and the expected timing of payments could range from less than one year to more than five years.
The Company has entered into certain licenses with collective management organizations ("CMOs"), and is currently involved in negotiations with other CMOs, that hold certain rights to music and other entertainment works "publicly performed" in connection with streaming content into various territories. Accruals for estimated license fees are recorded and then adjusted based on any change in estimates. These amounts are included in the streaming content obligations. The results of these negotiations are uncertain and may be materially different from management's estimates.

14


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. Management has determined a potential loss is reasonably possible however, based on its current knowledge, management does not believe that the amount of such possible loss or a range of potential loss is reasonably estimable
On November 23, 2011, the first of six purported shareholder derivative suits was filed in the Superior Court of California, Santa Clara County, against the Company and certain of its officers and directors. Five additional purported shareholder derivative suits were subsequently filed: two in the Superior Court of California, Santa Clara County on February 9, 2012 and May 2, 2012; and three in the United States District Court for the Northern District of California on February 13, 2012, February 24, 2012 and April 2, 2012. The purported shareholder derivative suits filed in the Northern District of California have been voluntarily dismissed. On July 5, 2012, the purported shareholder derivative suits filed in Santa Clara County were consolidated into In re Netflix, Inc. Shareholder Derivative Litigation, Case No. 1-12-cv-218399, and lead counsel was appointed. A consolidated complaint was filed on December 4, 2012, with plaintiffs seeking compensatory damages and other relief. The consolidated complaint alleges, among other things, that certain of the Company's current and former officers and directors breached their fiduciary duties, issued false and misleading statements primarily regarding the Company's streaming business, violated accounting rules concerning segment reporting, violated provisions of the California Corporations Code, and wasted corporate assets. The consolidated complaint further alleges that the defendants caused the Company to buy back stock at artificially inflated prices to the detriment of the Company and its shareholders while contemporaneously selling personally held Company stock. The Company filed a demurrer to the consolidated complaint and a motion to stay the derivative litigation in favor of the related federal securities class action on February 4, 2013. On June 21, 2013, the Court granted the motion to stay the derivative litigation pending resolution of the related federal securities class action. Management has determined a potential loss is reasonably possible however, based on its current knowledge, management does not believe that the amount of such possible loss or a range of potential loss is reasonably estimable.

The Company is involved in other litigation matters not listed above but does not consider the matters to be material either individually or in the aggregate at this time. The Company's view of the matters not listed may change in the future as the litigation and events related thereto unfold.
Indemnification
In the ordinary course of business, the Company has entered into contractual arrangements under which it has agreed to provide indemnification of varying scope and terms to business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the Company’s breach of such agreements and out of intellectual property infringement claims made by third parties. In these circumstances, payment may be conditional on the other party making a claim pursuant to the procedures specified in the particular contract.
The Company's obligations under these agreements may be limited in terms of time or amount, and in some instances, the Company may have recourse against third parties for certain payments. In addition, the Company has entered into indemnification agreements with its directors and certain of its officers that will require it, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. The terms of such obligations vary.
It is not possible to make a reasonable estimate of the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement. No amount has been accrued in the accompanying consolidated financial statements with respect to these indemnification obligations.


10. Segment Information

15


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 directly 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 and International streaming segments derive revenues from monthly membership fees for services consisting solely of streaming content. The Domestic DVD segment derives revenues from monthly membership fees for services consisting solely of DVD-by-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.
Cost of revenues are primarily attributed to the operating segment based on the amounts directly incurred by the segment to obtain content and deliver it to the specific region. Content rights increasingly include multiple geographies as the Company aspires to obtain global content rights to support global expansion. The Company allocates this content between the International and Domestic segments based on estimated fair market value. Marketing expenses are primarily comprised of advertising expenses which are generally included in the segment in which the expenditures are directly incurred.
The Company's long-lived tangible assets were located as follows:
 
As of
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
United States
$
168,569

 
$
138,704

International
12,699

 
11,171


16


The following tables represent segment information for the periods 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 tables represent segment information for the periods ended September 30, 2014:
 
As of/ Three Months Ended September 30, 2014
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total memberships at end of period (1)
37,219

 
15,843

 
5,986

 

Revenues
$
877,150

 
$
345,685

 
$
186,597

 
$
1,409,432

Cost of revenues
565,251

 
291,942

 
97,201

 
954,394

Marketing
61,045

 
84,609

 

 
145,654

Contribution profit (loss)
$
250,854

 
$
(30,866
)
 
$
89,396

 
$
309,384

Other operating expenses
 
 
 
 
 
 
198,977

Operating income
 
 
 
 
 
 
110,407

Other income (expense)
 
 
 
 
 
 
(12,870
)
Provision for income taxes
 
 
 
 
 
 
38,242

Net income
 
 
 
 
 
 
$
59,295


17


 
As of/ Nine Months Ended September 30, 2014
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total memberships at end of period (1)
37,219

 
15,843

 
5,986

 

Revenues
$
2,513,992

 
$
920,264

 
$
585,672

 
$
4,019,928

Cost of revenues
1,628,568

 
803,906

 
305,954

 
2,738,428

Marketing
206,030

 
197,485

 

 
403,515

Contribution profit (loss)
$
679,394

 
$
(81,127
)
 
$
279,718

 
$
877,985

Other operating expenses
 
 
 
 
 
 
540,383

Operating income
 
 
 
 
 
 
337,602

Other income (expense)
 
 
 
 
 
 
(33,749
)
Provision for income taxes
 
 
 
 
 
 
120,425

Net income
 
 
 
 
 
 
$
183,428


The following table represents the amortization of the content library:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Three months ended September 30,
 
 
 
 
 
 
 
2015
$
493,025

 
$
378,378

 
$
18,589

 
$
889,992

2014
433,266

 
252,888

 
18,269

 
704,423

Nine months ended September 30,
 
 
 
 
 
 
 
2015
1,387,242

 
1,056,279

 
60,587

 
2,504,108

2014
1,229,477

 
696,449

 
51,313

 
1,977,239

The following table represents total content library, net:
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
As of September 30, 2015
$
4,367,750

 
$
2,193,785

 
$
25,439

 
$
6,586,974

As of December 31, 2014
3,476,226

 
1,392,701

 
30,101

 
4,899,028



(1)
A membership (also referred to as a subscription or member) is defined as the right to receive either the Netflix streaming service or Netflix DVD service. Memberships are assigned to territories based on the geographic location used at time of sign-up as determined by the Company's internal systems, which utilize industry standard geo-location technology. The Company offers free-trial memberships to new and certain rejoining members. For inclusion in the definition of a membership in the above metrics, a method of payment is required to be provided even during the free-trial period. Total memberships therefore include those who are on a free-trial and have provided a method of payment. 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.




18



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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These forward-looking statements include, but are not limited to statements regarding: our core strategy; the impact of, and the Company’s response to, new accounting standards; pricing; dividends; impact of foreign currency and exchange rate fluctuations; investments in marketing and content, including original content; international expansion and investments related thereto; cash use in connection with content acquisitions and licensing and international expansion; contribution margin and free cash flow trends; unrecognized tax benefits; deferred tax assets; tax settlements with the IRS and the state of California; accessing and obtaining additional capital; 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, 2014 filed with the Securities and Exchange Commission (“SEC”) on January 29, 2015, in particular the risk factors discussed under the heading “Risk Factors” in Part I, Item IA. 
We assume no obligation to revise or publicly release any revision to any forward-looking statements contained in this Quarterly Report on Form 10-Q, unless required by law.
Investors and others should note that we announce material financial information to our investors using our investor relations website (http://ir.netflix.com), SEC filings, press releases, public conference calls and webcasts. We use these channels, as well as social media, to communicate with our members and the public about our company, our services and other issues. It is possible that the information we post on social media could be deemed to be material information. Therefore, we encourage investors, the media, and others interested in our company to review the information we post on the United States ("U.S.") social media channels listed on our investor relations website.

Overview
We are the world’s leading Internet television network with over 69 million memberships in over 50 countries enjoying more than 100 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 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 memberships has been seasonal with the first and fourth quarters representing our strongest net membership additions.
Our core strategy is to grow our streaming membership business globally within the parameters of our consolidated net income and 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 expanding our streaming service to more Internet-connected screens.

Results of Operations

The following represents our consolidated performance highlights:
 
Three Months Ended
 
Change
 
September 30,
2015
 
September 30,
2014
 
Q3'15 vs. Q3'14
 
(in thousands, except percentages)
Global streaming memberships
69,168

 
53,062

 
30
 %
Revenues
$
1,738,355

 
$
1,409,432

 
23
 %
Operating income
73,641

 
110,407

 
(33
)%
Net income
29,432

 
59,295

 
(50
)%

Consolidated revenues for the three months ended September 30, 2015 increased $328.9 million as compared to the three months ended September 30, 2014 due to growth in global streaming memberships, partially offset by the impacts of foreign currency exchange rate fluctuations. Cost of revenues and operating expenses increased due to increased expenses relating to our streaming content as well as to our international expansion. Net income decreased $29.9 million in the three months ended September 30, 2015 as compared to the three months ended September 30, 2014 as a result of the decrease in operating income and a $21.8 million increase in interest expense primarily related to our additional debt issued in February 2015.

19


In the third quarter of 2015, we changed the amortization method of certain content given changes in estimated viewing patterns of this content. The effect of this change was a $12.8 million increase in cost of revenues in the Domestic streaming segment, for the three and nine months ended September 30, 2015.
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 most popular streaming plan 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 $4.00 per month to $19.00 per month.
We expect that from time to time the prices of our membership plans in each country may change. For instance, we recently increased the price of our two-screen high definition plan in the U.S. and several European countries. In May 2014, in the U.S., we increased the price 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 high definition plan from $8.99 per month to $9.99 per month with existing memberships grandfathered for a one year period.

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 global corporate costs.

For the Domestic and International streaming segments, content expenses, which include the amortization of the streaming content library and other expenses associated with the licensing and acquisition of streaming content, represent the vast majority of cost of revenues. Streaming content rights are generally specific to a geographic region, but increasingly include multiple geographies as we aspire to obtain global content rights to support our global expansion. We allocate these content rights between the International and Domestic segments based on estimated fair market value. Our international expansion will require us to obtain additional streaming content to support new international markets. Other cost of revenues such as streaming delivery expenses, customer service and payment processing fees tend to be lower as a percentage of total cost of revenues as compared to content licensing expenses. We utilize both our own and third-party content delivery networks to help us efficiently stream a high volume of content to our members over the Internet. Streaming delivery expenses, therefore, also include equipment costs related to our content delivery network ("Open Connect") and all third-party costs associated with delivering streaming content over the Internet. Cost of revenues in the Domestic DVD segment consist primarily of delivery expenses, content expenses, including amortization of DVD content library 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 affiliates and device partners. Advertising expenses include promotional activities such as online and television advertising. Payments to our affiliates and device partners include fixed fee and/or revenue sharing payments. Marketing expenses are primarily incurred by our Domestic and International streaming segments given our focus on building consumer awareness of the streaming offerings. Marketing expenses incurred by our International streaming segment have been significant and will fluctuate dependent upon the number of international territories in which our streaming service is offered and the timing of the launch of new territories. We do not incur marketing expenses for the Domestic DVD segment.

We have demonstrated our ability to grow domestic streaming 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 32% in the third quarter of 2015. 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.



20


Domestic Streaming Segment
Three months ended September 30, 2015 as compared to the three months ended September 30, 2014
 
 
As of/ Three Months Ended
 
Change
 
 
September 30,
2015
 
September 30,
2014
 
Q3'15 vs. Q3'14
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
881

 
975

 
(94
)
 
(10
)%
Memberships at end of period
 
43,181

 
37,219

 
5,962

 
16
 %
Paid memberships at end of period
 
42,068

 
36,265

 
5,803

 
16
 %
Average monthly revenue per paying membership
 
$
8.53

 
$
8.20

 
$
0.33

 
4
 %
 
 
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
 
 
Revenues
 
$
1,063,961

 
$
877,150

 
$
186,811

 
21
 %
Cost of revenues
 
644,914

 
565,251

 
79,663

 
14
 %
Marketing
 
74,835

 
61,045

 
13,790

 
23
 %
Contribution profit
 
344,212

 
250,854

 
93,358

 
37
 %
Contribution margin
 
32
%
 
29
%
 
 
 
 

In the Domestic streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content. The increase in our domestic streaming revenues was primarily due to the 17% growth in the average number of paid memberships, as well as the 4% increase in average monthly revenue per paying membership resulting from our pricing changes and plan mix. Our two-screen high-definition plan continues to be the most popular plan choice for new memberships.
The increase in domestic streaming cost of revenues was primarily due to a $50.2 million increase in content expenses relating to our existing and new streaming content, including more exclusive and original programming. In addition, streaming delivery expenses increased by $16.1 million and other costs, such as payment processing fees and customer service call centers, increased $13.4 million due to our growing member base.
Domestic marketing expenses increased primarily due to an increase in advertising and public relations spending.
Our Domestic streaming segment had a contribution margin of 32% for the three months ended September 30, 2015, which increased as compared to the contribution margin of 29% for the three months ended September 30, 2014 due to growth in paid memberships and revenue which continued to outpace content spending.

Nine months ended September 30, 2015 as compared to the nine months ended September 30, 2014
 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2015
 
September 30,
2014
 
YTD'15 vs. YTD'14
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
4,067

 
3,799

 
268

 
7
%
Memberships at end of period
 
43,181

 
37,219

 
5,962

 
16
%
Paid memberships at end of period
 
42,068

 
36,265

 
5,803

 
16
%
Average monthly revenue per paying membership
 
$
8.45

 
$
8.10

 
$
0.35

 
4
%
 
 
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
 
 
Revenues
 
$
3,074,406

 
$
2,513,992

 
$
560,414

 
22
%
Cost of revenues
 
1,840,134

 
1,628,568

 
211,566

 
13
%
Marketing
 
237,813

 
206,030

 
31,783

 
15
%
Contribution profit
 
996,459

 
679,394

 
317,065

 
47
%
Contribution margin
 
32
%
 
27
%
 
 
 
 


21


The increase in our domestic streaming revenues was primarily due to the 17% growth in the average number of paid memberships, as well as the 4% increase in average monthly revenue per paying membership resulting from our pricing changes and plan mix.
The increase in domestic streaming cost of revenues was primarily due to a $153.7 million increase in content expenses relating to our existing and new streaming content, including more exclusive and original programming. In addition, streaming delivery expenses increased by $29.7 million and other costs, such as payment processing fees and customer service call centers, increased $28.2 million due to our growing member base.
Domestic marketing expenses increased primarily due to an increase in advertising and public relations spending.
Our Domestic streaming segment had a contribution margin of 32% for the nine months ended September 30, 2015, which increased as compared to the contribution margin of 27% for the nine months ended September 30, 2014 due to growth in paid memberships and revenue which continued to outpace content and marketing spending.

International Streaming Segment
Three months ended September 30, 2015 as compared to the three months ended September 30, 2014
 
 
As of /Three Months Ended
 
Change
 
 
September 30,
2015
 
September 30,
2014
 
Q3'15 vs. Q3'14
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
2,736

 
2,042

 
694

 
34
 %
Memberships at end of period
 
25,987

 
15,843

 
10,144

 
64
 %
Paid memberships at end of period
 
23,951

 
14,389

 
9,562

 
66
 %
Average monthly revenue per paying membership
 
$
7.56

 
$
8.44

 
$
(0.88
)
 
(10
)%
 
 
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
 
 
Revenues
 
$
516,870

 
$
345,685

 
$
171,185

 
50
 %
Cost of revenues
 
451,251

 
291,942

 
159,309

 
55
 %
Marketing
 
133,267

 
84,609

 
48,658

 
58
 %
Contribution loss
 
(67,648
)
 
(30,866
)
 
(36,782
)
 
119
 %
Contribution margin
 
(13
)%
 
(9
)%
 
 
 



In the International streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content. 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, the Netherlands in September 2013, and Germany, Austria, Switzerland, France, Belgium and Luxembourg in September 2014. In the first quarter of 2015, we launched our service in Australia and New Zealand. In the third quarter of 2015 we launched in Japan. In keeping with our global strategy, we expect to launch in additional markets, including Spain, Portugal and Italy in October 2015.
The increase in our international revenues was due to the 67% growth in the average number of paid international memberships offset partially by a 10% decrease in average monthly revenue per paying membership. The decrease in average monthly revenue per paying membership was due to the impact of exchange rate fluctuations and to a lesser extent the impact of absorbing higher VAT rates across our European markets beginning January 1, 2015. These decreases were partially offset by our pricing changes and plan mix. We believe international revenues in the third quarter of 2015 would have been approximately $96 million higher if foreign exchange rates had remained consistent with the foreign exchange rates from the third quarter of 2014. Average paid international streaming memberships account for 35% of global average paid streaming memberships as of September 30, 2015, as compared to 28% of global average paid streaming memberships as of September 30, 2014.
The increase in international cost of revenues was primarily due to a $130.7 million increase in content expenses relating to our existing and new streaming content, including streaming content for territories launched in the last twelve months as well as more exclusive and original programming. Other costs increased $28.6 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 three months ended September 30, 2015 increased as compared to the three months ended September 30, 2014 mainly due to expenses for territories launched in the last twelve months.
International contribution losses increased for the three months ended September 30, 2015 as compared to the three months ended September 30, 2014, due to increased spending for our international expansion and the impact of foreign currency exchange rate fluctuations.

22


Had foreign exchange rates in the third quarter of 2015 remained consistent with foreign exchange rates from the third quarter of 2014, we believe international contribution losses would have been approximately $42 million lower in the third quarter of 2015. Our International streaming segment does not benefit from the established member base that exists for the Domestic streaming segment. Therefore our investments in streaming content and marketing programs which drive membership growth and viewing in our International markets have been significant and are larger initially relative to revenues, in particular as new territories are launched.

Nine months ended September 30, 2015 as compared to the nine months ended September 30, 2014
 
 
As of/ Nine Months Ended
 
Change
 
 
September 30,
2015
 
September 30,
2014
 
YTD'15 vs. YTD'14
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net additions
 
7,710

 
4,913

 
2,797

 
57
 %
Memberships at end of period
 
25,987

 
15,843

 
10,144

 
64
 %
Paid memberships at end of period
 
23,951

 
14,389

 
9,562

 
66
 %
Average monthly revenue per paying membership
 
$
7.54

 
$
8.35

 
$
(0.81
)
 
(10
)%
 
 
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
 
 
Revenues
 
$
1,387,030

 
$
920,264

 
$
466,766

 
51
 %
Cost of revenues
 
1,249,495

 
803,906

 
445,589

 
55
 %
Marketing
 
362,106

 
197,485

 
164,621

 
83
 %
Contribution loss
 
(224,571
)
 
(81,127
)
 
(143,444
)
 
177
 %
Contribution margin
 
(16
)%
 
(9
)%
 
 
 
 
The increase in our international revenues was due to the 67% growth in the average number of paid international memberships offset partially by a 10% decrease in average monthly revenue per paying membership. The decrease in average monthly revenue per paying membership was due to the impact of exchange rate fluctuations and to a lesser extent the impact of absorbing higher VAT rates across our European markets beginning January 1, 2015. These decreases were partially offset by our pricing changes and plan mix. We believe international revenues would have been approximately $225 million higher in the first three quarters of 2015 if foreign exchange rates had remained consistent with the foreign exchange rates from the first three quarters of 2014.
The increase in international cost of revenues was primarily due to a $373.5 million increase in content expenses relating to expenses for territories launched in the last twelve months, coupled with existing and new streaming content, including more exclusive and original programming. Other costs increased $72.1 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, 2015 increased as compared to the nine months ended September 30, 2014 mainly due to expenses for territories launched in the last twelve months.
International contribution losses increased for the nine months ended September 30, 2015 as compared to the nine months ended September 30, 2014, due to our increased spending for our international expansion and to the impact of foreign currency exchange rate fluctuations. Had foreign exchange rates in the first three quarters of 2015 remained consistent with foreign exchange rates from the first three quarters of 2014, we believe international contribution losses would have been approximately $84 million lower in the first three quarters of 2015.


23


Domestic DVD Segment
Three months ended September 30, 2015 as compared to the three months ended September 30, 2014
 
 
As of/ Three Months Ended
 
Change
 
 
September 30,
2015
 
September 30,
2014
 
Q3'15 vs. Q3'14
 
 
(in thousands, except revenue per membership and percentages)
Memberships:
 
 
 
 
 
 
 
 
Net losses
 
(254
)
 
(275
)
 
(21
)
 
(8
)%
Memberships at end of period
 
5,060

 
5,986

 
(926
)
 
(15
)%
Paid memberships at end of period
 
4,971

 
5,899

 
(928
)
 
(16
)%
Average monthly revenue per paying membership
 
$
10.31

 
$
10.31

 
$

 
 %
 
 
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
 
 
Revenues
 
$
157,524

 
$
186,597

 
$
(29,073
)
 
(16
)%
Cost of revenues
 
77,793

 
97,201

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